The Southern Oregon University 2015 Economic Forecast (1)

The Southern Oregon University 2015 Economic Forecast

EC 478: Business Cycles and Macroeconomic Forecasting

AUTHORED BY:

Alfonso Chavez, Caje Cobb,

Maria Escalante, Patrick Hennessey, Jeremy Kauwe,

Chase Mayer, Tyler Mitchell, Jordan Mortimore,

Derek Oleson, Sophia Panacy, Damien Rennie,

Gannon Schroder, and Colin Torkelson

Table of Contents Page Number

Background Information

Introduction . . . . . . . . . . 1

Methodology . . . . . . . . . . 4

The Real Sector

Consumption Spending . . . . . . . . . 5

Consumption Spending Sensitivity Analysis . . . . . 6

Nonresidential Fixed Investment. . . . . . . . 7

The Housing Industry . . . . . . . . . 9

Government Spending . . . . . . . . . 11

Government Spending Sensitivity Analysis . . . . . 12

Fiscal Policy: Taxation . . . . . . . . . 13

Fiscal Policy Sensitivity Analysis . . . . . . . 13

State and Local Government . . . . . . . . 14

Labor Markets . . . . . . . . . . 15

The Financial Sector

Monetary Policy and the Interest Rate . . . . . . . 17

The Foreign Sector

Imports and Exports . . . . . . . . . 21

Imports and Exports Sensitivity Analysis . . . . . . 23

Conclusion

Comparisons . . . . . . . . . . 25

Comparison Sources . . . . . . . . 28

Conclusion. . . . . . . . . . . 29


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Background Information An introduction to the report and a summary of the methodological process leading to

the creation of the Forecast

Introduction

Despite having technically recovered from the Great Recession of 2007-2009 our

economy hasn’t experienced the growth that many have expected. This is, in large part, due to

changes in lending habits, changes in consumer habits, the lack of expansionary policies for

business, the lack of real wage growth, and the increased income disparity. These changes have

primarily been caused by this recent recession and will be discussed in depth through this report.

The Great Recession likely had its roots in the 1999 repeal of the Glass-Steagall Act. The

repeal of this act allowed depository institutions to take on riskier financial practices, which

increased debt held by the public as a whole. These risky financial practices were primarily in the

form of allowing investment banking and allowing depository institutions to originate loans with

higher potentials to default. These loans were given out specifically within the housing and

financial sectors. These effects were exaggerated by Congress removing many restrictions on

banks in the following years.

An increase in the availability for mortgages led to an increase in the demand for loans.

This increased their prices beyond their long-run value and created a housing bubble. The

suppliers of homes noticed the increase in demand and prices and began rapidly increasing their

supply. Due to the increase in debt held by the public, people began refinancing their debt by

using such increased equity as collateral. Further, like all financial commodities, debt can be sold

to investors. Depository institutions sold much of this debt, in the form of bundled mortgage-

backed securities (MBS), to financial institutions. The problem in the housing sector was carried

over to the debt market and also impacted the equity market.

When less-credit worthy borrowers began defaulting on their mortgages, banks did not

have enough capital to offset their losses. This caused depository institutions to effectively stop

lending altogether. However, suppliers had already increased the availability of real estate. In

2008, we saw manufacturing firms receiving an influx of orders to which they usually finance by

borrowing from the bank then paying off after they sell the goods. Yet due to the scarcity of loans

demand fell. When coupled with the massive increase in supply, the prices of real estate fell

causing the housing bubble to “burst.” This massive decrease in real estate prices equated to a

massive loss in wealth for homeowners.


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This fall in wealth resulted in a larger amount of borrowers being unable to make

payments on their mortgage. Additionally leading to a massive decrease in consumption. This

decrease in household spending led towards a decline in profitability, and firms compensated by

decreasing their labor employed.

Businesses that were in need of cash were unable to access loans because banks had less

cash on hand due to the poor financial situation in the economy. Securities that banks and similar

financial institutions had purchased fell drastically in value. These financial institutions realized

losses in actuality and on their books. Investors’ outlooks were grim, which caused these financial

institutions to reinvest their funds outside of the U.S. This led to a large decline in the value of

U.S. stocks, which decreased household wealth further and exasperated the fall in consumption

spending leading to a loss in aggregate demand in the economy and a lowered gross domestic

product (GDP).

Since the Great Recession, the Federal Reserve (the Fed) has held down the discount rate

and purchased significant amounts of short-term bonds in an attempt to stimulate economic

growth. These actions are known as “quantitative easing”. Quantitative easing is an open market

operation (OMO) of purchasing securities from banks in order to increase the reserves of

depository institutions and thus decrease the interest rate. While increasing the reserves of

depository institutions theoretically increases lending, decreasing the interest rate theoretically

increases consumption. The government also “bailed out” several firms such as Fannie Mae and

Freddie Mac, GM and AIG, and was willing to cover $29 million in losses in the sale of Bear Stearns

to J.P. Morgan. Despite the Fed accelerating its bond-buying program during the recession to

encourage banks to pass on loans to consumers, banks instead tightened their lending, choosing

instead to hold on to their excess reserves. With the Fed ending the quantitative easing program,

and signs of GDP growth recently, many assume the economy is back on track. However, we have

not experienced the growth that many have expected.

