macroblog

How fast can the economy grow?

The recession may be ending (and may, in fact, have ended, according to the majority of economists recently surveyed by the Wall Street Journal) but, as Friday's consumer confidence report suggests, the uncertainty about the course of future growth is far from resolved. The most recent consensus forecast from the panel assembled for the monthly Blue Chip Economic Indicators does suggest a nice bounce back into positive growth territory, bringing to an end a four-quarter run of gross domestic product (GDP) contraction.

What remains interesting, however, is the range of disagreement about just how fast the recovery will be. The upper and lower black lines in the chart above delineate the 10 most optimistic forecasts (the upper lines) and the least optimistic forecasts (the lower lines) among the Blue Chip panel's 51 economists. Most interesting is the fact that some collection of theses economists are, in any given quarter, guessing that growth will not break a 2 percent annual pace before we exit 2010.

That uncertainty is compounded by an even more consequential uncertainty, lucidly emphasized recently by Menzie Chinn (here, here, and here): How fast can we grow before straining the economy's capacity? In other words, is slow growth the best we can expect given the economy's current potential?

The output gap—the difference between the current level of GDP and estimated potential—has long been standard fare in policy analysis. Over at iMFdirect, the International Monetary Fund's blog, Ajai Chopra explains why we care:

"What would be merely a curiosity during better times—after all, potential output is a largely abstract concept measuring the level of output an economy can produce without undue strain on resources—has become a particular worry in the context of the global economic crisis…

"Right now, budget planners across Europe are scrambling to estimate the strength of the blow the crisis has dealt to public finances, and not knowing the growth potential of their economies greatly complicates their task. If they overestimate potential growth, they would underestimate the need for fiscal adjustment once the crisis has dissipated, raising thorny issues of fiscal sustainability in the longer run.

"Central bankers, too, are looking for guidance on the path of potential output. Their decision on when to start winding down current crisis policies depends on the difference between potential and actual output, the so-called output gap. If the output gap is closing faster because of a drop in potential, policymakers might decide to increase interest rates a little earlier and a little higher to prevent  inflation from rising."

Economists also do not lack methods for estimating the output gap and, just in case the field is not crowded enough, Atlanta Fed economist Jim Nason has done some investigating of his own. Jim looked at a variety of statistical estimates of the output gap and arrived at what is now a pretty familiar conclusion. To wit, there is substantial variation in output gap estimates across the different methods, and I do mean substantial: The gap estimates for the second quarter of 2009 range from –0.5 to nearly –11 percent depending on which method is used. In other words, some methods imply the gap is very large, others say the gap is rather small.

I am tempted to invoke the ancient economists' chant, "noh-bah-de-noz," but real-life policymakers don't have that luxury. So we delve in the details and try to sort out what seems like the best approach. (If you have a technical bent, you can do the same with Jim's estimates by following this link.) As we sort it out, though, Ajai Chopra gives some sound advice:

"As for central bankers, they should also act on the information they have, although researchers such as Athanasios Orphanides (now Governor of the Central Bank of Cyprus and member of the ECB's Governing Council) have sensibly suggested that central banks should tread carefully by reducing the importance of the output gap in their decision making.

"More generally, policymakers—be they in the central bank or in the ministry of finance—would do well by communicating their assumptions about potential output growth to the public."

With that in mind, I will leave you with the recent communication on the subject offered by Federal Reserve Bank of Atlanta President Dennis Lockhart:

"Many observers see substantial slack in the economy that could persist for some years. Economists' more formal term for slack is "output gap." We at the Atlanta Fed see a meaningful output gap developing, but in our view it is smaller than would normally be associated with the weak pace of growth we expect over the next couple of years because all the obstacles to the natural pace of growth already mentioned have brought down the economy's potential for the medium term."

So, as President Lockhart indicates, mark us down, for now, on the low end of output gap scale.

Update: The San Francisco Fed's John Fernald and Kyle Matoba offer some related thoughts in the newest edition of the Bank's Economic Letter (hat tip to Econbrowser).

