Outlook for the U.S. Economy

Joe Kennedy

Is there a Trade-off Between Inflation and Unemployment?

3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0-2.0

.02.04.06.08.0

10.012.014.016.0

Years

Annual Unemployment Rate

Annu

al In

flatio

n Ra

te

Growth is Moderate•Growth in the 1st Quarter of 2012 slipped to 2.2 percent.•This ended a streak of three straight quarters of accelerating growth and indicated that strong growth may not be just around the corner.

20002001

20022003

20042005

20062007

20082009

20102011

2012

-10

-8

-6

-4

-2

0

2

4

6

8

10

GDP Growth

The Economy has Finally Started Adding Jobs

2000 - Jan 2001 - Jul 2003 - Jan 2004 - Jul 2006 - Jan 2007 - Jul 2009 - Jan 2010 - Jul 2012 - Jan

-1000

-800

-600

-400

-200

0

200

400

600

Monthly Job Loss/Gain

Year

Change in Total Nonfarm Em-

ployment(Thousands)

•The economy added only 115,000 jobs in April 2011.•After three strong months at the turn of the year, job creation may be slowing.•Economists believe that the economy needs add approximately 125,000 each month just to accommodate new entrants into the workforce.

The degree of long-term unemployment remains high

•The unemployment rate fell to 8.1 percent in April although much of the recent improvement has been due to people leaving the workforce rather than finding jobs.•A broader measure of unemployment that includes marginally attached workers, discouraged workers and part-time workers who seek full-time work is much higher.•The average duration of unemployment is 39.1 weeks.•41.3 percent of the unemployed have been jobless for 27 weeks or longer.•An interesting question is whether the expiration of extended unemployment benefits helped create a sudden fall in unemployment that is now petering out.•Labor market participation has declined over 2 percentage points from its high going into the recession. 1994199519971999200120032005200620082010

0

2

4

6

8

10

12

14

16

18

20

Unemployment Rate

U-6

Education mattersThe unemployment rate for those without a high-school degree is much higher than for those with a college degree or more.•Age and race also matter.•The unemployment rate for teenagers is 24.9 percent, for those age 25-54 it is 6.9 percent.•The unemployment rate of blacks is usually double that for whites, currently 13.0 percent to 7.4 percent.

19941996199820002002200420062008201020120

2

4

6

8

10

12

14

16

18

Less than high school

College or more

The Economy is Still Driven by Consumer Spending

1950 1955-I 1960 1965-I 1970 1975-I 1980 1985-I 1990 1995-I 2000 2005-I 20100%

10%

20%

30%

40%

50%

60%

70%

80%

Personal Consumption and Private Investment as a Percent of GDP

Year

Percent of GDP

•Consumption has risen to over 70 percent of GDP, while private investment has fallen to just over 13 percent.•A persistent criticism is that America does not invest enough in infrastructure, education, and research and development.

And Consumers are Still Over-Leveraged

1980Q1 1983Q2 1986Q3 1989Q4 1993Q1 1996Q2 1999Q3 2002Q4 2006Q1 2009Q20%

200%

400%

600%

800%

1000%

1200%

1400%

1600%

Household Debt Service Ratio

Year

Percent of Dis-posable Income

•Much of the reduction in household debt has been due to write-offs as consumers and homeowners defaulted on outstanding loans. Only a portion has been due to a shift away from consumption and into savings.

Rising Gas Prices Could Depress Consumer Spending

19901991

19921993

19941995

19961997

19971998

19992000

20012002

20032004

20052006

20072008

20082009

20102011

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

Weekly Price of Regular Gasoline

Axis Title

Price

•Crude oil accounts for 65 percent of the cost of gasoline. Taxes add another 13 percent.

Business Fixed Investment Continues to Rebound

1980 - Q11983 - Q41987 - Q31991 - Q21995 - Q11998 - Q42002 - Q32006 - Q22010 - Q10

500

1000

1500

2000

2500Gross Private Domestic Investment

Year

$Billion

But the Financial Sector Still Accounts for a High Percent of Total Profits

1980-I 1983-I 1986-I 1989-I 1992-I 1995-I 1998-I 2001-I 2004-I 2007-I 2010-I

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

Financial as a percent of total corporate profits

Axis Title

Axis Title

•This is a dangerous sign. The financial sector is a service industry that should follow business activity in the rest of the economy, not lead it.•High profits may mean that financial institutions are building leverage and expanding risk again.

The Dollar Has Fallen

2000-01 2001-04 2002-07 2003-10 2005-01 2006-04 2007-07 2008-10 2010-01 2011-040

20

40

60

80

100

120

Major Currencies Index

Date

Index

•Most recently the dollar has been trending up after a long decline•The weak American economy has caused the dollar to depreciate against major currencies.•But this has been offset by the dollar’s position as the world’s reserve currency and the tendency of investors to flock to Treasuries in times of high risk.•The European and Japanese markets also have economic difficulties.

