Janet Yellen (photo courtesy of FRB SFO).

Housing. Unfortunately, it appears to me that there are at least three reasons for thinking that housing prices have further to fall. First, the ratio of house prices to rents-- a kind of price-dividend ratio for housing-- still remains quite high by historical standards.... Second, inventories of unsold homes remain at elevated levels.... Third, the futures market for house prices predicts further declines in a number of metropolitan areas this year....

Financial markets. The ongoing fall in house prices has important implications for the financial markets, and it is one reason that we may continue to get troubling news from that part of the economy.... [T]he market for private-label securitized mortgages of even the highest quality remains moribund. These securities were the primary source of financing for nonconforming residential mortgages, including subprime lending. Outside of the expanded FHA lending, there is little or no lending to higher-risk residential mortgage borrowers. Jumbo mortgages for prime borrowers are available, but at historically high spreads over rates on conventional mortgages, as banks have been reluctant to make these loans....

[S]ecuritization was a key driver of the credit expansion. Financial institutions originated loans that they then bundled into securities and sold to other investors. With hindsight, it is clear that this originate-to-distribute model suffered severe incentive problems-- the originator had insufficient incentive to ensure the quality of the loans, since someone else ultimately held them. Conflicts of interest and moral hazard problems also are nested in the many other linkages in the securitization process. Before private-label mortgage securitization can recover, financial markets must design mechanisms to align the incentives of originators with the interests of the ultimate investors. Second, there was a widespread failure of risk management, both in terms of liquidity and credit risk. An important shortcoming in credit risk management was an excessive reliance on what turned out to be flawed assessments of risk by rating agencies of certain asset-backed securities. Investors, even large sophisticated financial institutions, did not take adequate steps to assess risk independently. The lack of transparency in the credit process and the complexity of many of the newer financial products did not help. Third, even with changes in contracting and financial modeling, the re-intermediation process and deleveraging more generally is likely to continue. Re-intermediation involves a larger share of financing held in the portfolios of institutions such as commercial banks and less by other investors holding securitized assets. The re-intermediation is part of deleveraging-- that is less reliance on debt and more on equity financing-- to the extent banks tend to hold more capital than other less regulated financial institutions....

The encouraging news is that large commercial banks, investment banks, and mortgage specialists have, to some extent, been able to issue new equity capital and to rebuild capital positions that have come under pressure from a combination of losses and growth in assets.

The balance-sheet pressures, and broader financial market dislocations, are likely to be with us for some time. My expectation is that market functioning will improve markedly by 2009. But things could get worse before they get better...

Commodities. On the demand side, booming economic activity in developing countries has boosted their appetite for commodities. For example, since 2000, world demand for oil has increased by roughly 11 million barrels per day, with China accounting for roughly 30 percent of this increase, and other developing countries accounting for another 60 percent....

On the supply side, there have been constraints. Oil production has become more expensive, major discoveries are increasingly difficult to find, and spare capacity to supply more oil in the short run has been declining. As a result, energy supplies have not kept pace with growing worldwide demand....

I am not yet persuaded that speculation, rather than the fundamentals of global supply and demand, has played an important role in driving up prices. For example, it should be harder to speculate and take positions on commodities that are not easy to trade on futures markets and are not included in index funds. But the prices of individual commodities that are not in index funds have risen just as fast as those that are.

In addition, if speculators were important in driving prices up, then, at the high prices now prevailing, demand by nonspeculative end users would fall short of current supply, causing inventories to rise. In fact, however, inventories appear to have been declining in most commodity markets....

Policy. Between September and April, the [Federal Open Market] Committee reduced the federal funds rate by 3-1/4 percentage points to its current rate of 2 percent. With core consumer inflation running at about the same rate, the real funds rate is now around zero. These cuts in the target rate, along with the actions to foster greater liquidity in financial markets, have mitigated the worst effects of the squeeze on spending. I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided. Of course, the underlying housing, credit, and commodity-price issues are far from fully resolved. My discussion of those issues makes clear that a lot of uncertainty surrounds my outlook. A lot could still go wrong.

But maximum sustainable employment is only one of our mandates. The other is low and stable inflation. In the wake of rapid increases in prices for gasoline and food, consumer survey measures of longer term inflation expectations have turned up. In contrast, other surveys, such as the Survey of Professional Forecasters, show little erosion in long-term inflation expectations. In addition, the anecdotes I hear are more consistent with credibility than with an upward wage-price spiral. In particular, my contacts uniformly report that they see no signs of general wage pressures.

On balance, I still see inflation expectations as reasonably well anchored and I anticipate that consumer survey measures will come down once oil and food prices stop rising. But the risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop.

Yellen portrays a Federal Reserve that remains deeply troubled about risks to both real economic activity and to inflation. It seems she personally may be a little more frightened by the former, with her words containing no hint that the commodity price trends she mentions might have something to do with that 3-1/4 percent rate cut that she and her colleagues have voted for.

I presume that Yellen and her colleagues must see the possibility that Fed policy has contributed to the commodity price run-up as clearly as the rest of us. But I conclude that the first two witches-- particularly the second-- must still be scaring her the most.

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