William C Dudley: The US economic outlook
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Washington and Lee University H Parker Willis Lecture in
Political Economics, Lexington, Virginia, 1 April 2010.
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Thank you for that kind introduction and the opportunity to speak here today. The past few
years have been an extraordinary time for policymakers. We have been very aggressive in
providing support to the economy, and it now appears that a sustainable recovery is
underway. However, given the headwinds created by the collapse of the U.S. real estate
market and its consequent damage to the financial system and household balance sheets, it
seems unlikely that the recovery will be as strong as we would desire. As a result, the
substantial amount of slack in productive capacity that exists today will likely only be
absorbed gradually. Consequently, trend inflation, at least over the near term, should remain
very low. This is why the Federal Open Market Committee (FOMC) concluded at its March
meeting that "... economic conditions, including low rates of resource utilization, subdued
inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels
of the federal funds rate for an extended period".
What I would like to do today is to explain in some detail the logic underlying this expectation
that economic conditions will warrant exceptionally low levels of the federal funds rate for an
extended period. This conclusion stems from the observation that the current economic
environment is qualitatively different from previous post-World War II business cycles. Most
post-war recessions were preceded by high rates of resource utilization and rising trend
inflation. This prompted a tightening of monetary policy, which, in turn, dampened
interestrate sensitive spending, particularly on housing and consumer durable goods. Then, as
underlying inflation pressures subsided, monetary policy was eased and interest-rate
sensitive spending rebounded, often quite sharply.
The current business cycle is different in one key respect. It was preceded by a global
financial crisis. The financial crisis was due, in large part, to excessive leverage and
excessive investment in real estate assets. It will take time to unwind these excesses.
Today, I will offer a framework for assessing the forces that have shaped the recent
performance of the U.S. economy. This framework will provide context to the fiscal and
monetary policy responses to what is now being called the "Great Recession." Then, I will
discuss the economic outlook for the United States over the next year. Before I proceed, I
want to emphasize that these views are my own and do not necessarily reflect the views of
the FOMC or the Federal Reserve System.
Building an analytical framework
Say's law - named after the French economist Jean-Baptiste Say - states that the aggregate
value of incomes earned in an economy over some period of time must by definition equal
the value of all goods and services produced over that same time period. Or, put somewhat
differently, on an ex post (i.e., realized) basis, saving must equal investment. Investment in
this case means current spending on new physical, human and intangible capital. This
insight is the conceptual basis for national income accounting and the gross domestic
product (GDP) statistics that we follow so carefully.
Even so, economists have been debating the implications of Say's Law since it was first
expounded. Classical economists argued that this ex post balance would occur in a way that
kept the economy quite stable at full employment. If there were shocks to saving or
investment spending that pushed the economy away from full employment, prices and wages
would adjust quickly, providing the market signals needed to bring about the reallocation of
resources required to restore full employment.
The global depression of the 1930s raised serious questions about this classical theory.
Although saving must equal investment on an ex post basis, the two can diverge ex ante,
potentially sharply. For example, when ex ante (i.e., desired) saving exceeds ex ante
(desired) investment spending, inventories rise above desired levels. If prices of the products
in question do not fall sufficiently rapidly so that this unwanted build-up of inventories is sold
quickly, then production and employment must fall. Perhaps most famously, Keynes, in The
General Theory of Employment, Interest and
Money, argued that there are institutional
rigidities that inhibit price and wage flexibility. This means that periods in which ex ante
saving exceeds desired investment might lead to periods of persistent unemployment.
In this respect, the financial system plays an important role. Financial intermediaries match
borrowers and savers. If the financial system is under stress and lending standards are being
tightened, ex ante investment is likely to decline relative to saving, all else being equal.
The financial intermediation process and the creation of credit is the primary channel through
which monetary policy affects the economy. By influencing the volume of credit creation,
monetary policy strives to keep ex ante saving and investment - alternatively, aggregate
demand and aggregate supply - in rough balance. Too rapid a pace of credit creation would
overstimulate investment relative to saving, potentially increasing the rate of inflation and
this, in turn, could damage the economy's long-run performance. Too slow of a pace of credit
creation would likely lead to an ex ante shortfall of investment relative to saving, causing
unemployment to increase.
