FEDERAL RESERVE BANK

OF PHILADELPHIA

The Economic OutlookLoretta J. Mester*

Senior Vice President and Director of Research

Temple University Fox School of BusinessLeadership and Professional Development Seminar

February 19, 2009

*The views expressed here are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System.

“Those who have knowledge, don’t predict.Those who predict, don’t have knowledge.”

Laozi6th century B.C. Chinese philosopher and founder

of Taoism

“Those who have knowledge, don’t predict.Those who predict, don’t have knowledge.”

Laozi6th century B.C. Chinese philosopher and founder

of Taoism

“It is far better to foresee even without certainty than not to foresee at all.”

Henri Poincaré19th century A.D. French mathematician,

physicist, and philosopher of science

“A good forecaster is not smarter than everyone else, he merely has his ignorance better organized.”

Anonymous

• Review 2008 economic performance

• Discuss monetary policy actions in 2008

• Present forecast for 2009 and 2010

Economic growth was expected to continue in 2008, but the economy turned out considerably weaker

Central Tendency of FOMC Projected in January 2008

Actual for 2008

Real GDP Growth (4Q/4Q)

1.3 to2.0% –0.2%

Unemployment Rate (4th quarter average)

5.2 to 5.3% 6.9%

Core CPI Inflation (4Q/4Q)

2.0 to 2.2% 1.8%

Total CPI Inflation (4Q/4Q)

2.1 to 2.4% 1.7%

Philadelphia Fed Current Economic Activity Indexes, annualized growth in 2007

> 4%3% to 4%2% to 3%0.5% to 2%-0.5% to 0.5%-2% to -0.5%-3% to -2%<-3%

Growth remained positive in most states in 2007…

…but only 5 states had positive growth last year.PA and DE are among the weakest states.

Philadelphia Fed Current Economic Activity Indexes, annualized growth in 2008

> 4%3% to 4%2% to 3%0.5% to 2%-0.5% to 0.5%-2% to -0.5%-3% to -2%<-3%

Economic growth slowed considerably in the second half of the year

-5-4-3-2-1012345

2004 2005 2006 2007 2008

Real GDP Growth, SAARPercent

Tax rebates

By October, Fed policymakers had significantly reduced their forecasts for growth for 2008 and especially for 2009

Central tendency of economic forecasts of the Board of Governors and Reserve Bank Presidents

January 2008 Forecasts October 2008 Forecasts

2008 2009 2008 2009

Real GDP Growth actual in 2008

1.3 to 2.0% 2.1 to 2.7% 0 to 0.3% −0.2%

–0.2 to 1.1%

Unemployment Rate in Q4 actual in 2008

5.2 to 5.3%

5.0 to 5.3%

6.3 to 6.5% 6.9%

7.1 to 7.6%

Core Inflation (Core PCE) actual in 2008

2.0 to 2.2%

1.7 to 2.0%

2.3 to 2.5% 1.8%

1.5 to 2.0%

Inflation (PCE) actual in 2008

2.1 to 2.4% 1.7 to 2.0% 2.8 to 3.1% 1.7%

1.3 to 2.0%

The downside risks to growth most forecastersdiscussed a year ago came to pass

• Financial market conditions tightened further leading to a bank capital crunch, significant pull-back in lending from bank and nonbank firms, and rise in borrowing costs

– Failures/near failures of large financial firms including Bear Stearns, Fannie Mae, Freddie Mac, Lehman, AIG, Wachovia, Citigroup

• Equity price declines worsened and the loss in wealth curtailed consumption and investment

• Housing markets did not stabilize. The turndown in housing continued to be sharp

Housing investment did not stabilize last year.It has subtracted from growth since 2006.

8.1 9.8

4.00.2

-3.6

-16.6-19.5

-16.2-11.6

-20.6

-27.0-25.0

-13.3-16.1

-23.6-21.5

-35-30-25-20-15-10

-505

101520

2005

Q1

2005

Q2

2005

Q3

2005

Q4

2006

Q1

2006

Q2

2006

Q3

2006

Q4

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

PercentReal residential investment

Quarterly growth, SAAR

Housing starts and new home sales are down about 70% since their peaks in mid-2005

300

600

900

1200

1500

1800

2100

2400

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08100

150

200

250

300

350

400

450Thousands of units

Privately owned housing units started

New single family home sales

FHFA house price index

Index, 1980Q1 = 100

Quarterly data: Last point plotted is 2008 Q4 for housing starts and home salesand 2008 Q3 for FHFA house price index

