February 21, 2008Kevin L. Kliesen 1 The Outlook for the U.S. Economy Professors Conference, Federal...

February 21, 2008 Kevin L. Kliesen 1

The Outlook for the U.S. Economy

Professors Conference,Federal Reserve Bank of St. Louis

St. Louis, Missouri February 21, 2008

Kevin L. KliesenEconomist

Not an official document


Outline of Talk

1. The Fed’s Operating Strategy

2. The Big Picture and Current Developments

3. What Do the Recession Indicators Say?

4. The Near-Term Consensus Forecast

5. Risks to the Outlook


Disclaimer


Release Date: January 30, 2008

For immediate release The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.


• From the Fed’s perspective, the big picture is an assessment of where:

1. The economy currently is relative to its potential; and

2. Current inflation is relative to what is expected over the near-term and over the longer-term.

The Big Picture


• First, the economy relative to its potential:

Real GDP Growth: Actual & Potential Percent Change at an Annual Rate

0

1

2

3

4

5

6

2006-Q1

2006-Q2

2006-Q3

2006-Q4

2007-Q1

2007-Q2

2007-Q3

2007-Q4

The Big Picture

NOTE: Potential GDP measured by the Congressional Budget Office.


• Second, inflation relative to expectations.

NOTE: Shaded area is the FOMC’s central tendency forecast for PCE and core PCE inflation in 2010.

The Big Picture

The FOMC's Preferred Inflation Range for 2010 and the Overall and Core PCE Inflation Rate

Inflation Measured as 12-Month Percent Changes

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08

Overall PCE Inflation Core PCE Inflation


• The Fed operates in a data dependency framework. Also called “risk management.”

• Two key aspects of this approach to policymaking are worth noting:

– Policymakers give higher weight to low-probability damaging outcomes, than to lower probability, less damaging outcomes. (Bayesian)

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

Risk Management


Recent Economic Developments.1. The U.S. labor markets deteriorated sharply, and

unexpectedly, in January.2. A key measure of economic activity in the

nonmanufacturing sector fell sharply in January.3. Factory orders and shipments were unexpectedly strong

in December. Exports a source of strength.4. Auto sales weakened in January; non-auto retail sales

rose unexpectedly, but . . . 5. Housing sales, construction and prices appear

uniformly weak. 6. Banks still lending, but tightening standards and terms.7. Financial market strains improve in some areas.8. Fiscal stimulus package passes, but how important?9. Recession probabilities on the rise.


Recent Economic Developments


Recent Economic Developments

Tracking Data Releases Relative to Expectations

-28

-24

-20

-16

-12

-8

-4

0

4

8

7/1/07 9/2/07 11/4/07 1/6/08 3/9/08

2.50

3.00

3.50

4.00

4.50

5.00

5.50

The FOMC's Intended Federal Funds Target Rate and the Real Net Tracking Indicator, July 2007-Present

Correlation coefficient: 0.85

Fed Funds

Indicator

-28-24-20-16-12

-8-4048

1/9/08 1/23/08 2/6/08 2/20/08 3/5/08 3/19/08

2.50

2.75

3.00

3.25

3.50

3.75

4.00

4.25

4.50

The FOMC's Intended Federal Funds Target Rate and the Real Net Tracking Indicator for 2008:Q1 Data


Recession Probability in the Next 12 Months According to WSJ Forecasters

0%

10%

20%

30%

40%

50%

60%

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Dec-07

Mar-08

Jun-08

Feb. 2008


What are the Recession Indicators Telling Us?


Probability of Recession from Markov-Switching Model with Employment Data

0

0.2

0.4

0.6

0.8

1

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Last Observation: Jan. 2008Source: Haver/BLS, author's calculations.

Payroll

Household

21%


Probability of Recession from Markov-Switching Model with Leading & Coincident Indexes

0

0.2

0.4

0.6

0.8

1

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Recession Coincident LeadingLast Observation: Dec. 2007.Source: Haver/Conference Board, author's calculations.

53%

11%


18%

-0.25

0.00

0.25

0.50

0.75

1.00

1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Hamilton's Markov-Switching Recession Probability Estimate


Results from a Forward-Looking Probit Model (i.e., estimating the probability of a recession over the following four quarters)

The model uses the term structure (3-mo Treasury-bill less the 10-year Treasury note) and the nominal federal funds rate.

• Estimates from March 2007 (using data through 2007:Q1); probability of the economy being in a recession in 2008:Q1: 58%

• Estimates from February 2008 (using data through 2007:Q4); probability of the economy being in a recession in 2008:Q4: 9%


Inventory to Sales Ratio: New and Existing Single-Family Homes

2.0

4.0

6.0

8.0

10.0

12.0

1999 2001 2003 2005 2007

New Existing

SOURCES: U.S. Bureau of the Census and the National Association of Realtors.