This analytical framework also applies to the global economy, but with an added level of
complexity. At the global level, income equals output and saving equals investment on an ex
post basis. However, for an individual country, saving can exceed investment or,
alternatively, production can exceed domestic demand to the extent that a country's exports
exceed its imports. This requires that, for some other economy or group of economies,
investment must exceed saving, or alternatively, domestic demand must exceed production
and imports must exceed exports. This means that what happens abroad in terms of desired
saving and investment also influences the performance of our domestic economy.
This framework provides a simple way to evaluate the recent economic environment and the
current economic outlook. When desired investment rises relative to saving on an ex ante
basis, then an economy tends to strengthen. If the strengthening persists, inflation may rise
to levels above what is regarded as consistent with maximum sustainable growth and full
employment. This was the story for much of the 2004-06 period. The Federal Reserve
responded to rising trend inflation by tightening monetary policy to keep the economy from
overheating.
In contrast, when investment falls relative to saving on an ex ante basis, an economy
weakens and may slip into recession, as was the case between 2007 and mid-2009. During
this period, the Federal Reserve tried to support employment by cutting its federal funds rate
target nearly to zero; by creating a number of special liquidity facilities to support the
extension of credit; and by engaging in a large scale asset purchase program, buying
Treasuries, agency debt and agency mortgage-backed securities.
An economic recovery requires that desired investment must rise relative to saving. This has
happened recently as fiscal stimulus and an inventory cycle have led to a fall in ex ante
saving relative to investment. But for the recovery to strengthen further, this process must
continue. There has to be a further demand impulse - be it a decline in household saving
rates, a rise in business investment relative to profits, a further expansion of fiscal stimulus or
an improvement in the net trade balance via an increase in exports relative to imports.
Let's now apply this framework to evaluate what happened over the past decade and what it
implies for the economic outlook.
The last three decades have been marked by a shortage of U.S. domestic saving relative to
investment. The United States has almost continuously run a current account deficit since
the early 1980s (Chart 1). In 2005 and 2006 that current account deficit averaged around
6 percent of GDP. Yet, the real exchange value of the dollar today is not terribly different
from what it was in the early 1990s (Chart 2). A massive flow of saving into the United States
from around the world offset forces that otherwise would have driven the exchange value of
the dollar lower.
In addition to its sheer size, this inflow of saving into the United States is significant in several
respects. First, note the direction of the flow. One might expect that capital would flow from
the developed world to the developing world, but just the opposite has been the case. In
addition, foreign savers have been willing to lend to the United States in the U.S. currency.
This means that foreign savers are exposed to the exchange rate risk that the dollar's value
might change relative to their own currencies. Finally, one might expect that over time, as
their holdings of dollar-denominated assets increased, foreign savers would demand higher
interest rates, but, in fact, U.S. interest rates - in both nominal and real terms - have been
generally declining over the past three decades1 (Chart 3).
These facts are at odds with the prevailing view that spendthrift U.S. consumers and
governments are pulling those savings into the United States. Indeed, for some time the "twin
deficits" view held that large fiscal deficits in the United States were causing large U.S.
current account deficits. However, even when the federal government ran surpluses in the
late 1990s, our current account deficit continued to increase. Subsequent research at the
Federal Reserve Bank of New York indicates that the link between fiscal deficits and capital
inflows is not as strong as commonly suggested.2
Before proceeding, a few important qualifications are in order. First, despite the large flow of
foreign saving into the United States, our international financial position does not appear
precarious at the present time. The United States still has substantial investments in foreign
countries, and income from U.S. investments abroad still exceeds the income generated by
U.S. assets owned by foreigners. Part of the reason is that U.S. firms operating abroad earn
higher rates of profit than foreign firms operating here. In addition, low interest rates minimize
the cost to the United States of our substantial negative net debt position.