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

Every recovery is the same; each recovery is different

Two weeks ago, macroblog looked at the rather pessimistic expectations for what the economic recovery might look like this time around. Included was part of the narrative noting that structural adjustments are likely to impede a quick snapback in gross domestic product (GDP) over the coming quarters.

Macroblog reader Bryan Lassiter asked, "Do economists typically predict a weaker recovery than history suggests?" Good question. To state the question in a slightly different way, "Has the United States ever been in a situation where it experienced a deep recession and forecasters subsequently predicted a slow recovery that ultimately proved to be incorrectly pessimistic?"

To get at these questions, we can look at real-time real GDP data and the Survey of Professional Forecasters (SPF) available from the Federal Reserve Bank of Philadelphia (while the SPF started in 1968, forecasts of real GDP began in 1981).

The chart plots the depth of the recession on the x axis and strength of recovery on the y axis (updated from the 7/24 post to include last Friday's GDP release). The blue diamonds were constructed using forecasts that were made in the quarter the recession officially ended; the red squares are what actually happened.

To illustrate the exercise, pretend we're back in the fourth quarter of 2001 and the recession is over (although we didn't know it). Given what we thought we knew about the economy at the time, we can look at what forecasters were expecting in terms of GDP and compare it with what was ultimately reported by the U.S. Bureau of Economic Analysis. Looking at the 2001 recession, we can see that the expectations for recovery were not that far off, but the severity of the recession was lessened—partly because of data revisions and partly because of forecast error. The 1990–91 recession showed a similar pattern, but in reverse. That is, the recovery forecasts were close to the actual experience, but the depth of the recession ended up being more severe than initially thought.

What stands out in the chart is the recovery following the 1981–82 recession. In real time, four-quarter GDP growth was expected to be about 3.5 percent but wound up being much stronger at nearly 8 percent. In this instance, the response is yes to the initial question of whether economists typically predict a weaker recovery. With the 1981–82 episode, we saw a recession where economists had forecast a recovery that ultimately turned out to be much stronger than anticipated. However, the 1981–82 blue diamond was still relatively close to the cluster of other recessions on the chart, meaning the recovery forecast was not exceptionally weak. Thus, the current recession still seems to be an outlier. Given the almost 4 percent decline experienced in GDP, the hope would be to see something stronger than the 2.5 percent growth expected over the next year.

Whatever the impediments to a sharp recovery, forecasts are certainly telling us that economists are treating this recession as being different from previous ones.

To help track the economy going forward, check out our weekly Economic Highlights and Financial Highlights.

By Mike Hammill, economic policy analyst at the Atlanta Fed

A look at the recovery

Earlier this week my boss, Atlanta Fed President Dennis Lockhart, weighed in with his views about the shape of the economic recovery to come while speaking at a meeting of the Nashville, Tenn., Rotary Club:

"The economy is stabilizing and recovery will begin in the second half. The recovery will be weak compared with historic recoveries from recession. The recovery will be weak because the economy must make structural adjustments before the healthiest possible rate of growth can be achieved."

This quote was noted by Rebecca Wilder at News N Economics, along with similar sentiments from Nouriel Roubini and Mary Daly at the Federal Reserve Bank of San Francisco. You might add to the list Tim Duy's comments at Wall Street Pit and this assumption from Moody's Investor Services, reported at Seeking Alpha:

"Moody's predicts a 'hook-shaped' recovery path for banks, 'characterized by an upward tilt that lies somewhere in between a U- and an L-shaped economic recovery, implying a painful journey.' "

Says Dr. Wilder of the prospective recovery: "pathetic."

More colorful language than I would use, but if current forecasts come true, the early stages of the recovery will be as unusual as the recession itself.

How unusual? See for yourself:

The chart plots the four-quarter growth rate of gross domestic product (GDP) from the trough of a recession against the depth of the corresponding contraction, as measured by the cumulative loss of GDP over the course of the downturn. The points within the red circle represent all previous postwar recessions, and they form a nice, neat, easily discernible pattern. That is, the pace of growth in the first year after a recession has, in our history, been reliably related to how bad the recession was. The deeper the recession, the faster the recovery.

