Susan Bies

I expect that core inflation will remain in its current range. Moreover, surveys indicate that inflation expectations over the longer-term appear to have remained well-anchored.

Although pockets of financial stress exist among households, the sector as a whole appears to be in good shape.

The business sector is in good financial shape...In my view, even with a rise in interest rates and some moderation in profit growth, the business sector should remain financially strong and continue to expand.

Analysis by Board staff using data from the SCF indicate that households in the top income quintile can account for nearly all of the decline in the aggregate saving rate since 1989. Given that these higher-income households have more financial resources to weather shocks, the significant decline in savings is less troublesome than if it had occurred in the lower part of the income distribution.

Debt-service ratio has been stable and the financial obligations ratio has receded a bit, an indication that households, in the aggregate, have been keeping an eye on their financial commitments. Consistent with these patterns, delinquency rates for a wide range of household loans either have drifted down over the past year or held about steady at levels below recent highs.

We recognized, however, that there are risks to accelerated release: In particular, there is a possibility that, at times, the markets could misinterpret the minutes. In the end, our clear consensus was that the likely benefits outweigh the risks.

Speeding up the release of the minutes was seen as helping markets interpret our policy actions in the context of evolving economic developments and so better anticipate the course of interest rates.

Regulators recognize that Basel I can be enhanced and that the Basel II standardized approach is not well suited to the needs of our domestic-focused community banking organizations. Accordingly, we are now seriously considering making some targeted adjustments to our existing regulatory capital rules and looking for ways to enhance their risk sensitivity without increasing regulatory burden.

One of the most important limitations of the [Home Mortgage Disclosure Act ] data set is that it does not include data about many of the legitimate factors lenders use to determine prices in the mortgage market, including key credit-risk factors. Credit-risk factors absent from the HMDA data set include loan-to-value ratio, consumer debt-to-income ratio, and a consumer's experience with credit. Thus, price disparities by race or ethnicity, if revealed in the HMDA data, will not alone prove unlawful discrimination. Such disparities will, however, indicate a need for closer scrutiny--a look at these other variables.

With accommodative financial conditions, I expect that the economy will continue to expand at a solid pace this year.

Though inflation pressures have risen somewhat in recent months, longer-term inflation expectations appear to have remained well contained. I believe that, while underlying inflation is expected to continue to be low, the Federal Reserve must be more alert to monitoring incoming data, and continue to remove policy accommodation at a measured pace, consistent with the incoming data and its commitment to maintain price stability.

Consumer spending also has continued to expand, although higher energy prices may be crimping household purchases recently.

My forecast of rates a year ago when we started raising fed funds, I never came close to the 10-year rate today. My forecast was terrible

In the long run, it just appears that long rates cannot stay at this low a level.

The Fed keeps raising interest rates even though it hasn't hit the long end. The more we raise at the short end, this long end, as the chairman has said, has given us a conundrum, but at some point we do believe the 10-year Treasury will rise above 4% and take mortgage rates with it.

We need the risk-measurement and risk-management infrastructure and the risk sensitivity of Basel II; but we also need the supplementary assurance of a minimum equity base.

The easy explanation [for why long-term interest rates are so low] would be that everybody thinks the economy is really going to go through a soft spot -- or others may say, well, the Fed is so tough on inflation that inflation will fall in the future...We're trying to understand if the market is trying to send us a signal, and is it a good signal?

The only time I would really worry about low long-term rates is if they push down to say, the levels Japan has seen the last several years...So the low interest rates we have here - if that's just what we have because the economy is basically foreseeing continued contained inflation, and we can supply liquidity through the banking
system and the capital markets, then that could be very positive.

We expect that Basel II will complement the evolution of banks' own processes and systems, not supplant them...We also anticipate that Basel II will allow for the open development of new risk-management techniques, as they evolve over time.

This economy may be slowing but this is still a good economy...We are doing pretty good growing at 3-1/2 percent.

There might be a few projects in a few cities that deserve much more scrutiny from the lenders than what they're getting today.

Industry experts are increasingly concerned about the quality of collateral valuations relied upon in home equity lending and residential refinancing activities.

