Stern: U.S. Growth Could Be Weak For Years

Thursday, October 16, 2008 2:42 PM

HOUGHTON, Mich. -- U.S. economic growth could be restrained for as long as a few years by "unprecedented" problems in financial markets, a top Federal Reserve policy-maker said Thursday.

"We should anticipate further declines in employment and softness in most components of demand for goods and services," said Gary Stern, President of the Minneapolis Fed and a voting member of the U.S. central bank's monetary policy-setting Federal Open Market Committee this year.

In a speech on the economy and policy at Michigan Tech University in Houghton, Mich., Stern said the current downturn might be worse than the early 1990s recession:

"In view of the scope and severity of the recent financial shock, the restraint on economic activity stemming from credit market headwinds could exceed the experience of the 1990s."

He termed the 1990-1991 recession "brief but not especially mild."

Stern did not indicate whether he favored another big cut to the federal funds rate at the FOMC's next scheduled meeting on Oct. 28-29. Financial markets currently see a cut of either one-quarter or one-half percentage point from the current 1.5 percent level of the benchmark overnight lending rate.

"Depending on how one reads the data, financial headwinds restrained the pace of the ensuing expansion of the early 1990s from 12 to 36 months. Something similar is certainly conceivable today," Stern said.

Stern said the economy faces pressure from the ongoing decline in home prices and high inventories of unsold houses, a string of drops in payrolls, the negative wealth effect of a falling stock market and deterioration in credit availability.

Positive U.S. economic growth logged in 2007 and the first half of 2008 "do not tell the whole story," he concluded.

On a more cheerful note, Stern said the bulge in energy and commodity prices that peaked in July "is apparently behind us" and that inflation should recede.

That comment came on a day when September U.S. consumer inflation was reported unchanged and core prices, stripped of food and energy, rose an unexpectedly low 0.1 percent.

Stern said the Fed's actions to date, from severe cuts to lending rates to massive efforts to pump liquidity into the financial system, had been on target but not yet successful in restoring stability, and would take time:

"The Federal Reserve has responded to unprecedented times with equally unprecedented actions ... Despite these initiatives, financial markets remain unsettled, and some institutions continue to experience funding pressures."

Stern said that in light of the toll that the housing market crisis and its aftermath had taken on the economy, it was worth another think about how the Fed dealt with developing asset bubbles, including preemptive interest rate hikes.

"Identification of excesses in asset prices, although challenging, does not appear to be beyond the realm of possibility," he said.

Actions taken to rein in bubbles -- when increases of certain asset prices seemingly outstrip economic fundamentals -- "are likely to require raising interest rates earlier and probably more than otherwise would be the case" and would likely be unpopular, Stern said.

"Nevertheless, as the anti-inflation experience of 1979-82, for example, illustrates, it is possible to build considerable support (as then Fed Chairman Paul Volcker did), or at least tolerance, for policies that some considered risky and unappealing," he said.

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