1. The U.S. Recovery is for Real: Solid, Sustainable, but Sub-Par 16th Annual Business Forecast Luncheon Center for Business and Economic Research Sam M. Walton College of Business University of Arkansas January 29, 2010 Chris Varvares, President Macroeconomic Advisers, LLC www.macroadvisers.com © Macroeconomic Advisers

2. 2 January 2010 Hallmarks of the Macroeconomic Advisers' Forecast Above-consensus growth of real GDP: 2010 (4/4) = 3.8% vs. 3.2%* –Consumer spending: 2010 (4/4) = 3.3% vs. 2.1%* –Housing starts: 2010 annual average = 851,000 units vs. 790,000* –Unemployment rate peaks at 10.2% in 2010:q1; falls to 9.6% in 2010:q4 Below-consensus core PCE inflation: 2010 (4/4) = 1.0% vs. 1.5%* Expecting Fed to first raise rates in June 2011! Market looking for first hike in the Fall of 2010! Preceded by passive liquidity facility and balance sheet run-off * National Association for Business Economics - Quarterly Outlook Survey - November 22, 2009

3. © Macroeconomic Advisers3 January 2010 Deep Recession, Sub-par Recovery & Lingering Slack Above-trend Growth Caps & Turns Unemployment Rate Percent History Forecast Unemployment rate 10.2% Real GDP growth 09:q420102011 GDP Growth:5.4%* 3.8% 4.3% Un. Rate (Q4):10.0%9.6%8.1% * based on current tracking 1/8

4. © Macroeconomic Advisers4 January 2010 Slack Keeps Downward Pressure on Inflation Unit Labor Cost and Core PCE Inflation 4-quarter percent change Unit labor cost Core PCE inflation H F 09:q420102011 Core inflation:1.3%*1.0% 0.9% * based on current tracking 1/8 Fed "target"

5. © Macroeconomic Advisers5 January 2010 Fed Stands Pat, but Market, Long-Rates are on the Rise Percent H F Conventional mortgage rate Fed funds rate 10-year Treasury yield Below-Target Inflation & Lingering Slack Imply Late Exit

6. © Macroeconomic Advisers6 January 2010 Factors Contributing to Above-Trend GDP Growth Motor-vehicle production rebound (with or without C.A.R.S.) Inventory liquidation to slow sharply; X-auto: Q4=+$95b, Q1=+$20b ARRA actually is providing stimulus Housing bounces off the bottom, begins strong recovery Home prices are stabilizing, assumed to remain flat Broad financial conditions improving: –Especially equities –But spreads have narrowed also Implies improving balance sheets for households Helps stabilize & then boost consumer spending (pent-up demand!) Productivity "overshoot" could unwind and bring jobs back quicker Global nature of the recovery

7. © Macroeconomic Advisers7 January 2010 Recession Dynamics Hint at Upside Risk Strength of Early Recovery Depends on Depth of Recession Peak-to-trough decline in real GDP(%) y = 1.9184x + 1.7492 R 2 = 0.6578 0 2 4 6 8 10 01 2 34 4-quarter percent change 2001 1990-91 1970 1980 1960-61 1953-54 1981-82 1973-75 1957-58 * * MA Forecast NABE Consensus Pessimism gap Optimism gap

8. © Macroeconomic Advisers8 January 2010 Q3: Even Without C.A.R.S. MVO Was Set to Jump Motor Vehicle Output Swings to the Plus Column Percentage points Billions of chained 2005 $, SAAR 2004200520062007200820092010 0.0 0.8 1.6 2.4 3.2 -0.8 -1.6 -2.4 -3.2 0 20 40 60 80 -20 -40 -60 -80 Contributions to GDP growth (left) Change (right) Domestic Final Sales vis a vis CARS 09:Q309:Q4 "As reported"2.3%1.8% Excluding CARS1.7%2.4%

9. © Macroeconomic Advisers9 January 2010 2nd Half and Beyond – Lift from Inventories Nonfarm Inventory Investment excl. MV&P and I/S Ratio Ratio H F Billions of chain-type (2005) dollars I/S ratio Inventory investment Abundance of caution here in our forecast spells upside risk! 09:2H20102011 Cont. to GDP Growth:1.8pp 0.6pp0.3pp Source: Bureau of Economic Analysis, Macroeconomic Advisers, LLC; Forecast prepared on December 23, 2009.

