Glenn Rudebusch of FRBSF: National Economic Outlook

With twenty-four supporting graphs, this is a thorough analysis of the outlook or the U.S. economy from Glenn Rudebusch of the SF Fed:

FedViews, by Glenn Rudebusch, Federal Reserve Bank of San Francisco: The FOMC statement released after the December 11 meeting stressed the recent deterioration in financial market conditions and the slowing in economic growth. 

Since the middle of this year as the economic outlook has soured, the Fed has eased monetary policy by cutting the discount rate by 150 basis points and the federal funds rate target by 100 basis points.  Treasury yields have also fallen—the 2-year rate is down almost 200 basis points from its peak.  Markets expect the Fed to continue to cut rates next year.

A key question involves gauging the appropriate stance of monetary policy.  The real funds rate now appears to be in the range of its long-run historical average, and such a neutral level may seem appropriate given essentially no slack in the economy and contained core inflation. (For example, in a backward-looking Taylor rule, the output and inflation gaps would essentially be zero, so the real funds rate would be set equal to its neutral level.)  However, higher energy prices, an intensifying housing correction, and greater financial market turmoil have lowered the outlook for economic growth and may require an offsetting, easier stance of monetary policy.  Furthermore, from a risk management perspective, recent developments in financial markets—tighter credit standards, higher risk spreads, impaired liquidity, dislocations in mortgage markets—imply a significant downside “credit crunch” recessionary risk that may warrant an easier policy.

Conditions in the interbank lending market appear to have deteriorated over the past month, with widening spreads between comparable-maturity LIBOR and OIS rates.  In part, the widening spreads may signal heightened concerns about counterparty risk related to commercial bank exposures to subprime mortgage securities.  The elevated spreads also may reflect a desire by banks to hoard their liquidity in the face of uncertain future re-intermediation demands on their balance shifts.  The latter concerns may be magnified by year-end balance sheet window-dressing.  The disruption of interbank lending has the potential to impede the monetary policy transmission process and may require lower rates than would usually be warranted by macroeconomic conditions (or the disruption might be amenable to a more surgical intervention, such as the Fed’s new term auction credit facility).

Credit has also become more expensive for many other businesses and consumers.  Despite the easing of monetary policy, short-term credit for lower-rated businesses remains about as expensive as it was during the middle of the year.  Commercial paper rates for highly rated borrowers have fallen with the funds rate target, but interest rates have increased for second-tier A2/P2 commercial paper, while asset-backed commercial paper, even with a nominal AA rating, has required a significant premium to place in the market.

Although yields on long-term investment-grade corporate bonds have been little affected by the recent financial turmoil, yields on low-grade bonds have surged.  The resulting widening credit spreads have likely been driven by a worsening economic outlook as well as a reduced appetite for risk.

There has also been a significant tightening of the financing terms for nonconforming mortgages.  In particular, interest rates on jumbo fixed-rate mortgages have remained quite high because of difficulties in securitization.

Equity markets have been buffeted by recent economic and financial developments (and policy announcements) but, on balance, have held up fairly well.

Tightening mortgage financing conditions have helped depress housing demand.  Home sales have been very weak, and the stock of unsold homes on the market continues to rise.  Indeed, to pare bloated inventories, homebuilders have cut new construction. October housing starts posted a 1.2 million unit annual rate.  Based on past trends, starts may not fall much below the 1 million unit mark during the next few quarters.  After some past housing market busts—notably in the 1970s—construction surged after its trough; instead, in this cycle, we anticipate a very slow recovery to trend, as in the 1990s.

According to the 10-city Case-Shiller repeat sales price index, home prices have declined 5-1/2 percent over the 12 months ending in September.  Futures contracts on this index suggest further declines in the year ahead. 

Declines in home prices can cause households to revise their wealth assessments downward and scale back their consumption.  Such spillovers to consumption pose a significant risk to the economic outlook.

Household spending was essentially flat in real terms in September and October, and although retail sales improved in November, surveys of consumer sentiment remained very pessimistic. 

Household spending has likely been curtailed by the smaller gains in employment and slower growth in income recently.  Residential construction lost 20,000 jobs in November, and other housing-related sectors, such as building materials supply, continued to trend down.  Another factor restraining household spending is the high price of energy.  Although the price of oil has fallen back after flirting with $100 per barrel, households are still facing significantly higher gasoline and fuel oil prices than they did just a few months ago.

