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Twelfth Federal Reserve District
FedViews
October 13, 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
Glenn D. Rudebusch, senior vice president and associate director at the Federal Reserve Bank of San Francisco,
states his views on the current economy and the outlook:
•
Five key questions are often asked about current economic and financial conditions: Has the
financial crisis ended? Is the recession over? Will the economy return to full employment
and normal conditions anytime soon? Is inflation going to jump too high? Does the Federal
Reserve have an “exit strategy” to undo its extraordinary policy actions of the past two
years? The answers, respectively, are: Mostly, Almost certainly, No, No, and Yes.
•
The financial crisis has eased. In particular, financial market conditions have improved, with
lower liquidity and risk spreads in the interbank lending, commercial paper, and corporate
debt markets. Also, although banks remain reluctant to lend, large financial institutions
generally appear more secure—buttressed by the acquisition of new capital. At the same time
though, prospects for many smaller banks appear bleak, with losses in the offing, especially
on commercial real estate loans.
•
The recession that began in the fourth quarter of 2007 appears to be over. Technically,
recessions are periods when broad measures of production, employment, real income, and
real sales are falling. Since the summer, many measures of overall economic activity have
been slowly growing, despite continued job losses. However, even if the recession is over,
the level of production is very low. And the pain this produces in the form of low income,
sales, and employment remains acute.
•
Although growth has returned, the economy will remain in a deep hole with high
unemployment and underutilized productive resources for some time. So, even though the
recession is over, production, income, sales, and employment will persist at subpar levels. A
large amount of unemployed or underutilized labor and capital remains in the economy, and
it will take a sustained period of growth for the economy to return to its normal or potential
level.
•
It appears highly unlikely that inflation is going to jump too high. In the short run, excess
supply is pushing inflation lower. Unemployment is holding down wages and labor costs,
housing vacancies are holding down rents, and ample unused production capacity limits
pricing power. In the long run, the Federal Reserve controls inflation. For the past thirty
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 November 16,
2009.
years, the Fed has taken difficult actions to lower inflation. After finally achieving effective
price stability, the Fed will do whatever is necessary to maintain it.
•
Although the recession and the associated economic slack have already lowered core price
inflation by about a percentage point, two scenarios cause some to worry about higher
inflation. First, some fear that a sharp drop in the dollar could cause inflation to jump. This
seems unlikely. A precipitous dollar depreciation would be associated with global financial
instability, but such instability would also probably foster significant safe-haven capital flows
back into dollar-denominated assets. Such safe-haven flows appear to have boosted the
dollar during the 2008 financial panic, and they would similarly play a countervailing force
supporting the dollar during any exchange rate disarray. Second, expansionary federal fiscal
policy has also caused many to worry about inflation. (See, for example, FRBSF Economic
Letter 2009-31, Disagreement about the Inflation Outlook.) The outlook for federal fiscal
deficits is indeed grim—driven by an aging population and rising per capita health care costs.
But higher inflation would not solve this problem, since the additional spending is essentially
indexed for inflation.
•
To achieve its goals of economic and financial stability, the Fed took two broad actions to
ease financial conditions: It lowered short-term interest rates to near zero and it doubled the
size of its balance sheet. The Fed has many options for a successful exit strategy to return
monetary policy to normal. However, given current conditions and the economic outlook,
such a renormalization appears to be a considerable period away. A rough benchmark for
calibrating the stance of monetary policy explains the level of the funds rate in terms of
inflation and unemployment. Currently, this simple rule of thumb, which has captured the
broad contours of policy over the past two decades, suggests that the funds rate will be near
its zero lower bound for several years. (Further discussion can be found in FRBSF Economic
Letter 2009-17, The Fed's Monetary Policy Response to the Current Crisis.) The Fed likely
will have more than ample time and opportunity to shrink the size of its balance sheet and
raise the funds rate when economic conditions require. In particular, the Fed can shrink the
amount of liquidity and monetary stimulus by taking any one or more of the following
actions: selling off securities, boosting liabilities other than bank reserves (such as reverse
repos or term deposits), and paying a higher interest rate on bank reserves (so banks are less
willing to lend out these funds).
Industrial production has started to rise
Enormous pool of unemployed workers
Index of Industrial Production
Unemployment Rate
Seasonally adjusted; 2002 = 100
Index
115
Seasonally adjusted
Percent
11
Sept.
10
110
9
8
105
7
Aug.
100
6
FRBSF
Forecast
5
95
4
90
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
3
78
Real GDP is expected to grow
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
A large output gap will likely persist
Real GDP
Real GDP
Percent change at seasonally adjusted annual rate
Percent
10
Seasonally adjusted chained 2005 dollars
$, Trillions
15
8
FRBSF
Forecast
14.5
6
4
CBO Potential
Output
2
14
0
Q2
Output
Gap
-2
13.5
FRBSF
Forecast
-4
13
-6
-8
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
12.5
2006
The recession has lowered core inflation
2007
2008
2009
2010
2011
2012
Inflation risk from exchange rate?
Exchange Rate Indices
PCE Price Inflation
Percent change from four quarters earlier
Percent
5
January 2007 = 100
Index
140
135
4
130
125
3
Overall PCE
Price Index
120
FRBSF
Forecasts
115
Broad Nominal
Dollar
2
Q2
110
105
Core PCE
Price Index
1
100
Narrow Nominal
Dollar
0
95
Sep.
90
85
-1
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
80
2002
2003
2004
2005
2006
2007
2008
2009
1
Inflation risk from federal fiscal deficits?
As in past recessions, Fed has cut rates
Federal Spending and Revenue
Federal Funds Rate
Percent of Gross Domestic Product (GDP)
Percent
30
Quarterly average
Percent
10
Spending
8
25
Fed's Target Rate
Medicare,
Medicaid
Revenue
6
20
Social Security
4
2
Estimated target rate
from a simple regression
15
0
Interest on Federal Debt
10
Other Spending
-2
-4
Simple policy rule regression:
5
Fed's Target = 2.1 + 1.3 x Inflation - 2.0 x Unemployment gap
-6
(Unemployment Gap = Unemployment rate - CBO NAIRU)
CBO Projection
0
80
85
90
95
00
05
10
15
20
25
30
35
When appropriate, interest rates will rise
Federal Funds Rate
Quarterly average
Percent
10
8
Fed's Target Rate
-8
88
6
90
92
94
96
98
00
02
04
06
08
10
12
Federal Reserve balance sheet; 7/26/2007
Assets ($ Billions)
Securities
Liabilities ($ billions)
791 Bank Reserves
13
Loans
.2 FR Currency
776
Other assets
78 Reverse Repos
31
Other Liabilities
14
Capital
33
4
2
Estimated target rate
from a simple regression
0
-2
Projected target rate based
on FRBSF forecasts of
unemployment and inflation
-4
-6
Total
869 Total
869
-8
88
90
92
94
96
98
00
02
04
06
08
10
12
Federal Reserve balance sheet; 9/24/2009
Assets ($ Billions)
Securities
Liabilities ($ billions)
1589 Bank Reserves
903
Loans
306 FR Currency
872
Other assets
267 Reverse Repos
71
Other Liabilities
265
Capital
Total
2162 Total
51
2162
Summary
1. The financial crisis and financial conditions have
eased, but we still must lower future systemic risk.
2. The longest postwar recession appears over.
3. Although growth has returned, the economy will
remain in a deep hole with high unemployment
and underutilized resources for some time.
4. The Fed remains completely committed to
preventing inflation from surging too high.
5. The Fed has many options for a successful exit
strategy to return monetary policy to normal.
2