The Economic Outlook

The Economic Outlook Loretta J. Mester* Executive Vice President and Director of Research 8 th Annual Temple University Fox School of Business Leadership and Professional Development Seminar February 21, 213 www.philadelphiafed.org/research-and-data/ *The views expressed here are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System

But the long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. John Maynard Keynes A Tract on Monetary Reform (1923), Ch. 3 Review 212 economic performance Present our forecast for 213 and 214 Discuss monetary policy tools

We expected the recovery to continue and on firmer footing in 212, with a pickup in growth, a gradual improvement in labor markets, and low inflation FOMC labor market and inflation forecasts were about right. FOMC forecast of moderate growth was too optimistic. Actual FOMC Central Tendency in January 212 Actual 211 212 212 Real GDP Growth (Q4/Q4 growth) Unemployment Rate (Q4 average) Total PCE Inflation (Q4/Q4 growth) Core PCE Inflation (Q4/Q4 growth) 2.% 2.2% to 2.7% 1.5% 8.7% 8.2% to 8.5% 7.8% 2.5% 1.4% to 1.8% 1.5% 1.7% 1.5% to 1.8% 1.5%

Many of the risks to the forecast we cited at the beginning of 212 tried to erupt. They were largely contained but caused concern and created uncertainty. The European sovereign debt, banking, and fiscal situation raised concerns at the start and mid-year, but then stabilized as some progress was made to improve fiscal arrangements and banking systems but there is still a considerable way to go We did not have a major natural disaster like the Japanese earthquake and tsunami in 211 but Hurricane Sandy affected the local economy Oil prices were fairly stable we did not see the surge we saw in 211 around the Arab spring, but tensions in the Middle East caused some jitters The U.S. fiscal policy situation was a major issue, and similar to the debt ceiling debacle in 211, dampened the appetite for spending

Percent 5 4 3 2 1-1 -2-3 -4-5 -6 Although the pattern of growth varied quarter to quarter, overall growth was moderate last year Hurricane Sandy did not change the national outlook, but likely resulted in a small reduction in growth in 212Q4, which will be made up in 213. Real GDP Growth, SAAR 212 1.5% 29 21 211 212 Quarterly data: Last point plotted is 212Q4

By the end of 211, activity had strengthened in most states Philadelphia Fed Current Economic Activity Indexes, annualized growth over the three months ending in November 211 > 4% 3% to 4% 2% to 3%.5% to 2% -.5% to.5% -2% to -.5% -3% to -2% <-3%

Economic activity continued to expand in most states in 212 Philadelphia Fed Current Economic Activity Indexes, annualized growth over the three months ending in November 212 > 4% 3% to 4% 2% to 3%.5% to 2% -.5% to.5% -2% to -.5% -3% to -2% <-3%

It weakened toward the end of the year but that was due to temporary factors Philadelphia Fed Current Economic Activity Indexes, annualized growth over the three months ending in December 212 > 4% 3% to 4% 2% to 3%.5% to 2% -.5% to.5% -2% to -.5% -3% to -2% <-3%

Percent 3 25 2 15 1 5-5 -1-15 -2-25 -3-35 After performing quite well in 211, business investment slowed significantly last year. Many of our business contacts report that uncertainty rather than lack of profits is holding back spending and hiring. Growth in Business Fixed Investment in Equipment and Software, 4Q/4Q SAAR (left scale) Corporate Profits SAAR (right scale) 1 2 3 4 5 6 7 8 9 1 11 12 Billions of $ 225 2125 2 1875 175 1625 15 1375 125 1125 1 875 75 625 212Q4 for Corporate Profits is an estimate

Manufacturing activity slowed last year, even before Hurricane Sandy hit. Our BOS current activity index weakened further in February, but respondents remain optimistic about the future. Diffusion Index 7 6 5 4 3 2 1-1 -2-3 -4-5 Business Outlook Survey: General Activity Index Future General Activity Index 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 213 32.1 12.5 Index represents percentage of respondents reporting an increase minus percentage reporting a decrease. Monthly data: Last point plotted is February 213