In addition, the fact that our foreign indebtedness is for the most part denominated in our own
currency is a huge advantage in the event the dollar were to come under significant
downward pressure. That is because a decline in the dollar would raise the value of the
income earned on our foreign direct investment and foreign-currency denominated assets,
relative to the income that foreigners earned on their dollar-denominated investments in the
United States. All else being equal, this would boost our net investment income balance.
Note that borrowing per se is not necessarily a bad thing. The key is what the borrowing is
used for - to finance consumption or investment. And, if it is used to fund investment, it is
also important how productive that investment turns out to be over time.
So what did we do with this inflow of foreign saving? We invested in a substantial volume of
physical capital, particularly residential and nonresidential real estate (Chart 4). It seems
clear that one important factor behind this investment was the decline in long-term interest
rates. For example, from 2003 through 2005 mortgage rates declined to just under 6 percent
on average, the lowest level since the first half of the 1960s. These lower mortgage interest
rates were capitalized into asset prices. Rising prices for residential and nonresidential real
estate assets induced entrepreneurs to produce more of those assets. In the housing market,
this increase in prices was helped along by the relaxation of loan underwriting standards,
which made it easier to obtain a mortgage and become a homeowner. Credit growth was the
strongest among households with relatively low credit scores (Chart 5). The homeownership
rate rose after being relatively stagnant for two decades (Chart 6). The increased availability
of credit to lower income borrowers and the sharp rise in housing values contributed to the
rise of consumption as a share of GDP and the decline of the personal saving rate3 (Chart 7).
Now, with the aid of hindsight, it is clear that we built too many houses, invested in too much
commercial real estate and overvalued both significantly. The market overshot for several
reasons. First, there was rampant speculative behavior. The longer these asset prices
continued to rise, the stronger the belief became that they would keep rising in the future.
Second, the rise in prices reinforced the initial relaxation of underwriting standards. During
the period of rising prices, defaults and loan losses were very low. A homeowner who had
difficulty servicing the debt could typically sell the home for a profit and pay off the loan.
Third, the boom was fueled by new financial products, such as collateralized debt obligations
that were backed by subprime and Alt-A mortgages. Investors misunderstood how risky
these products were and this resulted in lower mortgage rates for non-conforming residential
mortgages and lower funding costs for commercial real estate borrowing.
In the housing sector, these factors interacted to create a strong reinforcing dynamic. The
relaxation of underwriting standards that made it easier to become a homeowner and the low
mortgage rates - supported in part by the new financial products - made it easier to
speculate in real estate. Moreover, as home prices rose, household net worth increased,
making households more willing to consume a greater share of their current income.
Not surprisingly, this bout of speculative fever ended badly. Eventually, the supply of houses
caught up with and then vastly overshot demand. Easing underwriting standards to support
demand could only go on for so long. Prices turned down. At the national level, home prices
peaked in late 2005 to early 2006 with commercial real estate prices peaking about one year
later (Chart 8). From those peaks, home prices have fallen by about 30 percent on average,
with much larger declines in some areas, while commercial real estate prices have fallen by
about 40 percent on average.
As price declines intensified, the number of serious mortgage delinquencies surged and, in
fact, continue to rise (Chart 9). Research indicates that by 2007 the percentage of nonprime
mortgages that went into default within their first year rose to 10 percent compared with
3 percent of such loans originated in 2003. While falling home prices appear to be the
primary factor explaining this sharp increase in early defaults, most of the increase cannot be
explained by traditional risk factors.4 A potential explanation is that individual home buyers
often falsely indicated on their mortgage applications that the property they were buying
would be their primary residence. Using an extensive set of data on loan performance that
we have developed with Equifax, we find that multiple first mortgage lien holders - that is,
people owning more than one home - account for about 40 percent of the dollar volume of
seriously delinquent mortgage balances, up from about 5 percent in 2004 (Chart 10).
