the outlook for the u.s. economy “turmoil vs. stability: the fed’s response” conference for...

The Outlook for the U.S. Economy

“Turmoil vs. Stability: The Fed’s Response” Conference for College Teaching Faculty

Federal Reserve Bank of St. LouisSt. Louis, MO

November 6, 2008

Kevin L. KliesenEconomist

Federal Reserve Bank of St. Louis

November 6, 2008 Kevin L. Kliesen

Outline of Talk

Analyzing the Economy -- The Basics

The Big Picture and Current Developments

The Fed’s Strategy . . . And Dilemma

The Near-Term Forecast

Risks to the Outlook


DISCLAIMER


The Basics

Analyzing current U.S. macroeconomic conditions requires some “model.” Here’s a simple one:

1. Over time the economy grows at its trend, as determined by real factors.

2. Shocks cause the economy to fluctuate around the trend. Shocks are temporary, but can have permanent effects.

3. Inflation is ultimately determined by Fed actions and expectations; some use NK models.


The Basics of Fed Policy

The Fed operates under a “risk management” framework.

1. The evolving flow of data inform near-term risks to the economic outlook and, if necessary, policy responses.

Two key aspects of this “probabilistic” approach:

1. Policymakers worry a lot about the potential for damaging economic outcomes.

2. Continual updating of “best guess” scenario for the economy as more information becomes available.



FOMC Federal Funds RatePercent

0.00

1.00

2.00

3.00

4.00

5.00

6.00

11/1/07 2/1/08 5/1/08 8/1/08 11/1/08



Central Bank Policy RatesPercent

0.00

1.00

2.00

3.00

4.00

5.00

6.00

11/1/07 2/1/08 5/1/08 8/1/08 11/1/08

U.S. Canada ECB UK


The Big Picture


The Big Picture

• Dramatic interventions by U.S. and European central banks and governments.

• Financial market volatility has been extremely high.

• Inflation seems to be moderating . . . helped along by several factors.

• Near-term economic growth will be extremely weak in most major economies.


Current Developments

Prices and Inflation Expectations



Headline inflation has retreated markedly over the past two months.

Energy and commodity prices stage a retreat. But for how long?


Percent change in Prices since Peak:-56.0%-28.7%

Oil Prices:Commodity Prices:

Crude Oil Prices($/barrel)

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

140.0

150.0

1/2/08 3/2/08 5/2/08 7/2/08 9/2/08 11/2/08

CRB Commodity Price Indexes(Index, 1967 = 100)

325

350

375

400

425

450

475

500

7/2/07 10/2/07 1/2/08 4/2/08 7/2/08 10/2/08




Energy and commodity prices stage a retreat.

Also helping matters . . . Inflation expectations, a stronger dollar, and a slowing in global growth (more on this later).


CPI Inflation, Sept. 2007 to PresentPercent change for period indicated

-4-202468

10121416

Sept. 2007 Dec. 2007 Mar. 2008 Jun. 2008 Sept. 2008

1-Month 12-Month




-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2006-Q1 2006-Q3 2007-Q1 2007-Q3 2008-Q1 2008-Q3 2009-Q1 2009-Q3

Inflation (CPI): Actual, Forecasted, and Long-Run ExpectationsPercent change at an annual rate

NOTE: Inflation expectations measured by the Survey of Professional Forecasters.

Forecast

Actual

Expectations




Energy and commodity prices stage a retreat.

Also helping matters . . . Inflation expectations, a stronger dollar, and a slowing in global growth (more on this later).

Falling energy and commodity prices will provide some relief to consumers and businesses.

Don’t expect a 1930s-style deflation!


Recent Developments


Q3 Real GDP Growth

-0.3

-3.1

-5.6

5.8

-1.9

5.9

0.7

-8

-6

-4

-2

0

2

4

6

8

GDP Consumption Investment Government Imports Exports Inventories

Percent

NOTE: Inventory investment expressed as contribution to real GDP growth.

Q3 Growth was the weakest in 7 years)


Actual & Potential Real GDP Growth

-0.25

0.05

-1

0

1

2

3

4

5

2007:Q1 2007:Q2 2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3

Percent

NOTE: Inventory investment expressed as contribution to real GDP growth.

