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Real
GDP grew by 1.9 percent from June 2006 to June 2007.
During the same time period industrial production expanded by a scant
0.4 percent and inflation as measured by the Consumer Price Index rose by
2.7 percent.
However, by
mid-summer it became clear that the national economic conditions were
beginning to deteriorate.
Early
in 2007 the majority of economists were forecasting a much stronger national
economy by the end of the year.
However, as I discussed in a previous Economic Indicator Report, there were
a number of potential threats that could undermine this forecast.
Unfortunately, one of these threats surfaced and is placing a
considerable amount of downward pressure on the economy.
Obviously, I am referring to the subprime lending mess which has hit the
nation’s economy with surprising force.
When you consider that the subprime market represents only $600
billion of an estimated $3 trillion mortgage market and that only a fraction
of the subprime loans are non-performing, it becomes hard for most to fathom
the severity of the subprime disaster on the overall economy.
On September 18th in response to the growing problem in
the financial sector, the Federal Reserve System lowered the key federal
funds rate and the discount rate by a large and unexpected 50 basis points.
Most economists forecasted a 25 basis point cut.
It is clear that the Federal Reserve has become very concerned about
the functioning of our nation’s financial system and the direction of the
economy.
The
reason that subprime lending woes have expanded and threaten to pull the
entire economy into a recession is complex.
The essence of the problem is that the spillover from the subprime
defaults affects the entire housing market.
As we know, housing is a very important activity because it involves
so many other economic goods and services.
In addition consumer spending has been to a large degree predicated
on the ability of homeowners to tap into growing home equity.
This becomes increasingly difficult and problematic with falling home
values. Further, mortgage
backed securities, held by many financial institutions for investment
purposes, are now being written off and in some cases threaten the solvency
of these institutions. Perhaps
of even greater concern was the damage being done to the nation’s commercial
paper market. These short term
borrowing obligations of large corporations are often backed by securities
that are in turn backed by home mortgages.
When the commercial paper market freezes up, because investors no
longer want to hold paper perceived to be risky, corporate access to
borrowing and liquidity becomes impaired.
As a result business expansion plans and day to day operations become
at risk.
The
Federal Reserve hopes that by easing credit conditions consumers and
businesses will be able to overcome the fallout of the subprime lending
situation and in turn keep the nation’s economy from slipping into
recession. The danger is that
by providing more liquidity to the economy, the Federal Reserve may kindle
higher inflation rates next year.
Moreover, the Federal Reserve’s willingness to bailout homeowners and
financial institutions from the effects of the housing bubble may encourage
future periods of irrational exuberance.
In other words, the Fed may be helping to foster an even greater
level of moral hazard in the economy than existed prior to the bailout.
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