Greater caution on the part of businesses and consumers will likely limit increases in their discretionary expenditures. And the strains on credit intermediation and financial balance sheets will likely hold down growth to a degree for some time. Since these financial issues are being worked out against the backdrop of a soft economy, we also have to recognize the risk that interactions between the two might reinforce the weakness in the economy.

In response to these downside influences, and with inflation expectations contained, I believe a relatively accommodative monetary policy is appropriate. At 3 percent, the current federal funds rate is relatively accommodative and should support stronger growth. Indeed, because monetary policy works with a lag, the effects of last fall's rate cuts are probably just being felt, while the cumulative declines should do more to promote growth as we move through the year.

In addition, the fiscal stimulus bill the President signed yesterday will likely boost spending in the second half of the year.

[O]ur outlook at the Chicago Fed is for real GDP to increase in the first half of the year, but at a very sluggish rate. However, we expect growth will pick up to near potential by late in the year and continue at or a bit above this pace in 2009.

In assessing the extent of the current slowdown, I find it useful to look at an index we developed at the Chicago Fed in 2000 to summarize the information in a large number of monthly indicators of economic activity. The index is the Chicago Fed National Activity Index, or CFNAI. An index value of zero is consistent with trend growth in overall GDP. The three-month moving average of the CFNAI fell to -0.67 in December. A study I did back in 2002 suggests that readings like this indicate a greater than 50 percent probability that the economy is in a recession. Although there are reasons to discount this likelihood somewhat, it is clear that the U.S. economy currently faces substantial headwinds.

Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt. At the same time, overall consumer price inflation should moderate from its recent rates, and the public's longer-term inflation expectations should remain reasonably well anchored.

The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term. On the other hand, growth in U.S. exports should continue to provide some offset to the softening in domestic demand, and the recently approved fiscal package should help to support household and business spending during the second half of this year and into the first part of next year.
 

We'll be looking over the next few quarters -- obviously the general performance of the economy, but as I mentioned in my testimony, there are a few areas of particular sensitivity that we could watch.

First is the housing market.  We need to begin to see some stabilization in starts and sales, it would be very productive in terms of both the economy and the credit markets.

Secondly is the labor market.  We don't expect a riproaring labor market by any means, but it would be nice if the labor market would begin to stabilize close to current levels.

Third, credit markets.  Senator Schumer was correct that there is a lot of concern among participants of the financial markets about the state of the credit markets. Much of that is connected with uncertainty about the broader economy. A significant worsening in financial conditions or credit availability would certainly be a warning bell that we need to take further action.

From Q&A, when asked how the Fed would decide if January's policy actions were sufficient. As reported by Market News International.

Congress has now passed a fiscal stimulus package to help the economy and it could provide notable stimulus in the latter half of this year.

The best bet is that we will not have a recession.  My take on the current policy situation is that policy is at a good place for both the long-run and for cushioning the impact of financial disturbances.
 ...
There is no question that the odds of a recession are higher than they used to be.

From Q&A, as reported by Bloomberg News and Market News International

While identifying housing as still a key drag on the economy, he warned, "We must not allow our concern about 5% of the economy to screw up the other 95% of the economy." 

"Consumer debt, putting mortgages aside, is not likely to be a serious issue unless we have a serious rise in unemployment," he said.
"If we get a big decline in employment then there will be further shoes to drop."

From Q&A as reported by Market News International

My baseline forecast envisions weakness in the first half of 2008 followed by improvement in the second half, with inflation moderating from recent levels. The liquidity injections and easing of monetary policy should help housing and financial markets stabilize and avoid an "adverse feedback loop" in which a decline in housing prices fuels financial market volatility with spillover to the broader economy.    

I believe that accommodation is appropriate because the financial shock and the housing cycle have significantly restrained economic growth. While growth seems likely to be sluggish this year, the Fed’s policy actions should help to promote a pickup in growth over time. I consider it most probable that the U.S. economy will experience slow growth, and not outright recession, in coming quarters. At the same time, core consumer inflation seems likely to decline gradually to somewhat below 2 percent over the next couple of years, a level that is consistent with price stability.

However, economic prospects are unusually uncertain. And downside risks to economic growth remain. This implies that, going forward, the Committee must carefully monitor and assess the effects of ongoing financial and economic developments on the outlook and be prepared to act in a timely manner to address developments that alter the forecast or the risks to it.

I expect core inflation to moderate over the next few years, edging down to around 1¾ percent under appropriate monetary policy. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. Moreover, I believe the risks on the upside and downside are roughly balanced.

For the past few years, we have had a raucous party of economic growth fueled by an intoxicating brew of credit market practices that financed a housing boom of historic, and late in the cycle, hysteric, proportions. With the benefit of perfect hindsight, some have argued that the Fed failed to take away the punchbowl as the subprime party spun out of control, leaving rates too low for too long and not using our regulatory powers to restrain excessive complacency in the pricing and monitoring of risk. But that is beside the point.

Now we are faced with the consequences of a process that lawyers would call the “discovery phase”: As big banks and other financial agents confess their acts of fiduciary omission and excesses of commission, credit markets have effectively de-leveraged important segments of the economy, slowing growth suddenly and precipitously. Instead of taking the punchbowl away, the Federal Reserve is now faced with the task of replenishing the punch.

In response to recent economic circumstances, the Federal Open Market Committee (FOMC) acted decisively. Over a period of nine days, from January 22 to January 30, the FOMC lowered the fed funds rate 125 basis points, from 4.25 to 3 percent. Since last August, the committee has dropped the fed funds rate 225 basis points.

These actions were taken to avert a deep and protracted economic downturn. In the face of economic weakening, the FOMC acted to avoid a restrictive posture and get rates to a level I believe will support movement toward trend growth by the second half of 2008.