The Economic Outlook for

2010Presented to:

Houston Economics ClubFebruary 18, 2010

Harvey Rosenblum Executive Vice President &

Director of Research

Jessica RenierSenior Economic Analyst

Federal Reserve Bank of Dallas The views expressed in this presentation are strictly those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or of the Federal Reserve System.

Economic Model: Recessions

Guitar-string theory:Deeper recessions are

followed by stronger, more rapid recoveries.

- Milton Friedman

Economic Model: Financial Crises

“The aftermath of deep financial crises shows deep and lasting effects on asset prices, output and employment. Unemployment and house price declines extend out for five and six years. Output declines last two years on average. Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt.”

- Reinhart and Rogoff (Dec. ‘08)

Summary Forecasts for 2010

• GDP: 2-3%, more likely close to 3%– Absent the financial crisis: 5-6%

• Headline inflation: 3.0%• Core inflation: 1.5%• Unemployment:

– 10.4% peak in 2010 Q2– Sustained employment growth to begin

Feb. 2010

But This Time is a Combination

This recession was…• Most painful since the Depression

– Longest, Deep and Wide• Followed 25 years of growth

interrupted by two short, mild recessions

Bottom Line:• Relative to a generation of

experience, this was a truly traumatic event.

Behavior Modification

Only traumatic events, not hiccups,

produce behavior modification.

Global Backdrop

IMF World Economic Outlook:What a Difference a Year Makes

2005 2006 2007 2008-2-10123456% annual rate

IMF

HR

3.0

0.2

2009

One Year Ago: 2009 Forecast

Source: IMF World Economic Outlook, Oct. ’08/’09

IMF World Economic Outlook:What a Difference a Year Makes

2005 2006 2007 2008-2-10123456% annual rate

IMF

HR

3.0

0.2

2009 2005 2006 2007 2008 2009-2-10123456

-1.1

% annual rate

2009

One Year Ago: 2009 Forecast Current: 2010 Forecast

Source: IMF World Economic Outlook, Oct. ’08/’09

IMF World Economic Outlook:What a Difference a Year Makes

2005 2006 2007 2008-2-10123456% annual rate

IMF

HR

3.0

0.2

2009 2005 2006 2007 2008 2009-2-10123456

-1.1

3.1

% annual rate

IMF HR3.0

20102009

One Year Ago: 2009 Forecast Current: 2010 Forecast

Source: IMF World Economic Outlook, Oct. ’08/’09

Purchasing Managers’ Indexes of Manufacturing Activity

U.S. U.K. Germany Euro Zone Japan China30

35

40

45

50

55

60Index

Dec ‘09

Nov ‘09

Mar ‘09

Expand

Con-tract

Jan ‘10

Source: Institute for Supply Management, Bloomberg

G10 Industrial Production(excluding construction)

'00 '01 '02 '03 '04 '05 '06 '07 '08 '0970

75

80

85

90

95

100

105

110

115Index, 2000=100

U.S.

Source: Federal Reserve Board

G10 Industrial Production(excluding construction)

'00 '01 '02 '03 '04 '05 '06 '07 '08 '0970

75

80

85

90

95

100

105

110

115Index, 2000=100

U.S.

U.K.

E.U.

Japan

Source: Federal Reserve Board, UK Office for National Statistics, Statistical Office of the European Communities, Japanese Ministry of Economy, Trade & Industry

U.S. Economy

Elements of Trauma

• High unemployment• Actual deflation• Negative wealth shock

– Bursting of multiple bubbles• Synchronized global shocks• Near-demise of banking/financial

system

Going Forward…Headwinds• Credit to households

and small businesses• Banking system –

capital, CRE losses• Anticipated taxes• Policy uncertainty• Higher energy prices

Tailwinds• Emerging Market

economies• Inventories• Labor availability• Idle plants• Lagged impact of

global stimulus• Equity market

rebound and anticipated profit growth

• Improving capital markets – lower credit spreads, stronger risk appetite

Crosswinds• Monetary policy• Fiscal policy• Regulatory policy

Positive Momentum• Growth in temp employment• Declining initial unemployment claims• Declining layoff announcements• Nearly 40% of industries adding

workers, vs. 80% of industries cutting employment a year ago

• Synchronized global recovery• Capex

– Rig count and Semi equipment orders• Industrial production bounce-back

GDP and Inflation

Real GDP Growth

2007

2008

2009

-8

-6

-4

-2

0

2

4

6

8SAAR, % change

5.7%

Low-to-Moderate Inflation

2007

2008

2009

-3

-2

-1

0

1

2

3

4

5

6% Yr/yr

Headline CPI

Core CPI

Trimmed Mean PCE

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Dallas Fed

Why were we so wrong about year-end inflation?

