The view of the economy from the San Francisco Fed:
Glenn Rudebusch, senior vice president and associate director of research at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:
- The initial estimate of real GDP growth during the third quarter was 1.6 percent at an annual rate—about half the average pace during the previous two years. Strong gains in consumption and business investment were partially offset by a drop in homebuilding. Looking ahead, the economy seems likely to grow at a 2-1/2 to 2-3/4 percent pace in each of the next few quarters. This projection balances the effects of a cooling in housing markets with solid growth in the remaining 95 percent of the economy outside of residential construction.
- Real residential investment has declined almost 10 percent over the past year, which is not as large as the declines posted during earlier periods when housing booms and busts were exacerbated, in part, by financial restrictions, such as Regulation Q. Also note that, unlike in past episodes, the current drop in housing does not coincide with a recession. Although housing permits and starts are down about 25 percent from the beginning of this year, there is no clear indication that the housing downturn is ending or that it is intensifying.
- Despite the housing slowdown, the rest of the economy remains healthy. Real consumer spending in the third quarter increased 3.1 percent at an annual rate, and auto sales are holding up well.
- On balance, any spillover from the housing slowdown to the rest of the economy appears to have been offset by four important factors that are supporting growth. The first of these factors is the solid growth in employment, with associated increases in labor income. The solid pace of hiring this year raises questions about whether recent flagging GDP growth reflects a transitory lull rather than a substantial slowdown. The second factor supporting growth is the recent drop in energy prices. The third factor is the recent increases in equity markets, which bolster household wealth. And, finally, as the fourth factor, borrowing costs—especially conventional fixed mortgage rates—continue to be relatively low.
- A crucial question facing policymakers is how soon will core inflation return to a more comfortable level. One reason for cautious optimism is that inflation expectations appear to remain contained, as various indicators of these expectations are in the same range that has prevailed over the past two years. Therefore, this year's surge in price inflation has not changed the market's view about where inflation will eventually be returned to by the Fed.
- In contrast, the upside risk to the inflation outlook from labor market pressures appears to have been growing. As the FOMC noted in its October 25 statement: "the high level of resource utilization has the potential to sustain inflation pressures." Since then, the labor market continues to tighten, and the unemployment rate fell to 4.4 percent in October, the lowest level since May 2001.
- With labor markets fairly tight, labor costs appear to have begun to accelerate. The broadest measure of compensation in the nonfarm business sector increased 6.7 percent over the past year. In contrast, the employment cost index (ECI), which excludes stock option realizations and a few other forms of compensation that are included in the broader measure, increased only 3.3 percent over the past year. (The ECI is also based on a fixed employment structure, which would not capture any shift in the mix of jobs to higher compensation occupations.) The true underlying marginal cost pressures that firms face probably lie somewhere in between these two measures.
- Still, core inflation will likely moderate gradually over time as labor cost pressures are absorbed by reduced markups of prices over costs and restrained by a below-trend growth. However, the upside risk to this inflation projection is an important concern for policymakers.