2010 Economic Outlook:Prospects for an

Enduring Recovery William Testa Vice President and Economic Advisor Federal Reserve Bank of Chicago

IndianapolisMay 5, 2010

www.chicagofed.org/midwest

The “Great Recession” appears to have cometo an end around the middle of last year and

the economy expanded by 3.2% in the first quarter

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Real gross domestic productpercent

Quarterly change (saar)

Percent change from a year earlier

First quarter GDP expanded at a solid pacewith contributions largely coming from

consumption and inventories

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GDP Consumption Business Fixed

Investment

Residential Investment

Change in Inventories

Government Net Exports

Contributions to real GDP growth in Q1:2010percentage points (annual rate)

The inventory to GDP ratio has fallen to record low readings

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Inventory to GDP ratioratio

The pace of inventory accumulation ispredicted to continue to increase through 2011

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0255075

100125

2000 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11

Change in business inventoriesbillions of chained 2005 dollars (saar)

Q1-2010

Blue Chip Forecast

GDP is forecast to growabove trend in 2010 and 2011

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Real gross domestic productpercent

Quarterly change (saar)

Percent change from a year earlier

Q1-2010

Blue Chip GDP Forecast

Actual Forecast 2009 2010 2011

0.1 2.9 3.2

What will recovery look like?

1. “Shallow in-Shallow out violated, a weak recovery

-- exports gaining, and consumer, business equipment

-- financial sector stabilizing (non bank esp.)2. What will hold us back?

-- Previous wealth destruction/consumption spending weak

-- Overhang in housing and CRE-- Fragile capital markets

The forecast path of the current recovery is relatively muted compared with past deep recession recovery cycles

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Business cycle recovery pathindex - business cycle trough = 100

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2008-09

Blue Chip forecast recovery path

1974-75

quarters before trough quarters after trough

Consumer Sector

The stock market has improved since March 2009,but remains well below previous levels

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S&P 500 stock indexIndex: 1941-43 = 10

Home price declines have been large

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Midwest

Median sales price - existing single family home3-month smoothed - percent change from a year earlier

United States

In the fourth quarter, home prices fell by just overone percent over the past year

3 Red States19 Light Blue States

Household Balance Sheets

Ratio of Household Net Worth to DPI(hundreds of percent)

Household Debt and Savings Rate(percent)

Financial Obligations RatioPersonal Savings Rate

Q3-2009Q3-2009

Q3-2009

FOR: Ratio of hh debt payments to DPI

Consumer spending is expected torise at a slower pace in the fourth quarter of 2009

and then gradually improve through 2011

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Real personal consumption expenditurespercent

Quarterly change (saar)

Percent change from a year earlier

Q4-2009

Blue Chip PCE Forecast

Actual Forecast 2009 2010 20111.1 2.2 2.7

Labor Market

Employment has fallen by over 8.2 million jobssince December 2007

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Total employmentpercent

Monthly change (saar)

Percent change from a year earlier

Job Performance by state

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MI

Total employmentpercent change from a year earlier

US

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WI

The unemployment rate has risen tothe highest level since April 1983

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Unemployment ratepercent

19

UnemploymentUnemployment Rate (percent)

Mar-2010

FOMC Forecasts as of late January 2010

Late Jan April FOMC BC BC2010 9.6 9.7 9.62011 8.3 8.9 8.82012 7.1Long-run 5.0 – 2.8

The unemployment rate is forecast to peak at 10.2%early this year and then begin to edge lower

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Unemployment ratepercent

Unemployment ratepercent

Q4-2009

Blue Chip UR Forecastpeaks at 10.2% in Q1-2010

Industrial Production

Industrial output fell quite sharply during the recession,but has risen strongly over the past eight months

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Industrial production - manufacturingpercent

Monthly change (saar)

Percent change from a year earlier

Export growth has been rising over the past year

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Exports, monthlypercent change from a year earlier

Industrial production is forecast torise at a solid pace through the end of 2011

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Total industrial productionpercent

Quarterly change (saar)

Percent change from a year earlier Q4-2009

Blue Chip IP Forecast

Actual Forecast 2009 2010 2011-4.8 5.1 4.1

Housing

Housing starts have been cut-back sharply

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Housing starts3-month smoothed - percent change from a year earlier

Mortgage rates are very low

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Mortgage rate - 30-year fixedpercent

Housing affordability improved dramatically

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Composite housing affordability indexindex=100 when median family income qualifies for an 80% mortgage

on a median priced existing single family home

The forecast calls for a very slow recovery in housing

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Housing startsthousands

Blue Chip Housing StartsForecast (thousands)

Actual Forecast 2009 2010 2011553 685 952

CRE, Financial Sector and Bank Lending

CRE is a banking issue

• Unlike residential mortgages that were heavily securitized, most CRE is on bank balance sheets

• Smaller banks tend to have larger concentrations

• A major source of recent growth & profits for community banks

Commercial Banking

45%

CMBS, CDO, and other ABS Issues

21%

Life Insurance Companies

9%

Savings Institutions6%

Government-Sponsored Enterprises

6%

Agency- and GSE-Backed Mortgage

Pools4%

Governments4%

Other5%

Nonresidential Investment: Structures

Nonresidential Private Construction(billions of dollars, three month moving average)

Vacancy Rates(percent)

Nov-2009Q3-2009

OfficeIndustrial

j

CMBS delinquency rises to record levels

• Delinquency rates rising across all property types to record levels• Over 50% of current maturities unable/unwilling to refinance• CMBS Special Servicers have limited ability to extend maturities

Bank Lending

Total Loans and Credit Outstanding(three month percent change in MA3)

C&I Loans Outstanding(three month percent change in MA3)

Nov-2009 Nov-2009

Shading corresponds with NBER recession periods Shading corresponds with NBER recession periods

Inflation

The Fed has been very aggressive, lowering theFed Funds rate by nearly 525 basis points

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Fed Funds ratepercent

Inflation has begun to move higher

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Personal consumption expenditure - chain price indexpercent change from a year earlier

Removing the volatile food and energy components from the PCE,

“core” inflation remains contained

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Personal consumption expenditure - less food and energy -chain price indexpercent change from a year earlier

Inflation is anticipated to riseby 1.8 percent this year and 2.1 percent next year

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Consumer price indexpercent

Quarterly change (saar)

Percent change from a year earlier

Q4-2009

Blue Chip CPI Forecast

Actual Forecast 2009 2010 20111.5 1.8 2.1

•The outlook is for the U.S. economy to expand at a solid pace this year and next year

Summary

•Employment is expected to rise moderately this year and next year, with the unemployment rate edging lower through 2011

•Slackness in the economy will lead to a relatively low inflation rate over the next two years

•Growth in manufacturing output will be solid in 2010 and 2011 due to improving demand and rebuilding of depleted inventories

•The volatile credit markets, concerns about commercial real estate, and the weak housing market are some of the biggest risks on the horizon for the U.S. economy