12 Consumer sentiment and confidence stayed positive but low. The drop in December may have reflected concerns about the fiscal cliff. Sentiment index, 66Q1 = 1 Confidence index, 1985 =1 1 8 Consumer Sentiment Index, University of Michigan 6 4 2 Consumer Confidence Index, Conference Board National and Mid-Atlantic States Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Monthly data: Last point plotted is January 213 for confidence and February 213 for sentiment

Consumer spending held up in 212 Percent 6 Real personal consumption 4Q/4Q growth, SAAR* 5 4 3 2 4.4 2.8 1.9 3.4 4. 2.8 3.2 1.7 2.9 1.9 1.9 1-1 -2-3 -2.5 -.3 1 2 3 4 5 6 7 8 9 1 11 12

The recession destroyed wealth. Consumers have been saving more to shore up their balance sheets, so consumer spending has been growing a bit slower than its long-run average. Billions of chain-weighted 25 dollars 11. 1.5 1. 9.5 Real personal consumption expenditures 2.5% trend from peak 12/27 9. 8.5 8. 7.5 7. Average growth (SAAR) Jan 1987 Dec 212 = 2.7% Jun 29 Dec 212 = 2.1% 1 2 3 4 5 6 7 8 9 1 11 12 Monthly data: Last point plotted is December 212

Labor market conditions continued to improve in 212. Job gains averaged 181 per month in 212, about the same as in 211. Thousands of jobs 6 Monthly change in nonfarm payrolls 4 2 Jan 213: 157-2 -4-6 -8-1 26 27 28 29 21 211 212 Last month plotted is January 213 Average monthly gains for each year are indicated by the grey lines

Total employment growth in the nation is weaker than in the 1991 recovery and earlier ones Cumulative % change in nonfarm payrolls since recession trough 12 U.S. payroll employment 1 8 6 4 2-2 Avg of 8 recoveries, 1949-1982 1991 29 21-4 -12-8 -4 4 8 12 16 2 24 28 32 36 4 44 Last point plotted for 29 recovery is January 213 Trough Mar 1991 Nov 21 Jun 29 Months Since Recovery Began

Employment in our three states grew at a slower pace than in the nation, which is typical. Both the region and nation continued to lose government jobs. 2 Year-over-year payroll job growth, as of December November 212 Job growth ann. yr-over-yr as of Dec 212 1 3 4 3-state employment as share of nation: 8% PA employment as share of 3-state: 57% NJ employment as share of 3-state: 39% DE employment as share of 3-state: 4% 5 1. Pittsburgh, 2. Erie, 3. Johnstown, 4. Altoona, 5. State College, 6. Williamsport, 7. Harrisburg-Carlisle, 8. York-Hanover, 9. Lebanon, 1. Lancaster, 11. Reading, 12. Scranton-Wilkes-Barre, 13. Allentown-Bethlehem-Easton, 14. Newark-Union, 15. Bergen-Passaic-Hudson, 16. Trenton-Ewing, 17. Edison, 18. Philadelphia, 19. Camden, 2. Wilmington, 21. Dover, 22. Vineland-Millville-Bridgeton, 23. Atlantic City, 24. Ocean City 7 6 8 9 1 12 11 2 13 21 18 22 14 19 16 17 23 24 15 US: 1.4% 3-state:.9% PA:.7% NJ: 1.2% DE:.4% < 3% 2.9% to 2% 1.9% to 1%.9% to %.1% to 1% 1.1% to 2% > 2%

The U.S. is over the halfway point on recovering lost jobs. Pennsylvania is outperforming the nation and the rest of the region. Percent 8 % of jobs lost from employment peak to employment trough and % of lost jobs regained since employment trough 7.8% = 34 thousand jobs 7 6 6.3% = 8.7 million jobs 6.3% = 26 thousand jobs 5 4 3 2 1 63.% % of lost jobs regained 4.4% = 255 thousand jobs % of jobs lost 71.1% 32.6% 32.7% US PA NJ DE Incorporates January 213 data for US (includes benchmark revisions) and December 212 data for states.

