Rosengren: Economic shocks happen but certain factors makes it worse

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Financial disruptions have and will continue to happen over the course of time, but there are certain variables that make these shocks even worse, according to Eric S. Rosengren, president of the Federal Reserve Bank of Boston.

Rosengren said there needs to be more attention paid to the “seriousness of outcomes in recessions,” that are then compounded if there is no action taken against “emerging imbalances.”

“I would reiterate that shocks happen, but certain factors make them worse and while the monetary and fiscal policy response in the United States has been an important economic mitigant to problems generated by the pandemic since the onset this spring, excessive risk-taking during the previous recovery period is, unfortunately, likely to prolong the country’s economic distress — especially for those most disproportionately affected,” he said.

“Easy monetary policy requires more guardrails protecting against rising financial instability risks," said Eric Rosengren, president of the Federal Reserve Bank of Boston.

He gave the same remarks at two events on Tuesday, the UBS European Virtual Conference 2020 and the Annual Robert Glauber Lecture hosted by the Mossavar-Rahmani Center for Business & Government at Harvard University’s Kennedy School of Government.

“Financial factors, including excessive leverage, can influence how severe the consequences of a shock will be, and how painful a recession becomes,” Rosengren said. “Imbalances in the real economy and financial factors accelerating recession dynamics can make the effects of a shock and the severity of a recession much worse. The excessive risk-taking of some firms in the consumer discretionary sector and imbalances in the household and financial sector have often been problematic, as well — particularly in the Financial Crisis and Great Recession.”

He added that these have policy implications, as in both Europe and Asia, “many countries have a governance structure able to focus on the financial stability imbalances that are occurring in their economies, and those countries have tools to try to prevent the buildup of excessive risk.”

He said no such structure or tools are available in the U.S.

"This is a problem, both now and for future economic downturns,” he said. “With many central banks focused on keeping interest rates low for an extended period to achieve their mandates — for example in the last recovery — it is particularly important to watch for reaching-for-yield behavior and excessive risk-taking. Easy monetary policy requires more guardrails protecting against rising financial stability risks. Without financial stability governance and tools, recessions have the potential to be more severe and fall disproportionately on those that can least afford it. And the recessions are likely to be deeper and longer, requiring more fiscal and monetary stimulus than would otherwise be necessary.”

One of his takeaways from his speech, talks about the impact of these risks, tends to have the biggest effect on workers who are “least able to adjust and adapt.”

“Workers who are women and minorities may not only be disproportionately impacted by excessive risk-taking by defaulted firms, they are more likely to leave the workforce altogether,” he said. “Those segments of the labor market most affected by amplified business cycles — when financial stability ‘guardrails’ are limited — can be populated by those workers who are most vulnerable and least able to adapt to the changed economic environment. That imbalanced human toll is a bad outcome for democracy as well as the economy.”

The COVID-19 pandemic has had a longer lasting effect in economies that “disproportionately involve services, which tend to require more personal interaction than the production and sale of goods,” he noted.

“This is because service activities proved to be more affected by the need to social distance,” Rosengren said. “In the U.S., consumption of goods now exceeds what was consumed at the beginning of the year, while services consumption remains depressed. Americans have continued remodeling houses and buying durable goods, but things like traveling and recreational activities outside of the home are taking place at a lower rate.”

Rosengren added that now is a time to work on preventing the buildup of imbalances financially, as a greater number of central banks worldwide are thinking about changing their responses to shocks.

“In the U.S., that implies more reluctance to raise interest rates until full employment and 2% inflation are achieved,” he said, noting that he supports these goals but they should be “accompanied by a more proactive supervisory and financial stability focus.”

“Easy monetary policy requires more guardrails protecting against rising financial instability risks,” he said. “Without financial stability governance and tools, recessions have the potential to be more severe and fall disproportionately on those that can least afford it. And the recessions are likely to be deeper and longer, requiring more fiscal and monetary stimulus than would otherwise be necessary.

“Instead of pushing the unemployment rate below its natural rate, the focus should be on avoiding the subsequent large spikes of unemployment and slow recovery that occur when the downturn is made worse by a lead-up that involves excessive risk-taking and the associated imbalances, both real and financial.”

Small business optimism
Small business optimism “remained steady” in October, as there is even more uncertainty among small business owners, according to the National Federation of Independent Business.

The group's index stayed steady at 104.0 in October from September.

“Leading up to the presidential election, small businesses continued to focus on stabilizing their businesses but were uncertain about the future economic conditions due to COVID-19 government regulations on all levels,” said Bill Dunkelberg, chief economist for the NFIB. “We see solid momentum going into the 4thquarter, and another good quarter could get the GDP back to its 2019 closing levels.”

Four out of the 10 index components gained in the month, while five components moved backwards and one was unchanged.

The uncertainty index climbed to 98, the highest reading in four years.

"The small business optimism index was unchanged and just below the consensus forecast of 104.1,” said Scott Anderson, chief economist at Bank of the West. “Despite stalling, small business optimism is well above the 2020 low of 90.9 in April and the six-month average of 100.3.”

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Eric Rosengren Federal Reserve Bank of Boston Economic indicators Monetary policy
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