Feras Zarea

Professor Veronika Dolar

Federal Research Paper

12/19/15

The United States’ economic activity has been soaring as of late. The numbers might not be sky high, but they do indicate respectable signs of sustainable growth in the economy. While this might be milder than previous recoveries have been, the numbers show that the economy has nonetheless recovered. The most effective method to track an economy is to check its indicators after they have been adjusted for inflation. Real GDP (Figure 1) has increased steadily over the past 5 years. And since GDP is the chief indicator for judging an economy, we should segment it to its components and see where the positives and negatives are; starting by consumption.

By looking at Figures 3 A and B, which depict the real personal consumption expenditure, we can see real consumption in the economy. Consumption compiles roughly 2/3 of GDP; making it the most important component. Prior to the 2008-2009 recession, also known as “The Great Recession”, real consumption has increased steadily by 2% to 3.5%. However, starting in mid-2007, the growth rate of consumption seemed to halt. And towards the end of 2008, consumption started falling, the growth rate reaching -2.4%. Thankfully, after the all-decade-low of -2.67% in June 2009, consumption started increasing steadily again. And in 17 months, the percent growth of real consumption reached 3.23%. Real consumption has been steadily increasing in the past 5 years, Real consumption increased from almost $10 trillion a year to over $11.3 trillion in the past five years. In the time spanning March 2011- July 2015, the growth rate stood between 1% and 3.7%.  Moreover, starting in August 2014 and ending in September 2015 consumption consistently increased by over 3%. Finally, the current problem is that real consumption growth has, in accordance to the latest information dating October 2015, fell under 3%.

The second component of Real GDP is Real Investment; depicted in Figure 4, titled “Percentage Change in Real Gross Private Domestic Investment”. Investment is the most volatile part of the GDP, meaning it’s the quickest to respond to economic shocks. Therefore, real investment will aid us in tracking the economic conditions of the country. Investments approached 5.7% in 2006. However, by 2007, they reached fell to -4.9%; and by 2009, fell to -26.4%; falling from almost $2.7 trillion to $1.8 trillion. Such a regression is strikingly quick. And it probably has a lot to do with the housing bubble bursting. But, in 2009, investments started increasing exponentially, and within a year business investments increased by 47.5% to

21.1% in 2010. And by 2012, the investment growth rate fell to the pre-recessionary levels. And since Q4 2012, the percentage change has stood between 1.9% and 7.6%.  However, while the growth rate of investment has averaged 5.05% in the past 12 quarters, the real gross private domestic investment only surpassed the pre-recessionary high of $2.77 trillion in Q4 of 2014; with the most recent estimates putting it at $2.86 trillion.

The third component of GDP is government spending. Real Government spending (adjusted for inflation) is depicted in Figure 5, labeled “Real Government Consumption Expenditures and Gross Investment”. Government spending is different from consumption and investment in that it largely maintained growth up until the end of recession, and only began to decrease after the recession. In only 2 years, Q3 2005, till Q3 2009, real government spending increased from $2.84 Trillion to $3.1 trillion; a growth ray that  averages 4.55% per year. It was not until Q3 2010 that government spending started dropping. And by the final quarter of 2013, government spending was for the first time lower than the pre-recession low of $2.84 trillion. Moreover, in the past 2 years (Q4 2013 – Q3 2015), Government spending has roughly averaged 2.843 trillion, roughly matching the pre-recession low of 2.84.

The final major component of GDP is the net exports in the United States. Net exports (Figure 6) are typically negative, as the United States imports more than it exports. For the 5 quarters dating from Q3 2005 to Q3 2006, real net exports averaged -$799.88 billion. By looking at their percentage changes (Figure 7), real imports and real exports have both trended through similar paths. However, real imports fluctuated more than real exports. In Q1 2007, the growth percentages of real imports and exports were 3.9% and 7.9% respectively. And real exports were still increasing going into 2008. However, they both eventually crashed; and, in respect to their decade-low growth rates, real imports fell by a larger margin. In Q2, 2009, real imports reached negative 18.6%, while the real exports fell to minus 14%. This shows that the two growth rates both respond to economic conditions in a similar manner. Such a statement is strengthened by studying the similar rises they experienced in the next year; as, in Q3 2010, real imports and real exports increased by 16.4% and 13.6% respectively. They started falling, however, and towards the end of 2011, up until the latest quarter, the growth rate has been sitting between negative 0.1% and positive 6.5% for imports, and between positive 1.2% and 4.2% for real exports. Net exports do show that the economy is stabilizing and recovering, as net exports are falling to pre-recessionary levels.

