October 30, 2012
Dear Mr. Secretary:
Since the Committee last met in early August the economy has continued to expand at a pace near, or somewhat below, trend. Real GDP grew at a 2.0% annual rate in the third quarter, an acceleration from the anemic 1.3% pace registered in the second quarter. The sectoral drivers of growth have rotated in recent months, as consumer spending and housing activity have firmed, while the pace of business spending has stepped down. The slowing in business spending may owe to uncertaintanties regarding the so-called fiscal cliff, as well as to a softening in the global growth backdrop. While business capital outlays have displayed greater caution, the pace of business hiring has remained relatively steady. Ongoing modest gains in employment have brought down the unemployment rate to 7.8%, and over the past year the jobless rate has fallen just over one percentage point, a much greater decline than would be expected given the tepid pace of economic growth. Even so, the employment situation remains dispiriting, and recently the Federal Reserve has taken strong actions aimed at fostering a more rapid improvement in labor market conditions. Those actions, along with actions taken by European authorities, have served to ease financial conditions since the last meeting. Nontheless, uncertainty about the near-term outlook is unusually high, as a number of important year-end fiscal issues remain unresolved.
Real consumer outlays increased at a 2.0% annual rate last quarter. Although this pace of spending is not particularly impressive, it did occur in spite of some noticable headwinds, including an increase in energy prices that limited real disposable income growth to a mere 0.8% annual pace. Consumer spending on motor vehicles has been particularly strong, as light vehicle sales reached a 14.9 million annual pace in September. The outlook for consumer spending in the fourth quarter looks favorable: gasoline prices have been moving down, consmer sentiment has ticked up, and household balance sheets are receiving support from firming house prices. Thus far there is little evidence – in either sentiment measures or in the behavior of the saving rate – that the fiscal cliff is impacting consumer behavior, though how the associated tax issues are resolved is an important determinant of the outlook for disposable income and consumer spending early next year.
The housing market recovery continues to be a particularly bright spot for the economy. Residential investment increased at a 14.4% rate last quarter, and recent increases in housing starts suggest another double-digit pace of activity growth in the current quarter. In addition to the growth in construction, house prices have also continued to improve across a variety of metrics. Moreover, the increase in house prices appears to be geographically broad-based.
In contrast, investment spending by businesses has taken on a more negative tone recently. Total business fixed investment contracted at a 1.3% pace last quarter, as spending on equipment and software was unchanged, while business outlays for new structures fell at a 4.4% pace. Spending on high-tech equipment was noticably weak, contracting at a 1.1% pace, the second consecutive quarterly decline. The slowing in overall captial spending has come as a bit of a surprise, and may owe to uncertainties arising from the fiscal cliff and from the global slowdown. The surveys and orders data are not indicating a rapid recovery in capital spending in the current quarter. Businesses built up inventories at a trend-like $34 billion annual rate last quarter. Nonfarm inventories were accumulated at a $63 billion pace, while the drought led to farm inventories being pared at a $20 billion rate.
The global growth slowdown appears to be affecting real economic outcomes in the US, as exports declined at a 1.6% rate last quarter, the first decline since the expansion began. Imports, meanwhile, edged down modestly, declining at a 0.2% pace, and overall net exports subtracted 0.2%-point from GDP growth last quarter. The recent improvement in European financial conditions, as well as some hints of stabilization in Chinese activity data, provides some glimmers of hope for the export outlook. Even with these improvements, however, exports are unlikely to rebound in a robust manner.
Real government spending increased briskly last quarter, expanding at a 3.7% annual rate, the fastest pace since 2009. Much of the gain was due to a surge in defense spending. The outlook for government spending, however, remains downbeat, as an easing in the pace of state and local cutbacks should give way to more intense spending reductions at the federal level.
In the three months since the Committee last met, monthly job gains have averaged 146,000 and the unemployment rate has dropped 0.4%-point to 7.8%. Some of this decline in the unemployment was the effect of falling labor force participation, and the employment-to-population ratio has only ticked up 0.1%-point to remain at a very low 58.7%. In that period, wage gains have remained quite modest, as average hourly earnings have increased at only a 1.4% annual rate. Thus far, timely indicators such as jobless claims point to a continuation of employment growth, though ongoing fiscal policy uncertainty may pose a downside risk to the labor market in coming months.
Consumer price inflation indicators have been supported recently by gains in energy prices, as the headline PCE price index increased at a 1.8% rate last quarter. Excluding food and energy, the increase in the core PCE price index, however, has been much more muted, and last quarter had increased only 1.6% on a year-ago basis. Looking ahead, the recent decline in energy prices should bring headline inflation back down, while continued modest labor costs are likely to keep core inflation well below 2%.
At its September meeting, the FOMC initiated a new round of asset purchases, focused on agency MBS, and unlike past rounds of asset purchases has vowed to continue such purchases until substantial improvement in the labor market conditions has been achieved. Most primary dealers expect the Fed will initiate a new program of Treasury purchases after the Maturity Extension Program concludes at the end of December. At the September meeting the FOMC also pushed back their near-zero interest rate guidance to mid-2015.
The outlook for fiscal policy is increasingly dominating near-term economic prospects. Since the Committee last met in early August there has been no progress in addressing the year-end fiscal cliff issues, even though policymakers are aware that grave economic risks attend to the failure to take action on these issues. A timely and orderly resolution of this uncertainty would contribute meaningfully to an improvement in the economic outlook.
Against this economic backdrop, the Committee’s first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. The Committee did not feel that any immediate changes to Treasury coupon issuance were necessary at this time.In the final charge, the Committee considered the composition of marketable financing for the remainder of the October 2012 to December 2012 quarter and the January 2013 to March 2013 quarter. The Committee’s recommendations are attached.