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November 2011 (October 14, 2011-November 8, 2011) In This Issue: Monetary Policy The Shout with Operation Twist Yield Curve and Predicted GDP Growth: October 2011 Banking and Financial Markets Sovereign Debt Implications on the European Banking System Households and Consumers Household Debt Regional Economics Local Government Employment in Ohio, Pennsylvania, Kentucky, and West Virginia Inflation and Price Statistics Recent Employment Cost Index Estimates Inflation In the Developed Countries Labor Markets, Unemployment, and Wages Emergency Unemployment Compensation and Long-term Unemployment Growth and Production Weak Wage and Income Growth Is Holding Consumption Back Monetary Policy The Shout with Operation Twist 10.18.11 by John B. Carlson and John Lindner Much attention has been given to the Federal Open Market Committee’s September decision to extend the average maturity of its portfolio by selling short-term Treasury securities and purchasing longer-term Treasury securities. This policy action is commonly called operation twist since its intended effect is to lower long-term interest rates relative to short-term rates—that is, to twist the yield curve. In addition to the largely anticipated maturity extension program announced by the Federal Open Market Committee (FOMC) in September, the Committee altered its reinvestment strategy on agency securities. Instead of reinvesting principal payments and prepayments from agency debt and agency mortgage-backed securities (MBS) in Treasury securities, the new directive is for those funds to be reinvested in agency MBS. The policy statement clearly communicated that this action was taken to help support conditions in mortgage markets. But has it been effective? Agency Securities Holdings Trillions of dollars 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 12/07 Let’s start with the Fed’s position prior to the September announcement. The balance of agency securities held by the Fed had been declining steadily since the end of March 2010, when the first round of large-scale asset purchases was being completed. After peaking at nearly $1.3 trillion, the amount of agency security holdings now stands just below $1 trillion. Agency mortgage-backed securities Agency debt 7/08 2/09 9/09 4/10 11/10 6/11 Source: Federal Reserve Board. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 The total amount of reinvestment purchases that will be made will depend on expected rates of prepayment and principal payments, but it is predicted that somewhere between $200 billion and $300 billion will be purchased through 2012. Initially, approximately $10 billion of purchases were made in the first few weeks of the program, with another $22 billion expected to be reinvested through the middle of November. The effect of the policy will keep the Fed’s portfolio of agency securities at nearly $1 trillion. 2 Mortgage-Backed Security Yields Percent 3.50 30-year Fannie Mae 3.25 The guidelines for these purchases are very similar to those established during the initial purchasing program. Securities will be limited to those that are guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, and they will largely be concentrated in newly issued agency MBS. 3.00 2.75 2.50 30-year Ginnie Mae 2.25 FOMC meeting 2.00 09/01 09/11 09/21 10/01 10/11 Source: Bank of America Merrill Lynch. Mortgage-Backed Security Prices Price (12/31/1986=100) Price (12/31/1986=100) 630 670 FOMC meeting 625 665 Fannie Mae 620 660 615 655 610 650 605 Ginnie Mae 645 640 09/01 600 595 09/11 09/21 10/01 10/11 Source: Wall Street Journal. Mortgage Rates Percent Percent 4.50 4.45 3.80 FOMC meeting 3.75 4.40 3.70 4.35 3.65 15-year 30-year 4.30 3.60 4.25 3.55 4.20 3.50 4.15 3.45 4.10 09/01 3.40 09/11 Even though the maturity extension program received the lion’s share of the attention following the September FOMC meeting, at least part of the downward spike in mortgage-related yields can likely be attributed to the MBS reinvestment program. The higher demand for agency MBS created by the Fed re-entering the market should raise the value of these packaged securities, lowering the yields. Those effects were seen immediately on MBS yields for both Ginnie Mae and Fannie Mae, whose 30-year current coupon bond yields each fell roughly 50 basis points following the FOMC announcement. 09/21 10/01 10/11 Source: Wall Street Journal. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 Alternatively, one can examine the impact of the policy change in the prices of MBS. The 30-year current coupon MBS prices from Ginnie and Fannie rose sharply on September 21. The indexed prices for Ginnie Mae and Fannie Mae rose at least 5 index points each, led by a 12-point gain in Fannie Mae’s prices. The higher coupon prices tend to increase the value of portfolios holding such longterm securities. Since the securities being purchased are a packaged group of mortgages, another intended effect of this program will be to lower retail mortgage interest rates relative to what they would have been in the absence of the policy action. This result was observed after the September FOMC meeting, as the 30-year fixed mortgage rate fell to 4.15 percent. Smaller declines were also realized in the 15-year fixed mortgage rate. Combined with the lower yields on mortgage securities, the cumulative result should be a more accommodative mortgage market. In the weeks following the announcement, the effects have dissipated noticeably. While some may be quick to judge the program as ineffective, the matter is not that clear cut. It could also be argued that the effect of the policy actions on mortgage rates have been obscured by the effect of other economic developments after the September FOMC meeting. For example, the employment report for October 3 beat market expectations, as did retail sales and the ISM manufacturing survey. This improvement in economic conditions had the effect of generally raising the level of interest rates, offsetting the initial movements created by the Fed’s announcement. Similarly, the negative news related to the FrancoBelgian bank Dexia had dampening effects on overall interest rates, including MBS bond yields. Mortgage-Backed Security Yields Price 3.50 ISM manufacturing Employment report 3.25 3.00 30-year Fannie Mae 2.75 2.50 30-year Ginnie Mae 2.25 FOMC meeting 2.00 09/01 09/11 Dexia up for downgrade 09/21 10/01 10/11 Source: Bank of America Merrill Lynch. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 The volatile nature of these types of financial markets makes a simple study of yields and prices an incomplete exercise. However, the immediate effect of the FOMC statement shows that the policy did influence markets and that the policy is likely to influence the expectations of market participants in the future. 4 Monetary Policy Yield Curve and Predicted GDP Growth Covering September 23, 2011—October 28, 2011 by Joseph G. Haubrich and Margaret Jacobson Overview of the Latest Yield Curve Figures Highlights October September August 3-month Treasury bill rate (percent) 0.02 0.01 0.01 10-year Treasury bond rate (percent) 2.28 1.87 2.19 Yield curve slope (basis points) 226 186 218 Prediction for GDP growth (percent) 0.8 0.8 0.08 Probability of recession in 1 year (percent) 4.3 7.0 4.8 Yield Curve Spread and Real GDP Growth Percent 10 8 6 GDP growth (year-over-year change) 4 2 0 -2 -4 Ten-year minus three-month yield spread -6 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 Note: Shaded bars indicate recessions. Source: Bureau of Economic Analysis, Federal Reserve Board. If September saw a flattening in the yield curve in the wake of Operation Twist (formally, the Maturity Extension Program and Reinvestment Policy of the Federal Reserve), October saw a reversal, with the yield curve steepening. Long rates rose back to summertime levels, and short rates edged up but remained extraordinarily low. The three-month Treasury bill rate ticked up to 0.02 percent (for the week ending October 28), up from the 0.01 percent seen in August and September. The ten-year rate surged back above 2 percent, to 2.28 percent, which is up from September’s 1.86 percent. Naturally, the slope increased, up to 226—an increase of 40 basis points. Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 0.8 percent rate over the next year, even with the projections in August and September. The strong influence of the recent recession is leading toward relatively low growth rates. Although the time horizons do not match exactly, the forecast comes in on the more pessimistic side of other predictions, but like them, it does show moderate growth for the year. Following the usual pattern, the steeper slope indicates a lower probability of recession. Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next October is 4.3 percent, down from September’s 7 percent, and from August’s 4.8 percent. So although our approach is somewhat pessimistic as regards the level of growth over the next year, it is quite optimistic about the recovery continuing. The slope of the yield curve—the difference between the yields on short- and long-term maturity bonds—has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb Federal Reserve Bank of Cleveland, Economic Trends | November 2011 5 Yield Curve Predicted GDP Growth Percent Predicted GDP growth GDP growth (year-over-year change) 4 2 More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between ten-year Treasury bonds and three-month Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it. 0 -2 Ten-year minus three-month yield spread -4 -6 2002 2004 2006 2008 is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). One of the recessions predicted by the yield curve was the most recent one. The yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. 2010 2012 Sources: Bureau of Economic Analysis, Federal Reserve Board, authors’ calculations. Predicting GDP Growth We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward. Predicting the Probability of Recession Yield Spread and Lagged Real GDP Growth Percent 10 8 One-year lag of GDP growth (year-over-year change) 6 4 2 0 -2 -4 Ten-year minus three-month yield spread -6 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Federal Reserve Board. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward. Of course, it might not be advisable to take these number quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other 6 Recession Probability from Yield Curve Percent probability, as predicted by a probit model 100 90 80 Probability of recession 70 60 Forecast 50 indicators, should be interpreted with caution. For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary “Does the Yield Curve Signal Recession?” Our friends at the Federal Reserve Bank of New York also maintain a website with much useful information on the topic, including their own estimate of recession probabilities. 40 30 20 10 0 1960 1966 1972 1978 1984 1990 1996 2002 2008 Note: Shaded bars indicate recessions. Sources: Bureau of Economic Analysis, Federal Reserve Board, authors’ calculations. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 7 Households and Consumers Household Debt 10.27.11 by O. Emre Ergungor Household Liabilities Billions of dollars Billions of dollars 12,000 10,000 3,500 Housegold liabilities excluding home mortgages 3,000 8,000 2,500 Household home mortgage liabilities 6,000 2,000 4,000 1,500 2,000 2000 1,000 2002 2004 2006 2008 2010 Source: Flow of Funds, Federal Reserve Board. Delinquency Rates Percent of total mortgages 8 30 7 25 Subprime mortgages 6 The level of U.S. household debt relative to disposable income has been declining since the financial crisis. This household deleveraging is still continuing, according to the latest data. The deleveraging is taking place primarily because liabilities on home mortgages are falling. Nonmortgage liabilities have been flat since 2007. The primary driver of declining mortgage balances is mortgage write-offs. Given the persistently high level of delinquency rates, mortgage write-offs are likely to remain high. Mortgage balances will drop further as result, unless purchase-mortgage originations pick up. So far, purchase activity remains highly subdued. The most recent data show that originations are still close to the lowest levels seen during the crisis. 20 5 15 4 3 10 2 Prime mortgages 1 0 2000 5 0 2002 - 2004 2006 2008 2010 Source: Mortgage Bankers Association. Purchase Mortgage Originations: One to Four Family Billions of dollars 500 450 400 350 300 250 200 150 100 50 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Refinancing activity has also been declining despite the historically low mortgage rates. The obvious culprit is the lack of equity. Median price appreciation of the refinanced properties from the time the original loan was made to the time it was refinanced is -7.4 percent in the most recent Freddie Mac data. This suggests that the Fannie Mae and Freddie Mac are mostly refinancing underwater mortgages in their effort to revive the housing market. This opportunity to refinance without equity is not available to mortgages not owned by the two housing GSEs. Therefore, the overall refinancing activity is lackluster despite the low mortgage rates. It is also worth noting that refinancing activity is not uniform across all market segments. Currently, around 80 percent of mortgage originations under the Freddie Mac loan limit are refinancings. In the broader market, the refinance share is around 60 percent. This observation also supports our earlier claim that the housing GSEs are more active in this market because they can refinance loans that would Source: Mortgage Bankers Association. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 8 Refinance Mortgage Originations not qualify for a refinancing in the private market due to lack of equity or low credit score. Billions of dollars The nature of refinancing activity has also changed in the last few years. While cash-out refinancings were the most popular type of activity before the crisis, the current trend is to benefit from low rates without taking on new debt. This suggests that refinancings may not give a boost to consumption the way they did earlier in the last decade. 900 800 700 600 500 400 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Mortgage Bankers Association. Median Appreciation of Refinanced Property Percent 40 35 30 25 20 15 10 5 0 -5 -10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Freddie Mac. Mortgages Refinanced for Higher Loan Amounts Refinance Shares Percent of total mortgages 90 Percent of refinancings with 5 percent higher loan amounts 80 100 70 60 Mortgage originations: 1–4 family 80 70 50 60 40 30 90 Freddie Mac primary mortgage market 50 40 20 30 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20 10 0 Source: Mortgage Bankers Association; Freddie Mac 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Mortgage Bankers Association. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 9 Inflation and Price Statistics Recent Employment Cost Index Estimates 11.02.11 by Kyle Fee Employment Cost Index and CPI: Services 4-quarter growth rate 16 14 CPI: Services 12 10 8 6 Compensation 4 2 0 1980 Wages and salaries 1984 1988 1992 1996 2000 2004 2008 Note: Shaded bars indicate recessions. Source: Bureau of Labor Statistics. The Employment Cost Index (ECI) is one of the data releases we monitor to help shape our inflation outlook. The latest figures for the ECI continue to point to restrained wage growth. Over the past four quarters, total compensation for private workers is up 2.2 percent, while wages and benefits are up 1.7 percent and 3.4 percent, respectively. Even though total compensation for private workers has been slowly increasing following the end of the recession, much of that increase has been associated with rising benefits costs and not wage growth. In fact, wage growth has not returned to pre-recession levels. Since the recovery began nine quarters ago, the wage series has made minimal progress toward 2.0 percent growth and remains well off of its 1990 to 2007 average growth rate of 3.3 percent. Restrained wage growth has implications for the inflation outlook. Wages are the primary input cost that business owners must account for when they set their prices, especially for services. This tight relationship between wages and prices is evident in the high correlation (0.89) between wage growth and the services component of the CPI. Total compensation is also highly correlated (0.88) with the services component of the CPI. The correlation with the CPI service measure, while it does not prove wage increases cause inflation, is certainly noteworthy. Given that services account for a large share of the consumer market basket (60 percent), it seems appropriate to make the connection between subdued wage growth and inflation. CPI: Services Percent of market basket 61 60 59 Previously, we noted that subdued labor costs will act as a drag on future inflation. The recent ECI reading suggests that labor costs are still subdued. 58 57 56 55 54 53 52 51 1987 1992 1997 2002 2007 Source: Bureau of Labor Statistics. