The Outlook for the U.S. Economy CFA Society of Louisville Louisville, Kentucky August 18, 2010

1. The Outlook for the U.S. EconomyCFA Society of LouisvilleLouisville, KentuckyAugust 18, 2010 Kevin Kliesen Business Economist Not an official document

2. Outline of Today’s Talk • The Big Picture • Current Macroeconomic Conditions • Costs and Benefits of Low Interest Rates • Thinking about Deflation Risks (The Bullard View)

3. Disclaimer The views I will express are my own and do not necessarily reflect the positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

4. The Big Picture

5. The Big Picture • Economic activity is expanding and improving, but . . .

6. The Big Picture • Economic activity is expanding and improving, but . . . • U.S. financial markets seem worried about a “double-dip.” The majority of economists are less worried.

7. The Big Picture • Economic activity is expanding and improving, but . . . • U.S. financial markets seem worried about a “double-dip.” The majority of economists are less worried. • The Fed’s interest rate has been stuck at zero since December 2008. Should we be concerned?

8. The Big Picture • Economic activity is expanding and improving, but . . . • U.S. financial markets seem worried about a “double-dip.” The majority of economists are less worried. • The Fed’s interest rate target has been stuck at zero since December 2008. Should we be concerned? • Inflation is low; some are concerned that it will head even lower—perhaps into negative territory (deflation).

9. Current Economic Developments

10. Current Economic Developments An abnormally subdued recovery. But at least conditions have improved since 2008-2009!

11. Current Economic Developments Consumers: Where’s their mojo? The growth of consumer spending remains much weaker than normal during this recovery.

12. Current Economic Developments A higher savings rate is a good thing, isn’t it?

13. Current Economic Developments A conundrum: Why are businesses boosting capital spending (equipment, software, and structures) when consumer spending is so weak and showing some loss of forward momentum?

14. Current Economic Developments Some loss of momentum in stock prices recently—but larger declines have been seen more recently. Are markets still spooked from developments in Europe?

15. Current Economic Developments But the loss of momentum in stock prices does not appear to be related to financial market stresses.

16. Current Economic Developments The recession was deeper in Kentucky and Tennessee compared to the nation. More recently, though, economic activity in both states have grown at a faster rate than for the U.S.

17. Current Economic Developments Forecasts for real GDP growth over the second half of 2010 have been marked down about 0.5 percentage points over the past two months.

18. Monetary Policy in the Current Macroeconomic Environment

19. Monetary Policy in the Current Environment • Monetary policy can affect the U.S. economy through numerous channels (transmission mechanisms). • Interest sensitive goods • Asset prices • Exchange rates • Expectations about future inflation

20. Monetary Policy in the Current Environment Monetary policy can affect the U.S. economy through numerous channels (transmission mechanism). The strength or weakness of these effects will depend to an important extent on the underlying state of the macroeconomy.

21. Monetary Policy in the Current Environment Monetary policy can affect the U.S. economy through numerous channels (transmission mechanism). The strength or weakness of these effects will depend to an important extent on the underlying state of the macroeconomy. Accordingly, what economic challenges are policymakers presently facing?

22. Monetary Policy in the Current Environment • Financial crises have long lasting effects, producing weaker recoveries. • Reinhart and Rogoff (This Time is Different: Eight Centuries of Financial Folly) • Sovereign debt crises and higher inflation often follows severe financial crises.

23. Monetary Policy in the Current Environment • Financial crises have long lasting effects. • The composition of GDP appears to be changing—because of forces unleashed by the financial crisis, or those that caused the crisis in the first place. • This means unemployed labor and capital in affected industries (autos, housing, finance) must find alternative uses. • This adjustment takes time.

24. Current Economic Developments This chart shows why the unemployment rate will probably only decline gradually.

25. Current Economic Developments That 70s show? Is the natural rate of unemployment beginning to drift upward?

26. Monetary Policy in the Current Environment • Financial crises have long lasting effects. • The composition of GDP appears to be changing—because of forces unleashed by the financial crisis, or those that caused the crisis in the first place. • Uncertainty about the economy and the longer-term effects some public policies. • “Businesses invest when there’s demand. There’s not going to be any capacity expansion, or for that matter job creation, until you seen an increase in demand.” International Paper CEO John Faraci, Aug. 12, 2010, WSJ.

27. Monetary Policy in the Current Environment • Financial crises have long lasting effects. • The composition of GDP appears to be changing—because of forces unleashed by the financial crisis, or those that caused the crisis in the first place. • Uncertainty about the economy and some public policies. • Unsustainable fiscal policy (i.e., large budget deficits). • More on this later.