As delinquency and foreclosure rates rose, structured finance products backed by riskier
mortgage loans performed particularly poorly. The securitization market for non-conforming
mortgages collapsed. Credit availability tightened as underwriting practices became much
more restrictive, even for plain vanilla mortgages.
The cascading effect of the sharp increase in mortgage delinquencies and the resulting steep
decline in the market value of mortgage assets was a key contributing factor to the financial
crisis. As the financial crisis intensified and the economic outlook deteriorated, equity prices
eventually declined by 50 percent from their late 2007 peak before bottoming out about one
year ago.
But while the value of real estate and equities plunged, the debt incurred to acquire those
assets remained, leaving households very highly leveraged. According to the Flow of Funds
Accounts, the ratio of household liabilities to net worth rose from around 20 percent to nearly
30 percent in just three years (Chart 11).
The result was a sharp decline in desired investment relative to saving. The number of
housing starts plunged, commercial real estate investment fell and households cut back on
their spending as their net worth plummeted. The economy slumped into what is now called
the "Great Recession".
The dimensions of the downturn
According to the Business Cycle Dating Committee of the National Bureau of Economic
Research (NBER), the U.S. economy has experienced 10 recessions since 1950. The
duration of those previous recessions averaged slightly less than a year during which real
GDP fell an average of 1.75 percent and the unemployment rate increased an average of
2.3 percentage points.
The Great Recession was far worse. From its peak, real GDP declined 3.8 percent - more
than double the average decline of prior downturns (Chart 12). The unemployment rate
began to increase in the second half of 2007. Over the next two years, it increased
5.5 percentage points. The rise would have been even more pronounced except that the
average workweek and the labor force participation rate declined unusually sharply
(Charts 13 and 14). Overall, total hours worked in the nonfarm business sector declined a
staggering 10.6 percent (Chart 15). In addition to the decline in demand for labor, the
manufacturing capacity utilization rate declined to 65.1 in June of 2009, the lowest level of
the post-World War II period.
The result is that the "output gap" - that is, the difference between actual output and the
output achieved at the highest resource utilization rate consistent with price stability - has
climbed sharply. This, in turn, has put downward pressure on trend inflation. For example, on
a year-over-year basis, the core inflation rate declined to 1.5 percent in January 2010 from
nearly 3 percent in the fall of 2006 (Chart 16).
The road ahead
Fortunately, the U.S. economy is very flexible and resilient. Although it does not adjust as
fast as classical economists envisioned, in the United States prices and wages respond
relatively quickly. Moreover, policymakers have been aggressive in supporting the economy
by easing monetary policy and by implementing a large fiscal-stimulus program.
As a result, although the unemployment rate remains unacceptably high, output has begun to
expand again, and we appear to be on the verge of seeing sustained growth in employment.
We'll know more about this tomorrow when the March employment figures are released.
Equity prices have recovered sharply and home prices and commercial real estate prices
appear to be stabilizing. Household indebtedness is declining, due to a combination of debt
repayment and credit that has been written off by lenders. After falling off a cliff during the
first half of 2009, global trade has rebounded. Both U.S. exports and U.S. manufacturing
output have expanded rapidly over the past six months (Chart 17).
Although these are encouraging developments, I believe that the recovery is likely to be quite
muted compared with past recoveries. This comes back to the framework discussed earlier.
For faster growth, we need ex ante investment to rise relative to saving and ex ante spending
to rise relative to the current trend of income. But it is difficult to see where this impulse will
come from in the near term.
The early stages of past recoveries have been led by consumer spending, particularly for
durable goods and residential investment. For example, in the first year of recovery following
the deep recessions of 1973-1975 and 1981-1982, real consumer spending increased an
average of 6.5 percent and residential investment rose an average of 38 percent. It is
unlikely that we will experience this type of strength this time. Households have suffered
unusually large shocks to both income and wealth and many remain highly leveraged
(Chart 18). Although the household debt to net worth ratio has declined considerably from its
peak, it is still around 26 percent, well above the already elevated average of the past
decade (Chart 19). Moreover, even if consumers wanted to borrow, credit availability is still
constrained and underwriting standards remain relatively tight. Real consumer spending
increased at a 2.25 percent annual rate over the second half of 2009 and looks to be growing
at about that rate in the first quarter of 2010.
