FRBSF: The Economic Outlook

The economic outlook from John Fernald of the San Francisco Fed:

FedViews, by John Fernald, FRBSF: John Fernald, vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:

After sharp declines in home sales since mid-2005, recent indicators suggest that housing demand may be stabilizing. Sales of new and existing homes appear to have bottomed out, and consumer attitudes towards home-buying recovered somewhat in the fourth quarter.

In contrast, forward-looking indicators of homebuilding have generally continued to trend down. Housing starts bounced up a bit in November after a very sharp fall in October. But permit issuance for new homes has continued to fall.

One reason to expect further reductions in homebuilding is that the supply of homes on the market remains high. Inventories of both new and existing homes (measured as a ratio to monthly sales) are up sharply since 2005, suggesting that builders are still dealing with an overhang of home supply. Existing home inventories have, in the past, tended to lag new home inventories. This lag probably contributed to persistent downward pressure on housing prices in the early and mid-1990s.

Consumer spending remains strong, suggesting that adverse spillovers from the housing slowdown remain contained. In mid-2006, real consumption growth slowed markedly. But the recent consumer spending data have been solid.

Other indicators have been more mixed. For example, orders for nondefense capital goods excluding aircraft came in on the weak side, suggesting some weakness in equipment and software investment; but net exports in November were stronger than expected. On balance, these indicators are consistent with solid growth outside of residential investment.

A reason for optimism about the outlook is that employment continues to grow, which should provide support for household income and spending. In December, payroll employment rose by 167,000 jobs. The unemployment rate remained at 4-1/2 percent. Hence, the job market still appears relatively tight.

Energy prices provide another reason for optimism. Oil prices have fallen about $20/barrel from their peak last summer. Natural gas prices have also come down recently. Hence, less of nominal household expenditure is tied up in paying for gasoline and other energy products, leaving more disposable income to spend on non-energy goods and services.

Outside of residential investment, GDP growth is projected to remain solid. Overall GDP growth has been held down by falling residential investment, which pulled growth well below trend in the second and third quarters of 2006. As the drag from the housing slowdown diminishes, GDP growth is projected to pick up gradually over 2007 and 2008.

Core inflation (measured, for example, with the personal consumption expenditures price index excluding food and energy) has been elevated for some time. In recent months, the year-over-year inflation rate has turned down a bit. Indeed, looking over the past three months, inflation has been running below 2 percent. Of course, in the past several years there have been other periods when, for a few months, inflation appeared tame, so it’s too early to say that inflation is under control. But, the recent data are in the right direction and provide some reassurance that core inflation may have peaked.

Upside risks to the inflation outlook remain. One risk is that, with tight labor markets, firms might see rising labor costs and then try to pass these cost increases through to prices. In fact, one measure of labor costs, compensation per hour in the nonfarm business sector, spiked up earlier this year but receded somewhat in the third quarter; that measure remains at a high level. An alternative indicator, the employment cost index, remains more contained, though it did pick up in the third quarter.

Another inflation risk is that productivity growth might slow. If labor costs rise, but the cost increases are offset by productivity gains, then firms might not try to pass those cost increases through to prices. Indicators of productivity for the entire nonfarm business sector and for nonfinancial corporations have diverged recently. In the nonfarm business data, productivity gains have slowed sharply. But in nonfinancial corporations, productivity growth has remained solid.

The divergence in the two productivity indicators reflects differences in source data, and it is unclear which is more reliable. A reasonable interpretation is that, although slowing productivity growth remains a risk factor for the inflation outlook, there are reasons to downweight the apparent slowdown in the nonfarm business figures.

On balance, core inflation is projected to continue moderating over 2007 and 2008, moving consistently below 2 percent by the end of 2008. Overall inflation is likely to be more volatile, reflecting the impact of recent declines in energy prices.

With the data on economic activity generally coming in above expectations, financial markets have pared back expectations that the Federal Reserve will reduce its fed funds target before next summer.

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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.

Comments

[FredW]

Isn't he being rather optimistic suggesting that home sales have leveled off? Don't we need a few more months to make that call - or maybe he's trying to boost the RE sector a bit.

[calmo]

It's a nice general view for the general public with those graphs that have those titles on them just to remind us who is stupid (ok, it could be a new format for the executive summary) and likely to mess up a perfectly good illustration by getting the wrong impression.
Is this 'GDP less RI' a new metric for measuring economic performance? Why is residential investment excluded by Fernald? With no explanation, it's just too easy to view this cynically. My impression is that autos are going to take even more from the q4 number, but I suppose excluding that component even though it has better grounds using a volatility excuse, would show a dismal q3 number.
I'm reassured (alright somewhat appalled too) by the sheer confidence of the view...until the last graph where the Market is consulted for its expectations and then that impression of sheer confidence becomes an appearance, an uncertainty, a hope.
Imagine if we took a different snapshot of these Futures (like a funnel of possibilities opening to the right) and we saw a hockey stick? [Actually what I really want to do is draw a pussy cat in there @ 2008.] The message is that not only does the SFRB think the soft landing is a done deal, but the Future players are betting the same way, (so what's wrong with you and your bear friends?)
Well, that's why I'm for line drawings of cats, because I think the reader needs relief.

[ilsm]

I would like a glass of what he is having.

[anne]

Though economic growth has slowed, I just do not find reason to fear a recession. Market performance suggests that there has been adaptation to the slowing of housing and with employment holding the economy should be relatively healthy these coming months. As I have pointed out, no developed economy these last 5 years has been in recession despite selective housing slow-downs and rising energy prices. With long term interest rates low, I am optimistic about general growth though there are selective important economic problems to deal with.

[Gavin]

Anne:

Don't you think just looking back 5 years is a form of tunnel vision. By that standard I could say technology stocks are immune to crashes because the dot-com bust was in a different era.

If you look at economic performance in the 1990s there were many countries that had recessions accompanied by a housing slowdown. The current world economy is not that different.

Here is a IMF study on housing and stock market bubbles
http://www.imf.org/external/pubs/ft/weo/2003/01/pdf/chapter2.pdf

[Emmanuel]

Yeah, I mean, who cares that Americans don't save jack. It doesn't matter; deficits don't matter. GDP can keep going on strong--until consumers get foreclosed or end up in bankruptcy court. Ah, the wonders of growth fueled by debt and dissavings.

[Movie Guy]

Where are the related stats for:

Consumer credit? Retail sales? Wholesale inventories? Import price index? U.S. trade balance? Personal savings rate?

[anne]

Yes; I believe the current world economy is that different. The last 5 years were fastest international growth period of any since 1945, and the resistance to recession and market stability during this time has been important and encouraging even if surprising to some clever analysts. Interestingly, the most successful investing these last 5 years, actually these last 10 years, has been conservative, valuation centered investing. As I have been pointing out for quite a while, we are passing through as broad and deep an international bull market in investments as I know of, however conservatism has been the criteria for most success.

[anne]

As I was taught, valuation comes before all else, then reading markets and letting market reading help in reading macro-economic data. I have never known an investor who begins with macro data to be a successful investor, though lots of analysts hold they can do just this.

[Nouriel Roubini was not harmed in making these comments. Stephen Roach?]