TEXT: Kohn's Speech

The Outlook for Economic Activity and Inflation
How long the adjustment in financial markets will take and the consequences of that adjustment for economic activity are subject to considerable uncertainty.  In my view, the most likely scenario is one in which the economy experiences a period of sluggish growth in demand and production in the near term that is accompanied by some further increase in joblessness.

New building activity will continue to decline until the overhang of inventories of unsold homes has been substantially reduced, and the demand side of the market is not likely to revive appreciably until buyers sense that price declines are abating and financing conditions for mortgages are improving.  Consumer spending will be damped by the effects on real incomes of a weak labor market and rising energy prices and by the effects of declines in the stock market and home prices on household wealth.  Business spending on capital equipment should be held down by slower sales and production and by caution in a very uncertain economic environment.  Nonresidential construction is likely to lose some momentum in the wake of both weak growth in overall economic activity and tighter credit.  Some modest offset to these areas of weakness should come from export demand, which should be boosted by the lagged effects of recent declines in the dollar and supported by still-solid growth abroad.

By midyear, economic activity should begin to benefit from several factors.  One is the fiscal stimulus package that the Congress recently enacted.  The rebates that households are scheduled to begin to receive in May should provide a temporary boost to consumption.  Although the timing and the magnitude of the spending response is uncertain, economic studies of the previous experience suggest that a noticeable proportion of households are quite sensitive to temporary cash flow.  The potential effects of the business incentives are perhaps more uncertain.  Although economic theory suggests that they should bring forward some capital spending, past experience has been mixed.

Second, the decline in residential investment should begin to abate later this year as the overhang of unsold homes is worked off, reducing what has been a significant drag on economic growth over the past two years.  Finally, the declines in interest rates that began last summer should be supporting activity over coming quarters, and their effects should show through more clearly to improvements in economic activity as the stress in financial markets dissipates.

Although a firming in the growth of economic activity after midyear now appears the most likely scenario, the outlook is subject to a number of important risks.  Further substantial declines in house prices could cut more deeply into household wealth and intensify the problems in mortgage markets and for those intermediaries holding mortgage loans.  Financial markets could remain quite fragile, delaying the restoration of more normal credit flows.  As observed in the minutes of its most recent meeting, the FOMC has expressed a broad concern about the possibility of adverse interactions among weaker economic activity, stress in financial markets, and credit constraints.

I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years.  This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets.  Moreover, greater slack in the economy should reduce pressure on prices and wages.  Despite high resource utilization over the past couple of years and periods of elevated headline inflation, labor cost increases have remained quite moderate, and inflation expectations remain reasonably well anchored.

Nonetheless, policymakers must remain very attentive to the outlook for inflation.  As I mentioned earlier, the recent uptick in core inflation may reflect some spillover of the higher costs of food, energy, and imports into core prices.  And the prices of crude oil and other commodities have moved up further in recent weeks.  A related concern is that inflation expectations might drift higher if the current rapid rates of headline inflation persist for longer than anticipated or if the recent easing in monetary policy is misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation over the medium run.  Persistent elevated inflation would undermine the performance of the economy over time.

Conclusion
These have been difficult times for the U.S. economy.  The correction of excesses in sectors of the economy and financial markets has spilled over more broadly.  Growth has slowed, and unemployment has increased; both borrowers and lenders are facing problems, and the functioning of the financial markets has been disrupted.  At the same time, inflation has risen.  I believe we will see a return to stronger growth, lower unemployment, lower inflation and improved flows in financial markets, but it probably will take a little while.  And adverse risks to this most likely scenario abound:  Uncertainty could trigger an even greater withdrawal from risk-taking by households, businesses, and investors, resulting in more pronounced and prolonged economic weakness; events beyond our borders could continue to put upward pressure on inflation rates.

But we should not lose sight of some fundamental strengths of our economy.  Our markets have proven to be flexible and resilient, able to absorb shocks, and quick to adapt to changing circumstances.  Those markets reward entrepreneurship and risk-taking, and many people are looking for opportunities to buy distressed assets and restructure and strengthen businesses to take advantage of the economic rebound that will occur.  Monetary policy has proven itself, under a wide variety of circumstances, very effective in recent decades in damping inflation when needed and in stimulating demand and activity when that has been appropriate.  Our job at the Federal Reserve is to put in place those policies that will promote both price stability and growth over time.  We have the tools.  As Chairman Bernanke often emphasizes: We will do what is needed.