The Current Economic Activity And Financial Markets Economics Essay

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Describe the Federal Reserve's assessment of the current economic activity and financial markets.

The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market--the number of new and continuing claims for unemployment insurance through late May--suggests that sizable job losses and further increases in unemployment are likely over the next few months.

However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households' spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline--a precondition for any recovery in homebuilding.

Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall's sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production.

Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts; then again, heightened economic uncertainties and the desire to increase precautionary saving or pay down debt might reduce households' propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO's estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3-1/2 million jobs.

The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II.

Explain the Federal Reserve's current view about inflation.

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.50 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed's estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the "break-even" rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium.

Describe the monetary policy tools the Federal Reserve uses to stabilize the economy and maintain price stability.

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

Based on the information you researched from Federal Reserve publications, present and justify your own economic outlook for the next 12 to 18 months.

We expect low growth, not no growth - and the growth scare should end in the coming months.  We think the transition to muted trend growth in developed markets is well under way but don't expect a relapse into outright recession.  As we have noted before, though, in a post-bubble, creditless environment, equities will closely follow swings in growth expectations.  That represents a near-term headwind to stocks until growth indicators start to stabilize. 

As the U.S. and global economies recover, a substantial number of businesses are taking the opportunity to expand or open new facilities in emerging markets such as China, Brazil, India and many others. With this potential upward trend in play, this quarter the Manufacturing Barometer incorporated questions to learn about panelists' plans for the longer term around expanding into emerging markets. U.S. Economic Outlook Continues to Stabilize, Uncertainty About the Global Economy Lingers Among U.S. Industrial Manufacturers. Expected international sales dipped in the second quarter of 2010 for industrial manufacturers marketing abroad. The projected contribution of international sales to total revenue over the next 12 months dipped slightly to 36 percent; down 4 points from last quarter's survey high of 40 percent but above the previous three quarters. Additionally, of respondents selling abroad, 42 percent reported an increase in sales, which dipped from last quarter but is notably above the prior three quarters. However, 24 percent reported a decrease in sales abroad, while 34 percent stayed about the same.