January 4, 2009 / 2:21 AM / in 10 years

Yellen: Pull out all stops for grim economy

SAN FRANCISCO (Reuters) - The U.S. economy faces a potentially long period of weak growth and a rising risk of deflation, making it worth “pulling out all the stops” with a big fiscal spending program, Janet Yellen, president of the San Francisco Federal Reserve Bank, said on Sunday.

The Federal Reserve Building in Washington while the Fed is inside meeting, October 29, 2008. REUTERS/Larry Downing

“The financial and economic firestorm we face today poses a serious risk of an extended period of stagnation — a very grim outcome,” Yellen said on a panel discussion at the American Economics Association’s annual meeting in San Francisco.

“If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now.”

Yellen said she was skeptical about suggestions for broad-based, permanent tax cuts and backed the “diversified package of policies” suggested recently by the International Monetary Fund.

Specifically, Yellen urged “spending on goods and services with higher rather than lower social value,” but said measures should be consistent with “long-term fiscal discipline” to be the most effective.

If the public doesn’t believe that spending increases are temporary, then long-term interest rates are likely to rise in response, “undercutting, conceivably even overwhelming, the short-term stimulus,” Yellen said.

President-elect Barack Obama has said that signing a major economic stimulus package will be his first priority when he takes office, with a goal of creating or saving 3 million jobs over two years.

Speaking on the same panel as Yellen, renowned economist Martin Feldstein said that $300 billion to $400 billion in fiscal measures in 2009 and 2010 seemed justified.

Feldstein, former head of the National Bureau of Economic Research, also warned that the current recession, with its roots in a financial crisis rather than restrictive Fed interest rate policy, could easily drag on for the rest of 2009.

DEFLATION RISK

With the United States already bogged down by a year-long recession, Yellen said there is a rising risk of deflation, or a persistent decline in prices that could cause consumers to delay purchases, dragging down the economy further.

“With an extended period of abnormally high unemployment in the forecast, it is increasingly likely that inflation will fall to undesirably low levels,” she said.

That, in turn, would risk pushing up real interest rates as inflation expectations decline at a time the Fed has already reached the “zero bound” on official rates.

Yellen said the trigger for the current recession, the eruption of a severe financial crisis, suggested U.S. growth would remain weak “for an extended period.”

“The current downturn is likely to be far longer and deeper than the ‘garden-variety’ recession in which GDP bounces back quickly,” she said. “Many forecasters expect this to be one of the longest and deepest recessions since the Great Depression.”

Yellen said the Fed has not run out of monetary policy options, despite having set its official lending rate at a rock-bottom range of zero to 0.25 percent in December.

The Fed’s “nonconventional measures” would likely remain focused on improving the functioning of credit markets, complementing the actions of the Treasury and the Federal Deposit Insurance Corp.

A “thoroughgoing report of the financial system” is essential for a sustained economic recovery but will be “a long, drawn-out process,” she said.

Editing by Leslie Adler

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