November 17, 2015

Galina Alexeenko: Welcome to the Federal Reserve Bank of Atlanta's ECONversations. We're glad you could join us today. I'm Galina Alexeenko from the Regional Economic Information Network. I'll be your moderator. Today, Dave Altig will share economic and monetary policy updates. Dave will also take your questions at the end of today's webcast. So please, go ahead and submit your questions [with] the button on the screen. And now, I'll turn over to Dave.

Dave Altig: Thanks, Galina. Thanks to you who are joining us again and welcome to those of you who are joining us for the first time. I'm going to start off with this passage from a speech that our boss, Dennis Lockhart, gave in Bern, Switzerland, a little more than a week ago, offering up his assessment of the state of the economy. So, basically involving three elements: above-potential growth, labor markets that are continuing to improve, and an inflation outlook which is not quite where we would like to see it (near the Fed's 2 percent objective), but certainly not deteriorating and with a forecast that we will eventually move toward that projection. So our job, Galina's job, and my job, here at the Atlanta Fed and the research department, is to provide President Lockhart with some information about whether or not his assessment in our view is holding on track. I'm going to share those thoughts with you today, and it starts with this picture here, this is just four quarter GDP growth; and I put a reference point in this picture for you, the red line, which is the Atlanta Fed staff's view of potential GDP. So in the long run, we're guessing that GDP growth for the U.S. economy is roughly 2 percent, a little bit higher, so when President Lockhart says "above-potential growth," he is referencing growth above that red line. So you can see starting at about the end of 2013, we were pretty reliably and pretty consistently on a year over year basis above that point, with some backsliding that has occurred recently as a result of a relatively weak third quarter, coupled with a very weak first quarter (which we talked about last time I was able to join you on this ECONversation).

The question to address is whether or not we're worried about that return to the red line or do we think that we're still on the track of above-potential growth referenced by President Lockhart. I'm going to tell you, we believe we are on track despite these numbers here, so there's your third-quarter estimate of economic growth, GDP growth, which came in below 2 percent at 1.5 percent; most of you are aware of this. It's a significant step down from the second quarter. Well, here's the deal with that number that we are really holding to [in order] to give us some encouragement. There was a big chunk of that story that had to do with inventories; so often one of the things that we'll do is we'll look to not just the headline GDP number, but the statistic known as final sales. Final sales is really just the GDP taking out the inventory contribution which was a significant negative in the third quarter. That's not necessarily a good thing, but in general, these numbers on inventories are very volatile. They bounce up, they bounce down, and as long as we aren't seeing a persistent run of negative inventory numbers, or they're not signaling some weakness in the economy, we generally try to look through these things, and the news is even stronger, probably, than is suggested by these initial numbers.

So as you all know, when we get the first estimate of GDP for any quarter, that's not the end of the story. We're going to get a revision in the next month, and a revision after that, and we do keep track of what those revisions are like with a look-like. Currently, based upon our own internal tracking measures, and the end data that has come in subsequent to the initial GDP report, we're thinking that 1 1/2 percent growth rate for the third quarter is going get revised up to over 2 percent. Right now, our internal tracking estimates are saying the third quarter number will probably be revised up to somewhere near 2.2 percent; that number of course is subject to revision as well. But the big negative shift in inventories in the third quarter that was in the initial result, we do think is going be reversed somewhat. I've offered the final sales growth number as well, and as far as we know, that is going to hold up at a fairly robust 3 percent. Not only is the headline number going get a little bit better, we still think that the underlying growth statistic is going to look pretty good.

Now having said that, I think that there are reasons to be not completely sanguine about this inventory picture. Here is a picture of the inventory-to-sales ratio. You can see over this period of time when the economy has stepped up, that inventory-sales ratio has really increased fairly significantly. There's a couple interpretations of what this picture might mean. One interpretation is that inventories were being held pretty low as businesses were being cautious; this rise in this ratio is symptomatic of businesses feeling better about the prospects for the economy, and it's really sort of nothing to worry about. That's the good interpretation. The bad interpretation of this statistic, of course, is that businesses have found themselves sort of caught off guard by weak sales; that this is an unwanted buildup in inventories, and it is perhaps symptomatic of some weakness ahead. We have spent a lot of time; one of Galina's jobs here at the Atlanta Fed is to go out, and as part of our REIN program, put boots on the ground and investigate with businesses in a face-to-face manner what the meaning of some of these statistics might be. One of the things we've been pretty keenly interested in is what to make of this inventory story, which again showed a lot of weakness in the third quarter, and as this picture illustrates, looks fairly elevated. I can only tell you at this point that we're not picking up anything really substantially to suggest that this is problematic, so in our forecast the inventory picture is not really a negative. We expect this to not exert a drag on the fourth quarter or going into next year, but it is one of the things that we're watching and trying to puzzle through and make some assessment of the risk involved.

