U.S. Economy Developments and Outlook

March 4, 2011

Outline of my talk today

• Current state of the economy• Output growth: decent overall; encouraging details• Labor market: slowly recovering, ways to go• Inflation: remains low despite rising commodity prices

• Where is the economy heading in 2011?• Recent forecasts have improved• Incoming data: mixed signals

• Some upside and downside risks• Normal business cycle dynamics• Oil prices• Fiscal drag

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3

WHERE IS THE ECONOMY CURRENTLY?

GDP Growth: Solid but not spectacular

• GDP has grown six straight quarters; 2.8 percent revised growth rate for Q4

• Q4-over-Q4 growth rate for 2010 was 2.7 percent—a bit higher than long-run potential GDP growth, but not much

• Recovery comparable to two most recent recessions, but lags recovery from previous deep recessions of 1975, 1982.

4

0.4

1.9

3.83.1 2.7 2.4 2.3

-2.8

0.2

2.7

-4.0

-6.8

-4.9

-0.7

1.6

5.0

3.7

1.72.6 2.8

01 02 03 04 05 06 07 08 09 10 08-III IV 09-I II III IV 10-I II III IV

REAL GDP GROWTHPercent Change

Q4 to Q4 Quarterly at Annual Rate

95

98

100

103

105

108

110

113

115

-8 -7 -6 -5 -4 -3 -2 -1 Trough 1 2 3 4 5 6 7 8

Real GDP During RecoveriesNBER Trough = 100

Quarters from Trough

1982

Current(2009Q2 Trough)

1975

Average 8

recessions

2001

1991

Breaking GDP into its components

• Econ 101: Y = C + I + G + NX

• Can break level of GDP up into its component parts: consumption, investment, government and net exports

• Can do the same thing for GDP growth rate—can break it into parts due to growth of each component

• Rule of thumb: component’s contribution to GDP growth equals

(Growth rate of component) * (Component’s share of GDP)

• For example: consumption spending is about 70 percent of the economy

• Therefore, consumption’s contribution to GDP growth is about (0.7) * (Growth rate of consumption spending)

• In 2010Q4, consumption grew at 4.1 percent; it’s contribution to GDP was 2.88 percentage points

5

Looking under the hood of GDP

• Handoff of recovery from inventories to sustainable final demand

• Consumption accelerated sharply in Q4, led by almost 30 percent annualized growth in auto sales

• Equipment and software slows down a little in Q4 but remains solid

• Residential and nonresidential construction have not joined party

• Net exports extremely volatile quarter to quarter—partly measurement problems with oil imports, but exports grew 8.5 percent annualized in Q4

6

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

Real GDP 2.9 -2.8 1.6 5.0 3.7 1.7 2.6 2.8 1.6 5.0 3.7 1.7 2.6 2.8

Personal Consumption Expenditures (PCE) 3.5 -1.6 2.0 0.9 1.9 2.2 2.4 4.1 1.4 0.7 1.3 1.5 1.7 2.9Residential Fixed Investment 0.3 -25.9 10.6 -0.8 -12.3 25.7 -27.3 2.8 0.3 0.0 -0.3 0.6 -0.8 0.1Nonresidential Structures 1.6 -12.7 -12.4 -29.2 -17.8 -0.5 -3.5 4.5 -0.4 -1.0 -0.5 0.0 -0.1 0.1Equipment and Software 5.7 -13.6 4.2 14.6 20.4 24.8 15.4 5.5 0.3 0.9 1.2 1.5 1.0 0.4Government 2.3 2.5 1.6 -1.4 -1.6 3.9 3.9 -1.5 0.3 -0.3 -0.3 0.8 0.8 -0.3

Inventory Investment 0.0 -0.9 1.1 2.8 2.6 0.8 1.6 -3.7Net Exports -0.4 1.2 -1.4 1.9 -0.3 -3.5 -1.7 3.4* Percent change is at annual rate, measured from 1997Q4 to 2007Q4; percentage point contribution is annual average.

2009 2010

quarterly % change at annual rate pct point contribution to % chg of GDP

201020091998-2007*

pct point contrib. to % chg

% change at annual rate

07Q4-09Q2

Labor market: slowly moving in the right direction

• Private sector jobs have grown 11 straight months; over 1.3 million private jobs added over that span.