Interest rates are still at an all-time low at around zero percent. In addition to desiring to

increase consumption, the Fed has been hoping that the low rates will be enough to entice

businesses to start investing and taking risks with their businesses. But the opposite actions have

taken place because the businesses are afraid to invest too much just to see all that hard work

lost. The most current recession has been the cause of this behavior. Small business investments

would help spark the growth that the Fed has been looking to see. Even given the reluctance of

businesses scared to invest, the Fed has been strongly considering raising interest rates to avoid

further complications in the workings of the economy stemming from extremely low interest

rates. Businesses have been producing a lot of goods to find that the company products being

produced are not being bought up as quickly; demand has fallen. This also has been plaguing the

businesses ability to expand and help the economy grow. Further, banks have yet to increase


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their lending, of which is either the cause of the lack of business expansion, or a symptom; in

either case, however, it is holding back economic growth.

Shifting the focus to the consumer and the consumer’s ability to spend money this has

been an area in which the economy has continued to struggle. 95% of wage growth since the

recession has gone to the top 5% of wage earners; however, real wage growth as a whole has

remained relatively stagnant. Further, as businesses aren’t expanding, we can assume the

increased profit hasn’t been reinvested in capital. The distribution of wealth being this skewed

doesn’t give the other 95% of the population more disposable income to spend, and on average

it decreases the amount, per dollar, that is consumed which negatively impacts aggregate

demand and thus GDP. Instead, the other 95% have been have been trying to save rather than

spend the money they earn, or at the least, have shown a trend of increased “thriftiness,” as new

products that are being produced are being passed up on for used products. Consumers being

thriftier haven’t been helping the economy grow because a used product doesn’t contribute to

the businesses producing new products, bottom line. The unemployment rate has continued to

drop to 5.4%, which is a near seven-year low. However, there has been an increase in workers

who are employed in jobs below their levels of skill/education, and there hasn’t been the growth

in real wages that is typically expected when the economy nears “full employment.” The causes

and specifics of the economic realities we face today and our predictions moving forward will be

covered throughout the rest of the report.


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Methodology

In order to create the macroeconomic forecast for 2015-2017 we made use of a

forecasting model called the Fair Model, which was developed by Yale University professor Ray

C. Fair. This model is used to explain the numerous economic sectors using historical data and

equations that are believed to best capture the structure of the U.S. Economy.

Additionally, some of the variables are explained by a set of equations that are recognized

by general economic theory. The model is updated every quarter (3 months) using the latest

economic data with the intention of making sure historical data is accurately current. However,

this is not to say that the model in its base form is without flaws.

Unfortunately, the model itself is structurally bound to a series of equations that rely on

historical data (as updated every quarter). This means that the model is slow to adjust to changing

economic movements as they actually occur. For this reason it is necessary to have thoughtful

human manipulation of certain values and equations in order to create an accurate forecast.

These adjustments are essential in order to correct non-historical conditions or

tendencies that the model did not anticipate, such as unexpected recessions. In order to figure

out which sections of the model were not accurately depicting the current economic conditions,

dividing the whole forecast into small teams and assigning certain sectors of the economy was

needed to determine which equations would need to be modified.

For each sector of the economy, a group was assigned. For Instance, groups were divided

to focus on fiscal policy (national, and state and local), monetary policy, consumption,

investment, housing markets, labor markets, and the international sector (imports/exports and

exchange rates). Each group than performed research for the designated sector, examined the

projecting accuracy of the Fair Model for recent years and made necessary adjustments so that

our prediction is similar to that of the actual outcome of economy predicted by the Fair Model.

Each group individually tried to determine the sensitivity of their corresponding sections

to exogenous economic shocks. Thus, the final part to the forecast was to attempt to anticipate

the changes within the forecast if certain assumptions were not accurate.


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The Real Sector: The impacts of Household spending, Business spending, and Government Policies on the

U.S. Economy

Consumption Spending

Consumption spending is the single largest sector of the U.S. economy; it accounts for

roughly 70% of the national output each year. For this reason, changes in consumption spending

and the shape of consumption spending functions can have a large impact on the forecast each

year. Initially we looked into the effects of different spending in the economy and how this would

affect our projections. The changes in consumption slowly affect the output of the economy and

the decrease in the output of the economy will be realized over the period of the prediction.

The factor that we incorporated into our forecast was that of a changing amount of

consumer spending as compared to income. The effects of the increasing disparity of wealth in

the years since the recession has led to a rate of consumer spending that is likely below the

historical average. Since the recession, roughly 5% of the U.S population has acquired 95% of the

income; income disparity has increased. The outcome of this change in the economy’s income

structure has led high-income earners to earn a higher proportion of income nationally than

middle and low-income individuals.

High-income earners are generally able to save at a higher rate compared to their lower

tax bracket counterparts in regards to a disposable income. This has led to an incremental

increase in national income not having as large of an effect as it would have pre-recession. This

is for the reason that the higher-income individuals are less likely to spend as much as lower-

income Americans. This is incorporated in our model through the output of the economy slowing.

