- Five key questions are often
asked about current economic and financial conditions: Has the
financial crisis ended? Is the recession over? Will the economy return
to full employment and normal conditions anytime soon? Is inflation
going to jump too high? Does the Federal Reserve have an "exit
strategy" to undo its extraordinary policy actions of the past two
years? The answers, respectively, are: Mostly, Almost certainly, No,
No, and Yes.
- The
financial crisis has eased. In particular, financial market conditions
have improved, with lower liquidity and risk spreads in the interbank
lending, commercial paper, and corporate debt markets. Also, although
banks remain reluctant to lend, large financial institutions generally
appear more secure—buttressed by the acquisition of new capital. At the
same time though, prospects for many smaller banks appear bleak, with
losses in the offing, especially on commercial real estate loans.
- The
recession that began in the fourth quarter of 2007 appears to be over.
Technically, recessions are periods when broad measures of production,
employment, real income, and real sales are falling. Since the summer,
many measures of overall economic activity have been slowly growing,
despite continued job losses. However, even if the recession is over,
the level of production is very low. And the pain this produces in the
form of low income, sales, and employment remains acute.
- Although
growth has returned, the economy will remain in a deep hole with high
unemployment and underutilized productive resources for some time. So,
even though the recession is over, production, income, sales, and
employment will persist at subpar levels. A large amount of unemployed
or underutilized labor and capital remains in the economy, and it will
take a sustained period of growth for the economy to return to its
normal or potential level.
- It
appears highly unlikely that inflation is going to jump too high. In
the short run, excess supply is pushing inflation lower. Unemployment
is holding down wages and labor costs, housing vacancies are holding
down rents, and ample unused production capacity limits pricing power.
In the long run, the Federal Reserve controls inflation. For the past
thirty years, the Fed has taken difficult actions to lower inflation.
After finally achieving effective price stability, the Fed will do
whatever is necessary to maintain it.
- Although
the recession and the associated economic slack have already lowered
core price inflation by about a percentage point, two scenarios cause
some to worry about higher inflation. First, some fear that a sharp
drop in the dollar could cause inflation to jump. This seems unlikely.
A precipitous dollar depreciation would be associated with global
financial instability, but such instability would also probably foster
significant safe-haven capital flows back into dollar-denominated
assets. Such safe-haven flows appear to have boosted the dollar during
the 2008 financial panic, and they would similarly play a
countervailing force supporting the dollar during any exchange rate
disarray. Second, expansionary federal fiscal policy has also caused
many to worry about inflation. (See, for example, FRBSF Economic Letter 2009-31, Disagreement about the Inflation Outlook.)
The outlook for federal fiscal deficits is indeed grim-driven by an
aging population and rising per capita health care costs. But higher
inflation would not solve this problem, since the additional spending
is essentially indexed for inflation.
- To
achieve its goals of economic and financial stability, the Fed took two
broad actions to ease financial conditions: It lowered short-term
interest rates to near zero and it doubled the size of its balance
sheet. The Fed has many options for a successful exit strategy to
return monetary policy to normal. However, given current conditions and
the economic outlook, such a renormalization appears to be a
considerable period away. A rough benchmark for calibrating the stance
of monetary policy explains the level of the funds rate in terms of
inflation and unemployment. Currently, this simple rule of thumb, which
has captured the broad contours of policy over the past two decades,
suggests that the funds rate will be near its zero lower bound for
several years. (Further discussion can be found in FRBSF Economic Letter 2009-17, The Fed's Monetary Policy Response to the Current Crisis.)
The Fed likely will have more than ample time and opportunity to shrink
the size of its balance sheet and raise the funds rate when economic
conditions require. In particular, the Fed can shrink the amount of
liquidity and monetary stimulus by taking any one or more of the
following actions: selling off securities, boosting liabilities other
than bank reserves (such as reverse repos or term deposits), and paying
a higher interest rate on bank reserves (so banks are less willing to
lend out these funds).
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