The points within the blue circle are based on forecasts of GDP growth from the third quarter of this year through the third quarter of 2010, obtained from the latest issue of Blue Chip Economic Indicators (which reports survey results from "America's leading business economists"). From top left of the circle to bottom right, the points represent the 10 lowest forecasts of the most optimistic members of the 50 Blue Chip forecasting panel, the panel's consensus (or average) forecast, and the 10 highest forecasts of the most pessimistic panel participants.

I chose the third quarter as the reference point because nearly two-thirds of the Blue Chip respondents indicate that, in their view, the recession will indeed end in the third quarter of this year. Assuming this occurs, this recovery would appear to be a big outlier. Either we are about to continue making history—and not in a good way—or current guesses about the medium-term economy are way too pessimistic.

On another note, if you would like to do a little prognosticating of your own, I commend to you our new weekly editions of Economic Highlights and Financial Highlights.

By David Altig, senior vice president and research director at the Atlanta Fed

Dueling forecasts

When smart people debate, something interesting is bound to come of it, so I have been reading an interchange over the past couple of days in the blogs of Greg Mankiw and Paul Krugman. Krugman's blog provides the necessary background on the source of the debate:

"Greg Mankiw challenges the administration's prediction of relatively fast growth a few years from now on the basis that real GDP (gross domestic product) may have a unit root—that is, there's no tendency for bad years to be offset by good years later.

"I always thought the unit root thing involved a bit of deliberate obtuseness—it involved pretending that you didn't know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall."

It is certainly true that when "unemployment is high, it tends to fall," but where it falls to is not always so obvious:

Prior to the 1973–75 recession, the average quarterly unemployment rate was 5 percent. If you had a forecast contemplating a return to "normal" following this particular recession you would have been holding your breath for a couple of decades.

Professor Krugman makes the central point, I believe, when he makes reference to the "difference between, say, low GDP growth due to a productivity slowdown… and low GDP growth due to a severe recession." That statement is, itself, recognition that the economy does periodically experience protracted episodes during which average growth and average unemployment simply do not revert to previous levels—at least not for a long time.

One of the striking things about the economic projections reported by the Reserve Bank presidents and Board's governors in the minutes from the last meeting of the Federal Open Market Committee was the rather large variation in views about GDP growth, even as far out as 2011:

That sense of uncertainty is shared by private forecasters:

What gives? There are lots of reasons for differences of opinions, and I obviously cannot (and should not) try to divine what is anyone else's deepest forecasting thoughts. But for me, "low growth due to severe recession" does not automatically imply a demand-driven downturn from which the economy will quickly spring back.

When I look ahead, I envision the U.S. economy over the next several years in terms of a simultaneous process of recovery and reformation: Recovery in the sense that the actual contraction of GDP will end, but reformation in the sense of structural transformation in financial markets, consumer behavior, and perhaps an adjustment of the global imbalances that are arguably at the root of much of the financial instability that has characterized the past decade.

If we are right, the long run is indeed rosy, but the long run will only arrive after some significant and protracted headwinds abate. And that is not a picture that suggests a rapid bounce back to "normal" growth.

By David Altig, senior vice president and research director at the Atlanta Fed

Thinking about averages

In a recent macroblog post [http://macroblog.typepad.com/macroblog/2008/12/the-recession-i.html], Dave Altig described the employment patterns in the current U.S. recession relative to the average recessionary experience. Dave made some observations from the data supported, in part, by a similar chart to the one produced below:

Before the November job report, the overall employment picture had been fairly unexceptional compared with the average recessionary experience. That comparison changed, as I guess will happen when a half-million job loss statistic arrives. As of today, a milder-than-average recession has turned into a somewhat deeper-than-average recession, at least in terms of employment. Assuming that we remained in recession through November—and I don’t think that conjecture will draw much debate—the current episode is already a year in duration. A more apt comparison might therefore be the “bad” recessions of recent memory, the 1973–75 and 1981–82 episodes, both of which lasted 16 months.

