I think the Federal Reserve has taken appropriate policy steps to respond to a financial shock, a shock that may well produce parallels to the headwinds episode of the early 1990s. In this environment, we need to remain sensitive to evolving financial conditions and to incoming information on business activity in order to further determine the relevance of that earlier experience. And the aftermath of that episode may also prove relevant, in that it illustrates the underlying resilience of the American economy and the value of policy adherence to the dual mandate.

The potential for headwinds is integral to thinking about economic prospects over the next year or two. To the extent that these headwinds gain momentum, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate. Their implications for inflation are not so clear, although I would note that the pace of inflation diminished in the early 1990s relative to its performance over the preceding several years.

Importantly, the Federal Open Market Committee’s most recent action, the 50 basis point cut in the target federal funds rate in September, was an attempt to help offset the potential effects of financial market turmoil on real economic activity.  The breakdown in the price discovery process can, after all, have real economic consequences that the Federal Reserve should, in my opinion, consider when fulfilling its statutorily mandated goals of maximum employment and price stability.

Financial Headwinds in the Early 1990s... 

[C]apital shortfalls meant that banks had to either raise new capital or restrict their asset growth by cutting back on lending. Because of their weak condition, banks could not raise much new capital, so they chose the latter course. The resulting slowdown in the growth of credit was unprecedented in the post-World War II era (Reifschneider, Stockton, and Wilcox, 1997). Because banks have informational advantages in making certain loans (e.g., Mishkin, 2007a), many bank-dependent borrowers could no longer get access to financing and thus had to cut back on their spending.

As best we can tell thus far, the imprint of these developments on economic activity appears likely to be most pronounced in the housing sector.  However, economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and business spending.  That scenario cannot, in my view, be ruled out, and I believe it poses an important downside risk to economic activity.

The U.S. economy appears to have become more resilient to financial shocks. Over the past two decades, the U.S. economy has experienced several episodes of significant financial market strain. These episodes were associated with spikes in risk perception and significant market volatility within financial markets, but none proved exceptionally damaging in terms of the overall macroeconomic impact. The mild impact of these episodes on the real economy contrasts with financial events such as the “credit crunch” that exacerbated the 1990-91 recession. That episode was characterized by a widespread reduction in the provision of credit by banks in response to loan losses and the need to raise capital.

However, the {early 1990s} recovery also was more modest than usual, in large measure because of the notable financial "headwinds" that confronted businesses. Those headwinds were primarily generated by the constriction of credit in response to major losses at banks, associated with real-estate and foreign lending, coupled with a crisis in the savings and loan industry that had its origins in a serious maturity mismatch as interest rates rose. With their access to managed funds threatened and the quality of their loan portfolio--and hence their capital--uncertain, these depositories were most reluctant to lend....

By early 1994, as the headwinds of financial restraint abated, it became clear that underlying price pressures were again building.

The 50-mile-an-hour headwinds which troubled greater growth several years ago have now come down to perhaps 20 or 25 miles an hour. 

As reported by Reuters News