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On November 20, 2012, Federal Reserve Chairman Ben Bernanke offered his current thoughts on the U.S. economy and the “fiscal cliff” to the New York Economic Club. The Fed’s Open Market Committee next meets Dec. 11-12, at which point it is expected the Fed will announce a new bond-buying program in another attempt to keep long-term interest rates low as an economic stimulus.
The Recovery from the Financial Crisis and Recession
The economy has continued to recover from the financial crisis and recession, but the pace of recovery has been slower than FOMC participants and many others had hoped or anticipated when I spoke here about three years ago. Indeed, since the recession trough in mid-2009, growth in real gross domestic product (GDP) has averaged only a little more than 2 percent per year.
Similarly, the job market has improved over the past three years, but at a slow pace. The unemployment rate, which peaked at 10 percent in the fall of 2009, has since come down 2 percentage points to just below 8 percent. This decline is obviously welcome, but it has taken a long time to achieve that progress, and the unemployment rate is still well above both its level prior to the onset of the recession and the level that my colleagues and I think can be sustained once a full recovery has been achieved. Moreover, many other features of the jobs market, including the historically high level of long-term unemployment, the large number of people working part time because they have not been able to find full-time jobs, and the decline in labor force participation, reinforce the conclusion that we have some way to go before the labor market can be deemed healthy again.
Meanwhile, inflation has generally remained subdued. As is often the case, inflation has been pushed up and down in recent years by fluctuations in the price of crude oil and other globally traded commodities, including the increase in farm prices brought on by this summer’s drought. But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC’s longer-run objective for inflation. Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public’s inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee’s objective….
The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years. In particular, slower growth of potential output would help explain why the unemployment rate has declined in the face of the relatively modest output gains we have seen during the recovery. Output normally has to increase at about its longer-term trend just to create enough jobs to absorb new entrants to the labor market, and faster-than-trend growth is usually needed to reduce unemployment. So the fact that unemployment has declined in recent years despite economic growth at about 2 percent suggests that the growth rate of potential output must have recently been lower than the roughly 2 ½ percent rate that appeared to be in place before the crisis.
There are a number of ways in which the financial crisis could have slowed the rate of growth of the economy’s potential. For example, the extraordinarily severe job losses that followed the crisis, especially in housing-related industries, may have exacerbated for a time the extent of mismatch between the jobs available and the skills and locations of the unemployed. Meanwhile, the very high level of long-term unemployment has probably led to some loss of skills and labor force attachment among those workers. These factors may have pushed up to some degree the so-called natural rate of unemployment – the rate of unemployment that can be sustained under normal conditions – and reduced labor force participation as well. The pace of productivity gains – another key determinant of growth in potential output – may also have been restrained by the crisis, as business investment declined sharply during the recession; and increases in risk aversion and uncertainty, together with tight credit conditions, may have impeded the commercial application of new technologies and slowed the pace of business formation….
Headwinds Affecting the Recovery
What are the headwinds that have slowed the return of our economy to full employment? Some have come from the housing sector. Previous recoveries have often been associated with a vigorous rebound in housing, as rising incomes and confidence and, often, a decline in mortgage interest rates led to sharp increases in the demand for homes. But the housing bubble and its aftermath have made this episode quite different. In the first half of the past decade, both housing prices and construction rose to what proved to be unsustainable levels, leading to a subsequent collapse: House prices declined almost one-third nationally from 2006 until early this year, construction of single-family homes fell two-thirds, and the number of construction jobs decreased by nearly one-third. And, of course, the associated surge in delinquencies on mortgages helped trigger the broader financial crisis.
Recently, the housing market has shown some clear signs of improvement, as home sales, prices, and construction have all moved up since early this year. These developments are encouraging, and it seems likely that, on net, residential investment will be a source of economic growth and new jobs over the next couple of years. However, while historically low mortgage interest rates and the drop in home prices have made housing exceptionally affordable, a number of factors continue to prevent the sort of powerful housing recovery that has typically occurred in the past. Notably, lenders have maintained tight terms and conditions on mortgage loans, even for potential borrowers with relatively good credit. Lenders cite a number of factors affecting their decisions to extend credit, including ongoing uncertainties about the course of the economy, the housing market, and the regulatory environment. Unfortunately, while some tightening of the terms of mortgage credit was certainly an appropriate response to the earlier excesses, the pendulum appears to have swung too far, restraining the pace of recovery in the housing sector.
Other factors slowing the recovery in housing include the fact that many people remain unable to buy homes despite low mortgage rates; for example, about 20 percent of existing mortgage borrowers owe more on their mortgages than their houses are worth, making it more difficult for them to refinance or sell their homes. Also, a substantial overhang of vacant homes, either for sale or in the foreclosure pipeline, continues to hold down house prices and reduce the need for new construction. While these headwinds on both the supply and demand sides of the housing market have clearly started to abate, the recovery in the housing sector is likely to remain moderate by historical standards….
Upcoming Fiscal Challenges
What are these looming challenges? First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law – the so-called fiscal cliff. The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery – indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession. Second, early in the new year it will be necessary to approve an increase in the federal debt limit to avoid any possibility of a catastrophic default on the nation’s Treasury securities and other obligations. As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached. A failure to reach a timely agreement this time around could impose even heavier economic and financial costs.
As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then. Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend. Of course, we should all understand that long-term projections of ever-increasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path – for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines – is thus urgently needed to ensure longer-term economic growth and stability.
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