Despite declines in construction, housing inventories remain high, so we expect further reductions in residential construction

0

2

4

6

8

10

12

14

16

18

90 92 94 96 98 00 02 04 06 08

Months’ supply atcurrent sales pace

Months’ supply ofsingle family homes

Months’ supply of condos and co-ops

Source: National Association of RealtorsMonthly data: Last point plotted is December 2008

14.7

8.7

Housing prices are down considerably from their peaks

Year-over-year percentage change Percent

Quarterly data: Last point plotted is 2008 Q4 for Median Existing Home price and 2008 Q3 for FHFA House Price Index and Case-Shiller House Price Index

-20

-15

-10

-5

0

5

10

15

20

87 89 91 93 95 97 99 01 03 05 07 09

Case-Shiller House Price Index

FHFA House Price Index

Median Existing Home

House prices are down in our area, but not as much as in other places because we had less of a boom

2005 2006 2007 2008*

US 11.5 5.4 0.8 −5.8 PA 11.9 6.5 2.8 −1.7 NJ 15.2 5.3 -0.3 −6.7 DE 14.9 7.3 1.4 −2.9

CA 21.1 3.8 -8.2 −23.7 NY 12.6 4.8 1.1 −5.0 NV 18.2 3.7 -6.5 −24.7 FL 27.5 8.9 -5.5 −18.9 MI 2.5 -1.3 -4.3 −9.8

Annualized House Price Appreciation (%) (FHFA House Price Index)

* Year-to-date through 2008 Q3, annualized

-15

-10

-5

0

5

10

15

20

1984 1988 1992 1996 2000 2004 2008Q3-$6

-$4

-$2

$0

$2

$4

$6

$8Percent

Household net worth contracted sharply last year

Source: FRB Flow of Funds, annual data

Change in household net worth Trillions of $

ChangePercentage change,year to year

0

1000

2000

3000

4000

5000

6000

7000

95 96 97 98 99 00 01 02 03 04 05 06 07 08 091000

3000

5000

7000

9000

11000

13000

15000

Stock prices are down over 40% since their peaks in October 2007

Dow JonesNASDAQ &S&P 500

Dow Jones Industrials

NASDAQ

S&P 500

Monthly data: Last point plotted is January 2009

Oct 2007

-$3,000

-$2,500-$2,000

-$1,500

-$1,000

-$500$0

$500

$1,000

$1,500$2,000

$2,500

$3,000

97 98 99 00 01 02 03 04 05 06 07 08Q3

Billions of DollarsReal estate and stock market wealth both fell in 2008

Source: FRB Flow of Funds, annual data

Change in households’real estate equity

Change in households’stock and mutual fund holdings

3.5

4.3

5.44.9

4.1

1.9

3.2

2.2

-1.3

2.8

4.0

2.62.6

3.4

-3

-2

-1

0

1

2

3

4

5

6

95 96 97 98 99 00 01 02 03 04 05 06 07 08

PercentReal personal consumption

4Q/4Q growth, SAAR

Consumer spending contracted in the second half of the year

-800

-600

-400

-200

0

200

400

Payroll growth peaked at the end of 2007.We have lost over 3-1/2 million jobs since then.

Thousands of jobs Monthly change in nonfarm payrolls

2003 2004 2005 2006 2007 2008 2009

Average monthly gains for each year are indicated by the grey lines.Monthly data: Last point plotted is January 2009

-598

-600

-500

-400

-300

-200

-100

0

100

200

Job losses during the previous three recessionary periodsaveraged about 150 thousand per month.

Since the start of this recession in December 2007, job losses have averaged nearly 250 thousand per month.

Thousands of jobs Monthly change in nonfarm payrolls

Jul 1981 – Dec 1982 Jul 1990 - May 1991 Mar 2001 – May 2002 Dec 2007 – Jan 2009

Average monthly gains for each period are indicated by the grey lines. Recessions are indicated by grey bars.

-3-2-1012345678

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48

Months Since Previous PeakOct 1973Dec 1979Jun 1981Jun 1990Feb 2001Nov 2007

Jobs have declined 2-1/2% since their pre-recession peak.The pace of decline has quickened since last fall.

Percentage change in nonfarm payrolls since previous cycle peak

1973 recession 1990 recession1980 recession 2001 recession1981 recession 2008 recession

Jan 2009

3

4

5

6

7

8

9

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Civilian Unemployment Rate Percent

U.S.