• Will get new jobs report on Friday morning

• However, we still have over 7 million fewer jobs than we did in December 2007.

• As with GDP, employment recovery is following contour of the milder 1991 and 2001 recessions, rather than the more severe 1975 and 1982 episodes.

7

96

98

100

102

104

106

108

110

-24 -20 -16 -12 -8 -4 Trough 4 8 12 16 20 24

NBER Trough = 1001982

Private Payroll Employment During Recoveries

Months

1975

2001

1991

AverageLast 8

Recessions

Current (2009 June Trough)

102

104

106

108

110

112

114

116

118

04 05 06 07 08 09 10 11

Private Payroll EmploymentMonthly, millions

Labor market: slowly moving in the right direction

• Unemployment has fallen 0.8 percentage point in the last two months but is still quite elevated at 9 percent

• Recent decline robust to alternative unemployment indicators

• Long-term unemployment remains high—could increase long-run “natural rate” of unemployment

• Okun’s Law: Need GDP to grow 2 percent faster than long-run potential to reduce unemployment rate by 1 percentage point

8

05

101520253035404550

94 96 98 00 02 04 06 08 10

Percent of All Unemployed Out of Work for 27 Weeks or More

0

5

10

15

20

00 02 04 06 08 10

Unemployment Ratespercent

U-6Unemployed Plus Marginal & Part Time Workers

Unemployed

9

Core inflation still low despite rising commodity prices

• Commodity prices rose over 30 percent in 2nd half of 2010 due to supply shortages, worldwide growth

• But impact of commodity prices diminishes as goods move up production chain towards retail level, because labor market slack is keeping wages down.

• Wholesale inflation 0.8 percent in January, 3.6 percent over last 12 months

• Headline CPI inflation: 0.4% in January, 1.6% over 12 months. Gas prices up 13% over last 12 months.

• Core CPI inflation (excluding food and energy) 0.2% in January, 1.0% over last 12 months.

• Inflation expectations have remained stable

9

2.6

1.9

3.0

4.0

2.1

4.3

0.0

2.6

1.61.9

1.1

2.32.1

2.72.5

1.71.6

1.0

03 05 07 09 11 03 05 07 09 11

CONSUMER PRICES12-Month Percent Change, Jan to Jan

All Items Core

0.0

1.0

2.0

3.0

4.0

5.0

6.0

2007 2008 2009 2010 2011

Michigan Survey: Inflation ExpectationsPercent, Monthly

Next 12 months(line)

Next 5-10 years(bars)

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WHERE IS THE ECONOMY HEADED?

Recent forecasts point to accelerating recovery in 2011

11

• Analysts have raised their short-term forecasts in recent weeks. Forecasts for 2011 are centered around 3.5 percent. December tax cut deal and surge in consumption, exports in Q4 help explain improved outlook.

Real GDP 2011Q12011

(Q4 to Q4) 2011Q12011

(Q4 to Q4)(quarterly change at annual rate)

28-Feb National Association of Business Economists* 3.6 3.6 2.4 2.9

25-Feb Bank of America/Merrill Lynch 4.0 3.4 2.8 3.1

25-Feb Fannie Mae 3.6 3.7 2.6 3.4

18-Feb Goldman Sachs 3.5 3.9 3.5 3.9

18-Feb Mortgage Bankers Association 3.2 3.4 2.5 2.7

14-Feb Wall Street Journal Survey Average 3.6 3.5 2.7 2.8

11-Feb Economy.com 4.3 4.4 2.6 3.2

11-Feb Survey of Professional Forecasters* 3.6 3.4 2.4 2.9

10-Feb Blue Chip Average 3.5 3.5 2.5 2.9

10-Feb Blue Chip Top 10 Average 4.4 4.4 3.2 3.7

10-Feb Blue Chip Bottom 10 Average 2.8 2.7 1.9 2.1

10-Feb Freddie Mac 3.3 3.8 2.8 3.7

9-Feb Bloomberg Survey Median 3.5 3.5 2.4 -

9-Feb Wells Fargo 4.1 3.3 2.5 2.5

8-Feb Energy Information Administration 3.5 2.9 1.9 2.3

4-Feb Macroeconomic Advisers Baseline 4.0 4.4 3.5 4.1

4-Feb Morgan Stanley 4.4 4.0 3.3 4.1

Median Forecast 3.6 3.5 2.6 3.0*Previous survey was undertaken 3 months ago.