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 10 Inflation and Price Statistics Inflation in Developed Countries 11.08.11 by Margaret Jacobson and Mehmet Pasaogullari Headline inflation in Developed Countries Percent (seasonally adjusted, 3-month annualized) 15.00 Canada U.K. U.S. 10.00 Germany Japan 5.00 0.00 -5.00 -10.00 -15.00 1/2007 9/2007 5/2008 1/2009 9/2009 5/2010 1/2011 9/2011 5/2007 1/2008 9/2008 5/2009 1/2010 9/2010 5/2011 Sources: Bloomberg; Haver Analytics, Inc. Earlier this year we saw average consumer prices increase in the United States, largely due to increases in food and energy prices. Since then, the inflationary pressure brought on by energy prices has been largely alleviated. A similar trend has happened in most other developed countries. Inflation rates for developed countries tend to move together although the inflation levels can vary significantly (these data are seasonally adjusted). For example, over the last few years, CPI inflation in the UK seems to be significantly higher than in Germany (and also in other G7 continental European countries not shown in the graph). Japan, not surprisingly, has the lowest inflation as this country has been struggling with deflationary pressures. During the summer of 2008, when oil prices increased substantially, all of these countries, even Japan, experienced high levels of inflation. Something similar happened in the spring of 2011, when inflation increased to around 5 percent in Canada, the UK, and the United States. Since then, however, inflation has declined. Energy Price Inflation in Developed Countries What has been the main driver of the increase in Percent (non-seasonally adjusted, 3-month annualized) 150.00 100.00 Canada U.K. U.S. Germany Japan 50.00 0.00 -50.00 -100.00 1/2007 9/2007 5/2008 1/2009 9/2009 5/2010 1/2011 9/2011 5/2007 1/2008 9/2008 5/2009 1/2010 9/2010 5/2011 Sources: Bloomberg; Haver Analytics, Inc. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 the inflation in early 2011? The three-month annualized inflation of energy prices (not seasonally adjusted) showed a volatile pattern in 2011. After sharply increasing in the spring, the levels reversed course. Unsurprisingly, energy prices show a very high correlation across countries, but are also more volatile in the United States than in other developed countries. Another culprit causing high levels of inflation was elevated food inflation. A look at food-price inflation shows that food prices were at a high level in early 2011, especially in the United States, Canada, and the UK. However, food-price inflation fell less than energy inflation. Food-price inflation is still high. For example, three-month annualized foodprice inflation is 5.7 percent in the United States, 4.1 percent in Canada, and 8.8 percent in the UK 11 Food Price Inflation in Developed Countries Percent (seasonally adjusted, 3-month annualized) as of September 2011. However, we have to note that an episode of high food-price inflation is not uncommon, as the figure below suggests. 25.00 20.00 15.00 10.00 5.00 0.00 -5.00 -10.00 1/2007 9/2007 5/2008 1/2009 9/2009 5/2010 1/2011 9/2011 5/2007 1/2008 9/2008 5/2009 1/2010 9/2010 5/2011 Sources: Bloomberg; Haver Analytics, Inc. Core Inflation in Developed Countries Percent (seasonally adjusted, 3-month annualized) 6.00 5.00 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 -3.00 -4.00 1/2007 9/2007 5/2008 1/2009 9/2009 5/2010 1/2011 9/2011 5/2007 1/2008 9/2008 5/2009 1/2010 9/2010 5/2011 Sources: Bloomberg; Haver Analytics, Inc. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 Finally, we check inflation excluding food and energy prices, frequently called core inflation in the developed countries. Most economists believe that core inflation measures are better at capturing inflationary pressures and better predictors of future inflation, as they exclude noisy signals and temporary factors. When we look at the development of core inflation measures in the developed countries, we see several important facts. First of all, we see a lot less correlation between core inflation levels across countries than in overall inflation, food-, or energy-inflation. For example, the deflationary phase that Japan is experiencing is clearly seen in the core inflation level, which has been persistently negative since late 2008, except for a few temporary blips. On the other hand, the UK experienced sharp increases in core inflation in early 2011, which may be related to an increase in the country’s VAT tax. For the United States and Germany, it seems that the pass-through effects of energy-price increases led to peaks in core inflation—in May for the United States and in April for Germany. Now three-month annualized core inflation has declined to 2.1 percent and to 1.5 percent, respectively. On the other hand, core inflation in Canada, which was flat in the summer after higher levels in early 2011, jumped significantly in September. In summary, we see that in early 2011 major developed countries experienced an increase in inflation that was driven mostly by higher food and energy prices. Since then, inflation has stabilized at lower levels. The core inflation measures, though, showed; deflation in Japan, low inflation in Germany and the U.S., and higher inflation in Canada. 