New York Fed chief predicts moderate recovery; downplays inflation threat

Editor’s note: The City Wire does not typically push as a local story the comments from a Federal Reserve official from New York. However, the recent comments provide, in our opinion, an easy to understand and broad account of current and future economic issues.

Add William Dudley to the list of economists, business leaders and other economy watchers who are taking a “mixed,” or “cautious” approach to assessing current and near-term economic trends.

Dr. Latisha Settlage, an assistant economics professor at the University of Arkansas at Fort Smith, recently suggested a “long and bumpy road” to a recovery that is primarily dependent upon the willingness of consumers to start spending again. Officials with the American Trucking Associations’ see improving trends, but is predicting “moderate and probably inconsistent” growth in the trucking sector.

William Dudley, the newly installed president and CEO of the Federal Reserve Bank of New York, offered his mixed assessment during an Oct. 5 speech at the Fordham Corporate Law Center in New York. Following are the highlights of his prepared speech.

• “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.”

• “Turning first to the developments in financial markets, there is little doubt that we have seen a vast improvement over the past six months. … Industrial production has begun to rebound as the pace of inventory liquidation has slowed. Housing prices and activity have recovered somewhat — aided by the improvement in housing affordability and the first-time homebuyer tax credit. Fiscal stimulus is providing support to consumption and to state and local infrastructure spending.”

“However, 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 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. … The third, and perhaps most important factor, is that the banking system has still not fully recovered.”

• “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. … 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.”

• “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 —c redit 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. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector.”

• “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.”

• “The angst about the Fed’s ability to exit smoothly stems from the rapid growth of its balance sheet over the past year. In September 2008, on the eve of Lehman Brothers’ failure, the consolidated Federal Reserve balance sheet was about $900 billion. Today it is about $2.15 trillion, and it is likely to peak at around $2.5 trillion early next year.
Some observers are concerned that this expansion will ultimately prove to be inflationary. Proponents of this view say that the monetary base, the broad monetary aggregates, and total credit outstanding have historically tended to move together with inflation, at least over longer time periods. Thus, if the monetary base is growing rapidly, as it has been over the past year with the growth in the Fed’s balance sheet, the argument is that this growth will ultimately lead to inflation. This concern is not well founded because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), and this tool allows us to prevent excess reserves from leading to excessive credit creation.”