Full text of FedViews : April 14, 2011

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Twelfth Federal Reserve District

FedViews
April 14, 2011

Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
Also available upon release at
www.frbsf.org/publications/economics/fedviews/index.html

Glenn Rudebusch, senior vice president and acting director of research at the Federal Reserve Bank of San Francisco,
states his views on the current economy and the outlook:



Much of the recent economic news has been disappointing, with notably weaker data for consumer
spending, business investment, and government purchases. Over the past two months, our forecast for
first-quarter real GDP growth has been revised down by over a percentage point to an annual rate of
less than 2%. In addition, the list of headwinds that could potentially hold back the economic
recovery has grown.



In particular, higher gasoline prices will sap household income. Crude oil prices have jumped
because of heightened geopolitical risk in North Africa and the Middle East and greater projected
demand for fossil fuels in the wake of the nuclear catastrophe in Japan. Prospects for residential
construction have also dimmed, with home sales languishing despite bloated inventories of unsold
homes. In addition, greater cutbacks in federal spending are in train. Finally, the disaster in Japan
may push down growth directly a bit as supply problems disrupt production.



However, much of the first-quarter weakness appears to reflect transitory factors, including harsh
winter weather at the start of the year. The underlying pace of economic recovery appears intact.
Based on the underlying economic momentum, growth should rebound in the current quarter to above
3%.



Perhaps the key factor supporting further growth is the continuing improvement in financial
conditions. With greater investor confidence and improved profits, broad indexes of stock prices are
up about 12% over the past year. So even with stagnant home prices, household net worth has been
climbing. The falling dollar and some easing of credit conditions are also helping make financial
conditions more accommodative.



A revival of the labor market is a crucial underpinning of a strengthening, self-sustaining economic
recovery. The pace of private-sector hiring has picked up recently. During the past two months,
private employment has risen by almost a half million jobs. That’s a solid down payment on the 8.7
million jobs lost during the recession, but obviously there is a long way to go to return to full
employment.



This long road ahead is also apparent in the unemployment statistics. Over the past year, the
unemployment rate has fallen by about a percentage point to 8.8% in March, which matches our
April 2010 forecast. Going forward, the new headwinds suggest an even slower improvement in the
labor market than what was expected a year ago.



Real GDP growth over the past year was disappointing, but the underlying economic recovery
appears on track. Real GDP is expected to increase 3½–4% over the next year. Improving financial

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 16, 2011.

conditions, increasing credit availability, accommodative monetary policy, healthier labor markets,
and rising household and business confidence should all support a faster pace of growth.


While industrial production in the United States and other advanced economies remains well below
pre-recession levels, production in many emerging-market economies has been growing fast and
reaching new peaks. This strong growth has pushed up demand for many agricultural and industrial
commodities. The latest jump in oil and commodity prices is projected to push year-over-year
inflation in the personal consumption expenditures price index to 2½% by the middle of this year.
Still, as in the past, it does not appear likely that the run-up in commodity prices will have a longlasting impact on underlying inflation trends. Commodity prices are not generally expected to rise as
rapidly over the next two years as they have over the past few months, so the impetus to headline
inflation will diminish. In addition, with unemployment still high, there has been little upward
pressure on labor costs, which account for about 60% of total production costs.



One measure of underlying inflation strips out the transitory noise due to food and energy prices. This
measure is likely to move somewhat higher as commodity price increases pass through to some
extent to a variety of final consumer goods. Still, underlying inflation appears likely to remain
subdued.



A simple rule of thumb that summarizes the Fed’s policy response over the past two decades
recommends lowering the federal funds rate by 1.4 percentage points if inflation falls by 1 percentage
point and by 1.8 percentage points if the unemployment rate rises by 1 percentage point. Either
headline inflation or core inflation can be used with this rule to construct policy recommendations.
Relative to a core inflation formulation, a policy rule using headline inflation would have called for a
higher fed funds rate in 2005–2006 before the recession and in 2008 in the midst of a deepening
recession. Currently, both formulations call for substantial monetary accommodation.



