ATLANTA — Atlanta Federal Reserve Bank president Dennis Lockhart yesterday said  inflation has edged above his preferred level on the surge in energy prices, and that the recent rate cuts by the Federal Open Market Committee will help avoid a prolonged downturn as the economy moves toward trend growth in the second half of the year.

Mainly addressing the banks’ role during recent market tremors and how they will evolve as a result, Lockhart did not expand on the state of the economy or monetary policy. He did acknowledge there is wide speculation about a looming recession in his remarks to the Association for Corporate Growth conference in Atlanta.

“In the face of economic weakening,” he said, the FOMC brought the federal funds rate to a level which supports “movement toward trend growth by the second half of 2008.” He cautioned the steepening energy prices have tipped recent measures of inflation above his “comfort zone.” Lockhart is not an FOMC voter this year.

He said turbulence in the markets eased when the Fede injected liquidity and introduced the term auction facility as a way of addressing dried-up flows of credit. The market uncertainty has lead to adjustments and write-downs, especially with problems triggered by the deterioration of subprime mortgages, but he said the write-downs are “painful, but necessary.”

Lockhart said the business of credit has evolved from “one of on-balance-sheet whole loans to one involving substantially off-balance-sheet securitized loans.” He said securitization was a major financial innovation and, although beneficial, is raising legitimate questions about credit finance.

He questioned whether banks will make a comeback and asked whether or not securitization is dying and whether the leveraged loan market will shrink. That could lead to an evaporation of foreign investors’ appetite for U.S. credit markets.

In the end, Lockhart said he thinks banks will recover and lean towards the approach of “originate-to-hold-in-portfolio model,” and there is “little chance banks in their various forms won’t remain the cornerstone institutions of our financial system.”

While the recent turmoil has shown banks have a central role in the originate-to-distribute credit intermediation model, he said they held on to “substantial super-senior exposure.”

With a global response to erosion in the U.S. credit market, Lockhart said “some pullback is predictable” from foreign entities exposed to subprime and CDO securities. He said their retreat from the subprime market could possibly “persist for some time” and that the pause in investment from abroad in U.S. credit markets will not have any permanent effect.

For the time being, Lockhart said, “it’s more likely foreign investors will be more selective and rely more on carefully vetted expert intermediaries in the selection process.”

Concluding that it will take a return to the “old ways of finance,” Lockhart said a reformed market-based system will eventually be better for the banks and hopefully will refine risk-management practices by the financial markets.

— Market News International

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.