Forecasting in Uncertain Times
May 18, 2010
Presented to the Economic Club of Pittsburgh
"As we are all aware, we're emerging from the deepest and longest recession since the Great Depression. Our models would tell us that the deeper the downturn in the economy, the more rapid the recovery. You've probably heard this referred to as a V-shaped recovery.
However, my outlook is that our journey out of this deep recession will be a slow one because we face two primary headwinds that I expect will temper growth for awhile. The first is the effect of prolonged unemployment, and the second is a heightened sense of caution on the part of consumers and businesspeople. Let me explain the power of these headwinds, beginning with prolonged unemployment.
Millions of people have lost their jobs during this recession, and while job loss is common to all recessions, this time around it has been more severe. Typically, during a recession, for each 1 percent that GDP falls, the unemployment rate ticks up by about seven-tenths of a percentage point. In this recession, GDP fell by 4 percent, so you would expect unemployment to rise by a little less than three percentage points. Unfortunately, it shot up by more than five percentage points, which means an extra one-and-a-half million people lost their jobs compared with our historical experience.
Just as critical is the length of time people are remaining out of work in this recession. About half of those who are currently unemployed have been out of work for at least six months, and the longer someone is out of work, the harder it is to find a job. In the 1982 recession, which was another severe recession, the average duration of unemployment peaked at 21 weeks, but today the average is already over 30 weeks--a record high. Research also tells us that workers lose valuable skills during long spells of unemployment, and that some jobs simply don't return. So workers who are lucky enough to find jobs may be going to jobs that aren't familiar to them, which means they and the companies they join may suffer some loss of productivity. Multiply this effect millions of times over, and it has the potential to dampen overall economic productivity for years.
The second powerful headwind in this recession is a heightened sense of caution, driven by a deep uncertainty about where the "new normal" or baseline might be. A whole generation of Americans who began their working careers in the mid-1980s had experienced only long periods of prosperity punctuated by just two very brief downturns. Those experiences encouraged an expectation for relatively smooth growth. Now everyone's expectations have shifted as a result of this long and deep recession.
People's attitudes about their own prospects have fundamentally changed. In a recent survey by Ohio's Xavier University, 60 percent of those polled believe attaining the American dream is harder for this generation than ones before. And nearly 70 percent think it will be even more difficult for their children. Many people are now just aiming for "financial security" as their American dream.
This has led many people to delay major purchases until their circumstances are clearer. While home sales have risen slightly as of late, overall sales have fallen by more than two million since 2006. Car sales are also still down to an annualized rate of under 12 million instead of the 16 million or more seen in the years before the downturn.
Businesses are also cautious. Business leaders base many decisions on forecasts, and they tell me that they are attaching the same high degree of uncertainty around their projections as I am. Most business leaders say that they're not planning significant hiring until there's more clarity about how the recovery is going to progress and about policies relating to health care, energy, the environment, and taxes. This caution translates into fewer job opportunities, fewer equipment purchases, fewer building projects--and on and on.
These two factors--overall caution and the effects of labor market damage--lead me to an outlook for relatively subdued output growth through this year and next, with unemployment rates that decline only gradually.
The two headwinds will also have important implications for my inflation forecast. Again, the Federal Reserve's dual mandate compels us to promote maximum employment in a context of price stability. And, as I have noted, the inflation outlook is unusually uncertain when compared with historical norms. Some observers are concerned about the likelihood of much higher inflation. Those who support this view see the possibility of inflation expectations rising as a result of the public's concerns about the Federal Reserve's expanded balance sheet at a time of very large federal budget deficits. However, there are other observers who place more stock in arguments that support an outlook for further disinflation. Where do I stand? In emerging from this recession, there are three key elements that lead me to conclude inflation will remain subdued: current inflation, labor costs, and inflation expectations. Because of the importance I attach to keeping inflation low and stable, I would like to comment on each of these factors and explain how they fit into my inflation outlook.
Let's begin with current inflation. Recent evidence I am seeing puts momentum on the side of disinflation, at least in the short run. Measures of core inflation have been falling during the past year. Core inflation measures are fairly good predictors of near-term inflation because inflation itself tends to move sluggishly. At the Federal Reserve Bank of Cleveland, we track two measures of inflation--what we call the "trimmed mean" and the median CPI series. Both of these series have been on a disinflationary path since the middle of 2008, and the prices of roughly 50 percent of the items we track in our market basket of consumer expenditures have been declining over the past three months. In this economy, companies are really holding the line on prices to boost their sales, and they can do that profitably in part because labor costs are so restrained.
Now let's turn to the second element, unit labor costs, which I also see as a good short-term predictor of inflation. Unit labor costs, or output per labor hour, consist of two components: labor compensation and labor productivity. While higher productivity is always good for long-run prosperity, it is also critical for the near-term inflation outlook. Higher rates of productivity growth reduce the amount of labor needed to produce a given amount of goods and services. In today's labor market, wages are likely to be restrained by the unemployment situation -- labor supply far exceeds labor demand. Combining rising productivity with restrained wages causes the cost of producing goods and services to fall. In fact, the data show that labor costs have fallen by nearly 5 percent since the fourth quarter of 2008, and many of my business contacts continue to talk about wage and price reductions, not increases.
Finally, I pay close attention to inflation expectations. Fortunately, despite the Federal Reserve's accommodative monetary policy stance and well-publicized balance sheet, inflation expectations over the medium to longer term have remained anchored at near 2 percent. Here once more, I must temper my forecasting model with professional judgment. Over the half-century span of data, it is reasonable to expect that, on average, inflation expectations match up with actual inflation. It may sound like a self-fulfilling prophecy--that we get low inflation because we collectively expect low inflation, but it is nevertheless borne out by both models and historical precedent.
Let me bring all the elements of my outlook together. For the next couple of years, I expect employment levels to remain well below what I would consider full employment. Similarly, I expect inflation to only gradually drift up from its currently low level but nonetheless remain subdued. In my view, this outlook warrants exceptionally low levels of the federal funds rate for an extended period of time. That said, there is more uncertainty than usual around my outlook, so it will be critical to monitor incoming information and respond as necessary to promote economic recovery and price stability."