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Twelfth Federal Reserve District
FedViews
September 8, 2011
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.php
Eric T. Swanson, senior research advisor in the Economic Research Department of the Federal Reserve Bank of San
Francisco, states his views on the current economy and the outlook.

Revisions to second-quarter GDP showed that the U.S. economy grew at a 1% rate, down from the initial
estimate of 1.3% reported in July. The change was more than accounted for by downward revisions to net
exports and inventories, which tend to be volatile from one quarter to the next. Some of the more stable
components of GDP, such as consumption and business investment in equipment and software, were
actually revised upward, which provided a bit of a silver lining to the report. In addition, the March
Japanese earthquake and tsunami disrupted U.S. production in the auto and a few other manufacturing
industries, accounting for part of the weakness in second-quarter GDP.

As the Japanese supply-chain disruptions faded, we saw some bounce back in manufacturing production
in July relative to April, May, and June. We expect data to show that this rebound continued in August.
However, the Institute for Supply Management’s manufacturing survey was a little weak in July and
August, particularly the new orders component, which is a good leading indicator. The readings below 50
suggest that new orders in manufacturing contracted slightly in July and August, raising concerns about
the strength of manufacturing production in coming months.

The August employment report was weak overall, with no change in nonfarm payrolls in August and
downward revisions to June and July. However, a strike at Verizon during the survey week reduced
August payrolls by about 45,000 workers. Discounting the strike’s effects, the August numbers look very
similar to those for the previous three months. Nevertheless, these readings are far below the typical
increases in recoveries of 300,000 or more jobs.

The unemployment rate was also unchanged in August, remaining at a very high 9.1%. Although initial
claims for unemployment insurance have come down since their recession peak, they need to fall much
further to bring the unemployment rate down. There are still more people flowing into unemployment
every week—over 400,000—than at most points during the 2001 recession.

Business investment has been one of the economy’s brighter spots. Investment by businesses tends to be
correlated with purchases of durable goods, and both durable goods orders and shipments have recovered
substantially since 2009, almost reaching their pre-recession peaks. Moreover, new orders continue to
exceed shipments, suggesting that durable goods shipments are likely to increase over the next several
months.
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 October 17, 2011.

The housing sector is still extremely weak and shows no signs of improvement despite mortgage rates
that are again near all-time lows. In particular, new home sales continue to bounce along the bottom at
levels below the depths of the recession. New home sales remain lower than at almost any time in the 50year history of the series. Only at a few points in 2010 was the sales pace more lackluster.

Measures of consumer sentiment plunged in August to levels roughly in line with the depths of the
recession. Three main factors probably explain this. First, stock market volatility rose to extremely high
levels at the end of July and in the first few weeks of August, driven largely by financial market concerns
about Europe. Second, the contentious congressional debate over raising the federal debt ceiling seemed
to undermine public confidence in Congress and the U.S. outlook in general. Third, the Standard &
Poor’s downgrade of U.S. Treasury securities on August 5 seemed to amplify the public’s perception that
the U.S. economy was headed in the wrong direction. Hopefully, consumer attitudes will start to rebound
in September as these factors fade from public memory. When consumer sentiment is weak, households
are less likely to make big-ticket purchases, such as autos, furniture, and appliances. So the sharp drop in
consumer attitudes is a worrisome sign for future consumption.

Financial market concerns about possible European debt defaults spiked in July and early August, but
have since fallen back, probably for two reasons. First, the European Central Bank stepped in to support
euro zone bond markets by purchasing Spanish and Italian government bonds. Second, meetings between
French and German leaders in August appeared to reassure markets that the euro zone core would do
what was necessary to contain the crisis. However, market concerns about Europe have flared up again in
recent days.

Oil prices have fallen substantially from their peak a few months ago, reducing business costs and
providing a welcome boost to household spending power. This should put downward pressure on
inflation and help support growth in coming quarters.

Interest rates hit historic lows over the past few weeks. The 10-year Treasury yield briefly dipped below
2%, its lowest level since at least 1960. A small part of the drop was due to the Federal Reserve’s August
9 statement that exceptionally low levels of the federal funds rate are likely to be warranted “at least
through mid-2013.” But most of the decline was due to a series of generally weaker-than-expected data
releases, which lowered market expectations about economic growth and inflation, and pushed out the
date when market participants expect the Fed to begin tightening monetary policy.

