The Economy

Editor's note: Following are excerpts from a speech delivered Jan. 7, 2009 at the Central Exchange in Kansas City, Mo..It seems so clear now, doesn't it, that the key factor underlying the current economic downturn has been the behavior of financial institutions and consumers, who increased their borrowing to unprecedented and ultimately unsustainable levels in the excitement of the "boom" in housing. As the reality of this leverage finally emerged, its effects started to show, most notably in August 2007. An asset-pricing crisis eventually widened into a confidence crisis that spread through the economy….The process of absorbing financial loss, increasing savings and decreasing consumption, the pain of deleveraging, sets the context for the economic outlook. The hard fact is that the sharp deterioration of banking and credit conditions, the deepening slump in consumer and business confidence, and the ongoing housing correction must work their way through the economy. While we must do what we can to mitigate the effects of this deleveraging process, the attempt to avoid its effects entirely is to repeat past mistakes and may sow the seeds for the next crisis..Accordingly, my outlook calls for the economy to contract further through much of 2009 until later in the year when the effects of policy actions begin to stimulate GDP growth..Starting with consumption, we will most likely see a contraction at least into the second quarter. Improvements in both consumption and savings will be hampered by declines in disposable incomes as firms continue to cut costs through layoffs, reductions of hours and pay cuts..The outlook for business spending is also weak. Conditions in the manufacturing sector have worsened, and with this, the decline in corporate profits makes it unlikely that firms will expand equipment spending until they see a rebound in consumer demand. Spending on structures is expected to contract markedly due to tight credit conditions and waning demand for commercial building space..Of course, the outlook for residential investment remains weak as well. Housing starts have fallen by 60 percent from peak levels in 2006, and the inventory of existing single-family homes remains unusually high at an 11.5-month supply. The increase in foreclosure rates in the near term is likely to contribute to additional housing price declines..Even the one recent source of strength for the economy, net exports, is expected to slow in 2009. After a robust expansion of U.S. exports in the first half of 2008, a rapid appreciation of the dollar combined with weakening world demand likely halted the expansion of exports in the second half of the year. The recent decline in the dollar should reverse this somewhat, but world demand is likely to be weak over the next several quarters..Government spending at the state and local level is expected to slow as budgets are cut in response to a decline in tax revenues during this downturn. Government spending at the national level will provide a boost to the economy, depending on the size and content of the forthcoming stimulus package..Putting all of the pieces of the outlook together, the picture for the last quarter of 2008 and at least the first half of this year is grim. The magnitude of the downturn is likely to surpass that of the 1990 and 2001 recessions..While this immediate outlook is unsettling, over the longer horizon there is reason to expect that we can move through these difficulties and be a stronger economy when we emerge from recession. If we pursue systemic policies with the right balance of monetary and fiscal stimulus, the early signs of economic recovery could show themselves as early as the third quarter of 2009. It would be foolish to attempt to pinpoint the exact spark for the recovery, but there are important factors that should contribute to this result..First, the recent sharp decline in oil and gasoline prices does increase consumer disposable income by billions of dollars, improve their financial position and serve to restore confidence. Second, while the housing market will continue to struggle, low mortgage rates and some decline in inventory will serve to stabilize home prices and moderate housing's extended drag on the economy. Third, a gradual improvement in financial conditions will increase the supply of credit and encourage demand. And finally, expansive monetary and fiscal policy will stimulate the economy and serve to offset some of those factors pulling it down..Inflation will remain moderate over 2009 and much of 2010. Lower energy and commodity prices along with moderate improvements in demand for goods and services will keep price pressures temporarily contained. How prices behave beyond the immediate horizon depends most critically on how the Federal Reserve conducts policy and manages its expanding balance sheet in the strengthening economy. This is no doubt the central bank's most difficult longer-run challenge.