In the United States, weakness in the housing market, which has been exacerbated by the financial turmoil, has been a substantial drag on the growth of real gross domestic product (GDP) since early 2006. Declines in real residential investment subtracted about 1 percentage point from the pace of GDP growth last year, and the demand for homes has remained weak so far this year. Residential construction continues to contract, and the overhang of unsold new homes remains quite large relative to sales, although it has not risen too much further in recent months.

Different measures tell somewhat different stories, but it seems clear that U.S. home prices began decelerating a while back and have been posting outright declines in recent quarters. Mortgage defaults and foreclosures are at record highs and delinquency rates are at their highest level in 29 years, which could keep downward pressure on prices for some time to come.

An adverse feedback loop has emerged in the housing sector, as severe difficulties in the mortgage markets have significantly limited the availability of mortgage finance for many borrowers. The lack of mortgage credit, in turn, appears to have further driven down home sales and contributed to the decline in house prices. However, some of the slowdown in mortgage lending has been warranted.

There is a distinction to be made between a normalization of credit conditions from the very easy conditions that prevailed through mid-2007 (which is a good thing from a medium-term perspective) and a full-blown credit crunch in which many clearly qualified borrowers are not provided access to credit. Notably, these sorts of results are also seen in Europe. Surveys by both the ECB and the Bank of England have indicated that banks are tightening lending standards, although credit is still flowing to at least some firms and households.

Recent data suggest that the U.S. economy has proved more resilient than some had anticipated. Although the labor market has softened and consumer sentiment has declined sharply since last fall, consumer spending has thus far held up better than expected. The economy should be supported by monetary and fiscal stimulus, a reduced drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad.

However, the economy faces challenges. With housing construction continuing to decline and energy prices continuing to rise, risks to growth still appear, to my eye, to be to the downside. Households face significant headwinds, including falling house prices, tighter credit, a softer job market, and higher energy prices. Businesses are also facing challenges, including rapidly escalating costs of raw materials and weaker domestic demand, although the strength of foreign demand for U.S. goods and services has offset the slowing of domestic sales to some extent. All that said, we seem to have avoided some of the worst possible outcomes so far.

The economy has been quite resilient to the adverse shock from the recent financial turmoil, but the analysis of its sources I outlined earlier suggests that it will take a substantial amount of time to complete the cleanup of the financial mess and to get the financial system fully back on its feet. Although some of the most complex structured-finance products may be gone for good, securitization will only recover fully when new business models solve the agency problems that were inadequately dealt with in recent years.

Development of these business models by lenders, dealers, regulators, and the credit rating agencies will take time. Furthermore, in my view, financial institutions, particularly banks, will probably play a crucial role in this process. They have the ability to originate loans and make sure that there are incentives for accurate credit assessment of the underlying risks. To restore the public's faith, they need to show that sufficient mechanisms are in place to reasonably assure investors that financial institutions have the incentives to issue good credits. Only when they have rebuilt the confidence that investors previously had in them will banks be able to distribute securities backed by these loans.

There is a catch in all of this, however. Financial institutions cannot expand their activities in these markets without having the capital to do so. Unfortunately, the losses they have experienced recently have put pressure on their capital positions, and, although they are now actively raising capital, getting sufficient capital to fully take advantage of this new business will take some time.

The resulting slow recovery of financial markets that I think is likely suggests that the U.S. economy will be subject to substantial headwinds for some time. Indeed, the situation may be comparable to what happened in the early 1990s when the weakened condition of the banking industry in the United States led to a relatively slow recovery in economic activity. Thus, growth could continue to be quite weak, though I would hope it would pick up next year.

As I've already mentioned, the impacts of the events I've been discussing have not been limited to the United States. Although European growth has held up well so far, it now appears to be slowing, in part because the financial strains and rising commodity prices have weighed on consumer and business confidence and have weakened spending, but also as Europe's housing markets cool, especially in the United Kingdom, Ireland, and Spain.

The headwinds from the financial turmoil I have described may affect them as well. In addition, monetary policy in Europe has eased considerably less as inflation has continued to rise above central banks' targets, largely driven by continued sharp increases in commodity prices.

One important factor behind developments in recent years has been the rapid growth in emerging market economies such as China. On the one hand, rapid growth in Asia has stimulated strong increases in import demand, cushioning the slowdowns in the United States, Europe and Japan, but on the other hand, the rapid growth in demand has pushed up prices for commodities that are in short supply. Thus, inflation rates in many emerging economies have risen sharply. The central banks in most parts of the world are at a crucial juncture: We must all be vigilant to keep inflation expectations anchored and inflation low.

Conclusion
The recent financial turmoil has brought the Federal Reserve into uncharted waters. We found it necessary to build some lifeboats, but we seem to have steered clear of the worst weather. The measures taken by the Federal Reserve and other central banks seem to have helped keep the economy afloat, but this episode of financial distress has raised important questions about the structure of financial regulation and the appropriate role of the lender of last resort.

We expect to strengthen the financial system with an array of regulatory changes, which includes strengthening of capital and liquidity rules, more disclosure requirements, closer supervision of the measurement and management of firm-wide risks, and steps to increase the transparency and resilience of the financial infrastructure. Private investors and other market participants clearly also have crucial roles to play in strengthening the financial system.

While the current turmoil is not yet over, we have seen some signs of improvement. We have learned much from this episode. I am confident that it will be studied for some time to come, and that we will forge a better financial system as a result.

( Frederic S. Mishkin is Governor of US Fed Reserve, Speech at the Caesarea Forum of the Israel Democracy Institute, Eliat, Israel July 2, 2008)