Dec.

Dec.

500

800

1100

1400

1700

2000

1985 1988 1991 1994 1997 2000 2003 2006

Actual Average, 1985-2006 Average, 1997-2006

Single-Family Housing StartsThousands of units, SAAR

Dec. 2007

Case-Shiller/S&P 10-City Composite House Price ChangesPercent change from 12 months earlier

-10

-50

5

10

1520

25

1988 1991 1994 1997 2000 2003 2006

Data are through November 2007.


SOURCE: Blue Chip Consensus Forecast

-1

0

1

2

3

4

5

6

7

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08

Forecast Month

2008 Forecasts for Nominal Corporate Profit GrowthPercent


Recent Price and Wage Developments.1. Inflation in 2007 was 3.5%, the highest in 17 years!

2. Ex food and energy, though, inflation was about the same as last year (about 2.25%).

3. Nonpetroleum import prices rise 3% in 2007, largest increase in three years.

4. Commodity prices surging. $12 per bushel soybeans, $10/bushel wheat and nearly $5 per bushel corn!

5. Crude oil prices still remain high and fairly volatile.

6. A bright spot: Productivity and unit labor costs improved markedly in 2007 (vs. 2006).

7. Inflation expectations—a mixed bag.


Chairman Bernanke’s View

At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.

At the same time, overall consumer price inflation should moderate from its recent rates, and the public's longer-term inflation expectations should remain reasonably well anchored.


5-Yr, 5-Yr Forward Breakeven Inflation Rates

2.00

2.20

2.40

2.60

2.80

3.00

3.20

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

Board Constant Maturity


Actual CPI Inflation and Short- and Long-Term Inflation Expectations: Survey of Professional ForecastersPercent

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1991 1993 1995 1997 1999 2001 2003 2005 2007

1-Yr Forecast 10-Yr Forecast

2008:Q1


Mean Probability Attached to Core PCE Inflation: Survey of Professional ForecastersPercent

0

10

20

30

40

50

60

Less than 2% More than 2%

07Q4 TO 08Q4 08Q4 TO 09Q4


1. Economic growth looks to be fairly weak over the first half of the year—well below trend growth.

2. As far as a recession goes . . . It’s a coin toss.

3. Price pressures may moderate if growth remains weak for a few quarters, but no guarantees (Plosser).

4. Further declines in the dollar, continued strength in commodity prices, a seasonal upturn in oil prices, and an over aggressive easing all have the potential to keep inflation above the Fed’s preferred range.

The Near-Term Outlook



Real GDP Growth Forecasts, 2008-2009

0.6

4.9

-1

0

1

2

3

4

5

6

2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3 2008:Q4 2009:Q1 2009:Q2 2009:Q3 2009:Q4

Global Insight SPF Blue Chip Potential (CBO)



CPI Inflation Forecasts, 2008-2009

4.3

1.9

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3 2008:Q4 2009:Q1 2009:Q2 2009:Q3 2009:Q4

Global Insight SPF Blue Chip



2007 2008 2009 2010

Central Tendencies Real GDP Growth ? Oct. 2007 Projections 2.4 to 2.5 1.8 to 2.5 2.3 to 2.7 2.5 to 2.6 June 2007 Projections 2¼ to 2½ 2½ to 2¾

Unemployment Rate ? Oct. 2007 Projections 4.7 to 4.8 4.8 to 4.9 4.8 to 4.9 4.7 to 4.9 June 2007 Projections 4½ to 4¾ about 4¾

PCE Inflation ? Oct. 2007 Projections 2.9 to 3.0 1.8 to 2.1 1.7 to 2.0 1.6 to 1.9 Core PCE Inflation ? Oct. 2007 Projections 1.8 to 1.9 1.7 to 1.9 1.7 to 1.9 1.6 to 1.9 June 2007 Projections 2 to 2¼ 1¾ to 2

Table 1: Economic Projections of Federal Reserve Governors and Reserve Bank Presidents1


1. Spillovers from the housing downturn spread to the consumer and deepen.

2. Consensus forecasts does not assume a recession.

3. Fiscal and monetary stimulus boost economic growth by more than expected, boosting long-run inflation expectations even higher.

4. Foreign economic growth weakens.

Risks to the Outlook


Questions?

February 21, 2008Kevin L. Kliesen 1 The Outlook for the U.S. Economy Professors Conference, Federal...

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