WASHINGTON (MNI) – The following are excerpts from a speech by
Cleveland Federal Reserve President Sandra Pianalto Thursday to the
Rotary Club of Lexington, Kentucky:

State of the Economy

Let me begin with my assessment of current economic conditions and
my outlook for the next couple of years. Since I’m here in Lexington, I
could say that watching the economy recover has been like watching your
favorite horse run on a sloppy track-you know she’s going to turn in a
poor performance, and you just hope she doesn’t get injured. It is an
understatement to say that we live in challenging times. The recovery
from the recent financial and economic crisis has been frustratingly
slow. The economy has been recovering for more than two years now, but
times continue to be tough for businesses and households alike.

The United States has not experienced many serious financial crises
in the past century, so there is not much in our national memory about
how deep and painful the recessions that follow financial crises can be.
The Great Depression of the 1930s serves as the most relevant episode in
memory. The financial crisis of 2007 to 2008 had the potential to lead
to another depression of that scale, so we can take some comfort in the
knowledge that we avoided a repetition.

Unfortunately, we did not avoid a steep downturn and a slow
recovery from the bottom. We lost almost 9 million jobs in the
recession and have only gained back just over 1 million jobs in the
recovery so far. The unemployment rate stands at 9 percent, and millions
of people who want full-time work cannot find it. Even more troubling
is that many unemployed individuals are experiencing long periods of
joblessness. About 40 percent of the unemployed have been out of work
for more than six months, and this statistic does not include the
substantial number of individuals who have simply left the labor market.
The average duration of unemployment today is about 40 weeks. This is
double the previous high of 20 weeks, which occurred in 1984 following
the 1982 recession.[i]

Some people think that the recession has impaired our labor markets
and that we must accept permanently higher unemployment rates – that is,
that we have seen a rise in structural unemployment. I can understand
why employment in home building, for example, will not return to
pre-recession levels for a very long time. And it is true that some
skill sets of the unemployed no longer match well to those skills that
employers are looking for right now. Importantly, this structural
unemployment view implies that neither the actions of unemployed workers
nor economic policies can be expected to reduce the unemployment rate.

However, U.S. economic history does not support this explanation.
Based on research from my staff, the most important reason for our high
unemployment rates is the very low level of demand for goods and
services in our economy. There is a strong and steady relationship
between economic growth and employment patterns going back to the 1950s.
That relationship shows that our meager employment gains are entirely
consistent with the weak level of growth we have seen.[ii] In other
words, these higher rates of unemployment are predominantly cyclical in
nature. As such, I think unemployment can be reduced through economic
policies designed to support stronger economic growth. I will have more
to say on this topic later, when I discuss monetary policy.

So, the labor market will not improve until the economy grows
faster. Typically our economy needs to grow at a rate of 2 percent just
to accommodate new entrants to the workforce. Unfortunately, my current
outlook anticipates growth that is not much better than that. I am
expecting the economy to grow around 2 percent in 2012, and about 3
percent in 2013. At these rates, I expect it will take quite a few
years for the unemployment rate to fall back to a more normal level of
around 6 percent.

Our economy isn’t growing faster because a number of headwinds are
holding back growth. The government sector has been reducing spending
and employment. Housing markets continue to be depressed. Add to the
mix that Europe could well be headed for recession, which will
negatively affect exports.

Uncertainty also plays a key role in holding back growth. I spend
a lot of time talking with business leaders. Almost without exception,
they tell me that uncertainty is making them more cautious. There are
uncertainties regarding the resolution of federal, state, and local
budget problems, which will translate into tax and spending issues.
Then there are also regulatory uncertainties: healthcare, environmental,
and financial reform, to name just a few.

Uncertainty is clearly an important factor, but businesses leaders
tell me that weak demand is the primary reason they are not hiring new
workers or expanding their businesses. Consumer spending on goods and
services has accounted for about 70 percent of the nation’s GDP during
the past few years. Consequently, the spending pattern of households is
critical to overall economic performance. So let me turn to the
condition of U.S. households.

…

Monetary Policy

Let me take us down the home stretch and share my views on monetary
policy. Laws governing the Federal Reserve require us to promote low
inflation and low unemployment over time. These objectives are more
formally referred to as our dual mandate for price stability and maximum
employment. During the financial crisis, the Federal Reserve took
unprecedented steps to avoid another Great Depression, and we have
continued to act aggressively to promote economic growth while
maintaining price stability.

Our highly accommodative policy is designed to help lower interest
rates for consumers and businesses to encourage new borrowing, to help
facilitate the refinancing of loans, and to reduce the interest costs
associated with variable-rate loans. It is an important reason why
mortgage rates are near historic lows. These and other interest rates,
which are far lower than typical, have played a critical role in
lowering consumer debt service levels. Our policy is appropriate in
this economic environment; it is supporting a stronger recovery while
ensuring that inflation remains consistent with our mandate.

Monetary policy is well suited for controlling the average
inflation rate over the medium to longer run.Inflation has averaged
about 2 percent over the last three years, right in line with my
definition of price stability.My inflation outlook is for inflation to
remain around 2 percent for the next few years as well.Two key factors
support that view: labor costs have been moderate and productivity
growth has been solid.

While inflation has been running slightly above 3 percent this year
as a result of higher commodity and energy prices, inflation was well
below 2 percent the prior two years. I expect this year’s higher
inflation rate to be temporary, and in fact, I am already seeing signs
that energy and other commodity price pressures are abating. I’m not the
only one with this view. The inflation expectations of financial market
participants, who stand to lose real money, remain at or below 2 percent
well into the future.

In contrast with inflation, trends in employment over the medium
and longer term are not predominantly a monetary phenomenon. They are
subject to other forces, including demographics, productivity, and
technology. As I’ve already mentioned, unemployment remains stubbornly
high. I think it could take a quite a few years for the unemployment
rate to fall to the neighborhood of 6 percent, which corresponds with my
current estimate of what we will see when the economy attains a state
of maximum sustainable employment growth. It would be great if we could
attain this outcome sooner, but I don’t expect overall economic growth
to be strong enough to pull the unemployment rate down faster for the
reasons I have already explained.

Conclusion

In closing, it should be clear from my remarks that policymakers,
including those of us at the Federal Reserve, are dealing with an
economy that is struggling to recover from a recession that was far from
ordinary. We have suffered severe losses in wealth, output, and jobs.
Households have been stressed and are doing what they can to improve
their balance sheets by paying down debt and saving more. While this is
a positive development in the long run, it does restrain growth in the
short run.

Monetary policy must do its part, and has been doing its part, to
spur the pace of growth while staying consistent with our mandate for
price stability. But in this economy, monetary policy alone cannot cure
all of the economy’s ills. Federal Reserve actions to lower interest
rates are supporting the recovery, but the usual impact of our policies
has been somewhat blunted. Lower interest rates have benefited many
households, but the financial crisis was so large and so pervasive that
far fewer households than usual have been able to take advantage of the
lower interest rates.

Beyond monetary policy, our economy would benefit from policies
that help distressed households and from policies that give businesses
greater clarity about taxes and regulations.

I’m confident that by working together we can get our economy back
on track.

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

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