by Calculated Risk on 10/13/2009 04:12:00 PM

Fed Vice Chairman Donald Kohn spoke at the National Association for Business Economics conference in St. Louis, Missouri today: The Economic Outlook

Kohn outlines why he expects a moderate recovery (not V-shaped), and why he believes the risks to inflation are on the downside ...

A few excerpts:

All told, I expect that the recovery in U.S. economic activity will proceed at a moderate pace in the second half of this year before strengthening some in 2010. As we move into and through next year, inventory investment is likely to play a smaller role in supporting the growth of output, and aggregate activity should increasingly be propelled by stronger gains in final demand ...

[W]hy do I expect a gradual strengthening of economic activity? The fiscal stimulus program enacted earlier this year is likely playing a role, and it will continue to do so for a while as the states spend their stimulus funds to pay for infrastructure projects, hire more teachers, and finance other types of spending. But what will support economic activity as fiscal stimulus wanes?

Most importantly, support for private demand should come from a continuation of the improvements we've seen lately in overall financial conditions. Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years. As the economy improves and credit losses become easier to size, banks will be able to build capital from earnings and outside investors, making them more able and willing to extend credit--in effect, allowing the low market interest rates to show through to the cost of capital for more borrowers. A more stable economic environment and greater availability of credit should contribute to the restoration of business and household confidence, further spurring spending.

An encouraging aspect of the improvement in economic and financial conditions in recent months has been the firming in house prices that I mentioned earlier. House prices can affect economic activity through several channels. One channel is through the influence of house prices on the net worth of households and, thereby, on consumer spending. Another channel is through the effect of anticipated capital gains or losses from investing in residential real estate on the demand for housing. Finally, greater stability in house prices should help reduce the uncertainty about the value of mortgages and mortgage-related securities held on the balance sheets of banks and other financial institutions, which should have a positive effect on their willingness to lend. This circumstance should nourish a constructive feedback loop between the financial sector and the real activity.

Given this possibility, another reasonable question might be, Why do I expect the economic recovery to be so moderate? To be sure, many times in the past, a deep recession has been followed by a sharp recovery. But, for a number of reasons, I don't think a V-shaped recovery is the most likely outcome this time around. First, although financial conditions are improving and market interest rates are very low, credit remains tight for many borrowers. In particular, the supply of bank credit remains very tight, and many securitization markets that do not enjoy support from the Federal Reserve or other government agencies are still impaired. Consumers as well as small and medium-sized businesses are especially feeling the effects of constraints on credit availability. Banks are still rebuilding their capital positions, and their lending will be held back by the need to work through the embedded losses in their portfolios of consumer and commercial real estate loans. Over time, as I already have noted, bank balance sheets should improve, and the supply of bank credit should ease. But the financial headwinds are likely to abate slowly, restraining the economic recovery.

In addition, I do not anticipate that the recovery in homebuilding will exhibit its typical cyclical pattern. Even though the decline in residential construction began well in advance of the overall contraction in real activity, the sector continues to have an oversupply of vacant homes. To be sure, by August, the inventory of unsold, newly built single-family houses had fallen appreciably from its peak level in the summer of 2006. Nonetheless, when compared with still low levels of sales, the supply of new houses remains elevated. In addition, the overhang of vacant houses on the market for existing homesis sizable, and the pace of foreclosures is likely to remain very elevated for a while, which should further add to that overhang. Thus, even with affordability quite favorable and house price expectations brighter, I anticipate a relatively subdued pickup in housing starts over the coming year.

In the business sector, the extraordinary amount of excess capacity is likely to be another factor tempering the rate of recovery. In manufacturing, the utilization rate currently is below 67 percent--noticeably less than the low points reached in prior post-World War II recessions. I expect that the wide margin of unused capacity, combined with the tight credit conditions faced by firms that have to rely primarily on bank lending, will lead many businesses to be quite cautious about the pace at which they increase their capital spending.

In part, the gradual pace I expect in the recovery of the economy toward full employment reflects the process of shifting the composition of aggregate demand and the way it is financed in response to the events of the past few years. In particular, consumers probably will do more saving out of their income, reflecting the likelihood that household net worth will be lower relative to income than over the past decade or so and that credit, appropriately, will be somewhat less available than during the boom that preceded the crisis. In addition, housing is almost certainly going to be a smaller part of the economy than it was earlier in this decade, as financial institutions maintain tighter underwriting standards that also more adequately reflect underlying risks. Such an increase in private saving propensities and a reduced demand for residential capital should prompt movements in relative prices and other factors that will, in turn, make room for a larger role for business investment and net exports in overall economic activity.

The transition to full employment and the complete emergence of this new configuration will take time, in part because the rebalancing of the economy involves repairs to balance sheets, the movement of capital and labor across sectors of the economy, and shifts in the global pattern of production and consumption--adjustments that are likely to be gradual under any conditions. Current circumstances, however, may slow the re-equilibration process more than might otherwise be the case because of the essential role of changes in the relative cost of finance in the adjustment process. But with the nominal federal funds rate essentially constrained at zero, and spreads in markets already having narrowed, reductions in the effective cost of capital will mainly take place as conditions at financial institutions improve and lenders ease borrowing standards, which as I have already discussed I expect to happen gradually.

As noted earlier, I expect that inflation will likely be subdued, and that, for a while, the risk of further declines in underlying rates of inflation will be greater than the risk of increases. That outlook rests importantly on two judgments: First, that the economy will be producing well below its potential for some time, which will directly restrain production costs and profit margins; and second, that inflation expectations are more likely to fall than rise over time as the level of real activity remains persistently less than its potential and actual inflation remains low.
...
But it's not the current level of inflation or of output that figure into our policy decisions directly--rather, it is the expected level some quarters out, after the lags in the effects of policy actions have worked themselves out. In that regard, the projection of only a gradual strengthening of demand and subdued inflation imply that that these gaps--of inflation and output below our objectives--are likely to persist for quite some time. In these circumstances, at its last meeting, the FOMC was of the view that economic conditions were likely to warrant unusually low levels of interest rates for an extended period.
emphasis added