10. © Macroeconomic Advisers10 January 2010 Housing Recovery: House Prices Turning Up? Certainly Firming Ahead of Schedule 3-month annualized percent change Source: Loan Performance; FHFA; S&P; Flow of Funds Accounts (FF); Last data plotted is for October 2009. *Calculated as Holding Gains on Real Estate (market value) held by Households and Non-profit Organizations and Residential Real Estate held by Nonfarm Noncorporate Business, divided by Total Real Estate Holdings, lagged one quarter. Forecast prepared on December 23, 2009. 20012002200320042005200620072008200920102011 0 5 10 15 20 25 -5 -10 -15 -20 -25 -30 -35 0 5 10 15 20 25 -5 -10 -15 -20 -25 -30 -35 Case-Shiller composite 20 FHFA: PO LP-HPI Implied FF/MA Forecast*

11. © Macroeconomic Advisers11 January 2010 Single-Family Housing Starts Housing Recovery on Track! SAAR, thous. units 198619891992199519982001200420072010 0 500 1000 1500 2000 2500 0 500 1000 1500 2000 2500 Current forecast +/-1 S.E. A firming in home prices lowers the current user cost of housing and boosts demand for housing in a model that well understands the boom and bust…when fed the actual path of house prices! 1,216

12. © Macroeconomic Advisers12 January 2010 Housing Recovery: from Drag to Boost! Housing Starts and Residential Investment Turn Up SAAR, thous. units Residential investment (right) Private housing starts (left) 4-quarter percent change H F 09:2H20102011 Cont. to GDP Growth:0.4pp 0.6pp0.8pp

13. © Macroeconomic Advisers13 January 2010 Financial Conditions: Healing Apace Credit Conditions Much Improved Percent H F Conventional mortgage rate – 10-yr treasury spread BAA – 10-yr treasury spread

14. © Macroeconomic Advisers14 January 2010 Small Business Credit Problems No Worse than Early 1980s? Net percent harder to get There has been a cyclical tightening of credit terms for small business, but it is not unprecedented. Real GDP grew ~ 6% in first year after the 1974-75 recession. 197419771980198319861989199219951998200120042007 0 5 10 15 20 25 30 -5 0 5 10 15 20 25 30 -5 There has been a cyclical tightening of credit terms for small business, but it is not unprecedented. Real GDP grew ~ 6% in first year after the 1974-75 recession. Financial Conditions: Healing Apace

15. © Macroeconomic Advisers15 January 2010 Household Net Worth Trillions of dollars H F Other Equities Total Household Net Worth: A Start at Recovery! -$18 tril. (-1.4) -$4 tril. (-0.5) -$9 tril. -$11 tril.

16. © Macroeconomic Advisers16 January 2010 Personal Saving Rate Percent H F Saving Rate Reset Higher Decline since early '80s mostly explained by our life-cycle model to result from a rise in the wealth/income and transfers/income ratio. Either the "model breaks down" or combination of massive hit to wealth and transfer income!

17. © Macroeconomic Advisers17 January 2010 Durables Bear Much of the Burden Light Vehicle Sales Millions of units, annual rate Monthly sales Quarterly sales and MA forecast Replacement demand (m) 11.812.413.0 scrappage rate (%)5.005.255.50

18. © Macroeconomic Advisers18 January 2010 Broad, Trade-Weighted, Foreign Real GDP 4-quarter percent change Global Recovery, Upside Growth Risk Source: Oxford Economics, Macroeconomic Advisers 19741978198219861990199419982002200620102014 0 2 4 6 8 -2 -4 0 2 4 6 8 -2 -4 Forecast (OE) Equation OE forecast assumes "permanent" loss of 5% of ROW GDP. An alternative forecast that gets back that GDP has dramatically different short- run growth implications...and for US exports.

