The recovery that followed the recession in the early 1990s was fairly sluggish. And with a lackluster recovery after the 2001 recession, the evidence supporting rapid bouncebacks after downturns was weakened further. Some analysts have suggested that those slow recoveries reflected the shallowness of the downturns--indeed, the research on the pre-1990 episodes indicated that the strength of recoveries was correlated with the depth of the preceding recessions, and the slowness of the recoveries from the 1990 and 2001 recessions would be consistent with that correlation. However, many commentators instead attributed the slowness of those recoveries to the drag from structural factors--namely, the financial headwinds in the early 1990s and the need to work off capital overhangs after 2001. All in all, the historical record leaves us with at least two possibilities for the coming recovery: a strong recovery from the deep recession or a sluggish recovery because drag from the underlying structural factors partly offsets the usual forces that generate a rapid bounceback.

In 1983, John Kareken of the University of Minnesota and the Minneapolis Fed described financial deregulation as “putting the cart before the horse,” suggesting that expanding the powers of banking and thrift institutions without appropriate attention to design of the financial safety net could be a risky move.⁶ His analysis was prescient, given the savings and loan debacle that followed later in that decade. Karaken’s emphasis was on deregulation in the presence of deposit insurance, but in the current episode, lending by the Fed and the Treasury has become just as important a part of the federal financial safety net.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

I think that today’s circumstances align well, although certainly not perfectly, with the experience of the early 1990s.
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It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both banking and nonfinancial businesses was healthier at the onset of recent problems.

Overall, while there is considerable uncertainty about the outlook and while the policy environment is challenging to say the least, my view is that the early 1990s headwinds episode remains a valuable guide at this juncture. Specifically, it would imply a continuation of only modest expansion in the economy, the likelihood of further increases in unemployment for a time, and a diminution of inflation, absent a resurgence in energy and other commodity prices.

In considering these prospects, it is worth recalling that, despite early challenges, the 1990s turned out to be an excellent decade for the U.S. economy by almost all metrics. The economy is fundamentally flexible and resilient, and these characteristics should ultimately prevail.

This is bigger than the S&L. It's broader. It's deeper.  It's not unhealthy. It's the way capitalism works.

I think it is helpful at this point to note some similarities to the period following the recession of late 1990 and early 1991. You might recall that after the deregulation of the Savings and Loan industry, many S&Ls made imprudent real estate loans. The ensuing losses substantially reduced the lending capacity of the industry as insolvent S&Ls went out of business and others were forced to recapitalize. In addition, banks were reluctant to lend as they struggled to bring their capital in line with the then new risk-based standards set by the Basel I Accords. These restructurings created financial headwinds that made the recovery from recession frustratingly slow. In fact this period was later characterized as a "jobless recovery."

Today, banks again are recapitalizing after making imprudent loans; and again, they are doing so in the face of a sluggish economy. However, one key difference is that today much more overall lending activity is securitized. This has spread losses among a wider swath of financial institutions and has made it more difficult to quantify losses. As a result, we have seen a broader disruption of credit flows, even than those of the early 1990s. This suggests we may again be in for a period of weak growth.

Now let's consider the stance of policy. Today, the nominal funds rate is at 2 percent. In January, projections FOMC members made for PCE inflation in the medium term were in the range of 1-3/4 to 2-1/4 percent. This means the real fed funds rate is close to zero or perhaps slightly negative. Looking back at the early 1990s, the nominal funds rate bottomed out at 3 percent in 1992. Given the higher inflation expectations at the time, this also translated into a real funds rate that probably was close to zero—just like today.

In normal times, a real funds rate near or below zero would be considered highly accommodative. However, then, as now, the boost to aggregate demand from the accommodative funds rate was offset to some degree by financial market turmoil. Because we think the disruptions today are more significant than in the early 1990s, this offset also is larger today. In contrast, today we have in place the various additional measures that provide extra liquidity. No such facilities were in place in the early 1990s. It is difficult to weigh the various factors. But with this difficulty in mind, and given my reading today of economic prospects, my judgment is that the current net stance of monetary policy is accommodative—and this is appropriate in order to address the way we currently see the sluggish economy unfolding in 2008. I also believe that the current stance roughly balances out substantial risks to the outlooks for both growth and inflation—which I see as being to the downside for growth and to the upside for inflation.