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Monday, July 20, 2009

Fed's Lockhart sees Weak Recovery, Exit Strategy not needed for "some time"

by Calculated Risk on 7/20/2009 01:32:00 PM

From Atlanta Fed President Dennis Lockhart: On the Economic Outlook and the Commitment to Price Stability . Here is Lockhart's economic outlook:

Often a deep recession is followed by a sharp rebound in business and overall economic activity. Unfortunately, as I look ahead, I do not foresee this trajectory. I expect real growth to resume in the second half and progress at a modest pace. I do not see a strong recovery in the medium term.

There are risks to even this rather subdued forecast. The risk I'm watching most closely is commercial real estate. There is a heavy schedule of commercial real estate financings coming due in 2009, 2010, and 2011. The CMBS (commercial real estate mortgage-backed securities) market is very weak, and banks generally have no appetite to roll over loans on properties that have lost value in the recession. Refinancing problems will not directly affect GDP—it's commercial construction that factors into GDP—but I'm concerned problems in commercial real estate finance could adversely affect the otherwise improving banking and insurance sectors.

... the healing of the banking system will take time. Working off excess housing inventory will take time. The reallocation of labor to productive and growing sectors of the economy will take time. It will take time to complete the deleveraging of American households and the restoration of consumer balance sheets.

In short, I believe the economy must undergo significant structural adjustments. We're coming out of a severe recession, and it's not too much an exaggeration to say the economy is undergoing a makeover. We must build a more solid foundation for our economy than consumer spending fueled by excessive credit—excessive household leverage—built on a house price bubble.

The surviving financial system must find a new posture of risk taking. The balance of consumption and investment must adjust, with investment being financed by greater domestic saving. The distribution of employment must adjust to match worker skills, including newly acquired skills, with jobs in growth markets. Some industrial plant and equipment must be taken offline to remove excess and higher-cost capacity.

As I said, these adjustments will take time and will suppress growth prospects in the process. I believe the economy will underperform its long-term potential for a while because of the obstacles to growth that must be removed, adjustments it must undergo.
Let me summarize my argument here today. The economy is stabilizing and recovery will begin in the second half. The recovery will be weak compared with historic recoveries from recession. The recovery will be weak because the economy must make structural adjustments before the healthiest possible rate of growth can be achieved. While this adjustment process is going on in the medium term, I believe inflation and deflation are roughly equal risks and require careful monitoring. Slack in the economy will suppress inflation. And inflation is unlikely to result—by direct causation—from the recent growth of the Fed's balance sheet. In any event, the Fed has a number of tools being readied to unwind the policies used to fight the recession, and it will be some time before their use is appropriate.
emphasis added