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Twelfth Federal Reserve District
FedViews
April 9, 2015
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/
Mary C. Daly, senior vice president and associate director of research at the Federal Reserve Bank of
San Francisco, states her views on the current economy and the outlook.

Real GDP grew at a solid 2.4% pace in the four quarters of 2014, supported by low interest rates and
strong consumer spending. In contrast, data for the first quarter of this year have generally come in
weaker than expected. However, much of the weakness can be traced back to severe winter weather
in the Midwest and East Coast that snarled transportation networks, idled construction sites, and kept
shoppers at home.

With winter behind us, we expect above-trend growth to resume in the second quarter and continue
for the rest of 2015. Accommodative monetary policy along with ongoing improvements in credit
market conditions, asset values, and household incomes related to the strong labor market all are
expected to help sustain this solid growth.

We project the pace of growth to gradually slow over time and settle near our long-run trend estimate
of about 2% toward the end of 2016. This path is consistent with expected increases in interest rates,
the fading boost of lower gasoline prices to household spending, and the increasing drag of the dollar
appreciation on U.S. exports and on sectors exposed to import competition.

The addition of only 126,000 jobs to the labor market in March was a disappointment. However,
averaged over the past six months, trend job growth remains quite strong. And importantly, the
March numbers, including downward revisions for payroll job growth in January and February, bring
the labor market readings into better alignment with the pace of GDP growth.

As solid growth in GDP resumes in coming quarters, we expect monthly job gains to pick back up
and the unemployment rate to continue its gradual decline. We project the unemployment rate will
dip below our estimate of the natural rate around the middle of this year and remain there for the
duration of our forecast horizon.

Inflation remains low and well below the Federal Open Market Committee’s 2% target. We expect
inflation to fall further in coming months as the effects of lower energy prices and the stronger dollar
show through to final goods prices. As these temporary factors abate, we expect inflation to
gradually rise, moving back towards the 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 May 18, 2014.

The expectation that inflation will gradually return to 2% is based on several factors, including
higher inflation readings from alternative series such as the trimmed-mean compared with the overall
or core personal consumption expenditures series. The stability of long-run inflation expectations
among businesses and households and the historical link between diminishing labor market slack and
inflation reinforce this projection.

A lagging factor in the recovery has been growth in labor compensation, which remains tepid despite
the considerable drop in unemployment. The question is: Is this typical or troubling? In other words,
is it normal for wage growth to lag the decline in unemployment, or does this lag indicate that some
fundamental relationship in the labor market has been broken?

One way to answer this question is to look at what happened in the 1990 recession and recovery.
When the recession hit, the unemployment rate rose and growth in labor compensation slowed,
although less than one might expect or than simple models predicted. As the recovery ensued and
unemployment came down, wage growth continued to slow. Only when unemployment neared its
normal level or natural rate did growth in compensation begin to pick up.

The current period does not look that different from the 1990s. In 2008 and 2009, the unemployment
rate shot up and wage growth slowed slightly. As unemployment declined, labor compensation
growth slowed further and then began to oscillate around a tepid 2%.

Looking ahead, with unemployment approaching our estimate of its natural rate, we expect
compensation growth to accelerate this year and next. We already see signs of this in the data. The
March labor market report showed a surprising pickup in average hourly earnings of total private
employees.

A number of major corporations have announced they will increase their minimum wages and make
comparable pay increases for other hourly workers. These are expected to kick in sometime this year,
providing an additional boost to wage growth.

Small businesses also plan to increase wages in coming months. Surveys from the National
Federation of Independent Business show the share of small businesses planning to raise
compensation in the next three months has risen and is quite close to its pre-crisis average.

An especially clear signal that compensation growth is picking up comes from the improving job
market for new college graduates, following years of poor prospects. According to the National
Association of Colleges and Employers 2015 Job Outlook Survey, about two-thirds of employers
plan to raise starting salaries, and over half plan to offer signing bonuses.

Combined, these data point to a pickup in compensation growth over the next year and suggest that
the typical cyclical relationship between unemployment and wage growth remains alive and well.
Trend in job growth remains strong
Solid growth to resume after weak first quarter
GDP growth: Actual and FRBSF forecast
%
Quarterly percent change at seasonally adjusted annual rate
Nonfarm payroll employment
Thousands
Monthly change; seasonally adjusted
6
600
Q4
450
300
2
150
0
Actual
FRBSF
forecast
Monthly
change
-2
-6
-150
Mar. 2015 +126,000
Feb. 2015 +264,000
Jan. 2015 +201,000
6-month
moving average
-300
-450
-600
-750
2007
2008
2009
2010
2011
2012
2013
2014
-10
2015
2007
Source: Bureau of Economic Analysis and FRBSF staff
2008
2009
2010
2011
2012
2013
2014
-900
2015
Source: Bureau of Labor Statistics
Low inflation expected to be temporary
Unemployment approaching normal
Unemployment rate
%
Monthly; seasonally adjusted; forecast is quarterly average
12
PCE price inflation
%
Percent change from 4 quarters earlier
5
4
10
Overall PCE
price index
3
8
Mar.
5.5
6
1
Natural
rate
FRBSF
forecast
Core PCE
price index
4
FRBSF
forecasts
2
2007
2008
2009
2010
2011
2012
2013
2014
2
Q4
Target rate
2015
2016
0
2007
Tepid wage growth despite less slack
2010
2011
2012
2013
2014
2015
2016
Unemployment and growth in labor compensation
%
12 Labor compensation is percent change from 4 quarters earlier
10
Average
unemployment rate
10
Unemployment
-2
Look back to 1990s as a case study
%
Labor compensation is percent change from 4 quarters earlier
2009
-1
Source: Bureau of Economic Analysis and FRBSF staff
Source: Bureau of Labor Statistics and FRBSF staff
Unemployment and growth in labor compensation
2008
0
8
8
6
6
Natural rate
4
4
Growth in labor
compensation
1985
1988
1991
1994
1997
Growth in labor
compensation
2
2000
2003
Source: BLS, Haver Analytics, author's calculations
2006
2009
2012
0
2015
2
0
1990
1991
1992
1993
Source: BLS, Haver Analytics, author's calculations
1994
1995
1996
Current period not that different
More small firms expect to raise wages
Unemployment and growth in labor compensation
%
Labor compensation is percent change from 4 quarters earlier
10
Average
unemployment rate
NFIB compensation survey
Small businesses planning to raise compensation in next 3 months
8
%
25
20
Pre-crisis average
6
15
4
10
2
5
Natural rate
Growth in labor
compensation
0
2007
2008
2009
2010
2011
Source: Haver Analytics, author's calculations
2012
2013
2014
2000
2002
2004
Source: NFIB, BLS/Haver
2006
2008
2010
2012
2014
0
2016