In order to indicate how the changes in the economy are affecting the consumer, we should look at the GDP per capita (Figures 2 A and B). From 2005 to 2008, GDP per capita has fallen by 3 percent. However, starting mid-2007, it fell by roughly 6%, meaning the average person’s income fell by over $2,000 a year. GDP per capita, however, started increasing towards the end of the recession (almost 7% in less than a year), and currently stands at $51,018; the 10-year low was $46,781. Moreover, by averaging the per capita growth of the past 20 quarters (Q3 2010-Q3 2015), we can see that GDP per capita has increased by 1.36%.

By looking at the components of GDP, we can see that the economy is growing. However, there is a limit to what GDP, on its own, can explain to us. And there are many other indicators that must be analyzed to envision what direction the economy will walk through and what caused previous shocks in the economy. And a good way to understand how individuals are functioning is by looking at the labor force; specifically the unemployment in the economy. The labor market is where those who look for jobs interact with those who are offering ones The

main two indicators looked at for analyzing unemployment are The U3 rate, gives us a good indication of how the labor force is doing, and the U6 rate, which helps us understand the efficiency of those employed. One of the Federal Reserve’s dual mandates is to achieve maximum employment; therefore, tracking the unemployment rate is integral.

Figure 8 displays both the U3 and U6 unemployment rates in the country. The U3 rate is the officially accepted unemployment rate. And in the years preceding the recession, the U3 unemployment rate sat in the 4.5% to 5% range; while the U6 rate, which includes part-time and discouraged workers, sat between 7.9% and 8.4%. However, in December, both the U3 and U6 unemployment rates started increasing. And, in June 2009, the end of the recession, the U3 and U6 unemployment rates increased to 9.5% and 16.5% respectively. Over the years dated 2009-2011, the unemployment rate averaged the highest pace of the recorded data; with the U6 rate staying over 15% and the U3 rate approaching 10% unemployment. Luckily, both rates gradually started falling, and the U3 unemployment rate is back to the 5% range of natural employment. The U6 rate, however, still stands above the pre-recessionary levels; and is currently almost 10%. Figure 8 demonstrates that the gap between the U3 unemployment rate and the U6 unemployment rate is larger than it previously was. And the high U6 rate indicated that the efficiency of workers is lower than it could be in the economy. Moreover, even though the U3 unemployment rate is low, we should look at the labor force participation rate to better comprehend why the unemployment rate is low.

Prior to the recession, the Labor Force Participation Rate (Figure 9) was sitting near 66%; and this continued through the first recessionary year. However, starting in October 2008, the labor force participation rate started falling. And, disregarding few minor surges, the labor force has been shrinking ever since. Additionally, within 7 years (Oct 2008-Nov 2015), the labor force participation rate has fallen by 3.5%. And this shows that the low unemployment rate could is in part due to individuals leaving the workforce. The lower participation rate does show that discouraged workers are, in fact leaving the workforce, thereby increasing the U6 rate. We must understand, though, why workers are leaving the labor force, as they might not be as a result of a bad economy.

According to John C Williams, the president of the San Francisco Federal Reserve, the reasons the labor force participation rate is going down could be due to baby boomers retiring and people living longer. The participation rate counts everyone older than 16, and millennials prefer extending their education instead of working. Williams adds that those who were working are returning back to school.

Falling oil prices should be noted too when analyzing what the Fed’s next move should be, as the prices have a positive impact on American consumers; making them feel richer. Saving on the price of filling up their cars leads to consumers feeling richer; as they will be able to make more purchases with their same salary; leading to consumer confidence rising. This will lead to more consumption. And the high consumption rate is a motivating force for business investments to increases too and, therefore, two main components of GDP; consumption and investment, both increase.