12 Growth and Production Weak Wage and Income Growth Is Holding Consumption Back 11.02.11 by Margaret Jacobson and Filippo Occhino Real GDP and Private Domestic Expenditures Annualized percent change 12 Real private domestic expenditures 9 6 3 Real GDP 0 -3 -6 -9 -12 2007 2008 2009 2010 2011 Notes: Private domestic expenditures is the sum of private consumption and private investment. Shaded bar indicates recession. Source: Bureau of Economic Analysis. Real Personal Income Annualized percent change 15 12 Real personal income 9 6 3 0 Real disposable personal income -3 -6 -9 -12 -15 2007 2008 2009 2010 2011 Notes: Disposable personal income is personal income less taxes. Real values were calculated using the implicit price deflator for GDP. Shaded bar indicates recession. Source: Bureau of Economic Analysis Federal Reserve Bank of Cleveland, Economic Trends | November 2011 After feeble GDP growth in the first half of the year, third-quarter data came out a little stronger, suggesting that the recovery is continuing and the risk of recession is reduced. According to the advance estimate from the Bureau of Economic Analysis, real GDP grew at a 2.5 annualized percent rate in the third quarter, accelerating from its 0.8 annualized percent growth rate in the first half of the year. Real private domestic expenditures, the share of GDP that includes private consumption and investment and excludes government spending and net exports, also accelerated from 2 percent to 2.7 percent (both annualized growth rates) from the first half of the year to the third quarter. Even though third-quarter growth looks stronger, the pace of the recovery continues to be slow. Over the past year, real GDP grew only 1.6 percent, much less than is typical during recoveries. Real private consumption, which accounts for 70 percent of GDP, also grew slowly—only 2.2 percent in the last year. One reason why consumption is rising so slowly is that personal income is rising slowly. In real terms, personal income grew a modest 2.1 percent in the last year and fell 1.6 percent in the last quarter (annualized rate). Net of taxes, household income fared even worse. Disposable personal income grew only 0.8 percent in the last year and fell 1.9 percent in the last quarter (annualized rate). With disposable income barely growing, it is no surprise that household consumption is not growing much either. In fact, unless income accelerates soon, households will not even be able to sustain their current low rates of consumption growth for long. Household consumption is currently growing at a higher rate than income. This is possible only because households are lowering their saving rate— the saving rate dropped from 5.2 percent last year to 5.1 percent last quarter and to 4.1 percent this quarter. This pattern cannot continue indefinitely. Either household income will pick up, or house 13 holds will have to cut back on their consumption growth to avoid further declines in the saving rate. Personal Saving Rate Percent 8 7 6 5 4 3 2 1 0 2007 2008 2009 2010 2011 Notes: Personal saving rate is personal saving as a percentage of disposable personal income. Shaded bar indicates recession. Source: Bureau of Economic Analysis. Real Employee Compensation Percent change from business cycle peak 25 Average, all other cycles Range, all other cycles Current cycle 20 15 10 5 0 -5 -10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 The main reason household income is not growing at a stronger pace is that wage growth is stagnant. Real employee compensation grew only 1.1 percent in the last year and decreased 0.6 percent in the last quarter (annualized rate). Compensation peaked in early 2008, fell more than 5 percent during the recession and is still 3.1 percent below that peak, depressed by sluggish employment and wage growth. It has been lagging relative to other components of national income—the ratio of employee compensation to national income, the labor share, has been decreasing steadily since the end of the recession, and is currently 62 percent, the lowest level in more than forty years. While household consumption is growing slowly, business investment is in better shape. Real fixed investment grew a solid 7.8 percent in the last year, driven by 10 percent growth in investment in equipment and software. Investment growth in the future could be fueled by corporate profits, which have rebounded strongly from their recession levels. In real terms, corporate profits have almost doubled since their lowest point during the recession, and they are now in line with the pace of previous recoveries. Quarters from NBER peak Note: Range refers to the minimum and maximum values over all other cycles. Real values are calculated using the implicit price deflator for GDP. Source: Bureau of Economic Analysis Real Corporate Profits Percent change from business cycle peak 60 50 40 30 20 10 0 -10 -20 -30 -40 Average, all other cycles Range, all other cycles Current cycle 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quarters from NBER peak Notes: Range refers to the minimum and maximum values over all other cycles. Real values are calculated using the implicit price deflator for GDP. Source: Bureau of Economic Analysis Federal Reserve Bank of Cleveland, Economic Trends | November 2011 14 Banking and Financial Markets Sovereign Debt Implications on the European Banking System 11.04.11 by Ben Craig and Matthew Koepke As European leaders work to define the terms of the European Financial Stability Facility (EFSF), concerns have arisen about sovereign debt write-downs and the impact they could have on the European banking system. European finance ministers just approved a plan that would require euro-zone banks to raise $150 billion (€108 billion) in additional capital over nine months to cover potential losses. The additional capital would allow banks to meet a 9.0 percent threshold for tier-one capital after positions in distressed euro-zone debt are marked-to-market. Assets and Loans of All FDIC-Insured Institutions Dollars in trillions 16 Net loans and leases Total assets 12 8 4 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011:Q1 2011:Q2 Sources: FDIC, Haver Analytics. Number of Problem Banks and Total Assets Dollars in billions 500 400 Total asset Number of banks Number 1000 800 