In light of the slowing economy and higher financing costs for lower-rated borrowers, businesses appear to have become more cautious about future capital outlays.

The economy grew very quickly during the summer; indeed, the revised estimate of real GDP growth in the third quarter showed a 5 percent increase at an annual rate.  To some extent, transitory factors, notably in exports and inventory investment, pushed up growth in the third quarter, and the reversal of these factors appears likely to depress growth in the current quarter.  In addition, several shocks, including tightening credit, slumping housing, and higher energy prices, appear to have depressed final domestic demand.  All in all, we foresee anemic growth through the spring of next year.  There appears to be a significant chance of registering at least one quarter of negative GDP growth, which in the past has often been associated with a recession.  (See Rudebusch and Williams, “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve,” FRBSF working paper 2007-16, July 2007 at http://www.frbsf.org/publications/economics/papers/2007/wp07-16bk.pdf).  Indeed, the latest Blue Chip survey reports that economic forecasters assess the odds of a recession at around 40 percent.

In 2004 and 2005, headline price inflation was boosted by the effects of higher energy costs.  The recent jump in crude oil prices will again push up overall inflation; however, we anticipate little pass-through to other prices.  Indeed, we anticipate that core PCE price inflation will remain below 2 percent through next year.

Last month, the FOMC announced a new communications strategy involving expanded and more frequent economic projections.  This new strategy is not a change in the way to conduct policy; instead, it is an enhanced means of communicating policy. The genesis of this new communications initiative occurred 1-1/2 years ago when Chairman Bernanke asked Federal Reserve Board Vice Chairman Kohn and Federal Reserve Bank Presidents Stern and Yellen to help organize a wide-ranging review of FOMC communication policies.  One of the resulting initiatives, an enhanced role for public FOMC economic projections, was unveiled last month.  Specific numerical forecasts of the FOMC participants, which were collected at the time of the October 30-31 FOMC meeting, were released with the minutes of that meeting on November 20.

Given the lags in the operation of monetary policy, central bankers have long emphasized the importance of being forward-looking, but in the past, they often communicated to the public very little or very obscurely.  Although the Federal Reserve has published economic projections for almost 30 years, it is only over the past decade or so that a general appreciation of the value of such public central bank forecasts has grown among economists and policymakers.  The new appreciation has been part of a veritable revolution in central bank communications, so central bankers often expound on the importance of transparency—most fittingly in new or more frequent central bank Monetary Policy Reports, press conferences, and speeches.

Communicating the Fed’s views about where it thinks the economy is likely to go in the future can help inform the public about the Fed’s monetary policy strategies and objectives, such as a preferred range for the future rate of inflation, the Fed’s assessment of the near-term economic outlook, and the Fed’s view about long-run aspects of the economy, such as the natural rate of unemployment.  With such information, households and businesses can make better-informed economic decisions.  Financial market participants also will be better informed about what the Fed is expecting, so they can respond appropriately to incoming data even before the next scheduled policy meeting.  More generally, the added transparency of public central bank forecasts can foster greater accountability and hence legitimacy.

There are a variety of new features of the enhanced FOMC projections.  The forecasts will be more frequent, four times a year instead of two.  The forecast horizon will be longer, about three years ahead instead of two.  A forecast for overall PCE price inflation will be added to the existing forecasts for real GDP growth, the unemployment rate, and core PCE price inflation.  The forecast summary will include a discussion of the key factors or influences shaping the FOMC outlook.  The summary will also include a discussion of the risks to the economic outlook, including a qualitative assessment of the amount of uncertainty and the balance of that uncertainty around the forecast.  Finally, the dispersion of views among the FOMC participants will be detailed.

The projections from the October 2007 FOMC meeting have a number of interesting features.  First, the 2008 central tendency of the FOMC real GDP growth forecasts is consistent with a slowdown in economic growth over the next few quarters.  Furthermore, most participants judged that there was greater uncertainty around their growth projections than suggested by the average historical uncertainty and that this uncertainty was weighted to the downside.  However, the subpar economic growth was not expected to persist, and by 2010, the FOMC viewed the economy as likely to grow at a sustainable pace, which appeared to have been estimated to be about 2-1/2 percent. 

Likewise, the unemployment rate is expected to settle in at an estimated natural rate of around 4.8 percent. 

Finally, both core and overall inflation are expected to remain well contained going forward, converging to about 1-3/4 percent at the end of the forecast horizon.