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

Overview Despite significant disturbances… additional large energy price increases major hurricanes … the US economy keeps growing

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 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 - ΔY n / Y n ) = - b (ΔY/Y ) 3.Phillips curve (with π e = π -1 ) π – π -1 = - a (u – u n ) 4.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 * ΔI/I * ΔG/G * 0.1

Real Personal Consumption Expenditures % Change - Year to Year Source: Bureau of Economic Analysis Consumer Spending Remains Robust Note: Shading represents NBER recessions.

Michigan Consumer Sentiment Conference Board Consumer Confidence Index But Consumer Confidence Has Dropped Sharply Source: University of Michigan and the Conference Board Note: Shading represents NBER recessions.

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 Note: Shading represents NBER recessions.

Source: Bureau of Economic Analysis % Change - Year to Year% Change – Year to Year All Other Info Processing Equipment and Software Note: Shading represents NBER recessions. Investment Growth Has Recovered Well

T - G: Changes in the full employment budget balance (percent of potential output) Source: Congressional Budget Office Fiscal Year GRH-1 85 GRH-2 87 BEA 90 OBRA 93 BEA 97 Note: Shading represents NBER recessions.

Federal budget forecasts Source: Congressional Budget Office and Goldman Sachs.Note: Shading represents NBER recessions. Percentage of GDP Optimistic Pessimistic Forecast

AD ΔY/Y = ΔC/C * C/Y + ΔI/I * I/Y + ΔG/G * G/Y ΔY/Y = ΔC/C * ΔI/I * ΔG/G * 0.1 ΔY/Y = 3 * * ? = ?

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 derived from assumptions: productivity growth, 2% labor force growth, 1% Phillips curve π – π -1 = - a (u – u n ) u n = ? π – π -1 = 0  u = u n  ΔY n / Y n = 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

Employment Solid Until the Hurricanes Hit Thousands Source: Bureau of Labor Statistics Change in Private Employment, Three-Month Moving Average Note: Shading represents NBER recessions.

Source: Bureau of Labor Statistics Unemployment Drifting Down, Participation Leveling Unemployment (Left Axis) Percent Note: Shading represents NBER recessions.

Source: Bureau of Labor Statistics Unemployment Drifting Down, Participation Leveling Unemployment (Left Axis) Percent Participation (Right Axis) Note: Shading represents NBER recessions.

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 : depends on productivity growth

1003 Source: Bureau of Labor Statistics Productivity Growth Nonfarm Business Sector Output per Hour % Change - Year to Year Note: Shading represents NBER recessions.

1003 Source: Bureau of Labor Statistics Productivity Remains Solid, Unit Labor Costs Up Nonfarm Business Sector Output per Hour % Change - Year to Year Unit Labor Costs Note: Shading represents NBER recessions.

The Phillips Curve π – π -1 = a (u – u n ) u n = ? π – π -1 = 0  u = u n  ΔY n / Y n = 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

Source: Bureau of Labor Statistics Nominal Wages ECI: Private Industry Wages and Salaries % Change - Year to Year Total Private Average Hourly Earnings Note: Shading represents NBER recessions.

Source: Bureau of Economic Analysis % Change - Year to Year Core PCE Total PCE PCE Deflator: Total Up Sharply, Core Relatively Flat Note: Shading represents NBER recessions.

Source: Bloomberg $/Barrel May 13 (Last EAP) $/Barrel Crude Oil Futures Prices Oil Prices Remain Elevated

Source: Bloomberg $/Barrel May 13 (Last EAP) $/Barrel August 26 (Pre-Katrina) Crude Oil Futures Prices Oil Prices Remain Elevated

Source: Bloomberg $/Barrel May 13 (Last EAP) $/Barrel August 26 (Pre-Katrina) August 30 (Post-Katrina High) Crude Oil Futures Prices Oil Prices Remain Elevated

Source: Bloomberg $/Barrel May 13 (Last EAP) $/Barrel August 26 (Pre-Katrina) November 3 (Current) August 30 (Post-Katrina High) Crude Oil Futures Prices Oil Prices Remain Elevated

Can we measure inflation expectations? TIPS Percent 3-5 Years 0-2 Years 2-3 Years Source: Bloomberg, 8:40AM quotes and FRBNY Calculations Note: 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 %

Funds Rate Rate Percent Actual Fed Funds Rate Source: FRBNY. Last rate hike December 13

Percent 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.

Source: Federal Reserve Board 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

Source: Federal Reserve Board Percent August 8 May 13 – Last EAP August 8: Day Before August FOMC September 19: Day Before September FOMC November 1: Current May 13 Expected Funds Rate Path Has Risen, Steepened

Source: Federal Reserve Board Percent August 8 September 19 May 13 – Last EAP August 8: Day Before August FOMC September 19: Day Before September FOMC November 1: Current May 13 Expected Funds Rate Path Has Risen, Steepened

Source: Federal Reserve Board Percent November 3 August 8 September 19 May 13 – Last EAP August 8: Day Before August FOMC September 19: Day Before September FOMC November 1: Current Expected Funds Rate Path Has Risen, Steepened May 13

But how powerful is the Fed ? Investment depends on “long” rates but the Fed only controls “short” rates

Source: FRBNY Calculations Percent May 13 October 24 The Yield Curve Has Risen and Flattened Maturity Date (Years) *Estimated using off-the-run Treasury securities November 3

Source: FRBNY Calculations Percent May 13 October 24 But “Conundrum” Remains in Forward Rates Maturity Date (Years) November 3

Short-Term Real Rates Up, Long-Term Flat Treasury Yield minus Philadelphia Fed Survey Inflation Expectations Percent Source: Federal Reserve Board and Philly Fed Percent 1-Year 10-Year Note: Shading represents NBER recessions.

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

Note: Shading represents NBER recessions. 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

Public Savings Changes in the full employment budget balance (% of potential output) Source: Congressional Budget Office Fiscal Year GRH-1 85 GRH-2 87 BEA 90 OBRA 93 BEA 97 Note: Shading represents NBER recessions.

The Current Account Deficit SAAR, Bill$, BOP Basis Source: Bureau of Economic Analysis % of GDP % of GDP (Right Axis) Current Account Balance (Left Axis)

US external debt: 25% of gdp

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 ?