• Given fears of deflation at year-end 2008, we thought a 1% deflation over 2009 was the most likely outcome.

• We averted that outcome, and that’s a prediction we’re very happy to have been wrong about.

• Credit Chairman Bernanke and the FOMC

Job Market Simply Awful, But Poised to Turn as Temp Leads Gains

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10-200

-150

-100

-50

0

50

100

-800

-600

-400

-200

0

200

400Change, thousands

Temp employment

Source: Bureau of Labor Statistics

Job Market Simply Awful, But Poised to Turn as Temp Leads Gains

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10-200

-150

-100

-50

0

50

100

-800

-600

-400

-200

0

200

400Change, thousands

Payroll employment

-20k

-150k

+64k

Temp employment

Change, thousands

Source: Bureau of Labor Statistics

Benchmark added 930k lossesTotal jobs lost: 8.4 million

• Level of employment is lowest since Sep. 1999

• Private sector job level similar to Nov. 1998

• Unemployment fell to 9.7%– Likely to rise again once people re-enter

labor force • Initial jobless claims have declined,

more needed• Wages, hours worked and productivity

increasing

Bottom Line: Existing workers being pushed harder

Labor Market: A Mixed Bag,

But Fixin’ to Improve

A Look At Housing

GDP Inventories Consumption Nonres. Invest.

Res. Invest. Net Exports Government-1

0

1

2

3

4

5

6 5.7

3.4

1.4

0.30.1

0.5

0.0

Percentage Points

Contributions to Real GDP Growth(Advance Release: Q4 2009)

Source: Bureau of Economic Analysis

Ex. Equipment & Software: -0.5

GDP Inventories Consumption Nonres. Invest.

Res. Invest. Net Exports Government-1

0

1

2

3

4

5

6 5.7

3.4

1.4

0.30.1

0.5

0.0

Percentage Points

0.8

-0.5

Equipment & Software

Commercial Real Estate

Contributions to Real GDP Growth(Advance Release: Q4 2009)

Source: Bureau of Economic Analysis

U.S. House Price Index (Case-Shiller)

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.52.0

Percent change

Source: S&P, Fiserv, MacroMarkets LLC Note: Composite 10-City Index

Nov0.2%

Jan-2.1%

U.S. Housing Affordability Index

'71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '0960

80

100

120

140

160

180Index

Source: National Association of Realtors

Dec164

Mortgage Rates

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-104.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

Jumbo6.1

30-year5.3

4.8

15-year

Source: Bloomberg, Bankrate.com

Percent

Home Sales Noisy

'06

'07

'08

'09

3500

4000

4500

5000

5500

6000

6500

200300400500600700800900100011001200

Thousands Thousands

New 1-family homes

Existing 1-family homes

Permits & Starts Sideways

'06

'07

'08

'09

200

400600

8001000

12001400

160018002000

Thousands

1-Family per-mits

1-Family starts

Source: Census Bureau, National Association of Realtors

Home Inventories Lower…

'06

'07

'08

'09

456789

10111213

Months’ supply

New 1-family homes

Existing 1-family homes

But Foreclosures Climbing.

'06 '07 '08 '090

1

2

3

4

5Percent

Foreclosure inventory

Foreclosures started

4.5

1.4

Source: Census Bureau, National Association of Realtors, Mortgage Bankers Association

The Consumer

1.4

1.2

1.0

0.8

1980 1985 1990 1995 2000 2005 2010

1.4

1.2

1.0

0.8

50

40

30

50

40

30

HOUSEHOLD DEBT-TO-INCOME RATIOTREND LINE

BANK LOANS AS % OF GDPTREND LINE% %

The Credit Overshoot Has Not Been Unwound

Source: BCA Research 2010, Martin Barnes

Annual Consumption Growth Rate

1930

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

exp

-15

-10

-5

0

5

10

15Percent, yr/yr

2010Forecast

2.2%

Source: Bureau of Economic Analysis

Household Wealth

'90 '92 '94 '96 '98 '00 '02 '04 '06 '08300

350

400

450

500

550

600

650Percent of disposable personal income

Household net worth

Household finan-cial assets

Peak-to-trough declinesNet worth: $17.5 trillionFinancials: $11.2 trillion

486

404

Personal Saving Rate Climbing

'90 '92 '94 '96 '98 '00 '02 '04 '06 '080

1

2

3

4

5

6

7

8

9

10

4.6%

Percent, 3MMA

Source: Bureau of Economic Analysis

Investment Spending

Business Spending Recovers Slowly Following Recessions

'81 '84 '87 '90 '93 '96 '99 '02 '05 '08-25-20-15-10-505

10152025

Yr/yr %, private fixed investment (nominal)

