Remarks by Bill Dudley, NY Fed President and CEO, at the Fordham Corporate Law Center Lecture, New York
A Bit Better, But Very Far From Best
Thank you for having me here to speak today. It is a real pleasure to have this opportunity to discuss the economic outlook and the challenges that face the Federal Reserve in terms of monetary policy going forward. As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.
My assessment of where things stand today is mixed. On the positive side, the financial markets are performing better and the economy is now recovering. In fact, the improvement in financial conditions has caused usage of the Fed's special liquidity facilities to fall considerably. Consistent with their design, these facilities have become relatively less attractive as market conditions have improved. Also, the Federal Reserve has begun to taper its rate of asset purchases. The Treasury purchase program will end this month and the agency MBS purchase program by the end of the first quarter of 2010.
On the negative side, the unemployment rate is much too high and it seems likely that the recovery will be less robust than desired. This means that the economy has significant excess slack and implies that we face meaningful downside risks to inflation over the next year or two. Also, there are those who express anxiety about whether the Fed has the tools and the will to raise the federal funds rate when the time is appropriate. I want to assure you that the Fed has the tools to tighten monetary policy regardless the size of its balance sheet. Moreover, we have the will to do so in order to keep inflation in check.
Turning first to the developments in financial markets, there is little doubt that we have seen a vast improvement over the past six months. The major equity indices have risen sharply, credit spreads have narrowed and bank equity prices have generally shown a substantial recovery. Many large financial and nonfinancial firms have found it relatively easy again to tap the debt and equity markets.
The recovery in financial asset prices has been mirrored—albeit with a lag—in the economy. Industrial production has begun to rebound as the pace of inventory liquidation has slowed. Housing prices and activity have recovered somewhat—aided by the improvement in housing affordability and the first-time homebuyer tax credit. Fiscal stimulus is providing support to consumption and to state and local infrastructure spending.
The vicious cycle we had a year ago—in which the deterioration in financial markets led to economic weakness and that weakness reinforced the tightening of financial conditions—has been broken. In fact, to some extent, it has been replaced with a virtuous cycle. As financial markets have recovered, that has led to an improvement in business and consumer sentiment that, in turn, has helped to lift the economy, spurring further gains in financial asset prices.
In the same way that the improvement in market conditions is helping to support a sustainable economic recovery, the fact that the recovery in economic activity is a world-wide phenomenon helps mitigate the risk of a so-called "double-dip." The recovery in foreign demand should help to support the U.S. economy even if U.S. domestic demand grows more slowly than anticipated. Given these developments, the consensus forecast of about 3 percent annualized real GDP growth in the second half of the year appears reasonable.
However, I also suspect that the recovery will turn out to be moderate by historical standards. This is a disappointing outcome in that growth will likely not be strong enough to bring the unemployment rate—currently 9.8 percent —down quickly.
I see three major forces restraining the pace of this recovery. First, households are unlikely to have fully adjusted to the net wealth shock that has been generated by the housing price decline and the weakness in share prices. Peak to trough, home prices nationwide have declined by 11.5 percent measured by the FHFA (Federal Housing Finance Agency) index and by 32 percent according to the 20-city Case-Shiller index. With respect to stock prices, the S&P 500 index has recovered by more than 50 percent from the trough reached in March. But this should be put in context. The S&P 500 index is still about one-third below its recent peak in October 2007. Moreover, compared with its level ten years ago, the S&P 500 index is down by about 20 percent.
The shock to household net worth seems likely to have several important implications for household behavior. The shock creates a risk that the household saving rate could increase further. For example, during the period from 1990 to 1992, the household saving rate averaged about 7 percent of disposable personal income, considerably higher than the 4.3 percent average rate during the first half of this year. If the household saving rate were to rise, then consumption would rise more slowly than income, making it more difficult for the economy to develop strong forward momentum. In addition, it seems likely that some workers will respond to the wealth shock by postponing their retirement. This suggests that the labor force participation rate may rise once labor market conditions improve. This would tend to push up the unemployment rate, all else being equal.
The second force that could restrain the recovery is the fiscal outlook. The fiscal stimulus that is currently providing support to economic activity is temporary rather than permanent. This has to be the case if we are to ensure that fiscal policy is on a sustainable path over the long-run. This means that the positive impulse from fiscal stimulus will abate over the next year.