SELECTED U.S. ECONOMIC FORECASTS

Most Recent 2 Months Ago

Date of Forecast

12

Recent Data: some very encouraging signs…

• Consumer confidence surging

• Michigan, Conference Board measures now at highest level since early 2008.

• Institute for Supply Management (ISM) manufacturing growth index highest since May 2004

• Employment component of ISM highest since 1973; export component highest since 1988

• Nonmanufacturing ISM out today; January index highest since 2005

• Unemployment Insurance claims have dropped to lowest levels since July 2008

• Other data also show drop of inflows into unemployment

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-350

-300

-250

-200

-150

-100

-50

0

50

-104 -78 -52 -26 Peak 26 52 78 104

1981/82 CyclePeak claims: 674,250

(thin solid line)

Weeks

Four-Week Moving Average of Initial ClaimsDifference from Peak Value of Claims, Thousands

Weeks

Four-Week Moving Average of Initial ClaimsDifference from Peak Value of Claims, Thousands

Current CyclePeak claims: 643,000

(thick solid line)

1973/75 CyclePeak claims: 560,750

(dashed line)

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45

60

75

90

105

120

135

150

15

30

45

60

75

90

105

120

135

150

90 92 94 96 98 00 02 04 06 08 10

CONSUMER ATTITUDESMonthly

Reuters/U. Mich.sentiment

Conf. Boardconfidence

• Real Personal Consumption Expenditure dropped 0.1 percent in January; data so far suggests only 1.2 percent annual PCE growth in Q1

• Core durable goods shipments (excluding defense, aircraft) down 2 percent in January; new core orders down 7 percent.

• Taken at face value, limited data so far suggests equipment and software spending will fall in Q1

• Private payrolls up only 50K in January, well below expectations for 150-200K private payroll jobs.

• February jobs report will be released tomorrow morning

• How to reconcile weak hard numbers with strong survey evidence?

• Bad weather in January depressed payrolls, and possibly PCE

• In recent quarters, durables spending has been weak in first month, grown strongly in 2nd and 3rd month.

• We look for numbers to bounce back strongly in February.

• February auto sales jump sharply: over 6 percent in just one month

13

Hard data for Q1 not strong so far—but with an asterisk

Housing: prices are starting to decline again

• House prices trending down in recent months.

• Case-Shiller/S+P house price index down 2.4 percent in 2010 (December to December); FHFA index down 3.3 percent; CoreLogic down 5.5 percent.

• Recent forecasts call for continued declines in 2011 and 2012, although at a much slower pace than in 2007-2009.

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House Price Forecasts(Cummulative Percent Change From 2009, Q4/Q4)

2010 2011 2012 2013

MacroMarkets Survey (Avg.) December -1.1 -0.2 1.9 2.9 June -1.4 1.3 2.7 3.5

Economy.com December -3.1 -7.4 -5.0 0.9 June -5.9 -5.2 -1.5 4.6

Nat. Assoc. of Realtors December -0.5 -5.5 -5.5 -4.5 June 1.2 4.2 7.4 11.1

60

65

70

75

80

85

90

95

100

105

60

65

70

75

80

85

90

95

100

105

2007 Jul 2008 Jul 2009 Jul 2010 Jul 2011 Jul 2012 Jul 2013

CoreLogic w/ distressed

CoreLogic w/o distressed

Case-Shiller 20

FHFA Purchase Only

MacroMarketsLow

MacroMarketsAvg

Monthly House Prices2007:Q1=100

Housing: too much supply, not enough demand

• Prices are falling because of adverse supply and demand conditions

• Home sales have been weak since expiration of home buyer tax credit in April 2010, although they did jump in December

• Supply is elevated because of overbuilding during mid-1980s, and because of large overhang of distressed properties

• Mortgage delinquency rates fell sharply in Q4, suggesting that inflows of new homes into distress will slow down.

