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Twelfth Federal Reserve District
FedViews
February 14, 2013
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
Bart Hobijn, senior research advisor at the Federal Reserve Bank of San Francisco, states his views on the
current economy and the outlook.

The initial estimate of gross domestic product (GDP) growth in the fourth quarter of 2012 was a
slightly negative –0.1% at an annualized rate. The quarter’s weak GDP was due to various one-time
factors including a sharp decline in inventory investment and a historic drop in defense spending. We
don’t believe these factors will continue to put negative pressure on economic growth or stifle the
pace of the recovery. Importantly, private-sector final demand for goods and services was strong in
the fourth quarter. Consequently, we forecast that GDP growth in 2013 will probably be about a
percentage point stronger than in 2012, that is, 2.7% versus 1.5%.

We see two risks that economic activity could be weaker than our forecast. The first stems from
greater fiscal austerity. With the March 1 sequestration deadline looming, substantial additional cuts
in federal spending have become more likely. The second risk reflects the continued economic
weakness in Europe and the possibility of a resurgence of strains in the global financial sector. If
either of these risks materializes, a sizable drag on U.S. economic growth would result.

In the absence of such events, we anticipate that the unemployment rate will continue to decline at
about the same pace it has fallen over the past two-and-a-half years, reaching 7% by the end of 2014.
Continued labor market slack and a moderate pace of recovery are likely to keep inflationary
pressures subdued. We expect inflation to come in below the Federal Reserve’s 2% target over the
next two years.

In the short run, the subdued pressures on prices are showing up in a broad set of inflation measures.
Importantly, these measures are very much in line with our main inflation gauge, the personal
consumption expenditures (PCE) price index. Moreover, we do not see any significant changes in
longer-term inflation expectations, whether in financial markets, private-sector forecasts, or surveys
of households. Thus, inflation expectations remain well-anchored.

Over the past year, house prices have risen about 7.5%. Private residential investment, which is the
main component through which housing affects GDP, has increased 11.9%. These are signs of a
robust turnaround in the housing market. An important question is how such a housing recovery will
affect overall economic activity and job creation.
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 25, 2013.

As far as housing is concerned, new home sales are the main direct contributor to GDP growth. Apart
from some transaction fees, existing home sales do not generate new assets or income and are not
counted as economic output. Hence, housing directly affects GDP mostly through investments in the
construction and renovation of homes and apartments. As noted, such private residential investment
has grown over the past year. Nevertheless, the nation is still spending only half as much on such
investment as it did at the beginning of 2006.

Private residential investment currently makes up 2.6% of GDP. This small share means that
residential investment is not expected to contribute much to overall GDP growth over the next couple
of years. For example, if residential investment grew at a rapid 15% in 2013, it would still contribute
only 0.4 percentage point to GDP growth. Though not negligible, such a contribution could not on its
own support a robust recovery.

A similar view comes from examining the jobs contribution of increased homebuilding. A 15% rise
in residential investment would create about 550,000 jobs, of which 360,000 would be in
construction. To put this in perspective, there are currently two million fewer payroll jobs in
construction than at the beginning of 2006.

However, housing can “punch above its weight” in economic growth in at least two ways. First,
recent house price increases have brought many homeowners to the cusp of having a 20% equity
stake in their properties. Twenty percent is generally the threshold at which they can borrow against
their homes. Thus, continued house price appreciation would give a substantial fraction of households
access to credit unavailable to them over the past few years. Second, increases in house prices lead to
greater household net wealth and can thereby boost household demand more generally.
Dip in growth a temporary setback
Steady growth in private-sector spending
Real Consumption and Investment Spending
GDP Growth: Actual and FRBSF Forecast
Quarterly obs, seasonally adj; annualized growth
Percent
20
Seasonally adjusted annualized growth rates
Percent
6
Consumption
2
0
Actual
FRBSF
Forecast
Investment
(equipment & structures)
-2
-20
-6
-10
-40
2006 2007 2008 2009 2010 2011 2012 2013 2014
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Bureau of Economic Analysis and FRBSF
Source: Bureau of Economic Analysis
Unemployment rate continues slow decline
Unemployment rate and forecast
Monthly observations; forecast is quarterly average
Percent
12
PCE Price Inflation
4
Overall PCE
Price Index
8
FRBSF
Forecast
Percent
5
Percent change from 4 quarters earlier
10
Jan.
7.9
Unemployment
rate
Inflation remains subdued
FRBSF
Forecasts
6
0
2
2006 2007 2008 2009 2010 2011 2012 2013 2014
-1
0
2006
Source: Bureau of Labor Statistics and FRBSF staff
2007
2008
2009
2010
2011
2012
2013
2014
-2
Source: Bureau of Economic Analysis and FRBSF staff
Long-run inflation expectations not adrift
Long-Term Inflation Expectations
Households, financial markets, and forecasters
2
1
Core PCE
Price Index
4
3
Percent
4
House prices are rebounding
Change in House Prices
12-mo change, single-family (combined) house prices
Michigan Median
next 5 to 10 years
Percent
20
3
10
TIPS 5-to-10 yr
ahead CPI
2
0
SPF PCE Median
Next 10 years
1
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Michigan Survey, SPF, FRBSF calculations
-10
0
-20
1991
1994
1997
Source: CoreLogic
2000
2003
2006
2009
2012
Direct effects of housing remain small
… also in terms of job creation
GDP Growth Contribution of Residential Investment
Labor requirements of residential investment
Quarterly observations; seasonally adjusted
Jobs required for a 15% increase in 2013
360
% (annualized)
10
GDP
Jobs (000s)
400
Total: 550
5
200
0
132
Contribution of
residential investment
100
-5
41
2000
2002
2004
2006
2008
Source: Bureau of Economic Analysis
300
2010
2012
17
0
-10
Construction
Manufacturing
Source: BEA, BLS, and FRBSF staff
Real estate
Other