      

Dave’s comparison addresses two important dimensions of the data—the magnitude of the recession and the duration of the recession. Another important dimension is the “breadth” of the recession. Here, perhaps, the distinction between this recession and historical average could be equally insightful.

We can gauge the breadth of the employment decline by way of the employment diffusion index, which simply calculates the proportion of the industries (a total of 274, according to the U.S. Bureau of Labor Statistics) reporting an employment gain relative to the proportion experiencing a decline. Recall that in a diffusion index, if a greater number of the measured series are rising than are declining, the index will be above 50; if fewer are rising than declining, it will be below 50. In the figure below, we see that the employment diffusion index during the three months ending in November was a mere 27 percent. Compare this number to the three-month employment diffusion index of the previous two recessions for which there are data. In the 2001–02 recession, the diffusion index bottomed out at 31.4 percent. In the 1990–91 episode, it hit a low of 30.1 percent.

Another diffusion index (for which there is a longer data history) comes from the industrial production data (shown below). A total of 255 component industries are measured in this index. Here, the three-month diffusion measure hit 23.7 percent in November. This “breadth” of production decline is greater than what we saw in the previous two recessions and is more on par with the “bad” recessions of 1973–75 and 1981–82. These indicators of the scope of the economic downturn would seem to confirm a point Dave made in his earlier post, that “the [more severe] recessions of 1973–75 and 1981–82 are almost certainly more sensible comparisons [to the current recessionary experience] at this point.”

So, while the magnitudes of the employment and production declines are near their postwar averages, the recent data appear to show a clear acceleration in the pace of the decline. Given the length of the recession to date, the current recession experience is approaching the more extreme postwar recessions in terms of its length. To this we would add the following—that the breadth of the current downturn, at least in terms of employment and production, would also seem to be on par with those more virulent episodes.

By Michael Chriszt, assistant vice president in the Atlanta Fed research department

December 5 macroblog Q&As

Dave Altig’s December 5 blog entry, “The recession in pictorial context,” elicited an array of interesting commentary. In this recessionary period, the questions that arose are relevant to today’s current economic state and it is worthwhile taking a blog to explore these issues in greater depth.

Comments

I might suggest that considering the 1981–82 recession by itself, rather than in combination with its 1980 little brother, somewhat understates the "badness" of that period.

The 81–82 recession graphs include data from 12 months before the first day of the recession to 12 months after the last day of the recession, therefore the dates range from 7/1/1980 to 11/1/1983. The 1980 recession ended in July of 1980, so these time periods overlap each other by one month. Including this month does not “understate the ‘badness’ of the period” because the calculations are based solely on the recessionary period being examined. In other words, the time span has no effect in this case. The first day of the recession is set to one. The months before and after are normalized to the first day of the recession. If we were to remove the 1980 recession date and run the time span 10 months before the 1981 recession to 10 months after, the graph does not change in anyway apart from a shorter time span. This is because the data is scaled to 7/1/1981, the beginning of the recession. You can see this by looking at the 12-month and 10-month graphs, below.

Are the unemployment rate comparisons U-3 across the various recessions? If so, I would be keen to see a U-6 comparison as well, I suspect it would be...illuminating.

The graphs used were U-3 comparisons. To clarify, the U-3 employment rate is the official employment rate used by the Bureau of Labor Statistics and is the most commonly used measure. The employment measures range from U-1 to U-6, U-1 being the most restrictive and U-6, the most broad. The U-3 rate is defined as: “Total unemployed as a percentage of the civilian labor force” (BLS), while the U-6 is defined as “Total unemployed plus all marginally attached workers, plus total employed part time for economic reasons as a percentage of the civilian labor force plus all marginally attached workers” (BLS). U-6 data only ranges back to 1994, therefore only the 2001 recessionary period can be examined.

The following graphs are U-6 comparisons—the first graph compares the two unemployment measures, and the second is comparing the 2001 recession and the current levels (normalized to 3/1/2001, the first day of the recession).

Are these apples to apples comparisons? Are the numbers from the prior recessions the numbers that were reported in "real time" or are they "final/revised" numbers?