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3000

3500

4000

4500

5000

5500

6000

6500

7000

00 01 02 03 04 05 06 07 08 09 10 11

Single-Family Existing Home Sales(1000s at an annual rate)

0

5

10

15

20

25

30

35

40

45

50

0

1

2

3

4

5

6

7

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9

10

00 01 02 03 04 05 06 07 08 09 10 11

Seriously Delinquent Loans(90 days past due + foreclosed, percent of serviced loans)

Total (left scale)

Conv. Fixed (left scale)

Sub Prime ARM (right scale)

Percent Percent

Impact of housing market on GDP

• How will weak housing market affect GDP?

• Direct effect: residential construction will remain low until excess supply worked off.

• Indirect effect: declining prices could slow down PCE growth by reducing home equity.

• Fortunately, recent price declines have been mostly concentrated in distressed homes, limiting impact on consumer spending.

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0.0

0.3

0.5

0.8

1.0

1.3

1.5

1.8

2.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Starts

Permits

Single-Family Starts and PermitsAnnual rate, millions

1.5

7.4

11.5

6.6 5.3

-15.7

-20.7

-24.6

-13.4

-4.7

-22.6

-32.6

-36.2

-19.7

10.6

-0.8

-12.3

25.6

-27.3

2.7

01 02 03 04 05 06 07 08 09 10 08-III IV 09-I II III IV 10-I II III IV

RESIDENTIAL INVESTMENT Percent Change

Q4 to Q4 Quarterly at Annual Rate

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UPSIDE AND DOWNSIDE RISKS TO THE ECONOMY

• While recovery is projected to accelerate in 2011, growth at 3.5 to 4 percent is still below what we might expect from a recovery from a deep recession

• Following the 1982 recession, real GDP grew 7.7 percent (Q4 over Q4) in 1983, and 5.6 percent in 1984. Following the 1975 recession, economy grew 5.0 percent in 1977 and 6.7 percent in 1978.

• Typical business cycle dynamics that support rapid growth during a recovery:

• The virtuous cycle: as businesses create more jobs and expand capacity, consumption and investment demand will accelerate…which will businesses to create more jobs and further expand capacity.

• Will surge in PCE in Q4 trigger strong hiring in 2011?

• Durable goods catch-up: should promote sharp acceleration of consumer durables, business equipment and (eventually) residential investment.

• Consumer durables surged 21 percent in Q4, led by cars.

• Rising population and household formation will drive housing demand in the long run.

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Upside risk: normal business cycle dynamics

Downside risk: oil price shock

• Crude oil up about $10/barrel over past 10 days, to around $100.

• Gas prices are up about 25 cents to $3.44 per gallon over past 2 weeks.

• Sustained $10 increase will reduce real GDP about 0.1 percentage point this quarter, about 0.25 ppt after one year.

• Most of the effect comes through consumption.

• Gasoline is about 5 percent of typical household’s budget.

• An 8 percent price increase reduces household resources available for spending on other goods and services by about 0.3 percentage point.

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-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

2010.1 2010.3 2011.1 2011.3 2012.1 2012.3 2013.1 2013.3

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Real GDP - Percentage Difference from Baseline - $10 Simulations

Domestic Spot Market Price: West Texas Intermediate, Cushing

$/Barrel

100908Source: Wall Street Journal /Haver Analytics

150

125

100

75

50

25

150

125

100

75

50

25

Downside risk: fiscal drag

• State and local governments have balanced budgets by cutting spending and raising taxes, creating a drag on GDP

• Local government has lost 366K jobs since September 2008, and is continuing to decline

• December tax cut deal prevented federal fiscal drag for 2011, but sharp spending cuts could undo stimulus from December package

• A $61 billion dollar spending cut concentrated into the last 7 months of FY2011 would reduce aggregate demand by roughly 0.7 percentage point.

• A one-week shutdown would reduce Q1 GDP by 0.1-0.2 percent, mostly due to lost federal work hours and delayed defense purchases. 20

90

95

100

105

Payroll Employment: Private v. State and Local GovernmentJanuary 2008 - January 2011, (December 2007 = 100)

State Gov't Employment

Local Gov't Employment

Private Employment