MICHIGAN - US ECONOMIC growth could be restrained for a few years by contagion from unprecedented problems in financial markets, a top Federal Reserve policy-maker said on Thursday.
'We should anticipate further declines in employment and softness in most components of demand for goods and services,' said Mr Gary Stern, president of the Minneapolis Federal Reserve Bank and a voting member of the US central bank's monetary policy-setting Federal Open Market Committee this year.
In a speech at Michigan Tech University, Mr Stern said fixing the financial system was more important than assigning blame at this point, given the 'contagion effect' between the financial system and the broader economy.
'It's that process, that spillover effect, that's my concern,' he said. 'The real economy is adversely affected'.
'Jobs and living standards are affected.'
In recent months Mr Stern has repeatedly compared the current downturn to the early 1990s recession, but on Thursday said the outcome could be worse.
'In view of the scope and severity of the recent financial shock, the restraint on economic activity stemming from credit market headwinds could exceed the experience of the 1990s.'
He termed the 1990-1991 recession 'brief but not especially mild.' Mr Stern did not indicate whether he favoured another big cut to the federal funds rate at the FOMC's next scheduled meeting on Oct 28-29.
Financial markets currently see a cut of either one-quarter or one-half percentage point from the current 1.5 per cent level of the benchmark overnight lending rate.
'Depending on how one reads the data, financial headwinds restrained the pace of the ensuing expansion of the early 1990s from 12 to 36 months. Something similar is certainly conceivable today,' Mr Stern said.
Mr Stern said the economy faces pressure from the ongoing decline in home prices and high inventories of unsold houses, a string of drops in payrolls, the negative wealth effect of a falling stock market and deterioration in credit availability.
Asked whether the housing downturn was near to an end, Mr Stern said it was hard to generalise across the nation.
'Housing markets are heterogeneous, and if you generalise you risk missing something,' he said.
Economic growth in 2007 and the first half of 2008 'do not tell the whole story', he concluded.
On a more cheerful note, Mr Stern said the bulge in energy and commodity prices that peaked in July 'is apparently behind us' and that inflation should recede'.
That comment came on a day when September US consumer inflation was reported unchanged and core prices, stripped of food and energy, rose an unexpectedly low 0.1 per cent.
Mr Stern said the Fed's actions to date, from severe rate cuts to massive efforts to pump liquidity into the financial system, had been on target but not yet successful in restoring stability and would take time.
Getting the dosage right
The Treasury's massive package to support the banking system is notable for having the flexibility to tackle complex problems, Mr Stern said.
'Knowing what the appropriate medicine is, what the appropriate does is hard to know in advance,' Mr Stern said.
New financial regulations will also likely be on the agenda once the crisis has passed, but Mr Stern said warned against a reflexive tendency to pass restrictive new laws that could stifle innovation.
'It's important that we get the incentives right, get risk taking right,' he said.
Rethinking approach to bubbles
Mr Stern said that in light of the toll that the housing market crisis and its aftermath had taken on the economy, it was worth another think about how the Fed dealt with developing asset bubbles, including preemptive interest rate hikes.
'Identification of excesses in asset prices, although challenging, does not appear to be beyond the realm of possibility,' he said.
Actions taken to rein in bubbles - when increases of certain asset prices seemingly outstrip economic fundamentals - 'are likely to require raising interest rates earlier and probably more than otherwise would be the case' and would likely be unpopular, Mr Stern said. -- REUTERS