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Twelfth Federal Reserve District
FedViews
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
November 10, 2011
Also available upon release at
www.frbsf.org/publications/economics/fedviews/index.php
John Fernald, group 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 economic recovery is proceeding at a subdued pace, with substantial and persistent resource
slack and low underlying inflationary pressures.

Businesses have been slowly but steadily hiring since early 2010. The economy has recovered about
2¼ million of the 8¾ million jobs lost in the recession. Private businesses have increased
employment by about 2¾ million jobs, while federal, state, and local governments have reduced
employment.

Household net worth fell sharply during the recession, reflecting declines in home and equity prices.
These balance sheet changes have prompted households to save more rather than spend. During the
recession, the personal saving rate rose to its highest levels since the early 1990s and has largely
moved sideways during the recovery. In the third quarter of 2011, the saving rate ticked down to 4%,
the lowest rate since before the recession. Spending during the quarter rose only modestly, but real
disposable personal income fell.

Consumers lack confidence. Sentiment never fully recovered after the recession. In July and August,
the two principal consumer surveys showed that attitudes clearly soured again and are now at levels
comparable to the lows of the financial crisis. A risk to the outlook is that households may put their
money where their mouths are—and reduce spending.

Housing has been a persistent factor weighing on the recovery. Construction of new homes has been
flat since 2009. The long-term fundamentals of population growth should support much higher levels
of home construction. One factor suppressing new construction is competition with homes that have
already been built. These include not only the large inventory of existing homes currently for sale,
but also the shadow inventory of homes in foreclosure or on which the mortgage payer is seriously
delinquent, properties that could come on the market soon.

Over time, one factor that should help support the housing market is that home prices now are more
in line with fundamentals. The precipitous slide in home prices after 2006 weighed on household
finances and discouraged potential buyers worried that prices would keep falling. One measure of
fundamentals is home prices relative to what it would cost to rent those homes. This price-rent ratio is
analogous to a price-earnings ratio for a stock. During the housing boom, this ratio ran up sharply. By
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 December 19, 2011.
some measures, the price-rent ratio is now close to its average value in the two decades prior to 2002,
before the housing bubble. Based on expectations for median home prices from a survey of
professional housing market watchers, this price-rent ratio should remain relatively stable over the
next few years.

We expect the subdued pace of economic recovery to continue. Consumers are reluctant to spend,
firms remain cautious about hiring and investing, and government purchases are contracting. Growth
in the fourth quarter of 2011 is likely to be around 2½%, roughly on par with the third quarter. Over
the next year, we expect growth to run a bit below that pace.

In addition to lackluster demand, a key factor contributing to the subdued pace of activity is
restrained growth in underlying potential output. Potential is what output would be if the workforce
and the productive capacity of the economy were fully employed at sustainable, noninflationary
levels. We estimate that potential output is growing at only about a 1¾% pace, which we expect to
continue in 2012. That compares with an annual rate of about 2½% in the years before the recession
and almost 3½% in the late 1990s.

During and since the recession, business investment in productive capacity has been restrained, and
labor markets have experienced notable disruption. But, over the longer term, the slower pace of
underlying productivity growth is the key factor explaining slower growth in potential output. Since
2003 or 2004, productivity growth—output per hour worked—has been growing significantly more
slowly than in the years before. The productivity acceleration of the mid- to late-1990s appears to
have ended.

Although potential output growth has been slow in recent years, actual output growth has been even
weaker. Reflecting the shortfall of aggregate demand, there is a large cyclical gap in labor markets
between the unemployment rate and most estimates of the natural rate of unemployment, that is, the
equilibrium rate of unemployment that would cause inflation neither to rise nor fall. This natural rate
rose during the recession and has stayed elevated, reflecting some degree of mismatch between the
skills of the unemployed and the jobs that are available, plus the effects of extended unemployment
insurance benefits. Nevertheless, any reasonable estimate of these effects still leaves a sizeable and
persistent gap between unemployment and its natural rate.

In recent months, there has been a general flight from risky to safe assets. For example, 10-year
Treasury securities were yielding near 3% early in the summer. A weaker and more uncertain outlook
for U.S. and global growth, as well as monetary policy actions, have pushed 10-year rates down to
around 2%. With the worsening outlook, low-grade bond yields have risen since the summer, though
they have retraced most of their spike of late September and early October.

