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Twelfth Federal Reserve District
FedViews
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
September 14, 2012
Also available upon release at
www.frbsf.org/publications/economics/fedviews/index.php
Simon Kwan, vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy and
the outlook.

Incoming data indicate that economic activity has continued to expand at a moderate pace in recent
months. Nonfarm payrolls rose by only 96,000 in August, while gains in July and June were revised
down by 41,000 jobs. That put June-through-August job growth at a meager 94,000 per month, a
notable downshift from average job creation of over 200,000 per month over the first three months of
the year.

Amid slow job growth, the unemployment rate remains elevated at 8.1%, nearly unchanged since the
beginning of the year and well above its longer-run normal level. Other indicators, including the rate
of participation in the labor force, confirm pervasive labor market weakness. The recent stagnation of
the labor market, if not reversed, could pose a serious threat to the economy’s long-term health.

While household spending has continued to advance, capital outlays have slowed. New orders for
core capital goods have also dipped below shipments lately, pointing to potentially further slowing in
business capital investment.

During the current recovery, aggregate capital expenditures by nonfinancial corporations have
consistently been below the funds these businesses have generated internally, which consists mainly
of after-tax profits and noncash business expenses such as depreciation.

The sluggish business investment seems even more striking given the strength of corporate balance
sheets. Profit margins of nonfinancial corporations have been holding up well, and equity analysts are
forecasting robust earnings growth in future quarters. Meanwhile, data suggest that nonfinancial
firms are sitting on a lot of cash and other liquid assets, and have ample borrowing capacity.

One crucial factor driving sluggish hiring and lackluster capital investment appears to be heightened
uncertainty about the future. This uncertainty is fueled by several factors, including the halting
recovery in sales and demand, the protracted European debt crisis, and a lack of clarity on what will
happen with near-term and longer-term federal fiscal policy, including the “fiscal cliff.”

With excess capacity in the economy and below-trend growth, inflation has been subdued. The
medium-term outlook is that inflation is likely to run at or below the 2% target that Federal Reserve
policymakers consider most consistent with their maximum employment and price stability goals.
Looking ahead, the odds appear to have risen that the Fed will continue to miss both its maximum
employment and price stability mandates.
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 October 15, 2012.

Thus, the stage was set for the Fed’s policy body, the Federal Open Market Committee (FOMC), to
act boldly. At its September meeting, the FOMC moved to provide additional monetary stimulus,
using both its balance sheet and its communication tools. The FOMC announced that the Fed will
purchase additional agency mortgage-backed securities at a pace of $40 billion per month. The Fed
will also continue the Maturity Extension Program announced in June to increase holdings of longerterm Treasury securities and decrease holdings of short-term Treasuries. And the Fed will maintain
its existing reinvestment policy to replace maturing securities. If the labor market outlook does not
improve substantially, the Fed will continue purchases of agency mortgage-backed securities, carry
out additional asset purchases, and employ other policy tools as appropriate until improvement is
achieved in a context of price stability.

The policy of open-ended purchases of securities is unprecedented for the Fed. The shift to a flowbased balance sheet policy instead of a fixed quantity of purchases provides greater flexibility for the
Fed to respond to new information. As always, the Fed will monitor economic and financial
developments to assess the efficacy and costs of asset purchases.

The new policy initiatives have a critical communications component. In explicitly laying out the
conditions for stopping the asset purchase program—a broad-based improvement in the labor
market—the Fed is underscoring its resolve to support economic growth. Doing so should reduce the
uncertainty about whether asset purchases will be enough to improve labor market conditions. And,
by stressing that it will conduct asset purchases in a context of price stability, the Fed is reconfirming
its commitment to its dual mandate.

The FOMC also emphasized that it expects a highly accommodative stance of monetary policy to
remain appropriate for a considerable time after the economic recovery strengthens. This reassures
the public that the Fed will not tighten policy prematurely as the economy picks up. In particular, the
FOMC extended its guidance on future policy by stating it anticipates exceptionally low levels for the
Fed’s benchmark federal funds rate are likely to be warranted at least through mid-2015.

The additional monetary stimulus is expected to support a stronger recovery, boosting GDP growth to
about 2.5% in 2013 and about 3.3% in 2014. At the same time, the unemployment rate is expected to
come down a bit faster, to about 7.9% by the end of 2013 and about 7.3% by the end of 2014.
Inflation as measured by the personal consumption expenditures price index is projected to be only
slightly higher than without the stimulus—1.7% in 2013 and 1.8% in 2014.
New orders have dipped below shipments
Nondefense Capital Goods (Ex. Aircraft)
Seasonally adjusted, three-month moving average $ bil.
70
Strong cash flow but sluggish investment
Components of Financing Gap
$ bil.
Nonfinancial corporations
1400
Jul.
New orders
Internal
Funds
65
Q1
1000
60
Shipments
800
55
Capital
Expenditures
50
45
05
06
07
08
09
10
11
12
$
0.15
03
04
05
06
07
08
09
10
11
12
Analysts forecast robust earnings growth
Corporate Earnings Growth
%
Year-over-year
NIPA, economic profits
before tax,
seasonally adjusted
Q2
Forecast
0.10
Q2
S&P 500
Operating
Earnings
0.05
0.00
05
01 02 03 04 05 06 07 08 09 10 11 12
Firms holding lots of cash
Liquid Assets to Total Assets
Nonfinancial firms in S&P 500
%
12
Q2
600
400
02
Source: Flow of Funds
Profit margin is high
NIPA Profit Margin for Nonfinancial Corporations
After tax with IVA and CCA per unit; s.a.
1200
06
07
08
09
10
11
12
90
70
50
30
10
-10
-30
-50
-70
-90
-110
13
Firms have ample debt capacity
Debt to Asset
Nonfinancial firms in S&P 500
%
35
10
Q2
30
8
25
6
4
00 01 02 03 04 05 06 07 08 09 10 11 12
Source: Compustat
20
00 01 02 03 04 05 06 07 08 09 10 11 12
Source: Compustat
Stimulus supports a stronger recovery
Gross Domestic Product (GDP)
Percent change at seasonally adjusted annual rate
FRBSF
Forecasts
without
additional
stimulus
Q2
Accelerates progress on unemployment
%
5
Unemployment Rate
without
additional
stimulus
4
2
Aug.
7.5
FRBSF
Forecasts
6.5
2011
2012
2013
2014
Ensures inflation close to 2 percent
PCE Inflation
Percent change from four quarters earlier
%
5
Overall PCE
Price Index
4
Q2
FRBSF
Forecasts
3
2
Core PCE
Price Index
without
additional
stimulus
1
0
-1
04
05
06
07
08
09
10
11
12
13
14
-2
5.5
4.5
1
2010
9.5
8.5
3
0
%
10.5
04
05
06
07
08
09
10
11
12
13
14
3.5