It's impossible to measure what economists call a counterfactual—what might otherwise have happened. But without a willingness to use all available tools and to adapt policy tools as conditions required, I'm convinced the economy's performance and current outlook would have been considerably worse.

Looking ahead, the overall economy is very weak, and I expect it will remain weak at least through the first half of 2009. The incoming data suggest fourth quarter GDP contracted somewhere between 4 and 6 percent (annualized). And this quarter's performance could be similar. At some point—perhaps later this year—I believe financial markets will have stabilized sufficiently to support a recovery. So I am looking for an improving economy in the second half. To temper that a bit, there is always the risk of a shock or reversal in the financial sector or elsewhere that could again alter the outlook to the downside.

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To buttress confidence, I want to assure you the Federal Reserve still has considerable ammunition in reserve to be used as needed.

(I)t strikes me as reasonable to expect the U.S. economy to regain positive momentum sometime in 2009, for several reasons. First, monetary policy is now quite stimulative and real interest rates are quite low. Second, the energy and commodity price shocks that dampened economic activity last year have subsided already or are in the process of doing so. And third, as I said, the drag from declining residential investment seems likely to diminish significantly in the next year. In fact, I would be surprised if we don’t see a bottom in housing construction sometime in 2009.

While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it’s essential that we not let inflation drift from view. Since 2004, overall inflation has trended upward, and has been higher than I would like over the last few years. Much of the acceleration we saw last year reflected energy prices, however, and with oil prices down, we have seen overall inflation subside in recent months. Moreover, many economists are forecasting relatively low inflation in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. I would be cautious about relying on this correlation as a causal relationship, however, even though it is detectable in many datasets.⁶ There have been times in the past when inflation declined only temporarily when activity slowed, and re-accelerated when the recovery began. And while it may seem premature to be worrying about how inflation behaves after the recession is over, we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.

(T)his recession looks to be longer and more severe than was originally forecast. Still, there are indications that the second half of the year will show improvement.

(W)hile inflation is receding for the moment, I must remind you that monetary policy is extremely accommodative, and if it remains so too long, as history suggests it may, inflation pressures could re-emerge as the economy recovers.
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Inflation will remain moderate over 2009 and much of 2010.  Lower energy and commodity prices along with moderate improvement in demand for goods and services will keep price pressures temporarily contained.  How prices behave beyond the immediate horizon depends most critically on how the Federal Reserve conducts policy and manages its expanding balance sheet in a strengthening economy.  This is no doubt the central bank's most difficult long-run challenge.

My outlook calls for the economy to contract further through much of 2009 until later in the year when the effects of policy actions begin to stimulate GDP growth.
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Putting all of the pieces of the outlook together, the picture for the last quarter of 2008 and at least the first half of this year is grim.  The magnitude of the downturn is likely to surpass that of the 1990 and 2001 recessions.
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If we pursue systematic policies with the right balance of monetary and fiscal stimulus, the early signs of economic recovery could show themselves as early as the third quarter of 2009.

Typically, recessions occur when monetary policy is tightened to subdue the inflationary pressures that emerge during a boom. This time, the cause was the eruption of a severe financial crisis. Cross-country evidence suggests that, following such an event, GDP remains subdued for an extended period.2 And consistent with this evidence, many forecasters expect this to be one of the longest and deepest recessions since the Great Depression.

The Federal Reserve has undertaken policy actions of historic proportion. We have aggressively cut the federal funds rate, our traditional policy lever. We have also created multiple new lending facilities and transformed the asset side of our balance sheet. And, going forward, we will be expanding nontraditional policies now that the fed funds rate is approximately zero. Accordingly, we are faced with the challenge of calibrating these unfamiliar policies and, in the future, determining the appropriate time and methods for winding them down.

The most cogent description of this year’s economic developments might best be summarized by a woman who, having just commiserated with her accountants, put it this way: “This has been like the divorce from hell: My net worth has been cut in half and I’m still stuck with my husband.” The mood and pace of the economy have shifted from near bliss to acrimony and an almost palpable sense of betrayal. Many of our fellow citizens feel trapped in an unsustainable situation.

Looking ahead, uncertainty about the outlook is greater than usual, though probably not greater than is typical for this phase of a business slowdown. It strikes me as reasonable to expect the U.S. economy to regain positive momentum sometime in 2009, for several reasons. First, monetary policy is now quite stimulative. Second, the energy and commodity price shocks that dampened economic activity earlier this year have subsided already or are in the process of doing so. And as I’ve mentioned, the drag from housing seems likely to lessen in the next year, and in fact, I would be surprised if we don’t see a bottom in housing construction sometime in 2009. This is the third straight year, however, that I’ve been expecting a bottom in the housing market in the middle of next year, so my outlook is tempered by more than the usual amount of humility.

While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it’s essential that we not let inflation drift from view. Since 2004, overall inflation has trended upward, and has been higher than I would like, over the last few years. Much of the acceleration we saw earlier this year reflected energy prices, however, and with oil prices down we have seen overall inflation subside in recent months.

Many economists are forecasting relatively low inflation in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. While this correlation is detectable in many datasets, I would be cautious about relying on it as a causal relationship.⁵ And while it may seem premature to be worrying about how inflation behaves after the recession is over, we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.

During 2009 the housing sector should finally bottom and the actions taken by the Federal Reserve and the Treasury will gradually help financial markets return to some semblance of normalcy. So I expect the economy will start to pick up in the second half of next year with a gradual return to growth close to its trend of 2.7 percent in 2010 and 2011.

At this time it is very difficult to judge how long the downturn might last and how deep it ultimately will be. As financial markets work through their problems—with important help from government policy—and credit flows improve, we will see a return of growth in spending, production, and employment. But given the magnitude of the problems that we face, we could see activity remaining quite sluggish through much of 2009.

"We don't expect deflation," Richmond Fed chief Jeffrey Lacker told reporters after a speech to the Tech Council of Maryland.

With the federal funds rate at a low level of 1% and the economy weakening, many Fed watchers have begun to discuss other means of boosting the economy, also called "quantitative easing."

Lacker seemed confident that the Fed has sufficient ammunition, saying that the U.S. central bank has "a wide variety of choices" with which to conduct policy even if interest rates were lowered to zero.

"I don't see our inability to reduce the funds rate below zero as hampering our ability to make monetary policy," he commented.

As reported by Market Watch.

(I)t is far too early to organize a funeral for the Great Moderation. Even though financial market volatility is exceptionally high and even though the U.S. economy is contracting during the second half of 2008, the demise of the Great Moderation would require much more evidence than currently exists. Real economic variables, in particular, would have to swing much more than they have to date, and the increased volatility would have to continue for a number of years before we could start to compare the current environment to the pre-1984 experience and pronounce the moderation dead.

(W)hile credit supply concerns are real, the weakened state of the economy appears to be the more serious challenge facing most small businesses in the current environment.  Importantly, there is some evidence that concern over access to credit is relatively stronger at larger businesses.