Using the book to understand the state of
the U.S. economy
14.02 – 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
% Change - Annualized Rate
9
% Change - Annualized Rate
9
8
8
7
Top 10
May 2005
Consensus
Forecast
6
7
4
6
October 2005
Consensus 5
Forecast
4
3
3
5
2
2
Actual
1
Bottom 10
1
0
0
-1
-1
-2
-2
2001
2002
2003
Source: Bureau of Economic Analysis and
Blue Chip Economic Indicators
2004
2005
2006
Note: Dashed lines represent average of
the top and bottom 10 forecasts.
… 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 - ΔYn / Yn) = - b (ΔY/Y - 0.03)
3. Phillips curve (with πe = π-1 )
π – π-1 = - a (u – un )
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 * 0.7 + ΔI/I * 0.2 + ΔG/G * 0.1
Consumer Spending Remains Robust
% Change - Year to Year
8
% Change - Year to Year
8
7
6
7
Real Personal
Consumption
Expenditures
6
5
5
4
4
3
3
2
2
1
1
0
1998
0
1999
2000
2001
Source: Bureau of Economic Analysis
2002
2003
2004
2005
Note: Shading represents NBER recessions.
But Consumer Confidence Has Dropped Sharply
Index
160
Index
160
Conference Board
Consumer Confidence
140
140
120
120
100
100
Michigan
Consumer
Sentiment
80
80
60
1998
60
1999
2000
2001
Source: University of Michigan and the
Conference Board
2002
2003
2004
2005
Note: Shading represents NBER recessions.
Investment: Housing Starts and Home Prices Remain Strong
Thousands of Units
1800
% Change - Year to Year
14
1700
12
1600
10
OFHEO Home
Price Index
(Right Axis)
1500
8
1400
6
1300
4
Single-Family
Housing Starts
(Left Axis)
1200
2
1100
0
1998
1999
2000
2001
Source: Census Bureau and Office of Federal
Housing Enterprise Oversight
2002
2003
2004
2005
Note: Shading represents NBER recessions.
Investment Growth Has Recovered Well
% Change – Year to Year
20
% Change - Year to Year
20
15
15
10
10
5
5
All Other
0
0
-5
-5
-10
Info Processing
Equipment and
Software
-15
-20
1991
-10
-15
-20
1993
1995
Source: Bureau of Economic Analysis
1997
1999
2001
2003
2005
Note: Shading represents NBER recessions.
T - G: Changes in the full employment budget balance
(percent of potential output)
2
GRH-1
85
GRH-2
87
BEA
90
OBRA
93
2
BEA
97
1
1
0
0
1980
1985
1990
1995
2000
2005
-1
-1
-2
-2
-3
-3
Source: Congressional Budget Office
Fiscal Year
Note: Shading represents NBER recessions.
Federal budget forecasts
Percentage of GDP
3
Percentage of GDP
3
2
2
1
1
0
0
Optimistic
-1
-1
-2
-2
Forecast
-3
-3
Pessimistic
-4
-4
-5
-5
1993
1997
2001
2005
Source: Congressional Budget Office and Goldman Sachs.
2009
2013
Note: Shading represents NBER recessions.
AD
•
ΔY/Y = ΔC/C * C/Y + ΔI/I * I/Y + ΔG/G * G/Y
•
ΔY/Y = ΔC/C * 0.7 + ΔI/I * 0.2 + ΔG/G * 0.1
•
ΔY/Y = 3 * 0.7 + 8 * 0.2 + ? =
3.7 + ?
Forecast Comparison: May and November 2005
FRBNY Forecast
2005
2006
May 2
Nov 4
May 2
Nov 4
Real GDP (Q4/Q4 Growth)
3.5
3.5
3.6
3.3
Core PCE Deflator (Q4/Q4 Growth)
1.9
1.8
1.8
2.0
Unemployment (Q4 Level)
5.2
4.9
5.2
4.9
Source: Federal Reserve Bank of New York
Is current growth rate consistent with stable inflation?
Okun’s law
u – u-1
= - b (ΔY/Y - 0.03)
0.03 derived from assumptions:
•
•
productivity growth, 2%
labor force growth, 1%
Phillips curve
π – π-1 = - a (u – un )
un =
?
π – π-1 =
0 
u = un 
ΔYn / Yn = 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
Change in Private Employment, Three-Month Moving Average
Thousands
400
Thousands
400
300
300
200
200
100
100
0
0
-100
-100
-200
-200
-300
-300
-400
1998
-400
1999
2000
Source: Bureau of Labor Statistics
2001
2002
2003
2004
2005
Note: Shading represents NBER recessions.
Unemployment Drifting Down, Participation Leveling
Percent
8
Percent
67.6
7.5
67.4
7
67.2
Unemployment
(Left Axis)
6.5
67
6
66.8
5.5
66.6
5
66.4
4.5
66.2
4
66
3.5
3
1991
65.8
65.6
1993
1995
Source: Bureau of Labor Statistics
1997
1999
2001
2003
2005
Note: Shading represents NBER recessions.
