Fed Sees a Weak Economic Recovery

The speech on October 5th on the US outlook by Bill Dudley the President of the New York Federal Reserve is well worth reading. He is essentially making the case that the US economic recovery in 2010 is going to be sub-par and that deflation rather than inflation is going to be the more likely near-term risk to the US economy. It is clear from his speech that he sees no reason for the Fed to be in any hurry to start raising interest rates.

If Bill Dudley and I are right, the mid-term elections will not be easy for the Administration next year. My view is that unemployment is going to dominate the mid- term elections and that unemployment will be above 10 percent in November 2010, which will be awkward for an Administration that promised to create 3 million jobs.

Bill Dudley cites the following three major reasons for expecting that the recovery will be weak:

(a) Households are unlikely to have fully adjusted to the net wealth shock that has been generated by the housing price decline and the weakness in share prices. This means that they will try to increase savings, which will constrain any consumption growth.

(b) The fiscal stimulus that is currently providing support to economic activity is temporary rather than permanent. This means that the positive impulse from fiscal stimulus will abate over the next year

(c) The banking system has still not fully recovered. Bank credit losses lag the business cycle and are still climbing. Thus, while banks’ access to the capital markets has sharply improved, banks are still capital constrained and hesitant to expand their lending. Most importantly, some significant classes of borrowers—namely commercial real estate and small business—are almost wholly dependent on the banking sector for funds, and those funds are not easily forthcoming.

It is clear from Bill Dudley’s speech that the Fed is highly concerned about the impact that further declines in the commercial property market might have on the banking system. He notes that the decline in commercial real estate valuations has created a significant amount of “rollover risk” when commercial real estate loans and mortgages mature and need to be refinanced. This means that more pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures.

Bill Dudley also highlights the problems for small and medium sized businesses. In this context he notes the following three points:

(a) The fundamentals of their businesses have often deteriorated because of the length and severity of the recession making many less creditworthy;

(b) Some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards;

(c) Small businesses have few alternative sources of funds

On the issue of inflation, he argues that “the current balance of risks around the inflation outlook lie to the downside due to the very low level of resource utilization and the fact that long-run inflation expectations remain stable. This balance of risks is problematic because the current level of inflation is already so low—the core PCE (personal consumption expenditures) deflator has increased only 1.3 percent over the past 12 months. Thus, we would not need much of a decline in inflation to run the risk of an outright deflation.