28. Monetary Policy: Potential Responses

29. Monetary Policy in the Current Environment Lowering the FOMC’s federal funds rate target or interest rate on excess reserves.

30. Monetary Policy in the Current Environment We can’t go any lower, folks—or can we?

31. Monetary Policy in the Current Environment Lowering the FOMC’s federal funds rate target or interest rate on excess reserves. More Quantitative Easing (Further Expand the Fed’s Balance Sheet from Current Levels)

32. Monetary Policy in the Current Environment Room to grow?

33. Monetary Policy in the Current Environment • Lowering the FOMC’s federal funds rate target or interest on excess reserves. • More Quantitative Easing (Further Expand the Fed’s Balance Sheet from Current Levels). • Open Mouth Operations • Revising the extended period language to influence the expectations of firms, households, and financial market participants about future short-term rates, the economic outlook, strategy, etc. • Potential trade-offs of increased clarity (e.g., alarming investors)

34. Costs and Benefits of Low Interest Rates (Life is full of trade-offs)

35. Cost & Benefits of Low Rates • Benefits • Low short-term rates can help push down long-term rates, helping to spur investment and consumption of consumer durables. • Help raise asset prices. • Improves the financial condition of banks. • A standard response to a large degree of slack in the economy.

36. Cost & Benefits of Low Rates • Costs • Penalizes savers and those who rely on interest income. • Encourages speculative risk taking. • Hoenig’s criticism • Misallocates resources; prevents necessary adjustments. • Impairs short-term credit allocation (money market funds) • Implications for monetary policy (Bullard).

37. Deflation Risks and the Bullard Critique

38. Inflation Developments Core inflation is nearing the levels that cause FOMC policymakers much angst in 2003. At the time, the inflation data was lower than it is now (because of subsequent data revisions).

39. Inflation Developments Near-term inflation expectations have drifted downward since the first of the year. However, forecasts for inflation in 2011 are unchanged (about 1.75%).

40. Inflation Developments Most forecasters continue to place an extremely low probability of a decline in the CPI in 2011 (and this year also).

41. Inflation Developments Yields on long-term, inflation-sensitive Treasury securities have fallen sharply over the past four months—and probably by more than can be explained by the “soft patch” in the data.

42. Inflation Developments In the sin bin! Core inflation in Japan has been negative nearly continuously since 1998. Core inflation in the U.S. has slowed sharply over the past two years.

43. The Bullard View • Key Assumptions • Policymakers can’t push interest rates below zero • The Fed follows an “active” policy rule; that is, • When inflation > target => Fed’s policy rate > “normal”

44. The Bullard View • Key Assumptions • Policymakers can’t push interest rates below zero • The Fed follows an “active” policy rule • Taking the Fisher Relation seriously • i = r + Πe , • Where • i = nominal interest rate; • r = real interest rate; and • Πe is the expected inflation rate.

45. The Bullard View • Key Arguments • At a low core inflation rate, an adverse economic development (what economists call a “shock”) has the potential to push inflation down to extremely low levels—maybe below zero.

46. The Bullard View • Key Arguments • At a low core inflation rate, an adverse economic development (what economists call a “shock”) has the potential to push inflation down to extremely low levels—maybe below zero. • If policymakers pledge to keep the fed funds target rate near zero, then the Fisher Relation suggests that actual and expected inflation will turn negative and remain there. • Recall that i = r + Πe , • If i = 0, and r > 0, then for the Fisher relation to hold, Πe has to be negative.

47. The Bullard View • Key Arguments • At a low inflation rate, such as now, an adverse economic development (what economists call a “shock”) has the potential to push inflation down to extremely low levels—maybe below zero. • If policymakers pledge to keep the fed funds target rate near zero, then the Fisher Relation suggests that actual and expected inflation will turn negative and remain there. • Deflation is bad because the real cost of servicing debt rises (incomes fall relative to debt).

48. Inflation Developments One reason why the growth of consumer spending has been much weaker than normal during this recovery.

49. The Bullard View • Key Arguments • In the event of a negative shock, the FOMC should increase its purchases of Treasury securities (quantitative easing) to avoid a low interest rate, deflation trap (ala Japan).

50. The Bullard View • Key Arguments • In the event of a negative shock, the FOMC should increase its purchases of Treasury securities (quantitative easing) to avoid a low interest rate, deflation trap (ala Japan). • This policy would raise inflation expectations, allowing the FOMC some room to maneuver away from a zero interest rate target (but still keep policy accommodative).