National Economic Update
Modest to Moderate Growth Expected for Rest of Year
June 25, 2013 · Update in PDF
As has often been the case during the economic recovery, U.S. growth can be described as tepid, with expectations of stronger growth once temporary headwinds subside. Financial market indicators suggest that a pickup from modest to moderate growth is possible over the remainder of the year despite federal budget cuts and a continued weak growth outlook overseas. Consistent with the elevated but falling unemployment rate, inflation over the coming year should run between recent lows and 2 percent.
A Modest First Half
Economic indicators released so far for second quarter 2013 have generally been weaker than those for the previous quarter. The Blue Chip survey of forecasters predicts 1.8 percent real gross domestic product (GDP) growth in the second quarter, down from an annualized 2.4 percent in the first. This would put growth in the first half of 2013 at an annualized 2.1 percent, near the 2010–12 average of 2 percent.
The manufacturing sector continued to weaken from the relative strength it showed last winter. The Institute for Supply Management (ISM) manufacturing index fell to 49 in May—the lowest level since 2009 and below the dividing line between contraction and expansion of 50. The industrial production manufacturing index increased only 0.1 percent in May after falling the previous two months, indicating that the moderate first-quarter contribution to real GDP growth from goods production will likely not carry over to the second quarter (Chart 1). The trend in manufacturing output has slowed considerably from the early stages of the recovery, partly due to diminished foreign demand growth.
The ISM nonmanufacturing index averaged 53.4 in April and May—below the first-quarter average of 55.1, close to the recovery average of 54.4 and well above the contraction threshold (Chart 2). Nonfarm payroll employment also confirms a small step down to trend growth. The economy added 175,000 jobs in May and 149,000 in April—on balance no better than the expansion average of 163,000.
A Possible Pickup to Moderate or Better Growth
Financial market indicators suggest that acceleration above modest growth could be on the horizon. A forecast of employment growth that takes proper account of data revisions and three financial indicators—the junk-bond spread, a yield-curve inversion indicator, and a Federal Reserve measure of banks’ willingness to extend consumer credit—has been shown to be more accurate than the Survey of Professional Forecasters (SPF) reading over a two- to five-quarter horizon. It predicts that job growth will accelerate to an annualized 2.2 percent (250,000 jobs per month) in the second half of the year (Chart 3). That would be the fastest two-quarter growth rate since 2005 and a welcome surprise to most analysts—the SPF expects job growth to slow to 1.5 percent in the second half.
The forecast based on financial indicators could be overly optimistic because it does not account for shifts in demographics. The Congressional Budget Office (CBO) estimates that the potential rate of labor force growth—the trend not influenced by the business cycle—fell from 1.3 percent in the 1990s to 0.9 percent in the 2000s. Subtracting this percentage-point gap from the forecast gives 1.8 percent growth (200,000 jobs per month), still above the recovery average but more consistent with the job growth experienced so far this year.
Inflation Should Rebound
Inflation continued to decline in April as personal consumption expenditures (PCE) inflation fell to 0.7 percent at a 12-month rate, and the less-volatile Trimmed Mean PCE inflation fell to 1.3 percent, driven by the only month-over-month negative rate in the series history. A forecast of Trimmed Mean PCE inflation based on the unemployment rate, the change in the unemployment rate, and a few other variables to capture short-term dynamics has proven to be more accurate over the last decade than extrapolating from previous inflation or long-term expectations.
The current forecast is 1.8 percent over the four quarters ending first quarter 2014—a rebound from recent low rates but still short of the Federal Open Market Committee’s target rate of 2 percent (Chart 4). The forecast is dependent on long-forward inflation expectations remaining anchored.
The unemployment rate has declined from its peak of 10 percent in October 2009 to 7.6 percent in May 2013. Some analysts have argued that this average decline of 0.7 percentage points a year should not be interpreted as a reduction in slack (economic resource underutilization) because it has been driven primarily by declines in labor force participation rather than employment gains. In other words, the employment-to-population ratio has remained essentially flat. But declines in labor force participation could be driven by demographics rather than a weak labor market. The CBO’s potential labor force estimate attempts to filter out changes in the labor force driven by labor market conditions, which provides an alternative unemployment rate that counts the “disguised” unemployed but not those who would have dropped out of the labor force even in a healthy labor market.
Chart 5 shows the three measures of labor market health and their considerable range of improvement over the recovery. The unemployment rate using potential labor force has shown some improvement but much less than the conventional unemployment rate, while the employment-to-population ratio hasn’t budged. Neither of the two alternative indicators displays marginal predictive power in the Trimmed Mean PCE inflation-forecasting model when the unemployment rate is already included. This finding suggests that people who are unemployed but not actively seeking work do not have a significant impact on the evolution of inflation. However, this does not dismiss “disguised” unemployment as a concern.
Most indicators suggest that economic growth remained modest in April and May, consistent with the recovery’s disappointing average. Beyond second quarter 2013, signs of optimism persist despite fiscal cutbacks and weak foreign demand growth. Financial markets appear to expect the economy to weather government sequestration relatively unscathed. The stage should be set for acceleration to consistent, solid growth once temporary drags abate—a probability that has been stated before but has yet to materialize.—Tyler Atkinson
- "Credit Indicators as Predictors of Economic Activity: A Real-Time VAR Analysis," by N. Kundan Kishor and Evan F. Koenig, Journal of Money, Credit and Banking, forthcoming.
- “Inflation, Slack and Fed Credibility,” by Evan F. Koenig and Tyler Atkinson, Federal Reserve Bank of Dallas Staff Papers, no. 16, 2012, www.dallasfed.org/assets/documents/research/staff/staff1201.pdf.
About the Author
Atkinson is a senior research analyst in the Research Department of the Federal Reserve Bank of Dallas.