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By Christine Benz | 02-23-2012 03:00 PM

Recovery Missing Normal Expectations

The economy is improving, but sluggish manufacturing-jobs growth and still-weak lending and housing markets are keeping the recovery from typical levels, says Fed economist William Strauss.

Christine Benz: I am Christine Benz for Morningstar. I am here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with William Strauss. He is a senior economist at the Federal Reserve Bank of Chicago, and he shared his views on the economy and what he sees as the potential headwinds and tailwinds to an economic recovery.

Christine Benz: Bill, thank you so much for being here.

William Strauss: Happy to join you.

Benz: You are here to talk about the state of the economy, and I am hoping you can kind of summarize what you will discuss in your presentation. I think there is a general consensus that there is some strengthening in the economy, maybe not as much as one would hope, but still strengthening. Is that your general view?

Strauss: Yes. We certainly saw some improvement for the U.S. economy as the year came to a close, and that has continued into the early part of this year. That being said, the expectation is for growth this year to be roughly around trend rate of growth next year, perhaps a bit better than that, but still not the type of recovery/expansion period that you would typically expect given that we went through one of the deepest drops in economic activity that we've seen since the Great Depression.

Benz: What do you think have been the key impediments to the economy not strengthening at the pace one would hope?

Strauss: So, I think in large part it's really the whole financial crisis. Carmen Reinhart and Ken Rogoff went ahead and wrote the book, This Time Is Different. What they were basically highlighting is that, unlike any other recession that we've had since the Great Depression, this one has been associated with a financial crisis. What we've seen is that recovery periods that are associated with financial issues tend to be far more muted than a typical type of recovery. There is very little pent-up demand. In fact, leading us into this was just probably an overconsumption in particular of housing. So, this time around we are seeing absolutely no contribution to the recovery coming from the housing sector, which is very unusual.

Benz: You noted that still-tight credit is another headwind here.

Strauss: So you look at the banks' balance sheets, and these firms are sitting on a lot of deposits. The question is why is that the case because historically banks have these excess reserves. It has been much more profitable for banks to lend that cash out, charging an interest rate higher than what they are paying the depositors, and that--on a risk-adjusted basis--is how they make their money. They are not doing it at this point, and I think that's occurring for a number of reasons. Some of it has to do with supply. You look at the number of underperforming assets that are out there. We mentioned the housing sector, and there's probably still a year's worth or more of an excess amount of homes out there. So, if you are looking at a marketplace where there is excess supply of homes, you can't imagine there is great willingness on the part of a lender to lend to a builder that plans to build an extra 200 homes in a development.

So, I think for those kinds of risky issues at this point, there is some hesitancy there. In addition, with commercial real estate, we see similar things with the vacancy rates still being quite high. Then on the demand side, we have an economy which is expanding but not setting the world on fire. Since the recovery expansion began in the middle of 2009, growth has been roughly at trend rate of growth. This is, again, well below what we would typically expect. For example, during the mid-1970s and the early '80s, growth for a three-and-a-half-year period was well north of 5% for that entire period, significantly above what we thought of as trend.

With the fact that the economy is not taking off like a skyrocket, companies are really being very hesitant to want to expand capacity, wanting to push their businesses, and wanting to take on debt. I think when you look at those companies that put themselves in an overleveraged position, they got themselves in trouble. So, I think that we are in a state right now where there is this preference for being very cautious with regard to debt.

Benz: How about consumers?

Strauss: I think in a similar vein there. We have an unemployment rate that is above 8%; incomes are rising but not very rapidly. Consumers similarly were put into a position of having too much debt, and some of their main assets have really taken a hit on values, such as their homes, which are down about 30% nationally, and in certain markets they are down by more than 50%. Down here in Florida, this is one of the key states that has seen tremendous loss of value of homes. And the stock market is another factor. Granted we've been on this great bull market run since March 2009. But unless you put your money in the market in March '09, unless you've been riding this horse all the way through, we're still well below the levels where we were back in 2007. So, investors look at their 401(k)s and their other assets that they have perhaps invested in the stock market, and they are just not feeling all that wealthy relative to 2007.

Benz: Bill, I know a big focus for you at the Chicago Fed is the manufacturing sector. There has been a lot of excitement about what's been going on in Detroit, and I'd like your take on that area and the strength of manufacturing overall?

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