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Twelfth Federal Reserve District FedViews October 14, 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 Mary Daly, vice president at the Federal Reserve Bank of San Francisco, states her views on the current economy and the outlook: On September 20, the National Bureau of Economic Research’s Business Cycle Dating Committee officially called an end to the recession. It will go into the history books as the longest and deepest downturn since the Great Depression. The recession officially lasted 18 months from December 2007 to June 2009. Over that time, the U.S. economy shed 7.3 million jobs, GDP fell by 4.1%, and household net worth declined by 21%. Despite the official announcement, the public thinks the recession is ongoing. According to a CNN/Opinion Research Corporation Poll in September, more than 70% of those surveyed thought the U.S. economy was still in a recession. One reason for that view is that the economic recovery is proceeding at a very slow pace and has lost momentum since the spring. The effects of this downshift are visible in consumer confidence, which has fallen from earlier in the year. The September jobs report highlights one of the difficulties—the reluctance of businesses to add jobs. Payroll employment declined by 95,000 as large cuts in government staffing levels more than offset modest private job gains. Sluggish job growth left the unemployment rate for September unchanged at 9.6%. Data on initial claims for unemployment insurance also have remained elevated, suggesting that the pace of layoffs has yet to return to a level consistent with a solid recovery. With consumer confidence low, labor markets weak, and households still working to trim debt and boost savings, consumption growth remains modest. Federal Reserve Bank of San Francisco business contacts say retailers are working to keep inventories lean in anticipation of continued modest consumption growth going forward. Data on housing continues to disappoint. Despite low mortgage interest rates, housing markets have shown little ability to move forward now that the federal first-time homebuyer tax credit has expired. With continued weakness in home sales and prices, residential building remains virtually nonexistent. Business investment remains a bright spot, although the pace of expansion in this category appears to be slowing. The Institute for Supply Management purchasing managers index suggests that the manufacturing sector is expanding. That said, the index has been falling in recent months, indicating a less robust pace of expansion than earlier in the year. 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 15, 2010. Consistent with the disappointing data, we have marked down our GDP forecast for the remainder of 2010 and 2011. We currently project that real GDP will expand around 2½% in 2010, below its potential of about 3% annually. We expect the recovery to gain momentum over the course of next year and that real GDP growth for 2011 will reach about 3½%. One reason for our more modest outlook is that no sector of the private economy stands ready to drive a robust recovery. As federal fiscal stimulus wanes and state and local government cutbacks accelerate, the private sector has failed to pick up the slack. With only modest gains in private economic activity, the overall pace of growth has slowed. The slow pace of growth projected over the forecast horizon suggests it will take a long time to return to normal. Based on our forecasts of real GDP growth and our estimates of potential GDP, we project that considerable economic slack, known technically as an output gap, will remain at least into 2013. With this sizeable output gap hanging over the economy, we expect both core and headline inflation to be restrained for some time. We project personal consumption expenditures (PCE) inflation to be around 1% in 2011 and 2012. The September 21, 2010, Federal Open Market Committee (FOMC) statement noted: “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” This was a stronger statement on the Federal Reserve’s dual mandate than had previously been made. To understand what the Committee was referring to when it said it was failing to achieve its mandates—maximum sustainable employment and price stability—it is useful to look at the unemployment rate relative to