A major source of economic and financial risk arises from the sovereign debt crisis in Europe. Debt
yields for peripheral European economies are very high, indicating persistent credit-market concerns.
European authorities have been seeking to contain the crisis. Nevertheless, Greek and Italian yields
have generally risen further in recent weeks.

Wage pressures have generally remained modest, helping to anchor production costs and price
pressures. Measures of compensation are rising more slowly than their pre-recession pace.

With wage pressures contained, inflation is likely to remain subdued. Overall prices have risen
rapidly over the past year, reflecting a sizeable bump from commodities and imports. Some of this
bump has shown up in other goods and services as well. However, commodity prices, though
remaining high, appear to have stabilized. We expect inflation to run at around a 1½% pace for the
next few years.
Businesses are slowly hiring
As household wealth fell, saving rose
Nonfarm Payroll Employment
Seasonally adjusted
140
Change in Nonfarm
Payroll Employment
Saving rate (right axis)
136
7
55
5.5
130
128
2006
2008
Q2
134
Oct. 132
2004
9
6
8.7 million
jobs lost
2002
2010
5
5
Net worth (left axis)
4.5
1
4
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
-1
Housing market still stalled
Index
120
Index
Single-Family Housing Starts and Permits
Thousands
2000
Seasonally adjusted annual rate
Housing starts
Consumer
sentiment (right
scale)
120
3
Q3
Consumers lack confidence
Consumer Attitudes
140
Percentage
of income
11
Multiples of income
6.5
138
July
+127K
August
+104K
September +158K
October
+80K
2000
Household Net Worth and Saving Rate
Millions
1800
1600
100
1400
100
Oct.
80
1000
Consumer
confidence (left
scale)
60
1200
80
Housing permits
800
60
Sep.
600
40
400
20
2000
40
2002
2004
2006
2008
2010
200
2000
Housing prices are more in line with rents
Residential Price-to-Rent Ratio
2002
2004
2006
2008
2010
Subdued economic recovery continues…
Real Gross Domestic Product (GDP)
Home prices relative to owners' equivalent rent;
seasonally adjusted, average 1983-2002 = 1
Ratio
1.8
Quarterly percent change at seasonally adjusted annual rate
Percent
6
1.7
Q3
1.6
FRBSF
forecast
2
1.5
Forecast*
14
1.4
0
1.3
-2
1.2
Sep.
-4
1.1
Average
1983-2002
1.0
-6
0.9
-8
0.8
1987
1991
1995
1999
2003
*Refer to author for calculation detail
2007
2011
4
-10
2015
2006
2007
2008
2009
2010
2011
2012
Potential growth slows with productivity
Still a cyclical gap in labor markets
Business Sector Labor Productivity
Percent
Cumulative growth rate since 1987:Q1
1997
Q2
60
2003
Q4
Unemployment Rate
Percent
12
Seasonally adjusted
Q3
Unemployment rate
FRBSF natural
rate estimate
40
FRBSF
forecast
Q3
50
Large gap
remains
8
6
30
4
20
2006
2007
2008
2009
2010
2011
2012
Source: Bureau of Labor Statistics, Survey of Professional Forecasters
“Safe” debt yields down since mid-summer
Percent
Aug 9 Sept 21
FOMC
FOMC
mtg
mtg
European sovereign debt yields are high
Ten-Year Bond Yields
Percent
11/9
Government debt
11/8
10
8
Low-grade bond yield
BAA bond
2
0
0
1987 1990 1993 1996 1999 2002 2005 2008 2011
Interest Rates
Range of SPF natural
rate estimates
10
Broken linear
trend
10
Greece
Portugal
Ireland
Spain
28
23
Italy
18
6
AAA bond
30-yr. conforming
mortgage
10-yr. Treasury
2-yr. Treasury
Fed funds target
4/11
6/11
13
4
8
2
8/11
0
10/11
3
4/11
Modest wage growth anchors costs/prices
Compensation Growth
Percent change from same period one-year earlier
Percent
6
Compensation
per hour
6/11
PCE Inflation
Percent
5
Percent change from four quarters earlier
4
Overall PCE
price index
4
ECI total
compensation
10/11
We expect inflation to stay low
5
Q3
8/11
Q3
2
3
Core PCE
price index
2
FRBSF
forecasts
0
1
0
1
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
3
-1
2000
2002
2004
2006
2008
2010
2012