Fed Yellen on The Uncertain Economic Outlook and the Policy Responses

Speaking to the Forecasters Club in New York, the San Francisco Federal Reserve Bank President Janet L. Yellen said Wednesday that the Federal Reserve must continue to boldly use all available tools to fight a deepening recession, and warned that in terms of unemployment, the “worst of the contraction is not expected to occur until next year.” In addition, the San Francisco bank president, who is a voting member of the U.S. central bank’s policy-setting Federal Open Market Committee in 2009, stressed that “for some time to come, disinflation, and even deflation, will represent greater risks than inflation,” and predicted a sluggish economy for several more years. Here are some excerpts from Yellen’s speech.

After recognizing the fact that predicting the course of the economy has for sometimes now become an hazardous occupation, Fed Yellen said that her confidence in the expressed optimism of most professional forecasters – in terms of the economy beginning to grow again within the next several quarters – “is greatly diminished by the nearly unprecedented set of circumstances we face, circumstances that severely challenge our ability to use historical economic relationships to anticipate future developments.”
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“While there are good reasons to think the economy could begin to recover fairly soon, I’m far from confident,” she said, “and thus don’t want to press the case too strongly.” Indeed, in all humility, most of us have failed to anticipate the depth of this downturn and have had to mark down our forecasts repeatedly.

Yellen said an array of effective fiscal and monetary policy programs put in place by the government and the Federal Reserve are “the best hope for recovery.”

“We face an extraordinarily uncertain future, and our main hope for economic recovery lies in the sorts of innovative and aggressive economic policy responses that are being carried out by Federal Reserve and federal government policymakers.”

Yellen said she supports the Fed ‘s current broad approach of targeting a range of credit markets through a variety of programs and said the various Fed and Treasury roles, necessitated by today’s extreme circumstances, offer the prospect of “more normal” financial market functioning over the course of this year.

On the subject of deflation, Yellen cautioned that “With economic activity weakening, economic slack is likely to be substantial for several more years. We need to be sure that we avoid the kind of deflation that Japan experienced during its lost decade. While I don’t think such an outcome is likely, it should be on our list of concerns.”

Yellen said core inflation could remain below 1% for the next several years.

On the unemployment front: “The level of the unemployment rate would still rise throughout 2009 and into 2010,” she said. “So, in this sense, the worst of the recession is not expected to occur until next year. And, even by the end of 2011, I would expect the unemployment rate to be above its full-employment level. So I wouldn’t call this a particularly rosy scenario.”

In terms of the housing crisis, Yellen hesitated to call a bottom in the crash, saying that there is not yet any clear sign that the contraction in home building is near its end.

“The recent news that housing starts and permits had jumped in February provides a ray of hope, but it’s too soon to know if this is noise or a signal that the contraction will soon end. The ongoing decline in house prices poses significant downside risk to future consumer spending and the health of the financial system,” she added.

With regard to an exit strategy from the current unconventional policies, Yellen said a possibility is for Congress to give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. “Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet,” she said.

In concluding her speech Fed Yellen pointed out again the fact that we will continue to face serious challenges as we try to right the economy, and “the resumption of growth that we expect by the end of 2009 is far from assured.”

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