300 600 200 400 100 200 0 0 The additional $150 billion of capital, while steep, was less than the $417 billion (€300 billion) that the International Monetary Fund (IMF) estimated the cumulative spillover effects of the write-downs on the euro-zone banking system would be. According to the IMF’s September Global Stability Assessment Report, cumulative spillovers from the high-spread area (Belgium, Greece, Ireland, Italy, Portugal, and Spain) account for nearly $278 billion (€200 billion) of the $417 billion, with an additional $139 billion attributed to interbank exposures. The IMF expects the spillover effects to mostly affect the banking systems in the highspread euro area. Nonetheless, the Bank for International Settlements exposure tables show that the banking systems of Germany, France, and the United Kingdom have significant exposure to the high-spread euro area, accounting for nearly 70.0 percent of the euro-zone’s total exposure. 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 YTD Sources: FDIC, Haver Analytics. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 The specter of sovereign defaults and bank exposures to the debt has increased credit risk in the euro zone interbank lending markets. Evidence of the increased credit risk can be seen by examining the euribor-OIS spread. Since June, the euriborOIS has risen to levels not seen since the financial crisis of 2008. The euro interbank offered rate (euribor) is the rate at which banks participating in the European Union money markets are willing to lend to other banks for a specified term. 15 Bank Coverage Ratio Dollars in trillions 2.0 1.6 Ratio Allowance for loan losses Total bank equity capital Bank coverage ratio 30 25 20 1.2 15 euro zone. Since May 2011, the net due to foreignrelated offices has increased from −22.0 billion (the foreign-related bank had a balance with the U.S. subsidiary) to $289.6 billion (the U.S. subsidiary has a balance with the foreign-related bank). This increase suggests that foreign banks are using their U.S. subsidiaries to shore up liquidity. 0.8 10 0.4 5 0.0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011:Q1 2011:Q2 Source: FDIC. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 16 Regional Economics Local Government Employment in Ohio, Pennsylvania, Kentucky, and West Virginia 11.02.11 by Stephan Whitaker In the past year, policymakers in the Fourth District and across the nation have focused tremendous attention on local government employees. In aggregate across the United States, local government employment has fallen approximately 3 percent since the recession. The ratio of local government employment to total payroll employment rose sharply in the year after the recession because there were widespread layoffs of private sector workers. Private sector jobs, and the local tax bases they support, have recovered only slowly. In the national figures, cuts in local government employment are bringing the ratio of public to private workers back to where it was before the recession. In the Fourth District, only Ohio has cut local government payrolls in line with the national trend. However, the ratios of public to private workers are returning to their pre-recession levels in all four states. Local government employment has historically been a stabilizing force during recessions. That is because when the economy slows down, local government employment usually remains stable, and the workers who stay employed help to support demand for goods and services until growth returns. Local government payrolls can usually weather a recession because the largest source of local tax revenue is property taxes. In past recessions, property values did not decline, or they recovered before the multiyear tax assessment process reflected the declines. Local sales and income taxes fall during recessions and recover afterward, which forces some temporary reduction of payrolls. Local taxes receipts fell during the most recent recession, as they normally do. To help local governments bridge the decline in tax receipts and avoid layoffs, Congress directed a major portion of the 2009 American Recovery and Reinvestment Act ($180 billion of the $787 billion) to state and local governments. In the intervening months, sales Federal Reserve Bank of Cleveland, Economic Trends | November 2011 17 Change in Local Government Employment Percent 8 6 West Virginia 4 2 Kentucky Pennsylvania 0 U.S. Ohio -2 -4 -6 2007 2008 2009 2010 2011 Source: Bureau of Labor Statistics. Local Government Employment as a Percent of Total Nonfarm Employment Percent 11.5 U.S. West Virginia 11.0 10.5 Ohio 10.0 Kentucky 9.5 9.0 Pennsylvania 8.5 8.0 2001 2003 2005 2007 and income taxes have only partially recovered, and property taxes are now falling as the dramatic, nationwide decline in property values is being reflected in the assessment process. State revenues are still below 2008 levels, and many states are cutting aid to local governments. For example, Ohio is cutting state-to-local transfers by 28 percent in FY2012. This may force municipal governments to raise taxes or lay off employees. 