its natural rate and core inflation relative to the preferred range cited by Committee members. The Survey of Professional Forecasters places the natural rate of unemployment—the lowest sustainable rate consistent with stable inflation—between 5% and 6.75%. The higher values and increased range of estimates for this rate, often called the non-accelerating inflation rate of unemployment (NAIRU), since the recession began reflect the view that there has been an increase in structural unemployment caused by skill or geographical mismatches between workers and available jobs. Even if structural unemployment has increased, the unemployment rate is still far above the highest survey estimate of the natural rate. This implies there is a way to go before achieving maximum employment. Relative to the preferred level of inflation among FOMC members, as reflected in their calculations from the June 2010 FOMC forecasts of the central tendency of the long-run level of inflation under appropriate monetary policy, core PCE inflation is running low. This low level of inflation, combined with the sluggish GDP forecast and large amount of slack in the economy, suggests that further disinflation is possible. Japan’s experience beginning in the early 1990s underscores the risk of getting into a long period of sustained disinflation. Japan fell into deflation in the mid-1990s and has yet to recover. Public is not convinced Recession is officially over Do you think the economy is in a recession or not? U.S. Business Cycle Peak and Trough Dates Final Tally 18 months 7.3 million jobs lost 4.1% decline in GDP 21% decline in net worth Percent saying "yes" Peak Trough Nov 48 Jul 53 Aug 57 Apr 60 Dec 69 Nov 73 Jan 80 Jul 81 Jul 90 Mar 01 Dec 07 Oct 49 May 54 Apr 58 Feb 61 Nov 70 Mar 75 Jul 80 Nov 82 Mar 91 Nov 01 Jun 09 80 60 40 20 0 May-09 Source: NBER Business Cycle Expansions and Contractions. Percent 100 Officially over Aug-09 Sep-09 Dec-09 Jul-10 Sep-10 Source: CNN/Opinion Research Corporation Job growth still constrained Unemployment remains stubbornly high Unemployment Indicators Nonfarm Payroll Employment Millions of employees; seasonally adjusted 140 Percent 10.5 Thousands 650 9.5 136 550 8.5 Unemployment Insurance 75 7.5 132 450 128 350 Sep 6.5 5.5 4.5 124 2000 2002 2004 2006 2008 Unemployment Rate 250 2000 2010 Interest rates remain low 2002 2004 3.5 2006 2008 2010 Marked down our forecast Interest Rates Percent 10 Daily Frequency Real GDP Percent 6 Percent change from four-quarters earlier March 2010 Forecast 30yr Jumbo Mortgage 4 8 10/15 BAA Bond Current Forecast 6 June 2010 Forecast 2yr Treasury 30yr Conforming Mortgage 4 10yr Treasury 2 -2 0 2008 0 -4 Futures Fed Funds Target 2007 2 2009 2010 2011 -6 2007 2008 2009 2010 2011 2012 1 Modest growth across the board Contributions to Real GDP Growth Seasonally adjusted annual rates Real GDP Growth Consumption Residential Investment Non-residential Investment Government Net Exports Inventories 2009Q3 2009Q4 2010Q1 2010Q2 A long time to return to normal Real GDP Percentage points 7 6 5 4 3 2 1 0 -1 -2 -3 Forecast -4 -5 -6 -7 2010Q3 2010Q4 $, Trillions 15 Seasonally adjusted chained 2005 dollars Average GDP growth rate during 1983-84 recovery 14.5 CBO Potential Output 14 Output Gap Real GDP FRBSF Forecast 13.5 13 Q2 12.5 2006 Inflation remains subdued 2007 2008 2009 2010 2011 2012 Unemployment above NAIRU Unemployment Rate and the NAIRU PCE Price Inflation Percent 5 Percent change from four quarters earlier Percent 12 Seasonally adjusted 11 4 Overall PCE Price Index Sep. 10 9 3 8 2 Q2 Core PCE Price Index 1 FRBSF Forecasts 2002 2004 2006 2008 2010 7 6 5 0 -1 2000 Unemployment rate Range of estimates for natural rate 2012 4 3 1998 2000 2002 2004 2006 2008 2010 Source: Range of estimates for natural rate: Survey of Professional Forecasters. Inflation below preferred level History suggests this is a risk PCE Price Inflation Excluding Food and Energy Annualized percentage change 3-month change Percent 4 Core Inflation in the US and Japan CPI ex. food and energy; Percent change from 12 months earlier Percent 4 3.5 3 3 2.5 2 2 US 1.5 12-month change 1 Japan 1 0.5 0 0 2003 2004 2005 2006 2007 2008 2009 2010 Source: Preferred level of inflation reflects the central tendency of the long-run level of inflation among FOMC members as of June 2010. -2 -1 0 1 2 3 4 5 6 7 8 9 -1 US 10Japan 2