Percent 8 7 6 6.3% Progress is being made: Compare this year s chart with last year s. % of jobs lost from employment peak to employment trough and % of lost jobs regained since employment trough Revision 6.4% Revision 6.3% 6.5% 7.8% Revision 7.9% 5 4 3 2 1 63.% 4.4% % of lost jobs 71.1% regained 36.1% 51.1% 32.7% US PA NJ DE % of jobs lost 19.6% 32.6% 1.% Monthly data: Orange/yellow bars: As of Feb 213; incorporates Jan 213 data for U.S. and Dec 212 data for states. Green bars: As of Feb 212; incorporates Jan 212 data for U.S. and Dec 212 data for states. Note, % of jobs lost peak to trough for 212 and 213 can differ because of data revisions.

The U.S. unemployment rate continued to gradually decline last year. It is down.4 percentage point from a year ago. The region saw an increase in the unemployment rate, especially in NJ. Percent 11 1 9 8 7 6 5 4 Civilian unemployment rate US: 7.9 (Jan) PA: 7.9 (Dec) NJ: 9.6 (Dec) DE: 6.9 (Dec) Three States: 8.5 (Dec) NJ PA US DE 3 92 93 94 95 96 97 98 99 1 2 3 4 5 6 7 8 9 1 11 12 13 Source: Bureau of Labor Statistics Monthly data: Last point plotted is January 213 for US and December 212 for states

Percent 2 Households continue to make progress on shoring up their balance sheets. Household debt has been declining since 29. 15 1 Yr-over-yr growth in household debt 5-5 198 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 21 212 Quarterly data: Last point plotted is 212 Q3

Percent 15 Household debt-to-disposable income continued to fall and creditworthiness is improving. The drag from deleveraging will wane over time. 125 1 Debt-to-Disposable Income 75 1.25% trend = growth over prior expansion 1991-2 5 198 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 21 212 Quarterly data: Last point plotted is 212 Q3

Since the steep decline in 28, household net worth has been rising Percent 15 1 5 Change in household net worth Trillions of $ $9 $6 $3 $ -5-1 -15-2 -25 Percentage change, year to year $ Change 212 91 92 93 94 95 96 97 98 99 1 2 3 4 5 6 7 8 9 1 11 Q1 Q2 Q3 -$3 -$6 -$9 -$12 -$15 Source: FRB Flow of Funds, annual data for 1995-211; quarterly data for 212

Housing markets strengthened in 212, but housing as a share of GDP remains near its post-wwii low Percent 15 1 5 1.5 7.4 Real residential investment 4Q/4Q growth, SAAR* 11.5 4. 5.3 3.9 14.4-5 -1-1.6-5.7-15 -2-25 -13.3-15.7-2.7-24.4 1 2 3 4 5 6 7 8 9 1 11 12

Housing as a share of the economy is near its post-wwii low Percent 78 74 Share of GDP Business Investment Percent 14 12 7 66 Personal Consumption 1 8 62 6 58 4 54 Residential Investment 1955 196 1965 197 1975 198 1985 199 1995 2 25 21 2 Dotted lines represent average shares from 1955Q1 212Q4

Housing starts are expected to pickup to keep up with demand stemming from household formation and deterioration of the existing housing stock Thousands of units 25 225 2 175 15 125 1 75 5 25 Privately owned housing units started Household formation Household formation plus estimated demolitions 92 93 94 95 96 97 98 99 1 2 3 4 5 6 7 8 9 1 11 12 Monthly data: Last point plotted is December. Household formation is 12-month moving avg in change in no. of households, break adjusted. Estimated demolitions = 288 thousand per year = average difference betw. housing starts and household formation 1992-2.

House prices at the national level began rising in mid-212 Percent 2 15 1 CoreLogic Excluding Distressed Sales Year-over-year percentage change SPF Forecast of Case-Shiller 5-5 -1-15 FHFA Purchase-Only House Price Index Case-Shiller House Price Index 3.3% 4.% -2 2 3 4 5 6 7 8 9 1 11 12 13 14 Quarterly data: Last point plotted is 212Q3 for Case-Shiller and FHFA and 212Q4 for CoreLogic; 213Q1 Survey of Professional Forecasters (SPF)

Inflation fell in 212 to slightly under the FOMC s longer-run goal of 2 percent Percent 5. Total PCE Inflation and Core PCE Inflation 12-month % change 4. 3. 2. 1. 1.4% 1.3%. -1. -2. 2 21 22 23 24 25 26 27 28 29 21 211 212 213 Monthly data: Last month plotted is December 212