Sep. 11

Housing bubble

Source: Bureau of Economic Analysis, Wall Street Journal

U.S. Oil and Gas Rig Counts Rising

'94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '090

200

400

600

800

1000

1200

1400

1600Rig Count

Gas Rig Count

Oil Rig Count

Source: Baker Hughes, Inc.

Capacity Utilization Still Very Low…

'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '0965

70

75

80

85

90

60

70

80

90

100

110

120

72.0%

Total Industry Capacity Utilization

SA, Percent of Capacity

25yr average: 80.3%

Source: Federal Reserve Board

…But Industrial Production Improving

'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '0965

70

75

80

85

90

60

70

80

90

100

110

120

72.0%

100.3

Industrial Production

Total Industry Capacity Utilization

Index, 2002=100SA, Percent of Capacity

Source: Federal Reserve Board

Manufacturing Orders Up Sharply

123456789101112131415161718192021222324252627282930313233343536373839404142434445464748495051525354555657585960616263646566676869707172737475767778798081828384858687888990919293949596979899100101102103104105106107108109110111112113114115116117118119120121122123124125126127128129130131132133134135136137138139140141142143144145146147148149150151152153154155156157202530354045505560657075

50+ = Expanding

ISM New orders

Source: Institute for Supply Management

Manufacturing Exports Expanding Reasonably Well

123456789101112131415161718192021222324252627282930313233343536373839404142434445464748495051525354555657585960616263646566676869707172737475767778798081828384858687888990919293949596979899100101102103104105106107108109110111112113114115116117118119120121122123124125126127128129130131132133134135136137138139140141142143144145146147148149150151152153154155156157202530354045505560657075

50+ = Expanding

ISM New export orders

Source: Institute for Supply Management

Financial Markets

Interbank Frictions Mostly Gone

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-100.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0Percent

3M LIBOR – Expected Fed Funds

Source: Financial Times, Reuters

0.12

A Tale of Two Credit Markets

Junk Bond Spread

2007

2007

2007

2008

2008

2008

2009

2009

2009

0

4

8

12

16

20

24Percent

Junk-7yr Treasury

Junk-AA

Interest rates charged on credit

cards up to 29.99%

Source: Merrill Lynch, Federal Reserve Board, Moody’s

The Wind Is Beginning To Shift Direction

Banks Close to Beginning an Easing of Credit Standards

'96

'97

'98

'99

'00

'01

'02

'03

'04

'05

'06

'07

'08

'09

'10

-40

-20

0

20

40

60

80

100Percent tightening standards

Commercial loans(large and medium firms)

Consumer loans

Source: Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)

Long-Term Willingness of Banks to Make Consumer Loans is Increasing

'70 '75 '80 '85 '90 '95 '00 '05 '10-80

-60

-40

-20

0

20

40

60

80Percent

Net Percentage of Banks More Willing to Make Consumer Installment Loans

more willing

less willing

9.6%

Source: Senior Loan Officer Opinion Survey on Bank Lending Practices (Federal Reserve Board)

The Number of “Problem” Institutions on the FDIC’s List

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q30

100

200

300

400

500

600

53 61 65 76 90117

171

252305

416

552

$346B

2007 2008 2009

Number of banks, or$ Billions

Assets of problem banks

Source: FDIC

Monetary Policy

Rosenblum’s First Law

For every Federal Reserve policy action, there is an equal and

opposite criticism.

Fed Balance Sheet Outstanding:Economy Still on Life Support

Sep. 3, 2008 Dec. 31, 2008 Mar. 25, 2009 Jan. 6, 2010200

450

700

950

1200

1450

1700

1950

2200

2450Billions $

Week ended:

$1,020

$2,426

$2,144 $2,216

$2,247$2,051

$2,199

$894

Fed AgencyFed Agency

Fed Agency

MBS

MBSTreasurys

Treasurys

Treasurys

Treasurys

TSLF

TSLF

TSLFTSLF

Special Credit Facil-

itiesSpecial

Credit Facil-ities

Special Credit Facili-

tiesSpecial

Credit Facili-ties

Source: Federal Reserve Board

FOMC Central Tendency Projections(average of tendency range)

