Using the book to understand the state of the U.S. economy 14.02 – last class, December 14, 2005...

Using the book to understand the state of the U.S. economy

14.02 – last class, December 14, 2005

Francesco Giavazzi

Overview

Despite significant disturbances…

• additional large energy price increases

• major hurricanes

… the US economy keeps growing

-2

-1

0

1

2

3

4

5

6

7

8

9

2001 2002 2003 2004 2005 2006

-2

-1

0

1

2

3

4

5

6

7

8

9

GDP Growth: Remarkable Stability

Source: Bureau of Economic Analysis and Blue Chip Economic Indicators

October 2005 Consensus

Forecast

May 2005 Consensus

Forecast

Note: Dashed lines represent average of the top and bottom 10 forecasts.

% Change - Annualized Rate % Change - Annualized Rate

Bottom 10

Top 10

Actual

… the US economy keeps growing, but

• is this growth rate consistent with stable inflation?

• are imbalances building up?

Trying to answer these questions using our model

1. Aggregate demand growth

Y = C + I + G

ΔY/Y = ΔC/C * C/Y + ΔI/I * I/Y + ΔG/G * G/Y

2. Okun’s law

u – u-1 = - b (ΔY/Y - ΔYn / Yn) = - b (ΔY/Y - 0.03)

3. Phillips curve (with πe = π-1 )

π – π-1 = - a (u – un )

• CA = S private + S public - I

AD

• Y = C + I + G

• ΔY/Y = ΔC/C * C/Y + ΔI/I * I/Y + ΔG/G * G/Y

• ΔY/Y = ΔC/C * 0.7 + ΔI/I * 0.2 + ΔG/G * 0.1

0

1

2

3

4

5

6

7

8

1998 1999 2000 2001 2002 2003 2004 2005

0

1

2

3

4

5

6

7

8

Real Personal Consumption Expenditures

% Change - Year to Year % Change - Year to Year

Source: Bureau of Economic Analysis

Consumer Spending Remains Robust

Note: Shading represents NBER recessions.

60

80

100

120

140

160

1998 1999 2000 2001 2002 2003 2004 2005

60

80

100

120

140

160

Michigan Consumer Sentiment

Conference Board Consumer Confidence

Index IndexBut Consumer Confidence Has Dropped Sharply

Source: University of Michigan and the Conference Board Note: Shading represents NBER recessions.

1100

1200

1300

1400

1500

1600

1700

1800

1998 1999 2000 2001 2002 2003 2004 2005

0

2

4

6

8

10

12

14

Single-Family Housing Starts

(Left Axis)

OFHEO Home Price Index (Right Axis)

Thousands of Units % Change - Year to Year

Source: Census Bureau and Office of Federal Housing Enterprise Oversight

Investment: Housing Starts and Home Prices Remain Strong


-20

-15

-10

-5

0

5

10

15

20

1991 1993 1995 1997 1999 2001 2003 2005

-20

-15

-10

-5

0

5

10

15

20


% Change - Year to Year % Change – Year to Year

All Other

Info Processing Equipment and

Software


Investment Growth Has Recovered Well

-3

-2

-1

0

1

2

1980 1985 1990 1995 2000 2005

-3

-2

-1

0

1

2

T - G: Changes in the full employment budget balance (percent of potential output)

Source: Congressional Budget OfficeFiscal Year

GRH-185

GRH-287

BEA90

OBRA93

BEA97


-5

-4

-3

-2

-1

0

1

2

3

1993 1997 2001 2005 2009 2013

-5

-4

-3

-2

-1

0

1

2

3

Federal budget forecasts

Source: Congressional Budget Office and Goldman Sachs. Note: Shading represents NBER recessions.

Percentage of GDPPercentage of GDP

Optimistic

Pessimistic

Forecast

AD

• ΔY/Y = ΔC/C * C/Y + ΔI/I * I/Y + ΔG/G * G/Y

• ΔY/Y = ΔC/C * 0.7 + ΔI/I * 0.2 + ΔG/G * 0.1

• ΔY/Y = 3 * 0.7 + 8 * 0.2 + ? = 3.7 + ?

May 2 Nov 4 May 2 Nov 4

Real GDP (Q4/Q4 Growth) 3.5 3.5 3.6 3.3

Core PCE Deflator (Q4/Q4 Growth) 1.9 1.8 1.8 2.0

Unemployment (Q4 Level) 5.2 4.9 5.2 4.9

2005 2006

Forecast Comparison: May and November 2005

Source: Federal Reserve Bank of New York

FRBNY Forecast

Is current growth rate consistent with stable inflation?