European sovereign debt and banking problems continued to be a risk to the global outlook in 212 and Europe is in recession. But European countries have taken some positive steps and sovereign debt spreads have been moving down since mid-212. Percent Percent 2 5 16 12 Spread of 1-year government bond over 1-year German government bond Greece (right scale) 4 3 8 4 Portugal Ireland Italy Spain France 1/3/11 4/4/11 7/6/11 1/5/11 1/16/12 4/18/12 7/19/12 1/18/12 1/24/13 2 1 Daily: Last point plotted is February 14, 213

Financial markets continued to be volatile in 212. Prices fell sharply in mid-year on concerns of the European sovereign debt crisis and the outlook for weaker global growth, and in the fall on fiscal cliff worries. But, on net, stock prices were up between 1 to 2 percent in 212 NASDAQ & depending on the index. Dow Jones S&P 5 32 145 3 28 26 24 NASDAQ 14 135 13 125 22 2 18 Dow Jones Industrials 12 115 11 16 14 12 S&P 5 15 1 95 1 4 Jan 1 6 Jul 1 5 Jan 11 7 Jul 11 6 Jan 12 9 Jul 12 8 Jan 13 9 Daily data: Last point plotted is February 2, 213

The FOMC had another active year in 212 January: Announced an inflation target of 2% and explained why it is inappropriate to set an employment target January: Began publishing FOMC participants appropriate fed funds rate paths in the Summary of Economic Projections. June: Extended the Maturity Extension Program Operation Twist to year-end. September: Began a flow-based purchase program of agency mortgagebacked securities ($4 billion per month) QE3. September: Changed forward guidance on the fed funds rate: zero rates likely at least through mid-215. December: Announced a flow-based purchase program of longer-term Treasuries ($45 billion per month). December: Changed forward guidance on the fed funds rate from calendar date to economic conditions: zero rates likely as long as U > 6.5%, outlook for inflation between one and two years ahead <= 2.5%, and longer term inflation expectations remain well anchored.

Monetary policy accommodation increased in 212. The Fed has kept the fed funds rate at essentially zero for 4 years and has pushed out expectations for when the first rate hike is likely to occur. Percent 7. 6. 5. 3-year mortgage rates are around 3.5% and 1-year Treasury yields are around 2%. 3-year mortgage rate 4. 3. 2. 1-year Treasury bond yield 1. Fed funds effective rate. Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Weekly data: Last point plotted is February 15, 213

Trillions $ 4.5 4. 3.5 3. 2.5 2. 1.5 1..5. -.5-1. -1.5-2. -2.5-3. -3.5-4. -4.5 Assets Treasury Supplementary Financing Program Liabilities Other assets Loans Trillions $ 4.5 4. 3.5 3. 2.5 2. 1.5 1..5. -.5-1. -1.5-2. -2.5-3. -3.5-4. -4.5 Jan-7 Dec-7 Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Dec-13 Weekly data: Last point plotted is February 13, 213 The Fed is expanding its balance sheet. It is buying agency mortgage-backed securities at a pace of $4 billion per month and longer-term Treasury securities at a pace of $45 billion per month. Other Liabilities Agency securities Treasury securities Federal Reserve notes in circulation Reserve Balances

What does the future hold?

Fed and private sector forecasters expect growth to accelerate, unemployment to gradually decline, and inflation to move toward its long-run goal of 2 percent. Central tendency of Fed Governors and Presidents December 212 Forecasts Survey of Professional Forecasters 213 Q1 Survey 213 214 213 214 Real GDP Growth* 2.3 to 3.% 3. to 3.5% 2.4% 2.8%* Unemployment Rate in Q4 7.4 to 7.7% 6.8 to 7.3% 7.5% NA PCE Inflation (Q4/Q4 growth) 1.3 to 2.% 1.5 to 2.% 1.8% 2.% * Q4/Q4 growth for Fed forecasts and 213 SPF; annual growth for 213 SPF *Q4/Q4 growth for Fed forecasts and 212 SPF; annual growth for 213 SPF

