NEW YORK – Economic recovery has been slow and still faces threats, yet the key to reaching a balanced and sustained recovery may be making “difficult, but necessary, adjustments,” according to Federal Reserve Bank of Kansas City President and Chief Executive Officer Esther L. George.
Calling the current situation “challenging and uncertain,” George noted “monetary policymakers find themselves in uncharted waters,” and must “weigh the potential costs and benefits of future actions.”
Current economic performance reflects “the problems that led to the financial crisis,” George told the Central Exchange, according to prepared text released by the Fed. The “crisis did not suddenly materialize. Its roots grew over time, in seemingly benign spurts, as consumers, financial institutions and much of the economy took on unsustainable amounts of debt,” she said.
Recovery “has been uneven and underwhelming,” George said. “With moderate economic growth have come modest job growth and a too-high unemployment rate, in addition to lingering doubts about whether the recovery is sustainable.”
Some of the bumps can be attributed to “temporary factors,” such as oil price spikes and natural disasters. “I take some solace in the resilient nature of the economy and its ability to sustain an even modest pace of growth,” she said.
“However, temporary factors explain only part of the slow recovery,” George continued. “A considerable drag on the recovery remains the consequences of the buildup in leverage leading to the financial crisis.”
And, of course, the housing market reflects this. “Recently, the housing market has shown some signs of stabilization, but activity remains very weak.” The decline in home prices forced homeowners carrying too much mortgage debt relative to their incomes, to start deleveraging through paying down debt or through default.
And home equity lending, which had fed consumer spending was no longer an option. “A less-than-healthy financial sector limits the strength of the recovery,” she said.
While banks’ net income have risen since 2009, “this improvement mostly is related to a reduction in loan loss provisions—banks are putting away less money in anticipation of fewer problem loans.”
Banks still have problem loans to deal with. “Unfortunately, there are no quick or simple solutions to these problems,” George noted. “As is historically common in the aftermath of a financial crisis, the recovery takes time, and while there is some progress, it is frustratingly slow. All of this suggests a moderate recovery remains the most likely outlook, depending on developments in Europe and Asia’s economies, as well as U.S. fiscal policies that have yet to be defined.”
Additionally, monetary policymakers continue to face “considerable” challenges. “Traditional monetary policy tools have been exhausted, and unconventional tools are now in play. As policymakers consider additional options and possible actions, it is necessary to appropriately weigh their costs and benefits. For example, how can policy enable and encourage the financial system to undertake prudent risk-taking that has been temporarily suppressed by the recession and slow recovery while preventing the recurrence of poorly allocated resources and mispriced risk that contributed so significantly to this most recent crisis?”
Any attempt to hasten housing and labor market recovery may seem attractive, however, any efforts “must be traded off against the need to foster long-term stability within our financial sector.”
While adding risk “is fundamental to banking and desirable in this environment, creating conditions that encourage the financial system to take on mispriced risk could lead to distortions that will only haunt us later.”
Avoiding mispricing of risk “is a tremendous challenge. Losses are few during good times, which can make adverse events seem unlikely and their risk difficult to estimate. … As a result, conservative bankers can be caught in the illusion of soundness and bank supervisors caught flat-footed.”
