Thank you, Mr. Chairman. My own views on the economy haven’t changed much since we last met and aren’t terribly at odds with the Greenbook. I’d highlight a couple of reasons for concern, a couple of areas in which the misses could be severe. I share the views expressed by many around the table, most recently by Governor Kohn, on the inflation front. I remain quite concerned about inflation prospects, and I’m keeping a wary eye on inflation expectations, particularly if there were to be acceleration in the trends on commodity prices or the foreign exchange value of the dollar. My sense is that the markets haven’t fully taken into account what that could be, and we could find the markets more preoccupied with an inflation scare than they appear to be at this moment. So I think that, during the balance of ’07, the inflation risks tend to be more significant than the growth risks, and I would expect to see sequential increases in GDP, as in the Greenbook, as we go through the next several quarters. The big point of what that is predicated on is really the continued accommodation in the credit markets and the capital markets, as several people have noted.
I was thinking about my projections and, as we look to ’08 and ’09, the bigger risks there tend to be more policy oriented as we head into the next election, and they may well have some effect on the capital markets. So as I think about the second half of ’08 and the first half of ’09 and what the likely GDP implications would be, I can’t help but think that changes or perceived changes in tax policy and trade policy could be the biggest drivers to the capital markets and, as a result, have the biggest effects on the macroeconomy. So there are huge risks, as I look beyond ’07, in terms of where GDP might come out; but as a central case, the Greenbook formulation looks roughly in accord with my own.
Let me spend a moment on consumption. My view is broadly consistent with what others have said earlier today. I spoke in the past week with one credit card company whose customer base is similar to the average aggregate customer base in the United States. They have about one-fifth of all credit card spending, and they reported to me their April results, which might provide us with some clues about PCE growth and credit quality. Card spending for April, from their perspective, was consistent with moderate deceleration in real consumption. They ended up in April with nominal year-over-year growth of about 4 percent in non-auto retail sales, which is a slowdown from the fourth quarter of ’06 and a slowdown from January, but it is up a bit from February and March, when they were getting quite despondent and were worrying a bit about their projections for the next three quarters. They think their April numbers look okay, quite consistent with the moderate deceleration that many folks here have talked about. They believe that they have hit the floor on that, but time will tell. What they have not been able to do, at least up to the time of my discussions with them, is to break out retail purchases outside fuel to find out whether less strength is there than the 4 percent top-line number would suggest. I suspect that would be the case. How all this fits into market expectations we’ll know over the next couple of days. This strikes me as an average, okay number that may be a touch better than market expectations, but it shouldn’t give us a whole lot of comfort if we’re trying to suggest that there is a robust recovery on consumption and PCE. Credit quality remains very strong across consumer credit and the company’s mortgage products. I would note that they don’t have much subprime in their portfolio—what is subprime has fallen to that level rather than having begun there when they issued the credit. Payment rates, use of credit lines, delinquencies, charge- offs—all are at very positive levels with little indication of more-serious weakening of consumer demand. So, again, I think the prospects outlined by the Greenbook in terms of PCE look broadly consistent with the April numbers.
Let me turn now to the capital markets and the credit markets and speak about three or four observations that may be a bit more newsworthy than when we last met six weeks ago. First, I will talk a little about the dearth of defaults in corporate loans, then spend a couple of moments on private equity, building on Bill Dudley’s discussion at the outset on the correlation among asset classes, and finally spend a moment on the shakeout in the mortgage markets. The predicate for this is something that we all know, and several people have spoken about earlier today. As corporate America has become more cautious, Wall Street has become more aggressive to satisfy investors’ appetites for risk. So we’re seeing risk aversion in one category on Main Street and real risk-seeking behavior on Wall Street. Financial risk-taking remains high and may well have even increased since we last met. If you’ll look at the MOVE options index measuring one-month volatility on Treasuries, it’s the lowest it has been in about nine years, since the index came into being, and it suggests President Minehan’s point that all the forces of liquidity and froth that might be in the market are probably more present today than any of us could have imagined given the tumult in the markets in late February. At the same time, nonfinancial corporate risk-taking continues to be more subdued than objective measures would suggest it should be. There is reason to hope that the cap-ex data will come around to where many of us expected it to be already, but some determination still needs to be done on that. So we hear, and some of us even say, that these capital markets appear priced to perfection, that credit markets are as strong as ever, and that liquidity is plentiful. I would add my concern to the implausibility of that notion, which President Geithner and others spoke about. The reason for central bankers to worry is, of course, that these narrower spreads provide less of a shock absorber for unforeseen events.