The model which the SOU forecast put together best matches the rate of consumer

spending that occurred over the last year. The original model we had worked with used a

historical regression of the data to come up with expected output. We feel that the updated

model provides a better prediction than the historical average.

We had also taken a look at services, specifically higher education. We had read an article

that spoke of an interesting trend. The article stated that more of the population is heading to

college to get degrees in hopes of bettering their position at their current jobs. We planned to

modify the spending by consumers on services to account for this trend, but the findings weren’t


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enough to make any major changes to the consumption aspect of the report. The changes in the

economies total spending would have amounted to less than .025 percent annually.

We discovered that there were not any large changes in spending behavior on the part of

consumers that would have a large enough influence on the model to change the outcome

regarding consumption spending. Overall, one can expect a slowing of consumer spending as a

product of the increasing disparity of wealth currently occurring in this country.

Consumption Spending Sensitivity Analysis:

We ran our forecast and accounted for overly optimistic and overly pessimistic

estimations of consumer spending. In these scenarios, the optimistic projection had the potential

to change output by up to one percent upward while the pessimistic projection had the potential

to change output downward by up to one percent. This is for the reason that consumer spending

in the economy accounts for close to 70 percent of the economy’s total spending. The assumption

that the income structure of the economy has changed as compared to historical distributions is

key in the projections which this forecast makes.


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Nonresidential Fixed Investment

Nonresidential Fixed Investment is what businesses spend on equipment, machinery,

software, buildings and intellectual property. Equipment accounts for nearly half of

Nonresidential Fixed Investment and has led the recovery in business spending since 2009.

Nonresidential Fixed Investment is driven by the consumers’ demand for goods and services and

the cost of capital investment, which is determined by the interest rates.

Our forecast anticipates that the interest rates will remain low throughout the forecast

period and that consumption will continue to increase. These low rates and the increasing

consumer demand will encourage businesses to invest in capital expenditures to expand their

operations while new firms borrow capital to enter the market.

According to the U.S. Bureau of Economic Analysis (BEA), Nonresidential fixed investment

has been rising by more than 4% during each quarter of 2014, primarily driven by higher

consumer and business spending and the energy and technology booms. This trend is expected

to continue throughout our forecast and have a positive effect for both business investment

activity and real GDP.

Much of the improvement will be the result of a stronger labor market. According to the

Bureau of Labor Statistics, the unemployment rate fell to 5.5% during February 2015. This is a

positive improvement since the end of the recession in June 2009 when the unemployment was

at 9.5%. During 2013 - 2014, employment grew with gains in high-paying sectors such as

construction, manufacturing and professional and technical services helping to drive income

growth as most of these jobs were full-time positions.


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Employers will continue to add jobs keeping a low unemployment rate and it is expected

for inflation to move closer to the Fed’s target of 2.0%. Consumer spending will be encouraged

during the forecasted period by a stronger income growth and lower gasoline prices resulting in

more disposable income.

On the other hand, if the Fed decides to raise the interest rates, the credit cost may

discourage some business investment and others may rush to take advantage of the current low

borrowing rates. However, the increase in consumer spending will require more businesses’

investment to cope with demand. Manufacturing industries have been major drivers of

investment in nonresidential structures. However, the recent drop in oil prices is likely to restrict

energy-related investment in 2015 for domestic producers.


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The Housing Industry

The housing industry is a large part of the U.S. economy. This industry has been growing

at a very slow pace these past few years. The Great Recession has left people wary of investing

in homes given the all too recent memory of the housing bubble.

Three factors greatly affect growth of the housing industry market: interest rates,

inventory, and home prices. Interest rates are currently very low, this creates a favorable

environment for businesses to finance the construction of new homes. New construction is

currently happening, but it is not happening fast enough to keep up with the demand for housing.

Low interest rates have caused loan companies to be stricter with who they loan to on such low

margins. This makes it harder for families to qualify for new home loans. This trend towards

stricter loan requirements has slowed the growth of the housing industry. If the housing industry

begins to see increased growth, then the growth of the U.S. economy would also improve.

Inventory for the housing industry is currently low, and the demand for new construction

is growing. The current inventory available for sale in the U.S. is right around two million homes.

This amount of inventory is only able to sustain the growing market for around 4.6 months. This

is contrasted with a healthier economy where a larger inventory of homes is available for sale. In

a healthier economy the inventory of homes would be able to sustain the market for around 6

months.


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Home prices across the U.S. have risen by 4.2% over the last year. This is because of the

low inventory available for sale, and that there is currently some demand for houses. The prices

for houses will continue to grow throughout our forecast at a rate of around 3-4% per year for

the next few years while new construction tries to catch up with the demand.

We believe that the Fed will not raise interest rates until the third or even fourth quarter

of 2017. If the Fed decides to raise interest rates earlier than this, this decision could cause major

problems for the housing industry and the whole economy. The economy is currently not stable

enough to withstand an interest rate hike. Higher interest rates could make homes more difficult

to afford which could drive down housing demand enough to create a decline in economic

growth.


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Government Spending

In 2014 with Bipartisan support, Congress passed the Consolidations Appropriations Act

(CAA). This act negate the prior year’s cuts to education, research, infrastructure, and national

security. The federal government used three fiscal policies to accomplish this — government

purchases, taxes, and transfer payments.