Figures 10 A and B show the price of oil in the past 10 years. Oil prices have fluctuated heavily in the past decade. And in the years prior to the Great Recession, crude oil prices have maintained a price of $58-$75 per barrel. However, in January 2007, when oil prices reached their lowest point of the pre-recessionary period at $58.17 per barrel, prices started surging. And

18 months later, in July 2008, oil prices reached an all-decade high price of $139.96 per barrel. This means that the spike in the prices of oil, which occurred in only 18 months, totaled a 140% increase in price increase. And as a result inflation’s dependability on the price of oil, the CPI year over year (YoY) percentage increase (Figure 11) raised from 1.4% in Oct, 2006, to 5.5% in July 2008; with the YoY percent increase in the price of oil increasing by 96% in comparison to the January 2007 rate of -12.67%. However, after that large spike in oil prices, in mid-2008, at the height of the recession, crude oil prices crashed down. And in only 6 months, in January 2009, oil prices fell to almost 41.73$ (-56.6%). Such a low oil price was short lived, though, as roughly a year later, the first quarter of 2010, the price of oil exceeded $70. And in April of 2011, oil prices reached a post-recession high of $113; 40% higher than the already high previous year. In the three year span of June 2011 – June 2014, crude oil prices fluctuated in the unusually high $80-$120 per barrel range. However, oil prices crashed again; and in January 2015, oil prices fell to $47.79; a 60% decline from the previous year. And in the past year, oil prices fell even further; currently at an all-decade-low of only $37.64.

What must be of note for the Federal Reserve is that it does not seem as though oil prices will increase soon. Reasons for such an assumption include what is occurring with oil suppliers. The Organization of the Petroleum Exporting Countries, also known as OPEC, has ultimately functioned as a cartel for the past few decades. And OPEC does not want to cut the supply of Crude Oil; which they usually do in order to raise prices. Among the reasons for keeping prices low is to make an emerging supplying competitor’s method, oil fracking, unprofitable and drive its companies out of business. In addition to the trade bans finally being lifted from Iran, thereby introducing a new worldwide oil supplier. However, other main reasons for not cutting the supply of oil are political, and they currently do not serve to aid the Fed in making a decision affecting monetary policy. Therefore, we will not delve into details regarding them.  

The effects of falling oil prices on the US economy are mostly positive. A drop in falling oil prices leads to business investments increasing; which means GDP increases. Moreover, adding investments leads to higher employment. Additionally, even though falling oil prices can be terrible for some American businesses, such as the aforementioned oil frackers, they are mostly positive for the economy; as the US tends to import much more oil than it exports. There is major problem caused by falling oil prices that affects the US economy however, as the inflation rate will fall. And inflation is already extremely low, averaging an almost zero percent change from last year. In a formulaic view, falling oil prices equal falling inflation. And such low prices mean we run a true risk of deflation; as we are already facing severe disinflation.

The second part of the Federal Reserve’s (Fed) dual mandate is inflation. And the most commonly used method to measure inflation is the Consumer Price Index (CPI), exhibited in Figure 11. The CPI mixes a basket of goods commonly purchased by consumers and compares the prices to a base year. There are two main CPI indicators used, “all items”, and “all items less food and energy”; also known as core prices. The measurement of core prices is used as a result of the rapid-fire fluctuations in the price of oil and food product. Starting by the core CPI, we can see that, for the years 2006-mid-2008, core CPI has maintained a growth rate of 2-3%. However, in the middle of the recession (end of 2008), we can see that the core CPI dropped to below 2%. And by 2011, it fell to less than 1%. Thankfully, quickly after that 10-year low, core CPI increased over 2% in mid-2011. In the four to five years since, core CPI has been averaging just under a 2 percent rate. The CPI that includes food and energy, however, has fluctuated much more drastically. And by comparing it with the price of oil, shown in Figures 10 A and B, we can

see that crude oil prices play a major role in order to shape the CPI; thereby oil plays a large part in shaping the inflation rate; Meaning that falling oil prices can play a big part in the economy.