As the real estate lending cycle matures and lender competition increases, banking supervisors tend to worry. In particular, in the commercial and residential real estate sectors, we worry that borrowers could become increasingly speculative, buying beyond their means and hoping for asset price appreciation--whether they are buying for their own use or strictly for the sake of investment. We worry that competitive pressures could drive banks to lower their underwriting standards, implicitly encouraging such speculation. And we worry that, in the inevitable downturn, credit quality could deteriorate to the extent that some banks could experience significant losses.

We would like to allow the banking community to compare and comment on both proposals, for the very reason that we are sensitive to the potential for competitive distortions. Moreover, as in the past, if competitive or other issues later arise that we cannot now foresee, the Federal Reserve will make appropriate adjustments to the rules.

The Federal Reserve has conducted a number of studies on whether Basel II will create significant market distortions for the vast majority of banking organizations that remain on Basel I. These studies have suggested that competitive impacts will be mild for some business lines, while for others, such as some types of small-business loans, it does appear that unintended competitive advantages and disadvantages might be created--depending in part on how Basel II is ultimately implemented in the United States.

I want to assure you that the approach taken by the Fed and the other federal banking agencies is not one of zero tolerance and that supervisors do not issue enforcement actions against banking organizations because they have failed to file a single suspicious activity report. On the contrary, we continue to expect examiners to use their best judgment and to look for systematic weaknesses in programs, policies, procedures, and internal controls.

Overall, the credit quality is good. But we are beginning to see in some markets, with some customers and banks, where people are buying property now in anticipation of rising values...When you start to push to buying homes in anticipation of rising property values, safety and sound lending says you should look at the ability to service the loan first and we want to keep to that sound practice.

I don't see a bubble in the sense that property values over the United States as a whole are at a level that could radically drop in value...there are local markets where it is hard to really believe the underlying demand for housing can sustain the current prices...It's very localized...We're seeing faster property prices going up in leisure locations on the coast and in Las Vegas.

We have recently seen signs that [underwriting] standards may be under some downward pressure as a result of strong competition and tight spreads.

Any bank of any size should always be on guard for suspicious activities, and whenever they know, suspect, or have reason to suspect a violation of law, they should file suspicious activity reports according to Federal Reserve and FinCEN regulations. Bankers must practice enough due diligence to know when a transaction is suspicious.

Federal Reserve staff is currently considering supervisory guidance on sound risk-management practices for commercial real estate exposures, with the goal of issuing the guidance on an interagency basis.

During previous downturns in the credit cycle, banks with high commercial real estate concentrations suffered significant losses.

[Federal banking agencies] have observed some easing of underwriting standards...Lenders are sometimes offering interest-only loans and are sometimes requiring very small down payments and limited documentation of a borrower's assets and income. They are also relying more on automated-valuation models and entering into more transactions with loan brokers and other third parties. Given this easing of standards, there is concern that portions of banks' home equity loan portfolios may be vulnerable to a rise in interest rates and a decline in home values...There is concern that not all banks fully recognize the embedded risks in some of their portfolios.

More homes are being purchased not as primary dwellings, but as vacation homes or pure investments, in which case anticipated price appreciation may be a large factor influencing purchase decisions.

Market participants are also expected to play an important role as Basel II is implemented.  Not just supervisors will be expected to evaluate information provided by institutions.  As Basel II rolls out, bankers would be expected to disclose where their institution is in its stages of implementation, how the institution assesses and manages risk, and relevant information for third parties to ascertain the effectiveness of the bank's risk management.

Affordability products pose special risks--for instance, there is a greater likelihood that borrowers will experience negative amortization, that is, since the monthly payments do not cover current accruing interest, their mortgage balances will increase over time...When affordability products are offered along with easing of traditional credit underwriting practices, such as income verification and sound property appraisals, these products may pose potentially higher risks of default than traditional mortgages.

During U.S. implementation of Basel II, if at any stage in the process we see something that concerns the banking agencies, we will reassess and propose amendments to relevant parts of the framework...The Federal Reserve considers all of the planned safeguards and checks and balances to be sufficient for Basel II to be implemented in the United States effectively, and with no negative impact on safety and soundness or the functioning of banking markets. 

