Rarely has a year been so turbulent as 2007. The first part of the year was marked by slow GDP growth, while the second-half numbers are expected to show above average growth.
The housing bubble burst, sending prices steadily lower and foreclosure rates steadily higher. Business pundits and some economists labeled the housing problems as the worst since the Great Depression.
Throughout the year, the stock markets have been plagued with triple-digit declines from day-to-day and even within a single trading day. The debt markets twitched and turned slightly until August, when the subprime slime from the housing sector spread its virulent infection deep and wide into the U.S. and worldwide financial markets. The dollar fell against the euro to historic lows, and oil prices teased the $100-a-barrel level, prior to breaking through that level in the first week of 2008.
While the 2007 economic news was dismal and depressing, and problems ahead may be even worse, a very few bright spots dotted the economic picture. Exports moved higher, and inflation pressures failed to derail overall growth, as measured by the gross domestic product. Overall, the U.S. economy showed remarkable resilience throughout the year. One of the brightest spots—the agricultural sector—has been ignored by much of the business and political media.
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Liquidity injections rivaling those of 9/11, an upsurge of foreclosures, a continuing increase in nonperforming loans. And talk of an impending recession.
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Some Win and Some Lose
Rising prices in the agricultural sector is good news for farmers but may be a key element in pushing inflation higher in 2008. Keep in mind that any and every economic factor and event of 2007 has had both positive and negative consequences: Economic good news for one sector can be bad news for another sector of the economy. The doubled-edged nature of economic events can be baffling, but it does help to explain why there are so many different interpretations of the markets and the economy. Of course, some of those differences are based on wishful thinking, while others are based on political or social agendas.
The Downside of a Low Fed Funds Rate
Any review of 2007 must take into consideration the double-edged sword of a low fed funds rate. The benefits are obvious, but the downside consequences are not as often recognized. Cheap money tends to weaken the dollar and lending standards. It also can fuel inflation.
The upshot of easy money has helped to create the current volatility and turmoil in the credit markets, as well as the deteriorating housing sector. That, in turn, has made consumers reluctant to spend—as witnessed by the disappointing holiday sales—and ultimately cuts business profits.
Fortunately, inflationary pressures were kept in check, for the most part, in 2007. Despite higher oil, commodity and food prices, the Fed's favorite index to measure overall inflation hovered near the top range of the Fed's target of between 1.0 percent and 2.0 percent.
The Search for Liquidity
Liquidity is the lubricant for the economy's engine. It represents the availability of money that is circulating through the economy. In 2007, the flow of liquidity was uneven. Even worse, liquidity came to a screeching halt in some sectors of the financial markets. Worst of all, it has remained stuck for months, not merely a couple weeks, and may continue to be log-jammed for months to come, despite actions and jawboning by the Fed and the Treasury Secretary.
In years past, a financial crisis such as the collapse of the hedge fund Long-Term Capital Management in 1998 impeded liquidity, but only for a period of weeks. The Federal Reserve made high-minded statements in public that it would do whatever it might take to keep the financial system sound, while it jawboned, in private, the nation's largest financial institutions to keep making loans to business and consumers. The result was the return to a more normal flow of liquidity.
What the Fed Did and Did Not Do in 2007
Similar such tinkering by the Fed and the Administration in 2007 failed to lubricate the markets as in the past. That failure, in part, may be a result of too little, too late from the Fed, which seemed intent on balancing the advantages of liquidity against the dangers of inflation.
On July 26, bond yields and stock prices plummeted worldwide and liquidity problems began to emerge. At its August 7 meeting, the Federal Open Market Committee maintained the fed funds rate at 5.25%, rather than lowering it and thereby signaling that it recognized the severity of the market's liquidity problems. Those problems arose because, as the housing market collapsed, banks and investment banking firms found it was difficult to put a value on subprime mortgages and other assets that had been sliced and diced into a myriad of complex financial securities.
Do You Know What Your Assets Are Worth?
Since the August 7 non-move by the Fed, the credit markets have been in disarray. Prior to August 7, major banks and investment bankers were clamoring for a reduction in rates. They needed cheaper money to keep liquidity flowing because they were becoming increasingly worried that they did not know the individual ingredients that were contained in the sliced and diced instruments they had purchased. Some ingredients—such as a mortgage to a conservative, well-heeled homeowner—were nourishing, while other ingredients—such as an interest only mortgage to someone who lives from paycheck to paycheck—were toxic.