We have lowered our forecast since the last FedViews, but our projections remain qualitatively similar.
We expect continued sluggish growth for the next several quarters, gradually picking up to a more
normal recovery pace in 2013 and beyond. The zigzag pattern in the second and third quarters of 2011
reflects the effects of the Japanese earthquake and tsunami, which reduced second-quarter growth but
probably is increasing growth in the third quarter, as idled production starts coming back on line and
extra shifts are added to bring inventories back to normal levels.

Finally, despite the uptick posted earlier this year, we see inflation moderating over coming quarters as
the weak labor market keeps wages low and the decline in oil prices puts downward pressure on energy
and transportation costs.
Some production bounce back,
new orders remain weak
GDP in 2011:Q1 weak, Q2 revised down
Gross Domestic Product (GDP)
Percent
10
Percent change at seasonally adjusted annual rate
Downward
revision
Manufacturing Sector
Index
80
Percent
30
ISM New Orders Index*
(Left Scale)
70
Aug.
20
5
0
60
10
50
0
Jul.
40
-5
30
-10
-20
Manufacturing Production**
20
-30
-10
Employment growing very slowly
Nonfarm Payroll Employment
140
138
136
134
132
130
128
2003
2005
2007
2009
Non Defense Capital Goods (Ex. Aircraft)
New orders
Percent
11
10
600
9
Aug.
550
8
500
7
Unemployment rate
(right scale)
6
400
9/03
350
Initial Claims
(left scale)
3
2000
2002
2004
2006
2008
2010
Housing sector still moribund
billions of dollars
70
Home Sales
Thousands
2000
60
55
6500
Existing home sales
(right scale)
1600
5000
1200
1000
4500
New home sales
(left scale)
600
4000
Jul.
400
45
2002
2004
2006
2008
2010
6000
5500
1400
800
50
Thousands
Seasonally adjusted annual rate
1800
Jul.
65
2000
5
4
250
2011
Shipments
2010
650
Business investment recovering
Seasonally adjusted, three-month moving average
2008
Unemployment Indicators
300
2001
2006
Thousands
700
450
Aug.
2004
Unemployment remains stubbornly high
Millions
From peak -6.9 M
2002
* Index above 50 means new orders are increasing
** Annualized percent change from three months earlier
2003 2004 2005 2006 2007 2008 2009 2010 2011
Millions of employees; seasonally adjusted
Monthly Changes
May. 53 K
Jun. 20 K
Jul. 85 K
Aug. 0 K
2000
3500
3000
200
2000
2002
2004
2006
2008
2010
1
Consumer sentiment has plunged
Market concerns about European debt
Ten-Year Government Bond Yields
Consumer Attitudes
Index
120
Index
Consumer
sentiment
(right scale)
140
120
9/02
Greece
Portugal
Ireland
Spain
Italy
France
Germany
US
100
100
80
80
Percent
20
subtitle
15
10
5
60
Consumer
confidence
(left scale)
40
60
Aug.
0
20
40
2000
2002
2004
2006
2008
2010
Oil prices have fallen sharply
from recent peaks
Price of Oil
$ per barrel
150
140
130
9/02
120
110
100
90
80
70
60
50
40
30
20
10
West Texas Intermediate; daily closing price
2000
2002
2004
2006
2008
Interest rates hit historic lows
Interest Rates
9/02
We forecast continued slow recovery
Gross Domestic Product (GDP)
5
4
Ten-year
Treasury
3
Two-year Treasury
0
2005
2006
2007
2008
2009
2010
2011
PCE Inflation
Percent
Percent change from four quarters earlier
5
4
Overall PCE price index
5
3
Q2
Q
0
2
Core PCE price index
1
-5
FRBSF
forecasts
-10
04
05
06
07
08
09
10
11
12
13
14
2
1
Federal funds rate
Q2
03
6
And recent uptick in inflation will dissipate
Quarterly percent change at seasonally adjusted annual rate Percent
10
FRBSF forecast
8
7
30-year mortgage
2004
2010
Percent
Weekly average
0
-1
2000
2002
2004
2006
2008
2010
2012
2