The Outlook for the Economy and Challenges for Monetary and Fiscal Policymakers The Outlook for the Economy Dallas, Texas July 8, 2011 Mark Thoma Department of Economics University of Oregon

The GDP Gap

Is the Recent Slowdown Temporary or Permanent? GDP grew at a 1.8% in Q1 of 2011, a significant slowdown from the fourth quarter of How much is due to temporary factors: effects of the supply chain disruptions caused by the earthquake in Japan, the recent tornadoes and floods in the South and Midwest, and the spike in commodity prices, especially oil? But, the pace of hiring slowed in May, with only 54,000 jobs added to nonfarm payrolls The unemployment rate stalled Growth of household spending has tapered off Housing prices continue to fall lowering consumer wealth Manufacturing growth has slowed

FRBSF Forecast of GDP Growth

IMF Forecast of GDP Growth

FRBSF Forecast of Employment Growth

FRBSF Unemployment Forecast

Employment Recovery Likely to be Slow

Weak Links

Real Private Residential Fixed Investment

Real Private Non-Residential Fixed Investment

Real Personal Consumption Expenditures

To summarize, our results indicate that, so far, the federal fiscal expenditure stimulus has mostly compensated for the negative state and local stimulus associated with the collapsing tax revenue and the limited borrowing capacity of the states. While this is a significant accomplishment, the net effect is that the consolidated fiscal expenditure stimulus is small, at a time when the private sector’s deleveraging has reduced private consumption. “On the ease of overstating the fiscal stimulus in the US, ,” by Joshua Aizenman and Gurnain Kaur Pasricha, NBER Working Paper No , February 2010 Net Stimulus Small, and Set to Contract

Real Net Exports (Ex-Im)

Housing Prices are Still Falling

Nominal House Prices

Real House Prices

Inflation Remains Subdued

Key Challenges for the Economy Continued weakness in housing markets, with further house price declines a possibility (likely). The resulting fall in wealth will cause households to devote more resources to balance sheet rebuilding and less to consumption. Short-run fiscal risks: debt ceiling not raised (interest rates spike, stay high, loss of credibility in longer run leading to higher interest rates, global repercussions due to loss of safe asset), lower demand due to deficit reduction. Long-run fiscal risks: deficit not brought under control (higher interest rates, less ability to respond to a crisis, deficit monetization and inflation) Additional commodity price shocks. This could impact both growth and inflation (though the effects on inflation are generally transitory). Tight credit supply conditions. I don’t think this risk is large. To the extent this is a problem, it’s lending standards not the availability of funds. Though things are looking a bit calmer recently, events in Europe could create a new global financial shock. Inflation, property bubble, etc. problems in China. There are lots of uncertainties here, and a slowdown in China would have global consequences. Upside: Perhaps pent up demand kicks in, and we takeoff. But I hope monetary and fiscal policymakers aren’t counting on this (even though they seem to be doing just that).

Short-Run Policy Differences: Austerity versus Stimulus There are two competing views, austerity and stimulus The austerity advocates want immediate deficit reduction. They argue that such reductions will increase business confidence and spur the economy. Those who admit that austerity will be painful in the short-run make a different argument, that pain now avoids even more pain later. The other side says we tried this in the Great Depression, they’ve tried it in Europe, and it’s clear it doesn’t work. Our long-run debt problem is really a health care cost problem, and the real acceleration in these costs won’t occur for many years. Thus, we have time to sort this out without wrecking the economy. What we need is short-run stimulus and a credible plan for long-run debt reduction. But in any case, reducing deficits and reducing demand right now would be harmful to the recovery, and harmful to long-run growth.

Short-Run Policy Differences: Cyclical versus Structural Unemployment In normal times, we think of full employment as being equal to the level of frictional and structural unemployment, and this is generally in the 4%-5% range. The unemployment rate is currently 9.1%, and there is a debate about how much of this is structural and how much is cyclical (think of this as supply versus demand factors). If the problem is mostly structural, there’s not much that policymakers can do to help (though they aren’t completely helpless). If the problem is cyclical, there’s quite a bit that can be done through policies that stimulate demand. I think that the problem is mainly cyclical. There has been some structural increase, but I agree with the FRBSF that it’s probably less than 2% of the increase.

Short-Run Policy Differences: The Debt Ceiling

Debt Levels Around the World

Previous bar graph was for 2009 This graph is for 2010 Note that the US moved from 65 th place to 37 th in one year, and as a % of GDP from 36.8% to 59.9% The change is partly due to the fall in taxes and increase in spending on the recession, but it reflects LR trends as well But in the LR, debt expected to grow to % of GDP by 2035

Sources of Recent Changes in the Debt

CBO’s Long-Run Debt Projections

Long-Run Policy Difference: The Size and Role of Government In the long-run, and it’s at the heart of budget negotiations over health care costs and other social insurance programs, is the size and role of government. Will taxes be increased to support new and existing social insurance programs, or are we headed for a smaller government sector in the future? Should government do more or less? My own view is that as societies grow wealthier, they tend to purchase more insurance for their citizens, and I expect we’ll do the same. But it won’t happen without a fight over how to pay for it, and who controls the government in the next decade or two will have a large impact on how this plays out.

Monetary Policy Challenges for the Federal Reserve The biggest challenge is reducing the size of the balance sheet to prevent inflation without killing the recovery Because of the long and variable lags in monetary policy – estimates of 9-18 months to reach the peak impact are common – the Fed will be inclined to tighten before it knows for sure that the economy is on solid ground. If it gets this wrong and begins too soon – and some Fed official seem to have an itchy trigger finger – it could hamper the economy’s ability to recover or even help to send it into a second dip. They could get this wrong, but right now it’s far from my biggest worry.

The Fed’s Balance Sheet

Signals the Fed is Beginning to Tighten First step will be to test the waters by stopping the reinvestment of the proceeds from maturing securities Next will be actual asset sales, and I think the pace will be “measured.” Finally, they will raise the federal funds rate, again at a “measured pace.”

When Will This Happen? I don’t expect the first step for several months, and it will likely be longer than that. I don’t expect interest rate increases until the new year, and that is conditional upon the economy showing it is determined to maintain the recovery. That brings up the next point…

Will There be a QE3? Not unless there is clear evidence we are headed for a double dip. But even that won’t be enough for some if it isn’t accompanied by evidence of a deflation threat. That’s the key – if deflation is a threat, then I think the Fed will respond. But the bar for this is high.

What Does This Mean for Banks? Interest rate risk from default, LR budget gap. Risk is one-sided, rates already at rock bottom Inflation risk Regulatory uncertainty (e.g. cap req?) Commercial real estate Risk of slow recovery or second dip Commodity price spikes Yield curve – Hedge the risk of flattening? Change in status for the dollar Overzealous search for yield as things Improve (i.e. watch for the next bubble)

Commercial Real Estate Prices: Indexes from Moody’s and Case-Shiller

Commodity Price Indices