Let me now go through the points that I mentioned at the outset and describe their implications for the decisions we make. First is the dearth of defaults on corporate loans. Historically low year-ahead default rates were referenced in the Greenbook, and they should give us comfort, at least in theory. I share the Greenbook view that corporate defaults should increase as profits level out and leverage increases to more normal levels. But fewer defaults are even possible in this financing environment, and that makes me a little less sanguine about those data. If we think about covenant packages on corporate loans, both originated on Wall Street and originated at community banks—I think President Yellen spoke at a previous meeting about covenant-lite deals—it is incredibly hard to get defaults in the context of these loans, never mind event-of-default notices and everything else that would find its way into the indentures. As a result, we have seen a recent spate of financings with covenant packages that are increasingly issuer-friendly, without triggers that would otherwise cause defaults: no debt payment schedules, never mind even the need to make interest payments, with the ability to turn those into sort of pay-in-kind notes. All of that, it strikes me, should make us nervous if business fundamentals shift abruptly and investors are left with little opportunity to gain access to their capital or to be in a position to force companies to restructure their operations. As a result I am less sanguine about these low default data that we continue to receive from Wall Street.
A second point is the state of private equity in the capital markets. What I note builds on the recent history that we’ve seen: massive fund-raisings; larger LBOs; increasing leverage; in the past twelve months, we’ve seen the so-called club deal phenomenon; the growth of equity bridges, which I and others have talked about; and when we last met, we discussed the interest many of these firms have for rushing into the capital markets by finding permanent capital. The newest development is the growth of syndication in the equity placement in these LBO markets. The same way that we have syndicated debt markets that have matured incredibly over the past six to ten years, on the equity side there are huge investments that are presently being considered and potentially being made. So one LBO sponsor might fund a certain portion of the equity check on an LBO and then line up, through an equity syndicate manager at a traditional investment bank or a commercial bank, the ability to sell down the rest of that equity through an infrastructure and distribution system that is being built. I doubt that we will see that syndication market five years from now as deep and as large as the debt markets. But I do think that it shows us that new liquidity continues to come even to the private placement 144(a) markets alongside the growth in the public capital markets. That liquidity could well improve tradability. To the extent that these syndications are new, they show us that liquidity is plentiful; but they also show us that many of these new mechanisms have not been stress-tested. The other implication of this boom in private equity is that it has raised the floor on equity prices. My sense is that there is a private equity put that may well have replaced what used to be thought of as a Federal Reserve put on the floor of equity prices, and that equity put appears to be larger than it has ever been. Thus we have seen increased total leverage through these structured products; credit markets, as I’ve mentioned, are more robust; and there is a question of stress testing, which is still to be determined.
Another point on the capital markets relates to what Bill said about the correlation among asset classes. CEOs, CFOs, and chief risk officers of large financial firms have found quite troubling the greater correlation among asset classes than most of their internal models had suggested. As they looked at their dashboards in the weeks after the tumult that we saw last February, they grew increasingly uncomfortable about whether they had accurately measured what their firms’ downside risks are. Certainly it’s encouraging, as Bill showed us, that there appears to be less correlation over recent weeks. That’s a lesson being learned and relearned and tested and retested in these institutions. That they may be heeding the wakeup call is good news, but time will tell whether it will be enough to catch up before problems arise in the market.
My final point concerns the consequences of a shakeout in the mortgage markets. My sense is that, after the fallout in subprime, the market is becoming more consolidated with larger, more-sophisticated lenders that can more quickly provide more markets that satisfy customers’ newest wants. The success in these markets of investment banks and hedge funds will go to those with scale, with strong distribution systems, and with control over their servicing businesses, so that they are effectively able to engineer workouts and avoid the need to foreclose. I think that over the balance of this year we will hear more news from small and medium-sized commercial banks that feel as though their market share is being taken away during this tumult, and that is something that we need to continue to observe. With that, Mr. Chairman, I’ll save the rest of my comments for the next round.