The U.S. economy may face “subdued” performance for the next two quarters, with output that’s barely positive or barely negative, Gary Stern, president of the Federal Reserve Bank of Minneapolis, said in an interview Tuesday.

stern1_blog_20080219140410.jpg

Stern

The current environment is similar to the early 1990s when “headwinds,” a phrase then Federal Reserve Chairman Alan Greenspan used to refer to the lenders’ reluctance to lend, weighed on the economy, he said. “It took some time for that to all dissipate,” Mr. Stern said. “There was a lot of concern about the initial sluggishness of the recovery. … I personally expect that’s going to turn out to be the case here as well.”

Mr. Stern, co-author of “Too Big To Fail: The Hazards of Bank Bailouts,” talked with Wall Street Journal reporters and editors about the Fed’s recent liquidity measures and his outlook for the economy. Excerpts:

Do you think the Fed’s move to help investment banks opened up Pandora’s box?

I’m not sure I’d use the phrase Pandora’s box. … I do think that was a major step in providing credit to investment banks and primary dealers. Personally I don’t think there’s any going back from that. That’s not to say that the current facilities are going to be permanent or anything. But the precedent’s been set. I’ve written a lot and expressed a lot of concern about too big to fail and moral hazard and so forth. And I think those issues, once we get some of the current turmoil and strain behind us, I think some of those issues are going to require a very, very careful look….

One of the points we’ve made repeatedly both in the book and other places is, in the middle of a great deal of turbulence is not the time to try to teach somebody a lesson about too big to fail. We’ve never advocated no support or bailout under any conditions, because that’s not good public policy. If you’re really worried about systemic risk and spillover and contagion effect, there may be cases — and I think Bear Stearns was one of them — where intervention is appropriate. It’s appropriate because the potential costs of not acting were potentially very, very high. … Extension of the safety net, the perverse incentive effects of that, the signal it sends to creditors, means you need to find some way to the extent you can of containing too big to fail going forward. … You’ve got to do it when times are tranquil in the financial system. In the middle of a crisis is not the time. That could turn out to be exceedingly costly and exceedingly bad public policy.”

Some of your colleagues have said that maybe it wasn’t wise to keep rates as low or for as long as the Fed’s policy committee did earlier this decade. Do you agree?

It’s hard to separate what I think now from what I thought at the time. I think with the benefit of hindsight, rates may have stayed too low for too long. But if you put yourself back in that environment, don’t forget: There was concern about we were heading toward deflation … and that it might be very difficult to execute effective policy in that environment. We look to bring as much economic science to this as you can, but you’re always making judgments, there’s no getting around it.

How do you prevent the perception that the Fed, after doing whatever it takes in cutting rates, would be measured and gradual in raising them?

It’s not impossible. … We have to be prepared to put some weight on forecasts. You can’t wait until you’re 100% confident that all the problems are behind us, the economy’s now growing robustly and it’s time to change policy. … Maybe we’ll be dealt that hand where that actually plays out, but I don’t know that we will be. So you have to put some weight on forecasts. You’ve got to be prepared to say, yes there are still some problems, the current environment isn’t all that we might like it to be, but we really think the outlook is pretty good and it’s time to act. The other part of it is to remind ourselves how flexible and resilient the economy is.”

Do you think we’re going to avoid a recession?

No. But there are recessions and then there recessions. The previous two were short, and the most recent one was not only short but shallow. I think that’s what really matters to people. The average resident doesn’t distinguish between whether the economy is growing half a percent or one and a half percent. That’s not their interest. It’s more, how does this feel? Are conditions generally improving noticeably or aren’t they?