Based on the results of QIS4, the Federal Reserve recognizes that all institutions have additional work to do. In our view, the findings did not point to insurmountable problems, but instead identified areas for future supervisory focus. In that way, the analysis was critical in providing comfort to enable us to move forward...While the QIS4 results clearly provided a much better sense than before of the progress in implementing Basel II and offered additional insights about the link between risks and capital, QIS4 should not be considered a complete forecast of Basel II's ultimate effects. It was a point-in-time look at how the U.S. implementation was progressing.

The Federal Reserve considers the agencies' September 30 announcement relating to Basel II a good outcome and an example of successful interagency cooperation. As you may recall, in April of this year the agencies announced jointly their reaction to initial results of a fourth quantitative impact study pertaining to Basel II, known as QIS4. As the April statement indicated, we were concerned about results from QIS4 that showed a wider dispersion and a larger overall drop in minimum regulatory capital requirements for the QIS4 population of institutions than the agencies had initially expected. The initial QIS4 results prompted the agencies to delay issuance of a notice of proposed rulemaking (NPR) for Basel II in order to conduct further analysis of those results and their potential impact. The agencies' reaction to the initial QIS4 results, deciding to take additional time to understand more fully the information provided by the QIS4 institutions, is an indicator of how seriously we are taking Basel II implementation.

The emphasis in Basel II on improved data standards should not be interpreted solely as a requirement to determine regulatory capital standards, but rather as a foundation for more advanced risk-management practices that would strengthen the value of the banking franchise. But while the new framework would, in our view, provide useful incentives for institutions to accelerate the improvement of risk management, we believe that in most areas of risk management institutions would continue to have the choice among which methods they employ.

The Basel II framework should improve supervisors' ability to understand and monitor the risk taking and capital adequacy of large complex institutions, thereby allowing regulators to address emerging problems more proactively. It should also enhance the ability of market participants, through public disclosures, to evaluate the risk positions at those institutions by providing much better risk measures. The advanced approaches under Basel II, which include the advanced internal ratings-based approach (or A-IRB) for credit risk and the advanced measurement approaches (or AMA) for operational risk, offer particularly good improvements in terms of risk sensitivity, since they incorporate advanced risk-management processes already used today by best-practice institutions.

While the balance sheet focus of Basel I is appropriate for most banking organizations, the largest organizations have significant exposures off the books, and these risk exposures need to be considered explicitly in determining minimum regulatory capital for these sophisticated organizations.

While the current Basel I-based rules have served us well for nearly two decades, they are simply not appropriate for identifying and measuring the risks of our largest, most complex banking organizations. Basel I, even when periodically amended, must be straightforward enough for even the smallest banking organizations to implement with relative ease. Thus, the categories of risk used to determine capital are very broad and are intended to capture the "average" risk levels across the banking system for that generic exposure.

There have been two major developments within the past six weeks regarding U.S. regulatory capital requirements that apply to banking institutions. First, on September 30, the U.S. banking agencies announced their revised plan for the implementation of the Basel II framework in the United States. Second, the agencies published for comment an advance notice of proposed rulemaking (ANPR) pertaining to amendments to the existing Basel I-based capital rules (the amended Basel I). Taken together, these proposals on Basel II and the amended Basel I represent substantial revisions to the regulatory risk-based capital rules applied to U.S. banking institutions, from the very largest to the smallest. From the Federal Reserve's perspective, these two initiatives, when implemented successfully, should produce a much-improved regulatory capital regime in the United States that enhances safety and soundness.

One of the questions regulators have been asked as we work toward implementing Basel II is whether we can just continue to encourage the improvement in risk modeling at banks and stop there, i.e., not tie risk models to capital. While improvements in the methodology of risk models and the transparency of better risk modeling in business decisionmaking are very useful, I believe we cannot stop there...For safety and soundness reasons, bank supervisors must be sure that a bank with greater exposure to riskier lines of business, products, and customers holds more capital than a bank that is more risk adverse and designs its business plan to minimize risk taking. That is, just looking at risk models and not tying capital to the measured risk exposures does not provide the backstop that supervisors need to ensure that each institution has the appropriate capital in place before the unexpected loss occurs. Capital should be based on risk exposures, and the evolving risk modeling methodologies provide improved tools to better determine the appropriate level of capital. 