Unemployment Drifting Down, Participation Leveling
Percent
8
Percent
67.6
7.5
67.4
7
67.2
Unemployment
(Left Axis)
6.5
67
6
66.8
5.5
66.6
5
66.4
4.5
66.2
4
66
Participation
(Right Axis)
3.5
3
1991
65.8
65.6
1993
1995
Source: Bureau of Labor Statistics
1997
1999
2001
2003
2005
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)
0.03 : depends on productivity growth
Productivity Growth
1003
Nonfarm Business Sector
% Change - Year to Year
% Change - Year to Year
6
6
Output per Hour
4
4
2
2
0
0
-2
-2
1998
1999
2000
Source: Bureau of Labor Statistics
2001
2002
2003
2004
2005
Note: Shading represents NBER recessions.
Productivity Remains Solid, Unit Labor Costs Up
1003
Nonfarm Business Sector
% Change - Year to Year
% Change - Year to Year
6
6
Output per Hour
4
4
2
2
0
0
Unit Labor Costs
-2
-2
1998
1999
2000
Source: Bureau of Labor Statistics
2001
2002
2003
2004
2005
Note: Shading represents NBER recessions.
The Phillips Curve
π – π-1 =
un =
a (u – un )
?
π – π-1 =
0 
u = un 
ΔYn / Yn = 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
Nominal Wages
% Change - Year to Year
5
% Change - Year to Year
5
4.5
4.5
4
4
ECI: Private
Industry Wages
and Salaries
3.5
3
3
2.5
2.5
Total Private
Average Hourly
Earnings
2
1.5
1998
3.5
2
1.5
1999
2000
Source: Bureau of Labor Statistics
2001
2002
2003
2004
2005
Note: Shading represents NBER recessions.
PCE Deflator: Total Up Sharply, Core Relatively Flat
% Change - Year to Year
4.0
% Change - Year to Year
4.0
3.5
3.5
3.0
3.0
Total PCE
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
Core PCE
0.5
0.5
0.0
1998
0.0
1999
2000
2001
Source: Bureau of Economic Analysis
2002
2003
2004
2005
Note: Shading represents NBER recessions.
Oil Prices Remain Elevated
Crude Oil Futures Prices
$/Barrel
$/Barrel
75
75
70
70
65
65
60
60
55
55
May 13
(Last EAP)
50
50
45
45
40
Jun-05
40
Oct-05
Source: Bloomberg
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Oil Prices Remain Elevated
Crude Oil Futures Prices
$/Barrel
$/Barrel
75
75
70
70
August 26
(Pre-Katrina)
65
65
60
60
55
55
May 13
(Last EAP)
50
50
45
45
40
Jun-05
40
Oct-05
Source: Bloomberg
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Oil Prices Remain Elevated
Crude Oil Futures Prices
$/Barrel
$/Barrel
75
75
August 30
(Post-Katrina High)
70
70
August 26
(Pre-Katrina)
65
65
60
60
55
55
May 13
(Last EAP)
50
50
45
45
40
Jun-05
40
Oct-05
Source: Bloomberg
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Oil Prices Remain Elevated
Crude Oil Futures Prices
$/Barrel
$/Barrel
75
75
August 30
(Post-Katrina High)
70
70
August 26
(Pre-Katrina)
65
65
November 3
(Current)
60
60
55
55
May 13
(Last EAP)
50
50
45
45
40
Jun-05
40
Oct-05
Source: Bloomberg
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Can we measure inflation expectations? TIPS
Percent
Percent
3.3
3.3
3.2
3.2
3.1
3.1
3
0-2 Years
3
2.9
2.9
2.8
2.8
2.7
2.7
2.6
2-3 Years
2.6
2.5
2.5
2.4
2.4
2.3
2.3
2.2
2.1
2/1/05
3-5 Years
2.2
2.1
3/14/05
4/21/05
6/1/05
7/12/05
Source: Bloomberg, 8:40AM quotes and FRBNY Calculations
8/19/05
9/29/05
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
Percent
10
10
8
8
6
6
Last rate hike
December 13
4
2
4
Actual Fed Funds
Rate
0
1990
Source: FRBNY.
1992
1994
2
1996
1998
2000
2002
2004
0
2006
Higher nominal rates have raised real rates as well
Percent
2.5
Percent
2.5
(TIPS Yields)
Ten-Year
Yield
2
2
1.5
1.5
Five-Year
Yield
1
1
0.5
0.5
Constructed
Two-Year
Yield
0
-0.5
1/2/04
0
-0.5
3/26/04
Source: Bloomberg and
FRBNY Calculations
6/18/04
9/10/04
12/3/04
2/25/05
5/20/05
8/12/05
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.
Percent
4.75
What do financial markets expect?
