donald l kohn : the economic outlook speech by mr donald l kohn, vice chairman of the board of governors of the us federal reserve system, at the national association for business economics, st louis, missouri, 13 october 2009. * * * i'm pleased to be here at the national association for business economics. most of you are in the business of making or using economic forecasts to inform the strategies of your organizations as they try to meet their objectives. so am i, and i thought this would be a good opportunity to discuss my view of the outlook and the implications that i draw for monetary policy. i'll start with a brief overview of recent developments and the near - term outlook. then i'll turn to a few of the issues that bear on the medium to longer - run outlook. i emphasize that the views you are about to hear are my own and not necessarily those of my colleagues on the federal open market committee. 1 in broad terms, the data that we have in hand indicate that economic activity turned up in the third quarter. to some extent, the pickup in activity in recent months reflects the dissipation of some of the forces that had been exerting downward pressure on the economy during the preceding several quarters. perhaps the most important of these downward forces was the turmoil in financial markets that began in late 2007, which not only tightened credit availability and reduced wealth, but also undermined confidence, especially when conditions took a decided turn for the worse in the fall of 2008. the stabilization, and more recently the improvement, in risk appetites and financial conditions, in part responding to actions by the federal reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession. a turn in the inventory cycle is another key element in the recent firming in aggregate activity. during the second half of 2008, many firms were apparently surprised at the sharp falloff in demand. in response to a buildup of unwanted inventories, they began aggressively liquidating stocks by slashing production well below the level of sales. the pace of liquidation intensified through the middle of this year. more recently, however, with inventories now less burdensome, firms have begun boosting production to slow the pace of inventory destocking and bring output into closer alignment with expected final sales. this process is particularly evident in the motor vehicle industry, where the stock of cars and trucks on dealers'lots had become extremely lean,

, construction, and motor vehicles – will have a restraining influence on potential output for a time. in addition, prolonged periods of unemployment could have adverse effects on the skills of workers and their attachment to the labor force. the financial crisis may also have affected potential output by reducing the ability of financial markets to effectively lubricate the flow of credit throughout the economy – and to allocate capital resources to their most productive uses. the deterioration in the health of the financial system conceivably may have disrupted the credit allocation system enough to seriously impair the efficiency of business operations, and this impaired efficiency could show up at some point in more meager gains in productivity. and, some have argued, as governments seek to build more stable financial and economic systems, they may impede innovation and efficiency. each of these arguments contains a grain of truth, and they are worthy of further research. but in my view, the cumulative reduction in aggregate demand has been much greater than any possible cutback in potential supply. the unemployment rate has risen by 5 percentage points in a very short period, and capacity utilization in industry hovers just above its lowest level in the history of the series, dating back to 1948. the downward pressures on both prices and labor compensation reinforce my impression that our economy is operating well below its productive potential. and, if anything, productivity has been surprisingly strong, not weak, in recent quarters. the improving picture for financial markets and the economy since last spring has meant that the federal open market committee ( fomc ) has not undertaken any new initiatives to ease financial conditions and stimulate demand at its past several meetings. we have left the unusually accommodative posture of policy – in terms of our plans for our balance sheet and the level of our policy interest rates – in place. it's important to judge this posture against how the economy is likely to evolve against our objectives in the future. importantly, our objectives in the federal reserve act are in terms of levels – the level of inflation relative to effective price stability and the level of output relative to the economy's potential to produce over the long run. right now, smoothing through the short - run fluctuations in energy prices, inflation seems to be running a little below the 2 percent objective for pce prices that i have seen as best promoting our dual mandate of maximum employment and stable prices. and, as i indicated, employment and output seem to be substantially below plausible estimates of their potential. but it's not the