Changes to our forecast were based on the assumption that current laws will remain

relatively unchanged. Purchases of consumption and investment goods are forecasted to remain

relatively unchanged. The result is a negligible increase in total income because changes in

government purchases have a “multiplier effect,” meaning, when the government makes a

purchase, total output increases by an amount greater than that of the purchase.

Transfer payments to the household sector rise by approximately 74 billion, or 5.3 percent

of total government spending, over the forecast period. This increase leads to additional

disposable income that can be used for consumption spending, which then stimulates total

output and employment.

Transfer payments consist of social security, Medicare, Medicaid, and other mandatory

and discretionary governmental programs. In the past few years, the federal budget deficit has

declined sharply because of gaps between spending and revenues. Our forecast predicts it will

continue along this downward trend by 35 percent through 2017. These predictions regarding

transfer payments reflect the assumptions below:

Under current law, spending in 2015 will total $3.7 trillion, increasing spending by $152

billion. We forecast this rate of spending to remain steady over the next two years. Mandatory

spending is projected to rise by $158 billion, in part, due to major health care programs —

Medicare, Medicaid, and subsidies offered through insurance exchanges that will increase by $82

billion because of the expansion of optional coverage sanctioned by the Affordable Care Act

(ACA). The assumption is that people in states that have already expanded Medicaid eligibility

under the ACA will enroll in the program with other states following suit. Additionally, spending

for Social Security is projected to remain at 4.9 percent of total output in 2016 and 2017 amount

to a $38 billion dollar increase.


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Furthermore, defense spending decreased significantly in the first quarter of 2015

because of a reduction in appropriations for overseas contingency operations, which are not

constrained by caps agreed upon by the Bipartisan Budget Act of 2013 (BBA). This trend will

continue over the next two years. It’s important to note that we don’t really know what is going

to happen in regards to defense spending primarily because it is contingent on overseas

operations.

Government Spending Sensitivity Analysis

In one scenario, a 3.8 trillion dollar budget is passed in the House and Senate that will be

effective Oct. 1. Mandatory spending accounts for two-thirds of this budget. Congress allocates

the rest between defense ($523 b.), other federal agencies ($493 b.), overseas contingency

operations ($96 b.), and natural disasters ($7 b.), respectively. This scenario will reduce real

government purchases, which will directly decrease aggregate demand resulting in an overall

decline in employment and national income. Thus, consumers will have less money to consume

and invest.


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Fiscal Policy: Taxation

Following the 2014 election cycle, the federal government has been divided between a

Republican Congress and a Democratic White House. The Republican budget and the White

House budget have both been put forward, but are at odds with each other. Right now the most

overlap in tax policy seems to be centered on corporate tax reform. The United States currently

has the highest corporate tax rate in the world, which has led businesses to relocate overseas in

a phenomenon known as “inversion”. Policy analysts suggest that it is unlikely for any tax reform

to be passed until the next presidential election. Tax rates on corporations and individuals are

forecasted to remain unchanged by policy for 2015 and 2016.

For 2017 onward the forecasted policies are the passage of corporate tax reform, and

estate tax reform. These two policies are current priority tax legislation in congress, but haven’t

passed due to disagreements between the White House and Congress. Corporate tax reform is

expected to have a $36.65 billion effect on the economy, driving unemployment down and

boosting economic growth. This is based on current tax policy proposals from the White House

and the Republican congress, assuming a new 28% tax rate down from 35%, new revenue from

closed loopholes, a 19% tax rate on foreign profits, and an 8.75% transition tax rate. Estate tax

reform, a current policy agenda with the Republican congress, would relieve household taxes of

$27 billion. Similar to corporate tax reform, estate tax reform would help drive down

unemployment and boost growth.

Fiscal Policy Sensitivity Analysis:

The presidential election following into 2017 could have substantial effects on fiscal tax

policy. Some Republican candidates are in favor of tax reform and lowering rates, while some

Democrats are in favor of raising taxes on high-income earners. Candidate platforms remain

vague, but we have put together two scenarios for the 2017 outcome. In one scenario corporate

tax reform ($36.65 b.) and estate tax reform ($27 b.) are passed at the beginning of 2017,

providing an immediate boost to growth and decrease in unemployment. In another scenario

corporate tax loopholes will be closed ($10 b. increase in effective taxes), middle class tax rates

will decrease slightly and top bracket tax rates will increase (net $3.17b. decrease in taxes). From

the tax perspective, this would lead to slightly increased unemployment and decreased growth.

Additionally, there is a possibility that corporate tax reform is passed in 2015 or 2016. If

enacted in 2015, corporate tax reform would boost growth and reduce unemployment through

2015 and 2016, which could beneficially position the economy before the next president is

elected.


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State and Local Government

State and local governments effect the economies of all 50 states (and their various

municipalities). However, generally only the largest states’ spending shows up on a national scale.

As such, in order to show significant changes only those states with the largest impact on the

national economy were used.

