Twelfth Federal Reserve District

FedViews

May 10, 2012

 

John Fernald, group vice president and associate director of research

  • Businesses are slowly hiring, consistent with an economy that is growing moderately. The economy has recovered about 3¾ million of the 8.8 million jobs lost during the downturn. In April, job gains were a somewhat disappointing 115,000. Still, upward revisions to jobs in February and March left the level of employment close to our expectations. The weaker apparent employment momentum may reflect warm winter weather in many parts of the country, which could have pulled some hiring forward.
  • The unemployment rate was 8.1% in April. We expect the rate to remain near 8% at the end of this year and to decline to near 7½% by the end of next year. The unemployment rate is only slowly closing the gap towards its natural rate, which is the equilibrium rate consistent with neither upward nor downward pressure on wages and inflation. The natural rate appears to have risen markedly since the onset of the Great Recession, reflecting factors such as skills mismatch and extended unemployment insurance benefits. Most of these effects are likely to fade over time.
  • Gross domestic product expanded at only a 2.2% pace in the first quarter. We expect growth to remain moderate, picking up only gradually to about a 2¾% pace in the second half of this year and in 2013. The moderate pace reflects continuing obstacles facing the economy. For example, the European debt situation continues to weigh on financial conditions. Credit availability remains constrained for many borrowers. All levels of government are trimming budgets. And lingering uncertainty about the economy and policy are constraining spending and investment.
  • The gap between the actual and natural rate of unemployment is one measure of resource slack. A related measure is the gap between potential and actual output. Potential is what output would be if the workforce and productive capacity were fully utilized at sustainable, noninflationary levels. Our current estimate of potential output is markedly lower than it was before the financial crisis and recession. One reason is labor market disruption, as indicated by the increase in the natural rate of unemployment. Those disruptions reduce our estimate of total hours that would be worked if the economy were at full employment.
  • Lower potential output also reflects slower productivity growth than we expected in 2007. Over the longer term, productivity growth is key to explaining growth in potential output. In retrospect, it appears that growth in inflation-adjusted output per hour worked has been growing significantly more slowly since the mid-2000s than before. The productivity acceleration of the mid- to late-1990s, fueled by information technology, appears to have run its course.
  • Potential output has also been reduced because growth in productive capacity ground to a halt during the recession. Depressed investment was only sufficient to replace worn out capital. Businesses did not add to the stock of stores, office buildings, computer servers, and other capital items. In the recovery, growth in equipment and software has resumed. But growth in structures remains lackluster.
  • Other indicators also point to sizeable economic slack. In surveys, few households say that jobs are plentiful. And relatively few businesses report they have a hard-to-fill vacancy, although the percentage has been rising somewhat. Anecdotal reports suggest that businesses find most positions easy to fill, except for those that require specialized engineering or technology skills.
  • Labor costs have been growing only modestly, another indicator of slack. This is true for both wages and overall compensation, including benefits. Modest compensation growth anchors costs for businesses and is a key factor in our forecast of subdued inflation.
  • Business profit margins are a link in the chain running from labor costs to prices. These margins look extraordinarily strong now. According to the national-accounts data used to compute GDP, the pretax corporate profit rate is the highest in decades and the after-tax corporate profit rate is the highest on record. We do not forecast that the profit rate will rise further.
  • Underlying inflation remains subdued. Overall inflation has run up, reflecting gasoline prices. However, gasoline prices are off their highs as crude oil has fallen from its peak. With low growth in labor costs, we expect inflation to average about 1¾% this year and next.
  • With substantial resource slack, moderate growth, and subdued inflation, interest rates are low. Indeed, in its statement following its April meeting, the Federal Open Market Committee pointed to “economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run” as factors that led it to anticipate “exceptionally low levels for the federal funds rate at least through late 2014.”

The views expressed are those of the author, 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. Please send editorial comments to Research Library.