WASHINGTON (MNI) – The following are 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.”

Recent Developments

After declining for a year and a half, economic activity bottomed
out in the middle of last year and subsequently turned up. A number of
factors have fostered the recovery. The steps taken in the United States
and abroad to stabilize financial markets and end the panic so evident
in late 2008 and early 2009 helped steady the economy. In addition,
extraordinary monetary and fiscal stimulus, both here and around the
world, have supported the upturn. These actions helped the financial
markets to turn around, and they set the stage for recovery in
combination with reductions in the inventory overhangs of houses and a
broad range of other goods. Real gross domestic product (GDP) expanded
at an annual rate of about 4 percent in the second half of last year.
The gain was especially large in the last quarter of 2009, although a
sizable chunk of that increase reflected a marked slowing in the pace of
inventory liquidation. The most recent data on spending and production
from the first few months of this year have been encouraging and suggest
that the recovery remains on track. I expect the expansion to be
sustained by continued increases in private final demand, even as the
temporary boost from inventories passes and the contribution of fiscal
stimulus to growth likely wanes later this year.

On the positive side, consumer spending has been expanding at a
solid pace, supported by low interest rates, improving household wealth,
recovering confidence, and fiscal stimulus. Business outlays for
equipment and software appear to be rebounding appreciably, consistent
with improved financial conditions and business sentiment.

Exports are another bright spot. International trade tends to be
highly sensitive to the business cycle, and foreign demand for U.S.
products fell sharply during the global slump. But with economic
conditions improving abroad, export volumes have rebounded since the
middle of last year. At the same time, however, a sizable increase in
imports has accompanied the upturn in our economy, and the effect of
exports and imports on GDP growth has been roughly offsetting.

On the negative side, some sectors of the economy remain quite
weak. Home sales, which seemed for a time last year to be starting to
slowly recover, have stalled recently, and housing starts are only a
little above last year’s low. Moreover, nonresidential building
continues to contract amid rising vacancy rates, plunging property
prices, and strained financing conditions. And, as I’m sure you are only
too aware, difficult fiscal conditions have restrained spending by state
and local governments. The latest data on employment and construction
suggest that spending by state and local governments has continued to
decline this year.

Signs of recovery are just beginning to emerge in the labor market.
Private payrolls appear to have bottomed out earlier this year and to
have posted a noticeable increase in March, and the unemployment rate is
down a bit from its recent high. Despite that good news, the labor
market remains extremely weak. Businesses, facing considerable
uncertainty and under pressure from weak sales and tight financial
conditions, have been reluctant to hire even though output has begun to
recover and instead have found ways to boost worker efficiency. Indeed,
output per hour in the nonfarm business sector is reported to have risen
almost 6 percent during 2009. But such outsized productivity gains are
not likely to continue. If labor productivity growth slows to a more
normal rate of increase, then further increases in demand and production
should lead to additional increases in hiring. However, if economic
growth remains moderate, as I anticipate, employment gains are likely to
lower the unemployment rate only slowly.

An ongoing concern in this recovery is whether unemployed workers
may experience unusual difficulties in re-entering the workforce. The
duration of unemployment has been exceptionally long in this business
cycle, a development that could erode worker skills and decrease
re-employment probabilities. In addition, it may take some time for
those who are unemployed to move or retrain for the new jobs that the
recovery will bring. For these and other reasons, part of the increase
in unemployment over the past two years may be structural, and this part
would tend to reverse only slowly.

Even if a portion of the rise in unemployment is structural,
however, most appears to be cyclical, suggesting that the economy is
operating well below its productive potential. This conclusion is
supported by other measures of slack, such as capacity utilization in
manufacturing, and by the ongoing deceleration in wages and prices.

Although headline consumer price inflation has been boosted in
recent quarters by an increase in energy prices, a substantial
deceleration has been observed in measures of prices that exclude such
volatile elements. For example, the price index for personal consumption
expenditures (PCE) excluding food and energy rose 1.3 percent over the
12 months to February, down 1/2 percentage point from a year earlier and
down more than a full percentage point from the start of the recession
in late 2007. Other measures of underlying inflation trends also show
substantial deceleration; for example, the Federal Reserve Bank of
Dallas’s trimmed mean measure of PCE inflation, which excludes the most
extreme price changes in a month, was only 1.0 percent in the 12 months
to February, compared with 2.4 percent in the preceding 12-month period.

Labor costs have also decelerated. The employment cost index–a
broad measure of wage and benefit costs in private industry–rose only
1.2 percent in the 12 months to December after hovering around 3 to 4
percent for most of the preceding two decades. Other measures of labor
compensation show comparable slowdowns and, when coupled with the
acceleration in productivity, imply the largest four-quarter drop in
unit labor costs in decades. This development also should work to
restrain price inflation.

The Shape of the Recovery

Often in the past, very steep recessions, such as the one we have
been through, are followed by sharp recoveries. As I noted at the
beginning of my talk, I don’t expect that outcome this time; instead, I
think the most likely scenario is a gradual pickup in economic activity
as the forces that got us into this difficult situation slowly fade
away. First, although financial conditions are improving and capital
markets are open for larger firms, credit remains unusually tight for
many borrowers, especially consumers and smaller businesses that are
dependent on banks. Banks are still rebuilding their capital, and their
lending will be held back as they work through the embedded losses in
their portfolios, particularly for consumer and commercial real estate
loans. Beyond this challenge, some securitization markets are still
impaired.

As the economy improves and credit losses become easier to
estimate, banks should be able to build capital from earnings and
outside investors, and they will have greater confidence in the
prospective profitability of lending. They will become more able and
willing to compete for new business–in effect, allowing low market
interest rates to pass through to more borrowers. These developments
will induce more borrowing and spending, further improving the economy,
but this process will take time.

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

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