NEW YORK – The underlying cause of the recent recession, the drop in land prices, dictated a painful, challenging period regardless of any policy response, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Tuesday.
“We have come through a very difficult recession, caused in no little part by the large fall in land prices that took place after 2006,” Kocherlakota told the Wisconsin Bankers Association, according to prepared text released by the Fed. “I believe that the size of this shock meant that this recession was going to be a painful and challenging one, regardless of the policy response. Nonetheless, it is clear to me that the recession and its subsequent recovery would have been significantly worse in the absence of the actions of the Federal Reserve.”
But, he noted, 2011 will be an improvement over 2010 in economic terms. “However, we cannot celebrate too much,” Kocherlakota said, noting that while GDP growth may return to pre-recession levels, growth should probably be 8.6% higher in the fourth quarter of 2010 than it is, showing, “the recession has had and will continue to have a large and persistent impact on the U.S. economy.”
The Fed expects GDP growth of 3% to 3.6% this year, but that was before the December tax changes. “ I would say that I expect that real GDP growth will probably be closer to 3% than 4% in 2011,” Kocherlakota said. “I still see two major headwinds in the U.S. economy.”
The headwinds, he said, are consumers will try to rebuild their net worth and banks are less likely to risk lending to small firms or young people because the banks suffer from asset-quality issues.
“I believe that the decline in household net worth, precipitated by falls in land values, was a key factor in generating the severity of the Great Recession. It will remain important in the recovery,” he said.
Kocherlakota said there are more than 800 banks on the FDIC problem list, and they “are more likely to preserve capital ratios by limiting their asset growth and allocating their lending staff to working out loans to existing borrowers.”
The banks’ stance kept small business from expanding. “As a result, their demand for bank financing remained low,” he said. “In 2011, as the economy improves, I expect loan demand to rise accordingly—but banks with poor asset quality will continue to focus on capital preservation rather than loan expansion.”
The jobs market will not improve rapidly in 2011. “Startup businesses and other young firms are a key source of employment growth in the early stages of recoveries,” he said, but if bank financing is difficult to obtain, these jobs won’t be created.
The FOMC forecasts unemployment will remain above 9% in 2011. “I would agree with those forecasts,” Kocherlakota said. “Even more troublingly, I expect too that unemployment is likely to be higher than 8% as late as the end of 2012.”
Inflation, he said, “remains extraordinarily low. ... too low to be consistent with usual formulations of the Fed’s price stability mandate. More troublingly, inflation continued to trend downward in 2010.” Kocherlakota sees inflation rising to between 1.5% and 2% in 2011.
