The Outlook for the U.S. Economy “Turmoil vs. Stability: The Fed’s Response” Conference for College Teaching Faculty Federal Reserve Bank of St. Louis St. Louis, MO November 6, 2008 Kevin L. Kliesen Economist Federal Reserve Bank of St. Louis

November 6, 2008Kevin L. Kliesen Outline of Talk Analyzing the Economy -- The Basics The Big Picture and Current Developments The Fed’s Strategy... And Dilemma The Near-Term Forecast Risks to the Outlook

November 6, 2008Kevin L. Kliesen DISCLAIMER

November 6, 2008Kevin L. Kliesen The Basics Analyzing current U.S. macroeconomic conditions requires some “model.” Here’s a simple one: 1.Over time the economy grows at its trend, as determined by real factors. 2.Shocks cause the economy to fluctuate around the trend. Shocks are temporary, but can have permanent effects. 3.Inflation is ultimately determined by Fed actions and expectations; some use NK models.

November 6, 2008Kevin L. Kliesen The Basics of Fed Policy The Fed operates under a “risk management” framework. 1. The evolving flow of data inform near-term risks to the economic outlook and, if necessary, policy responses. Two key aspects of this “probabilistic” approach: 1. Policymakers worry a lot about the potential for damaging economic outcomes. 2. Continual updating of “best guess” scenario for the economy as more information becomes available.

November 6, 2008Kevin L. Kliesen The Basics of Fed Policy

November 6, 2008Kevin L. Kliesen The Basics of Fed Policy

November 6, 2008Kevin L. Kliesen The Big Picture

November 6, 2008Kevin L. Kliesen The Big Picture Dramatic interventions by U.S. and European central banks and governments. Financial market volatility has been extremely high. Inflation seems to be moderating... helped along by several factors. Near-term economic growth will be extremely weak in most major economies.

November 6, 2008Kevin L. Kliesen Current Developments Prices and Inflation Expectations

November 6, 2008Kevin L. Kliesen Current Developments Headline inflation has retreated markedly over the past two months.  Energy and commodity prices stage a retreat.  But for how long?

November 6, 2008Kevin L. Kliesen

November 6, 2008Kevin L. Kliesen Current Developments Headline inflation has retreated markedly over the past two months.  Energy and commodity prices stage a retreat.  Also helping matters... Inflation expectations, a stronger dollar, and a slowing in global growth (more on this later).

November 6, 2008Kevin L. Kliesen Current Developments

November 6, 2008Kevin L. Kliesen Current Developments

November 6, 2008Kevin L. Kliesen Current Developments Headline inflation has retreated markedly over the past two months.  Energy and commodity prices stage a retreat.  Also helping matters... Inflation expectations, a stronger dollar, and a slowing in global growth (more on this later).  Falling energy and commodity prices will provide some relief to consumers and businesses.  Don’t expect a 1930s-style deflation!

November 6, 2008Kevin L. Kliesen Recent Developments

November 6, 2008Kevin L. Kliesen Q3 Real GDP Growth NOTE: Inventory investment expressed as contribution to real GDP growth. Q3 Growth was the weakest in 7 years)

November 6, 2008Kevin L. Kliesen Actual & Potential Real GDP Growth NOTE: Inventory investment expressed as contribution to real GDP growth. Potential

November 6, 2008Kevin L. Kliesen Consumers Pull Back Oil Shock!

November 6, 2008Kevin L. Kliesen Growth of Business and Household Fixed Investment in 2008-Q3 vs H1 (Q3)(H1) Nonresidential Equip. & Software Industrial Transportation Structures Residential Businesses becoming reluctant spenders. Profits wane; equity cost of capital high. Industrial and office vacancy rates turning up. Business Spending Softening

November 6, 2008Kevin L. Kliesen Industrial Production IP fell 2.8% in September. However, without the strike at Boeing and Hurricanes Gustav and Ike, IP would have been about unchanged in September. Manufacturing capacity utilization in September (76.4%) was the lowest since October 2003.

November 6, 2008Kevin L. Kliesen Current Developments The largest countries in Europe appear to be in recession, or headed there, as does Japan. Major European central banks cut their interest rate target on the same day as the Fed did (Oct. 8).