2009 2011 Source: Bureau of Labor Statistics. Since the beginning of the recession, the trend in local government employment has taken a different path in each of the Fourth District states. In West Virginia, there has been a modest increase in local government payrolls. In Pennsylvania, there was a slight increase and a decline. Kentucky’s local government employment has been essentially unchanged. In Ohio, the situation is much different. There has been a decline in local government employment, reaching a level in September 2011 that is 4 percent below the level just before the recession. Ohio has cut local public payrolls more than the nation as a whole. If local government payrolls are placed in the context of total payrolls, the Fourth District trends all reflect the national pattern. During the recession, private payrolls dropped sooner and faster than public payrolls. The states of the Fourth District, like the nation as a whole, witnessed a half-point increase in the percentage of total employees working for local governments in the year following the recession. Now, in three Fourth District states, the ratio appears to be returning to its level during the previous decade. In Pennsylvania and Kentucky, municipal payrolls are almost flat and the ratio is falling, so other employment is recovering. In Ohio, the public sector workforce is declining to match the diminished private sector workforce. In West Virginia, the ratio is steady, as public and private payrolls sustain similar growth. Local government employees as a percent of total nonfarm payrolls are below the national average in all the Fourth District states. Pennsylvania stands out with a percentage 2 points lower than the nation since the 1990s. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 18 MSA/Employment MSA Local Government Percent of Total Nonfarm Employment December 2006November 2007 Local Government Percent of Total Nonfarm Employment October 2010September 2011 Change TNF Local government Cleveland 10.9 −7.1 −3.8 11.2 Canton 10.4 −7.7 −3.5 10.9 Dayton-Springfield 10/1 −8.2 −3.0 10.7 YoungstownWarren 9.7 −6.9 −1.2 10.3 Toledo 9.5 −7.8 −7.8 9.9 Akron 9.6 −5.5 −4.1 9.7 Cincinnati 8.5 −5.5 −3.4 8.7 Columbus 8.6 −3.4 −1.3 8.7 Pittsburgh 8.1 −0.9 0.9 8.2 Lexington 7.2 −4.3 7.0 8.1 Source: Bureau of Labor Statistics. The metropolitan areas within a state always exhibit larger variations that get smoothed out in averaging. Since the recession, the ratio of public employees to total employees has increased in every metro area of the Fourth District. In most cases, both total and local government payrolls have fallen, but government payrolls have not fallen as far. Cincinnati and Columbus support relatively low percentages of their employment in the local government sector, similar to the average for Pennsylvania. The Cleveland MSA was the only Fourth District metro area to enter the recession with a percentage of workers in the local government sector that was above the national average, and it remains above the national average. In the coming months, municipalities will have to make some difficult decisions. They will choose between raising taxes, laying off employees, reducing compensation, or some combination of the three. The aggregate impact of their decisions will be felt in the economies of their metro areas and states. It will be interesting to see if local government employment will continue to serve as a stabilizing force as it has in the past. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 19 Labor Markets, Unemployment, and Wages Emergency Unemployment Compensation and Long-term Unemployment 11.08.11 by Murat Tasci and Mary Zenker The recent recession was the longest on record since the Depression. As it wore on, more and more workers entered the ranks of long-term unemployed. To minimize the impact of these unemployment conditions on household incomes, the federal government implemented an unemployment insurance benefit called the Extended Unemployment Compensation (EUC) program. The program allows unemployed workers to collect unemployment insurance benefits longer than they normally would be able to. In this article, we provide some context for interpreting the program’s effect on the unemployment rate. The EUC program was implemented in tiers. In June 2008 (7 months after the recession started), Congress legislated the first tier: unemployed workers could receive an additional 13 weeks of benefits. Five months later, that period was extended an additional 7 weeks and henceforth referred to as Tier 1. Tier 2 was introduced at the same time and gave an additional 13 weeks of benefits to those in states with unemployment rates above 6 percent. A year after it was enacted, Tier 2 extended benefits by 1 week and made the extension unconditional on state unemployment rates. As the economy continued to stagnate, more tiers were introduced. In November 2009, the Tier 3 extension went into effect, adding 13 weeks of benefits in states with unemployment rates above 6 percent, and Tier 4 gave an additional 6 weeks of benefits in states with unemployment rates above 8.5 percent. All of the tiers together amount to a potential maximum additional benefit duration of 53 weeks. Adding that to the what the states provide—the traditional 26 weeks of benefits and 20 additional weeks of extended benefits—amounts to potentially being able to receive unemployment insurance benefits for 99 weeks (just about 2 years). Federal Reserve Bank of Cleveland, Economic Trends | November 2011 20 Initially, EUC benefits were available to anyone who had exhausted his or her regular benefits before March 28, 2009. However, as the recession wore on this date was continually moved later and later and is currently January 3, 2012. Unemployment insurance is intended in general to provide some additional income during extended periods of unemployment, but it also creates incentives that can lead to effects that would otherwise not occur. One possible incentive might be that unemployment insurance encourages people to stay in the labor force who would otherwise drop out, since receiving benefits is conditional on searching for work. Or unemployment insurance might incentivize people to reject employment offers by raising their reservation wage, the wage above which they will accept a job. We can check the data to see if either of these effects is occurring