Part of the rationale for the speed with which the FOMC brought down the funds rate was the risk that the slowdown we are experiencing would prove to be more severe. While that uncertainty has not entirely disappeared, my sense is that such downside risks have diminished appreciably. And just as easing policy aggressively in response to emerging downside risks made sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well. Moreover, our attention to risks needs to be two-sided, I believe. As we move through this period of low growth, we need to be attuned to the risk that we emerge from the slowdown with inflation following a higher trend than when we went in. This danger associated with the persistence of elevated inflation warrants an additional measure of vigilance.

As the probability of severe damage to the financial system recedes, the likelihood of a measurable contraction in growth this year has lessened. These conditions complicate the inflation outlook, in which significant economic slack had been seen as helping to keep inflation in check.

An efficient monetary policy {following an oil shock} should attempt to facilitate the needed economic adjustments so as to minimize distortions to economic efficiency on the path to achieving, over time, its dual objectives of price stability and maximum employment.⁹

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.  By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.  Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly.  Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.  Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy.  However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside. 

...

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities.  Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand.  However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention.  Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.  The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Let me turn now to more specific comments on the housing sector. Private single-family housing starts peaked in January 2006 at an annual rate of 1.823 million units. Since that time, housing starts have continued to fall; in April 2008, they were only at an annual rate of 692 thousand units, roughly 38 percent of the previous peak value. As striking as these statistics appear, they are not unprecedented. To put the contraction in housing production in a longer-term perspective, it is useful to divide housing starts by the number of households. In February 2006, housing starts per household peaked at 1.65 percent. In March 2008, they had declined to 0.64 percent per household. A startling fall, to be sure, but it has happened before. In January 1973, housing starts per household peaked at 2.10 percent before declining to a trough of 0.94 percent in February 1975. The 1973-75 decline was similar in magnitude to our current situation, according to this metric. A similar phenomenon occurred later in the 1970s. In December 1977, housing starts per household were 2.03 percent before beginning to fall. They fell all the way to 0.66 percent in November 1981. These statistics remind us that housing can be a highly cyclical industry. They also illustrate that the current contraction has clear precedents. Indeed, it is perhaps comforting that the order of magnitude in the previous declines is not unlike today’s figures and that, when housing starts per household have fallen this low in the past, it was near a turning point.

In view of this uncertain outlook, additional capital injections and the consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions.  Stronger capital positions also will allow banking institutions to participate in and support the rebound in lending that will accompany the strengthening of the U.S. economy.

I'm hoping breathing will come more easily as the year plays out, as we enter 2009 and as immediate challenges subside. But recent experience tells me we won't be fully at ease until a sustainable trade, energy, and fiscal balance has been achieved.  

Over the past year, the economy has been buffeted by a series of shocks including financial turmoil; an emergency acquisition of a major investment bank to avoid a sudden, disorderly failure [Footnote 2]; falling national housing prices; and oil prices that have exceeded $130 a barrel. Despite all these challenges, the U.S. unemployment rate is at 5 percent; the rise in prices of “core” consumer goods and services (Personal Consumption Expenditures) to a little above 2 percent, while unwelcome, has not been large compared with past episodes; and the economy has been growing, albeit at a much slower pace then we would prefer. These relatively benign outcomes to date are at least partly the result of recent monetary and fiscal policy actions taken to mitigate some of the problems facing the economy.

What about today? Using the same rough method to approximate home equity for the same subset of homeowners, the data imply that about 10 percent of post-1987 purchasers were in a position of negative equity as of the fourth quarter of 2007. Assuming that the unemployment rate and benchmark interest rate (the 6-month London Interbank Offered Rate or LIBOR) stay at their fourth-quarter 2007 levels, the statistical default model of Gerardi, Shapiro and Willen predicts that less than 10 percent of these homeowners with negative equity will default.

Continued declines in house prices, higher unemployment, and possibly a greater willingness to default on home mortgages might raise this estimate of future defaults. Even so, many lenders will not be inclined to make concessions unless borrowers clearly lack the ability to pay.

To reiterate, falling housing prices continue to be a significant source of down-side risk to the economy.  Previous periods of real estate problems have taken significant time to be worked out, with foreclosures remaining elevated well after their peak.  The current foreclosure problem has been exacerbated by the difficulties related to many of the problem loans being held in securities.

The extent of eventual housing problems is highly dependent on the outlook for the economy and the future path of housing prices.  Fortunately, aggressive monetary and fiscal policy actions have been taken to help mitigate some of the downside risk.  These policies will likely result in some pick up in economic activity in the second half of this year, which should help to stabilize the housing market.

If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic' [economy].

From Q&A as reported by Bloomberg News

I think we’ll have a long period of anemic economic activity, it’ll take a while as bank and lending officers tighten their criteria. But it doesn’t mean we’ll have a recession.

From Q&A as reported by the Wall Street Journal economics blog.

Inflation expectations have remained reasonably well-anchored so far, which is encouraging -- but the key to maintaining low inflation and inflation expectations is likely to be the timeliness and the magnitude of decisions we make to reverse course.

We are highly sensitive to this issue and I am confident that we will conduct policy in an appropriate and timely manner.

As reported by Market News International and Reuters.

Right now, I think we are seeing challenges on both sides of that (dual mandate) and I think we are simply going to have to navigate the minefield...We have to take care that the policies we have pursued to date do not compromise the achievement of our dual mandate, and in particular, our objective of sustained low inflation.

As reported by Reuters.