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Welcome to the Oswego/Yorkville Economic Outlook Breakfast January 27, 2011

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1 Economic Outlook for U.S., and Illinois in 2011 Oswego/Yorkville Economic Outlook Breakfast January 27, 2011 Rick Mattoon Senior Economist and Economic Advisor Federal Reserve Bank of Chicago * The views expressed herein are my own and do not necessarily represent those of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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Presentation Road Map Understanding The Great Recession What is the recovery looking like? What is lagging? Any good news? What about Illinois/Chicago? 2

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Economic Activity Chicago Fed National Activity Index (standard deviation from trend, 3-month average) Shading corresponds with NBER recession periods

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Financial Conditions Financial Conditions Index Adjusted for Economic Conditions (deviation from trend) Shading corresponds with NBER recessionary periods

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Credit spreads between Corporate High Yield securities and Corporate Aaa securities have been edging lower

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GDP is forecast to grow around trend in 2010 and slightly above trend in 2011 and 2012

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Why was this recession so different? One wordleverage Why will the recovery be so different? One hyphenated wordde-leverage Big issuerepricing risk The New Normal 7

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CDOs of subprime mortgage backed securities (issued 2006-07, McKenzie) Estimated 3-year Default Rate Actual Default Rate AAA0.0010.10 AA+0.011.68 AA0.048.16 AA-0.0512.03 A+0.0620.96 A0.0929.21 A-0.1236.65 BBB+0.3448.73 BBB0.4956.10 BBB-0.8866.67

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All adds up to a slower climb out Financial recessions are different Still lots of slack in labor and housing and soft demand Everyone is still repairing their balance sheet 9

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The big hangoveremployment, housing and the government sector A jobless recoverywhen will hiring pick up? Housingstill working through foreclosures, inventory is too high and lack of demand even with record low mortgage rates Government sector is out of money and debt is piling up

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The unemployment rate only edged lower during 2010

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The unemployment rate is forecast to edge lower

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The forecast calls for a very slow recovery in housing

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Home price declines have been large, but appear to be close to a bottom

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Homeowners equity stake has been trending lower

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Government sector to the rescue? Not likelydebt as a share of GDP it is just over 80 percent

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Any good news? We are saving again Large banks have recapitalized No inflation on the horizon Consumer is coming backsort of Manufacturing has been doing well Large firm profits have been strongbut not necessarily from orderssmall firms are another story

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Removing the volatile food and energy components from the PCE, core inflation remains very low

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Inflation is anticipated to have increased by 1.1% in 2010and then rise 1.8% this year and 2.0% in 2012

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Industrial output in manufacturing fell quite sharply during the recession, but has risen strongly over he past seventeen months, averaging 7.9% and has recovered 53.7% of the loss during the recession

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Manufacturing capacity utilization has been rising since June of last year

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Industrial production is forecast to rise at a strong pace through the end of 2012

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Corporate profits have been rising

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Illinois and Chicago Common themeboth have done worse than the national average in this recession and so far in the recovery Performance appears to be related to underperforming Midwest region Biggest looming problem is public finance. Structural deficits and significant pension problems Both have significant assets but can they be leveraged? For Chicago a special issuereplacing da Mayor. Turning to Illinois first 24

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Midwest Unemployment Rates Have Been getting better in 4Q

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The Chicago area is steeped in services, Downstate steeped in farm, goods, and govt

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Production and Retention of Graduates Compiled of the New Economy Index, IPEDS, ACS, and the 2000 Census, this quartile chart divides the production and retention level of educated capital. The New Economy Index is described in later slides. It consists of a scoring that rates each states performance in categories that are part of the main drivers of the current economy. Source: Census/NCES/ITIF/NCHEMS High Production-Capital ExporterLow Production-Capital Exporter High Production-Capital ImporterLow Production-Capital Importer New Economy Index (2002) Top Tier Middle Tier Low Tier Import/Export Ratio of 22- to 29-Year-Olds with an Associate's Degree or Higher Production of College Grads (Undergrad Credentials Awarded per 1,000 residents ages 18 44 with HS Diploma or some college but no degree)