Overall, state and local economies are fairly stagnant, although moving slightly towards a

decline in their overall levels of spending due to declining revenues and increasing demands for

services. Based on this, we assume state and local economies will see a gradual increase of 1.2%

in spending in the first quarter of 2015 to an increase of 2.0% in government spending in the last

quarter of 2017. These changes are negligible when compared to the national economy.

Income taxes across the states fluctuating due an effort of coming out of the recession as

well as a drive to balance their budget specifically from an increase of .0005% to income taxes in

the first quarter of 2015 to with an aggregate net change of around -1.3% in income taxation over

the next 2 years.

Profit taxes will be negligibly decreasing over the 2 year period due to a projection of

more conservative fiscal politics as well as the movement of businesses from state to state and

to other countries, specifically a change from a decrease of 1% in 2015 to 2% in 2017.

Taxes on goods post-production will be negligibly decreasing over the next 3 years to

help ease the recession and foster consumer spending. Specifically, we forecast a change of about

.0001% to -0.0001% per quarter over the next three year period.


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Labor Markets

The labor market brings important factors to a growing or shrinking economy. Both are

interrelated and dependent on each other, thus labor markets affect the economy and the

economy affects labor markets. Two important factor of economic growth are the

unemployment rate and total employment. Changes in the unemployment rate and the total

employment of the economy can have effects across the economy.

What is driving dull growth in total employment? Several factors are contributing to an

increase in the unemployment rate and a stagnant increase in total employment: Low overall

production growth, wage stagnation, slowing consumption spending, and slow investment

spending to name a few. As mentioned before slow growth seen in GDP is tied in by all the factors

that also affect the labor market. This also explains how GDP and labor markets are interrelated.

Employment is driven by the growth of the economy, which in return affects the

unemployment rate. Unfortunately, while growth is observed in GDP through our forecast

period, the growth is not rapid enough to boost employment. In the forecast, near stagnant

growth in total employment is projected for the next two years; this leads to our forecast of the

unemployment rate increasing by nearly one percent in just the next year.

Jobs are not created rapidly enough to keep the unemployment rate low. The quarter of

2015 showed promising signs as unemployment hit a recent low of 5.5 %. Despite this, the truth

is our economy just doesn’t have enough momentum to create a healthy job market in the

foreseeable future.


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Wages are a huge factor in job markets, which are driven by demand for goods and

services sold. However, this is a catch 22—if wages are too little for laborers to have disposable

income which goes back into our markets on goods and services, then demand for goods and

services decrease. This only leads to further decreases in income feeding into the cycle.

The federal minimum wage has been stuck at $7.25 since 2009. Many feel that a lack of

wage growth is a huge factor in the slow growth of labor markets and our overall economy.

Incomes are not sufficient enough for workers to purchase goods, all the while inflation continues

to increase. The cost of living rises every year and households are struggling to put food on their

tables.

The labor market links closely with the overall economic health in the United States and

while reporting a healthy booming economy would be our preference, this is not the reality.

Stagnant wages and employment growth account for observed and forecasted slow economic

growth.


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The Financial Sector: The actions of the Central Bank and the impacts on the U.S. Economy

Monetary Policy and the Interest Rate

Monetary policy refers to the actions taken by the US Federal Reserve (“Fed”) in order to

manage or control the economy. Controlling the economy, however, is no easy task and the Fed

faces many difficulties. More specifically the Fed does not directly control bank lending, inflation,

or employment. They do, however, have “targets” in each of these categories which they take

actions in an attempt to meet. There are two primary schools of thought in relation to how the

Fed should meet these targets, the first being Monetarism. Monetarists believe that controlling

the money supply (how much money is in the economy) is the best way to manage the economy.

This belief is really based on the equation MV=PQ where M = the money supply, V = velocity, or

the number of times per year the average dollar is spent, P = the prices of all goods and services

and Q = the quantity of all goods and services. According to this theory, as long as V is constant,

or at least predictable, the Fed should be able to manage GDP by controlling the money supply.

While historically this may have been the case, the rapid evolution of technology over the

past two decades has made velocity much more difficult to predict. Instead, the Fed now

practices what’s called Keynesian economics, targeting interest rates in order to manage

consumption and savings, the backbone of inflation. A higher interest rate will lead towards

increased savings (as the interest rate is the return on savings) and thus decreased consumption

(as the two are inversely connected). When inflation is high the Fed will pursue higher interest

rates in an attempt to slow it, as the decrease in consumption will, in theory, cause inflation to

fall as an increase in the savings rate means fewer total expenditures (through consumption),

and therefore a slower growing economy. A lower interest rate leads towards increased

consumption and thus decreased savings. The Fed wants a low interest rate when inflation is low,

as the increase in consumption will lead towards higher inflation.