Potential


Consumers Pull Back

Oil Shock!

-250

-200

-150

-100

-50

0

50

100

150

200

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

Monthly Changes in EmploymentThousands of Jobs

Oct. Forecast370

375

380

385

390

395

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Sales Gasoline

Real Retail Sales and Gasoline PricesBillions of $ Cents/gallon

Oct.


Growth of Business and Household Fixed Investment in 2008-Q3 vs. 2008-H1

(Q3) (H1)Nonresidential -1.0 2.4 Equip. & Software -5.5 -2.8 Industrial -10.6 -1.4 Transportation -50.9 -32.2

Structures 7.9 13.4

Residential -19.1 -19.4

Businesses becoming reluctant spenders.

Profits wane; equity cost of capital high.

Industrial and office vacancy rates turning up.

Business Spending Softening


Industrial Production

106

107

108

109

110

111

112

113

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Index of Industrial Production

2002 = 100

Car & Light Truck Production52-week totals

14.00

14.50

15.00

15.50

16.00

16.50

17.00

6/1/2007 10/1/2007 2/1/2008 6/1/2008 10/1/2008

Light Veh.

IP fell 2.8% in September. However, without the strike at Boeing and Hurricanes Gustav and Ike, IP would have been about unchanged in September. Manufacturing capacity utilization in September (76.4%) was the lowest since October 2003.



The largest countries in Europe appear to be in recession, or headed there, as does Japan. Major European central banks cut their interest rate target on the same day as the Fed did (Oct. 8).

European Industrial Production

103.0

106.0

109.0

112.0

115.0

2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2

NOTE: Last observation is 2008:Q3

European Economic Sentiment

75.0

85.0

95.0

105.0

115.0

2005-Q4 2006-Q2 2006-Q4 2007-Q2 2007-Q4 2008-Q2

NOTE: Last observation is 2008:Q3


And Then There’s Housing!

Housing . . . Looking for the light at the end of the tunnel.

No bottom in house prices yet; economists and housing analysts say 2009 . . . maybe.

Nationally, home prices are down about 10% over the past year; considerable variance across regions, though.

Inventories of unsold homes too high; Mortgage market not helping; Some indication that home sales are stabilizing.


Housing Developments

4000

4250

4500

4750

5000

5250

5500

5750

6000

6250

6500

2005 2006 2007 2008

September

Existing Single-Family Home SalesThousands of units

SOURCE: U.S. Bureau of the Census.


Housing Developments

Real GDP Growth and Housing's ContributionPercentage Points

Real GDP Housing

Real GDP ex Housing

2006 - Q1 4.82 -0.23 5.052006 - Q2 2.68 -1.11 3.792006 - Q3 0.80 -1.40 2.202006 - Q4 1.50 -1.18 2.682007 - Q1 0.05 -0.91 0.962007 - Q2 4.79 -0.60 5.392007 - Q3 4.76 -1.06 5.822007 - Q4 -0.17 -1.33 1.162008 - Q1 0.87 -1.12 1.992008 - Q2 3.28 -0.62 3.902008 - Q3 -0.25 -0.72 0.47

Average 2.10 -0.93 3.04



Recent Financial Market Developments



Current episode

Peak-to-Trough Declines in Stock Prices During Recent Episodes

-48%

-20%

-49%

-34%

-46%

-27%

-60%

-50%

-40%

-30%

-20%

-10%

0%

1973-1975 1980-1982 1987 1990-1991 2001 2007-2008



Volatility in the Stock Market has been incredible!

Daily Percent Change in Stock Prices and their Average Volatility Over the Past 10 YearsPercent

-15

-10

-5

0

5

10

15

Jun 1 2007 Aug 142007

Oct 252007

Jan 9 2008 Mar 252008

Jun 5 2008 Aug 182008

Oct 292008

Last Obs.: Nov. 3, 2008



One Problem: Volatility in the Stock Market has been incredible!

In the face of extreme volatility, households and businesses disengage—focusing on the here and now because planning for the future is very difficult.