Okun’s law

u – u-1 = - b (ΔY/Y - 0.03)

0.03 derived from assumptions:

• productivity growth, 2%• labor force growth, 1%

Phillips curve

π – π-1 = - a (u – un )

un = ?

π – π-1 = 0 u = un ΔYn / Yn = ΔY/Y

Labor Market

• Until the hurricanes, solid employment growth

• Latest headline numbers are off, but distorted by hurricane effects

• Productivity growth remains solid

• Labor costs edging up

-400

-300

-200

-100

0

100

200

300

400

1998 1999 2000 2001 2002 2003 2004 2005

-400

-300

-200

-100

0

100

200

300

400

Employment Solid Until the Hurricanes Hit

Thousands Thousands

Source: Bureau of Labor Statistics

Change in Private Employment, Three-Month Moving Average


3

3.5

4

4.5

5

5.5

6

6.5

7

7.5

8

1991 1993 1995 1997 1999 2001 2003 2005

65.6

65.8

66

66.2

66.4

66.6

66.8

67

67.2

67.4

67.6


Unemployment Drifting Down, Participation Leveling

Unemployment(Left Axis)

PercentPercent


3

3.5

4

4.5

5

5.5

6

6.5

7

7.5

8

1991 1993 1995 1997 1999 2001 2003 2005

65.6

65.8

66

66.2

66.4

66.6

66.8

67

67.2

67.4

67.6


Unemployment Drifting Down, Participation Leveling

Unemployment(Left Axis)

PercentPercent

Participation(Right Axis)


Is current growth rate consistent with stable inflation?

u – u-1 = 0 ( or even < 0 )

Other evidence on potential output growth ?

u – u-1 = b (ΔY/Y - 0.03)

0.03 : depends on productivity growth

1003

-2

0

2

4

6

1998 1999 2000 2001 2002 2003 2004 2005

-2

0

2

4

6


Productivity GrowthNonfarm Business Sector

Output per Hour

% Change - Year to Year% Change - Year to Year


1003

-2

0

2

4

6

1998 1999 2000 2001 2002 2003 2004 2005

-2

0

2

4

6


Productivity Remains Solid, Unit Labor Costs UpNonfarm Business Sector

Output per Hour


Unit Labor Costs


The Phillips Curve

π – π-1 = a (u – un )

un = ?

π – π-1 = 0 u = un ΔYn / Yn = ΔY/Y

Which inflation rate should we look at ?

• Headline inflation reflects oil price surge

• Core inflation excludes food and energy: it moves closer to wages

1.5

2

2.5

3

3.5

4

4.5

5

1998 1999 2000 2001 2002 2003 2004 2005

1.5

2

2.5

3

3.5

4

4.5

5


Nominal Wages

ECI: Private Industry Wages

and Salaries


Total PrivateAverage Hourly

Earnings


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1998 1999 2000 2001 2002 2003 2004 2005

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0


% Change - Year to Year % Change - Year to Year

Core PCE

Total PCE

PCE Deflator: Total Up Sharply, Core Relatively Flat


40

45

50

55

60

65

70

75

Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08

40

45

50

55

60

65

70

75

Source: Bloomberg

$/Barrel

May 13 (Last EAP)

$/BarrelCrude Oil Futures Prices

Oil Prices Remain Elevated

40

45

50

55

60

65

70

75


40

45

50

55

60

65

70

75

Source: Bloomberg

$/Barrel

May 13 (Last EAP)

$/Barrel

August 26 (Pre-Katrina)

Crude Oil Futures PricesOil Prices Remain Elevated

40

45

50

55

60

65

70

75


40

45

50

55

60

65

70

75

Source: Bloomberg

$/Barrel

May 13 (Last EAP)

$/Barrel


August 30 (Post-Katrina High)


40

45

50

55

60

65

70

75


40

45

50

55

60

65

70

75

Source: Bloomberg

$/Barrel

May 13 (Last EAP)

$/Barrel


November 3 (Current)

August 30 (Post-Katrina High)


2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

3

3.1

3.2

3.3

2/1/05 3/14/05 4/21/05 6/1/05 7/12/05 8/19/05 9/29/05

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9

3

3.1

3.2

3.3

Can we measure inflation expectations? TIPSPercentPercent

3-5 Years

0-2 Years

2-3 Years

Source: Bloomberg, 8:40AM quotes and FRBNY CalculationsNote: Data from 8/19/05 to 8/31/05 is

currently unavailable

So, what should the Fed do ?

