Full text of FedViews : April 8, 2010
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Twelfth Federal Reserve District FedViews April 8, 2010 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 associate director of research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook: It is interesting to examine the recession and recovery of the economy through the prism of the stock market—particularly the broad Standard & Poor’s (S&P) 500-stock index, and the narrower S&P Homebuilders Industry and Dow Jones financial institution indexes. The first stage in the economic downturn was a housing bust, which was evident in steep declines in homebuilder stock prices in 2006 and 2007. Next, financial institutions suffered severe losses, and financial institution stocks posted steady price declines throughout 2007 and 2008. Finally, fallout from the housing bust and financial meltdown led to a deep recession, which was accompanied by a sharp decline in the overall stock market in 2008. More recently, as the financial crisis receded, the S&P 500 and financial institution indexes rebounded significantly. In contrast, the housing market and homebuilder stock valuations have not yet started to recover. Another measure of equity market investor sentiment is the VIX volatility index, which is based on the expected volatility over the next 30 days in the S&P 500 stock index. According to the VIX index, the market has returned from an expected level of volatility we can characterize as “terrified” at the height of the crisis to more normal levels. The gains in stock market wealth have put household balance sheets on a firmer footing, and recent growth in consumption has been solid. Consumer sentiment may also improve if the labor market recovers. The latest labor market readings have been encouraging. Nonfarm payrolls increased by 162,000 jobs in March, and most of that increase came from the private sector. Still, there is a long way to go to make up the more than 8 million jobs lost since the start of the recession. Furthermore, the unemployment rate remained unchanged at 9.7 percent in March, and a greater share of the jobless were classified as long-term unemployed. This enormous pool of unemployed workers represents a substantial shortfall from full employment. Federal Open Market Committee (FOMC) members appear to disagree about the extent of resource slack, which is subject to considerable measurement uncertainty. The output gap—which is the deviation of real output from its potential—is usually measured using gross domestic product (GDP) data. But an alternative measure uses data on gross domestic income (GDI). In theory, GDI should equal GDP. GDP measures total output by adding up all the spending in the economy, including consumption and investment. GDI measures total output by adding up all the income generated in the economy, including wages and profits. In practice, given imperfect data collection, GDP and GDI don’t quite match. Some economists argue that GDI provides the more reliable measure of U.S. output. By that measure, the recession was even deeper—and the current output gap even larger— than indicated by GDP. FOMC participants also disagree about the best way to measure the underlying trend in inflation. (See FRBSF Economic Letter 2010-11, “The Housing Drag on Core Inflation.”) An inflation measure 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 17, 2010. that excludes volatile food and energy prices is often used to eliminate transitory movements in prices. Researchers have also constructed trimmed mean and median measures of underlying inflation, which exclude the most extreme price movements in each period rather than singling out specific spending categories for permanent exclusion. All these measures are showing a steep downtrend in rates of inflation over the past two years below levels reached in 2002 and 2003, when deflation fears were widespread. Even more unsettling are the recent very low rates of increase in wages and compensation. In particular, the rate of compensation increases has been falling steadily since the start of the recession, and is now running two to three percentage points below levels posted in 2002 and 2003. This suggests that the probability of deflation is even higher now than during that earlier period. Going forward, we expect the economy to grow fairly rapidly—almost 3½ percent this year and over 4 percent in 2011 and 2012. However, the level of economic activity is so depressed that, even with solid growth, it will take years to eliminate slack and return to full employment. There are risks to this forecast. On the upside, the last deep recession ending in 1982 was followed by very rapid growth as pent-up consumer and business demand was unleashed. However, it seems likely that the financial crisis will leave lasting scars, thereby slowing the growth rate of the economy. Furthermore, monetary policy has been constrained by the zero bound on nominal interest rates, that is, the inability to set a federal funds rate target below zero. In addition, fiscal policy stimulus, which has propped up recent economic growth, is waning. Therefore, few