The president of the Federal Reserve Bank of Philadelphia expects the economy to slowly start recovering in the second half of 2009 and inflation to remain below 2 percent over the next year.
In a speech Wednesday at the University of Delaware, Charles Plosser also said that the unemployment rate probably won't drop anytime soon, but that he doesn't expect it to rise to double digits, as it did during the recession of the early 1980s.
"I expect the housing sector will finally hit bottom in 2009 and the financial markets will gradually return to some semblance of normalcy," said Plosser, adding that the current recession could be one of the longest in the post-World War II era.
At the same time, Plosser warned that the Fed's unprecedented decisions to reduce the target federal funds rate close to zero and provide new lending facilities in an effort to stabilize troubled financial markets pose a number of challenges for the central bank.
"Since we are in uncharted territory, I believe we must proceed with some caution," he said. "While the lending programs are designed to improve the flow of credit, they are currently injecting enormous amounts of liquidity into the economy. I believe we need to monitor that liquidity and its composition closely so that we are able to withdraw it when the time comes or else we risk fueling inflation in the future."
Plosser said the Federal Reserve's creative actions to stabilize the economy pose potential risks to the central bank's independence, and that it needs to have an exit strategy from its lending facilities.
"We must consider the possibility that our presence in these credit markets will deter private-sector participants from returning to and restoring these markets to health," he said. "To prevent our policies from having these perverse effects, we should consider gradual increases in the cost of borrowing from these facilities to discourage their use and encourage other participants to return to the markets."
Plosser noted that the mere establishment of the special lending programs has created what he described as "moral hazard."
"To the extent that market participants now feel more comfortable asking for central bank support when they get into trouble, they may be inclined to take on more risk than would otherwise be prudent — thus sowing the seeds for the next financial crisis," he warned.
"Clarifying the criteria under which we will intervene in markets or extend credit, including defining what constitutes the 'unusual and exigent' circumstances which form the legal basis for the Fed's nontraditional lending, will be essential if we are to mitigate the moral hazard we have created," Plosser said.