President Obama’s State of the Union speech on Tuesday will be about economic inequality and the struggles of the middle class, but this week’s most important speech about the American middle class was almost certainly an address given today by Federal Reserve Vice Chair Janet Yellen: A Painfully Slow Recovery for America’s Workers: Causes, Implications, and the Federal Reserve’s Response.

Yellen would have been and still would one day be a viable option to take over the chair from Ben Bernanke. None of the Federal Reserve members were ahead of the game in understanding the housing bust, but Yellen at least had a good sense of what was happening in real time. We know that from the recently released minutes of the Fed Open Market Committee’s minutes from 2007.

From the NYT’s Days Before Housing Bust, Fed Doubted Need to Act (with emphasis added):

More than five years later, the Fed continues to prop up the financial system, and the transcripts of the 2007 meetings, released after a standard five-year delay, provide fresh insight into the decisions made at the outset of its great intervention.

They show that Mr. Bernanke and his colleagues continued to wrestle with misgivings about the need for action, because at the time there was little evidence of a broader economic downturn. Several officials worried that the economy would instead overheat, causing inflation to rise. By December, as the Fed began to act with consistent force, the economy was already in recession.

Officials lacked clear information, relying on anecdotes like a reported conversation with a Wal-Mart executive who said Mexican immigrants were sending less money home. They were also limited by economic models that could not simulate the problems that seemed to be unfolding. [...]

“There’s no guarantee whatsoever that this thing will do what we’re trying to do,” Donald Kohn, then the Fed’s vice chairman, said at a meeting later in August. As the Fed debated a strategy to encourage bank lending, he said, “I just think it’s worth giving it a try under the circumstances.”

But eventually, Mr. Bernanke and his colleagues concluded that they could see the future, that they did not like what they saw and that it was time to act.

“At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage,” Janet L. Yellen, then president of the Federal Reserve Bank of San Francisco, said in December. “Subsequent developments have severely shaken that belief. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real.”

That was the month later dated as the beginning of the recession.

In today’s speech, Yellen outlined the current economic woes in clear terms that began by explaining the reasons for the slow recovery. Nothing new here to regular readers, but still worth a look.

Yellen talks of the usual tailwinds that help the economy out of recession:

  • fiscal policy (government spending),
  • the lack of new residential investment,
  • and confidence.

All of those were hampered by conditions this time. A few excerpts:

The first tailwind I’ll mention is fiscal policy. History shows that fiscal policy often helps to support an economic recovery. [...]

However, discretionary fiscal policy hasn’t been much of a tailwind during this recovery. In the year following the end of the recession, discretionary fiscal policy at the federal, state, and local levels boosted growth at roughly the same pace as in past recoveries, as exhibit 3 indicates. But instead of contributing to growth thereafter, discretionary fiscal policy this time has actually acted to restrain the recovery. State and local governments were cutting spending and, in some cases, raising taxes for much of this period to deal with revenue shortfalls. At the federal level, policymakers have reduced purchases of goods and services, allowed stimulus-related spending to decline, and have put in place further policy actions to reduce deficits. I was relieved that the Congress and the Administration were able to reach agreement on avoiding the full force of the “fiscal cliff” that was due to take effect on January 1. While a long-term plan is needed to reduce deficits and slow the growth of federal debt, the tax increases and spending cuts that would have occurred last month, absent action by the Congress and the President, likely would have been a headwind strong enough to blow the United States back into recession. Negotiations continue over the extent of spending cuts now due to take effect beginning in March, and I expect that discretionary fiscal policy will continue to be a headwind for the recovery for some time, instead of the tailwind it has been in the past.

A second tailwind in most recoveries is housing. Residential investment creates jobs in construction and related industries. Before the Great Recession, housing investment added an average of 1/2 percentage point to real GDP growth in the two years after each of the previous four recessions, considerably more than its contribution to growth at other times.

During this recovery, in contrast, residential investment, on net, has contributed very little to growth since the recession ended. The reasons are easy to understand, given the central role that housing played in the Great Recession. [...]

Beyond the direct effects on residential investment, the extraordinary collapse in house prices resulted in a huge loss of household wealth–at last count, net home equity is still down 40 percent, or about $5 trillion, from 2005.7 [...]

Another important tailwind in most economic recoveries is one that tends to be taken for granted–the faith most of us have, based on history and personal experience, that recessions are temporary and that the economy will soon get back to normal. Even during recessions, households’ expectations for income growth tend to be reasonably stable, which provides support for overall spending. In the most recent recession, however, surveys suggest that consumers sharply revised down their prospects for future income growth and have only partially adjusted up their expectations since then.

In addition to noting these weak tailwinds that usually get us out of recession, Yellen also details a few headwinds:

The fiscal and financial crisis in Europe has resulted in a euro-area recession and contributed to slower global growth. Europe’s difficulties have blunted what had been strong growth in U.S. exports earlier in the recovery by sapping demand worldwide. [...]

Long-term unemployment is also a great concern because it has the potential to itself become a headwind restraining the economy. Individuals out of work for an extended period can become less employable as they lose the specific skills acquired in their previous jobs and also lose the habits needed to hold down any job. Those out of work for a long time also tend to lose touch with former co-workers in their previous industry or occupation–contacts that can often help an unemployed worker find a job. Long-term unemployment can make any worker progressively less employable, even after the economy strengthens.

Yellen believes that our current high unemployment is cyclical, not structural. In other words, she thinks that an increase in aggregate demand will allow unemployment to come back to historical norms.

She details why she thinks Fed actions have been effective — even if not nearly as powerful as necessary to drive us toward a faster recovery.

Her conclusion:

It will be a long road back to a healthy job market. It will be years before many workers feel like they have regained the ground lost since 2007. Longer-term trends, such as globalization and technological change, will continue to pose challenges to workers in many industries.

Let me close with some words of encouragement. The job market is improving. The progress has been too slow, but there is progress. My colleagues and I at the Federal Reserve are well aware of the difficulties faced by workers in this slow recovery, and we’re actively engaged in continuing efforts to promote a stronger economy, more jobs, and better conditions for all workers.

And a few of the graphs from her talk:




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