forecasters foresee a V-shaped recovery. Indeed, the average private-sector forecast is even more pessimistic than our forecast. Measures of the unemployment and output gaps indicate the presence of a lot of slack in the economy, which is pushing the inflation rate down. We anticipate that much of that pressure will be offset by well-anchored inflation expectations, which should keep inflation from falling much further. The early recovery period of 1983–84 provides a cautionary alternative. Even with fast economic growth, the high unemployment of the early 1980s caused steep disinflation. Surprisingly, many private-sector forecasters foresee a quick pickup in price inflation. This average forecast may be boosted by a few forecasters who put more emphasis on the size of the Federal Reserve’s balance sheet than on the extent of economic slack. However, although the Fed has enlarged its balance sheet and boosted the level of bank reserves and the monetary base, banks are not lending out those reserves. Broad measures of money in the economy are also growing very slowly. To combat the global financial crisis and the deep economic recession, the Fed took two extraordinary actions. First, when money markets were disrupted, the Fed supplied emergency shortterm liquidity against good collateral to improve financial market functioning. Second, as the recession deepened, the Fed provided a lot of monetary policy stimulus to lower the cost of short- and long-term borrowing. The exit strategy for the first action is easy to describe because it is already completed. As financial conditions improved, demand for credit from the Fed fell and usage of the Fed’s lending facilities declined. Accordingly, the facilities were closed. The alphabet soup of Fed liquidity facilities did their job—helping to avoid an even worse financial collapse—and then closed up shop. No credit losses whatsoever were experienced. In contrast, a simple estimated monetary policy rule suggests that macroeconomic conditions still seem likely to warrant very accommodative monetary policy for a long time. Recession and recovery in the stock market Financial “Fear index” back to normal levels Implied Volatility on S&P 500 (VIX) Stock Prices January 3, 2006 = 100 Percent 90 Index 140 S&P 500 80 120 70 100 60 80 50 4/5 Dow Jones Financial Index 40 60 S&P 500 Homebuilders Index 4/5 30 40 20 20 10 0 Jan 2006 Jul Jan 2007 Jul Jan 2008 Jul Jan 2009 Jul Jan 2010 Consumer spending moving up Jul Jan 2007 Jul Jan 2008 Jul Jan 2009 Jul Jan 2010 Enormous pool of unemployed workers Real Personal Consumption Expenditures Unemployment Rate Billions of 2005$ 10000 Seasonally adjusted annual rate 0 Jan 2006 Percent 11 Seasonally adjusted Mar. Feb. 10 9500 9 9000 8 8500 7 6 8000 5 7500 4 7000 2000 2002 2004 2006 2008 2010 3 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Large output gap (may be even larger) Real GDP and GDI The recession has lowered inflation Three Measures of Underlying Price Inflation $, Trillions 15 Seasonally adjusted chained 2005 dollars Percent 4 Percent change from twelve months earlier Trimmed Mean PCE 3.5 FRBSF Potential Output 14.5 3 Median PCE 2.5 14 Real GDP (Gross Domestic Product) Output Gap 13.5 PCE ex. food and energy Feb. 1 13 0.5 Real GDI (Gross Domestic Income) 2006 2007 2008 2009 2010 2011 2 1.5 12.5 2012 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Wages and benefits are barely growing Large output gap likely to persist Labor Compensation Real GDP Percent 8 Percent change from four quarters earlier $, Trillions 15 Seasonally adjusted chained 2005 dollars Average GDP growth rate during 1983-84 recovery 7 14.5 6 Nonfarm Compensation per Hour FRBSF Potential Output 5 14 4 Real GDP 3 Q4 Employment Cost Index FRBSF Forecast Output Gap 2 13 Q4 1 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 12.5 2006 Inflation likely to remain subdued 2007 2008 2009 2010 2011 2012 Fed balance sheet is not inflating economy Monetary Base, Money Supply, and Bank Loans Core PCE Price Inflation Percent 3 Percent change from four quarters earlier Seasonally adjusted; 1/3/2007 = 100 Index 300 280 260 240 220 200 180 160 140 120 100 80 3/24 2.5 Private-sector consensus Q4 (SPF) Monetary Base (bank reserves+ currency) 2 1.5 1 FRBSF Forecast Average disinflation during 83-84 recovery Commercial and Industrial Loans 0.5 Money Supply (M2) 0 -0.5 2006 2007 2008 2009 2010 2011 2012 Extraordinary liquidity support has ended Federal Reserve Short-Term Liquidity Facilities PDCF $, Billions 1800 TSLF 1600 AMLF 1400 FX Swaps 1200 PCF Jan. 2007 Jul. Jan. 2008 Jul. Jan. 2009 Jul. Jan. 2010 Monetary policy stimulus still needed Federal Funds Rate Percent 8 Quarterly average 6 4 1000 CPFF 2010Q1 Fed's Target Rate 800 TAF 400 3/31 200 0 Jul Oct Jan Apr 2009 Jul Oct Jan Apr 2010 2 0 Suggested target rate from simple rule using FRBSF forecasts 600 Oct Jan Apr 2007 2008 13.5 Private-sector consensus (Blue Chip) -2 -4 Simple policy rule regression: Fed's Target = 2.1 + 1.3 x Inflation - 2.0 x Unemp. gap (Unemployment gap = Unemployment rate - CBO NAIRU) 2002 2004 2006 2008 2010 -6 -8 2012
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