Download FedViews

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