November 6, 2008Kevin L. Kliesen And Then There’s Housing! Housing... Looking for the light at the end of the tunnel.  No bottom in house prices yet; economists and housing analysts say maybe.  Nationally, home prices are down about 10% over the past year; considerable variance across regions, though.  Inventories of unsold homes too high;  Mortgage market not helping;  Some indication that home sales are stabilizing.

November 6, 2008Kevin L. Kliesen Housing Developments

November 6, 2008Kevin L. Kliesen Housing Developments

November 6, 2008Kevin L. Kliesen Current Developments Recent Financial Market Developments

November 6, 2008Kevin L. Kliesen Current Developments Current episode

November 6, 2008Kevin L. Kliesen Current Developments

November 6, 2008Kevin L. Kliesen Current Developments Volatility in the Stock Market has been incredible!

November 6, 2008Kevin L. Kliesen Current Developments One Problem: Volatility in the Stock Market has been incredible!  In the face of extreme volatility, households and businesses disengage—focusing on the here and now because planning for the future is very difficult.  One explanation:  Uncertainty about the direction of the economy.  Another explanation:  Uncertainty about the health of the financial sector—the “lemons problem.”

November 6, 2008Kevin L. Kliesen Current Developments Another Problem: The Credit Market Disturbance!  Liquidity risk and credit risk. Negative feed- back loops (Bernanke).  Bank are tightening lending standards, but lending is not contracting. More difficulties in the non-bank lending markets (e.g., commercial paper).

November 6, 2008Kevin L. Kliesen

November 6, 2008Kevin L. Kliesen A huge increase in bank lending over the past three months—or is it? According to the Board of Governors, large domestically chartered commercial banks acquired $259.2 billion in assets and liabilities of nonbank institutions in the week ending October 1, 2008.

November 6, 2008Kevin L. Kliesen Current Developments How Did We Get Into This Mess?  Public policies—Bi-partisan goal of increasing home ownership; low-cost of credit.  Securitization—willing lenders, borrowers, and investors (the search for high yield in an environment of unusually low risk premiums).  Wrong assumptions about house prices.  Bad timing—an oil shock and the housing bust.

November 6, 2008Kevin L. Kliesen The Fed’s Strategy

November 6, 2008Kevin L. Kliesen 1. Reduce the FOMC’s interest rate target... It is currently at 1.5% (as of Tuesday, Oct. 28) 2. Increase funds available to banks and financial institution to support borrowing and intermediation? The Fed’s Response

November 6, 2008Kevin L. Kliesen Summary of Fed Lending Facilities

November 6, 2008Kevin L. Kliesen The Fed’s Response Growth: Jan. 5, 2005, to Sept. 10, 2008: 11.5% Sept. 10, 2008 to Oct. 22, 2008: 35.6%

November 6, 2008Kevin L. Kliesen The Fed’s Response

November 6, 2008Kevin L. Kliesen The Near-Term Forecast

November 6, 2008Kevin L. Kliesen Forecast Are We in a Recession? If it walks like a duck, and quacks like a duck...

November 6, 2008Kevin L. Kliesen Forecast An “Average” Profile of the Past Four Recessions. Over the past four recessions, the average decline in real GDP is about 0.75%. The average decline lasts about 2 quarters.

November 6, 2008Kevin L. Kliesen Forecast The Consensus forecast: A short, shallow recession.

November 6, 2008Kevin L. Kliesen Forecast The Optimistic forecast: No recession.

November 6, 2008Kevin L. Kliesen Forecast The Pessimists’ forecast: A deeper, longer recession than normal.

November 6, 2008Kevin L. Kliesen SOURCE: OECD, August 2008 Real GDP Growth Residential Fixed Inv. Growth House Prices Short-term Real Interest Rates

November 6, 2008Kevin L. Kliesen What are Some Key Risks to the Outlook?  Difficult to forecast in an environment of uncertainty.  If equity prices continue to decline, the outlook for consumer and business spending will worsen.  By contrast, a rapid V-shaped recovery with a lot of monetary stimulus in the pipeline is worrisome.  FY 2009 budget deficit may exceed $1 Trillion! Forecast

November 6, 2008Kevin L. Kliesen QUESTIONS?