So, Why Has The Recovery Been So Tepid?

13593_charles-plosser So, Why Has The Recovery Been So Tepid? WORD ON THE STREET: The decentralized structure of the Fed is one of its most important features. It has deep roots in our nation's federalist structure. Independent Federal Reserve Banks ensure that policy reflects the economic and geographic diversity of the nation.

Americans have always been skeptical of too much centralized authority. The structure of the Fed was deliberately designed to preserve a diversity of views and provide checks and balances. Indeed, I believe the diversity of opinion around the Federal Open Market Committee (FOMC) table is one of its great strengths and serves to improve the quality of our policy decision-making. As the famous American journalist Walter Lippmann once said, ‘Where all men think alike, no one thinks very much.’

Preserving price stability, in my view, is the most important function of a central bank. In our modern economy, there is no other government agency that has the responsibility or capability to ensure the stability of the purchasing power of our nation's currency.

I will be the first to admit that over the 100-year history of the Federal Reserve, its track record has been mixed. At times, it has been successful, and at other times, it has failed spectacularly.

You may remember that early last year, the FOMC announced an explicit long-run inflation target of 2% a year. While you might argue, correctly, that 2% inflation is not truly price stability, it is widely believed because of measurement problems and the risks of deflation, or falling prices, that a 2% average inflation target is a reasonable compromise when weighing all the costs and benefits. In fact, most central banks around the world have a similar target.

Average inflation over the last three years has been running about 1.8%, a little under our 2% target. I expect that personal consumption expenditure inflation will remain close to our goal over the next year or two.

However, as they say in the investment community, ‘Past performance does not guarantee future results.’ The Fed must remain vigilant. Inflation is a monetary phenomenon. It often evolves slowly, and what sometimes appear to be purely temporary or transitory movements in volatile individual prices, like oil or other commodity prices, can prove to be precursors of more sustained movements in prices in general.

Nevertheless, I expect that inflation will be near our 2% target over the medium to longer term. But to achieve this outcome, the FOMC will likely need to begin stepping back from the extraordinary accommodation it has been applying. I will return to this point shortly.

Let me turn now to other aspects of the economy, including the prospects for growth and employment. The link between monetary policy actions and economic growth and employment is quite different from monetary policy's link with inflation. Economists understand that in the long run, inflation is a monetary phenomenon. Yet, in the long run, monetary policy cannot determine the growth of either output or employment. Even in the short run, the links between monetary policy and employment or output are tenuous at best and hard to predict.

The FOMC explained in its January 2012 statement of longer-term goals and objectives that factors other than monetary policy play the dominant role in determining the maximum level of employment. As a result, it is not feasible or desirable for the monetary authorities to specify a numerical objective for employment or unemployment.

Nevertheless, I have become increasingly concerned that many people inside and outside our government have come to expect too much from monetary policy. Monetary policy is not a panacea for all our economic ills. If society pressures monetary policy to overreach its capabilities, it will surely fail and, in doing so, will undermine not only the Fed's credibility, but also monetary policy's ability to deliver on the goals that it is most capable of achieving. The public and central bankers should scale back their expectations of the role and power of monetary policy.

Let me talk a little about the real economy, how I see it evolving and why I think the recovery has been so tepid. The recovery officially began nearly four years ago, in June 2009, yet real GDP growth has averaged just 2.1% a year since then.

According to the latest estimate, the economy grew just 1.6% in 2012, measured on a fourth-quarter-to-fourth-quarter basis. Growth in the fourth quarter was particularly weak, eking out just a 0.1% gain. Most economists pointed to a number of temporary factors that adversely affected performance in the fourth quarter – in particular, Hurricane Sandy had an enormous impact on economic activity in the Northeast.


Beneath the very weak headline number, there were some signs of improvement in consumption, business investments and residential investments. Thus, there is reason to be somewhat optimistic for the coming quarters.

I anticipate that the pace of growth will pick up somewhat, to about 3% in 2013 and 2014 – a pace that is slightly above the trend. My outlook is somewhat more optimistic than that of some forecasters.

For instance, the median forecast in the Philadelphia Fed's first-quarter Survey of Professional Forecasters is for the economy to grow at a 2.4% pace from the fourth quarter of 2012 to the fourth quarter of 2013.

