San Francisco, CA
By Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco
Delivered on September 14, 2009, 12:50 PM Pacific, 3:50 PM Eastern
The Outlook for Recovery in the U.S. Economy1
It’s a pleasure to appear before a group of professionals who spend as much time trying to understand the financial markets and the economy as I do. It’s fair to say that the last two or three years have provided all of us an education—a far-from-welcome one—of just how complex these subjects are. We have had to rethink old assumptions and question conventional wisdom in the face of a crisis whose dimensions few of us might have imagined.
I am hugely relieved that our financial system appears to have survived this near-death experience. And, as painful as this recession has been, I believe that we succeeded in avoiding the second Great Depression that seemed to be a real possibility. Much of the recent economic data suggest that the economy has bottomed out and that the worst risks are behind us. The economy seems to be brushing itself off and beginning its climb out of the deep hole it’s been in.
That’s the good news. But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability. As a result, monetary policy makers will continue to face a difficult task in the years ahead.
I’m happy to report that the downturn has probably now run its course. This summer likely marked the end of the recession and the economy should expand in the second half of this year. A wide array of data supports this view. However, payrolls are still shrinking at a rapid pace, even though the momentum of job losses has slowed in the past few months. The housing sector finally seems to be improving. Home sales and starts are once again rising from very low levels, and home prices appear to be stabilizing, even rising in recent months according to some national measures. Meanwhile, manufacturing is also beginning to show signs of life, helped particularly by a rebound in motor vehicle production. Importantly, consumer spending finally is bottoming out.
The all-important question is how strong the upturn will be. With unemployment at 9.7 percent of the workforce and capacity utilization at its lowest level of the post-World War II period, the economy has an enormous amount of slack. That gives us plenty of room to grow rapidly over the next few years. Indeed, we need to grow robustly to alleviate the enormous human toll resulting from high unemployment and the waste of so much idle industrial capacity. At first glance, history suggests that a vigorous expansion could very well take place. Following previous deep recessions, the United States typically saw V-shaped recoveries. For example, the economy grew at an average rate of nearly 6 percent during the two years following the severe recession in 1981-82.
This time though rapid growth does not seem to be in store. My own forecast envisions a far less robust recovery, one that would look more like the letter U than V. And I’m not alone. The Blue Chip consensus forecast, reflecting the views of nearly 50 professional forecasters, anticipates by far the weakest recovery of the postwar era over the next year and a half. A large body of evidence supports this guarded outlook. It is consistent with experiences around the world following recessions caused by financial crises. That seems to be because it takes quite a while for financial systems to heal to the point that normal credit flows are restored. That is what I expect this time.
While it is important for economic recovery that lenders provide credit to worthy households and businesses, they also must maintain enough capital to withstand losses—even if economic conditions turn out to be worse than anticipated. In the face of continuing credit losses, moves by lenders to shrink assets, reduce leverage, and conserve capital are restricting the provision of credit in the economy. For example, the Fed’s Senior Loan Officer Survey on Bank Lending Practices conducted in July showed that, for consumer loans, far more banks are tightening standards than easing them, despite some improvements in this measure in recent months.
Financial conditions have clearly eased compared to the darkest days of the financial crisis. But the financial system is still far from healthy and tight credit is likely to put a damper on growth for some time to come.
It may well be that we are witnessing the start of a new era for consumers following the traumatic financial blows they have endured. The destruction of their nest eggs caused by falling house and stock prices is prompting them to rebuild savings. The personal saving rate is finally on the rise, averaging almost 4½ percent so far this year. While certainly sensible from the standpoint of individual households, this retreat from debt-fueled consumption could reduce the growth rate of consumer spending for years. An increase in saving should ultimately support the economy’s capacity to produce and grow by channeling resources from consumption to investment. And higher investment is the key to greater productivity and faster growth in living standards. But the transition could be painful if subpar growth in consumer spending holds back the pace of economic recovery.
Putting the whole puzzle together, the main impetus to growth in the second half of this year will be inventory investment. The boost it provides will be a big help for a while, but we will need to look to other sectors to sustain growth. The fact that the largest sector of the economy—consumer spending—is likely to be lackluster implies a less-than-robust expansion. Even the gradual recovery we expect will be vulnerable to shocks, especially from the financial sector. As I said, financial conditions are better, but not back to normal. And the likelihood of continuing losses by financial institutions will add new fuel to the credit crunch. In particular, small and medium-size banks could experience damaging losses on commercial real estate loans. Thus far, the largest losses have been on loans for construction and land development. Going forward, however, rising loan losses on other commercial real estate lending is likely because property values are falling, office vacancy rates are rising, and credit remains tight or nonexistent for those many property owners that will need to refinance mortgages over the next few years. Financial contagion from this sector is one of the most important threats to recovery.
The slow recovery I expect means that it could still take several years to return to full employment. The same is true for capacity utilization in manufacturing. It will take a long time before these human and capital resources are put to full use.
This brings me to the complex topic of inflation. In my career, I have never witnessed a situation like the one that exists now, when views about inflation risks have coalesced into two diametrically opposed camps. On the one hand, one group worries about the long-term inflationary implications of a seemingly endless procession of massive federal budget deficits. At the same time, others fear that economic slack and downward wage pressure are pushing inflation below rates that are considered consistent with price stability and even raising the specter of outright deflation. This dichotomy is on display among the participants in the Survey of Professional Forecasters. The lowest quartile of forecasters focuses on disinflation over the next five years. The top quartile is preoccupied with the possibility of rising inflation five to ten years out.
My personal belief is that the more significant threat to price stability over the next several years stems from the disinflationary forces unleashed by the enormous slack in the economy.
From a monetary policy point of view, the landscape will continue to present challenges. We face an economy with substantial slack, prospects for only moderate growth, and low and declining inflation. With our policy rate already as low as it can go, it’s no wonder that the FOMC’s last statement indicated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” I can assure you that we will be ready, willing, and able to tighten policy when it’s necessary to maintain price stability. But, until that time comes, we need to defend our price stability goal on the low side and promote full employment. Thank you very much.
End Notes
- I would like to thank John Judd, Rob Valletta, and Sam Zuckerman for assistance in preparing these remarks.
- See Reinhart and Rogoff (2009) for evidence on this issue.
- These figures refer to mortgages that are delinquent for 60 or more days or are in foreclosure.
- See Glick and Lansing (2009).
References
Glick, Reuven, and Kevin J. Lansing. 2009. “U.S. Household Deleveraging and Future Consumption Growth.” FRBSF Economic Letter 2009-16 (May 15).
Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. “The Aftermath of Financial Crises.” American Economic Review Papers and Proceedings 99(2, May).