There are many good indicators we can examine in order to understand the economy. And even though we have discussed the main ones, the GDP, the inflation rate, and the unemployment rate, it is much more helpful to analyze different data in order to assess the direction of these main indicators; starting with consumer confidence.

The widely used tracker of consumer confidence is the Michigan Consumer Sentiment Index which can be seen in Figure 12. As a result of it being an index, the actual number is not as important as how the numbers have been changing. Prior to the recession, the Michigan sentiment has fluctuated in the 70 to 100 range. However, starting in mid-2007, right before the recession, the index started free falling; much like most other market trackers. And in less than 2 years, the index fell from being close to 100 to becoming under than 60. This meant consumer confidence fell heavily; and as a result, consumption fell similarly. If we look at the percent change of Real Personal Consumption Expenditures (Figure 3), we can see that the drop in consumer confidence in 2007-2008 led to a similar fall in consumption; and lest we not forget that consumption makes up 2/3 of the GDP.  Moreover, the recovery of consumer confidence also paralleled that of consumption; and, after the Michigan Sentiment fluctuated in the 55-72 point range in the 2008-2009 recessionary years, the consumer confidence increased again. And in mid-2009 to mid-2011, Figure 12 shows that the sentiment was averaging the 65-75 range. And, since the 10 year mid-2011 low, which was said to be caused by low employment numbers, the Michigan sentiment has continually increased; currently residing in the 90+ average again. The high current consumer confidence is most likely directly related to us being near maximum employment; and it aids with the stable increase in consumer spending.

Inflationary expectations are also tracked by the University of Michigan (Figure 13). However, they are not as positive as the consumer confidence is. Inflationary expectations respond quickly to changes in the market; thereby they tend to fluctuate heavily. And the heavy fluctuations of the inflationary expectations make them difficult analyze. However, they do provide a good outline for where the price level is expected to be. Moreover, inflationary expectations help households and firms to understand when they should spend money or save money. The problem with low inflationary expectations is that people will always think that waiting to spend at a later date, where prices will be lower, is better. This, in turn, discourages market activity and leads to complications in the industry. Prior to the recession, inflationary expectations have been relatively constant; ranging between 3-4%. However, inflationary expectations rose from by 1.4% from January 2008 - to May 2008 (from 3.4% to 5.2%). such high expectations were short-lived however, as, by December; expectations quickly fell to 1.4%. But the expectations recovered before there were deflationary expectations, and from May 2009 to December 2010, inflationary expectations ranged from 2-3%. Moreover, expectations rose from 2.2% in September 2010 to 4.6% in March 2011. However, this was short lived, as, by July 2011, inflationary expectations fell to 3.4%. And from August 2011 till August 2014, inflationary expectations ranged between 2.9% and 3.9%. Moreover, in the past year, inflationary expectations fell again, and have been standing from 2.5% and 3.5%. Finally, inflationary expectations currently lie at 2.7%; and the past year involved the lowest expectations since 2010. The current 2.7%, coupled with the low oil prices, means that deflation is a looming threat.

Another good reference for the performance of the US economy is that of the U.S dollar. By referencing Figure 14 (the U.S. Dollar Index), we can see that the dollar constantly fluctuated from 2007-2010. It can be seen that, in the first quarter of 2007, the value of U.S. dollar started depreciating from the index that was averaging the 80s. The weaker USD means that imports will fall and exports will rise; leading to net exports rising.  The U.S Dollar continued to depreciate till the third quarter of 2008; when the index point was almost 70. The USD, however, started appreciating, in July 2008, going back to the 80s by November. In Q2 2009, however, the dollar again began to depreciate again; reaching the low 70s again by the end of 2009. After the dollar fluctuated a bit more in 2010, 2011 marked the only time in the decade where the index fell below 70. The index did start rising gradually, and in 2013-14, it scored index points ranging 75-80 points. In Q3 2014, however, the dollar appreciated severely, most likely as a result of oil prices plummeting. And since February of 2015, the dollar value has been as ranging from 85-95; meaning the dollar is appreciating extremely highly. The currently appreciating dollar means that the U.S. will import more than it exports, and signals to the economy going back to how it used to be previously.