My forecast of 3% growth should allow for continued improvements in labor market conditions, including a gradual decline in the unemployment rate, similar to the improvements we have seen over the past two years.

So, why has the recovery been so tepid? To understand this, we need to understand the nature of the shocks that have hit the economy. We now understand that we entered the most recent recession over-invested in the housing and financial sectors. The economic adjustments as a result of the boom and bust in housing have been painful.

The housing and financial sectors have both shrunk as a share of the economy, and it would not be particularly wise to seek to return those sectors to their pre-crisis highs. We learned the hard way that those levels were not sustainable. Thus, labor and capital must be reallocated to other uses. Moreover, the labor force needs to be at least partially retooled to match the skills employers now demand. This adjustment takes time. It is painful, to be sure, but it will lead to a healthier economy in the long run.

The housing collapse also significantly reduced consumer spending, which accounts for about 70% of the nation's gross domestic product. The sharp decline in housing values destroyed a lot of the equity that families had built up in their homes. Thus, a huge chunk of their savings vanished.

With that wealth gone, it is only natural for consumers to want to rebuild savings. Consequently, private savings rates have risen substantially, and consumption by households has been restrained.

I believe these adjustments cannot be significantly accelerated through traditional government policies that seek to stimulate aggregate demand. This is especially true in the case of ever more aggressive monetary policy accommodation.

The conventional view is that by lowering interest rates, monetary accommodation tends to encourage households to reduce savings and thus consume more today. However, as I've noted, in the current circumstances, consumers have strong incentives to save. They are deleveraging and trying to restore the health of their balance sheets, so they will be able to retire or put their children through college. They are behaving wisely and in a perfectly rational and prudent way in the face of the reduction in wealth.

In fact, low interest rates and fiscal stimulus spending that leads to larger government budget deficits may be designed to stimulate aggregate demand or consumption, but they could actually do the opposite. For example, low interest rates encourage households to save even more because the return on their savings is very small. And large budget deficits suggest to households that they are likely to face higher taxes in the future, which also encourages more saving.

In my view, until household balance sheets are restored to a level that consumers and households are comfortable with, consumption will remain sluggish. Attempts to increase economic ‘stimulus’ may not help speed up the process and may actually prolong it.

Businesses interpret increased savings and the modest growth in consumer spending as weak demand. This causes them to slow production, as well as hiring and investment. And this has made progress on employment slower than it was in recoveries from earlier deep recessions. For instance, in the recession that occurred in 1981-82, unemployment peaked at 10.8%. Yet, by the end of 1985, three years later, the rate had fallen 3.8 percentage points to 7%.

In contrast, today's improvement in labor markets has occurred at a relatively slow pace. The unemployment rate peaked at 10.1% in October 2009, but in the three years since then, the rate has fallen only about 2.2 percentage points, to 7.9%, where it stood in January. With the economic recovery continuing, I believe we will see the unemployment rate fall at a similar pace, to near 7% by the end of 2013.

Uncertainty is the other factor restraining hiring and investment by businesses. Many U.S. firms have restrained hiring and investing as businesses and consumers wait to see how our own fiscal problems will be resolved.

There remains significant uncertainty about the choices that will be made. How much will tax rates rise? How much will government spending be cut? U.S. fiscal policy is clearly on an unsustainable path that must be corrected. Efforts by Congress and the administration at the end of last year reduced some of the near-term uncertainty over personal tax rates. But the impact of the sequester, the debate over the continuing resolution to fund the federal government and the debt ceiling, which will once again become binding in the spring, all have clouded the fiscal policy situation. So, the resultant uncertainty will likely be a drag on near-term growth.

In my view, until uncertainty has been resolved, monetary policy accommodation that lowers interest rates is unlikely to stimulate firms to hire and invest. Firms have the resources to invest and hire, but they are uncertain as to how to put those resources to their highest valued use.

To sum up, there are good reasons to expect that the recovery will continue but at a moderate pace over the next couple of years.

Charles I. Plosser is president and CEO of the Federal Reserve Bank of Philadelphia. This article is adapted and edited from a speech delivered before the recent annual meeting of the Economic Development Co. and Economic Development Finance Corp. of Lancaster County, Pa. The original text is online.


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