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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 13, 2014
Also available upon release at
http://www.frbsf.org/economic-research/publications/fedviews/
Kevin J. Lansing, research advisor at the Federal Reserve Bank of San Francisco, states his views on the current
economy and the outlook.

The initial estimate of real GDP growth in the third quarter of 2014 was 3.5% at an annual rate. A
jump in federal defense spending and an increase in net exports made outsize contributions to growth
in the initial estimate. More recent data on net exports suggest that third quarter growth is likely to be
revised down to around 3% in subsequent estimates.

We expect growth in the fourth quarter of 2014 to come in around 2.5%. For 2015, we expect growth
to pick up to around 2.8%. This is about 0.5 percentage point above the growth rate observed over
the 21 quarters since the end of the Great Recession. The primary downside risk to the U.S. growth
outlook is a possible slowdown in global economic activity, which may be a factor underlying the
recent sharp declines in crude oil prices.

Payroll employment growth has been consistent this year, with the latest figure for October
representing the ninth straight month of job gains above 200,000. Continued solid job growth is
expected to push down the unemployment rate to 5.3% by the end of 2015, close to the level of 5.2%
that we judge to be the natural rate of unemployment.

Inflation, as measured by the four-quarter change in the personal consumption expenditures (PCE)
price index, has remained below the Federal Open Market Committee’s (FOMC) 2% target since
mid-2012. Recent declines in energy prices are expected to temporarily push down PCE inflation in
the near-term. Looking past these transitory effects, we expect PCE inflation to rise gradually
towards 2% as economic slack dissipates.

The cumulative and ongoing improvements in labor market conditions are key factors underlying the
FOMC’s decision to end its asset purchase program in October. However, with substantial economic
slack and inflation below the FOMC’s target, monetary policy remains highly accommodative.

Stock market gains have been an important feature of the U.S. economic expansion. The ratio of the
Standard & Poor’s (S&P) 500 stock market index capitalization to GDP is currently around 100%—
approximately double the value that prevailed at the market bottom in 2009:Q1. While elevated, the
ratio remains below the value of 126% that was observed at the market peak in 2000:Q1.

The ratio of New York Stock Exchange margin debt to GDP has risen sharply in recent years and is
currently near all-time highs, signaling the increasing willingness of investors to buy stocks using
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, 2014.
borrowed money. Similar sharp rises in the ratio of margin debt to GDP in 1999 and 2006–07 were
followed by major downturns in stock prices.

The cyclically adjusted price-earnings ratio (P/E10) for the S&P 500 stock market index is a metric
that economist Robert Shiller has advocated to help judge whether the stock market is overvalued.
The ratio is computed as the real, or inflation-adjusted, value of the S&P 500 index divided by real
earnings averaged over the 10 most recent years. The current P/E10 ratio of 25.7 exceeds the long-run
historical average of 16.6 but remains below the values of 32.6 and 44.2 observed at the market
peaks in 1929 and 2000, respectively.

Higher values of the P/E10 ratio predict lower future real growth in stock prices over the subsequent
10-year period. Using the average historical relationship between these two variables as a guide, a
P/E10 ratio of 25.7 (the observed value in October 2014) would predict mildly negative real growth in
stock prices over the next 10 years. It is important to keep in mind, however, that there are many
examples in the data where the subsequent 10-year growth in stock prices turned out to be higher or
lower than predicted by the average historical relationship. This reflects the inherent difficulty of
predicting movements in stock prices.

Similar to the P/E10 ratio, a higher bull-bear spread—that is, the balance of bullish versus bearish
individual investors from surveys—also predicts lower future real growth in stock prices over the
subsequent 10-year period. Using the average historical relationship, the observed bull-bear spread in
October 2014 would predict mildly positive real growth in stock prices over the next 10 years.
Again, however, there are many examples in the data that deviate from the average historical
relationship on both the upside and the downside.
Solid job growth this year
Economy growing at moderate pace
Nonfarm payroll employment
GDP growth: Actual and FRBSF forecast
%
Quarterly percent change at seasonally adjusted annual rate
Thousands
Monthly change; seasonally adjusted
400
6
Q3
350
2
FRBSF
forecast
Actual
Monthly
change
Oct.
214
6-month
moving average
300
250
-2
200
150
-6
100
50
2007
2008
2009
2010
2011
2012
2013
2014
2015
-10
2016
2011
Source: Bureau of Economic Analysis and FRBSF staff
2012
2013
0
2014
Source: Bureau of Labor Statistics
Inflation gradually returning to target
Unemployment gradually declining
PCE price inflation
Unemployment rate and forecast
%
Sesaonally adjusted monthly observations, forecast is quarterly average
%
Percent change from 4 quarters earlier
5
12
4
10
Overall PCE
price index
8
Oct.
5.8
3
2
6
FRBSF
forecast
1
Core PCE
price index
4
Q3
FRBSF
forecasts
2
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
0
Source: Bureau of Labor Statistics and FRBSF staff
-1
2007
2009
2010
2011
2012
2013
2014
2015
Ratio
2014
Q3
0.03
P/E10 = real S&P 500 Index/10 yr. avg. real earnings
50
2000
40
1929
35
0.02
0.6
45
0.025
S&P 500 market cap
GDP
(left axis)
0.4
0.2
1901
Oct.
2014
1966
0.015
30
25
20
Margin debt
GDP
(right axis)
0.01
15
10
0.005
0
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Source: BEA; S&P; NYSE
-2
Ratio
Monthly data
1
0.8
2016
Cyclically adjusted P/E ratio is elevated
Stock margin debt near all-time highs
1.2
2008
Source: Bureau of Economic Analysis and FRBSF staff
Margin debt and stock prices
Ratio
1.4
0
5
1880
1900
1920
Source: Robert Shiller's website
1940
1960
1980
2000
0
2020
Bullish sentiment predicts low gains
High P/E ratios predict low future gains
Avg 10-year price growth versus bull-bear spread
15
Avg annual real price growth next 10 yrs
Avg annual real price growth next 10 yrs
Avg 10-year price growth versus P/E10
October
2014
10
5
0
-5
-10
15
October
2014
10
5
0
-5
November
2000
-10
-15
0
10
20
30
40
Cyclically adjusted price/earnings ratio, P/E10
Source: Robert Shiller's website; Brad DeLong August 17, 2014
50
-20
-10
0
10
20
30
Bull-bear spread (12 month moving avg)
40
Source: Robert Shiller's website; American Association of Individual Investors