One of the things we talked about last time, probably the bigger part of our story, and indeed of the risk that we might want to consider, has to do with the continuing story about the dollar, and the related story of the decline in oil prices. Both of these prices have stabilized recently, but are showing no indication of moving from the appreciated level of the dollar or the depreciated dollar price of oil. Last time I think I talked to you, we talked about the large effect of both of these developments in the first quarter, and they've really continued on in many important ways into the second and third quarters of this year. With respect to the oil-price statistic, one of the things that we've emphasized is that we've learned as of late that developments in the energy sector and particular developments of the falling energy prices, which we sort of grew up believing were unmitigated goods, have a downside, and they have a downside in the effect that they have now that the U.S. is not only a major oil producer in the world, but arguably becoming the major oil producer in the world. You can see the effect of those falling oil prices in this rig count picture, which gives us some sense of the effect of the decline of these oil prices on business investment on structures related to mining and energy-related developments. In the third quarter, for example, business structures contracted by 4 percent on an annualized basis; it looks like the impact is beginning to level out but quite frankly it's not clear that it's over yet and we are counting this as probably a continuing headwind for the U.S. economy as we move forward through the fourth quarter and into 2016.

Same with the dollar; it's very clear that manufacturing has taken a bit of a hit from the appreciation of the dollar. We just got the industrial production report for October; frankly, the manufacturing part of it was pretty good, it was a pretty healthy number. So it's possible that we are beginning to see some unwinding of these effects of the exchange rate appreciation on the manufacturing sector in the United States. Frankly, I'm not sure I would count on that. I think as we look forward, again we would expect that net exports [and] the impact on manufacturing will still be something of a headwind to fight against as we go into the immediate future, in any effect. That's assuming that the appreciation of the dollar doesn't pick up again, which is always just an assumption of course.

The impact that this has had can readily be seen in capital goods orders, which is really sort of a forward-looking measure for investment spending in the United States. You can see it as clear as day that any export-facing sector has really taken the brunt of the hit, as would be expected, from the rise in the value of the dollar. Again, this is one of those elements of the economic picture that we really aren't counting on changing much in the immediate future. So the near-term drag I think will be with us for a bit. Overall, the investment picture is a mixed bag, relatively weak in the third quarter. So the contribution to growth of overall fixed investment to the U.S. economy was about a half a percentage point or so, which is roughly 60 percent as much as it's been since the fourth quarter of 2013, where I showed you in that picture earlier GDP really seemed to kick into a higher gear.

So if we start adding up some of our stories here, we don't see a whole bunch of the strength of the economy coming from the net export sector, for sure; that will still probably be a source of some weakness. Investment, fair to middling I think is pretty much how I would describe what our outlook is. Where we're really pretty happy, is in the consumer spending part of the story. So again, I've marked the fourth quarter of 2013 as a turning point and you can really see it in consumer spending. We've been well above this longer-term value of the recovery now, going back eight quarters. Personal consumption expenditures grew by over 3 percent in the third quarter and that's really I think the positive part of our story.

As most of you know, we sort of track GDP growth in real time, via our GDPNow statistic, which is the statistic we use to try to guess what the GDP statistics will look like in real time.

Here is the history of our current estimates, going back to the end of October. So we basically entered the fourth quarter with the assumption that the U.S. economy will grow by about 2 1/2 percent in Q4. As data have come in, we've sort of tracked what we think that data is telling us about that 2 1/2 percent guess. I've also added some green diamonds there [on the graph], which is a similar exercise from macroeconomic advisers. If you'd been with us before, you've seen us report those statistics as well.

So basically right now, GDPNow is telling us that 2 1/2 percent is pretty good. The statistics coming in have been bouncing around between about 2 to 2 1/2 percent, and this is as "real-time" data as you can get; it includes today's CPI and industrial production reports. The bottom line I think of this picture is, as we think about President Lockhart's assertion that we've sort of settled into a period of above-potential growth, that appears to be holding up as far as we can see, both in our diagnosis of what was going on in the third quarter but also in terms of what we can see so far with the fourth quarter. Now I say that advisedly, it's very early, there's still a lot of data to come in, but so far, so good.