19. © Macroeconomic Advisers19 When Will the Fed Exit Zero Rate Policy? Rate Prescriptions from a Forward-Looking Policy Rule Macroeconomic Advisers forecast - December 4, 2009. Inflation and unemp. rate are November 2009 FOMC forecasts. H F -4 -2 0 2 4 6 8 10 1987198919911993199519971999200120032005200720092011 Policy Rule Prescription Actual and Predicted Funds Rate Percent R = 2.5 +  + 1.1 (  -  *) - 1.33 (U-U*)

20. © Macroeconomic Advisers20 How?: Exit Strategy End Easing –End Securities Purchase Programs Passive steps –Close Liquidity Facilities –Runoff Active steps –Raise interest on reserves ( IOR ) –Actively withdraw reserves ( reverse repos, term deposits) –Shrink the Balance Sheet ( asset sales vs. runoff )

21. © Macroeconomic Advisers21 January 2010 Significant Downside Risks Remain Securitization markets in key segments still “dependent” or broken CMBS market still facing a refi squeeze, with spillovers to banks RMBS spreads may widen sharply as Fed unwinds balance sheet Bank lending to consumer remains stingy; More HH de-leveraging? Foreclosures threaten home price stabilization; prices could turn down Recovery in equities could falter; further erode HH balance sheets Energy price increases still are a drag on growth; could be worse Foreign demand for $ assets could fall short, pressure $  and rates  Expiring Bush tax cuts could add drag... uncertain as to when Back side of ARRA stimulus implies drag; will recovery have legs? What about health care reform? Cap and Trade?

22. © Macroeconomic Advisers22 January 2010 Summary of the Macroeconomic Advisers' Forecast Above-consensus growth of real GDP: 2010 (4/4) = 3.8% vs. 3.2%* –Consumer spending: 2010 (4/4) = 3.3% vs. 2.1%* –Housing starts: 2010 annual average = 851,000 units vs. 790,000* –Unemployment rate peaks at 10.2% in 2010:q1; falls to 9.6% in 2010:q4 Below-consensus core PCE inflation: 2010 (4/4) = 1.0% vs. 1.5%* Expecting Fed to first raise rates in June 2011! Market looking for first hike in the Fall of 2010! Preceded by passive liquidity facility and balance sheet run-off * National Association for Business Economics - Quarterly Outlook Survey - November 22, 2009

23. Back-up Slides

24. © Macroeconomic Advisers24 January 2010 MA Forecast Details

25. © Macroeconomic Advisers25 January 2010 Forecast Comparison 09Q309Q410Q110Q220102011 GDP Growth MacroAdvisers (Dec 23)2.24.7 3.53.43.84.3 Blue Chip (Jan 10)2.24.02.92.82.93.2 PCE Growth MacroAdvisers 2.81.83.12.93.33.5 Blue Chip2.81.71.92.12.22.6 Unemployment Rate MacroAdvisers9.610.010.29.99.68.1 Blue Chip9.610.010.210.19.88.9 GDP Price Inflation MacroAdvisers0.40.81.00.9 0.8 Blue Chip0.41.31.41.31.4 1.7 Fed Funds Rate MacroAdvisers0.160.20 0.75 Blue Chip*0.160.20 0.250.752.00 10-yr Note Yield MacroAdvisers3.523.453.703.794.054.53 Blue Chip3.5 3.73.94.24.8 * Inferred from t-bill yield Q4/Q4 Q4 Average FOMC CT (Nov) −0.4-−0.1 2.5-3.5 FOMC CT (Nov) 9.9-10.1 9.3-9.7 Q4 Average

26. © Macroeconomic Advisers26 January 2010 Q4:A Solid Second Quarter of Recovery Domestic Final Sales adjusted for CARS = 2.3%

27. © Macroeconomic Advisers27 January 2010 Q1:Domestic Final Demand Finally Revs Up

28. © Macroeconomic Advisers28 January 2010 July Through October Saw Strong Growth Trillions of chained (2005) dollars MA’s Monthly GDP Index Jan.2001Jan.2003Jan.2005Jan.2007Jan.2009 11.2 11.6 12.0 12.4 12.8 13.2 13.6 11.2 11.6 12.0 12.4 12.8 13.2 13.6 October is 5.6% above Q3 avg. at annual rate! June was likely the trough

29. © Macroeconomic Advisers29 January 2010 2nd Half and Beyond – Lift from Housing! New and Existing Home Sales Turn Up SAAR, thousands Existing (left) New (right) SAAR, thousands

30. © Macroeconomic Advisers30 January 2010 Housing Recovery in Context Percent H F Billions of dollars, SAAR Nominal residential investment as a % of nominal GDP (left) Nominal residential investment (right) 2nd Half and Beyond – Lift from Housing!

