by Calculated Risk on 10/05/2009 08:00:00 PM

From NY Fed President William Dudley: A Bit Better, But Very Far From Best

... 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. ...

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. ...

... 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. ...

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. ...

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.

The third, and perhaps most important factor, is that the banking system has still not fully recovered. Bank credit losses lag the business cycle and are still climbing. ...

The commercial real estate sector is under particular pressure because the fundamentals of the sector have deteriorated sharply and because the sector is highly dependent upon bank lending. In terms of the fundamentals, there are two problems. First, the capitalization rate—the ratio of income to valuation—has climbed sharply. At the peak, capitalization rates for prime properties were in the range of 5 percent. ... Today, the capitalization rate appears to have risen to about 8 percent. ... Second, the income generated by commercial real estate has generally been falling. ...

The decline in commercial real estate valuations has created a significant amount of “rollover risk” when commercial real estate loans and mortgages mature and need to be refinanced. ... This means that more pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures.

For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. ...

All of these factors will tend to inhibit the pace of the economic recovery. Given that the recovery is starting with an abnormally large amount of slack, and the pace of recovery is not likely to be robust, this means the economy is likely to have significant excess resources for some time to come. As a result, the balance of risks to inflation lies on the downside, not the upside, at least for the next year or two.
...
In summary, I believe the current balance of risks around the inflation outlook lie to the downside due to the very low level of resource utilization and the fact that long-run inflation expectations remain stable. This balance of risks is problematic because the current level of inflation is already so low—the core PCE (personal consumption expenditures) deflator has increased only 1.3 percent over the past 12 months. Thus, we would not need much of a decline in inflation to run the risk of an outright deflation. Outright deflation, in turn, would be a dangerous development because it would drive up real debt burdens and make it much more difficult for households and businesses to deleverage.
emphasis added

There is much more in the speech about resource slack and the Fed's tools "to exit smoothly from the very low federal funds rate".