With the uncertainty of how to value these financial instruments, many investors took the traditional flight to safety in U.S. treasury issues. Compounding the valuation problem was that many institutions had little-to-no idea of the location and size of the toxic investments in their portfolios.
The Fed Uses Old and New Tools to Stimulate the Markets
To recharge the stalled markets, the Fed took a bold and different tact on August 10—three days after it refused to lower the fed funds rate. During the morning of August 10, the Fed provided $35 billion of liquidity into the markets with temporary reserves "to facilitate the orderly functioning of financial markets." The Fed acknowledged the banks were experiencing "unusual funding needs because of dislocations in money and credit markets."
The Fed injects liquidity by temporarily "buying" loans and other assets from the banks. Typically, the Fed buys only top-rated assets and buys them for a short period of time.
Fed Tries to Make Borrowing Easier for Banks
On August 17 in a special meeting, the FOMC made another stab at moving the credit markets into more normal trading patterns. The Committee announced a "temporary" change to its primary credit discount facility. It changed its "usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower." That maturity extension was designed to assure the banks "about the cost and availability of funding." In a separate move, the Fed broadened the universe of assets it was prepared to "temporarily" purchase from the banks.
In theory, by widening the collateral and maturity associated with the discount window, the Fed was able to provide liquidity to the markets without lowering either the fed funds rate or the discount rate. Essentially, the Fed was saying to the banks and investment firms, "To stimulate liquidity, we will take some of those assets you cannot value today, while you try to put a value on them."
Those series of moves failed to budge the dislocated credit markets.
Credit market participants wanted lower rates, but by the time the Fed reacted, the markets already had priced short-term rates as if the Fed made larger cuts that it did. The FOMC dropped the target fed funds rate by 50 basis points to 4.75 percent on September 18, and by 25 basis points to 4.5 percent on October 31. Both times, the markets reacted with the cry, "Too little, too late."
One Plan to Buy Frozen Assets Is Abandoned
Meanwhile, from early fall until mid-October and at the strong instigation of U.S. Treasury Secretary Henry Paulson, Jr., and Fed officials, the nation's three biggest banks—Citigroup, Bank of America and JPMorgan Chase—worked to create a backup fund to purchase some of those hard-to-value assets. A few days before Christmas, the banks announced they had scrapped that plan.
The Fed began to appear not only unwilling, but unable to stimulate the credit markets which remained frozen during most of November as buyers of debt securities abandoned almost all areas of the credit market except U.S. treasury securities. Every day, more bad news emanated from major financial institutions announcing multi-billion dollar losses in their investment portfolios, lower projections for sales and earnings, and huge layoffs of employees. Even the top honchos at Citigroup and Merrill Lynch got pink slips, although their severance packages were generous.
On December 11, the Fed lowered its target rate by 25 basis points to 4.25 percent. The credit markets reacted with disappointment because the cut was not 50 basis points.
Get to Know TAF—the "Term Auction Facility"
One day later, the Fed tried a new maneuver to defrost the credit market iceberg. In conjunction with major central banks across the globe, the Fed created a "Term Auction Facility" (TAF) that would provide liquidity through a special liquidity fund. The move was applauded but did little to restore confidence in investments outside of U.S. Treasuries.
As the year closed, the credit markets stayed frozen and forecasts of a recession mounted.
Liquidity or Inflation
During the second half of this year, the Fed Reserve Chairman Ben Bernanke and his fellow compatriots in the Federal Open Market Committee balanced the advantages of lowering the fed funds rate to help calm the crisis in the credit markets with the disadvantages of further weakening the U.S. dollar and of perhaps discouraging foreign money to finance America's mammoth deficit.
In its most simplistic form, the Fed has been balancing the advantages of liquidity against the corrosive dangers of inflation and the weakening dollar.
Agriculture Enjoys Good Time, but What About Inflation?
The woes of the housing and credit markets obscured the glowing developments in the agricultural sector. While the non-agricultural sector worries about foreclosures, tight credit, and the growing possibility of a recession, farm communities across the nation are enjoying a healthy resurgence. Of course, higher commodity prices may spark inflation.