31. © Macroeconomic Advisers31 January 2010 Can the Expected Housing Recovery be Financed? H F Nominal residential investment (right) Change in home mortgage debt Billions of dollars, SAAR 1972197619801984198819921996200020042008 0 200 400 600 800 1000 1200 -200 -400 0 200 400 600 800 1000 1200 -200 -400 H F Nominal residential investment Change in home mortgage debt 2nd Half and Beyond – Lift from Housing! Assumes return to long-term average aggregate LTV ratio of.72

32. © Macroeconomic Advisers32 January 2010 Senior Bank Loan Officer Survey Diffusion Indexes Index Net percentage “loosening” terms on C&I loans Net percentage “loosening” Terms on real estate loans Willingness to make consumer installment loans Financial Conditions: Healing Apace Last data plotted for Q4

33. © Macroeconomic Advisers33 January 2010 Interest Rates & Equity Values Billions of dollars Percent Financial Conditions: Healing Apace Equity wealth (left) Conventional mortgage rate (right) 10-year Treasury yield (right) H F

34. © Macroeconomic Advisers34 January 2010 Comparative Consumption/Income Ratios Consumption Ratios Reset Lower Percent 1985198919931997200120052009 84 86 88 90 92 94 96 98 6 8 10 12 14 16 18 20 EC$/YPD$ (left) ECD$/YPD$ (right) EC$ - Consumer expenditures ECD$ - Consumer expenditures durables YPD$ - Pers. Disposable Income H F

35. © Macroeconomic Advisers35 January 2010 PCE Aided by Improving Financial Conditions PCE Growth & Contributions from Wealth 4-quarter percent change Percentage points 19911993199519971999200120032005200720092011 0 3 6 -3 0 3 6 From equities wealth (right) Total PCE (left) From other net worth (right)

36. © Macroeconomic Advisers36 Growth of Personal Consumption Expenditures 4-quarter percent change H F Services Nondurables Durables...But PCE Growth Can Return to "Trend"

37. © Macroeconomic Advisers37 January 2010 Global Recovery, Dollar Decline “Help” Foreign Growth and the Dollar 4-quarter percent change Real trade-weighted exchange rate (right) H F Index Real foreign GDP (left)

38. © Macroeconomic Advisers38 January 2010 Sharply Rising Imports Depress Net Exports Exports, Imports, and Net Exports Billions of chain-type (2005) dollars 4-quarter percent change Exports (right) Imports (right) Net exports (left) H F

39. © Macroeconomic Advisers39 January 2010 Pent-up Demand Helps CapEx Tepid Recovery Growth of Nonresidential Fixed Investment 4-quarter percent change Computers and software “Other” equipment H F Structures

40. © Macroeconomic Advisers40 January 2010 A Low Base(!) Helps CapEx's Tepid Recovery Stock of Equipment & Software 4-qtr percent change H F

41. © Macroeconomic Advisers41 January 2010 Not Quite a Jobless Recovery! Employment, Labor Force, and Unemployment 4-quarter percent change Unemployment rate (right) Employment growth (left) H F Labor force growth (left) Percent

42. © Macroeconomic Advisers42 January 2010 Output per Hour in the Nonfarm Business Sector 4-quarter percent change Not Quite a Jobless Recovery! Overshoot on productivity in recession (cyclical anomaly) as firms shed workers quicker than typically (fearing deeper slump) argues for quicker re-hiring with recovery…somewhat slower productivity H F

43. © Macroeconomic Advisers43 January 2010 Why Might the Fed Exit “Early”? Emergence of an asset bubble (or asset bubbles) –Credit (already?) –Equities (next year?) –Housing (hard to believe, but…) Rise in LT inflation expectations => loss of credibility –Despite very low core inflation for an extended period Collapse in the dollar