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Turning to Chicago City finances are a big questiontax revenues are soft and impact of declining property values are still working its way into the system. Running out of things to sellparking meters and Midway Airport Like most places all sectors of the Chicago economy have seen declines. This was a broad-based recession. Even sectors that normally dont shed jobs didhealthcare, education. Labor recovery has been poor. Did Chicago lose its mojo? Olympics, Oprah, loss of convention business. Even Daley is retiring! The conundrum concerning Chicagos economic performance- are we still the capital of the Midwest. Good news still a talent magnet

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Specific areas of concern Labor recovery Housing market

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Chicago area labor market

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Chicago participated in the national house price bubble

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Financial serviceslittle relief here so far

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Tourism and convention

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Much like last time, manufacturing gives a boost from a very low point

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Transportation/warehousing, too

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A Final Wordthe big problem Illinois Fiscal Landscape State had a structural deficit prior to the recession Pension and OPEB liabilities loom largestate pension funds are only about 40 to 45% funded Reluctance to fix the problemlittle consideration of either tax reform or expenditure restructuring New tax increase will help with the operating deficit but not enough to deal with longer term problems

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What does the new tax law do? Increases the personal income tax rate from 3% to 5% through 2015. Then 3.75% until 2025 when it would be scheduled to reduce to 3.25%. A similar increase in the corporate income tax rate from 4.8% to 7 percent until 2015. After 2015 it would fall to 5.25% and in 2025 would then fall to 4.8%. A limit on state spending of 2% per year for the next four years. If the 2% threshold is exceeded the higher income tax rates would immediately revert back to the lower levels. This will be determined by auditor general. Approval to issue $ 4 billion in bonds to make pension contributions. However, several elements failed to pass including issuing $8.75 billion in bonds to pay off prior debts and a $1 increase in the cigarette tax. 38

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39 State Individual Tax Rate GraduatedCorporateGraduated Illinois5%No7%No Wisconsin 4.6-7.75% (at $225,000) Yes7.9%No Michigan4.35%No4.95%No Indiana3.4%No8.5%No Iowa 0.36-8.98% (at $63,316) No 6.0-12.0% (at 250,000) Yes California 1.25-10.55% (at $1 million), however 9.55% kicks in at $47,055 Yes8.84%No Massachusetts5.3%No8.75%No Minnesota 5.35-7.85% (at $74,780) Yes9.8%No New Jersey1.4-8.97% (at $500K) however 6.37% kicks in at $75,000 Yes9.0%No Source: Federation of Tax AdministratorsMarch 2010 (rates are as of January 1, 2010)

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However.Current conditions For FY 11 the estimated deficit ranges from $11 billion to $14 billion. This includes an estimated $5 to $7 billion in unpaid bills Total indebtedness (including pension obligations) range from $120 billion to $132 billion or roughly $25,000 per household Pension deficit alone is between $60 and $80 billion Federal ARRA money will run its course in FY11

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Illinois problems arent going un-noticed Moodys downgraded Illinois GO bonds from A2 to A1 in June (4 notches below investment grade) The Pew Center for the States has issued two reports noting the states poor fiscal health. In Beyond California: States in Fiscal Peril, Pew finds that Illinois is in the bottom ten in terms of fiscal condition and has revenues and expenditures out of alignment and a persistent history of shortfalls In Trillion Dollar Gap, Illinois is identified with the second largest total unfunded pension liability at $54 billion (California is largest at $59 billion) but the largest per capita liability in the nation. Spillover to local governments might be harsh. Declining state support coupled with poor property tax performance and continuing declines in development related revenues.

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Market indicator of perceived risk of default -Credit default swaps Nation/StateCDS Spread (May 2010)CDS Spread June 10, 2010 Greece712.3 Germany49.8 Ireland216.5 California170.9 Illinois217.8283.0 Michigan166.7 New York147.3 New Jersey142.5 100 bps=$10,000 to insure $1 million in debt

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Summary US recovery will be gradual but 2011 is looking like stronger performance than 2010. GDP growth could be around 4% but not enough for big labor market recovery. Still in the process of deleveraging While Illinois and Chicago are starting to show some improvement they are still performing below the US average is this a Midwest issue? Big uncertainty is the fiscal picture. Neither city nor state are in good shape. New state tax package will improve operating picture but structural issues will still need to be addressed. Pressure on local governments will increase. 43