Before we discuss what the Fed’s options are, we should mention what was occurring during the recession that led to setbacks in the economy, starting by the housing bubble. The housing bubble is agreed upon as one of the main reasons the US economy fell into recession. The cause of the bubble is the fact that banks. These banks securitized mortgages combined them. And traded them, which essentially means they put dollar values on mortgage loans, and sold them. The problem was that over time, these loans became riskier, as they were given to people with bad credit; and these high-risk mortgages are known as “subprime”. The banks offered different ways to entice borrowers, such as “teaser rates”. And the banks sold these securities to investors expecting less risky behavior from the borrowers. A major problem was that the credit agencies who assign grades to different mortgages based on riskiness were not practicing their moral rights of making sure the mortgages deserve their high ratings; while the regulators were not efficient enough in stopping them. The reason these banks were not worried over the repayment of debt is that they expected the large growth rate of real estate prices will continue. Moreover, these large scale banks, such as Lehman Brothers, American International Group (AIG) and Bear Stearns tied themselves to real estate prices. The problem, though, was that housing prices rose quicker than inflation and incomes. And the bubble finally burst. This lead to people being forced to default on their mortgage rates; which lead to the banks not having liquidity, putting them in grave danger.

As a result of these large investment firms attaching themselves to real estate prices, the stock market collapsed; as evidenced by Figure 15. In July 2007, the stock market started falling, and over a year later, in October 2008, it fell by almost 40%; driving the great recession. After many different institutions failed, leading to people losing their jobs and most likely their savings, a recovery insured. The Federal Reserve tried everything they could to correct the market; such as influencing the decrease of the Federal Funds Rate (Figure 16). In 2007, the Federal Funds Rate was over 5%. However, the Fed decided that they must decrease it, and they bought enough short-term bonds that the Federal Funds Rate (FFR) dropped to almost 0% in just over a year (by Dec 2008). And even though they committed an act drastic enough to wipe out all its traditional powers, they realized that it was not enough. And the Fed understood that it must now try some non-traditional methods of increasing the money supply; thus the idea of quantitative easing (QE) was born.

The Federal Reserve decided that they must go through all means to stimulate the economy to keep with their dual mandate of keeping prices stable and employment at a maximum; and initiated QE. In short, the Fed decided to buy mortgages (bad securities) to lower the interest on them, And to buy long-term government treasury bonds (they usually buy short term). By doing so, the Fed’s goal was to decrease long term interest rates and to increase asset prices, leading to those affected by the assets to feel richer (wealth effect). This wealth effect leads to both consumption and investment to increase, and therefore aggregate demand (GDP) increases. The U.S. treasury department was forced bailed out large companies that they deemed “Too Big to Fail (TBTF)”. And if they did not bail them out, the belief is that the failure of such large institutions would have been cataclysmic for the economy. Another major reason for the current sustainability of the economy is the many regulations added as a result of the risky behavior of these investment firms; such as the “Dodd-Frank Wall Street Reform and Consumer Protection Act”, which was passed in 2010 in order to lower risk by restricting and regulating bank investments.

Moving towards 2016, the Fed has a big decision to make. “Should the FOMC increase the interest rates?” is a question everyone is asking; as the Federal Open Market Committee (FOMC) has not increased the rates since they dropped them in 2008-2009. Low interest rates mean there is not much lending occurring in the economy. However, before the FOMC decides on what they must do in the next meeting (in only a few days), we must understand what difficulties the economy is facing. A recap of economic conditions shows that Real GDP has been increasing by 2-3% in the past 2 years. GDP’s components are also shifting back to their desired numbers, with real domestic investment and real consumption rising, Government spending declining, and real net exports falling (signals of a booming period). Moreover, in order to focus on the dual mandate, we must look at the unemployment rate and the inflation rate. the unemployment rate is near the natural level of 5%; albeit the U6 rate is still high, meaning both that there are more discouraged workers in the country than would be liked, and employees are not being used to their full abilities. Additionally, the inflation rate is extremely flat and inflationary expectations are low; as the economy is moving from the current state of disinflation to the looming threat of deflation.  Consumer confidence is high; and the stock market is booming; with the federal funds rate being near 0%. Finally, negative foreign indicators, such as China’s sluggish growth, and the deadly Paris attacks, discouraged the FOMC from increasing the interest rates in the past meeting.