Basel II, by tying regulatory capital to bank inputs, offers greater transparency about what stands behind the inputs provided by banks and exactly how they are calculated...Successful institutions understand that calculating internal capital measures is a serious and challenging undertaking, with many moving parts. Supervisors, through their analysis of bank inputs to Basel II, will develop an even better assessment of institutions’ risk-measurement and risk-management practices. Furthermore, the added transparency in Pillar 3 disclosures is expected to provide market participants with a better understanding of an institution’s risks and its ability to manage them.  Perhaps most importantly, Basel II’s advanced approaches create a link between regulatory capital and risk management. Under these approaches, banks will be required to adopt more formal, quantitative risk-measurement and risk-management procedures and processes.

We recognize that some may have concerns about the recent announcement by the U.S. agencies to implement Basel II with a one-year delay and with an extra year of transitional floors. Understandably, internationally active organizations may worry that cross-border implementation will be complicated by the timing differences between the United States and other Basel member countries. While not downplaying potential challenges, the U.S. agencies, in deciding to adjust implementation plans, thought it was important to ensure that implementation in the United States be conducted in a prudential manner and without generating competitive inequalities in our banking markets...As we did before our September 30 announcement of altered U.S. implementation plans, the U.S. banking agencies continue to work with institutions and foreign supervisors to minimize the difficulties in cross-border implementation.

Basel II provides a means for regulators to rely more on banks' internal estimates of risks--but only if those estimates meet certain supervisory standards. Our expectation is that Basel II will also promote further enhancements to risk management. Accordingly, the Federal Reserve considers Basel II to be a worthwhile undertaking and we look forward to its implementation.

Capital is obviously an invaluable support for the safety and soundness of our banking system...Generally, economic models of capital are tied to unexpected losses. The assumption is that expected losses in the ordinary course of business should be covered by normal operating earnings. For losses beyond the normal range of expectations, sufficient capital should be in place to absorb the loss and leave the financial institution stable and able to continue operating effectively.

Good risk management is more than just having high-quality data and sophisticated quantitative tools. Control and oversight mechanisms are vital elements of assessing internal capital needs.

The growth of profits and the related buildup of cash have been broadly distributed across industries. And with the sound corporate financial positions, credit spreads remain narrow, and bank lending terms remain favorable. These beneficial financial conditions, combined with rising utilization rates, bode well for further increases in business capital expenditures.

As in the mid- to late-1990s, resilient productivity growth appears to be helping contain the inflationary pressures that might otherwise be expected to accompany a narrowing margin of resource slack. That said, we at the Federal Reserve will remain vigilant for any sign of a deterioration in the inflation outlook...The core inflation rate has stayed relatively low in recent months, as rapid gains in productivity have tended to offset cost increases.

Many news reports and anecdotes suggest that the housing market is cooling and that investors are participating less actively. However, the construction of new homes has remained near recent highs.

Because technology feeds into various macroeconomic aggregates--including household and business spending, productivity, and inflation--its implications for the U.S. economy will continue to necessitate careful observation, improved measurement, and study...A significant slowing in the pace of technological change could have inflationary consequences. Accordingly, monetary policy makers will remain alert, carefully monitoring technological developments that have the potential to mitigate inflationary pressures as well as developments that could raise the risk of overheating.

Real economic activity has continued to expand at a solid pace. Clearly, the tragedy that hurricanes inflicted on New Orleans and surrounding areas of the Gulf Coast will have major implications for the people and the economy in those regions for a long time. However, for the nation as a whole, employment and industrial production indicators were only briefly disrupted by the hurricanes during the late summer and early fall.

Continued increases in industrial productivity have enabled a relative shift of employment into the production of services. Although manufacturing employment has fallen sharply in recent years, both in absolute terms and as a share of total employment, the output of the nation's manufacturers has continued to increase because of impressive productivity gains.

At the national level, consumer spending has been well maintained, and the fundamentals--such as income growth and household balance sheets--remain supportive.