The Fed is able to control the interest rate in three ways. The first is by controlling the

“reserve requirement” or the amount of money reserves that banks and credit unions must hold

onto as a percentage of the amount of demand deposits (the balances in savings or checking

accounts) they hold. According to the loanable funds model, an increase in the supply of loanable

funds leads towards a decrease in the interest rate, while a decrease in the supply of loanable

funds leads towards an increased interest rate. Thus, increasing the reserve requirement will

cause the interest rate to fall, and vice-versa. However, this method is very “blunt” and is not

meant for “fine tuning” the interest rate. Further, an increase in the amount of loanable funds


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that banks are not able to lend, ceteris paribus, has been argued to lead towards a decrease in

lending over the long run, and thus a decrease in investment and therefore GDP. The Fed does

not want to hamper economic growth in order to control inflation, so this tool is not commonly

used. The second tool is called the “discount rate”. This is the interest rate that banks use when

they borrow money directly from the Fed. However, this method more confirms what is

happening in the economy rather than controls the economy. The third method is called “open

market operations”. This is when the Fed will purchase securities from banks or credit unions to

control their reserves directly. Open market operations were the primary tool the Fed used to

respond the Great Recession of 2008.

Specifically, the Fed practiced open market operations by purchasing trillions of dollars’

worth of securities from banks. This caused reserves to increase proportionally, and thus caused

the interest rate to fall to near zero where it currently remains. Further, an increase in excess

reserves should, theoretically, increase lending in the long run, as depository institutions have

more funds to lend. This practice was termed quantitative easing, and while the Fed is no longer

purchasing securities from banks, we are still feeling its effects. Depository institutions currently

have roughly $2.6 trillion in excess reserves and are holding onto the reserves rather than

increasing their lending. This is a major reason why, while technically the economy is out of

recession, we haven’t experienced the growth that many have expected.

So what will the Fed do with the interest rate now? Many have been asking themselves

this question, as 6 years after the end of the Great Recession the interest rate still remains at

essentially zero. Eventually, many observers must be telling themselves, the interest rate will

have to go back up. However, when questioned on this topic Fed chairwoman Janet Yellen gives

the response that the Fed will likely not take action until a target of 2% annual inflation is hit, and

there are “significant decreases” in the unemployment rate.


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If we can take the chairwoman at her word then our forecast allows us to predict when

these targets might get hit. For years the inflation rate has been hovering in the neighborhood of

1%, only half the Fed’s target. Even our most optimistic predictions don’t have that figure

approaching 2% until the middle of 2017. Likewise, not only are we not predicting a sharp decline

in unemployment, we actually see it increasing over the next year. These are certainly not

conditions conducive to increasing interest rates.

However, as a government agency, the Federal Reserve is subject to political pressure.

For years various Fed agencies have talked about the possibility of rates going up, and now there

is a sizeable portion of the population that expects this. This means that the Fed, while still

careful, may make a hasty rate adjustment soon after conditions appear better. According to our

forecasts the inflation rate will hit 2% in the second quarter of 2017. Around this same time we

believe that unemployment, while still high, will begin to decline. We predict that after a quarter

of consistent results the Fed will cautiously raise rates to .15% in the third quarter of 2017, and

then very slowly raise the rates, probably by small increments every quarter, assuming that the

economy remains stable.


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Our predictions are dependent on economic realities matching what the Fair Model

predicts. However, this will not necessarily occur. There are scenarios that would result in the

Fed increasing the interest rate before the 3rd quarter of 2017. One of these scenarios is an

increase in depository institution lending. The relatively stagnant lending, and consequently high

amount of excess reserves, has resulted in slower than expected inflationary growth. However,

if these depository institutions begin to lend at a faster pace, it will increase aggregate demand

and thus increase inflation and GDP, and may lower unemployment depending on what type of

loans are being originated; if the loans being originated are for the purpose of business

investment, than this implies that businesses are growing which would, consequently, lead

towards a decrease in the unemployment rate, ceteris paribus. If inflation rises at a faster pace

than the model predicts, and unemployment falls at a faster pace, both of which caused by an

increase in lending, than the interest rate will rise before the third quarter of 2017.

If the interest rate does increase before 2017, it will likely not rise before 2016. This is due

to lags, primarily, the time it would take before the increase in lending actually does result in

changes in inflation, GDP, and unemployment, and then the time it would take for the Fed to

recognize this and then agree upon the correct course of action, in addition the potential

economic consequences, that the Fed is aware of, if it increases the interest rate too soon; the

Fed will want to make sure the economy is on the “right track” before engaging in open market

operations, instead of acting in accord with a short-run trend. This means that the interest rate

increase would occur somewhere in between 2016 and 2017. If the interest rate rises in the first

quarter of 2016.


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The Foreign Sector: The impacts of sending on imports and exports in the U.S. Economy

Imports and Exports

Our economic forecast over the next few years shows steady growth in real GDP, rising

unemployment, and inflation increasing. Our forecast was based on certain sectors of our

economy that already have built in assumptions and other sectors outside of the model that we

must predict. These excluded sectors are changed and added to the model according to our

predictions. Changing any one sector will produce different results and that outcome may or may

not be a significant amount depending on the assumption. In this section, we projected exports

and imports based on assumptions of the dollar exchange rate, oil prices, and the performance

of other economies that we engage in commerce with.

Imports and exports have a significant impact on the model. This is because imports

represent a flow of money exiting the U.S. and exports represent a flow of money entering the

U.S. If imports exceed exports, we have a trade deficit, which is an outflow of domestic currency

and can negatively impact GDP. In predicting imports, we assumed that oil prices would increase

and the dollar exchange rate would depreciate in value.

