Fed's peak at the National Economic Conditions

Latest Fed speak buzz words to watch for –

fiscal drag, fiscal restraint, moderate growth

…mild restraint in 2012 to much greater restraint in 2013,

…will continue purchasing assets until it sees substantial improvement,

…a self-sustaining economic expansion,

…situation has changed in a meaningful way

The Outlook for the National and Local Economy

April 16, 2013

William C. Dudley, President and Chief Executive Officer

National Economic Conditions

Turning to the national outlook, the U.S. economy remains on the slow growth track that has persisted since the recession ended in mid-2009. In fact, real gross domestic product (GDP) grew just 1.7 percent in 2012, below the 2.2 percent rate of the preceding two years. This lackluster and disappointing performance masks the fact that the underlying conditions that support growth have been gradually improving. However, in the near-term, this improvement in fundamentals is being offset by federal tax increases and spending cuts, which economists call “fiscal drag.”  The most obvious example of this is the end of the partial payroll tax holiday at the beginning of this year.  This reduced the take-home pay for all those that pay into the Social Security system. 

In a recent speech to the Economic Club of New York, I discussed a number of areas where economic fundamentals have improved.  Here, let me concentrate instead on some areas of the economy where the impact of this improvement in fundamentals has been most evident: consumer spending, the housing market, and investment in equipment and software.

Despite the increase in payroll taxes and in high-income tax rates, real—that is, inflation-adjusted—personal consumption expenditures rose solidly in January and February.  As has been the case for some time, the growth of consumer spending has been led by purchases of durable goods.  Car and light truck sales in the first quarter were at the highest pace since the fourth quarter of 2007.  This growth in consumer spending probably is due, in part, to improvements in labor market conditions, household balance sheets and household access to credit.  However, retail sales were quite weak in March, suggesting that the tax increases that occurred at the start of the year may be beginning to have a material effect.  

After a long period of being a drag on the economy, the housing market is now providing lift to economic activity, with upward trends evident in housing starts, home sales, and home prices.  To see why this is so important, in 2009 residential investment exerted a 0.4 percentage point drag on GDP growth, while in 2013 it is likely to provide a boost to growth on the order of 0.5 percentage point—a swing of nearly a full percentage point.  In addition, rising home prices can create positive spillovers to the rest of the economy as higher home prices lift household wealth and reduce the number of homeowners with negative equity.

Business investment in equipment and software, another component of private final demand, strengthened in the fourth quarter, and shipments and orders for nondefense capital goods suggest further growth in the first quarter.  Moreover, indicators of the U.S. manufacturing sector, including the ISM manufacturing index and most Federal Reserve regional manufacturing indexes, point to continued moderate growth in the sector.  

So why isn't the U.S. economy growing more quickly? The most important reason is the sharp shift in federal fiscal policy from mild restraint in 2012 to much greater restraint in 2013. The increase in payroll tax rates, the rise in high income tax rates, the increase in taxes associated with the Affordable Care Act, and the sequester will result in fiscal drag of about 1¾ percentage points of GDP in 2013, an unusually large amount of fiscal restraint when the economy doesn’t have strong forward momentum and unemployment is still elevated.

In terms of the labor market, we have seen only a moderate improvement in labor market conditions over the past six months or so. After an encouraging pick up in the pace of job creation around the turn of the year, the employment report for March showed a gain of only 88,000 jobs. While I don’t want to read too much into a single month’s data, this underscores the need to wait and see how the economy develops before declaring victory prematurely.  I’d note that we saw similar slowdowns in job creation in 2011 and 2012 after pickups in the job creation rate and this, along with the large amount of fiscal restraint hitting the economy now, makes me more cautious.  

Since September, payroll employment has increased an average of 188,000 per month, compared with an average of 172,000 per month over the previous two years.  The unemployment rate has declined from a peak of 10 percent in October 2009 to 7.6 percent in March; however, much of the decrease is due to a fall in the number of people actively looking for a job.  Furthermore, as of March there were still almost 3 million fewer jobs than at the end of 2007, and the ratio of employed Americans to the working age population was actually lower than it was at the end of the recession.  Also, in an indication that employment is far from healthy, job finding rates have changed little since the recession. New York Fed staff research agrees with the broad consensus that cyclical factors are the major reason for the continued weakness in labor market conditions. 

In sum, these developments lead me to expect sluggish real GDP growth over the course of 2013 of about 2 to 2½ percent.  As such, I anticipate that the unemployment rate will decline only modestly through the rest of the year.

In the near term, there is considerable uncertainty about the outlook, particularly because the multiplier effects from fiscal drag and sequestration are still unclear. This uncertainty should gradually decline—for better or for worse—over the coming months, as the sequester’s impact takes hold and more economic data come in, giving us a clearer picture of the forward momentum of the economy.

Inflation, as measured by the personal consumption expenditure deflator, is currently well below the Federal Reserve's objective of 2 percent. There is substantial slack in the labor market and in the markets for goods and services, and underlying measures of inflation are subdued.  Moreover, peoples’ expectations of inflation remain well anchored at levels consistent with our 2 percent longer-run objective. Thus, I conclude that the risk that inflation could significantly exceed our 2 percent objective is quite low over the next few years, even if the economy were to strengthen considerably.

With inflation well below its longer-run goal and high unemployment, the FOMC decided at its March meeting to maintain a “highly accommodative” policy stance: a federal funds rate in a range of 0 to 25 basis points with forward guidance based on economic thresholds.   Moreover, to support a stronger economic recovery, the FOMC is purchasing long-term Treasury securities at a rate of $45 billion per month and agency mortgage-backed securities (MBS) at a rate of $40 billion per month, and will continue purchasing assets until it sees substantial improvement in the outlook for the labor market, conditional on ongoing assessment of benefits and costs.  Combined, these actions are intended to ease financial conditions and thereby help to establish a self-sustaining economic expansion.

As I stated in my recent Economic Club speech, the benefits of our asset purchases—as reflected in improving financial conditions and the quickening pace of interest-sensitive spending such as that on consumer durable goods, housing, and capital goods—exceeds the costs.  Furthermore, the labor market outlook has yet to show substantial improvement.  Consequently, I see the current pace of asset purchases as appropriate.

At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases.  Of course, any subsequent bad news could lead me to favor dialing them back up again. As Chairman Bernanke said in his press conference following the March FOMC meeting "when we see that the…situation has changed in a meaningful way, then we may well adjust the pace of purchases in order to keep the level of accommodation consistent with the outlook."