The answer is that the bursting of the housing bubble and the resulting financial crisis unleashed at least four powerful forces that have sapped the recovery of its vigor: First, it destroyed household wealth. Second, it left the housing market in a deep depression. Third, it made credit hard to get. And, fourth, it left a legacy of uncertainty that clouds the future. Let's consider those in order.
The collapse of house prices contributed to a decline in the wealth of households of some $6.5 trillion – that's trillion with a ‘T.’ And with the financial system and economy on the brink, the stock market plummeted. This one-two punch deprived households of both the means and the will to spend. So it's hardly surprising that consumer spending has been subdued.
What about housing? Past recoveries typically got a jump-start from home construction and spending on household goods, such as furniture, appliances, and the like. This time, though, the housing market is mired in a historic state of depression. We still see millions of homes in foreclosure, and millions more on the verge.
With the housing market so distressed, there's little sign that prices are poised to rise. Meanwhile, about one in four home mortgages are currently underwater. No wonder construction and new home sales are still near the lowest levels recorded since the early 1960s.
Weak consumer spending and depressed housing are closely related to a third powerful force holding back the recovery: tight credit. It's the nature of a financial crisis that the pendulum swings from loose credit, when it's easy to borrow, to tight credit, when loans are hard to get. This time, that swing was breathtaking. In today's mortgage market, customers without excellent credit scores and cash for a hefty down payment find it tough to borrow.
Likewise, many small businesses are shut out of the loan market because they may not be able to use residential or commercial real estate as collateral. Anecdotal reports and surveys suggest that credit conditions have been easing. Indeed, corporations that can sell securities in the financial markets have great access to capital. But for households, the going can still be tough, and small businesses are finding that many of the community banks they relied on are too weak to open the credit spigots.
The final force I want to mention is uncertainty, which has a depressing effect on spending and investment. By almost any measure, uncertainty is high. Businesses are uncertain about the economic environment and the direction of economic policy. Households are uncertain about job prospects and future incomes. Political gridlock in Washington, D.C., and the crisis in Europe add to a sense of foreboding. I repeatedly hear from businesspeople that these uncertainties are prompting them to slow investment and hiring.
Yet, even in the face of these obstacles, the economy continues to grow, and it will likely continue to do so. This is a testament to the natural resilience of our economic system. Credit conditions are slowly improving. Little by little, households are repairing their finances. Businesses are gradually increasing production and hiring extra hands. The housing market is no longer falling, and home construction eventually will recover to levels consistent with a growing population.
The broadest barometer of economic conditions is gross domestic product (GDP), which measures the nation's total output of goods and services. My forecast calls for the GDP to rise about 2.25% this year and 2.75% in 2013. That's an improvement from 2011, when the GDP grew only a little over 1.5%.
Unfortunately, such moderate growth will not be enough to keep taking big bites out of unemployment. I expect the unemployment rate to remain over 8% well into next year and still be well over 7% at the end of 2014.
But that's a forecast, and things could obviously turn out differently than I expect. One risk in particular could cause the economy to perform much worse than this forecast: the situation in Europe. The governments of several countries that use the euro as their currency have been struggling to pay their debts.
Greece, in particular, appears unable to meet its obligations. At the same time, countries such as Italy have been forced to pay what might be unsustainably high interest rates. This has raised questions about the health of European financial institutions that invest in government bonds.
European leaders have been working to solve this problem, and they may be able to muddle through. But if they fail, all bets are off. The agreement binding together the countries that use the euro could break up, sending shock waves through financial markets around the world. Under such circumstances, the U.S. could hardly escape unscathed.
So what does the story I've told mean for Federal Reserve policy? The Fed has taken extraordinary action to boost growth and keep inflation low. That effort is ongoing. The Fed sets policy with an eye on the two goals Congress has assigned it: maximum employment and stable prices.
Clearly, with unemployment at 8.3%, we are very far from maximum employment. And I expect inflation to run somewhat below the 2% level that we at the Fed are aiming for. In this situation, it's vital that the Fed use all the tools at its disposal to achieve its mandated employment and price stability goals.
We at the Fed are doing everything we can to move the economy forward. We recognize that monetary policy cannot perform magic. Lower interest rates alone can't fix all the economy's problems.
But they do help. Conditions are far better today than they would be if the Fed hadn't administered such strong medicine. Looking ahead, we may still need to provide more policy accommodation if the economy loses momentum or inflation remains well below 2%. Should that occur, restarting our program of purchasing mortgage-backed securities would likely be the best way to provide a boost to the economy.
The policy actions the Fed takes from here will depend on how economic conditions develop, and they will change as economic circumstances change. I want to assure you that the Fed will do its level best to achieve the goals of maximum employment and stable prices.
John C. Williams is president and CEO of the Federal Reserve Bank of San Francisco. This article is adapted and edited from a recent speech delivered at the Bishop Ranch Forum in San Ramon, Calif. The full text is available online.