FRBSF Economic Letter
2001-35; December 7, 2001
The U.S. Economy after September 11
Letter is adapted from remarks by Robert T. Parry, President and CEO
of the Federal Reserve Bank of San Francisco, delivered on November 19,
2001, to the 24th Annual Real Estate and Economics Symposium sponsored
by U.C. Berkeley's Fisher Center for Real Estate and Urban Economics.
In many ways—even for those of us who have not lost friends, loved ones,
and livelihoods—our world has become a different place since the horrifying
events of September 11. In terms of the nation's economy, the attacks
struck while we were vulnerable, pushing us from sluggish growth to an
outright contraction. In these remarks, I'd like to review those difficult
days against the background of where the overall economy seemed to be
at the time. Then I'll take a look at where we are now, and finally where
I think we're heading over the longer term. To put it briefly, I'd say
that, over the short term, the outlook isn't great, and there's a lot
of uncertainty. But I think it's important to emphasize that the longer-run
outlook is good. Our economy is fundamentally strong, and it still affords
tremendous opportunity. And those qualities do bode well for our economic
The U.S. economy before September 11
Before the attacks, the national economy had been in the midst of a cyclical
slowdown that actually started back in mid-2000. What caused the economy
to slow? Much of the cause appears to stem from the consequences of some
over-reaching during the five years before, when strong fundamentals propelled
growth to phenomenal rates. Specifically, the technology boom led to huge
investments in information processing equipment and software, and with
that came a huge run-up in equity values.
By mid-2000, then, there was a pullback. Firms had already accumulated
a lot of capital equipment and inventories, so they just weren't in the
market to buy more for a while; and equity values began to drop as investors
re-evaluated the long-run profitability of many high-tech firms. This
isn't to say that the technology surge was merely a phantom. Rather—even
though the surge was real and substantial—markets appear to have gotten
carried away. As a result of these developments, we saw large declines
in business investment and manufacturing output.
So the slowdown was essentially part of a natural process—a correction—that
would eventually lead back to robust growth. In fact, up through the spring
quarter, growth was still in the positive range, if only barely, thanks
largely to moderate strength in consumer spending. Consumers appeared
to be "looking through" the downward part of the business-investment
cycle, confident that the longer-run fundamentals were still sound. So
the durability of the expansion depended importantly on consumer confidence.
And though the data for August and early September were mainly downbeat,
we expected to see more acceptable growth before too many more quarters
And then came September 11.
The Federal Reserve's response to the attacks
I'd like to speak briefly about the Fed's immediate response to those
terrible events. The literal response was in our press statement that
day: "The Federal Reserve System is open and operating. The discount
window is available to meet liquidity needs." Those 17 words were
meant to assure the public and the markets of two things—the Fed stood
ready to play its regular role in the payments system, and the Fed stood
ready to play its role of providing liquidity in times of crisis.
In terms of the payments system, we worked to ensure the continuation
of vital services like electronic funds transfers, check-clearing, and
currency processing. This took some extraordinary efforts—especially
with air transport shut down for three days—and, for the most part, the
In terms of providing liquidity, we were concerned that the disruptions
to the financial markets could have dire consequences for the economy
as a whole, so we provided additional funds until orderly functioning
could be restored. This included injecting massive amounts of liquidity
through discount window loans and open market operations: on the three
days after the attacks, the total injection amounted to over $100 billion
a day. In addition, we lowered short-term interest rates twice over the
next three weeks by 100 basis points in total.
To help foreign banks operating in the U.S. and their customers meet their
obligations, the Fed also set up swap lines with several foreign central
banks. This also was a time to bend and give firms some room to deal with
the disruptions. So we temporarily suspended our usual fees and penalties
on daylight and overnight overdrafts to ease banks' problems in managing
their reserve positions. And we also temporarily suspended our rules on
securities lending to make additional collateral available to the markets.
As markets returned to more normal functioning, we let the federal funds
rate fall below the formal target for a few days to ensure that there
was ample liquidity.
These actions helped ensure that the financial markets could function
efficiently as soon as possible, thereby minimizing disruptions to economic
The economic outlook over the short run
Besides the disruptions to financial markets, there were other reasons
for activity to stall in the weeks and months after the attacks. As I
already said, we were in the midst of a cyclical slowdown before the attacks,
and it was largely consumer spending that was keeping real GDP growth
barely positive. [Note: On November 26, the National Bureau of Economic
Research announced that it had determined that the U.S. economy entered
into a recession in March 2001.] By undermining consumer confidence, the
attacks hit directly at the economy's main pillar of support. And, of
course, it's not surprising that business confidence also suffered, since
consumer spending represents about two-thirds of overall demand for goods
Indeed, the latest surveys show that consumer confidence is way down.