Monthly data: Last point plotted is January 2009 for the U.S. and December 2008 for three states

7.6%(Jan)6.9%(Dec)

Three States

Unemployment is up sharply in the nation and our three states

Weak sales led businesses to cut inventories.Investment has been declining in the wake of economic uncertainty

and projections of continued weak demand.

-160

-120

-80

-40

0

40

80

120

00 01 02 03 04 05 06 07 08-20

-15

-10

-5

0

5

10

15

Billions of chain-weighted 2000 $

Change in Private Inventories, SAAR (left scale)

Growth in Fixed Private Nonresidential Investment, SAAR (right scale)

Percent

Manufacturing activity in the nation and in our region is very weak

-50

-40

-30

-20

-10

0

10

20

30

40

50

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index represents percentage of respondents reporting an increase minus percentage reporting a decrease.Monthly data: Last point plotted is February 2009.

Business Outlook Survey: General Activity Index

-41.4

According to our Business Outlook Survey, regional manufacturing activity is at recession levels

-70-60-50-40-30-20-10

0102030405060

1969 1974 1979 1984 1989 1994 1999 2004 2009

Index represents percentage of respondents reporting an increaseminus percentage reporting a decrease.Monthly data: Last point plotted is January 2009.

Business Outlook Survey: General Activity Index

-41.4-31.2

-57.9 -57.2

-34.6–48.2

–37.0

-20

-15

-10

-5

0

5

10

15

20

25

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Percent

Net export growth had been one of the economy’s strengths, but growth abroad has slowed

Quarterly data: Last point plotted is 2008 Q4Source: Census Bureau

Import growth

Export growth

Year over year growth in exports and imports

Inflation has decelerated, partly reflecting the sharp drop in energy prices since October

-1

0

1

2

3

4

5

6

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Consumer Price Index

Percentage change from a year ago, seasonally adjusted data.Monthly data: Last month plotted is December 2008.

Percent

Core Consumer Price Index

-0.1%

1.7%

In response to the weakening economy, the FOMC aggressively cut the fed funds rate last year to essentially zero in December

-2

0

2

4

6

2001 2002 2003 2004 2005 2006 2007 2008 2009

Real federal funds rate

Percent

Nominal federal funds rate

Quarterly data. Real federal funds rate is calculated as nominal federal funds rate minus expected inflation as measured by the one-quarter-ahead CPI forecast from the Philadelphia Fed Survey of Professional Forecasters .

The Fed established several lending programs targeted at easing short-term funding pressures, promoting credit extension,

and containing systemic falloutTerm Lending Facilities• Term Auction Facility (TAF): auctions off short-term credit to depository

institutions eligible to borrow at the discount window (established Dec 12, 2007)– Forward TAF auctions: auctions of TAF credit for settlement later

(announced Sep 29, 2008)• 28-day term RPs: to primary dealers (Mar 7, 2008)• Term Security Lending Facility (TSLF): lends Treasury securities from

Fed’s portfolio to primary dealers (established Mar 11, 2008)– Auctions of options on draws on TSLF (announced Jul 30, 2008)

• FX Swaps: with central banks of Europe, Switzerland, Japan, England, Canada, Australia, Sweden, Netherlands, Norway, New Zealand, Brazil, South Korea, Singapore

The Fed established several lending programs targeted at easing short-term funding pressures, promoting credit extension,

and containing systemic fallout

Term Lending Facilities, continued• Asset-Backed Commercial Paper Money Market Mutual Fund Lending

Facility (AMLF): loans to banks to fund purchases of high-quality asset-backed CP from MMMFs (established Sep 19, 2008)

• Commercial Paper Funding Facility (CPFF): liquidity backstop to U.S. issuers of CP through a special purpose vehicle (SPV) that will buy 3-month unsecured and asset-backed CP directly from eligible issuers (established Oct 7, 2008)

• Money Market Investor Funding Facility (MMIFF): to complement the CPFF and AMLF by purchasing CDs and CP from money market mutual funds (established Oct 7, 2008)

The Fed established several lending programs targeted at easing short-term funding pressures, promoting credit extension,

and containing systemic falloutStanding Facilities• Discount Window: loans to depository institutions at the primary credit rate (maturity

lengthened to 30 days on Aug 17, 2007 and to 90 days on Mar 16, 2008)• Primary Dealer Credit Facility: loans to Primary Dealers at the primary credit rate

(established Mar 16, 2008)Programs Focused on Longer-Term Asset Prices• Purchases of the direct obligations of and MBS backed by the housing-related GSEs

