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Twelfth Federal Reserve District
FedViews
December 10, 2009
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
Simon Kwan, vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy
and the outlook:
!
Incoming data continue to indicate that the economic recovery is taking hold. Deterioration
in the labor market is abating. Household spending is expanding at a moderate pace.
Tentative signs suggest that the housing sector may have bottomed, and housing
construction has begun to grow. Financial market conditions have improved further.
!
The employment report for the month of November was better than expected. Nonfarm
payroll employment edged down by just 11,000 jobs, much less than expected, and the
employment counts in September and October were revised to show smaller declines than
previously reported.
!
The unemployment rate fell 0.2 percentage point to 10.0%, which was also better than
expected. Based on all available data, including physical product data, it appears that the
unemployment rate is close to its cyclical peak and is expected to come down gradually.
Nevertheless, the unemployment rate is expected to remain elevated for several years.
!
Resource slack in the economy is both large and persistent, and longer-term inflation
expectations are fairly stable. As a result, inflation is expected to remain subdued over the
next few years.
!
A key driver of recovery is a pickup in household consumption. Real personal consumption
expenditures rose by a brisk 0.4% in October, boosted by a 2% jump in consumption of
durable goods. Economic fears are abating. The housing sector is stabilizing, as is housing
wealth. These developments allow for release of pent-up consumer demand, providing a
positive impetus to household consumption. However, going forward, a weak labor market,
sluggish income growth, and tight credit will likely restrain household consumption,
pointing to a slow recovery.
!
An important barometer of household consumption is auto sales, which have been holding
up reasonably well over the past two months, despite the end of the cash-for-clunkers
program. While heading in the right direction, car sales are still recovering from very low
levels of early this year.
!
In the housing sector, home sales surged in October as buyers rushed to lock in the firsttime homebuyer tax credit, which has since been extended and expanded. Residential
investment rose at an annualized rate of almost 20% in the third quarter, albeit from a very
low base, providing the first positive contribution to GDP growth since 2005.
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 January 18, 2010.
!
A key element supporting the housing sector is very low conforming mortgage rates. The
30-year conforming mortgage rate is the lowest since Freddie Mac began reporting the
weekly average in 1971. Since last November when the Federal Reserve announced the
purchase of up to $500 billion in agency mortgage-backed securities (MBS), since raised to
up to $1.25 trillion, the 30-year conforming mortgage rate has dropped from 6.04% to
4.71%, a decline of 1.33 percentage points. The spread between the yield on agency MBS
and 10-year Treasury bonds has also been very low. Currently it is just 0.77 percentage
point. From 2000 to 2007, this spread averaged about 1.30 percentage points. A reversion
to the pre-crisis average would widen the spread by about 0.50 percentage point, which
would push the 30-year conforming mortgage rate up by about the same amount, and could
pose a risk to the housing recovery.
!
Elsewhere in the credit markets, a substantial decline in corporate bond yields raises the
question of whether a bubble is brewing. It should be noted, though, that corporate bond
yields have come down from unusually high levels. The spike in bond yields following the
bankruptcy of Lehman Brothers reflected a classic flight to quality. As financial market
conditions improve and liquidity returns to the bond market, the retracing of bond yields
should be seen as a normalization process rather than as a sign of excessive risk-taking.
Indeed, the yield spreads of corporate bonds over Treasury securities remain somewhat
elevated, which seems to reflect default risk priced into corporate bonds due to
uncertainties about the economic recovery going forward.
!
Corporate profits have rebounded in the last two quarters, perhaps reflecting aggressive
cost cutting more than top-line revenue growth. Nevertheless, equity analysts are
projecting relatively respectable profit growth over the next four quarters. In response to
corporate earnings announcements and profit guidance, and investors’ increased risk
tolerance, overall stock prices have risen briskly since March, also raising concerns of
excessive risk-taking by market participants. The price/earnings (P/E) ratio for the
Standard and Poor’s 500 stock index, based on the past four quarters’ earnings, is
currently at about 22, somewhat higher than its long-term average of around 16.5. To the
extent that corporate profits are expected to be higher over the next four quarters, the
forward P/E ratio based on expected future earnings would be lower. Another measure of
stock valuation, the equity premium between earnings yield and bond yield, remains
elevated. Overall, the runup in stock prices also looks more like normalization than
excessive risk-taking.
