Download FedViews

Twelfth Federal Reserve District
FedViews
June 12, 2014
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
Also available upon release at
http://www.frbsf.org/economic-research/publications/fedviews/
Rob Valletta, research advisor at the Federal Reserve Bank of San Francisco, states his views on the current
economy and the outlook.

Real gross domestic product (GDP) fell in the first quarter of 2014. However, the decline mainly
reflected transitory factors, especially a sharp slowdown in the pace of inventory accumulation by
businesses and a decline in U.S. exports. With these factors excluded, real final sales to domestic
purchasers rose 1.6%, suggesting modest growth in underlying demand. Harsh winter weather in
much of the country likely held demand down to some degree. Given these considerations, we expect
solid growth for the remainder of this year through the end of next year, averaging just under a 3%
pace for the two years combined.

Data over the past few months show that the expected rebound is under way. Overall retail sales
bounced back after February, and automobile sales in May came close to their pre-recession peak rate
of 17 million on an annual basis. Moreover, employment gains from February through May generally
made up for the early winter lull. The six-month average of monthly payroll job growth is back near
the solid pace of approximately 200,000 per month that has largely prevailed since early 2013.

Sustained employment gains have helped to lower the unemployment rate. It has fallen about 1¼
percentage points over the past 12 months and held steady at 6.3% in May. Nonetheless, it remains
well above our estimate of the natural rate of unemployment, which is the lowest sustainable level in
a healthy labor market.

Unemployment above the natural rate is an indicator of the overall economic slack that has been a
key factor holding inflation at low levels. Our primary measure of inflation has been running below
the Federal Open Market Committee’s stated target of 2% for two full years. The San Francisco Fed’s
forecast projects that it will return to that target gradually over the next few years.

The combination of elevated unemployment and persistent low inflation underlies the current very
accommodative stance of monetary policy. At the same time, a recovering economy has prompted a
steady reduction this year in the pace of monthly asset purchases by the Federal Reserve.

The long-term unemployment rate—that is, the percentage of the labor force that has been
unemployed continuously for more than six months—has fallen slowly and remains quite elevated. In
contrast, the short-term unemployment rate, defined as those unemployed six months or less, has
dropped nearly to its pre-recession low.
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 July 14, 2014.

The unique role played by long-term unemployment in the ongoing labor market recovery raises an
inflation risk. In particular, recent research has emphasized the possibility that the long-term
unemployed put little or no downward pressure on wage and price inflation. This in turn implies less
labor market slack than is suggested by the overall unemployment rate. If this characterization is
correct, inflation may reach the 2% target a bit faster than we currently forecast.

Concerns about the limited impact of the long-term unemployed on wage and price inflation partly
revolve around their unfavorable employment prospects. Job-finding rates fell significantly for both
the long-term and short-term unemployed during the most recent recession. The subsequent
improvement in job-finding rates has been more evident for the short-term unemployed.

It is difficult to know whether the depressed job-finding rates of the long-term unemployed reflect a
persistent structural problem or simply a slow recovery from the severe recession. Recent research
suggests that employers place more emphasis on the short-term than the long-term unemployed in
their recruiting, but the long-term unemployed may become more attractive candidates as the overall
unemployment rate continues to fall.

One way to assess whether the long-term unemployed are contributing to labor market imbalances is
to examine wage and compensation growth. In particular, if there is limited labor market slack, wage
growth should pick up. Comprehensive measures of compensation and wage growth provide no
evidence of such labor market tightness. Instead, they show that compensation and wage growth has
been stable around a modest 2% pace.

Available data and anecdotal evidence indicate that selected worker groups with advanced,
specialized technical skills have been seeing relatively rapid wage gains. However, for skilled
workers overall, there is little evidence of a pickup in wage inflation. More generally, wage inflation
has been especially limited for low-skilled workers.
Unemployment gap closing slowly
Rebound expected following first-quarter lull
GDP growth: actual and FRBSF forecast
Unemployment rate
%
6
Quarterly percent change at seasonally adjusted annual rate
%
Seasonally adjusted monthly observations, forecast is quarterly average
12
4
10
2
FRBSF
forecast
0
Actual
FRBSF
forecast
Q1
8
6
-2
Natural rate
(FRBSF)
-4
4
-6
2
-8
2007
2008
2009
2010
2011
2012
2013
2014
2015
-10
2007
Source: Bureau of Economic Analysis and FRBSF staff
2008
2009
2010
2011
2012
2013
2014
2015
0
Source: Bureau of Labor Statistics and FRBSF staff
Inflation likely to remain below target
Long-term unemployment remains elevated
PCE price inflation
%
Percent change from 4 quarters earlier
5
Unemployment rates
%
As a percent of the labor force
8
4
Overall PCE
price index
4
FRBSF
forecasts
Core PCE
price index
6
May
2
Q1
Target rate
Short-term
(≤6 months)
3
1
Long-term
(>6 months)
0
2
-1
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-2
1994
Source: Bureau of Economic Analysis and FRBSF staff
%
Seasonally adjusted observations, 6-month moving average
40
Short-term unemployed
(≤6 months)
1998
2000
2002
2004
2006
2008
2010
2012
2014
Employment cost index (all civilian workers)
%
Index, 4-quarter percent change
6
35
5
30
Compensation
4
25
3
20
May
Long-term unemployed
(>6 months)
0
Compensation, wages show modest growth
Limited job-finding for long-term unemployed
Job-finding rates
1996
Source: Bureau of Labor Statistics
Q1
15
Wages and salaries
2
10
1
5
1994
1996
1998
2000
2002
Source: Bureau of Labor Statistics
2004
2006
2008
2010
2012
2014
0
1999
2001
2003
2005
Source: Bureau of Labor Statistics
2007
2009
2011
2013
0
Wage growth limited for all skill groups
Employment cost index, wages and salaries
%
Private industry workers, 4-quarter percent change
5
4
High skill
3
Medium skill
Q1
2
1
Low skill
2003
2005
2007
2009
Source: Bureau of Labor Statistics and FRBSF staff
2011
2013
0