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Twelfth Federal Reserve District
FedViews
March 10, 2011
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
Also available upon release at
www.frbsf.org/publications/economics/fedviews/index.html
Reuven Glick, group vice president in the Economic Research Department of the Federal Reserve Bank of
San Francisco, states his views on the current economy and the outlook:

The economy has shown more signs that recovery is proceeding at a moderate pace.

Real consumer spending rose solidly in the last three months of 2010, although it dipped slightly in
January due partly to weather. Vehicles sales have been increasing steadily over the past year and
rose strongly in February, up 27% from the year before. Escalating gasoline prices represent a
headwind on consumption by draining purchasing power and undermining consumer confidence.

Industrial production, which includes utilities and mining, declined in January, but this was
attributable to a large drop in utilities output as temperatures in some parts of the country returned to
more normal seasonal levels. Manufacturing production is experiencing solid growth. The Institute
for Supply Management indicated that new orders for manufacturers and nonmanufacturers were
very strong in February.

The housing sector continues to perform poorly. Single-family housing starts were unchanged in
January from the month before, while building permits fell substantially. House prices as measured
by the Case-Shiller index fell in December for the third month in a row and were down 2½% from
the year before and 31% from the July 2006 peak.

February’s payroll employment report provided evidence that hiring was improving following
unexpected weakness in January due to weather. The number of nonfarm workers employed in
February rose 192,000. In the past three months, job gains have averaged 136,000 per month while
private-sector job gains have averaged 152,000 per month. The unemployment rate in February fell
by a tenth of a percentage point. Over the past three months, it has declined from 10% to 8.9%,
although some of this decline is associated with discouraged workers leaving the workforce. Another
encouraging sign regarding labor markets is the continuing downtrend in new claims for
unemployment insurance.

Oil prices have been firming since the global recovery began in 2009, but in recent weeks they have
spiked further because of developments in the Middle East and supply uncertainty. Prices of nonenergy commodities, including metals, foodstuffs, and textiles, have also risen sharply. However,
natural gas prices have remained low as increased production has outpaced demand.

Global commodity prices have followed global economic activity as measured by world industrial
production. Commodity prices fell during the recent recession and rose with the recovery, which
increased demand for raw materials, particularly from developing countries such as China. In fact,
increased demand from developing countries accounts for most of the increased world demand for
The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not
intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle
of the month. The next FedViews is scheduled to be released on or before April 18, 2011.
commodities such as oil, wheat, and corn over the past decade. In the case of corn, a substantial
amount of increased demand also reflects its use in ethanol production.

Commodity price swings have a direct impact on headline inflation through higher costs of energy
and food, which account for 14% of overall consumer spending. However, commodity price
swings—even double-digit changes—historically have had only a small effect on underlying
inflation, which excludes spending on volatile energy and food components. To some extent, this
reflects decisions by businesses to adjust profit margins rather than pass through higher costs to
customers, particularly when demand is weak. A more important reason is that for many consumption
goods, commodities and raw materials account for only a small part of the overall cost of production,
particularly compared with the costs of labor, distribution, and retailing. Moreover, roughly threefourths of consumer spending is on services such as housing and medical care that do not involve
many commodities in production.

The data continue to suggest that the economy is gradually improving, albeit with a bit less
momentum than previously projected. As a result of weaker data, higher oil prices, and slightly more
fiscal stringency, we have lowered our real GDP growth forecast slightly to about 3½% this year and
4¼% in 2012 on a fourth-quarter-to-fourth-quarter basis. Unemployment is projected to decline
slowly to about 8½% at the end of this year and 7½% at the end of 2012, with the economy still
operating below potential. Higher oil prices pose a particular risk to this outlook by acting as a form
of tax on household income. However, most estimates indicate that another similar jump in oil prices
likely will shave only a few tenths of a percentage point off GDP growth this year.