The simple rule can also contrast the policy situation in Europe and the United States. During the
financial crisis, the European Central Bank, like the Fed, also lowered its policy rate essentially to
zero. Recently, unlike the Fed, the ECB raised its policy rate by ¼ percentage point. Such an increase
is broadly consistent with the policy rule recommendation for Europe. The higher policy rate
recommendation reflects the fact that the economic downturn was much milder in the euro area’s
core countries than in the United States. For example, the euro-area unemployment rates rose on
average about half as much as in the United States.

Housing: A faint pulse, no recovery yet

Better financial conditions support growth

Single-Family Housing Starts

Stock Market Index
Millions
2

Seasonally adjusted annual rate; three-month moving average

Index
120

S&P 500 weekly price; Indexed to 100 at 01/07/2000

1.8

110
04/11

1.6

100

1.4

1.2
Trend

0.8

0.6

0.4
Feb.

0.2
0

40
00

Businesses are slowly starting to hire

Long slow path to full employment

Nonfarm Payroll Employment

Unemployment Rate
Millions
140

Seasonally adjusted
Change in Nonfarm
Payroll Employment
December +152K
+68K
January
February +194K
+216K
March

Percent
11

Quarterly average

138

Current FRBSF
forecast
Q1

136

8.7 million
jobs lost

134

5
130

128
2006

2007

2008

2009

2010

2011

3
2006

Large output gap likely to persist
Real GDP

2007

2008

2009

2010

2011

2012

Steady labor costs anchor prices

$, Trillions
15

Seasonally adjusted chained 2005 dollars

Compensation and Labor Costs
Percent
10

Change from four quarters earlier; Nonfarm business sector

April 2010
FRBSF forecast

14.5
Compensation
per hour

FRBSF Potential
Output

Current FRBSF
Q4 forecast

4
2

13.5

Q4
0

Unit labor costs

-2

12.5
2006

2007

2008

2009

2010

2011

8
7

April 2010
FRBSF forecast

132

Mar.

2012

-4
00

Headline inflation bulge expected this year
PCE Price Inflation

Percent
5

Percent change from four quarters earlier

Core inflation did fall last year
Core PCE Price Inflation

Percent
3

Percent change from four quarters earlier

4
Current FRBSF
forecast

2.5
April 2010
Private sector
consensus (SPF)

1.5

Q4 April 2010
FRBSF forecast

Latest
data

April 2010
FRBSF forecast

0.5

-1
2006

2007

2008

2009

2010

2011

2012

0
2006

Underlying inflation likely subdued

2007

2008

2009

2010

2011

2012

Simple policy rule of thumb

Core PCE Price Inflation

Federal Funds Rate
Percent
3

Percent change from four quarters earlier

Percent
10

Quarterly average

2.5

Suggested rate
using headline inflation

Fed's target rate

8
6

2
Current FRBSF
Forecast

1.5
1

April 2010
Q4 FRBSF forecast

2008Q4

Suggested rate
using core inflation

2
0
-2

Simple policy rule:

-4

Fed's Target = 1.4 + 1.4 x Inflation - 1.8 x Unemployment gap

0.5

(Unemployment gap = Unemployment rate - CBO NAIRU)

-6

0
2006

2007

2008

2009

2010

2011

2012

-8
88

Monetary policy stimulus still needed

Contrasting policy in the US and Europe

Federal Funds Rate

Policy Rule Recommendations in US and Europe
Percent
8

Quarterly average

Suggested US policy
rate from simple rule

Suggested Euro-area policy
rate from simple rule

Percent
8

4
Suggested rate
using core inflation
Fed's target rate

2011Q1

4
Euro-area policy
rate (EONIA)

2
0

-2
Suggested rate
using headline inflation

-2

-4

Simple policy rule:

-4

-6

Target = 1.4 + 1.4 x Inflation - 1.8 x Unemployment gap

-6

(Calculated using core inflation and OECD unemployment gap)

-8
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Full text of FedViews : April 14, 2011

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