The unemployment rate does not go through revisions. It is, however, benchmarked annually in March. Payroll employment is revised as additional information becomes available. All of the payroll employment graphs in the December 5 posting contained revised data with the exception of November. To see how these numbers are revised over time, here’s a comparison of these same graphs with real time (unrevised) data and the revised numbers (from December 5 blog).

By Courtney Nosal, economic research analyst in the Atlanta Fed’s research department

The recession in pictorial context

If your head had not yet been turned by economic events, today’s startlingly weak employment report probably did the trick. Rather than repeat all the negative superlatives you are likely to hear, I’ll take the opportunity to step back and take in the current recession in a somewhat broader context. One way to look at this is to examine the trajectory of employment relative to December 2007 levels (when this recession began) and compare it with the average trajectory of relative employment in other recessions:

In the graph above “time 0” represents the peak of a business cycle, or the month before a recession begins (December 2008 for the current recession). “Average” refers to the average experience in the seven previous recessions since 1960 (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, and 2001). To facilitate comparison across recessions, I have normalized the level of employment at the peak of the business cycle to one. As noted, then, each point represents the level of employment relative to the peak: numbers below one indicate that the number of nonfarm jobs was below the number that existed as the economy entered recession.

Before the November job report, the overall employment picture had been fairly unexceptional compared to the average recessionary experience. That changed, as I guess will happen when a half-million job loss statistic arrives. As of today, a milder than average recession has turned into a somewhat deeper than average recession, at least in terms of employment.

Does this mean we are heading off the map in terms of past experience? It is hard to tell by just focusing on the average experience of the previous seven downturns. The previous two recessions—1990–91 and 2001—lasted only eight months. Assuming that we remained in recession through November—and I don’t think that conjecture will draw much debate—the current episode is already a year in duration. A more apt comparison might therefore be the “bad” recessions of recent memory, the 1973–75 and 1981–82 episodes, which both lasted sixteen months.

Here, for your viewing displeasure, are those comparisons:

Not surprisingly, in the last two recessions, which were relatively short-lived, the employment situation had already stabilized twelve months after the onset of the downturn. So there may not be much comfort in noting that the employment losses are not yet out of line with experiences of those episodes (especially the 1990-91 version). The trajectories suggested by the relatively long-lived, more severe recessions of 1973-75 and 1981-82 are almost certainly more sensible comparisons at this point. And, as bad as it is right now, we are still a fair distance from the pace of relative employment losses in those episodes.

The story is similar if we adopt the vantage point of the unemployment rate:

 

It is not yet clear whether the acceleration in job loss is a new trend or the lingering impact of a very bad few months, of which the worst is passing. It's always important to monitor new data and anecdotal reports to determine which way the wind is truly blowing. But today's report raised the stakes on that activity by a considerable amount.

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

Do you see what they see?

It is now official: On Monday the National Bureau of Economic Research (NBER) Business Cycle Dating Committee declared—or, perhaps more accurately, confirmed—that the U.S. economy began to contract in December of last year. Not that you probably missed it, as the announcement was ably covered at Businomics Blog, at Calculated Risk, at The Curious Capitalist, at Econbrowser, at Economist’s View, at Greg Mankiw’s Blog, at The Skeptical Speculator, at William Polley, among many other fine blogging locations.

As always, the NBER Committee was forthright about what helped them decide the time had come. Here’s what they said:

“Because a recession is a broad contraction of the economy, not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The committee believes that domestic production and employment are the primary conceptual measures of economic activity.

“The committee views the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment.”

In the graph below (which does not include the 12/5/08 employment report), I’ve included gray bars to indicate past NBER recession periods, and a yellow shaded area to indicate the current recession (assuming, not so heroically, that the contraction has persisted at least through October):

The statement continues:

“The committee uses real personal income less transfer payments from the Bureau of Economic Analysis as a monthly measure of output. …

“Real manufacturing and wholesale-retail trade sales from the Census Department is another monthly indicator of output. …

“The last monthly measure of production is the Federal Reserve Board’s index of industrial production.”