Given that the personal saving rate is still relatively low, it will be hard for consumer spending
to grow more quickly without large increases in real labor income. But big increases in real
labor income won't be possible without a much stronger recovery in output. And a much
stronger recovery in output is unlikely without stronger consumption.
Residential investment did increase over the second half of 2009, boosted by relatively low
mortgage interest rates, lower home prices and the first-time home buyer tax credit. But
recent data on the housing sector indicates that the recovery has stalled (Chart 20). As with
consumption, we are unlikely to see the typical surge of housing starts and residential
investment that was a key feature of most past recoveries. There is already an unusually
large volume of vacant homes for rent and for sale (Chart 21). More are likely to come onto
the market in the months ahead due to the large volume of mortgage loans currently in the
foreclosure process.
For the government sector, large federal budget deficits are a constraint and fiscal policy is
slowly shifting from an expansive policy back toward restraint. At the state and local level, the
constraints are even more binding, as budgetary gaps will need to be addressed by spending
cuts and tax increases (Chart 22).
Exports rebounded sharply over the second half of 2009, particularly to the emerging world
(Chart 23). However, domestic demand in Europe and Japan - important export markets for
the United States - remains very weak. This suggests that the U.S. trade balance is likely to
change little over the next year or two, and, thus, will be relatively neutral in terms of its
impact on growth.
Only business fixed investment is in a position to be a true locomotive of growth. Profits have
stayed high relative to investment, and corporate balance sheets are awash with cash
(Charts 24 and 25). However, even here, the growth impulse is likely to be weak. Prospective
startup businesses are going to find it difficult to obtain funding. And larger businesses will
unlikely increase investment spending sharply at a time when capacity utilization rates
remain unusually depressed (Chart 26).
Relatively sluggish growth implies that the output gap will be closed very gradually. This
suggests that inflation pressures will stay subdued. The excess supply of housing is putting
downward pressure on rents, which represent a large share of the consumer price index
(CPI) (Chart 27). In addition, unit labor costs have declined sharply over the past year due to
the combination of unusually rapid productivity growth and slowing labor compensation
growth (Chart 28). Fortunately, longer term inflation expectations remain well anchored.
These expectations have not declined and are broadly consistent with my views on the
appropriate inflation goal (Chart 29). This is actually a welcome development right now
because it will likely help to keep the trend inflation rate from falling too much.
Lessons to be learned
We have just lived through a period in which rapid increases in asset prices led to a serious
misallocation of resources and a severe financial crisis. What do we need to do to minimize
the likelihood of avoiding this type of experience in the future?
As I noted in a recent speech, we face three major challenges that will determine how
smooth this economic expansion turns out to be.5 First, we need regulatory reform that
makes our financial system more stable and resilient. This requires many steps, including
systemic risk oversight and solving the so-called too-big-to-fail problem. In this respect, we
need to think hard about what we can do to prevent the type of speculative bubbles that
occurred from causing so much damage in the future. In particular, are there macro
prudential tools that the Federal Reserve and other regulators can use to limit leverage and
speculation and thus prevent the type of asset price booms and busts that have proved so
troublesome?
Second, we need viable exit strategies from this recent period of monetary and fiscal policy
stimulus. On the monetary policy side, we have been working hard to ensure that we have
the tools in place so that we can be effective in tightening monetary policy when the time is
right, even with an enlarged balance sheet. Third, we need a rebalancing of global economic
growth. That means a smaller share of consumption relative to GDP in the United States and
offsetting shifts in Asia.
Circumstances have improved considerably from what they were a year ago. But job creation
is still much too slow and we have much to do on the regulatory side to make our financial
system more resilient and robust.
Thank you very much for your kind attention. I would be happy to take a few questions.
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