Most categories of consumer spending plummeted in September but recouped
a good bit in October. Of course, auto sales have been strong because
of temporary sales incentives. But industrial output and business investment
spending still appear to be dropping sharply, as they have for several
One of the clearest monthly measures of our economic performance is payroll
employment, and recent news is grim. In October, private payroll employment
fell by 439,000 jobs—the largest one-month decline in more than fifteen
years—and the unemployment rate jumped from 4.9% to 5.4%.
In terms of overall economic activity, real GDP contracted at about a
half a percent annual rate in the third quarter, after being pulled down
in the last three weeks of the quarter by the aftermath of the attacks.
For the current quarter, I'd have to agree with what most forecasters
are saying. We almost certainly face further rises in the unemployment
rate, which could put even more of a damper on consumer confidence, and
the falloff in activity is likely to be sharper than it was in the third
Of course, there are a lot of wild cards, and an important one going
forward is the spread of economic weakness around the world. Part of this
is related to our own downturn, as softer U.S. demand for foreign products
slows production and job growth abroad. But part also is related to developments
originating in other countries. For example, Japan is suffering from a
deflationary spiral, and efforts by the European Central Bank to ease
policy have been limited by inflationary pressures. So, in effect, the
world economy has been hit by several different shocks at the same time.
A longer-term perspective
So far, I've focused on the short run, and, admittedly, what we can see
looks pretty rocky. But let me turn now to the longer run, where the picture
is a good deal more positive. Why? Because there are several important
sources of stimulus that should make economic activity rebound.
First, the Fed has cut short-term interest rates ten times since January.
The federal funds rate now stands at 2%, compared to 6-1/2% back then.
The second source of stimulus is fiscal policy, which is coming in three
programs: the major tax reduction in June, including the recent tax rebates,
the emergency spending bill enacted just after the attacks, and the fiscal
stimulus bill currently in the Congress. These fiscal programs add up
to a major amount of stimulus—perhaps around $160 billion in fiscal year
2002. Third, energy prices have declined this year. The price of imported
oil has fallen by nearly half since last November, and the price of natural
gas has fallen even more dramatically. These price declines give firms
and households more purchasing power, and they should help stimulate demand.
Fourth, the "overhang" of capital equipment and software, as
well as inventories, that I mentioned earlier is one that will correct
itself with time. At some point, the stocks of these assets will get to
low enough levels that firms will need to start spending on them again.
Nowhere is a recovery in business demand for high-tech equipment and software
more critical than here in the Bay Area. About a third of our economy
depends directly on these sectors. Although high-tech manufacturers go
through periodic downturns, the heights reached during the recent technology
boom meant that the industry had further to fall this time. Moreover,
this tech downturn is unique because the hardware slump was reinforced
by the dot-com implosion. The resulting losses in jobs and wealth have
spilled over to other sectors and pulled the rug out from under the area's
expansion. For example, the job count has fallen substantially this year,
and the number of individuals looking for work has increased by over 100,000
since last December.
The effects in commercial real estate markets have been startling. Vacancy
rates on office space shot up this year, with the rate in San Francisco
rising above that in Los Angeles for the first time in recent memory.
And with sub-leases by struggling companies accounting for much of the
available space, the full financial shock to landlords has yet to be felt.
The events of September 11 have largely served to reinforce these trends.
The timeline for recovery in the high-tech sector has been pushed out
by business uncertainty in the aftermath of the attacks. And Bay Area
commercial real estate markets will remain weak until the high-tech sector,
and the national economy in general, are back on their feet.
Looking toward economic recovery
When will the recovery kick in? Most likely sometime next year. But,
frankly, there's no way to know exactly when. I do know this, however.
The economy will recover, and, in the long run, its fundamentals are strong.
First, both monetary and fiscal policies were sound going into the current
situation. Inflation in the U.S. has been relatively low and stable. This
allows our market system to work efficiently, and it has allowed the Fed
the flexibility to ease policy aggressively. In terms of fiscal policy,
we came into the current situation with the federal budget in surplus.
That promoted private saving and investment, and it allowed fiscal policy
to ease aggressively.
Second, our economy has a resilient structure—financial markets are deregulated,
the banking system is sound, and our labor markets are flexible—so we
can adjust relatively quickly to the kinds of shocks we've recently suffered.
Last, but by no means least, the kinds of technological advances that
propelled the economy in the latter half of the 1990s are still in train.
These developments operate on a long time scale, and they're not likely
to be affected much by the kinds of cyclical developments we face today.
The key point is that the outlook for productivity over the long haul
continues to be bright, and this is what matters for our standard of living.
These positive fundamentals are just as pertinent for the Bay Area—and
with this region's focus on technology, perhaps even more so. Over the
longer run, the technology and entrepreneurship we've become famous for
will be a source of strength to the economy both in the nation and here
Robert T. Parry
President and Chief Executive Officer