Thursday, July 28, 2011

The Outlook for the Economy and Monetary Policy

By John C. Williams, President and CEO, Federal Reserve Bank of San Francisco
Amplify’d from
The Outlook for the Economy and Monetary Policy

My subject today is the outlook for the economy. We are now two full years into the economic recovery, yet progress on restoring the economy from the damage caused by the financial crisis and ensuing Great Recession remains discouragingly slow. The news from the jobs front has been particularly disappointing, with the unemployment rate—currently 9.2 percent—stubbornly high. This afternoon, I’ll give my perspective on why economic growth has been so modest and offer my outlook for the future, which anticipates some improvement during the second half of this year and next year. I’ll also talk about inflation, which has seesawed in recent months. Finally, I’ll explain what the Federal Reserve is doing to promote maximum employment and price stability. As usual, my remarks represent my own views and not necessarily those of my Federal Reserve colleagues.

Before I go any further, I should say a few words about the budget and debt limit situation in Washington, which is going down to the wire. I’ll refrain from commenting on politics, but a few economic points are worth making. There is no question that we are currently on an unsustainable long-run path of federal fiscal deficits. It is essential that budget deficits over the next decade be brought under control. The costs of not doing so are enormous. First, uncertainty about future fiscal policy and doubts about whether Uncle Sam will pay his bills are likely damping consumer and business confidence. Second, heavy government borrowing pushes up interest rates for businesses and consumers, which tends to reduce capital spending and long-term productivity. That’s a recipe for long-run economic decline and lower American living standards. Sooner or later, we’ll have to deal with the deficit, and we should get our house in order sooner rather than later. Finally, the lessons from the events in Europe are clear—unsustainable deficits can cascade into a crisis. If that happens, policy options are limited and the damage to the economy can be severe.

Housing and the Recovery

On one level, that’s not surprising. We simply built too many—in fact, millions too many—houses during the boom and we are still feeling the effects of this overhang. Consider housing prices. From their peak in 2006 until early 2009, home prices nationwide fell by nearly a third. When you exclude distressed sales, prices appeared to bottom out in 2009 and early 2010. New housing starts also appeared to stabilize in 2009, after plummeting some 75 percent during the housing crash. I’m happy to report that Utah has done better than the nation as a whole, and certainly the housing market here is not as depressed as in such neighboring states as Arizona and Nevada. Prices here are down only about 20 percent from their peak, and foreclosure and delinquency rates are also lower.

The $64,000 question is when will the housing market finally recover? One daunting challenge for such a recovery is the huge number of homes in foreclosure. Almost 7 million homes have entered into foreclosure since the first quarter of 2008 and some 2 million are still in the foreclosure process. In addition, there is a shadow inventory of homes currently owned by delinquent borrowers. When you add up unsold new houses left over from the boom, homes for sale by owners, foreclosed residences for sale by lenders, and the shadow inventory of houses at risk of distressed sale, you come up with a massive supply overhang.
Restraints on consumer spending

Credit is far from the only factor keeping consumers and businesses in check. The weak job market and slow income growth limit what households have to spend. At the same time, households have been trying to repair their finances after years of taking on too much debt and setting aside too little in savings. Americans have come to realize the dangers of running up debt and they’ve rediscovered thrift. A key impetus has been rebuilding wealth lost when house prices collapsed and the stock market tanked. The combination of high unemployment, stagnant incomes, lower debt levels, and more saving is a recipe for feeble consumer spending gains. Research at the San Francisco Fed suggests that monthly consumer spending per person is running at a rate about $175 below where it would be if pre-recession trends had continued.3
Outlook for growth

Up to this point, I’ve focused on some of the factors holding back growth. On the plus side, there are important areas of strength in the economy. Manufacturing has been expanding thanks in part to a rebound in the auto industry and solid demand for U.S. exports, two sectors that were especially hard-hit during the recession. Corporate profits have been healthy, which has helped fuel rising business investment in equipment and software. Information technology has been on a roll, and there are even signs of a mini boom in public offerings and private share sales for Internet and social networking companies.