Over the past 12 months, overall headline inflation as measured by the personal consumption
expenditures price index has risen 1.2%, while core PCEPI has risen 0.8%. We expect recent
commodity and energy price surges to raise headline inflation temporarily. We foresee relatively little
pass-through to core inflation in 2011 and 2012. The slowly recuperating economy, excess capacity,
and well-anchored long-term inflation expectations will keep labor costs low. In fact, with labor
productivity continuing to rise, unit labor costs have actually been falling recently.
Consumption on an upward trend
Real Personal Consumption Expenditure
Car sales picking up
Percent
Percent change from 12 months earlier
20
Jan.
Durable goods
Nondurable
goods
g
Auto and Light Truck Sales
Seasonally adjusted annual rate
Millions
22
15
20
10
18
5
16
0
Services
Feb.
14
-5
12
-10
10
-15
2007
2008
2009
Source: Bureau of Economic Analysis
2010
8
2011
00
01
Manufacturing expanding
Percent
30
ISM New Orders Index*
(left axis)
70
03
04
05
06
07
08
09
10
11
Housing sector is still weak
Manufacturing Sector
Index
80
02
Feb.
Single-Family Housing Starts and Permits
Seasonally adjusted annual rate
Thousands of units
2000
Housing
starts
20
1600
10
60
50
Manufacturing production**
(right axis)
40
Housing
permits
0
Jan.
1200
-10
30
-20
20
-30
800
400
00
01
02
03
04
05
06
07
08
09
10
Jan.
11
0
* Index above 50 means new orders are increasing
** Annualized percent change from three months earlier
00
Hiring starting to gain traction
Millions
140
Monthly Changes
Nov. 93 K
Dec. 152 K
Jan. 63 K
Feb. 192 K
From peak -7.5
75 M
14
136
12
10
04
05
06
07
08
06
07
08
09
10
11
09
10
11
Natural gas
(Henry hub)
(left axis)
$/bbl
160
Oil (Brent)
(right axis)
140
120
100
80
132
6
60
130
4
128
03
05
8
Feb.
02
04
Average monthly spot price
$/MMBtu
16
138
134
01
03
Oil and Natural Gas Prices
Millions of employees; seasonally adjusted
00
02
Oil prices rising; natural gas prices falling
Nonfarm Payroll Employment
Source: Bureau of Labor Statistics
01
2
Oil (WTI)
(right axis)
40
3/10/11
20
0
0
00 01 02 03 04 05 06 07 08 09 10 11
Commodity prices track world demand
World demand reflects developing country growth
World Industrial Production and Commodity Prices
Oil Demand Increase from 2001 to 2009
Index (2000=100)
145
Dec.
140
Feb. 135
Index (2000=100)
300
World industrial production
275
(right scale)
250
Million barrels per day
World
9
Developing
countries
ex. China
7
130
225
5
125
200
China
120
175
115
150
110
125
100
United
States
105
Non-energy commodity prices
(CRB, left scale)
3
Industrial
countries
ex. US
1
100
-1
95
75
00 01 02 03 04 05 06 07 08 09 10 11
Source: Netherlands Bureau for Economic Policy Analysis and CRB
Pass-through from fuel and materials prices
to core inflation is low
Material Prices and Core PCE Price Index
12-month %change
60
Jan.
Most consumption spending is on services
Composition of Personal Consumption Expenditures
2010
20
Financial services
8%
0
Fuel & energy
6%
Apparel
3%
Other nondurables
8%
Restaurants
6%
-20
Fuel & crude
materials
Food
8%
Housing
excl. energy
16%
40
Core PCE
price index
-3
Source: US Energy Information Administration
-40
Motor vehicles
3%
Household durables
3%
Other durables
5%
Other
services
18%
Medical care
16%
-60
Note: Noncore consumption= Food+Fuel&Energy= 14% of spending;
red=nondurables, blue=durables, green=services. Source: BEA
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
Source: Bureau of Labor Statistics
Gradual expansion is on track
Real GDP
Underlying inflation remains low
Percent
10
Percent change at seasonally adjusted annual rate
FRBSF
Forecast
PCE Price Inflation
Percent change from four quarters earlier
Percent
5
4
Overall PCE
price index
5
Q4
FRBSF
forecasts
0
2
Q4
Core PCE
price index
-5
3
1
0
-10
00
01
02
03
04
05
06
07
08
09
10
11
12
-1
00
01
02
03
04
05
06
07
08
09
10
11
12