by Calculated Risk on 6/10/2011 10:10:00 AM

From NY Fed President William Dudley: The Road to Recovery: Brooklyn

On the national economy:

[E]conomic growth so far this year has been disappointing. Real GDP in the first quarter of 2011 grew at a tepid 1.8 percent annual rate, and the available data suggest that growth in the current quarter will not be much better.

A major factor behind this slowdown is that real consumption growth (that is, spending on goods and services adjusted for price increases) has been slower than in the last quarter of 2010. This occurred, in part, because higher gasoline and food prices reduced the income that households could spend on other purchases. High energy prices also contributed to lower consumer confidence, which may have had an independent negative effect on consumer spending.

As noted, a number of economic indicators suggest that economic growth in the second quarter will also be subpar. Manufacturing production fell in April. Most business survey indicators, including the New York Fed's own Empire State Manufacturing Survey, also have declined recently, although most continue to signal some growth. The housing market remains very weak and home prices fell in early 2011. After a notable improvement earlier in the year, the labor market showed more softness recently: more workers filed for unemployment insurance in the past few weeks, firms added fewer jobs on net in May, and unemployment inched up in April and May.

In part, this softness is related to factors that I expect will prove transitory. These factors include the rapid rise in gas and food prices that I noted earlier, supply disruptions associated with the earthquake in Japan, and severe weather and flooding in parts of the United States. All three suggest that the soft patch may not persist. However, we continue to monitor the data for signs of more persistent weakness, whether related to the interaction of housing and consumption or some other factor.

Another reason to expect the economy to recover from this soft patch is that many fundamentals have improved since last year. In particular:

• Financial conditions have improved, albeit gradually, which makes it easier for larger, well-established firms to borrow and invest. However, new startups and smaller businesses continue to find credit difficult to access.
• With stock market prices higher than a year ago and household debt lower, household balance sheets are in better shape, which should support household spending.
• Demand abroad—particularly in Asia—still appears robust, supporting our exports.
• Most importantly, and notwithstanding the May jobs report, the labor market appears more solid than it was a year ago. Private firms added jobs at a faster pace over the last five months than they did last year. This growth has been strong enough to more than offset government layoffs. Unemployment is also noticeably lower than it was in November, after a decline that was rapid by historical standards.

Consequently, I anticipate that economic growth will pick up enough in the second half of 2011 to sustain a moderate economic recovery. Still, the pace of recovery probably will be painfully slow for the many unemployed and underemployed workers. Even if the economy added 300,000 jobs per month over the next year and a half, we would likely still have considerable labor market slack at the end of 2012.

Even though I expect a moderate economic recovery to be sustained, the recent disappointing data suggest that downside risks to the outlook have increased. Let me list some of them for you:

• As I mentioned earlier, high oil and commodity prices have further strained many families that already had tight budgets.
• The renewed decline in home prices could dampen consumer spending and housing activity more than I expect.
• The recent slowing of consumer spending growth could prompt businesses to limit hiring and investment.
• Finally, aggressive near-term government spending cuts or tax increases could slow economic growth at least in the short- to medium-term. I would emphasize, however, that a credible plan for long-term fiscal consolidation is sorely required and would have many economic benefits.

Although these issues bear watching, I still believe that they remain risks rather than the most likely outcomes. ... To sum up, despite the recent soft patch, economic conditions have improved in the past year. I expect a moderate recovery to continue.

I think the downside key risk remains oil and gasoline prices. I'll have an update to my outlook soon ...