Economic Outlook Christopher J. Neely Assistant Vice President, Federal Reserve Bank of St. Louis NLB,LLC The Lodge, Des Peres, MO April 8, 2010
The opinions expressed are my own and not necessarily those of the Federal Reserve Bank of Saint Louis or the Federal Reserve System. I thank my colleagues, Dick Anderson, Cletus Coughlin, Tom Garrett, Bill Gavin and Kevin Kliesen, for generously sharing recent outlook presentations that they created. 2
Who Am I? I am a research economist, not a forecaster. o My research is primarily on exchange rates. 3 kinds of economic communication: o Greek letter; o ups and downs; o popular economics. Economists are much better on why the past happened. o There is a reason for this. 3
The Current Outlook Today s Topics o GDP, employment, manufacturing, housing, inflation o The recession was widespread How did we get into this mess? How did the Fed respond? o Where did the inflation go? o Exit strategies Structural issues for the U.S. Economy o A low savings rate/international imbalances o The Federal deficit 4
The Current Outlook GDP Employment Industry/manufacturing Construction /housing Credit/delinquency The Global outlook 5
The Current Outlook: GDP Percent 8 2009 Q4 GDP growth was revised downward, forecasted growth rate is around 3.5% for 2010 and 2011. 6 4 Real GDP Growth Mar-2010 BC Forecast Apr-2010 MA Forecast 2 0 2007 2008 2009 2010 2011-2 -4-6 -8 Source: Bureau of Economic Analysis Forecast: Macroeconomic Advisers and Blue Chip Economic Indicators 6
The Current Outlook: Civilian Unemployment Thousands 700 650 600 550 500 450 400 350 300 250 The U.S. unemployment rate is 9.7% in March. The St. Louis Unemployment rate is 11.5% in January. Unemployment Rate (SA, Right Axis) Initial Claims for Unemployment Insurance (4-week moving average, left axis) St. Louis City Unemployment Rate (Right Axis) Percent 13 12 11 10 9 8 7 6 5 200 2005 2006 2007 2008 2009 2010 Source: Bureau of Labor Statistics/Department of Labor. 7 4
The Current Outlook: NFP Employment Thousands(Changefrom previous month) 400 200 162 thousand jobs gained in March. 0-200 -400-600 -800-1000 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 8 Source: Bureau of Labor Statistics.
The Current Outlook: Long term Unemployment Percent 30 25 20 15 10 5 0 1929 1935 1942 1949 1955 1962 1969 1975 1982 1989 1995 2002 2009 Source: Bureau of Economic Analysis 9
The Current Outlook: Part Time Employees Thous, SA 29,000 27,000 25,000 23,000 21,000 19,000 17,000 15,000 Source: Bureau of Labor Statistics 10
The Current Outlook: Creation vs. Layoffs Thous. 7000 6000 5000 4000 3000 Total Job Hirings Total Layoffs and Discharges 2000 1000 0 Source: Bureau of Labor Statistics 11
The Current Outlook: Industrial Production Percent Change from Previous Month 2 Index 60 1 55 0 50 45-1 -2-3 Industrial Production (Left Axis) ISM Manufacturing (Right Axis) 40 35 30-4 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 25 Source: Federal Reserve Board/Institute of Supply Management. 12
The Current Outlook: Capacity Utilization and New Orders Mil.$, SA % of Capacity, SA 500,000 90 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Value of Manufacturers' New Orders (left axis) Capacity Utilization: Manufacturing (right axis) 80 70 60 50 40 30 20 10 0 Source: Federal Reserve Board and Census Bureau 13
The Current Outlook: Vehicle Sales Mil.$, SA 80,000 70,000 Cash for Clunkers 60,000 50,000 40,000 Source: Census Bureau 14
The Current Outlook: Existing Home Sales Thousands 7500 First time homebuyer tax credit. 7000 6500 6000 5500 5000 4500 4000 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: National Association of Realtors. 15
The Current Outlook: New Home Sales Thousands 1800 1600 1400 1200 1000 800 600 400 200 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: National Association of Realtors. 16
The Current Outlook: Existing Home % Change- Year to Year 20% Sales Price 15% 10% 5% 0% -5% -10% Housing prices have finally stabilized. -15% -20% Source: National Association of Realtors 17
90 days or more, % 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 The Current Outlook: Mortgage Delinquencies Source: Federal Home Loan Mortgage Corporation 18
The Current Outlook: Commercial Real %, SA 9 8 7 6 5 4 3 2 1 0 Estate Loan Delinquency Rate Source: Federal Reserve Board 19
The Current Outlook: Loan Delinquency %, SA 5 4.5 Rates All Commercial Banks: C & I Loans 4 3.5 All Commercial Banks: Consumer Loans 3 2.5 2 1.5 1 0.5 0 Source: Federal Reserve Board 20