as a result of EUC. Consider first whether EUC incentivizes unemployed workers to stay in the labor force when they would otherwise drop out. As their EUC benefits expire, unemployed workers can choose to leave the labor force or to stay in. If they leave, the number of long-term unemployed workers will decrease (all else equal), since, by definition, a worker receiving EUC is counted among the long-term unemployed. If they stay, they continue to seek work but receive no further unemployment benefits. Long-Term Unemployed and Emergency Unemployment Compensation Millions 7 6 If EUC creates this incentive, we ought to observe evidence of workers exiting the labor force as their benefits expire. Over the past two years, however, though we have seen a noticeable decline in the number of those receiving EUC and extended state benefits, the number of long-term unemployed workers has been stuck around 6 million and shows little sign of downward momentum. 5 4 EUC Tiers 1-4 (2008-2011) + EB 3 2 Unemployed 27 weeks or more 1 0 2005 2007 2009 The earliest workers who took advantage of of the full 99 weeks of unemployment insurance would have used up all their benefits around June 2010. As can be seen in the chart below, the number of people receiving EUC began declining markedly in 2010. 2011 Note: Shaded bars indicate recession. Sources: Department of Labor, Bureau of Labor Statistics. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 The fact that the decline in EUC recipients has not been coupled with a decline in the long-term 21 unemployed suggests those workers are staying in the labor market. This is not certain, however, as there are constant inflows to the long-term unemployed pool from the “medium”-term unemployed pool. Additionally, staying in the labor force is not unequivocally bad. Some analysis by Jesse Rothstein suggests that EUC, because it keeps workers in the labor force, may have increased the share of unemployed workers who were later reemployed. Average Replacement Rates by State Percent 70 60 50 40 30 20 10 0 DC AZ AL GA FL MO TN DE NE CT TX MI MD ND WV WA IN CO MN PA NH KY KS RI HI AK LA MS WI VA SC NY CA MT ID WY SD VT IL ME UT NC OH OR IA AR NJ NM NV Sources: Department of Labor, Bureau of Labor Statistics; as of September 2011 Market Tightness (V/U) Percent 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Note: Shaded bars indicate recessions. Source: Bureau of Labor Statistics, authors’ calculations. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 Consider now whether EUC creates an incentive to reject employment offers. In the chart below, we show a rough approximation of a statistic called a replacement rate. The replacement rate measures how much of their prior income EUC recipients are able receive with EUC. We lack direct data on this, but we can measure how much the average EUC benefits in a state are relative to the average wage in that state. This statistic is our proxy for the replacement rate. With an average replacement rate across all states of about 36 percent, we can surmise that when workers are receiving unemployment benefits, they are generally dealing with a nontrivial decline in income. This creates some uncertainty about the strength of the claim that receiving EUC provides an incentive to turn down a wage offer. However, these incentive effects could be weaker when there are not many job openings available in the economy. We can look at a metric called market tightness to relate the number of unemployed persons to the number of available jobs. Essentially, this measure gives the number of vacancies per unemployed worker. When market tightness is really low, there are too many unemployed workers chasing too few job openings. Looking at this metric, we see a low level of market tightness in the economy, suggesting there is a low probability of exiting the unemployment pool on average. Potentially, a low demand for labor will dampen the incentive effects of unemployment insurance benefits. Hence, a more plausible reason for the elevated level of the long-term unemployed is a lack of demand for labor, rather than an incentive effect of EUC motivating people to stay in their current unemployed state. Given that EUC significantly lengthened the length of time benefits could be received and increased 22 the number of eligible workers, the existence and significance of these incentive effects on the unemployment rate is a key issue. An EUC incentive effect may be there, but the data shown here, even though only suggestive, do not indicate a very strong effect. Our reading of the economic literature on this issue suggests that the effect of the EUC is relatively minimal, accounting for about 0.6 to 0.8 percentage points of the unemployment rate by the end of 2010 (see the Rothstein paper mentioned earlier). The Rothstein study focuses on both of the incentive effects mentioned above and provides evidence that the unemployment exit rate was not significantly affected by the availability of EUC. The low levels of job openings we observe in the data support this view, suggesting that the scarcity of available jobs might explain the bulk of the unemployment rate. Federal Reserve Bank of Cleveland, Economic Trends | November 2011 23 Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland. Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted provided that the source is credited. If you’d like to subscribe to a free e-mail service that tells you when Trends is updated, please send an empty email message to econpubs-on@mail-list.com. No commands in either the subject header or message body are required. ISSN 0748-2922 Federal Reserve Bank of Cleveland, Economic Trends | November 2011 24
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