One explanation: Uncertainty about the direction of the

economy.

Another explanation: Uncertainty about the health of the financial

sector—the “lemons problem.”



Another Problem: The Credit Market Disturbance!

Liquidity risk and credit risk. Negative feed-back loops (Bernanke).

Bank are tightening lending standards, but lending is not contracting. More difficulties in the non-bank lending markets (e.g., commercial paper).


3/17/08

Collapse of

Bear Stearns

8/9/07

BNP

Paribas

9/14/07

Northern

Rock Crisis

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Aug06

Oct06

Dec06

Feb07

Apr07

Jun07

Aug07

Oct07

Dec07

Feb08

Apr08

Jun08

Aug08

Oct08

9/15-16/08

Lehman-AIG

The Libor-OIS Yield Spread and Key Market EventsPercentage Points

10/13/08

Global Capital

Injections


A huge increase in bank lending over the past three months—or is it?

According to the Board of Governors, large domestically chartered commercial banks acquired $259.2 billion in assets and liabilities of nonbank institutions in the week ending October 1, 2008.

Growth of Bank LoansY-O-Y 3-Months

C & I: 10.8 31.3 Consumer: 15.3 25.1 Real Estate: 10.3 13.3

NOTE: date through Oct. 22, 2008

Bank Lending Since January 2008Index, Jan. 2, 2008 = 1.0

0.99

1.01

1.03

1.05

1.07

1.09

1.11

1/2/08 3/2/08 5/2/08 7/2/08 9/2/08

C&I Loans (left) Consumer Real Estate



How Did We Get Into This Mess?

Public policies—Bi-partisan goal of increasing home ownership; low-cost of credit.

Securitization—willing lenders, borrowers, and investors (the search for high yield in an environment of unusually low risk premiums).

Wrong assumptions about house prices.

Bad timing—an oil shock and the housing bust.


The Fed’s Strategy


1.Reduce the FOMC’s interest rate target . . . It is currently at 1.5% (as of Tuesday, Oct. 28)

2.Increase funds available to banks and financial institution to support borrowing and intermediation?

The Fed’s Response


Summary of Fed Lending Facilities



700

800

900

1000

1100

1200

1/5/05 10/5/05 7/5/06 4/5/07 1/5/08 10/5/08

High-Powered Money: The Adjusted Monetary BaseBillions of Dollars

Growth:Jan. 5, 2005, to Sept. 10, 2008: 11.5%Sept. 10, 2008 to Oct. 22, 2008: 35.6%


The Near-Term Forecast


Forecast

Are We in a Recession? If it walks like a duck, and quacks like a duck . . .

A 90% Recession Probability in the Next 12 Months According to WSJ Forecasters!

0%10%20%30%40%50%60%70%80%90%

100%

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08


Forecast

Real GDP Around Business Cycle Peaks, 1973-75 to Present

96

98

100

102

104

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Avg. Peak

An “Average” Profile of the Past Four Recessions.

Over the past four recessions, the average decline in real GDP is about 0.75%.

The average decline lasts about 2 quarters.


Forecast


96

98

100

102

104

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Avg. Current (Consensus) Peak

The Consensus forecast: A short, shallow recession.


Forecast


96

98

100

102

104

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Avg. Current (Optimistic) Peak

The Optimistic forecast: No recession.


Forecast


96

98

100

102

104

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Avg. Current (Pessimistic) Peak

The Pessimists’ forecast: A deeper, longer recession than normal.

November 6, 2008 Kevin L. KliesenSOURCE: OECD, August 2008

Real GDPGrowth

ResidentialFixed Inv.Growth

HousePrices

Short-termReal InterestRates


What are Some Key Risks to the Outlook?

Difficult to forecast in an environment of uncertainty.

If equity prices continue to decline, the outlook for consumer and business spending will worsen.

By contrast, a rapid V-shaped recovery with a lot of monetary stimulus in the pipeline is worrisome.

FY 2009 budget deficit may exceed $1 Trillion!

Forecast


QUESTIONS?

the outlook for the u.s. economy “turmoil vs. stability: the fed’s response” conference for...

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