The rest of the story, then, in pictures:

To the extent that contractions are judged on the basis of past episodes that bore the label “recession,” one can understand why the committee came to the decision it did.

That does raise the interesting question as to how similar to past episodes this particular period is shaping up to be. More on that to follow.

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

What do we know about infrastructure spending?

Recently, there’s been a great deal of discussion about developing, legislating, and implementing a second fiscal stimulus. One of the prominent components mentioned in the recent stimulus discussion is investing in infrastructure to create jobs.

The appeal of this category of spending is fairly obvious, as it represents one aspect of a stimulus package that might be expected to have a long-term benefit to the economy. A criticism has been that infrastructure spending is too slow in implementation to be a good source of short-term stimulus, but Martin Neil Baily, senior fellow at the Brookings Institution, has a couple of responses to that argument:

“… I am also aware of the objection to using infrastructure investment as a stabilization policy because it can be too slow to work. There are two ways in which this problem could be overcome: First, there is great need for improved maintenance of the infrastructure, including crumbling roads that need repair and bridges that may age prematurely or even collapse because they have not been looked after… Second, there are state and local projects that are being cancelled because of the short term budget pressures. Sustaining such projects would avoid layoffs that would otherwise take place.”

So far, so good, but then the question turns to whether public investment on infrastructure really is a good long-term social investment. As always seems to be the case, the details can be tricky. A few years back, Bates College economist and Jerome Levy Institute Scholar David Aschauer provided a good roadmap of the essential issues. There is a lot of empirical analysis in Professor Aschauer’s paper, but here is the bottom line:

“… three questions pertaining to economic growth may be asked: Does how much public capital you have matter? Does how you finance public capital matter? and, Does how you use public capital matter? The empirical results presented in this article allow affirmative answers to each of these questions. Specifically, 10% increases in either the quantity or the efficiency of public capital are estimated to increase output per capita by 2.9% over 2 decades while a 10% increase in external public debt is estimated to decrease output per capita by 1.7% over the same time frame… The main lesson to be drawn from these findings is that in formulating economic development policies, countries are well advised to pay as much attention to how public capital is financed and used as to how much public capital is accumulated.”

Aschauer’s study was based on aggregate, cross-country data. In a Brookings Institution piece published about the same time as David’s, New York Fed economist Andrew Haughwout considered the evidence from our state and local Main Streets:

“Analysis of the effect of state and local government investment on state-level economic growth has provided a range of estimates, and debate about the exact magnitude of the effect continues. But most authors now seem to agree that modest increases in state public capital stocks would not dramatically raise state economic growth. In other words, that increasing public investment will not add much to a given state's ability to create jobs and wealth.

“Economists have been hesitant to give the policy advice, "Don't do it," because they recognize that some projects may have a beneficial economic effect even if the average one doesn't. They also realize that the productivity evidence does not take into account the direct household benefit of having a better infrastructure stock.”

More than most of the currently popular stimulus ideas, the benefits of increased infrastructure spending really do seem to depend critically on the specifics. Best to think about those specifics sooner rather than later.

By David Altig, senior vice president and research director, Federal Reserve Bank of Atlanta

The ISM Index breaks the magic number

If you are weary of troubling news from the financial sector, the week thus far has provided no relief in the form of good news from the economy’s real side. Monday brought troubling signs from the August report on income and consumption, Tuesday more of the same dismal adjustment in house prices, and yesterday an eye-opening ISM manufacturing report that elicited the following sort of headlines (to which I’ve added the emphasis):

Stunning Decline in Manufacturing Sector (Mark Thoma, channeling Real Time Economics)

ISM manufacturing index plunges (Calculated Risk)

ISM Implodes… (Mike Shedlock)

No doubt about it, a 6.4 index-point drop in one month gets people’s attention. How unusual is that large a change in the index? Pretty unusual:

Even so, the more important part of the story may be the level to which the index fell:

The index now stands at 43.5. Over the past 30 years, index levels below 45 have not failed to be associated with a recession, either contemporaneously or with a short lag. Throw that and the other indicators of the week in with the most recent “freefall” in auto sales, and it’s enough to make some smart guys despair.