Real GDP2.7

2.9

3.1

3.3

3.5

3.7

3.9

4.1

4.3Percent

Unemploy...5

6

7

8

9

10Percent

PCE inflation1.3

1.4

1.5

1.6

1.7Percent

Core PCE1.20

1.25

1.30

1.35

1.40Percent

Source: Federal Reserve Board

2010 2011 2012

30

20

10 0

2000 2002 2004 2006 2008 2010

3020

10 0

3.0

2.5

2.0

1.5

3.0

2.5

2.0

1.5

NFIB PLANNED PRICE HIKES

% %

TRIMMED MEAN PERSONAL CONSUMPTION EXPENDITURES INFLATION RATE% %

Inflation is Muted Due to Lots of Excess Capacity

Source: Dallas Fed, NFIB and BCA Research

Inflation Expectations Still Moving Up?

2003

2004

2005

2006

2007

2008

2009

2010

-1.5-1.0-0.50.00.51.01.52.02.53.03.5

2.42.1

SA, Percent

10-year TIPS inflation expectations

5-year TIPS inflation expecta-tions

Source: Federal Reserve Board

• Drop phrase “likely warrant exceptionally low rates for an extended period.”

• Allow special liquidity facilities to expire – Most will expire Feb. 1, 2010– TALF will expire a few months later

• End large-scale asset-purchase programs– Scheduled to end by end of 2010 Q1

with slowing pace of purchases announced

FOMC Exit from Extraordinary and Massive Monetary Stimulus

FOMC Exit from Extraordinary and Massive Monetary Stimulus (Cont.)

• To reduce the credit-growth and money-growth potential of the current $1.1 TRILLION of excess reserves:– Begin reverse repurchase agreement

program– Raise interest rate on excess reserves– Establish a Fed term-deposit facility for

banks– Outright sales of assets

Use in combo. to increase

Fed funds rate

Timing of Exit Strategies

Depends on:• Long time lags for monetary policy

to impact economic growth and inflation

• Forecasts of when economy will return to more normal patterns– Cannot wait for return to actual high

resource utilization

Timing of Exit Strategies (Cont.)

• FOMC will focus particularly on anticipated resource utilization, inflation and inflation expectations in its decisions on exit timing

• Fed has no prior experience in creating or removing monetary stimulus of this magnitude and diversity

A Humble Note

“The way events have unfolded over the past few months simply has no precedent… No one knows the outcomes of an unprecedented event. No one.”

Zachary Karabell“The Economic News Isn’t All Bleak”

Wall Street JournalDec. 26, 2008, p.A13

The circulation of confidence

is better than the circulation of money.

- James Madison

Confidence Must be Restored in:

• Government leaders• Business leaders

– Especially bankers whose reputations are tarnished and diminished

• Workability and resilience of our institutions– Security breaches (White House, TSA)

• Fed Independence

• The economy is on a steadier positive trajectory.

• We have serious concerns about weaknesses in the labor market.

Economic Conclusions:

• The recovery depends on more than fiscal and monetary stimulus. They are necessary, but not sufficient for an economic recovery.

• True improvement requires the will and ability to overcome adversity, ending an attitude of complacency and entitlement.

• The U.S. has demonstrated this ability in the past and will continue to do so.

• The FOMC has already said, in essence: “We’ve done enough.”

Policy Messages:

Back of Tray

Words and Phrases to Never Use:

• Never again• Contained• This time it’s different

'81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09-6

-4

-2

0

2

4

6

8

10

Dec. Avg.

Euphoria

midpoint

Panic

Oil prices plunge

’87 stock run-up

’94 Recovery, EMG boom Irrational

ExuberanceNasdaq Bubble

Private Equity, CDO, Lending Boom

Secular Bear Stock Mkt ends

Oct. 87 Crash

Gulf War I

ERM crisis, Nikkei low Mex.

Default

Asian Crisis

Russian Default

Nasdaq Bust

Gulf War II looms

Subprime Crisis

Credit Suisse Global Risk Appetite Index Moderating

(1/12)

“The next few months are among the most important in U.S. history. Because of the financial crisis, Barack Obama has the bi-partisan support to spend $1 trillion in stimulus. But we must make certain that every bailout dollar, which we’re borrowing from our kids’ future, is spent wisely. …If we allow this money to be spent on pork, it will be the end of us.”

Thomas L. FriedmanNew York Times

Dec. 24, 2008, p.A21