What we wanted to convey in the alternative scenarios that we showed this time—and we reduced the number because we thought the possible little risks that you might be facing were being swamped by some really big ones—was our sense that the likelihood function is pretty flat around the baseline and the two alternative scenarios that we show here in exhibit 5. I share your discomfort. As I was telling President Evans at lunch today, I feel a bit as though the forecast is going to depend a lot on when the clock stopped, given how much volatility there has been in the stock market and in corporate spreads. When the clock stopped, we had close to a 25 percent weaker level on the stock market, 200 basis points higher on the Baa spread, and a 7 percent higher dollar. There were a whole lot of negative forces operating on this forecast. Indeed, both the conventional wealth effect and cost-of-capital channels account for about one-third of the downward revision we made. The special nonconventional credit channel effects account for a third, and a third of the downward revision really is a combination of the stronger dollar and the weaker foreign outlook.
The part that I feel most comfortable with in this forecast is that there has been a very significant negative shock to the economy and that it is difficult to imagine that activity will not be affected importantly by that. The part that I feel most uncertain about—and, as you point out, is relevant to the policy decisions that you are going to make over the next several meetings—is that I have no idea about the timing or the manner in which this will fade away. So we have it fading away gradually over the next two years. I think that a more rapid recovery is certainly a possibility. As you noted, even that scenario doesn’t go back to where we were in September. One, the incoming data suggest that the underlying economy is starting out at a weaker place, and even if conditions were to improve very rapidly over the next quarter or two, you have still sustained a hit that is going to take some time to play out through the system. By the same token, I don’t think that you can discount the more extended and deeper financial fallout here. We have certainly been surprised over the past year in many ways by just how virulent and persistent this shock has been. Two, looking at the current state of aggregate demand and aggregate activity, I think we are probably still just at the front edge of the credit constraint effects on actual spending. So you could still be faced with some very substantial restraint on spending—and more than we have built into the baseline forecast.
So, and as you noted, the difference in the policy prescriptions there—the worse scenario is that the funds rate stays as low as it can stay for several years. The other would be—putting too fine a point on it—that optimal control, even with the more rapid recovery, goes down to 1 percent on the funds rate and then starts recovering to 1½ percent. But that is obviously a very different policy picture. I just don’t think that, at this point, science is going to allow us to put a lot of probability mass on one of those scenarios versus the other two.