So very quickly, the balance of those three elements noted by President Lockhart in his speech. The above-potential GDP growth and the other was an improving labor market. Despite something of a scare in the third quarter of whether or not there might be some step down in the employment statistics, we got a gangbusters report, as you all know, for last month. (We) could really not find a bad thing in that report and we are back on track to a pace of employment growth that is well above the rate that would be necessary to maintain the unemployment rate at its current level, for example.

So I've put a little note in the slide down at the end; we attempt to estimate how many jobs per month that the U.S. economy has to produce or create to keep the unemployment rate constant. That involves several assumptions, it involves assumptions about the labor force participation rate, among other things. But based on what we think are fairly reasonable assumptions, it would take about 100,000 to 125,000 jobs a month to keep the unemployment rate constant, that is not rising and not falling. Of course, up near 200,000 jobs per month being created on the current trend, we're well above that so things are looking really great in the labor markets.

On the inflation picture, I just have to say what I've noted before, which is the inflation performance has been on a headline basis of course very weak, dominated by energy prices and the effects of the appreciation of the dollar. We really try to look through those temporary effects and look at trend measure, so I've shown you core PCE here. Basically the story is, well, we are still well below FOMC objective, but it's not deteriorating (that picture). With continued improvement in the labor market, continued above-potential growth, [we] have every reason to believe that once many of these transitory effects from energy prices, the dollar and so on, begin to dissipate, things will begin to move in the other direction. And in the CPI report from this morning I think we've begun to see some of that.

Let me just very briefly turn to comment about monetary policy. President Lockhart has said on a couple of occasions that going into this last meeting he thought it would be a reasonable guess, if you began to think about a December liftoff that the probability may be even money, about 50/50. This is basically just a chart at certain dates and events of what the market is telling us of their expectations; and right now the market appears to be pricing in about a 75 percent chance of liftoff in December. Now it's not really my job to say whether I think that's a reasonable guess or not a reasonable guess; I will simply again return to my boss, who is the definitive voice, at least from the Atlanta Fed, on this issue. In this Bern speech that I opened with he said, "you know, I'm looking at this assessment of the U.S. economy," which I've tried to relay, is so far being endorsed by his research staff. Based on that assessment, a case could be made for some adjustment soon. We will leave that open for now. The importance of that message being, even after liftoff commences it will probably not be your father's tightening cycle, or liftoff, or normalization cycle, that it's likely to be very gradual this time. As the economy continues taking a firm hold of recovery, although at its own pace that I think we should best describe as positive but modest. Let's leave it there and I'd be glad to turn to questions.

Alexeenko: Thank you, Dave. Let's take a few questions from the audience. Steven Blitz is asking whether the low cost of carry might be the reason for high inventory levels.

Altig: It could be, although I'll point out that those inventory-sales ratios were low at a period of time where not only the interest rate was low, but it was expected to remain low for quite a period of time. It would be not a story we could easily apply to the entire recovery period. My personal belief, maybe hope, is that the inventory sales ratio began to accelerate about the time that we saw consumer spending growth and GDP growth kick into a higher gear for the recovery. I'm going to put my money on that being the explanation, although it almost certainly is not one single explanation at play there.

Alexeenko: Another question from the audience member. He's saying a recent report has stated that imports have fallen and ports are seeing much less traffic recently, which is not merely contained to exports. What would be the impact of those developments? So, imports have fallen, so the decline in trade is not just related to exports. What's the impact of both imports and exports decline?

Altig: Well, if imports are declining, that would move in a positive direction, all else equal for GDP growth as they tend to raise net exports. It's a little bit hard to read the import numbers outright, because there's obviously some substitution between domestic spending and foreign spending, which of course, imports reflects. There was some softness in the retail sales numbers in the most recent report. So, one of the things we'll be watchful for is whether or not the imports softened, whether that will be indicative of a broader softening in consumer spending than what we're expecting, because that consumer spending part of the picture is the important positive that we're leaning on to keep some amount of confidence in our assessment that we are in a pretty good place right now. So far, that's not how we're interpreting it, but it is something to keep our eye on.

Alexeenko: We have another question on inventories. I was wondering if you could expand on your comments on inventories and whether part of the pickup in the inventory-to-sales ratio could be due to the energy sector.

