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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