Mary Daly of the Federal Reserve Bank of San Francisco gives
her views on the current economy and the outlook. There are two issues revealed in the graphs below that I wish I
had time to discuss further. First, the graph labeled "Gaps are typical in
downturns" shows what happens to state finances in recessions, and how severe
the current recession is in that regard. The budget problems of the states in downturns is a
key factor working against recovery -- many states have little choice but to reduce spending or increase taxes when the economy goes into recession -- and we need to find a way to fix that
problem so that this recovery impeding mechanism doesn't get in the way the next time we face the problem of reviving a stalled economy. Second, the last graph shows the relationship, or rather the lack of a relationship, between budget deficits and inflation. This is a counterpoint to the objection to using fiscal policy based upon the claim that it will have undesirable inflationary consequences. It is also noteworthy, as shown in the second to last graph, that inflationary expectations remain well anchored:
by Mary Daly, FRBSF [Charts]: Financial markets are improving, and the crisis mode that has
characterized the past year is subsiding. The adverse feedback loop, in
which losses by banks and other lenders lead to tighter credit availability,
which then leads to lower spending by households and businesses, has begun
to slow. As such, investors’ appetite for risk is returning, and some of
the barriers to credit that have been constraining businesses and households
The housing sector, which has been at the center of the economic and
financial crisis, also looks to be stabilizing—albeit, at a very depressed
level. The pace of house price declines is slowing, housing starts and new
home sales have leveled off, and existing home sales have edged up in recent
months. These positive developments suggest that the housing market may be
reaching a bottom.
Income from the federal fiscal stimulus, as well as some improvement in
confidence, has helped stabilize consumer spending. Since consumer spending
accounts for two-thirds of all economic activity, this is a key factor
affecting our forecast of growth in the third quarter.
Whether the adverse feedback loop will continue to slow and ultimately
reverse depends in part on the labor markets, which continue to
deteriorate. The economy lost 467,000 nonfarm jobs in June and the
unemployment rate rose to 9.5 percent. Although recent monthly job losses
remain sizable, the pace of declines, however, is lower than earlier this
That said, ongoing weakness in the labor markets continues to push up
foreclosures and pose risks to the fledgling recovery of housing.
Although the economy continues to face many downside risks, we expect
the easing of the financial crisis and the bottoming out of the housing
market to allow a modest recovery to ensue in the third quarter. In our
view, the recovery will be painfully gradual, with the economy expanding
below potential for several quarters.
The gradual nature of the recovery will put additional pressure on state
and local budgets. Following a difficult 2009, especially in the West, most
states began the 2010 fiscal year on July 1 with even larger budget gaps to
While such gaps are typical in recessions, state governments face far
larger problems than usual since all of their major sources of revenue
(income, sales, and property taxes) have been disrupted. The federal fiscal
stimulus payments to states should help stave off even worse difficulties,
but the states likely will face constrained budgets for years to come.
As the financial crisis has subsided and the economy has begun to
stabilize, some worries about inflation have emerged. In the near-term, we
expect the slow recovery and the persistent and considerable slack in
product and labor markets to keep inflation below its preferred longer-run
rate as reflected in the minutes of the Federal Open Market Committee
meeting held in April.
In manufacturing, capacity utilization is at an all time low. This
excess capacity should continue to exert downward pressure on both input and
final goods prices.
There also is unprecedented slack in the labor markets. Considering the
official unemployment rate plus the number of workers who are employed
part-time involuntarily for economic reasons, the overall measured slack is
in excess of the 1982 recession. Moreover, we foresee this measure rising
even higher by the end of the year.
This slack in the labor markets should continue to temper growth in
wages and salaries, which has dropped off sharply over the course of the
Despite the considerable downward pressures on prices, concerns about
deflation appear to have abated. Market participants now expect inflation
over the next five years to be on average around 1%, roughly in line with
Over the longer-run, inflation expectations are higher, hovering in a 2
to 3% range, and despite considerable media worries about future inflation
risk, expectations remain well-anchored.
Still, many remain worried that large fiscal deficits will eventually be
inflationary. However, a look at the empirical link between fiscal deficits
and inflation in the United States shows no correlation between the two.
Indeed, during the 1980s, when the United States was running large deficits,
inflation was coming down.
The views expressed are those of the authors, with input from the
forecasting staff of the Federal Reserve Bank of San Francisco. They are not
intended to represent the views of others within the Bank or within the Federal
Reserve System. FedViews generally appears around the middle of the month. The
next FedViews is scheduled to be released on or before September 14, 2009.