FRBSF: The Economic Outlook

John C. Williams, Federal Reserve Bank of San Francisco, uses twelve graphs to illustrate his views on the current economy and the future economic outlook:

FedViews, by John C. Williams, Federal Reserve Bank of San Francisco (dynamic link): Real GDP growth appears to have slowed in the first quarter to below 2 percent, a step down from the subdued 2-1/4 percent rate recorded in the second half of last year. The basic picture continues to be one of a bimodal economy – slumping residential investment and cutbacks in the auto industry pulling down growth, while the rest of the economy, for the most part, keeping on track.

Adding a new twist to the bimodal economy story, however, are data showing that businesses have trimmed investment spending. Some of this weakness can be traced to special transitory factors and spillovers stemming from the retrenchment in auto production and home construction. But the investment slowdown is also apparent outside of housing and autos, hinting at the possibility of a more widespread deterioration in the perceived profitability of capital investment. Nonetheless, with support from very favorable financial conditions and the probability of a gradual recovery in the housing and auto sectors, business investment looks to regain some traction going forward.

Domestic automakers have been successful at reducing unwanted inventories by cutting back sharply on production. Indeed, the cutback subtracted more than one percentage point from GDP growth in the fourth quarter. With inventories down to more acceptable levels, motor vehicle production is poised to pick up again. But, continued weakness in construction supplies and now in business equipment has put a drag on manufacturing, and the March ISM survey points to only modest near-term growth in this sector.

Recent housing indicators provide some tentative signs that the slump in residential construction may soon hit bottom. After falling nearly 30 percent over the past year, new housing permits and starts appear to be stabilizing. Although sales of new homes have continued to decline, sales of existing homes have risen markedly in recent months and are down only about 4 percent over the past year. Clouding the outlook for housing is the recent meltdown in the sub-prime market. Although these developments look to have modest macroeconomic implications, they do pose some risk to the outlook for housing.

Despite the housing slump, American consumers continue to spend, fueled by solid gains in real incomes, low interest rates, and past gains in housing wealth. Indeed, according to the national income accounts, households are spending even more than they earn, as the personal saving rate was negative 1.2 percent in February, about in the middle of its range of the past year.

Recent indicators point to a soft landing. After coming close to stalling last quarter, GDP growth looks to pick up to a pace somewhat above 2 percent in the current quarter, as the drag from housing, autos, and investment gradually ebbs. Consumption spending accounted for all or more than all of GDP growth in the second half of last year and the same was likely true for the first quarter of this year. But, with energy prices rising and house prices roughly flat, consumption growth looks to slow somewhat to a more sustainable pace.

Looking to the second half of this year and next year, real GDP is expected to grow at about 2-1/2 percent annual rate, a pace a bit below our estimate of the trend rate of growth. This forecast is influenced by two important conditions. First, household wealth is expected to increase only modestly over the next few years, owing to stagnant house prices. Second, the current stance of monetary policy is modestly restrictive, which, all else equal, should restrain spending slightly. But, there is a great deal of uncertainty regarding this outlook, with downside risks for both residential and business investment.

Despite sub-par GDP growth over the past year, businesses continue to add to payrolls at a healthy clip. The economy added 180,000 nonfarm jobs in March, and the pace of hiring has edged down only slightly over the past two years. With output growth slowing, but with job growth remaining solid, labor productivity growth has slowed noticeably.

The robust pace of hiring has also driven down the unemployment rate 0.3 percentage points over the past year, to 4.4 percent in March. This decline in unemployment is especially curious given that GDP is estimated to have increased a little more than 2 percent over the same period, well below conventional estimates of potential GDP growth. Although the puzzling strength of the labor market may reflect lags in the adjustment of employment to the slowdown in growth, it could also signal that either potential GDP growth is much slower than many believe or that output growth has been much stronger than the GDP numbers indicate. With respect to the latter explanation, gross domestic income grew more rapidly than GDP, and if this measure proves more accurate, the strength of the labor market is not as puzzling.

How tight are labor markets? In the chart, the blue band plots the range, from lowest to highest, of various measures of labor market conditions over time, where these measures have been translated into terms of the unemployment rate to aid in their comparison. These measures differ at any point in time, but tend to move up and down together with the business cycle. Currently they range from about 4-1/4 to 5 percent, with the unemployment rate, at 4.4 percent, near the low end of the range. These measures are at or below the “full-employment” benchmark, of the Congressional Budget Office’s estimate of the natural rate of unemployment, suggesting some tightness in labor markets. However, uncertainty about both the measurement of labor market conditions and the natural rate (indicated by the confidence bands) makes it difficult to come to clear conclusions at this time. By comparison, the evidence of tight labor markets was much stronger in 1999 and 2000, and the evidence for considerable slack during the past two recessions was similarly compelling.

Oil prices have gyrated over recent weeks, reflecting developments in the Middle East. Futures markets expect the price of oil to increase to over $70 a barrel.

Core measures of consumer price inflation remain somewhat elevated. The February increases in both the core CPI and core PCE price index were on net somewhat larger than expected. Special factors, including abnormally high increases in owner-equivalent rent and some pass-through of energy prices to other prices, have likely contributed to the bump-up in core inflation over the past year. These factors should dissipate going forward, and with labor markets expected to move more closely to being balanced, core inflation should edge down gradually later this year and next year.

Based on prices in the fed funds futures market, market participants expect the FOMC to remain on hold over the next few meetings and then to make one rate cut late this year. Yields on Treasury securities rates have edged up over the past month.