Exports have Increased but so have Imports

1980 - Q11983 - Q41987 - Q31991 - Q21995 - Q11998 - Q42002 - Q32006 - Q22010 - Q10

500

1000

1500

2000

2500

Real Value of Exports and Imports

Year

$ Billion

•Changes in the currency rate usually take about two years to fully affect trade patterns

Exports

Imports

Inflation Expectations Remain Low

1982 - Jan 1988 - Jul 1995 - Jan 2001 - Jul 2008 - Jan0

1

2

3

4

5

6

7

Cleveland 5-year Expected In-flation Rate

Inflation Remains Low Despite Rising Food and Gas Prices

2000 2001 2001 2002 2003 2003 2004 2004 2005 2006 2006 2007 2007 2008 2009 2009

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Major Indices of Inflation

Year

Monthly Percent Change

CPI

CPI Less Food and Energy

•Motor fuel accounts for 5.1 percent of all consumer purchases•Household energy accounts for another 4 percent of purchases•Food accounts for only 14.8 percent of all purchases

The Federal Deficit Has Expanded Rapidly

19351939

19431947

19511955

19591963

19671971

19751978

19821986

19901994

19982002

20062010

-35

-30

-25

-20

-15

-10

-5

0

5

10

Federal Defict as a Percent of GDP

Year

Percent of GDP

•The automatic rise in spending and fall in taxes accounted for much of the deterioration between 2008 and 2011.•Policy changes, in particular the ARRA accounted for a smaller portion.•Future deficits are driven largely by entitlement programs driven by the growing number of retirees and, especially, the expected rise in medical costs.

The Current Deficit is due to Both Rising Spending and Falling Revenues

19711973

19751977

19791981

19831985

19871989

19911993

19951997

19992001

20032005

20072009

20110.0

5.0

10.0

15.0

20.0

25.0

30.0

Revenues and Spending as a Percent of GDP

Year

Percent of GDP

•But even without additional taxes, revenues are expected to surpass the recent average of around 18 percent of GDP once the economy recovers.

Revenues

Outlays

Total Federal Debt is on Pace to Exceed World War II Highs

19711973

19751977

19791981

19831985

19871989

19911993

19951997

19992001

20032005

20072009

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

Federal Debt Held by Public

Year

Percent of GDP

Housing Remains Weak

January

1987

January

1989

January

1991

January

1993

January

1995

January

1997

January

1999

January

2001

January

2003

January

2005

January

2007

January

2009

January

20110.00

50.00

100.00

150.00

200.00

250.00

Case-Shiller 10-City Index of Home Prices

Year

Index Value

•Housing prices appear to have stabilized•A large number of foreclosures remain in the system. •Uncertainty over how these foreclosures will be handled and how quickly will continue to depress prices.•Approximately 25 percent of homes remain underwater.•It is unclear whether financial institutions have adequately marked down these assets.

Equity Markets have Rebounded

1/3/2

000

7/3/2

000

1/3/2001

7/3/2

001

1/3/2002

7/3/2

002

1/3/2

003

7/3/2

003

1/3/2

004

7/3/2

004

1/3/2

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7/3/2

005

1/3/2

006

7/3/2

006

1/3/2

007

7/3/2

007

1/3/2

008

7/3/2008

1/3/2

009

7/3/2

009

1/3/2010

7/3/2

010

1/3/2

0110

2000

4000

6000

8000

10000

12000

14000

16000

Major Stock Market Indices

Date

Adjusted Daily Closing Price

DJIA

NASDAQ

Volatility is Down

1/3/2000

7/3/2

000

1/3/2

001

7/3/2

001

1/3/2

002

7/3/2

002

1/3/2003

7/3/2003

1/3/2

004

7/3/2

004

1/3/2

005

7/3/2

005

1/3/2

006

7/3/2

006

1/3/2

007

7/3/2

007

1/3/2

008

7/3/2

008

1/3/2

009

7/3/2009

1/3/2

010

7/3/2

010

1/3/2011

7/3/2

011

1/3/2

0120

10

20

30

40

50

60

70

80

90

VIX Index Weekly Prices

Date

Index value

Although far down from its extraordinary highs during the financial crisis, the VIX index, is still subject to sudden swings.

But Markets Still Appear to be Overvalued

1960.011965.031970.05 1975.071980.09 1985.111991.01 1996.032001.052006.072011.090.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

Shiller P/E Ratio

Year

P/E Ratio

When prices are divided by a ten-year average of real earnings, they appear to be much higher than their long-run average.

Main Risks Going Forward

International• European Sovereign Debt• Unrest in the Middle East

(including Pakistan and Afghanistan)

• Overheating and Political Instability in China

Domestic• Fears of Inflation• Inevitable Fed Unwinding• Government Deficits• Continued Foreclosures• Policy Uncertainty