In looking at the strength of the dollar, we used the trade weighted U.S. Dollar Index. It is

a weighted average of foreign exchange currencies that circulate widely outside the country of

issue. These currencies include a broad index from the following countries: Euro Area, Canada,

Japan, United Kingdom, Switzerland, Australia, and Sweden.

Since the global recession that occurred, we have seen a strengthening of the dollar

against other currencies. However, a 40-year history shows a downward trend in the dollar. Our

assumptions in a depreciating dollar are based off this longer-term trend as well as the

performance of other economies. As other economies improve, this will push up demand for our

currency down and the dollar will depreciate. The second variable in predicting imports we

focused on was oil.

In analyzing oil prices, we used the West Texas Intermediate oil benchmark. Oil has

decreased from a high of over $105 a barrel a year ago, to a low of around $40 as of a few months

ago, to around mid-$50’s currently. This sharp drop off in oil prices was largely due to a

strengthening dollar and an increase in U.S. oil production. To further this price decline, large oil

exporting countries did not respond by cutting supply, but kept their production elevated. The


22

supply of oil, strength of the dollar, and world demand are going to be the main factors driving

oil price in the future.

Oil demand has been increasing globally as well as domestically because of the decline in

oil prices. Oil supply from the U.S. has increased because of a change in technology from hydraulic

fracturing. This increased the production of oil by the U.S. by almost double than what it was

before the implementation of the different technology. This increase pushed prices down and at

the same time was seen as a threat to Saudi Arabia, which is one of world’s largest exporters. In

hopes of maintaining some type of control over the market for oil, Saudi Arabia responded by

increasing production of oil to put downward pressure on prices and put hurt U.S. producers of

oil.

This tactic has worked, with the U.S. having a decrease in their active rigs from 1861 last

year, to 932 currently. This decrease in active rigs however, has not been accompanied by a

decrease in production. Domestic production appears to have plateaued as well. With plateauing

production and a decrease in active rigs, there should be time lag between a decrease in

production and the decrease in active wells.

We are assuming, that a decrease in production will be a catalyst for oil exporting

countries like Saudi Arabia to cut back production as well. With a decrease in production from

the U.S. and from other exporting countries, an increase in consumption, and a lower dollar in

the future, we will see a decrease in oil prices. However, we will most likely not see prices rise

above eighty a barrel because as prices increase, U.S. rigs that are inactive will most likely become

active again and begin to produce more oil. These two variables, the exchange rate of the dollar

and oil prices, as we have seen impact imports. With exports however, we have slightly different

assumptions.

Our forecast is based on the assumption that exports will increase. However, this increase

won’t be in a straight line. Variables looked at for this prediction is current economic situations

in countries that we export to and the strength of the dollar compared to a basket of other

currencies that we trade with. If we look at the trend since the last depression, we can see that

exports fell off sharply, but recovered and have growth moderately each year. However, the past

year or so we have seen slower to sideways growth in exports, most likely contributed to the

strength of the dollar and underperformance of key countries we trade with.

The strength of the dollar is projected to decrease as other economies improve. This

decrease in the value of the dollar will give other countries that we export to more purchasing

power and increase the amount of real exports. The improvement of other economies that we

trade with may be slow at first, but as other economies like Japan and China implement

expansionary monetary and fiscal policy, we should see demand for our exports to slightly pickup.


23

There will be a lag time to the time of expansionary policy to an increase in exports of about a

year.

The assumptions in both exports and imports have imports dropping initially then

increasing and exports slightly increasing and then increasing at a faster rate in the future. The

initial drop in imports can be explained by prices of oil and the exchange rate of the dollar staying

around current levels for the next two quarters. Exports slowly increase as well but accelerate as

other economies improve. These assumptions, along with other sectors already accounted for in

the model, result in the annual numbers in real GDP, inflation, and unemployment listed below.

When making forecasts, we understand that outcomes aren’t always certain. For this

reason, we have included a different scenario, showing another possible outcome. This scenario

assumes that imports are the same as the forecast but exports are decreasing.

This scenario comes from a change in the assumptions in exports. In the model, we

assume that different economies that we engage in commerce with will eventually improve as

their governments use expansionary fiscal and monetary policy. We also assume that the weaker

dollar will make American goods and services more appealing because they will be less expensive

to other countries.

Import and Exports Sensitivity Analysis

If other economies that we engage in international commerce with begin to contract, this

could drastically reduce the amount of exports, even if the dollar decreases. Current levels of

exports are around $530 billion, but in our new assumption of exports decreasing from

contraction of other economies, we project a decrease to around $480 billion by 2017. Shown

below is the outcome from said assumptions.

2.2

3.33.7

0.08

1.82.5

6 6.3 6

0

1

2

3

4

5

6

7

2015 2016 2017

Pe

rce

nt

Year

Imports and Exports Increasing

Real GDP*

Inflation*

Unemployment*


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As one can see from this scenario, although unlikely, there are far different outcomes

than what has been projected in our forecast. Real GDP appears to grow moderately in 2015,

slightly higher in 2016, and then turns negative in 2017. Unemployment also appears to be higher

in all three years as well.

