For release: April 4, 2002
Contact: Joe Elstner, (314) 444-8902; Charles B. Henderson, (314) 444-8311

Recession's Mildness Due in Large Part to Better Monetary Policy: St. Louis Fed's Poole

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JACKSON, Tenn. -- Early and sustained action by the Federal Reserve's Federal Open Market Committee (FOMC) to reduce the federal funds rate target played a key role in lessening the effects of the recent recession, said William Poole, president of the Federal Reserve Bank of St. Louis. Poole spoke at Lambuth University to students, faculty and Jackson community leaders.

Poole linked the fact that consumer spending remained relatively strong during the recession to "atypical" behavior of short-term interest rates. "Typically, short-term interest rates rise until the business cycle peak and then decline substantially, usually until the neighborhood of the cycle trough," Poole said. "This time, short-term interest rates began to decline about four months prior to the cycle peak. That's because policymakers responded much more quickly during this recession than in previous ones."

Poole noted that the FOMC began reducing the federal funds rate target three months before the business cycle peak. "Moreover, compared with previous recessions, our rate cutting was very aggressive. The effective funds rate was reduced by 475 basis points from January to December. Hence, it seems to me that the recession's comparative mildness is due in large part to better monetary policy. The FOMC responded quickly and aggressively to signs that the economy was weakening, but something just as important played a part: for some time now the FOMC has pursued a policy of reducing the long-run inflation rate to a level where concerns about inflation play a minor role in economic decisionmaking. This long-term policy has not only succeeded in fostering a significantly improved inflation outlook, it has enhanced the Fed's credibility as an inflation fighter, giving the FOMC considerable leeway to act aggressively to reduce the federal funds rate during this recession. And finally, because the market understands this process, long-term rates began to decline long before the FOMC acted to reduce the target federal funds rate."

Monetary policy was not the only factor working to offset the economic downturn, as other economic forces were at work, said Poole. A major one: the "spectacular" pace of labor productivity growth during the recession. "Nonfarm productivity increased 2 percent during the 2001 recession; this performance was surpassed only by the exceptionally mild 1969-70 recession and the milder-than-average 1948-49 recession," he said.

Looking at recovery, Poole said increased investment spending is usually an important factor in pulling an economy out of recession. "The payoff from investment opportunities on proposed plant and equipment expenditures that appear dubious or speculative before and during the recession suddenly become more favorable during recovery." He said business capital spending in the four quarters after the business cycle trough typically grows about 9 percent, with residential fixed investment spending playing an even bigger role with a typical 26 percent boost in the four quarters after a trough. Spending on consumer durable goods typically goes up about 16 percent during that period, he said.

For several reasons, however, Poole believes that typical pattern is unlikely to recur this time. "First, the strength of residential fixed investment spending suggests there's little pent-up housing demand. Also, the recent rise in long-term interest rates will inevitably dampen the burst in home sales we saw last year. Besides, home ownership stands at a nearly all-time high of 68 percent."

The outlook for business fixed investment, Poole said, is harder to gauge. "One possibility is that the rate of that investment will be somewhat attenuated relative to the average postwar recovery." Poole noted also that with consumer spending still fairly robust, "it's difficult to see how the economy can get a large boost from such spending."

All in all, Poole said, he expects the recovery to be "somewhat milder" than average. But there's another consideration, he said: "Fiscal policy became expansionary, and monetary policy became, I believe, highly expansionary. Money growth was high and short-term interest rates were driven low. This expansionary policy may show up somewhere, or a little bit in lots of places. The result could be upside surprises in coming quarters."

Looking ahead, Poole said the shape of the economy in coming years will depend heavily on the rate of productivity growth and the long-term inflation rate. "The economy's performance in recent years--both the high growth rate of the 1990s and its resilience in the face of recession and the shock of September 11--is evidence of the payoff from sustained low inflation. But success in keeping inflation low will not come automatically--the Fed must not fall asleep at the switch."

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