Full text of FedViews : October 11, 2012

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Twelfth Federal Reserve District

FedViews
October 11, 2012

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.php

Sylvain Leduc, research advisor at the Federal Reserve Bank of San Francisco, states his views on the current economy
and the outlook.


Incoming data have generally been in line with our view that the U.S. economy is growing at a
moderate pace. Despite the continued recovery, improvements in the labor market remain sluggish,
leaving a substantial amount of economic slack. Combined with steady inflation expectations, the
slack is keeping inflationary pressures at bay.



The U.S. unemployment rate fell three-tenths of a percentage point in September to 7.8%, according
to the U.S. Bureau of Labor Statistics (BLS) household survey, the largest single-month drop since
January 2011. September’s lower unemployment rate reflected a surprisingly large 873,000 increase
in employment.



In contrast with the sharp drop in the unemployment rate, nonfarm payroll employment grew only
modestly in September, posting a gain of 114,000 jobs, according to the BLS establishment survey.
This is slightly above the level of job gains needed to keep up with labor force growth. July and
August payrolls were revised up by a total of 86,000 jobs, mostly in the public sector. This is
positive, given that public-sector employment fell between March and June. Since the beginning of
the year, the economy has added an average of 146,000 jobs per month.



The BLS establishment and household surveys occasionally differ in the picture they give of the labor
market, due in part to differences in sampling and definitions of employment. A similar discrepancy
occurred in January when the household survey reported an employment increase of 895,000, but the
establishment survey found that nonfarm payrolls grew by 295,000. The household survey tends to be
more volatile because its sample size is smaller.



The housing sector has been improving. Housing starts and sales rose in August. And house prices
climbed 1.2% in July from a year earlier, according to the S&P/Case-Shiller Home Price Index of 20
metropolitan areas. The Core Logic House Price Index has also posted increases.



The Federal Open Market Committee eased monetary policy further at its September meeting, stating
that the pace of recovery was insufficient to substantially improve labor market conditions and that
the inflation outlook was subdued. The FOMC said the Fed will buy additional agency mortgagebacked securities at a pace of $40 billion per month and continue the program announced in June to
increase holdings of longer-term Treasury securities and decrease holdings of short-term Treasuries.
If the labor market outlook does not improve substantially, the Fed will continue purchases of agency
mortgage-backed securities, carry out additional asset purchases, and employ other policy tools as
appropriate until improvement is achieved in a context of price stability.

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 November 13, 2012.



The FOMC emphasized that it expects a highly accommodative stance of monetary policy to remain
appropriate for a considerable time after the economic recovery strengthens. Moreover, the FOMC
extended its forward policy guidance, stating it anticipates exceptionally low levels for the
benchmark federal funds rate are likely to be warranted at least through mid-2015.



The additional monetary policy easing appears to have brought down mortgage rates further. After
moving roughly sideways during July and August, the 30-year conventional mortgage declined below
3.4% in the first week of October, close to an all-time low.



We expect the economy to grow moderately for the remainder of 2012 and over the following two
years. Taking into account incoming data and the additional monetary stimulus, we anticipate that
gross domestic product will expand about 2.5% in 2013 and 3.3% in 2014. This is consistent with a
fall in the unemployment rate to 7.7% by the end of 2013 and 7.3% by the end of 2014. We assume
that Congress will let the payroll tax reduction and extended unemployment benefits expire at year
end, but will agree to extend the Bush tax cuts and adjust the alternative minimum tax. We also
expect Congress to limit the spending cuts mandated in the Budget Control Act of 2011.



We expect inflation to remain low over the next two years, reflecting high economic slack, subdued
wage growth, and steady inflation expectations. We expect both overall and core consumer prices to
grow at an annual rate of roughly 1.7% in 2013 and 2014, slightly below the FOMC’s inflation target.



The European debt crisis continues to pose a serious risk to the outlook. European Central Bank
support measures announced in September succeeded in lowering Italian and Spanish sovereign
borrowing costs to more sustainable levels by reducing the short-run risk of a disorderly outcome in
the euro area. Still, the situation remains volatile, as shown by the recent Standard & Poor’s
downgrade of Spanish sovereign debt.



The looming fiscal cliff is also an important risk to the outlook. The combination of tax increases and
spending cuts scheduled for the beginning of 2013 if Congress fails to agree on budgetary changes
would lead to massive fiscal contraction, according to the Congressional Budget Office (CBO). The
CBO estimates that the federal deficit would fall from 7.3% of GDP in fiscal 2012, to 4% in fiscal
2013, and 1% by fiscal 2017 if the full fiscal cliff package goes through. The CBO also
estimates that the complete package would lead to a recession next year and push the unemployment
rate toward 9%. However, the uncertainty around this forecast is high because estimates of the
transmission of fiscal policy changes to the economy vary widely in the economic literature.

A surprisingly large drop in unemployment

Payroll employment grew modestly
Nonfarm Payroll Employment

Unemployment Rate
Monthly data

Percent
12

Seasonally adjusted

10
8
6

8.8 million
jobs lost

4

Millions
140

Change in Nonfarm
Payroll Employment
(in thousands)
June +45
July +181
A +142
Aug
Sep +114

138
136
134
Sep

130

2

128

0
2004

2005

2006

2007

2008

Source: Bureau of Labor Statistics

2009

2010

2011

2006

2012

2007

2008

2009

Source: Bureau of Labor Statistics

House prices have started to rise

2010

2011

2012

Mortgage rate came down
30-Year Conventional Mortgage

House Price Changes
Percent change from 12 months earlier

Percent
20

9/13
September
FOMC

Percent
3.8
3.7

10

CoreLogic

August

3.6
0

July

3.5
3.4

-10

S&P/Case-Shiller: Composite 20

10/4
-20

2001

2003

2005

2007

2009

2011

Jul-2012

Aug-2012

Sep-2012

Source: Board of Governors, Federal Reserve System

We forecast moderate growth…

Oct-2012

…and subdued inflation

Real GDP Growth: Actual and FRBSF Forecast

PCE Inflation
Percent
6

Q2

4
2

Percent change from four quarters earlier

Percent
5

Overall PCE
Price Index

4
FRBSF
Forecasts

0
A t l
Actual

3.3
3.2

Jun-2012

Source: S&P, Fiserv, and MacroMarkets LLC; CoreLogic

Annualized growth rate, seasonally adjusted

132

FRBSF
Forecast

-2
-4

Core PCE
Price Index

Q2

3
2
1

-6

0

-8

-1

-10

-2

2005 2006 2007 2008 2009 2010 2011 2012 2013

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Bureau of Economic Analysis and FRBSF staff

Source: Bureau of Economic Analysis and FRBSF staff

Lower borrowing rates in Europe
10-year Government Bond Yields

9/6
ECB Announcement

Approaching the fiscal cliff

Percent

Federal Deficit Projections

% of GDP
8

8.0

7

7.5

Spain

6

7.0

5

65
6.5

4

10/11

Fiscal Cliff
(Under Current Law)

6.0
Italy

3

5.5

2

5.0

1

4.5
May-2012

Jul-2012

Source: Bloomberg

Sep-2012

2011

2013

2015

Source: Congressional Budget Office

2017

2019

0
2021