(announced Nov 25, 2008)• Term Asset-Backed Securities Loan Facility (TALF): financing to support the issuance

of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA) (announced Nov 25, 2008)

Programs to Contain Systemic Fallout• Maiden Lane I : Bear Stearns (Mar 16, 2008)• Credit to AIG (Oct 8, 2008)• Maiden Lane II: AIG residential MBS holdings and Maiden Lane III: AIG-backed CDOs

(Nov 10, 2008)• Credit to Citigroup (Nov 28, 2008)

The Fed’s balance sheet has grown and its composition has changed

Source: FRS H.4.1 data

3[2%]

11[7%]

Federal Reserve System AssetsJuly 11, 2007

Total assets = $0.873 trillion

Treasury securities 91%

All other assets (incl FX swaps) 7%

RPs2%

Treasury securities

26%

All other assets (incl FX swaps)

25%

Fed Agencysecurities

2%

TAF22%

DiscountWindow and otherloans8%

CP fundingfacility14%

Maiden Lanes:I (Bear Stearns) 1%II (AIG Resid MBS) 1%III (AIG CDOs) 1%

Federal Reserve System AssetsFebruary 11, 2009

Total assets = $1.845 trillion

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/3/07 4/4/07 7/4/07 10/3/07 1/2/08 4/2/08 7/2/08 10/1/08 12/31/08

The composition of the Fed’s balance sheet has changed dramatically

Trillions $

Weekly data: Last point plotted is February 11, 2009

Treasurysecurities

Commercialpaper

Loans

Maiden Lanes

Other assets

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan07

Mar07

May07

Jul 07

Sep07

Nov07

Jan08

Mar08

May08

Jul 08

Sep08

Nov08

Jan09

Funding pressures are easing in interbank markets.The spread between 1-month LIBOR and OIS is down after spiking in October.

Percent

Daily data: Last point plotted is February 13, 2009

1-month LIBOR rate minus OIS rate

0.00.51.01.52.02.5

3.03.54.04.55.0

Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09

Commercial paper spreads have fallen since OctoberPercent

Weekly data: Last point plotted is February 6, 2009

1-month AA nonfinancial CP yield minus1-month Treasury bill yield

1-month AA asset-backed CP yield minus 1-month Treasury bill yield

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09

Mortgage rates have fallen since last fallPercent

Weekly data: Last point plotted is February 6, 2009

Spread between 30-year mortgage rate and 10-year Treasury bond yield

10-year Treasury bond yield

30-year mortgage rate

0

2

4

6

8

10

12

Jan 07 Mar 07 Jun 07 Sep 07 Jan 08 Mar 08 Jun 08 Sep 08 Jan 09

Corporate bond credit spreads rose sharply last fall. They have fallen since year-end,

but remain elevated, especially for less creditworthy borrowers.Percent

Weekly data: Last point plotted is February 6, 2009

5-year corporate bond yield spread over 5-year Treasury yield

BB+ (junk)

BBB

A

AAA

Monetary policy becomes more complicated at the zero bound,but remains effective

• With a weak economy, optimal policy calls for low real interest rates

Real rate = Nominal rate – Expected inflation– Currently, the real ff rate ≈ −0.8 percent

• Normally, if the economy weakens further, market interest rates fall, and monetary policymakers reduce the ff rate target in tandem.– With stable inflation expectations, this means the real ff rate also falls.

– Other borrowing rates also tend to fall, since

Long-term interest rate = Average of current and expected future short-term

interest rate + Term premium

• Two issues for policymakers near the zero bound– The Fed has reduced the nominal ff rate as far as it can go.

– Inflation expectations and inflation have been falling. If this continues to happen, real rates will rise and the real cost of borrowing will increase.

Alternative methods can be used to help bring real borrowing rates down even when at the zero bound

Long-term interest rate = Average of current and expected future short-term interest rate + Term premium

Real rate = Nominal rate – Expected inflation• To lower real borrowing rates:

– Lower expected future short-term rates– Lower the term premium on long rates– Increase inflation expectations

(1) Quantitative easing or credit easing– Add more reserves to the banking system than needed to keep ff rate = 0– Use composition of the Fed’s balance sheet to target borrowing rates in

particular markets (e.g., ABCP, mortgages) (2) Buy longer-term Treasury securities

– Fed could buy securities with longer maturities to have direct effect on long rates; might also put downward pressure on term premium by increasing total demand for long-term issues, and reducing supply available to the public

(3) Communication and commitment: Announce commitment to keep rates low for specified period of time or until specified event occurs

(4) Communication and commitment: Set an explicit medium-run inflation goal– Helps to anchor inflation expectations

What does the future hold?

