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Twelfth Federal Reserve District
FedViews
February 11, 2010
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 Rudebusch, senior vice president and associate director of research at the Federal Reserve Bank of San
Francisco, states his views on the current economy and the outlook:
The economy appears to be in a moderate recovery, but questions remain about the
durability of growth and whether it can be sustained by private demand as the impetus from
the federal fiscal stimulus fades later this year. While the recession may be over,
production, income, sales, and employment are at very low levels. With moderate
economic growth, it could take years for the economy to pull out of its deep recessionary
hole. Accordingly, the unemployment rate seems likely to remain elevated for several
years.
The associated economic slack has reduced inflationary pressures. Over the past year, the
core PCE price index has increased by 1.5 percent—about a percentage point lower than
before the recession. Going forward, we expect inflation to continue to edge down,
averaging about 1 percent in 2010.
Given the remarkable nature of the recent financial crisis and recession, the amount of
uncertainty around our baseline forecast is likely to be larger than usual. However, the risks
to the outlook appear to be well balanced. Economic growth may turn out weaker if the
distress in labor markets curtails income and spending more than we anticipate. So far,
during this downturn, the economy has lost 8.4 million jobs. We anticipate a turnaround
this year, but, instead, we could be facing a jobless recovery with long durations of
unemployment degrading the skills and abilities of potential workers.
Alternatively, a more optimistic scenario is suggested by a few recent positive readings.
Notably, over the past few months, temporary employment and the average workweek have
risen. The latter increase reflects in part longer shifts for some part-time workers. Such
signs often presage an increase in permanent employment.
In addition, there may even be some upside risk to growth from higher consumer spending.
The level of consumption remains well below its pre-recession trend, in part because
households remain quite cautious. As uncertainty about the health of the economic
recovery is reduced, pent-up demand may provide a more pronounced snapback to earlier
levels of spending and boost growth above our expectations.
There are also upside and downside risks to the inflation outlook. Some of the historical
evidence linking economic slack and inflation would suggest somewhat more disinflation
than we anticipate. (See FRBSF Economic Letter 2010-02, “Inflation: Mind the Gap.”)
However, measuring the precise degree of economic capacity and slack is always difficult.
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 March 22, 2010.
In contrast to the experience of some countries, where productivity has fallen after large
adverse financial shocks, U.S. productivity has grown quite rapidly over the past year. If a
significant portion of this jump in productivity is permanent, as anecdotal reports suggest,
potential output could grow faster than we have estimated. The resulting wider output gap,
which would help reconcile labor-side and product-side measures of economic slack,
would argue for even lower inflation going forward. Indeed, while core inflation has
already fallen about 1 percentage point since the recession began, measures of labor
compensation are down by about 2 percentage points.
There is also a risk of higher inflation going forward. In part because of the high levels of
the federal fiscal deficit, the Federal Reserve balance sheet, and bank excess reserves, some
worry that the Fed’s monetary stimulus will not be appropriately removed when the
economy recovers. Such fears could help fuel higher inflation expectations and, in turn,
higher inflation.
So far, readings on inflation expectations have been mixed. (See FRBSF Economic Letter
2009-31, “Disagreement about the Inflation Outlook.”) Expectations of inflation over the
next five years have been falling, while longer-term expectations have edged up. (Recent
measures of inflation expectations from financial markets are similarly ambiguous. See
FRBSF Working Paper 2008-34, “Inflation Expectations and Risk Premiums in an
Arbitrage-Free Model of Nominal and Real Bond Yields.”) Economic theory and evidence
have not established which time horizon is more relevant for determining prices and
inflation over the next year or two, but there may be some risk that higher inflation
expectations could become a self-fulfilling prophecy.
To combat the financial crisis and recession, the Federal Reserve took several actions. It
lowered short-term interest rates to near zero, eased longer-term credit conditions, and
reduced longer-term yields by purchasing U.S. Treasury and government agency securities.
The Fed also provided short-term liquidity to alleviate financial market strains. One aspect
of this provision of liquidity involved a reduction in the spread of the discount rate—the
rate at which the Fed lends to depository institutions through its primary credit facility—
from 1 percentage point over the target federal funds rate to 1/4 percentage point. As
financial market strains have eased, the private sector has been able to fulfill its own
funding needs again and the Fed’s provision of liquidity has shrunk drastically.
