Many financial institutions are still deleveraging – a factor in why we are seeing too little lending rather than too much. Real estate can be a very important asset because it serves as collateral for many loans. However, in the current situation both residential and commercial real estate are, at best, stabilizing. 5  Banks must, of course, maintain their capital ratios. As some banks have taken significant losses that drained capital, they have been reluctant to expand lending, so that the supply of loanable funds has likely been constrained. But this supply-side effect has been exacerbated by the credit condition of potential borrowers in the wake of the Great Recession. Even for banks that are less capital-constrained, with the balance sheets of many potential borrowers in much worse shape than they were before the recession, lenders making prudent lending decisions will be reluctant to lend to high-risk potential borrowers. 4  BIS Review 62/2010  Even if we were to see asset prices rising, it is not obvious that somewhat tighter interest rates will make a significant difference. A more targeted approach would be to examine whether supervisors should require tighter lending standards, or higher capital requirements, in areas where asset prices are appreciating rapidly. This would make sense from the perspective of good risk management – if institutions hold assets that appreciate quickly, they should retain sufficient capital and be vigilant in credit standards to insure that they can weather a quick reversal in asset prices.
4 Such a growth rate has some historical precedent, as shown on the right side of the chart, but it is much faster than the growth rate in the past two recoveries. And to reach 5 per cent unemployment by 2015 would still take growth averaging 4.2 per cent per year – considerably faster than the average rate of growth after the 1991 and 2001 recessions. Given the need for very rapid growth to get unemployment back to 5 per cent, let me pose an oversimplified question – why would policymakers not keep monetary policy very accommodative, and fiscal policy very stimulative, until we had a sustained growth rate that brought the economy much closer to full employment? At least on the monetary side, one reason might be concern among policymakers that rapid growth would be inflationary. To explore that, let’s turn to Figure 7, which shows the total and core inflation rates, measured by changes in the CPI, with recession shading. What the chart shows is that inflation has declined in each recession, including this so-called Great Recession. It also highlights that inflation tends to continue falling in the early stages of a recovery. Figure 8 shows the change in the inflation rate from the business cycle peak. From the peak (shown at zero on the horizontal axis) the inflation rate is very restrained, and generally negative, for many months.