By Steven K. Beckner

LEXINGTON, Va. (MNI) – Explaining why the Federal Reserve expects
the federal funds rate to stay near zero “for an extended period”
Thursday night, New York Federal Reserve Bank President William Dudley
said the economic recovery is apt to remain “quite muted” with no
obvious source of increased demand for goods and services.

Dudley, in remarks prepared for delivery at Washington and Lee
University, said the housing market seems to have “stalled,” said it
will be hard for consumption to speed up and said even business
investment is apt to be fairly sluggish. So he said it will be closed
only “very gradually.”

And he said inflation is likely to stay “quite low.”

Dudley also had comments on the U.S. dollar, remarking that it has
changed in value relatively little since the early 1990s despite the
dramatic widening of the U.S. current account deficit. Despite the size
of the deficit, he said it is “not precarious,” and he noted that low
interest rates “minimize” the cost of financing America’s external
debt.

Were the dollar to fall in value, Dudley said the negative impact
would be offset by an increase in the value of U.S. investment income
denominated in appreciating foreign currencies.

Dudley said “it now appears that a sustainable recovery is
underway.”

“However,” he added, “given the headwinds created by the collapse
of the U.S. real estate market and its consequent damage to the
financial system and household balance sheets, it seems unlikely that
the recovery will be as strong as we would desire.”

“As a result, the substantial amount of slack in productive
capacity that exists today will likely only be absorbed gradually,” he
said. “Consequently, trend inflation, at least over the near term,
should remain very low.”

“This is why the Federal Open Market Committee (FOMC) concluded at
its March meeting that ‘economic conditions, including low rates of
resource utilization, subdued inflation trends, and stable inflation
expectations, are likely to warrant exceptionally low levels of the
federal funds rate for an extended period,'” he said.

Dudley went on to say that he wanted to “explain in some detail the
logic underlying this expectation that economic conditions will warrant
exceptionally low levels of the federal funds rate for an extended
period.”

“This conclusion stems from the observation that the current
economic environment is qualitatively different from previous post-World
War II business cycles,” he said. “Most post-war recessions were
preceded by high rates of resource utilization and rising trend
inflation.”

“This prompted a tightening of monetary policy, which, in turn,
dampened interest-rate sensitive spending, particularly on housing and
consumer durable goods,” he continued. “Then, as underlying inflation
pressures subsided, monetary policy was eased and interest-rate
sensitive spending rebounded, often quite sharply.”

But Dudley said “the current business cycle is different in one key
respect. It was preceded by a global financial crisis. The financial
crisis was due, in large part, to excessive leverage and excessive
investment in real estate assets. It will take time to unwind these
excesses.”

Dudley said “an economic recovery requires that desired investment
must rise relative to saving,” and he said “this has happened recently
as fiscal stimulus and an inventory cycle have led to a fall in ex ante
saving relative to investment.”

“But for the recovery to strengthen further, this process must
continue,” he said. “There has to be a further demand impulse — be it a
decline in household saving rates, a rise in business investment
relative to profits, a further expansion of fiscal stimulus or an
improvement in the net trade balance via an increase in exports relative
to imports.”

Dudley said it is not obvious where this new demand impulse is
going to come from.

He reiterated that, thanks to “aggressive” monetary and fiscal
stimulus, “although the unemployment rate remains unacceptably high,
output has begun to expand again, and we appear to be on the verge of
seeing sustained growth in employment.”

However, he added a series of caveats.

“Although these are encouraging developments, I believe that the
recovery is likely to be quite muted compared with past recoveries…,”
he said. “For faster growth, we need ex ante investment to rise relative
to saving and ex ante spending to rise relative to the current trend of
income. But it is difficult to see where this impulse will come from in
the near term.”

He said it is “unlikely that we will experience this type of
strength” in consumer spending seen in past recoveries.

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