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Fed President Predicts a Long, Slow Recovery

Sandra Pianalto, the president of the Federal Reserve Bank of Cleveland, gave a speech explaining how she analyzes the economy and forecasting a long, slow recovery, given the unusually high unemployment rate and the massive numbers of long-term unemployed. In her highly dovish speech, she says she recognizes strong disinflationary, not inflationary, pressures and stresses the problem of joblessness. (The Fed’s inflation hawks tend to worry more about inflation than employment.)

Most interestingly, Pianalto argues that the analytical paradigm that led economists and policymakers to miss the credit and housing bubbles en masse remains in place — essentially saying that economics has not yet caught up with the economy and that her job remains an exercise in judgment and guesswork. Indeed, she says that the historically unprecedented financialization of the United States economy and the lack of data about the housing market before 1950 led to grave misconceptions about the economy at the time of the bubble:

The initial phase of the recession was moderate and heavily connected to slowing in the housing sector. Indeed, the second quarter of 2008 had many signs of a recovery, with GDP posting a surprising spurt of growth. As we all know too well, those positive signs were fleeting. Models were telling us that the recovery was beginning; after all, the average recession lasts less than three quarters. At the same time, discouraging financial market information kept coming in over the summer, which weighed against the sustainability of the recovery. In September, the financial crisis deepened sharply following the collapse of Lehman Brothers. Outlooks were repeatedly revised down as forecasters, both public and private, tried to catch up with financial markets.

What happened? As the decline in housing prices began to accelerate across the country, this exposed underlying cracks in the financial system. Foreclosures began to rise, loan losses mounted, and housing prices dropped even more, creating a downward spiral not seen since the 1930s.

This episode revealed three clear reasons why models became less useful and why the use of judgment has become so critical. First, as I mentioned earlier, economic data go back only as far as the 1950s, so our model could not take into account housing price declines and troubles in the banking sector that had not been experienced since the 1930s. Second, with hindsight it is clear that macroeconomic models do not adequately capture the financial intermediation that has come to characterize today’s financial system or how it affects the real economy. Third, the emergency measures that the Federal Reserve took during this crisis, such as near-zero short-term interest rates or the large increase in our balance sheet, were entirely unprecedented and not accommodated by our models. For these three reasons, we have had to monitor current events closely and continuously apply judgment to the forecasting process.

And she also warns against expecting a rebound anytime soon:

As we are all aware, we’re emerging from the deepest and longest recession since the Great Depression. Our models would tell us that the deeper the downturn in the economy, the more rapid the recovery. You’ve probably heard this referred to as a V-shaped recovery.

However, my outlook is that our journey out of this deep recession will be a slow one because we face two primary headwinds that I expect will temper growth for awhile. The first is the effect of prolonged unemployment, and the second is a heightened sense of caution on the part of consumers and businesspeople. Let me explain the power of these headwinds, beginning with prolonged unemployment.

Millions of people have lost their jobs during this recession, and while job loss is common to all recessions, this time around it has been more severe. Typically, during a recession, for each 1 percent that GDP falls, the unemployment rate ticks up by about seven-tenths of a percentage point. In this recession, GDP fell by 4 percent, so you would expect unemployment to rise by a little less than three percentage points. Unfortunately, it shot up by more than five percentage points, which means an extra one-and-a-half million people lost their jobs compared with our historical experience.

Just as critical is the length of time people are remaining out of work in this recession. About half of those who are currently unemployed have been out of work for at least six months, and the longer someone is out of work, the harder it is to find a job. In the 1982 recession, which was another severe recession, the average duration of unemployment peaked at 21 weeks, but today the average is already over 30 weeks—a record high. Research also tells us that workers lose valuable skills during long spells of unemployment, and that some jobs simply don’t return. So workers who are lucky enough to find jobs may be going to jobs that aren’t familiar to them, which means they and the companies they join may suffer some loss of productivity. Multiply this effect millions of times over, and it has the potential to dampen overall economic productivity for years.

The second powerful headwind in this recession is a heightened sense of caution, driven by a deep uncertainty about where the “new normal” or baseline might be. A whole generation of Americans who began their working careers in the mid-1980s had experienced only long periods of prosperity punctuated by just two very brief downturns. Those experiences encouraged an expectation for relatively smooth growth. Now everyone’s expectations have shifted as a result of this long and deep recession.

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