FRB SF: The Economic Outlook

John Fernald of the San Francisco Fed gives his view of the economic outlook. The bottom line?:

The relatively strong incoming data suggest that growth in the second quarter was close to trend, after two anemic quarters. Going forward, the continuing and, indeed, intensifying pressures from housing, credit markets, and commodity prices, are likely to weigh on activity for some time. However, the fiscal stimulus program should help support growth in the current quarter.

A more solid recovery should take root in 2009, reflecting some waning of the drags on the economy. In particular, housing should begin to stabilize; credit conditions should gradually ease; and energy and food prices are expected to level off. In addition, the earlier policy easing by the Federal Reserve should provide some cushion for the economy.

Here are more details. I suspect some of you will view the inflation forecast - the third graph from the bottom - with suspicion:

FedViews, by John Fernald, FRBSF: Housing and credit markets remain troubled, and commodity prices have risen further. These factors are likely to weigh on the outlook for some time. In addition, reflecting surging food and energy prices, inflation is an increasing concern.

Housing wealth has continued to plunge, with home prices down sharply over the past year. The Case-Shiller ten-city home-price index has fallen about 15 percent over the past year and about 20 percent since its peak. The futures market on this index suggests that prices have considerably further to fall before leveling off.

Inventories of both new and existing homes—measured as the supply of homes on the market relative to the current monthly sales pace—are very high. Falling prices and an overhang of home supply are a drag on new home construction.

Mounting losses on securities tied to sub-prime and other mortgages helped spark the ongoing financial turmoil and financial market stress still remains high. In general, risk-adjusted interest rates on private debts remain at, or above, their levels from last summer, despite substantial reductions in the federal funds rate and resulting declines in rates on Treasury securities.

Business surveys do not suggest a major deterioration in overall conditions. For example, the Institute for Supply Management surveys purchasing and supply executives each month. For both manufacturing and non-manufacturing, these diffusion indices are currently close to 50, which is below their typical values. Hence, current readings appear consistent with slightly below-trend growth.

In contrast, falling employment suggests more deterioration in economic conditions. Over the past year, employment in goods-producing industries (mainly construction and manufacturing) has fallen about 3-1/2 percent. In previous recessions, job losses have always been more severe than we’ve seen so far. Employment growth in services-producing industries has slowed, but employment remains above its year-ago level.

Through February, household spending appeared quite weak. For example, the year-over-year growth rate of non-durables consumption—a category that includes food, apparel, and gasoline—had slowed to levels comparable to the 2001 recession. The non-durables category omits the purchases of durable goods, which tend to be volatile, as well as services, where the monthly data are likely to be less reliable.

Since March, however, consumer spending has bounced up notably. Some of the bump-up in May presumably reflects the effects of the $50 billion in stimulus checks that were delivered that month. Although it is possible that the increases in March and April reflected consumers spending early—knowing that they would soon be receiving a stimulus check—it could also reflect resilience on the part of consumers.

Vehicle sales have plummeted in recent months, reflecting gasoline prices that have risen above $4/gallon as well as tighter credit conditions.

Business capital investment spending is holding up. Orders and shipments for non-defense capital goods excluding aircraft—i.e., durable equipment goods—have been edging steadily up over the past year and a half. Some of that strength appears to reflect exports of capital goods in addition to domestic capital formation. Exports, in general, have been a source of strength for the economy.

The relatively strong incoming data suggest that growth in the second quarter was close to trend, after two anemic quarters. Going forward, the continuing and, indeed, intensifying pressures from housing, credit markets, and commodity prices, are likely to weigh on activity for some time. However, the fiscal stimulus program should help support growth in the current quarter.

A more solid recovery should take root in 2009, reflecting some waning of the drags on the economy. In particular, housing should begin to stabilize; credit conditions should gradually ease; and energy and food prices are expected to level off. In addition, the earlier policy easing by the Federal Reserve should provide some cushion for the economy.

Soaring food and energy prices have pushed up overall consumer inflation. With the recent surge in energy prices, headline inflation is likely to spike further before coming down. Core inflation has been better contained, but has still been running a bit high. Some pass-through of input costs for energy and transportation, as well as increases in non-fuel import prices, is likely to put continued upward pressure on core inflation.

Assuming that commodity prices will level off, as implied by the futures markets, core as well as headline inflation should moderate next year, as more slack in labor and product markets emerges.

A risk to the inflation forecast is that inflation expectations could rise. Such an increase could lead to a wage-price spiral, in which workers demand wage increases in an attempt to cover their increased living expenses, and firms grant these wage increases in the expectation that they can pass on those costs by raising their own prices.

Have inflation expectations risen? The Michigan survey of households shows higher long-term inflation expectations. However, there is some evidence that the Michigan survey responses are highly sensitive to the current inflation rate, so it is likely that this measure will come down once oil and food prices stop rising. In contrast, the Survey of Professional Forecasters sees the same long-term inflation trend as they’ve been seeing since the late 1990s. And inflation compensation five-to-ten years out, derived from a comparison of nominal and inflation-indexed government securities, has come down from its highs earlier this year.

Since last month, markets have pared back expectations about the pace of monetary-policy tightening. A month ago, markets thought the federal funds rate would rise steadily over the course of 2008. They now expect only one rate increase this year.