Percent 6 4 2-2 -4-6 -8-1.8 1.3 Our latest Survey of Professional Forecasters projects sustained economic recovery with growth gradually accelerating -3.7-5.2 -.3 1.4 4. Real GDP 4Q/4Q growth, SAAR 2.3 2.62.4 2.2.1 2.5 1.3 4.1 2. 1.3 3.1 -.1 2.62.5 2.12.3 SPF forecast 213 (Q4/Q4) = 2.4% 2.7-1 -8.9 28 29 21 211 212 213 214 Hatched bars are median forecasts from the 213Q1 Philadelphia Fed Survey of Professional Forecasters

Currently, payrolls are about 2¼ percent below their peak. It is projected to take almost two more years of job growth to return to that level. Millions of jobs 15 1% trend from business cycle peak 12/27 14 13 12 Payroll employment SPF Forecast through 214Q1 11 1 9 91 92 93 94 95 96 97 98 99 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 Monthly data: Last historical data point plotted is January 213. Dotted line is median forecast from the 213Q1 Philadelphia Fed Survey of Professional Forecasters

Respondents to our 213Q1 Survey of Professional Forecasters expect rising payroll employment will lead to a gradual decline in the unemployment rate this year Percent 1 9 8 7 6 5 4 3 2 1 Civilian Unemployment Rate 213Q1 SPF Forecast U = 7.5% by 213Q4 1 2 3 4 5 6 7 8 9 1 11 12 13 14 Percent 1 9 8 7 6 5 4 3 2 1 Quarterly data: Last historical data point plotted is 212 Q4 Dotted line is median forecasts from the 213Q1 Philadelphia Fed Survey of Professional Forecasters

Over the next two years, inflation remains moderate and near the FOMC s goal of 2 percent Percent, 4Q/4Q growth, SAAR 5 4 PCE price index PCE price index, excluding food and energy (= core inflation) 3 2 1 24 25 26 27 28 29 21 211 212 213 214 Hatched bars are median forecasts from the 213Q1 Philadelphia Fed Survey of Professional Forecasters

As always, there are risks to the baseline forecast Fiscal policy remains a risk: Progress has been made on the European sovereign debt and banking problems, but the problems are far from solved Labor market dynamics have been difficult to forecast during this recovery Internal dynamics of the economy + effect of accommodative monetary policy and resolution of some uncertainty could be stronger than we think The risks to inflation are balanced in the near term but are on the upside in the medium term Accommodative monetary policy Concerns about large looming fiscal deficits could increase inflation expectations Oil prices, as usual, are a wild card

How the U.S. decides to return to sustainable fiscal policy will matter for the economy Important dates: March 2 automatic sequestration cuts March 27 possible federal government shutdown Late spring/early summer debt ceiling becomes binding again Percentage points 2 175 15 125 1 75 5 25 Actual Government Debt as % of GDP CBO Projections Extended Alternative Fiscal Scenario = Current Policy Baseline after the fiscal cliff deal Extended Baseline Fiscal Scenario = Current Law before the fiscal cliff deal 199 1995 2 25 21 215 22 225 23 235 Source: CBO: The 212 Long Term Budget Outlook, June 212 for extended scenarios and CBO: The Budget and Economic Outlook: Fiscal Years 213 to 223 for baseline after fiscal cliff deal

Majority of FOMC participants believe it will not be appropriate to raise the funds rate until 215 Number of Participants 14 12 1 8 6 Appropriate Timing of Liftoff 13 Percent 6 5 4 2 2 3 1 213 214 215 216 Target Fed Funds Rate at Year-End 4 3 2 1 212 213 214 215 Longer Run Source: FOMC Minutes and Press Conference, December 212

The baseline forecast The economic recovery continues in 213 and 214, with growth 2.5 to 3%, which is at or slightly above trend. As some of the uncertainty on fiscal policy both here and abroad is resolved, business investment in equipment and software picks up, and firms gradually increase their hiring Improvement in labor market conditions and households balance sheets will support consumer spending. Continued emergency UI benefits help offset the effects of the expiration of the payroll tax holiday on the macroeconomy. Residential investment continues to improve, adding to growth Labor markets improve. Payroll growth strengthens and the unemployment rate falls gradually to around 7.5% at the end of 213. Monetary policy remains accommodative. Inflation moderates back toward 2%, consistent with price stability.