Eric Rosengren of Boston Fed in Lowell

Yesterday I joined 120 others at the UMass Lowell Inn & Conference Center for a talk by Eric Rosengren, President and CEO of Federal Reserve Bank of Boston. The event was co-sponsored by UML and the Parker Lectures. The formal portion of this hour-long talk was “How Should Monetary Policy Respond to a Slow Recovery?” During his remarks and the questions that followed, Rosengren outlined the challenges facing the Fed in addressing the Great Recession and provided some insight into the future of the housing sector. I took many notes which I’ve reproduced below in their entirety:

Rosengren began by placing this recession in the context of other recent ones. He showed unemployment data by industry from 1981-82, 1990-92, March 2001 – November 2001, and 2007-2009. In the other three recessions, only one or two industries suffered unemployment in excess of 5% (usually it was manufacturing or IT). This time, every industry lost more than 5% of its jobs and several lost a lot more than that. “That’s why we call it the GREAT Recession.”

One of the first questions to be addressed is whether this is “structural unemployment” or “demand unemployment.” In structural unemployment, you have too many construction workers and not enough health care providers, so putting people back to work would require time-consuming retraining. Demand unemployment, in contrast, has plenty of workers in every industry but not enough demand for their services. Rosengren said the evidence is that the recent recession resulted in “demand unemployment” – there is no lack of applicants for any given job; but no one is hiring because there’s not enough demand.

The news this summer that we were in an economic recovery is misleading. That was based on rising inventories which are only temporary. Corporations had allowed inventories to dwindle during the credit crisis so this year they began restocking. Once the inventories have been replenished, production will recede because there is still little demand for these products.

Since the start of the Great Recession, Americans have drastically changed their spending habits by increasing savings and decreasing expenditures. While we do need increased savings in the long run, since two thirds of our economy is based on consumptions, in the short term we need people to buy things. Individuals, banks and businesses are all averse to risk and are holding large amounts of cash which is rational given the economic conditions but also bad for the economy.

Normally in a recession, the Fed lowers interest rates. That makes borrowing more attractive and stimulates businesses to get back to work. But the Fed rate is already at zero and you can’t go lower than that, so the Fed is deprived of the use of that tool.

In the absence of the normal tools, what can the Fed do? One thing that has been done is to begin purchasing long-term, government backed assets (home mortgages and loans). This creates more demand for these assets which would lower their interest rates. This should stimulate long-term borrowing (home mortgages and corporate bonds) because of the lower long-term rate.

This step has the added consequence of devaluing the US currency. That makes imports more expensive and exports less expensive which leads to an increase in foreign sales. This also motivates big corporations to issue their own long-term corporate bonds. With corporations raising their own money through the sale of bonds rather than borrowing it from banks, the banks have more cash to lend to others. Despite these efforts, there is still room for long-term rates to go down more.

Purchasing long-term debt is an “unconventional tactic” that must be used judiciously. But since the benchmarks used by the Fed to set its policy are inflation of no more than 2% and unemployment of approximately 5% and today, inflation is under 1% and unemployment is above 9%, there is still plenty of need to employ these measures.

In reply to a question about deficits, Rosengren said that deficits is a result of Fiscal Policy. Congress and the President set it and the Fed, responsible of monetary policy, reacts to it. In the long run, we can’t allow the deficit to continue going up as it has. Social programs like Medicare and Social Security have to be brought under control long-term. But Rosengren emphasized that now was not the time to do this. Instead, he said the best outcome would be for Congress to structure a short-term stimulus that in turn deals with the long-term problem. But given the current stagnation in our political system, it’s unlikely that either approach will be used right now.

Another question was based on the observation that much of the consumer spending of the past decade used credit to purchase overvalued assets. With the value of those assets now depressed, who will pay the bill? Rosengren said that monetary policy has no effect on this but fiscal policy does. The follow-up question dealt with the uncertainty of who would suffer the loss. Rosengren said that uncertainty in economics is undesirable. The current foreclosure freeze just puts that off. The worst thing is to have a large amount of assets dumped on the market at the same time because that only drives down the price of the underlying assets.

Rosengren said low interest rates somewhat mitigate some problems like home values by keeping rates low. If rates go up, housing prices will go down because few will be able to a new home.

Rosengren said that the Dodd-Frank financial reform bill has done a lot to deal with some of the issues. He said we still need a good way to unwind big entities. When this crisis struck we didn’t have the tools needed to deal with the problems so everything was done on an ad hoc basis. This new legislation provides the tools that will be needed to address these types of situations in the future.

Another audience member asked Rosengren what things he would do to speed the recovery of the housing sector. He said there was a lot of uncertainty about the future of Fannie and Freddie and that we need to figure out the right kind of housing structure that’s needed. He also said we must decide what’s a reasonable amount of a down payment on a mortgage. Requiring a higher down payment would mean that there weren’t as many foreclosures, but it also would mean that fewer people could afford to buy houses. This is a societal judgment that has to be made. We need to get the rules for our housing and mortgage policy figured out. We don’t now. The Treasury and Congress must decide on what this will look like. Unfortunately, it hasn’t been addressed yet but Rosengren expects it to be dealt with after the election.