Turning to prices, core inflation has stayed relatively low in recent months despite the run-up in energy costs...Although energy prices have receded from the highs last fall, crude oil costs are still well above year-earlier levels. As a result, gasoline prices remain elevated despite a decline of about 70 cents per gallon from the peak recorded in the aftermath of the hurricanes. The prices for home heating oil and natural gas will add to consumers' budget pressures this winter; although spot prices have moved lower in recent weeks, they are still well above year earlier levels. Higher energy prices have also affected businesses, particularly in those industries with energy-intensive production processes and those that purchase a large share of energy-intensive products, such as industrial chemicals and plastics. There is only limited evidence, most of it anecdotal, of pass-through to consumer prices from the run-up in energy prices. However, we are seeing the effects in the price data for certain energy-intensive categories, such as transportation. 

In the business sector, investment in new equipment continues to expand at a good clip, boosted by robust sales as well as ongoing replacement and upgrading needs. In addition, as I'll discuss in a moment, corporate financial conditions are favorable for investment.

A bank with significant concentrations may need to both strengthen its control environment and hold capital well above regulatory minimums. In certain cases, it may be prudent for an institution to reduce its concentrations. This is particularly important, since CRE lending in recent years has occurred under fairly benign credit conditions and, naturally, those conditions are unlikely to continue indefinitely.

Nontraditional mortgage products have been available for many years; however, these types of mortgages were historically offered to higher-income borrowers only. More recently, these products have been offered to a wider spectrum of consumers, including subprime borrowers who may be less suited for these types of mortgages and may not fully recognize their embedded risks.

In addition to enhancing the meaningfulness of regulatory capital measures, Basel II should make the financial system safer by substantially improving risk management at banks.

As the central bank and the supervisor of banks, bank holding companies, and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital.

This means that during and after the transition to Basel II, supervisors will rely upon ongoing, detailed analysis to continuously evaluate the results of the new framework and ensure prudent levels of capital. To be quite clear, the Federal Reserve believes that strong capital is critical to the health of our banking system and we believe that Basel II will help us continue to ensure that U.S. banks maintain capital levels that serve as an appropriate cushion against risk-taking.

I noted that CRE underwriting appears substantially better compared to the late 1980s and early 1990s. However, we have noticed some recent slippage. Therefore, the proposed CRE guidance underscores the existing interagency guidance on real estate lending standards.

There's a variety of views on the FOMC, but everyone agrees we're getting closer to the stopping point.  And that's why we're so much focused on incoming data and how that's changing our outlook to make the call on when we're actually there.

It is important for organizations to make sure they do not ignore or accidentally overlook lower-profile activities that still might bear substantial risks. As I noted, such activities can include financial statement reporting, information security, and back-office systems. And operational risk, more broadly, has the potential to create disruptions for the organization that could reduce the value of the organization. Often, the solutions to these problems are basics such as training, developing internal controls, and establishing the appropriate culture across the organization. Therefore, organizations should look at the discipline of enterprise risk management as a way to ensure that they effectively deal with uncertainty and the associated risk and opportunity.

[The FOMC] generally feels we're in the ballpark of where we want [the targeted fed funds rate] to be.

Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

The proposed guidance is not intended to cap or restrict banks' participation in the commercial real estate sector, but rather to remind institutions that proper risk management and adequate capital are essential components of a sound CRE lending strategy. In fact, both of these components are already in place at many institutions. No element of the proposed guidance is intended to act as a "trigger" or "hard limit" signaling the need for an immediate cutback in or reversal of CRE lending; rather, the thresholds in the proposed guidance are intended as benchmarks identifying cases for further review.

Lenders should recognize that certain nontraditional mortgage loans are untested in a stressed environment; for instance, nontraditional mortgage loans to investors that rely on collateral values could be particularly affected by a housing price decline. Investors have represented an unusually large share of home purchases in the last two years. Past loan performance indicated that investors are more likely to default on a loan when housing prices decline, than owner occupants.

I just wonder about the consumer’s ability to absorb shocks. The buildup of home equity and the ability to borrow against it have helped individual homeowners when they have had layoffs, medical problems, divorces—all the things in life that create month-to-month problems for cash flow. With the growth of negative amortization, home equity is not being built up anymore. Negative amortization clearly helps consumer spending because consumers, in effect, have a smaller amount of their take-home pay that has to go to the mortgage payment every month, and so it is available to be spent elsewhere. It is probably a more pernicious type of home equity withdrawal because you don’t take an action to withdraw it. Now it is planned that you will have negative amortization. It clearly changes the way we look at the role of savings as a precautionary balance to get the consumer through bad times, and it also has long-run implications regarding the importance of asset values vis-à-vis default rates both for the banking sector and for the household sector. So the growing ingenuity in the mortgage sector is making me more nervous as we go forward in this cycle, rather than comforted that we have learned a lesson. Some of the models the banks are using clearly were built in times of falling interest rates and rising housing prices. It is not clear what may happen when either of those trends turns around.

