FRBSF: The Economic Outlook

The economic outlook from the San Francisco Fed shown in twelve graphs (click on graphs for larger versions):

FedViews, FRBSF: John Fernald, Vice President of Macroeconomic Research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:

In the second quarter, real GDP growth slowed from its very rapid first quarter pace and was well below the 3-3/4 percent pace it had averaged since the beginning of 2003. We expect the pace of growth to remain modestly below our estimate of potential output of about 3 percent over the next several years.

The July annual revision to the national income and product accounts lowered average GDP growth by about 0.3 percentage points per year from 2003 through 2005 from the previous estimate. As a result, labor productivity growth—a key underpinning for potential output growth—has also been revised down. The average rate of labor productivity growth since 1996 is now measured at about 2-3/4 percent, still substantially above the 1-1/2 percent rate of the prior two decades.

Labor markets remain strong. Nonfarm payrolls rose by 128,000 jobs in August. Employment growth has been running at about a 1 percent pace in recent months, down slightly from its average pace of the past couple of years. The unemployment rate remains low, at 4.7 percent in August, below most estimates of the unemployment rate consistent with "full employment."

Investment spending continues to grow. Shipments and (especially) orders of non-defense capital goods excluding aircraft—key indicators of equipment and software spending—rose strongly in July.

In July, real consumer spending rose solidly from June. Nevertheless, the underlying pace of spending has been slowing, with the 12-month growth rate in total consumer spending falling to its lowest rate since 2003. Personal saving remained negative in July. Over the next few years, we expect growth in consumption to be slightly lower than growth in disposable income, as consumers start saving again.

The long-predicted slowdown in the housing sector finally seems to have arrived. Housing permits, for example, have fallen more than 20 percent from their peak in September 2005 and are now at their lowest level in about four years. Inventories of new homes, measured as the ratio of new homes for sale to new homes sold, have also risen sharply of late.

Surveys suggest that fewer households think it's a good time to buy a house, with perceptions of interest rates and home prices prominent among the reasons cited. For example, in 2003 and 2004, about two-thirds of those surveyed said that it was a good time to buy a house because interest rates were low, compared with about one-quarter this year. In 2003 and 2004, about one-tenth of the respondents said that it was a bad time to buy because home prices were high, compared with about one-quarter this year.

House price appreciation has slowed. The Office of Federal Housing Enterprise Oversight indicated that in the second quarter, prices rose about 10 percent from a year earlier. Another indicator, the Case-Shiller Index (CSI), covers ten metropolitan areas and shows an even sharper deceleration. Since May, investors can trade futures contracts on the CSI on the Chicago Mercantile Exchange. The futures market predicts that home prices have now peaked and should show outright declines over the next year. By this indicator, the deceleration in prices should look similar to that experienced during the 1990-91 period.

Core inflation has been running at, or above, 2 percent on a 12-month basis for about two years and recently rose to nearly 2-1/2 percent. We expect that inflation will steadily ease. Among the reasons for inflation to come down are the following. First, the monthly change in core PCE prices in July was modest. This favorable reading suggests that some of the recent run-up in inflation might be transitory rather than persistent. Second, the slowing economy should help relieve any cyclical inflation pressures. Third, oil prices have ticked down recently, which should reduce any pressure from energy pass-through to core prices.

Inflation expectations are well contained. Inflation compensation measured from market yields on nominal and real Treasury securities indicate that inflation compensation for the next five years has fallen in recent weeks. Inflation compensation for the five year period beginning in five years (i.e., 5 to 10 years out) has remained more stable, but is well below its levels seen earlier in the year. The Survey of Professional Forecasters continues to see CPI inflation of about 2-1/2 percent over the next 10 years.

One upside risk to inflation comes from recent revisions to the data on compensation per hour, a fairly comprehensive measure of wages, salaries, and benefits. These data suggest a ramping up of compensation growth. Wages are a major production cost. Hence, firms might respond to the increased costs of production by raising prices. Alternatively, the gains in compensation might come at the expense of profit margins, which have been very high in recent years. Historically, strong productivity growth leads to roughly corresponding increases in wage growth, so workers may be regaining some of the ground they have lost.

Financial markets currently forecast that the Federal Reserve is finished raising rates. As the view of a "stop" has solidified in recent weeks, longer term rates on Treasury securities edged down.