1.3

3.7

-0.4

0.1

1.42.1

6.26.9

6.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2015 2016 2017

Pe

rce

nt

Year

Imports Increasing and Exports Decreasing

Real GDP

Inflation

Unemployement


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Conclusion: A short comparison of the SOU Forecast and selected professional forecasts and a

summary of the SOU Forecast’s Results

Comparisons

Federal Reserve

The economists at the Federal Reserve are projecting that real GDP growth is consistent for the

next two years but declines in 2017. Inflation is projected to increase each year to just under the

Fed target of 2% in 2017. Unemployment is projected to decrease slightly over the next three

years.

Key Assumptions behind this Forecast:

Fed Funds are expected to have a rate hike of around 25 basis points in 2015. Consumers are

expected to spend more because of lower energy costs. Businesses and households are expected

to improve their balance sheets. Labor markets are projected to be improving along with an

increase in wages. FOMC projects fiscal policy to have less restraints and monetary policy to be

accommodating to their dual mandates. Some analysts have lowered projections because of

recent weakness in spending and projection as well as the appreciation of the dollar. The dollar’s

appreciation as well as weak demand abroad will translate into lower exports.

PNC Financial Services Group

This group of economist projects real GDP to remain fairly consistent around the 2.8% mark until

2017 where it drops to 2.4%. Unemployment is on a steady downward trend the next three years

and inflation is low this year, but increases next year and into 2017.


Wage growth into 2016 will boost consumer spending. We will also see a stronger dollar and

weaker growth overseas, which will increase consumer spending, business investment, and

housing here at home. Job growth for 2015 will be less than job growth in 2014. Inflation will be

below 2% until the second half of 2015, when wages increase and oil prices rebound. Short-term

rates will increase and long-term rates will only slightly increase.


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The Philadelphia Fed

39 forecasters surveyed by the Philadelphia Fed. The Philadelphia Fed projects real GDP to slightly

increase over the next three years. The unemployment rate falls and inflation increases steadily

to just under the Fed’s target inflation rate in 2017.


Weaker outlook for growth will be accompanied by improvement in unemployment. Job growth

of non-farm payrolls in 2015 will be 223,000 a month and 2016 will be 180,100 on average.

Following are graphs which directly compare key data from the selected professional forecasts

and the 2015 SOU Economic Forecast.

2.7 2.72.4

2.8 2.9

2.42.4

2.8 2.8

2.2

3.3

3.7

2015 2016 2017

Pe

rce

nt

Years

Real GDP

Federal Reserve PNC Financial Services Philadelphia Fed SOU Forecast


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1.41.6

2

0.4

2.42.3

1.4

1.71.9

0.3

1.8

2.5

2015 2016 2017

Pe

rce

nt

Year

Inflation


5.1 5 4.9

5.4

4.94.7

5.45

4.8

66.3

6

2015 2016 2017

Pe

rce

nt

Year

Unemployment



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Sources:

Board of Governors Federal Open Market Committee. (2015, March 18). Minutes of the Federal

Open Market Committee. Retrieved May 21, 2015, from Federal Reserve:

http://www.federalreserve.gov/monetarypolicy/fomcminutes20150318ep.htm

Federal Reserve Bank of Philadelphia. (2015, May 15). Second Quarter Survey of Professional

Forecasters. Retrieved May 21, 2015, from Philadelphia Fed:

http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-

professional-forecasters/2015/survq215.cfm

Hoffman, S. F. (2015, May). National Economic Outlook. Retrieved May 21, 2015, from PNC:

https://www.pnc.com/content/dam/pnc-

com/pdf/aboutpnc/EconomicReports/NEO%20Reports/NEO_May2015.pdf


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Conclusion

While the economy has technically recovered from the 2007 recession, we have not

experienced the rebound that typically occurs after a trough. 95% of wage growth has gone to

the top 5% of wage earners, interest rates are still being held at near zero, and in the first quarter

of 2015 real GDP fell by 0.7%.

Even though many believe that the economy is back on track, it will be at least another

year until we see consistently larger increases in GDP. A major reason for this slowed growth is a

lack of real-wage growth. While unemployment has been falling, real wages are relatively

stagnant. As we are predicting the unemployment rate to rise slightly in 2016, real wage growth

will be further slowed. However, consumption as a whole will steadily increase, albeit at a slower

pace than pre-recession due to the increase in income disparity and stagnant real wage growth,

which, with the help of consistently low interest rates, will lead towards increased business

investments. In the next few months, housing investment will begin to increase as suppliers are

regaining confidence, demand for housing is increasing, and interest rates are low.

The Fed will be keeping the interest rate down until economic indicators tell them that

the economy is getting better; the interest rate will stay low until targets for inflation and

unemployment are met. One should not overlook the importance of the foreign sector; net

exports are dependent on the health of foreign economies, and a significant decline in

international output could stall domestic economic growth. However, we predict a positive

outlook for our trading partners, which will lead towards increased net exports, which should


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help bolster growth. Finally, an increase in mandatory government spending due to the

Affordable Care Act and the high priority of tax reform will lead to the economy receiving some

boost from government spending.

The Southern Oregon University 2015 Economic Forecast (1)

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