EconSouth (Fourth Quarter 2008)

Dennis Lockhart is the president and chief executive officer of the Atlanta Fed. Toward a Durable Recovery

Editor's note: This column is based on an early November speech Dennis Lockhart gave in West Palm Beach, Fla., regarding financial turbulence. (For a summary of a more recent speech on the U.S. economy, see Research Notes and News.)

The country is suffering from a severe financial crisis that has accelerated an economic downturn during the second half of 2008. Policymakers have responded with programs that should remediate the many pressing economic challenges we face moving into 2009, and some hopeful signs have emerged in credit markets that a corrective process is under way.

As term funding shows sustained improvement and other indicators point to the credit market's gradual return to health, I expect severe economic weakness in the short term should give way to an eventual recovery of growth near potential, with inflation returning to an acceptable range.

Let me begin with a summary of the economic situation according to the most recent data. Economic activity as measured by real gross domestic product (GDP) declined an estimated 0.5 percent at an annualized rate in the third quarter, according to the preliminary estimate. An even steeper decline in GDP is likely for the fourth quarter.

Unemployment in November was 6.7 percent—up from 4.9 percent in January 2008 and the highest rate in 14 years. In the first 11 months of 2008, nearly 1.9 million jobs were lost.

Retrenchment of the housing sector has continued to weigh heavily on the overall economy. A spike in foreclosures in 2008 added to the supply of homes for sale and accelerated price declines in many areas.

Beyond the housing sector, forces of contraction also took hold in consumer spending, business investment, industrial production, and foreign demand for U.S.-made goods. Problems are now broad based. Activity has fallen in auto manufacturing, transportation and distribution, retail trade, financial services, and some segments of commercial real estate.

Without question, the dramatic events of September and October in global financial markets have contributed to an extremely cautious posture on the part of consumers and businesses.

As a result of the widespread weakness in the U.S. economy, inflationary pressures appear to be declining. In particular, sharply lower energy and other commodity prices have contributed to lower headline inflation measures, and businesses appear to be more hesitant to pass on cost increases to their customers.

Near-term outlook
Looking ahead, I foresee substantial economic weakness at least through the first half of 2009. This weakness will likely exacerbate the employment picture. In the Atlanta Fed's outlook, unemployment will rise further. Also, I expect headline inflation to decline over the coming months.

As we evaluate the economy my colleagues and I are closely watching credit conditions. About 75 percent of domestic banks last month reported tighter lending standards for loans to smaller firms, according to the Fed's Senior Loan Officer Opinion Survey. That figure is up from July.

In this environment of faltering confidence, policymakers in the United States and other countries have employed an array of creative measures to forestall further deterioration.

Policy actions
Since August 2007—when financial turmoil began to emerge—the Federal Open Market Committee has lowered the federal funds rate target by a total of 425 basis points to its current level of 1 percent. [Editor's note: On Dec. 16, the Fed set the target rate to a range of 0–0.25 percent.]

In addition, the Fed also has undertaken several moves to enhance liquidity during the past year. These temporary programs expand the Fed's role as lender of last resort by making credit available to a broader range of borrowers, by extending the term of lending, and by accepting a broader range of collateral.

Other agencies are active in the broad-based efforts to stabilize financial markets. To encourage resumption of interbank and wholesale lending, for instance, the Federal Deposit Insurance Corp. has temporarily guaranteed most short-term deposits.

Also, the fiscal authority—the U.S. Treasury, with Congress approving—put Fannie Mae and Freddie Mac into conservatorship. In addition, the Treasury Department is now implementing the Emergency Economic Stabilization Act, a key feature of which is the injection of capital into the banking system to preserve solvency. Congress enacted a fiscal stimulus package earlier this year.

In an international effort, the Fed has put in place dollar swap facilities with a number of central banks. These facilities provide U.S. dollars to the monetary authorities of countries whose commercial banks require dollar-based liquidity support.

The path to recovery
I expect these cumulative measures will help create the conditions that financial markets need to stabilize and find an environment in which trend growth can resume. What has to happen to achieve this favorable outcome?

First, U.S. house prices need to stop falling, and the volume of defaults and foreclosures needs to stop rising. These factors should help stabilize troubled asset values. Second, deleveraging of the financial sector must run its course. The deleveraging, or the selling off of assets, that began late in 2008 has continued—both voluntary and forced. Progress on these fronts should clarify the condition of financial sector counterparties and lead to a general restoration of confidence, which is essential.

In some respects, the current financial crisis and economic fallout can be seen as a painful adjustment made necessary by macro imbalances that are global in nature. Symptoms in this country of such imbalances have included a highly leveraged financial system, a savings shortfall in the household sector, and growing public sector deficits.

In my view, a mere cyclical recovery that returns to the status quo ante will not be durable. The shaping of that recovery must come to grips with deep structural imbalances in our economic arrangements if we are to lower the potential for a recurrence of instability. Ideally, the return of confidence and the better conditions this will bring should be accompanied by progress or even resolution of these imbalances as part of a durable recovery for the long term.