• In 2 years the Federal Funds rate has been raised from 1,5 % to 4,25 %

• And financial markets expect more rate increases, with Fed Funds stabilizing around 4,5 %

0

2

4

6

8

10

1990 1992 1994 1996 1998 2000 2002 2004 2006

0

2

4

6

8

10

Funds Rate RatePercentPercent

Actual Fed Funds Rate

Source: FRBNY.

Last rate hike December 13

-0.5

0

0.5

1

1.5

2

2.5

1/2/04 3/26/04 6/18/04 9/10/04 12/3/04 2/25/05 5/20/05 8/12/05

-0.5

0

0.5

1

1.5

2

2.5PercentPercent

Source: Bloomberg and FRBNY Calculations

Higher nominal rates have raised real rates as well (TIPS Yields)

Five-Year Yield

Ten-Year Yield

Constructed Two-Year

Yield

Note: Two-year yield was constructed from a combination of interpolating and extrapolating yields of ten-year bonds maturing

1/15/2007 and 1/15/2008. Yields are not adjusted for carry.

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

Jul-05 Nov-05 Mar-06 Aug-06 Feb-07 Aug-07 Feb-08

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

Source: Federal Reserve Board

Percent Percent

May 13 – Last EAP August 8: Day Before August FOMC September 19: Day Before September FOMC November 1: Current

May 13

What do financial markets expect?Expected Funds Rate Path Has Risen, Steepened

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


Percent Percent

August 8


May 13

Expected Funds Rate Path Has Risen, Steepened

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


Percent Percent

August 8

September 19


May 13


3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75


Percent Percent

November 3

August 8

September 19



May 13

But how powerful is the Fed ?

• Investment depends on “long” rates

• but the Fed only controls “short” rates

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

0 1 2 3 4 5 6 7 8 9 10

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

Source: FRBNY Calculations

Percent Percent

May 13

October 24

The Yield Curve Has Risen and Flattened

Maturity Date (Years)*Estimated using off-the-run Treasury securities

November 3

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

0 1 2 3 4 5 6 7 8 9 10

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

5.25

Source: FRBNY Calculations

Percent Percent

May 13

October 24

But “Conundrum” Remains in Forward Rates

Maturity Date (Years)

November 3

-2

-1

0

1

2

3

4

5

1992 1994 1996 1998 2000 2002 2004

-2

-1

0

1

2

3

4

5

Short-Term Real Rates Up, Long-Term FlatTreasury Yield minus Philadelphia Fed Survey Inflation Expectations

Percent

Source: Federal Reserve Board and Philly Fed

Percent

1-Year

10-Year


NX

• Export growth has strengthened

• But imports keep running faster than exports

• Current account deficit has leveled off (as percent of GDP)

Importazioni e esportazioni

CA = S private + S public - I

Net National Saving = (Private + Public Saving) – Investment

= Current Account

= (Exports – Imports) + Net Investment Income

0

1

2

3

4

5

6

7

1998 2000 2002 2004

0

1

2

3

4

5

6

7

0

1

2

3

4

5

6

1998 2000 2002 2004

0

1

2

3

4

5

6


Real Disp. Personal Income

Real PCE

Personal Saving Rate(% of DPI)

% Change - Year to Year

Percent

% Change - Year to Year

Percent

Source: U.S. Bureau of Economic Analysis.

Households Saving

Forecast

-3

-2

-1

0

1

2

1980 1985 1990 1995 2000 2005

-3

-2

-1

0

1

2

Public SavingsChanges in the full employment budget balance (% of potential output)

Source: Congressional Budget OfficeFiscal Year

GRH-185

GRH-287

BEA90

OBRA93

BEA97


-800

-700

-600

-500

-400

-300

-200

-100

0

1998 1999 2000 2001 2002 2003 2004 2005

-8

-7

-6

-5

-4

-3

-2

-1

0

The Current Account DeficitSAAR, Bill$, BOP Basis


% of GDP

% of GDP (Right Axis)

Current Account Balance (Left Axis)

US external debt: 25% of gdp

Figure 2: US External Assets and Liabilities, 1982-2002

-20%

-10%

0%

10%

20%

30%

40%

1980 1985 1990 1995 2000 2005

Pe

rce

nt

of

We

alt

h

Foreign Assets

Foreign Liabilities

Net Foreign Assets

Who finances the United States?

Share of US assets in world equity portfolio

Source: Caballero, Fahri and Gourinchas, (2005)

What if the rest of the world stopped financing the US?

• Demand for US assets falls:– Dollar down– stock market down– Interest rates up

• Consumption and investment down but NX up

• and ….– Fed can cut short term interest rates

• So, really no reason to worry ?

Using the book to understand the state of the U.S. economy 14.02 – last class, December 14, 2005...

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