Fed Chairman Testifies to the Joint Economic Committee of the U.S. Congress

• The near-term U.S. economic outlook has deteriorated—Bernanke now projects that the economy is likely to be flat in the first half of 2008, and could even contract slightly.
• Credit conditions have tightened, with strains on credit cost and availability spreading to municipal bonds, student loans, and highly rated GSE securities.
• The Fed's response has been amplified in three major directions: reducing benchmark lending rates, providing new facilities to promote liquidity and unlock trading in the securities markets, and direct intervention in the markets to prevent the collapse of Bear Stearns.
• But even with the huge amplification of the Fed's response in March, risks to the economy remain on the downside.
• Fed actions to prevent a Bear Stearns bankruptcy were taken in view of current exceptional pressure on the global economy, and its judgment that the damage from a potential collapse would have been difficult to contain and would have negative consequences for the real economy.
• The Fed's new facilities have been helpful in addressing recent strains in financial markets, including better liquidity conditions and lower spreads—importantly, this increases the efficacy of monetary policy.
• The Fed has reduced benchmark rates aggressively—the federal funds rate was chopped by 125 basis points in January, and by a further 75 basis points in March.

Bernanke delivered a short and very candid testimony on the state of the economy and the financial markets. The chairman was more blunt and upfront about the prospects for the economy than what we heard in testimony earlier this year: "It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly." Moreover, Bernanke believes that risks to the outlook remain on the downside. His comments on the economic outlook presage another downward revision to the Fed's central tendency forecast at the upcoming semi-annual testimony in July, and bring the Fed's outlook more closely into line with Global Insight's expectation of a slight contraction during the first half of 2008.

The chairman also detailed the recent deterioration in credit conditions, with strains on the cost and availability of credit spreading to municipal bonds, student loans, and GSE-backed mortgage securities. In addition, risk spreads in the commercial paper market remain high and the volume of asset-backed commercial paper has declined. Commercial banks have remained under pressure, as capital levels have been severely depleted by write-offs, while balance sheets have involuntarily expanded due to breakdowns in the securitization and auction-rate municipal markets. This recent escalation of pressures in the credit markets prompted the Fed to take unprecedented action in March, including the opening of the Fed's discount window to primary dealers, the launching of a new term securities lending facility for primary dealers aimed at unlocking trading in asset-backed securities, and the orchestration of the takeover of the venerable, but failing, Bear Stearns company. The Fed is clearly navigating through uncharted waters.

Bernanke vigorously defended the Fed's actions to prevent the bankruptcy of Bear Stearns. According to the chairman, given current exceptional pressures on the global economy and financial system, the damage of a Bear Sterns default would have been severe and extremely difficult to contain. It would have led to a chaotic unwinding of positions in a number of critical markets. These adverse effects would have radiated out into the financial system and impacted the real economy through reduced asset values and a further tightening of credit availability. Global Insight agrees with this view, given the progressive and severe deterioration in financial market conditions that we have seen since early August 2007.

Overall, his testimony was refreshingly candid and blunt about the risks to the financial system and the outlook for real growth. The Fed was somewhat tardy in terms of its recognition of these systemic risks as they unfolded over the past eight months. This forced it to pull out all the stops by the end of first-quarter 2008 to reduce the risks of further tightening in credit conditions and another major financial domino going down, leading to a very severe downturn in the economy. The Fed is close to being "back on the curve," but the Federal Open Market Committee has needed to engage in a wide range of unprecedented financial gymnastics in order to get there.

Looking forward, we would agree that the dominant risks to the outlook remain on the downside. While Bernanke states that the economy "could contract in the first half of 2008," Global Insight holds the view that a fairly significant contraction of domestic demand and gross national income is very likely during this time period, while risks to the financial system, including the financial health of critical players such as the bond insurers, remain extremely elevated. As a result, we expect the FOMC will move to lower interest rates by a further 75 basis points over the next two months, which will take the target federal funds rate down to 1.50% by July.