The Economic Outlook

As you are well aware, we are suffering through a severe recession. It is likely that, by at least some measures, this recession will prove to be more severe than any other recession in the last 60 years. The beginning of last year marked the onset of the recession, and the rate of decline became particularly acute last fall. All economic contractions eventually come to an end, however, and the growth process resumes. Where are we in this process? As I will discuss, while overall activity is still contracting, it now appears as if the pace of contraction is diminishing, and at some point later this year, activity will bottom out and begin expanding again. Before getting to the outlook, I would like to provide a little background on some notable developments that preceded the recession. As always, the views expressed are my own, and not necessarily the official views of the Federal Reserve System. The most spectacular event undoubtedly was the boom/bust cycle in housing activity. Residential investment rose from 4.1 percent of GDP in 1995 to 6.2 percent of GDP in 2005, which is almost a 50-percent increase in housing's share of overall economic activity. It is important to remember that a large part of that increase reflected solid fundamentals, such as strong income and employment gains and low long-term interest rates. Another important factor in the housing boom was the multifaceted commitment to use public policy to boost housing activity and home ownership, from favorable tax treatment of home ownership to the implicit subsidies flowing through the housing-related government sponsored enterprises. In addition, genuine innovation in mortgage lending and securitization helped to bring home ownership to a wider segment of the population. In retrospect, we can see that this beneficial financial innovation was accompanied by lax underwriting standards by many lenders, overly complex and opaque securitization, and the expectation of future housing price appreciation by almost every borrower, lender, investor and analyst. In essence, a housing boom that was based on solid economic fundamentals was intensified by the assessments of mortgage-market participants that, in hindsight, were overly optimistic.