Fed policymakers and private sector forecasters see flat to negative growth this year,

with some recovery in 2010

Central tendency of FOMC Survey of Professional Forecasters

January 2009 Forecasts 2009 Q1 Forecasts

2009 2010 2009

Real GDP Growth (Q4/Q4)

−1.3 to −0.5% 2.5 to 3.3% −1.1%

Unemployment Rate in Q4

8.5 to 8.8%

8.0 to 8.3%

8.9%

Core Inflation (Core PCE) (Q4/Q4)

0.9 to 1.1%

0.8 to 1.5%

1.1%

Inflation (PCE) (Q4/Q4)

0.3 to 1.0% 1.0 to 1.5% 0.2%

4.8

0.00.9

3.0

-5.2

-1.8

2.72.6 2.8

4.8

3.9

4.8

0.8

-0.5

1.0

-0.2

-3.8

1.31.8

1.5

-6-5-4-3-2-1012345

Our latest Survey of Professional Forecastersforecasts negative growth over the first half of the year

and a slow recovery in the second halfPercent

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2005 2006 2007 2008 2009Hatched bars are median forecasts from the 2009Q1 Survey of Professional Forecasters

3

4

5

6

7

8

9

10

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Percent

Our latest Survey of Professional Forecasters indicates the unemployment rate will continue to rise through 2009

Dotted line is median forecast from the 2009Q1 Survey of Professional Forecasters

Civilian Unemployment Rate

1.8 1.9

3.13.3

1.9

3.5

1.7 1.8 1.8

2.3

1.5

1.1

1.82.22.22.2

1.41.6

0

1

2

3

4

5

2002 2003 2004 2005 2006 2007 2008 2009 2010

Past declines in oil and other commodity prices and weak demand mean headline and core inflation will decelerate in 2009.

Our SPF forecasts inflation is below 2% over the next two years.

Percent, 4Q/4Q growth, SAAR

Personal Consumption Expenditure Index Personal Consumption Expenditure Indexexcluding food and energy (= core inflation)

Hatched bars represent median forecasts from the 2009 Q1 Survey of Professional Forecasters.

The forecast assumes further policy stimulus

• A fiscal stimulus package of around $800 billion dollars, which includes tax cuts, subsidies to distressed homeowners, grants tostate and local governments, and infrastructure spending.– Adds about 1 percentage point to real GDP growth in both 2009 and 2010. – The government deficit as a percent of GDP rises from about 2% to over 7% by

the end of next year, the highest since WWII.

• “The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of thefederal funds rate for some time…The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.”

• Progress on clearing up financial system system problems and in stemming the rate of home foreclosure

There are significant risks to the baseline forecast

• The risks to growth are on the downside– Financial market conditions could worsen instead of improve

• Fed’s targeted liquidity provisions may be less effective than hoped• Financial system still has to repair itself

– Housing markets may not stabilize next year, house prices might decline more significantly than expected, commercial real estate markets may decline significantly

– Labor markets could deteriorate more than expected• The risks to inflation are on the downside in the near term and on

the upside in the medium term– Weak demand and recession-deflation psychology may put

further downward pressure on prices – Excess liquidity may put upward pressure on inflation later in

the forecast horizon when the recovery is underway– Oil prices may rise or fall rather than stabilize

Our baseline forecast • No growth in 2009: Contraction in the first half followed by weak positive growth

in the second half

– Declines in financial and housing wealth and employment, and tighter credit conditions keep consumer spending weak, despite support from fiscal stimulus and low energy prices

– Business investment and residential investment subtract from growth this year

– With weak growth abroad, the export sector does little to buoy our economy

• Growth begins to improve modestly in the second half of 2009 and in 2010, as the housing contraction stabilizes, credit conditions improve, the effects of monetary and fiscal stimulus are felt, progress is made on banking system problems and foreclosures

• Labor markets are weak. Firms cut payrolls sharply in the first half of 2009. Job growth doesn’t resume until mid-2010 when firms are convinced the recovery is in place. The unemployment rate rises this year into next year.

• Past declines in oil and other commodity prices and weak demand mean inflationdecelerates in 2009 to around 1%. Inflation rises in 2010 as the economic recovery is underway, but remains below 2%.

FEDERAL RESERVE BANKOF PHILADELPHIA