Full text of FedViews : March 13, 2014

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Twelfth Federal Reserve District

FedViews
March 13, 2014

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/

Bart Hobijn, senior research advisor at the Federal Reserve Bank of San Francisco, provides his views on
current economic developments and the outlook.



Some data for January and February, such as auto sales and housing starts, came in softer than
expected. It is likely that this weakness primarily reflects weather-related disruptions. These
disruptions should have a temporary effect on the pace of the recovery, with a bounce back in growth
likely when they dissipate. As a result, we recently lowered our forecast for GDP growth in the first
quarter of 2014 and raised it slightly for the remainder of 2014. Our view of the underlying strength
of the economy has not changed. We continue to see a moderately paced recovery that has generally
gathered momentum since the start of 2013.



The February labor market report showed a return to a solid pace of job growth. Though the
unemployment rate ticked up in February, this appears to be only a brief interruption in the largely
steady decline of the unemployment rate that we have seen since mid-2009.



We expect inflation to remain quite low over the next few years, returning only slowly to the
FOMC’s 2% target. This view is guided by factors that affect the long-run inflation outlook as well as
those that have more short-term effects.



The long-run outlook for inflation is mainly driven by inflation expectations. As measured in
household surveys, reported by business forecasters, and implied by pricing in financial markets,
inflation expectations remain well-anchored. Consequently, our long-run inflation forecast is for a
return to the 2% target consistent with general price stability.



In the short run, however, other factors can cause persistent deviations of inflation from its target.
One of the main factors contributing to the currently low inflation rate is that firms are not facing
high cost pressures. Compensation costs, which make up the bulk of firms’ operating expenses, have
been growing at approximately a 2% rate over the past two years.



It is common for wage growth to remain slow even after the unemployment rate declines. A similar
pattern was evident in the wake of the 1990 and 2001 recessions. Once the unemployment rate
declined enough to significantly reduce labor market slack, wage growth accelerated. Thus, as the
unemployment rate declines, compensation growth will put increased upward pressure on firms’
costs.



The extent to which such upward cost pressures translate into price inflation will depend on how
much firms absorb them into their profit margins or pass them on to higher prices for their products.
Currently, compensation as a share of firms’ income is at a postwar low, while profit margins are

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 April 14, 2014.

high, implying plenty of room for businesses to absorb wage increases into profits. This suggests that
rising compensation may not create substantial inflation pressures over the next few years.


Two other factors are currently contributing to the low inflation rate. The first is health-care price
inflation. Health-care expenditures make up 17% of the goods basket that is used to calculate the
Federal Open Market Committee’s preferred inflation measure, the personal consumption
expenditures (PCE) price index. The expenditures are calculated in two parts. One is the direct outof-pocket household costs for medical care. The other is the payments health insurance companies
make on behalf of their customers. This is the same rate at which health-care providers are
reimbursed for the services they provide. Reimbursement rates have been growing very slowly over
the past year, causing the rate of health-care price inflation to fall to a 50-year low. Over the past year
the rate of health-care price inflation fell more than 1 percentage point, thus contributing 0.2
percentage point to the slowdown in overall inflation.



The second factor contributing to low inflation is the decline in the price of imported goods and
services over the past year. This decline is largely a response to the strengthening of the U.S. dollar.
Such a decline in import prices tends to subdue inflation of goods with high import content, like
clothing and consumer electronics.



Recent data and the change in the Chair of the FOMC have not significantly altered financial market
perceptions of future monetary policy. As of March 10, the path of the forward fed funds rate had
barely moved since the January 29 FOMC meeting.

Recovery continues with moderate growth

Labor market slack declines further
Unemployment rate and forecast

GDP Growth: Actual and FRBSF Forecast
Quarterly obs.; seasonally adjusted; annualized growth rate

%
12

Monthly observations; forecast is quarterly average

%

6

10

Actual

2
FRBSF
Forecast

FRBSF
Forecast

-2

8
6

Feb.
6.7

4

-6
2

2007 2008 2009 2010 2011 2012 2013 2014 2015

-10
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bureau of Labor Statistics and FRBSF staff

Source: Bureau of Economic Analysis and FRBSF

Inflation slowly returns to target

Wage growth accelerates as slack declines
Compensation growth and unemployment

Overall PCE Price Inflation

%
6

Percent change from 4 quarters earlier

%
%
Quarterly observations; 4-quarter percent growth in compensation
12
6
Compensation growth
(left axis)

5

4

PCE Price Index
FRBSF
Forecast

2

10

4

8

3

6
4

2
Unemployment rate
(right axis)

0
1

2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bureau of Economic Analysis and FRBSF staff

-2

2

0
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Health-care inflation at historical low
Health-care price inflation

Composition of nonfarm business sector income

100

%
10

90

8

%

Quarterly observations; share of gross value added

Profits
Rental, interest, and depreciation

80

Taxes

70

Proprietor's income

60

12-mo percent change; PCE price index for health-care services

6
4

50
Compensation

1964

1972

2

40
30

1956

0

Source: Bureau of Labor Statistics and FRBSF calculations

Compensation share low, profit share high

1948

0

1980

Source: FRBSF staff calculations

1988

1996

2004

2012

0
1990

1993

1996

1999

2002

Source: Bureau of Economic Analysis

2005

2008

2011

2014

Stronger dollar makes imports cheaper
Import price inflation and dollar appreciation
% 12-mo growth rate; imports ex. fuels; trade-weighted dollar

New Fed Chair, same message
%

8

20

6

15

4

Import price inflation
(left axis)

5

0

0

-2

-5

-6

Dollar appreciation
(right axis)

2003 2004 2006 2007 2009 2010 2012 2013
Source: Bureau of Labor Statistics and Federal Reserve Board

%
2.5

Implied by fed funds and eurodollar futures
January FOMC
Meeting

2

10

2

-4

Forward Fed Funds Rate

1.5
Data as of
March 10, 2014

1
0.5

-10
-15

0
01/14
07/14
01/15
Source: Bloomberg

07/15

01/16

07/16

01/17