Expected Funds Rate Path Has Risen, Steepened
Percent
4.75
4.50
4.50
4.25
4.25
4.00
4.00
May 13
3.75
3.75
3.50
3.50
May 13 – Last EAP
August
8: Day Before August FOMC September 19:
Day Before September FOMC November 1:
Current
3.25
3.00
3.25
3.00
Jul-05
Nov-05
Source: Federal Reserve Board
Mar-06
Aug-06
Feb-07
Aug-07
Feb-08
Expected Funds Rate Path Has Risen, Steepened
Percent
4.75
Percent
4.75
4.50
4.50
August 8
4.25
4.00
4.25
4.00
May 13
3.75
3.75
3.50
3.50
May 13 – Last EAP
August
8: Day Before August FOMC September 19:
Day Before September FOMC November 1:
Current
3.25
3.00
3.25
3.00
Jul-05
Nov-05
Source: Federal Reserve Board
Mar-06
Aug-06
Feb-07
Aug-07
Feb-08
Expected Funds Rate Path Has Risen, Steepened
Percent
4.75
Percent
4.75
4.50
4.50
August 8
4.25
4.00
September 19
4.25
4.00
May 13
3.75
3.75
3.50
3.50
May 13 – Last EAP
August
8: Day Before August FOMC September 19:
Day Before September FOMC November 1:
Current
3.25
3.00
3.25
3.00
Jul-05
Nov-05
Source: Federal Reserve Board
Mar-06
Aug-06
Feb-07
Aug-07
Feb-08
Expected Funds Rate Path Has Risen, Steepened
Percent
4.75
Percent
4.75
November 3
4.50
August 8
4.25
4.00
September 19
4.50
4.25
4.00
May 13
3.75
3.75
3.50
3.50
May 13 – Last EAP
August
8: Day Before August FOMC September 19:
Day Before September FOMC November 1:
Current
3.25
3.00
3.25
3.00
Jul-05
Nov-05
Source: Federal Reserve Board
Mar-06
Aug-06
Feb-07
Aug-07
Feb-08
But how powerful is the Fed ?
• Investment depends on “long” rates
• but the Fed only controls “short” rates
The Yield Curve Has Risen and Flattened
Percent
4.75
Percent
4.75
November 3
4.50
4.50
October 24
4.25
May 13
4.25
4.00
4.00
3.75
3.75
3.50
3.50
3.25
3.25
3.00
3.00
0
1
2
Source: FRBNY Calculations
3
4
5
6
7
8
9
10
Maturity Date (Years)
*Estimated using off-the-run Treasury securities
But “Conundrum” Remains in Forward Rates
Percent
5.25
Percent
5.25
5.00
5.00
4.75
4.75
November 3
4.50
4.50
October 24
4.25
4.25
4.00
4.00
May 13
3.75
3.75
3.50
3.50
3.25
3.25
0
1
2
Source: FRBNY Calculations
3
4
5
6
Maturity Date (Years)
7
8
9
10
Short-Term Real Rates Up, Long-Term Flat
Treasury Yield minus Philadelphia Fed Survey Inflation Expectations
Percent
5
Percent
5
4
4
3
3
10-Year
2
2
1
1
0
0
1-Year
-1
-1
-2
1992
-2
1994
1996
1998
Source: Federal Reserve Board and Philly Fed
2000
2002
2004
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
Households Saving
% Change - Year to Year
7
% Change - Year to Year
7
Real PCE
6
Forecast
5
6
5
4
4
3
3
2
2
1
0
1998
Percent
Real Disp. Personal Income
1
0
2000
2002
2004
Percent
6
6
5
5
4
3
Personal Saving Rate
(% of DPI)
4
3
2
2
1
1
0
1998
0
2000
Source: U.S. Bureau of Economic Analysis.
2002
2004
Note: Shading represents NBER recessions.
Public Savings
Changes in the full employment budget balance (% of potential output)
2
GRH-1
85
GRH-2
87
BEA
90
OBRA
93
2
BEA
97
1
1
0
0
1980
1985
1990
1995
2000
2005
-1
-1
-2
-2
-3
-3
Source: Congressional Budget Office
Fiscal Year
Note: Shading represents NBER recessions.
The Current Account Deficit
SAAR, Bill$, BOP Basis
0
% of GDP
0
-100
-1
-200
-2
-300
-3
% of GDP
(Right Axis)
-400
-4
-500
-5
-600
-6
Current Account Balance
(Left Axis)
-700
-7
-800
-8
1998
1999
2000
Source: Bureau of Economic Analysis
2001
2002
2003
2004
2005
US external debt: 25% of gdp
Figure 2: US External Assets and Liabilities, 1982-2002
40%
Percent of Wealth
30%
Foreign Assets
Foreign Liabilities
Net Foreign Assets
20%
10%
0%
1980
-10%
-20%
1985
1990
1995
2000
2005
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 ?