Let me assure you that we at the Federal Reserve would not be pursuing Basel II if we thought that it would in any way undermine the strong capital base that U.S. institutions now have. As a central bank and a supervisor of banks, bank holdings companies, and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital for our largest and most complex banking institutions.

As supervisors, we want to ensure that loan-to-value standards and debt-service-coverage ratios are meeting the organization’s policies--and that there is not an undue increase in the exceptions to those standards and ratios. We also continue to monitor whether lenders routinely adjust covenants, lengthen maturities, or reduce collateral requirements. To be clear, we have not yet seen underwriting standards fall to unsatisfactory levels on a broad scale, but we are concerned about some of the downward trend in these standards.

Compliance-risk management can be more difficult for management to integrate into an organization's regular business processes because it often reflects mandates set out by legislation or regulation that the organization itself does not view as key to its success.

The more widespread use of nontraditional loan products may present greater opportunity for fraud, as these products sometimes lack some of the quality checks typical of more-traditional mortgages.

Leading indicators of commercial construction spending, such as billings by architectural firms for design work, point to further increases in activity in coming months. An upturn in commercial construction could offset part of what is anticipated to be a waning contribution to GDP growth from the housing sector.

Homeowners appear to be able to manage these higher [mortgage] payments: we have seen only a little deterioration in mortgage credit quality as yet, and overall delinquency rates remain low. Going forward, I expect aggregate homeowner mortgage payments to continue to rise, especially as adjustable-rate mortgages reach their initial reset dates.

Historically, only around 5 percent of U.S. homes were purchased each year by investors; in 2005, it appears that figure was considerably higher. In many cases, investors purchased homes because they believed prices were going to rise further, not necessarily because they wanted to retain the property over time for rental income. As prices level off or even decline, it will be important to see whether this investor activity subsides significantly, and if so, the impact on mortgage markets more broadly.

Also, as to the extent that bank borrowing and funds provision are forecast to drop, the bankers I talked with said that they aren’t going to let the amount of loans that they extend drop as much as I think is in that forecast. So I really believe that the drop in housing is actually on net going to make liquidity available for other sectors rather than being a drain going forward and that will also get the growth rate more positive than the current Greenbook forecasts.

Naturally, we must also ensure that our regulations and supervisory oversight are in tune with bank practice, are able to identify the risks being taken by banks today, and have enough flexibility that they will continue to be prudent and relevant in an ever-changing risk environment. As Chairman Bernanke has noted, a regulatory and supervisory system that is not in tune with the financial marketplace may increase the costs of regulation, stifle efficiency and innovation, and ultimately be less effective in mitigating the moral hazard problems associated with the federal safety net.

At present, mortgage delinquencies remain low, although delinquencies on subprime mortgages have risen in recent months. The recent rise in subprime mortgage delinquencies has been concentrated among adjustable-rate subprime loans, which is probably related to interest rates resetting--as the first reset tends to occur much earlier for subprime ARMs than prime ARMs. The outlook for mortgage credit quality remains favorable, but modestly cautionary signs are on the horizon. We have had clear initial signals in recent months that housing prices are no longer rising as they had been and are declining modestly in some key markets. Growth in housing wealth may slow or stagnate while the debt service obligation continues to rise, as teaser rates expire and fully-indexed loan rates eventually catch up with increases in market rates. While we continue to expect that mortgage delinquencies will remain manageable, lenders should closely monitor future developments.

Thus, in my judgment, inflation appears poised to decelerate in coming months as energy prices stabilize and resource pressures ease. But the risks to that outlook seem tilted toward the upside.

Although productivity growth has stepped down from the scorching pace seen early in the recovery, factors remain in place for continued solid growth over the next few years. One element is capital deepening, that is, the rate at which the stock of equipment, software, and so forth is expanding relative to the number of workers, or--to put it even more simply, how fast workers are getting more of the tools they need. As I mentioned earlier, business investment spending has been strong in recent years and seems likely to remain at a high level for some time. Another element is improvements in the efficiency of how businesses do business. Here it appears that the flexibility of business processes and product, financial, and labor markets in the United States will continue to allow for the quick adoption of new technologies and the efficient reallocation of resources.