The Current Outlook: Bank Credit % Change-Year to Year, SA 50% 40% 30% Loans continue to decrease All Commercial Banks: C & I Loans All Commercial Banks: Consumer Loans 20% 10% 0% -10% -20% -30% -40% -50% Source: Federal Reserve Board 21
The Current Outlook: Inflation 12-month Percent Change 6% 5% 4% 3% 2% 1% 0% 2005 2006 2007 2008 2009 2010-1% -2% Headline CPI Headline PCE Core CPI Core PCE -3% Source: Bureau of Economic Analysis and Bureau of Labor Statistics. 22
U.S. Employment has Fallen Fast Compared with Output 23
The Current Outlook: A summary GDP: Modest growth forecast Employment: Lagging Industry/manufacturing: Strength Construction /housing: Weakness Credit/delinquency: Lagging The Global outlook: Recession is widespread. 24
The Current Outlook: Real Activity Forecasts 25
The Current Outlook: Inflation forecasts 26
The Current Outlook: A summary Why is the recession so protracted? Why all this talk about U and L shaped recessions? o Recessions precipitated by financial crises tend to be severe. o Financial firms are crucial for all sorts of economic activity. o Activity will resume when their balance sheets improve substantially. 27
How did we get into this mess? House prices rose well beyond historical measures. House prices fell; borrowers default on mortgages. Assets backed by mortgages lose value. Capital falls. Financial firms could go bankrupt. Huge uncertainly dries up the market for these assets. o What are they worth? No one knows who owns these risky assets. Bad idea to lend or trade with a risky counterparty. Lending and financial trading dries up. The whole economy suffers. 28
Why didn t economists predict it? Some economists recognized the housing bubble. o The housing bubble wasn t obvious in real time. o Changes in long-term real rates appeared to justify higher house prices. o U.S. house prices had not fallen, year-over-year, nationally from 1967-2006. o How was one to prick it? What if it was a bubble? o House price would fall; borrowers would default; bondholders would lose. o Interconnectedness, derivatives/leverage greatly magnified the problem. 29
Why didn t economists predict it? NAR Median Sales Price: Existing 1-Family Homes, United States $ 240000 240000 200000 200000 160000 160000 120000 120000 80000 80000 40000 40000 0 70 75 80 85 90 95 Source: National Association of Realtors /Haver Analytics 00 05 0 30
How does monetary policy work? Central banks buy and sell assets to change the liquidity and risk composition of assets held by the public. o The Fed usually transacts in T-Bills. Such changes influence the economy primarily through asset prices. o Bills, bonds, stocks and exchange rates. 31
Monetary policy response Monetary policy in normal times. The lender-of-last resort function. Monetary policy at the zero bound. 32
How does monetary policy work in normal conditions? Raise interest rates in good times and/or when inflation picks up. o Reduce liquid assets and increase illiquid assets. o Higher interest rates and lower asset prices reduce spending. Lower interest rates in bad times and/or when inflation is too low. o Increase liquid assets and reduce illiquid assets. o Lower interest rates and higher asset prices reduce spending. The interest rate cycle is driven by changes in inflation pressures the MPK. 33
How does monetary policy work in normal conditions? Interest rate channels o Direct effect on business and residential investment. Effects through asset prices: stocks, exchange rates, house prices, etc. o Increase net exports through currency depreciation. o Increase business investment through rising stock prices. o Wealth effect: Increase consumption/decrease precautionary savings, from a rise in stock and housing prices. o A rise in house prices increases demand for new housing. Credit channels o Reduce problems with adverse selection and moral hazard, making banks more willing to lend to firms and consumers with better balance sheets. All these channels require a change in interest rates. 34
How does monetary policy work in crises? The Fed was created because of the 19 th century experience with bank panics. o Bank panics are not unique to banks. The lender of last resort function. o Financial markets really want safe, liquid assets when times are uncertain. o Lend freely at a high rate on good collateral. Walter Bagehot, Editor of The Economist, 1860-1877 The Fed provides liquidity to financial markets during crises, preventing illiquidity from causing recessions. o E.g., the stock market crash of 1987, the Russian default and 9-11-2001. 35