In response to the recovery of private funding markets, the Fed has also reduced the
maximum maturity of discount window loans. A likely next step in normalizing the terms
of these loans would be to raise the discount rate spread over the fed funds rate target.
Importantly, such an increase in the discount rate would be a purely technical adjustment in
response to improved financial market functioning. It would not reflect a change in the
stance of monetary policy, nor foreshadow a removal of monetary accommodation.
Ideally, the level of the spread should be low enough to encourage the use of the discount
window as a backup source of funds during temporary liquidity shortfalls or financial
market disruptions. However, the spread should be high enough to discourage its use as a
routine source of funds when market alternatives are available. Balancing these objectives
may involve some learning over time to determine the spread’s appropriate level.
A self-sustaining economic recovery?
Real GDP
The large output gap will persist
Real GDP
Percent
10
Percent change at seasonally adjusted annual rate
8
FRBSF
Q4 Forecast
$, Trillions
15
Seasonally adjusted chained 2005 dollars
FRBSF Potential
Output
6
14.5
4
14
2
Output
Gap
0
-2
13.5
FRBSF
Forecast
-4
13
-6
12.5
-8
00
01
02
03
04
05
06
07
08
09
10
11
2006
12
Enormous pool of unemployed workers
Unemployment Rate
Jan.
2008
2009
2010
2011
PCE Price Inflation
Percent
5
Percent change from four quarters earlier
10
9
6
0
3
-1
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Has labor market reached bottom?
A few promising signs on the margin
Nonfarm Payroll Employment
Workweek and Temporary Employment
Millions of employees; seasonally adjusted
139
Change
138
-224K
October
November +64K
December -150K
-20K
January
137
136
134
133
132
Jan.
131
3
Average workweek*
(right axis)
Hours
35
Jan.
34.5
2.5
34
05
06
07
08
09
10
2
33.5
1.5
1
33
Temp. help employment
(left axis)
130
129
04
Millions
3.5
135
From peak -8.4M
03
1
4
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
02
2
Core PCE
Price Index
5
01
3
Q4
7
FRBSF
Forecast
4
FRBSF
Forecasts
Overall PCE
Price Index
8
00
2012
The recession has lowered inflation
Percent
11
Seasonally adjusted
2007
0.5
32.5
90
92
94
96
* Three-month moving average
98
00
02
04
06
08
10
Consumers showing signs of life
Real Personal Consumption Expenditures
Remarkable strength in productivity
Billions of 2005$
10000
Seasonally adjusted annual rate
Dec.
Nonfarm Business Labor Productivity
Annualized percent change from eight quarters earlier
9500
9000
8500
8000
7500
7000
00
01
02
03
04
05
06
07
08
09
10
89
Wages and benefits are barely growing
Labor Compensation
93
95
99
01
03
05
07
Headline PCEPI Inflation Forecasts
Median forecasts from Survey of Professional Forecasters
Percent
2.75
Forecast for average
inflation six to ten
years ahead
8
Nonfarm Compensation
per Hour
97
Mixed readings on inflation expectations
Percent
9
Percent change from four quarters earlier
91
Percent
5
4.5
4
Q4
3.5
3
2.5
2
1.5
1
0.5
0
09
7
2.5
6
2.25
5
Q1
4
Q4
3
Employment Cost
Index
2
Forecast for average
inflation over the next
five years
2
1
1.75
0
89
91
93
95
97
99
01
03
05
07
09
Fed’s balance sheet: size and composition
Federal Reserve Assets
Aid systemicallyimportant firms
Billions of Dollars
2500
2/3
Jul
2008
2009
2010
Discount rate spread could be raised
Percent
7
Discount Rate and Federal Funds Rate
Discount Rate
6
2000
Provide shortterm
liquidity
5
Ease overall
credit
conditions
Oct
Jan Apr
2009
1500
4
Federal Funds
Target
1000
3
2
2/3
500
Treasury portfolio and other
assets
Oct Jan Apr
2007 2008
1.5
2007
Effective Federal
Funds Rate
1
0
Jul
Oct
Jan
2010
0
2004
2005
2006
2007
2008
2009
2010