!
One area of potential concern may be prices of certain commodities, most notably gold.
Unlike other asset classes that can be examined under a capital asset pricing framework,
commodity prices are largely determined by supply and demand, which can be
challenging to analyze precisely.
Recovery taking hold
Job cuts decelerate
Real GDP
Percent
10
Percent change at seasonally adjusted annual rate
Nonfarm Payroll Employment
Millions of employees; seasonally adjusted
FRBSF
Forecast
Jul.
Aug.
Sep.
Oct.
Nov.
6
4
Q3
139
Monthly Changes
8
2
138
-304K
-154K
-139K
-111K
-11K
137
136
135
134
0
Nov.
-2
01
02
03
04
05
06
07
08
09
10
11
132
-4
131
-6
130
-8
00
133
12
129
00
01
02
Unemployment peaking
03
04
05
06
07
08
09
10
Inflation subdued
Unemployment Rate
Percent
11
Seasonally adjusted
PCE Price Inflation
Percent
5
Percent change from four quarters earlier
Nov.
10
Overall PCE
Price Index
9
4
FRBSF
Forecasts
8
Q3
7
FRBSF
Forecast
2
Core PCE
Price Index
6
5
1
0
4
3
78
82
86
90
94
98
02
06
10
14
-1
00
01
Consumption reasonably solid
Real Personal Consumption Expenditures
02
03
04
05
06
07
08
09
10
11
12
Auto sales holding up
Percent
10
3-month percent change at annual rate
3
Light Vehicle Sales
Millions
22
Seasonally adjusted annual rate
8
20
6
Oct.
18
4
16
2
14
0
Nov.
-2
10
-4
-6
00
01
02
03
04
05
06
07
08
09
10
12
2005
2006
2007
2008
2009
8
2010
1
Housing sector bottomed?
Conforming mortgage rates very low
Home Sales
Mortgage Rate and Agency MBS Spread
Thousands; seasonally adjusted annual rate
Weekly
1600
Percent
9
6500
Existing Homes Sold
(right scale)
1400
1200
8
30-year Conforming
Mortgage Rate
6000
7
6
5500
5
1000
5000
800
New Homes Sold
(left scale)
600
4
12/3
Spread of Current Coupon Agency MBS
over 10-year Treasury
4500
Oct.
3
2
4000
400
1
Avg. 2000-2007
200
0
3500
00
01
02
03
04
05
06
07
08
09
00
10
01
Corporate Bond Rates
Percent
25
Nov.
20
04
05
06
07
08
09
10
Corporate Earnings
2000
Billions of dollars
1600
1200
250
S&P
Forecast
NIPA Economic
Profits before tax,
seasonally adjusted
(left scale)
15
High-Yield
03
Corporate profits rebound
Credit spreads narrow, but remain elevated
Monthly close
02
200
150
Q3
800
100
10
BAA
S&P 500
Operating Earnings
(right scale)
400
5
10-yr. Treasury
0
50
0
AAA
0
86
88
90
92
94
96
98
00
02
04
06
08
10
Stock prices advance, lifting valuation
S&P 500 Index and P/E Ratio
70
60
Monthly close; P/E ratio based on last four quarters earnings
1600
S&P 500 Index
(right scale)
Commodity prices increase briskly
Commodity Price Indices
Index
650
Weekly
Futures
1200
12/1
1000
40
P/E Ratio
(left scale)
800
Nov.
20
10
-50
88 90 92 94 96 98 00 02 04 06 08 10
1400
50
30
-400
450
Spot Industrials
350
600
400
Average
0
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10
250
Spot Foodstuffs
200
0
550
150
91
93
95
97
99
01
03
Source: Commodity Research Bureau
05
07
09
2