Altig: It doesn't look like you can point to the energy sector as the explanation. That is a very plausible conjecture, but if we look across wholesale, if we look across trade, if we look across retail, basically all components of those inventory sales numbers are elevated. It's not confined to a single sector, it really is a fairly broad phenomenon. We had that thought and we're looking in that direction, but I don't think that's it. It's a much broader phenomenon than that.

Alexeenko: Another question: What do you think is the biggest downside risk to the inflation forecast?

Altig: I'll tell you the one we're worried about the most is the possibility that inflation expectations will become un-anchored to the low side. It really is critically important that the expectations remain pretty much centered on the 2 percent objective. Because once you start fighting against peoples' beliefs, monetary policy becomes very much more difficult. We've been fairly satisfied that measures of inflation expectations have remained anchored and are relatively stable. Certainly in the survey data that has been the case. There was some slippage in the Survey of Professional Forecasters numbers as of late and so we'll be watching that. If you look to market-based measures of inflation compensation, of course they softened in the early part of the year and have stayed relatively low, but it's our assessment that those are probably about things like risk premium, liquidity premium, and not so much about inflation expectations per se, but again, one of those things we'll have to keep a pretty careful watch on.

Alexeenko: Another question about the global economy. What are the channels, in addition to exports, through which weak economic growth abroad could spill over to the U.S. economy?

Altig: Well again, I'll give you the answer we're the most worried about. The most concerning aspect of the global economic environment would be if there's some spillover into financial markets that creates some instability or turmoil or another bout of volatility, because not only are U.S. goods and service markets not immune from global developments, certainly financial markets which are completely integrated, are not. We've done simulations many times about global events and global risks. Quite frankly, usually when we look at the GDP consequences directly, they're not insignificant but they're manageable. With a healthy consumer sector, a healthy domestic investment sector, they're headwinds that can be overcome, but if you couple that then with a bout of real turmoil in financial markets, you're starting to get scenarios that look a little bit dicey, so I think the big risk that we would worry about is another repeat of what happened around the time of the September meeting and uncertainties involving that, or even going back to 2011 with the Greek crisis would be an even better example of those things and would be very unwelcome.

Alexeenko: Ok, we have a question about our GDPNow forecast. An audience member is asking whether this forecast is a combination of actual data to date, plus forecast based on those numbers, or does it extrapolate the current quarter's growth from what we know so far?

Altig: It is a combination of internal forecasts about the quarter with the data as it comes in. So there's an element of it that is taking the statistics that we know will go into the GDP statistic itself and building up from that. There is always some forecasting that's involved. For example, GDP is a quarterly number, and you get a month's data and you take that and have to extrapolate what the other months are. It's a combination of what we call bridge equations that take monthly data and turn it in to a quarterly estimate; that is then updated with the actual statistics as they come in.

Alexeenko: We have a question about consumer spending; the question is whether the increase in consumer spending is related to income growth, or how much of it is related to the increased debt load?

Altig: It is very definitely related to income growth. If you look over the course of the recovery, personal income growth was pretty good early on in the recovery [but] really took a dive near the end of 2012 into 2013 and has recovered into 2014 and 2015. My view is that personal income growth is exactly what's supporting consumer spending growth. If you think back to that picture, consumer spending is in a much better place on a sustained basis now that it has been through most of the recovery. So, even though we had pretty healthy personal income growth early on in the recovery for the first several years, consumers weren't quite responding to that growth. So again, I think if we put all these pieces together, one of the things that you conclude is that businesses—and maybe this is what is in the inventory sales numbers—consumers and their reaction to the sustained growth in personal income, are just feeling more confident that we really are in a place now that is sustainable, and the U.S. economy, despite all the headwinds and challenges, is moving ahead.

Alexeenko: Great. One last question. To what extent should the Fed be worried about divergence between services inflation and goods inflation? One can envision a scenario where inflation does not hit this 2 percent target, but the services inflation is north of 3 percent.

Altig: The simple answer to that is that relative prices of different goods are always changing. It is the basket in its entirety that the target is about. It has long been the case that services inflation has been a lot higher than goods inflation. That's not unusual. We expect that, and it really is the average that we are concerned about.

Alexeenko: All right, at this point we will have to end today's webcast. Dave, thank you so much! We look forward to seeing you at our next ECONversations in February 2016. In the meantime, you can always find economic information on the Atlanta Fed's website. We thank you for joining us today, have a good afternoon.