The deep recession that ended in June 2009 has been followed by a very tepid recovery. Economic activity has grown-but only slowly from levels far below the productive capacity of the economy. With demand growth barely keeping pace with firms' ability to increase productivity, job creation has been too weak to significantly reduce unemployment. And, as is typical in such circumstances, the rate of inflation has declined.
Viewed through the lens of the Federal Reserve's dual mandate-the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually, it will likely be several years before employment and inflation return to levels consistent with the Fed's dual mandate.
There is no question that credit conditions are still tight. Financial institutions have tightened underwriting standards and a decline in property prices has cut collateral values and made the refinancing of many residential and commercial mortgages difficult.
But overall, the situation is one in which credit availability is slowly improving. The most recent data indicate that virtually no banks are tightening standards, and a number of banks have begun to relax credit terms.
Still, the decline in collateral values remains a significant impediment. Housing prices have declined so far that nearly one quarter of homes are now worth less than the value of the mortgages that finance the them. Lacking sufficient collateral value, such homeowners cannot take advantage of the fact that conforming mortgage rates are at their lowest level in history and refinance. So what could the Fed do? First, we could take steps to make our current stance of monetary policy more effective in stimulating economic activity by providing additional guidance about what we are trying to achieve today and in the future.
Communicating clearly our intention to return inflation to more normal levels can help keep inflation expectations well anchored around levels consistent with our inflation goals. The Fed alone can control inflation-if not precisely in the short run, then over the medium term. By clarifying our intentions, we can reduce the risk of further disinflation-or even an outright debt-deflation spiral that would make it still more difficult to accomplish the necessary balance-sheet adjustments.
The Fed has a second set of tools, namely the ability to expand its balance sheet either by purchasing medium and long-term Treasuries or agency mortgage-backed securities. Such purchases will pull down the level of long-term interest rates by removing duration from private-sector hands, who respond by purchasing other long-dated assets.
Some simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point. I am very mindful of concerns here and abroad that balance sheet expansion could be interpreted as a policy of monetizing the federal debt. I regard this view to be fundamentally mistaken. It misses the point of what would be motivating the Federal Reserve. The Federal Open Market Committee would only engage in large-scale asset purchases in order to push the economy more rapidly toward full employment and price stability. Once these goals were accomplished, there would be no basis for further purchases regardless of the government's fiscal position.
In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice.
The current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. The longer this situation prevails, the greater the likelihood that a further shock could push us still further to outright deflation. We have the tools to provide additional stimulus at costs that do not appear to be prohibitive. Further action is likely to be warranted unless the economic outlook evolves in a way that we will see better outcomes before too long.