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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
September 11, 2014
Also available upon release at
http://www.frbsf.org/economic-research/publications/fedviews/
Zheng Liu, senior research advisor at the Federal Reserve Bank of San Francisco, states his views on the
current economy and the outlook.

Real GDP expanded at an annual rate of 4.2% in the second quarter, according to the latest Bureau of
Economic Analysis estimate in late August. This was similar to the initial estimate in July, and
confirms that the economy bounced back sharply from the first-quarter dip.

Recent data suggest that economic momentum was largely sustained entering the second half of this
year, although growth is likely to slow somewhat from the strong second quarter. Overall consumer
spending in recent months has been disappointing, but motor vehicle sales have been robust. Housing
market activity has been encouraging, and overall construction spending has risen. Industrial
production also continued to expand in recent months. The July durable goods report was mixed but
generally consistent with ongoing growth in the manufacturing sector. On balance, we expect real
GDP to grow at about a 3% pace over the remainder of this year and next year.

Labor market conditions continue to improve, although more slowly than earlier in the year. Nonfarm
payrolls rose by 142,000 in August, which was well below expectations. Total payroll employment in
June and July were revised downward. Despite the August disappointment, the overall labor market
improvement over the past year remains solid.

Solid employment growth this year has helped lower the unemployment rate, which fell slightly from
6.2% in July to 6.1% in August. Moreover, the labor force participation rate, which had been steadily
declining since 2008, was largely stable in recent months. Among other indicators of labor market
improvement, a broader measure of underemployment, including people who are unemployed,
marginally attached to the labor force, and working part-time for economic reasons, has declined
significantly since the beginning of this year. The share of long-term unemployed—those who have
been without jobs for 27 weeks or more—has also declined substantially over the past few months.
Despite this sustained improvement, the broad array of labor market indicators suggest continued
slack.

Although inflation stepped up in the second quarter of this year, it remains below the Federal Open
Market Committee’s objective of 2%. In July, both the overall and the core personal consumption
expenditures price index (PCEPI) rose at a very modest pace, suggesting that the second-quarter
pressures have ebbed. Recent declines in oil prices are also likely to further constrain the rise in the
overall PCEPI. We expect inflation to continue to rise slowly towards the 2% target.
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 14, 2014.

The improving labor market has been a key factor underlying the steady reduction this year in the
pace of monthly asset purchases by the Federal Reserve. However, with substantial economic slack
and inflation below the FOMC’s target, monetary policy remains highly accommodative.

Looking ahead to longer-term growth in the U.S. economy, population aging may be a significant
headwind. In the next two decades, the share of individuals age 65 and older in the total U.S.
population will increase sharply according to projections from the U.S. Census Bureau. This
demographic change will be driven mainly by the aging of the baby-boom generation—the 76 million
people born between 1946 and 1964.

An aging population may have an adverse impact on the U.S. equity market and the macroeconomy
in general. Evidence suggests that an investor’s risk tolerance changes over the life cycle. As the
boomers transition from work into retirement over the next 10 to 15 years, they are likely to switch
from buying to selling stocks. Since the boomers represent a large fraction of the population, changes
in their investment behavior can have a meaningful effect on the U.S. stock market.

Recent research shows that the long-term swings in the price-to-earnings (P/E) ratio of the U.S. stock
market are highly correlated with the evolution of the population’s age structure during the postWorld War II period. A substantial fraction of the fluctuations in the stock market’s P/E ratio can be
explained by changes in the ratio of people ages 40 to 49 years to those ages 60 to 69.

As U.S. boomers approach retirement and decide sell their equity holdings, the number of sellers
relative to buyers will increase, putting downward pressure on stock prices. This pressure can be
partially offset, in principle, if foreign investors are willing to buy U.S. equities. However, the rest of
the world is also aging, so other countries may face similar challenges, dimming that hope.
Overall job growth remains solid
Moderate growth expected to continue
GDP growth: Actual and FRBSF forecast
%
Quarterly percent change at seasonally adjusted annual rate
Nonfarm payroll employment
Monthly change; seasonally adjusted
Thousands
400
6
Q2
350
2
300
6-month
moving avg
Monthly
change
FRBSF
forecast
Actual
250
Aug
-2
200
150
-6
100
50
2007
2008
2009
2010
2011
2012
2013
2014
2015
-10
2011
Source: Bureau of Economic Analysis and FRBSF staff
2012
2013
0
2014
Source: Bureau of Labor Statistics
Inflation expected to rise gradually
Unemployment continues to decline
Unemployment rate
%
Monthly; seasonally adjusted; forecast is quarterly average
12
PCE price inflation
%
5
Percent change from 4 quarters earlier
10
4
Overall PCE
price index
3
8
Aug.
6.1
Q2
6
FRBSF
forecast
2
Target rate
FRBSF
forecasts
Core PCE
price index
4
0
2
2007
2008
2009
2010
2011
2012
2013
2014
0
2015
1
-1
2007
2008
2009
2010
2011
2012
2013
2014
2015
-2
Source: Bureau of Economic Analysis and FRBSF staff
Source: Bureau of Labor Statistics and FRBSF staff
U.S. population is aging
People sell equity as they age
Fraction of ages 65 and over in U.S. population
Stock market participation rate
%
25
Projections begin in 2014
%
Percentage of households holding stocks by age of head, 2010
70
60
20
50
40
15
30
20
10
10
1950
1960
1970
1980
1990
Source: U.S. Bureau of the Census
2000
2010
2020
2030
2040
2050
5
<35
35-44
Source: Survey of Consumer Finance
45-54
55-64
65-74
0
The rest of the world is also aging
Demographics correlated with stock prices
Fraction of ages 65 and over in population
Price/earnings (P/E) and middle/old (M/O) ratios
M/O ratio defined as ratio of ages 40-49 to ages 60-69
Ratio
2.8
%
40
US projections begin in 2014. Other projections begin in 2011.
Japan
Euro
Area
2.0
UK
China
25
US
20
P/E ratio
(left scale)
2013
1.6
M/O ratio
(right scale)
35
2.4
30
15
10
1.2
5
1954
1964
1974
1984
1994
2004
2014
Source: Bloomberg, U.S. Bureau of the Census, Liu and Spiegel (2011, updated)
0.8
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060
Source: U.S. Bureau of the Census, United Nations
0