The changing age distribution--primarily the aging of the baby boomers--is expected to lower the participation rate by about 0.2 percentage point next year and continue to lower it over the next several years...

Similarly, changes in the expected growth rate of the labor force affect our interpretation of the monthly employment data. If the labor force participation rate remains at its current level, then what might be thought of as the “equilibrium” growth rate of payroll employment--that is, the increase consistent with a stable unemployment rate--would be about 140,000 per month. However, if the labor force participation rate instead declines 0.2 percentage point over the next year, as suggested by the Fed’s staff research, then the comparable equilibrium payroll employment growth would be closer to 110,000 per month.

A key aspect of Basel II implementation in the United States relates to scope of application. In the United States, Basel II is expected to apply to only a handful of large, complex organizations, which is the principal reason why the U.S. agencies are proposing only the advanced approaches (A-IRB for credit risk and AMA for operational risk). Perhaps the main difference between the implementation of Basel II in the United States and the implementation in most other countries is that the U.S. banking agencies plan to retain a revised form of the existing Basel I-based capital rules for the vast majority of U.S. banks; most other countries are replacing Basel I entirely and will apply Basel II to the entire banking system.

As noted, we anticipate that only one to two dozen institutions would move to the U.S. version of Basel II in the near term, meaning that the vast majority of U.S. institutions would continue to operate under Basel I-based rules. The U.S. Basel I framework has already been amended more than twenty-five times since its introduction, in response to changes in banking products and the financial services marketplace. In October 2005, the agencies issued an ANPR for Basel IA, which discussed possible changes to increase the risk sensitivity of the U.S. Basel I rules and to mitigate competitive distortions that might be created by introducing Basel II.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with "risk layering" practices--such as by not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates on adjustable rate mortgages rise due to indexing or at the end of a "teaser" rate period.  We are also seeing more frequent use of limited or no documentation in evaluating an applicant's income and assets.  Although some lenders may have used elements of nontraditional mortgage products successfully in the past, the recent easing of traditional underwriting controls and the sale of some types of nontraditional products to subprime borrowers may generate losses on these products greater than has been observed in the past.

While much of the downshift in the housing market appears to have occurred already, some further softening in housing starts may yet lie ahead as the inventory of unsold homes is reduced to appropriate levels.

To be clear, nontraditional mortgages certainly serve a useful purpose when used appropriately. These products have increased the range of financing options available to consumers and have grown in popularity over the past few years. Some consumers may benefit from these products’ more flexible payment options. For example, consumers with seasonal or irregular income or who expect their incomes to increase are more likely to be able to absorb the increase in payments in the near term of the loan.

But nontraditional mortgage loan products can be complex and may not be appropriate for everyone. Concerns have been raised that consumers are not getting clear and balanced information about the risks and features of interest-only and payment option ARMs. These products have been advertised and promoted based on their initially low monthly payments when compared with traditional mortgage products. By focusing on initial monthly payments without appropriate understanding of how the payments can vary over time or that minimum payments may actually increase the amount owed, many consumers have become financially overextended.

On balance, the Federal Reserve believes that an appropriately conservative approach to capital adequacy serves the United States' interest in maintaining the safety, soundness, and resiliency of our banking system.  However, we also recognize the impact that differences among countries can have and that it is worthwhile to minimize them whenever possible.  As Chairman Bernanke noted this past fall, we intend to review and consider international differences before issuing a final Basel II rule.    

`What's happening is the front end of this wave of teaser-rate loans that are coming into full pricing,'' Bies said at a risk-management forum in Charlotte, North Carolina. ``So what we're seeing in this narrow segment is the beginning of the wave -- this is not the end, this is the beginning.''   ... Bies said the problems in the mortgage market are well-contained.  ``We're seeing this in a very narrow segment,'' Bies said.  ``We're watching for contagion, we haven't seen it.''  Outside of the housing and auto industries, ``the economy is strong,'' Bies said.   (As reported by Bloomberg News)