How did the Fed respond to the financial crisis? Goals of monetary policy o Stable prices & maximum employment require financial markets. Channels of monetary policy o The zero bound limits traditional policy. Responses to the current crisis o Full response of traditional policy. o Special programs in specific markets. o Quantitative easing versus credit easing. (LSAP) Money and inflation Exit strategy 36
How did the Fed respond to the financial crisis? Federal funds and Discount Rate Cuts Swap lines with foreign central banks Term Auction Facility (TAF) 12/2007 Term Securities Lending Facility (TSLF) 3/2008 Primary Dealer Lending Facility (PDCF) 3/2008 ABCP MMMF LF (AMLF) 9/2008 Commercial paper funding facility (CPFF) 10/2008 Purchase of Agency MBSs 11/2008 Term Asset-Backed Securities Loan Facility (TALF) 11/2008 Purchase of long-term Treasuries 3/2009 37
Current Monetary Policy Situation The federal funds rate has been close to zero since December 2008. The Fed has provided enormous liquidity by lending to the private sector and buying illiquid assets. o The Fed has expanded the monetary base currency plus bank reserves enormously. Why no inflation? o Expectations have been anchored (so far). o Broader aggregates e.g., M2 have not grown very fast because banks have accumulated the additional money as excess reserves. o Banks are essentially lending the excess reserves back to the Fed. o Does slow output mute price pressures? Widely believed but not really much evidence for this. 38
Current Monetary Policy Situation Percent 7 6 5 FOMC brings borrowing rates way down 4 3 2 Fed Funds Target Rate Discount Window Primary Credit 1 0 From September 2007 to December 2008, the FOMC cut the funds target by 425 basis points and on Dec. 16, 2008, it established a 0 to 0.25 b.p. Target Range. Source: Federal Reserve Board 39
Current Monetary Policy Situation SA, Mil. $ 2,500,000 2,000,000 1,500,000 Traditional easing starts here. Adjusted Monetary Base 1,000,000 500,000 0 Quantitative/credit easing starts here, after Lehman Brothers. Source: Federal Reserve Board 40
Current Monetary Policy Situation The monetary base more than doubled in a few months. Where did the inflation go? o The monetary base is not the money supply. 41
Current Monetary Policy Situation % Change Year to Year 18% 16% 14% 12% M2 MZM 10% 8% 6% 4% 2% 0% Source: Federal Reserve Board 42
Current Monetary Policy Situation There appears to be little near-term inflation risk o Anchored expectations, modest M growth & a weak real economy. Over the longer term, the Fed needs to reduce the base dramatically. o o Some positions, such as short-term credit facilities, will unwind quickly, naturally. The Fed will let some assets run off without replacing them. o Other assets, such as long-term MBSs and Treasuries, must be actively reduced. Active reduction must mean some combination of o o Borrowing money from the public (banks) through paying interest on reserves or issuing Fed CD s to borrow money from Banks. Traditional Open Market Operations: Reverse repos. o Selling illiquid assets Treasuries and MBSs back to the public. 43
Current Monetary Policy Situation When will short-term interest rates begin to rise? o The futures market provides as good a guess as any. 44
Structural problems with the US economy Private savings is very low. The counterpart to low savings is a current account deficit. Projected public deficits/dissavings are not sustainable. The common denominator: We consume too much and save too little. 45
Structural Issues for the U.S. Economy A low savings rate/international imbalances Percent 12 10 8 Personal Saving Rate 6 4 2 0 Source: Bureau of Economic Analysis 46
Structural Issues for the U.S. Economy Percent 96 94 92 90 88 86 PCE as a Percent of Disposable Personal Income 84 82 80 Source: Bureau of Economic Analysis 47
Structural Issues for the U.S. Economy Percent 2 1 0-1 -2-3 -4-5 U.S. Current Account Balance as a percentage of GDP -6-7 Source: Bureau of Economic Analysis 48
Structural Issues for the U.S. Economy: The Federal Deficit 49
Structural Issues for the U.S. Economy: The Federal Deficit 50
Structural Issues for the U.S. Economy: The Federal Deficit 51
Structural Issues for the U.S. Economy: The Federal Deficit Source: John Taylor 52
Structural Issues for the U.S. Economy: The Federal Deficit Source: John Taylor 53
Summary Despite positive signs, the recovery will probably not be strong or quick. The recent subprime crisis was actually sort of a classic banking crisis. Bubbles are easier to recognize in hindsight and easier to deal with on paper. The U.S. economy consumes too much and this cannot go on forever. 54
The End 55