Approaching the next meeting, the FOMC has two traditional options: with the third traditional method being impossible at the current rate. The impossible option that the Fed normally had at their disposal would have been to lower the interest rates. However, as a result of the Federal Funds Rate residing near the zero-lower-bound for the past 6 years (Figure 16), that is not currently an option. The extremely low interest rates mean that the Fed is left with two options. The first option is to keep the interest rate at its current “zero-lower-bound” rate. That will mean that the inflation rate will fall further as a result of oil still prices still declining. Keeping the rates also means that there will be low output growth and almost maximum employment of those in the U3 rate. If the FOMC, however, decides to engage in contractionary monetary policy; which means to decrease monetary supply by increasing the Required Reserve Ratio, the Discount Rate, and/or by selling short-term Treasury-bills.

We believe that the FOMC must increase interest rates. And, they should do so by engaging in “Contractionary Monetary Policy”. They decrease the monetary supply by increasing the Reserve Requirement Ratio (RRR), the discount rate, and/or by selling T-bills. Increasing the reserve ratio is not a good option, though, as banks are not leveraging in high risk measures anymore. Even though Contractionary Monetary Policy will decrease investments (interest rates and investments are inversely related), increase the unemployment rate, and further risk deflation, there must come a time when the country actually raises rates in order to better prepare us for future uncontrollable negative shocks. The FOMC engaging in the contractionary policy might be a negative shock, but at least it would be controllable. And we must raise the interest rates now, at a time of stability. The unemployment rate is currently low enough for the contraction of the economy to not be extreme. Moreover, we need to increase the rates that banks lend to each other; and we need people to entice people to invest more money in low-risk assets. The Federal Funds Rate has been close to 0% for almost 6 years, making it unserviceable. Currently, the economy is booming. GDP is high, the Unemployment rate is low, and oil prices are low. The low oil prices mean that that this is the best time to increase the interest rates. Moreover, contractionary monetary policy must not be extreme, as deflation is a looming threat. The effective method that must be used in order to increase interest rates is by doing it gradually. Thereby, we propose to increase interest rates at by a maximum of 0.5%. And, only if in the next 3 quarters the economy appears to comply with our dual mandate, we should influence the increase of the FFR once more next year.

APPENDIX

Figure 1: Percentage Change in Real Gross Domestic Product

Figure 2 A: Percent Change in Real Gross Domestic Product Per Capita

Figure 2 B: Real Gross Domestic Product per Capita (Chained 2009 dollars)

Figure 3 A: Real Personal Consumption Expenditures (chained 2009 dollars)

Figure 3 B: Percent Change in Real Personal Consumption Expenditures

Figure 4: Percentage Change in Real Gross Private Domestic Investment

Figure 5: Real Government Consumption Expenditures and Gross Investment (Chained 2009 Dollars)

Figure 6: Real Net Exports of Goods and Services (Chained 2009 Dollars)

Figure 7: Percent Change in Real Exports and Real Imports of Goods and Services

Figure 8: The U3 and U6 Unemployment Rates

Figure 9: Labor Force Participation Rate

Figure 10 A: Crude Oil Prices (Dollars per Barrel)

Figure 10 B: Percent Change in Crude Oil Prices

Figure 11: Percent Change in the Consumer Price Index (CPI)

Figure 12: Consumer Confidence (Michigan sentiment)

Figure 13: Inflationary Expectations

Figure 14: U.S. Dollar Index

Figure 15: Percentage Change in the Stock Market Indicators:

Figure 16: Effective Federal Funds Rate

Additional Sources used: http://www.frbsf.org/economic-research/files/el2015-36.pdf

https://www.stlouisfed.org/publications/regional-economist/july-2012/quantitative-easing-lessons-weve-learned