Indeed, in view of the scope and severity of the recent financial shock, the restraint on economic activity stemming from credit market headwinds could exceed the experience of the 1990s.

I would, however, be cautious about this conclusion, for several reasons. First, many 'initial conditions' prevailing prior to the current financial shock were perceptibly better than in the early 1990s...

Second, the policy response, including the Treasury program to purchase troubled assets from financial institutions and to inject capital into banking firms, as well as the extension of deposit insurance, is substantial and far-reaching...

The Treasury program, properly implemented, will improve capital positions and help to establish values for assets currently locked up...

I thought it might be useful to begin by giving you my perspective on where the economy stood prior to the recent intensification of financial turmoil. Overall economic activity--as measured by the growth of real gross domestic product (GDP)--held up surprisingly well over the first half of 2008 given the ongoing stresses in broader financial markets and the further rise in oil prices. At the same time, however, a number of disquieting signs lay underneath the surface of the aggregate growth figures.

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

(A)s a long-time student of banking and financial crises, I can attest that the current situation also has much in common with past experiences. As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume.

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The trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning.

Over the last year, Fed policymakers have acted to address both the escalating financial crisis and rising unemployment. But inflation has also been an important concern, since it has been running at unacceptably high levels. In recent months, however, the outlook for inflation has noticeably changed. Commodity prices, including the price of oil, have plunged. And I expect this development, along with a further increase in slack in labor and product markets, to push inflation down to, and possibly even below, rates that I consider consistent with price stability.

Growth in the fourth quarter appears to be weaker yet, with an outright contraction quite likely. Indeed, the U.S. economy appears to be in a recession. This is not a controversial view, since the latest Blue Chip consensus projects that there will be three consecutive quarters of contraction in real GDP starting last quarter.   

When markets are this volatile, I think it is unwise to guess the level of future economic activity, because the economy can take sudden turns in one direction or another. One way to cope with this uncertainty is to describe two possible paths for the economy. Along the first possible path, financial market turmoil has a dampening effect on output and employment, but these effects are mild in comparison with periods of weakness experienced by the U.S. economy since the 1970s. I will call this the benchmark scenario. Along a second possible path, financial market turmoil causes severe dislocation, which sends the economy into a prolonged downturn that matches or exceeds previous recession experiences. I will call this the downside risk scenario.

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It now appears that the economy may have slowed significantly in the third quarter. This slowing is associated not so much with financial market turmoil, but instead with the rapid run-up in energy and commodities prices during the spring and summer, along with increasing weakness in labor markets.

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The U.S. economy by the numbers looks like it is slowing. Many of the most recent events have injected tremendous uncertainty into the national outlook, but we have few hard numbers at this point that directly indicate the effect of that uncertainty. If financial market turmoil can be contained, possibly through aggressive government policy, then a relatively benign outcome is possible in which U.S. economic performance is sluggish but does not involve a protracted downturn.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

In view of what we have seen at some large financial institutions and in some funding markets, the need to address TBTF through a framework which reduces spillovers is critical, and we propose systemic focused supervision as a constructive first step in this process...Given the headwinds associated with the financial shock, the economy appears likely to be restrained until these conditions improve, and that will take some time.

These are momentous steps, but they are being taken to address a problem of historic dimensions. In one respect, however, we are fortunate. We have learned from historical experience with severe financial crises that if government intervention comes only at a point at which many or most financial institutions are insolvent or nearly so, the costs of restoring the system are greatly increased. This is not the situation we face today. The Congress and the Administration chose to act at a moment of great stress, but one at which the great majority of financial institutions have sufficient capital and liquidity to return to their critical function of providing new credit for our economy.

A working financial sector matters to us all. Credit is the lifeblood of a modern economy. Illiquid credit markets mean illiquid banks and ultimately illiquid businesses. I don't need to explain to a room full of businesspeople what happens when credit dries up and a business becomes illiquid. Cash becomes king, efforts are made to accelerate inflows, and cash outlays are reduced. Managers focus on discretionary expenses, and then the biggest categories of cash outflows—salaries and investments. Jobs, and livelihoods, are at stake.

My sense is that the pace of growth in the U.S. economy over the second half of the year will be positive but slower than its pace over the first half of the year. Although recent developments suggest that headline inflation may moderate from its current levels, price pressures are elevated and several measures of inflation expectations are inconsistent with the medium-term projections of FOMC participants. A key challenge in the current environment is to navigate through substantial financial market turmoil without creating a new and difficult-to-solve inflation problem in its wake.
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Going forward, falling oil prices, if sustained, should help households and businesses cope with existing strains. In fact, given that the recent decline in oil prices has probably exceeded the near-term assumptions of most forecasters, it is conceivable that economic growth over the second half of the year may turn out to be moderately stronger than the consensus expects.

A key concern is that the current level of the federal funds target rate, at 2 percent, is well below the current rate of overall inflation. This means that the real cost of borrowing short-term is negative. In other words, the FOMC’s interest rate target is unusually low. Over time we will need to adjust this rate to a level that is more conducive to long-run price stability and maximum sustainable employment.
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The near-term outlook for economic growth and inflation is above all uncertain. Two keys to future economic performance will be stabilization in housing and financial markets. Financial market turmoil has recently been severe, and the consequences of this turmoil on real economic performance entail clear downside risk. If financial market turmoil can be contained, the FOMC can turn attention to achieving better inflation results than those recently experienced. Until inflation clearly moderates, my colleagues and I will need to be especially watchful that our accommodative policy stance does not begin to worsen the outlook for long-run price stability.

Since the beginning of the year, I have been worried about the efficacy of reducing the fed funds rate given the problems of liquidity and capital constraints afflicting the financial system. As I see it, the seizures and convulsions we have experienced in the debt and equity markets have been the consequences of a sustained orgy of excess and reckless behavior, not a too-tight monetary policy.

There is no nice way to say this, so I will be blunt: Our credit markets had contracted a hideous STD—a securitization transmitted disease—for which lowering the funds rate to negative real levels seemed to me to be not only an ineffective treatment, but a palliative and maybe even a stimulus that would only encourage further mischief.

Real gross domestic product is likely to expand at a pace appreciably below its potential rate in the second half of this year and then to gradually pick up as financial markets return to more-normal functioning and the housing contraction runs its course.  Given the extraordinary circumstances, greater-than-normal uncertainty surrounds any forecast of the pace of activity.  In particular, the intensification of financial stress in recent weeks, which will make lenders still more cautious about extending credit to households and business, could prove a significant further drag on growth.  The downside risks to the outlook thus remain a significant concern.
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If not reversed, these developments {the retreat in energy prices}, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.  Nevertheless, the inflation outlook remains highly uncertain.  Indeed, the fluctuations in oil prices in the past few days illustrate the difficulty of predicting the future course of commodity prices.  Consequently, the upside risks to inflation remain a significant concern as well.