Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

President Broaddus used the term “bottoming out,” and I think that expression also applies to the two issues that I want to discuss—fiscal policy and the banking system. First, with respect to fiscal policy, you undoubtedly know that the omnibus spending bill passed the Senate last week and was signed by the President. This means that the government is no longer being funded on a continuing resolution. You may or may not have noticed, because it got lost in the reports of the victory of John Kerry in the Iowa caucus, that the closure vote in the Senate to bring the bill to the floor failed the first time around. It received fewer votes than there are Republican members of the caucus, which a lot of people took to be a signal that many Senators have reached a point where they recognize the need for some discipline in the government spending process. The short-term result of the spending bill is that it will provide a whole lot of stimulus for 2004 but in ways that most of us would not approve. The bill included somewhere between 8,000 and 10,000 separate earmarks, which we used to call “pork.” It does seem, though, that in a response to the last spending effort, both Republicans and Democrats see the need to go back to a budget process that will impose some discipline. The future reductions in deficits that are being discussed are more consistent with what we have in our Greenbook.

With respect to the banking system, “bottoming out” has a much more positive connotation. As has been reported, the quality of assets in the banking industry has reached the point that there is an expectation that it could go down. Nevertheless, my discussions with bankers this past week differed from many of my conversations in other recent weeks. Instead of talking about loan losses, they are now talking about watch lists. What that means is that, rather than being corrective in terms of their approach to bad loans, they are now being preventive, which would suggest that the economy is now probably bottoming out. That is important for a couple of reasons. Despite the improvement in bank profits, we see that interest income margins continue to decline and are at their lowest level in many years. What bankers are telling me is that low margins are putting great pressure on lenders to increase loan volume. Now, because the consumer loan side has stayed strong, the only opportunity for significant growth is in the C&I loan component. What I’m hearing now is that there is a lot more loan demand and tremendous competition among bankers for loans. It seems to me that bankers are willing to take on more risk than I have heard them admit to in recent years. This includes both credit risks and interest rate risks, with a lot of bank financing involving commercial real estate ventures. So we may be at a point where in 2004 there will be many lenders competing for a relatively small number of loans, a conclusion that is supported by the financing gap of nonfinancial businesses as described in the Greenbook and anecdotally. One of the bankers I spoke with told me that they use the demand deposits of their commercial customers as an additional benchmark for forecasting loan volume. The low level of such deposits suggests that the need for bank financing of business capital expenditures is going to be very limited. This conclusion is also supported by the chart that Larry Slifman showed us earlier today, which indicated that debt– asset ratios, both short term and total, are at a record low.

In summary, I conclude that we will have a lot of stimulus stemming from the federal budget process but perhaps more fiscal discipline going forward. From the bankers’ side, we have significant indications of more interest in capital spending by business firms. Unfortunately for the bankers, most of it will be financed internally or outside the banking system.

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