Fed Says Economy Weak for Short Term

Federal Reserve Vice Chairman Donald Kohn said on Friday moderate growth should return to the economy after a period of softness due to a prolonged housing slump and higher borrowing costs.

"Once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment," Kohn told the Greater Philadelphia Chamber of Commerce.

The Fed's half-percentage point interest rate cut September 18 was necessary to offset tighter credit conditions and encourage moderate growth, but will not prevent parts of the economy from softening further, Kohn said.

"Our policy action will not be able to avert all of the weakness in the economy that may be in train for the next several months," he said. "In particular, housing markets are likely to remain depressed in coming months."

Greater obstacles getting home loans and an inventory overhang will restrain demand for housing in months ahead, Kohn said. Construction is likely to decline further, creating a "significant drag" on overall economic growth in the world's largest economy, he added.

The Fed cut rates last month after increasing mortgage delinquencies rattled stock and credit markets, threatening to drag down the broader economy.

Some of the most disrupted financial markets have shown signs of improvement since the Fed meeting, Kohn said. But recent market turmoil will raise the cost and constrain the availability of credit for households and businesses, even after market functioning improves, he said.

"It would not be surprising to see less-generous credit for a wide variety of loans to businesses and households," Kohn said.

It is too early to say what effect financial market turmoil is having on household and business spending, but initial signs suggest the effects have been limited, the Fed official said. However, a combination of tighter credit, lower consumer confidence and business cautiousness are likely to subdue demand in coming months, he said.

The U.S. central bank's aggressive rate cut was warranted by rapid market deterioration and high degree of uncertainty at the time, Kohn said. Also, the easing of inflation pressures gave policy-makers some breathing room to lower benchmark borrowing costs.

"I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little or too slowly," he said. "I believed that we would be able to offset the cut in the federal funds rate — if it turned out to be larger than needed — in time to preserve price stability."

While recent inflation data has been benign, Kohn said the decline in the value of the dollar has put upward pressure on imports, which could affect consumer prices. Low unemployment, slower productivity growth, and higher incomes have also contributed to potential price pressures, he added.

"We will need to monitor inflation developments carefully," he said.