WASHINGTON (MNI) – The following is the second part of excerpts
from the speech Thursday by Fed Vice Chairman Donald Kohn, focusing on
his outlook for the U.S. economy. He says he expects economic growth to
remain moderate and that the unemployment rate will drop slowly as a
result. Looking ahead, however, he said the U.S. economy should emerge
from this episode stronger, more resilient, and on a more sustainable
growth path than before the recession. “In addition, housing is almost
certainly going to be a smaller part of the economy than it was when lax
credit standards encouraged overbuilding and overborrowing.”

Second, I do not expect that the recovery in housing construction
will boost growth substantially this year, in contrast to its usual
pattern early in economic recoveries. A large overhang of vacant homes
is likely to weigh on new construction for some time, even though
residential construction activity has declined dramatically since its
peak in 2005 and inventories of unsold new homes have fallen to very low
levels. In addition, the pace of foreclosures is likely to remain
elevated for a while, adding to the stock of homes for sale. On the
positive side,housing affordability is quite favorable, in part
reflecting low mortgage rates, and house prices appear to be
stabilizing. Still, problems persist in housing, and I anticipate a
relatively subdued pickup in housing starts over the coming year.

Third, households need to continue rebuilding wealth. They became
too indebted and too dependent on housing wealth to finance current
purchases and provide for future events like the education of their
children and their retirement. Now they need to repay debt and save more
out of current income. In addition, restraints on consumer credit
continue to hold down spending, and high unemployment and uncertainty
have weighed on consumer confidence.

Again, these constraints will fade as consumers adjust to the
shocks they have been dealt. Indeed, the effects on spending of past
reductions in wealth are receding, and household net worth is rising
again. And as employment continues to pick up, income will rise more
rapidly and households will presumably become more confident about the
future–and thus more willing to spend. But they are unlikely to return
to the spending patterns of old, and we cannot expect outsized gains in
consumer outlays to provide an extra push to the economic expansion.

Last, business investment spending has been depressed by a weak and
uncertain sales outlook, tight credit conditions, and significant unused
capacity. However, signs are growing that confidence is returning as the
outlook for sales brightens and bond spreads narrow. Moreover, spending
on equipment and software is likely getting a boost from replacement
demand. Gross investment in equipment and software has fallen so low
that it is not even covering estimated depreciation, meaning that
further spending increases are needed just to prevent the capital stock
from continuing to shrink, let alone to foster a modest expansion of the
capital stock as the recovery proceeds. So this sector has the potential
to be a source of strength for the economy.

With only a moderate recovery likely on tap, I expect unemployment
to come down only slowly from its currently elevated level. Although the
persistent high level of unemployment will tend to restrain inflation
further, the effect of resource slack on inflation does not appear to be
as great as some previous episodes might have led us to expect. The
difference is that inflation expectations now appear to be much more
firmly anchored than they once were, probably reflecting the extended
period of low inflation that we have experienced and a credible monetary
policy directed at sustaining this performance. I anticipate that
inflation will remain low for a while, with core PCE inflation not
likely to fall much further from the subdued pace I cited a few minutes
ago.

Longer-Run Rebalancing

The U.S. economy should emerge from this episode stronger, more
resilient, and on a more sustainable growth path than before the
recession. This outcome will entail a gradual longrun shift in both the
composition and financing of aggregate spending. In particular, as I
already noted, consumers probably will save more than in the past,
reflecting the likelihood that household net worth will be lower
relative to income than it was over the past decade or so and that
credit, appropriately, will be somewhat less available than during the
boom. In addition, housing is almost certainly going to be a smaller
part of the economy than it was when lax credit standards encouraged
overbuilding and overborrowing. Increased private saving and reduced
demand for housing should prompt movements in relative prices and other
factors that will, in turn, make room for a larger role for business
investment and net exports in overall economic activity. In addition,
households that have worked down debt levels will be less vulnerable and
better able to withstand shocks in the future.

As I have been emphasizing, the transition to full employment and
the emergence of this new configuration of spending and production, and
borrowing and saving, will take time. This rebalancing involves repairs
to balance sheets, the movement of capital and labor across sectors of
the economy, and shifts in the global pattern of production and
consumption–adjustments that are likely to be gradual under any
conditions. Moreover, the re-equilibration may be slower than might
otherwise be the case because tight credit will limit the ability of
some households and firms to make the necessary adjustments.

Government policies will be essential to supporting the smooth
transition to moresustainable economic growth with greater investment
and exports. We must ensure that changes in taxation and regulation do
not blunt incentives for business investment. In addition, although
fiscal policy has provided important support for the economic recovery,
it will need to be put on a more sustainable path in the medium term.
Failure to do so risks a market reaction that could increase longer-term
interest rates; economic growth would be hindered if government
borrowing boosts the cost of capital and diverts resources away from
private investment.

Reducing the deficit and avoiding a continuing buildup in
government debt relative to income will be essential for bringing
national production and spending into better balance. That balance, in
turn, is necessary so that we are no longer so reliant on borrowing from
other nations. Heavy dependence on foreign borrowing by the United
States is not a solid foundation for longterm economic growth either
here or in those countries extending us credit. The actions of U.S.
authorities and private parties to bring about a better balance of
saving and investment must be matched by action overseas in chronic
surplus countries. While we reduce demand relative to our productive
potential, the surplus countries must increase their domestic demand if
the global economy is to thrive.

Finally, as has been so painfully demonstrated over the past few
years, sustained growth requires a financial system that is much more
resilient and thus better equipped to continue to supply funds to
creditworthy borrowers when the unexpected happens. To this end, banks
and other lenders must hold capital and liquidity to cover more of the
risks they are taking, and they must have the capability to know what
those risks are and to manage them effectively. Critically, the
financial regulatory structure needs to be modernized to bring oversight
and market discipline to bear much more effectively on our rapidly
evolving financial system and to give regulators more tools to deal with
problems as they arise. At the Federal Reserve, we are improving our
supervision and regulation to incorporate a broader view of emerging
risks in the financial system and to become more effective at
translating identified risks to supervisory oversight and, if required,
remedial actions by the banks.

(2 of 2)

** Market News International Washington Bureau: 202-371-2121 **

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