Fed Upgrades GDP Forecast

Remains significantly concerned about unemployment

The minutes of the January FOMC meeting show the Fed more optimistic about economic growth in 2011. The Fed raised the central tendency for real GDP growth in 2011 to 3.4% - 3.9% from the November forecast of 3.0% to 3.6% (see Table 1). The revisions to projections of economic growth in 2012 and 2013 were small compared with the revision of estimates for 2011. Consistent with the upward revision of real GDP, the unemployment rate was lowered from the November prediction. However, the unemployment rate remains at an elevated level of 8.8% to 9.0% in the fourth quarter of 2011. Predictions of inflation, overall and core, were both raised slightly for the entire forecast period.

Source: Federal Reserve

Most members continue to hold that there is a great deal of uncertainty still. The minutes listed five major sources of uncertainty - (1) the nature of economic recoveries after financial crisis, (2) the effects of unconventional monetary policies, (3) structural problems in the labor market, (4) the future path of fiscal policy, and (5) global economic outlook. Despite these significant sources of concern, most members view that risks are broadly balanced with regard to real GDP growth. This is marked change from the view held in November, when most members held the opinion that downside risks to economic growth by far outweighed the upside risks. Pent-up demand and increased ease of credit availability were cited as factors leading to stronger-than-expected growth. Budgetary woes of state and local government translating to a decline in their spending that exceeded expectations, lower house prices and its attendant adverse consequences on household balance sheets and spending, and significantly slow improvements in the labor market which would raise household savings and reduce spending were seen as factors that could stall economic growth.

With regard to the labor market, although the outlook for the unemployment rate was balanced, members noted that if firms are pessimistic about underlying economic conditions and remain reluctant to increase payrolls, the pace of decline of the jobless rate would be less than the current prediction. The staff presented the current status of research about structural unemployment in the January deliberations. The main conclusion was that structural unemployment had risen but by less than actual increase in the unemployment rate. The minutes also noted that many factors that accounted for the increase in structural unemployment would "recede over time." The discussion also mentioned that mismatches of labor skills and "hiring practices" could not be solved by monetary policy. A few others hold that under current conditions monetary policy still had a positive role to play in reducing joblessness.

On the inflation front, compared with the assessment in November, the probability of deflation had dropped significantly. A few members saw upside emanating from the large size of the Fed's balance sheet. The persistent gap between the jobless rate and the long-run benchmark was seen as source for inflation to be lower than projected. A few members noted that higher energy and commodity prices presented an inflationary risk. Others added that there is only small pass-through of these higher prices to overall consumer price indexes.

Given the nature of economic conditions, the Fed plans to complete its purchases of longer dated Treasury securities. The minutes indicate a difference in opinion about quantitative easing, with some members suggesting a reduction as economic conditions improve, while others were unsure about the impact and held that the program should continue. A few others indicated that it was not likely that economic conditions would change sufficiently to justify a termination of the second round of quantitative easing.

Construction of Apartment Buildings Lifts Housing Starts, But Overall Trend is Soft

Total housing starts increased 14.6% to an annual rate of 596,000 in January. The headline reflects a 77.7% jump in starts of multi-family units and a 1.0% decline in construction of new single-family homes. Starts of new single-family have dropped in three out of the last four months.

Construction of single-family homes makes up the bulk of home building activity in the nation. The level of single-family starts (see Chart 2) stood at an annual rate of 413,000 in January, which is slightly higher than the record low reading of 360,000 registered in January 2009. The record high mark of 1.823 million units was established in January 2006 (see Chart 2). The median level of single-family housing starts during 1959-2000 is around 1.05 million units. Putting these numbers in perspective, the latest tally of housing starts is significantly below historical norms. Stronger growth in payrolls and a reduction in foreclosures are the essential ingredients for an improvement in housing starts in the months ahead.

The number of permits issued for new multi-family homes fell nearly 24% in January, while permit extensions for single-family units declined 4.8%. Typically, permit extensions lead housing starts. Therefore, this information suggests a strong likelihood of a decline in housing starts during February.

Autos and High-Tech Sectors Boost Factory Production

Industrial production edged down 0.1% in January after a robust 1.1% increase in the prior month. A reversal of production at the nation's utilities to a 1.6% drop in January after a 4.1% increase in December was part of the reason of the overall decline in industrial production during January. Factory production, excluding utilities and mining, moved up 0.3% in January after an upwardly revised 0.9% jump in the prior month. In January, a 3.2% increase in production of motor vehicles and a 1.2% increase in high-tech production accounted for most of the increase in factory output. Excluding autos and high-tech, factory production rose only 0.1% during January after a hefty 0.8% increase in December.

The industrial production index in January was 95.1 vs. the peak reading of 100.7 in September 2007. Reflecting the enormous unused capacity, the operating rate of the nation's factories was 73.7% in January vs. a long-term average of 79.1%. The slack in factories has lead to firms not considering expansion plans in the near term as they remain unsure of demand conditions.

Energy, Food, Medicine Raise Wholesale Prices in January

The Producer Price Index (PPI) for finished goods increased 0.8% in January, following similar noticeable in each of the five previous months. During five out of six months ended January, higher prices for both food and energy have raised the overall PPI of finished goods. Food prices rose 0.3% in January, putting the three-month annualized increase at 8.1%. The finished energy price index moved up 1.8% in January, which translates to a 28.6% jump in the last three months.

The core PPI, which excludes food and energy, increased 0.5% in January and the largest monthly gain since October 2008. The report of wholesale prices indicated that nearly 40% of the increase in the core PPI was due to higher prices for medicines (+1.4%). Car prices moved up 0.4% in January, while prices of women's clothing declined, men's clothes were more expensive in January compared with December.

Higher energy and food prices have raised the year-to-year readings of the PPI of finished goods, the core PPI shows a benign trend (see Chart 7) despite the uptick of the year-to-year change (+1.6% in January vs. 1.3% in December 2010).

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

About the Author

Senior Vice President and Economist