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Twelfth Federal Reserve District
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
FedViews
Also available upon release at
www.frbsf.org/publications/economics/fedviews/index.html
FedViews – July 9, 2009
Mary C. Daly, vice president and director of the Center for the Study of Innovation and Productivity at the
Federal Reserve Bank of San Francisco, states her views on the current economy and the outlook:
•
Financial markets are improving, and the crisis mode that has characterized the past year is subsiding.
The adverse feedback loop, in which losses by banks and other lenders lead to tighter credit
availability, which then leads to lower spending by households and businesses, has begun to slow.
As such, investors’ appetite for risk is returning, and some of the barriers to credit that have been
constraining businesses and households are diminishing.
•
The housing sector, which has been at the center of the economic and financial crisis, also looks to be
stabilizing—albeit, at a very depressed level. The pace of house price declines is slowing, housing
starts and new home sales have leveled off, and existing home sales have edged up in recent months.
These positive developments suggest that the housing market may be reaching a bottom.
•
Income from the federal fiscal stimulus, as well as some improvement in confidence, has helped
stabilize consumer spending. Since consumer spending accounts for two-thirds of all economic
activity, this is a key factor affecting our forecast of growth in the third quarter.
•
Whether the adverse feedback loop will continue to slow and ultimately reverse depends in part on
the labor markets, which continue to deteriorate. The economy lost 467,000 nonfarm jobs in June
and the unemployment rate rose to 9.5 percent. Although recent monthly job losses remain sizable,
the pace of declines, however, is lower than earlier this year.
•
That said, ongoing weakness in the labor markets continues to push up foreclosures and pose risks to
the fledgling recovery of housing.
•
Although the economy continues to face many downside risks, we expect the easing of the financial
crisis and the bottoming out of the housing market to allow a modest recovery to ensue in the third
quarter. In our view, the recovery will be painfully gradual, with the economy expanding below
potential for several quarters.
•
The gradual nature of the recovery will put additional pressure on state and local budgets. Following
a difficult 2009, especially in the West, most states began the 2010 fiscal year on July 1 with even
larger budget gaps to solve.
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 September 14, 2009. •
While such gaps are typical in recessions, state governments face far larger problems than
usual since all of their major sources of revenue (income, sales, and property taxes) have
been disrupted. The federal fiscal stimulus payments to states should help stave off even
worse difficulties, but the states likely will face constrained budgets for years to come.
•
As the financial crisis has subsided and the economy has begun to stabilize, some worries
about inflation have emerged. In the near-term, we expect the slow recovery and the
persistent and considerable slack in product and labor markets to keep inflation below its
preferred longer-run rate as reflected in the minutes of the Federal Open Market
Committee meeting held in April.
•
In manufacturing, capacity utilization is at an all time low. This excess capacity should
continue to exert downward pressure on both input and final goods prices.
•
There also is unprecedented slack in the labor markets. Considering the official
unemployment rate plus the number of workers who are employed part-time involuntarily
for economic reasons, the overall measured slack is in excess of the 1982 recession.
Moreover, we foresee this measure rising even higher by the end of the year.
•
This slack in the labor markets should continue to temper growth in wages and salaries,
which has dropped off sharply over the course of the recession.
•
Despite the considerable downward pressures on prices, concerns about deflation appear
to have abated. Market participants now expect inflation over the next five years to be on
average around 1%, roughly in line with our forecast.
•
Over the longer-run, inflation expectations are higher, hovering in a 2 to 3% range, and
despite considerable media worries about future inflation risk, expectations remain wellanchored.
•
Still, many remain worried that large fiscal deficits will eventually be inflationary.
However, a look at the empirical link between fiscal deficits and inflation in the United
States shows no correlation between the two. Indeed, during the 1980s, when the United
States was running large deficits, inflation was coming down.
Three Issues


subsides
Fiscal/Fed
actions
Consumers
hang on
Labor market
struggles
problem
Multiyear issue
Usual pattern,
unusual size


Chained 2000 dollars, Seasonally Adjusted Annual Rate
Billions of $
9000
 Near-term:
 Widespread
 Crisis
Real Personal Consumption Expenditures
Inflation
worries
State
budget gaps
Economic
Outlook

Consumers hanging on
8500
low inflation
due to weak
economy
8000
 Longer-term:
7500
high inflation
due to
extraordinary
monetary
accommodation
and fiscal
deficits
7000
6500
6000
2000
Job losses continue to mount…
2001
2002
2003
2004
2005
2006
2007
2008
…pushing up unemployment.
Alternative measures of labor utilization
Nonfarm Payroll Employment
Millions of employees; seasonally adjusted
2009
Percent of labor force
18
Millions
140
Monthly Changes
Mar.
Apr.
May.
Jun.
15
-652 K
-519 K
-322 K
-467 K
138
Official unemployment rate
+PT for econ reasons
12
136
From peak -6.5 M
9
134
6
132
Jun.
Official unemployment rate
3
130
128
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
0
1967
Modest recovery to begin in Q3
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
State budget gaps pervasive in 2009
Real Gross Domestic Product (GDP)
Percent change at seasonally adjusted annual rate
Percent
8
FRBSF
Forecast
6
4
2
0
Q2
-2
-4
-6
Q1
-8
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1
Gaps are typical in downturns…
Near-term: expect inflation to fall
State and Local Govt Receipts minus Expenditures
Core PCE Price Inflation
As percent of U.S. GDP
Percent
3
Percentage change from four quarters earlier
Percent
3
2.5
2.5
2
Preferred rate
2
1.5
1.5
1
0.5
1
FRBSF forecast
0
…but current magnitude is
unprecedented.
0.5
-0.5
0
-1
1995
1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
Capacity utilization at all time low
Manufacturing Capacity Utilization
Percent
90
2000
2005
2010
Near-term deflation fears abating
Inflation Expectations Next 5 years
based on breakeven inflation rates adjusted for an indexation lag
Percent
4
85
3
80
2
75
1
1968-2008
average
70
0
65
-1
May
60
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
-2
2004
Long-run inflation expectations…
Inflation Expectations 5-10 years ahead
2005
2006
2007
2008
No link between deficits and inflation
Fiscal deficits and core inflation
based on breakeven inflation rates adjusted for an indexation lag
2009
Percent
15
Percent
4
Michigan Survey Inflation Expectations
10
3
TIPS-implied
breakeven inflation rate
2
Core PCE
inflation
5
0
1
Federal deficit
as % of GDP
…appear to be well-anchored.
2004
2005
2006
2007
2008
2009
0
-5
-1
-10
-2
-15
1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
2