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Goldman Sachs - Time to Rethink the 6.5_


Time to Rethink the 6.5% Unemployment Threshold

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									May 3, 2013

Issue No: 13/18

US Economics Analyst
                                                                                                     Economics Research

Time to Rethink the 6.5% Unemployment Threshold

                                                                                 Jan Hatzius
                                                                                 (212) 902-0394
    The stronger-than-expected April employment report has reduced the          Goldman, Sachs & Co.
     probability that Fed officials will increase the flow rate of their asset
     purchases anytime soon, despite the hint in that direction in               Alec Phillips
                                                                                 (202) 637-3746
     Wednesday’s FOMC statement. We expect an unchanged $85 billion              Goldman, Sachs & Co.
     per month pace through 2013, followed by tapering from early 2014.
                                                                                 Jari Stehn
    But the other aspect of the Fed’s unconventional monetary policy—the        (212) 357-6224
                                                                                 Goldman, Sachs & Co.
     6.5% unemployment threshold for the first hike in the funds rate—may
     need to change. It is based on the assumption that the unemployment         Kris Dawsey
     rate is the best single indicator of US labor market conditions. This       (212) 902-3393
                                                                                 Goldman, Sachs & Co.
     only holds if the 2¾-point drop in labor force participation since 2007
     mostly reflects structural forces.                                          David Mericle
                                                                                 (212) 357-2619
                                                                                 Goldman, Sachs & Co.
    We do not believe that this is the case, at least outside the 1¼-point
     impact of population aging. The remaining 1½ percentage points—the
                                                                                 Shuyan Wu
     equivalent of 3½ million jobs—is probably mostly related to the             (212) 902-3053
     weakness of labor demand. As shown in a recent study by two Fed             Goldman, Sachs & Co.

     economists, labor demand shocks can have very protracted effects on
                                                                                 Michael Cahill
     participation.                                                              (801) 884-4621
                                                                                 Goldman, Sachs & Co.
    Our empirical analysis builds on that study but uses a much bigger
     data set of state-level labor market data. We find that the decline in
     participation since 2007 (over and above the aging-related portion) is
     well explained by the magnitude of the labor demand shock and the
     slow speed of the recovery. The model suggests that participation
     should level off in coming years. We also find that depressed
     participation holds down wage growth at the state level.

    Given our forecasts for the growth of GDP and employment, the model
     implies a somewhat more rapid decline in the unemployment rate, and
     we now expect a 6% rate by early 2016. However, we still think that
     Fed officials will not hike the funds rate until early 2016 as they
     recognize that the unemployment rate is becoming a less useful
     indicator. This shift could come via even greater emphasis that the
     6.5% figure is only a necessary but not sufficient condition for rate
     hikes, a reduction in the threshold, or a more formal shift in emphasis
     toward broader measures of labor market performance.

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification
and other important disclosures, see the Disclosure Appendix, or go to

The Goldman Sachs Group, Inc.                                                                                          Goldman Sachs
May 3, 2013                                                                                                      US Economics Analyst

Time to Rethink the 6.5% Unemployment Threshold
                                  The second half of 2012 saw a decisive shift in US monetary policy. One aspect was the
                                  move to open-ended asset purchases of $85 billion per month. In this week’s statement,
                                  the FOMC indicated that they might adjust the pace of these purchases up or down
                                  depending on the outlook for employment and inflation. However, our base case remains
                                  that the pace of purchases will remain constant through 2013, before tapering down from
                                  early 2014.

                                  The other aspect—and our focus today—was the adoption of a 6.5% unemployment rate as
                                  a threshold for the first hike in the federal funds rate. The motivation for the move from
                                  calendar-based guidance to outcome-based guidance is simple and compelling. It is much
                                  more sensible for a central bank to guide expectations about future policy actions in terms
                                  of an economic criterion than in terms of a particular date. A statement that the central
                                  bank will keep policy easy until economic activity has recovered is likely to have a more
                                  expansionary impact on private sector expectations than a statement that the central bank
                                  expects conditions to be weak enough to keep policy easy until a particular date. Moreover,
                                  a central bank has a much bigger informational edge with regard to its own reaction
                                  function than with regard to the economic outlook. Outcome-based guidance focuses on
                                  the reaction function alone, while calendar guidance mixes information about the reaction
                                  function and the economic outlook and thereby dilutes the signal.

                                  But the 6.5% threshold for the unemployment rate is not an ideal outcome-based target.
                                  For one thing, an unemployment threshold rule does not come as close to an optimal
                                  policy at the zero bound as other policy rules such as a nominal GDP level target. 1 But the
                                  more practical reason is that we have doubts about the Fed’s view that “…the
                                  unemployment rate is probably the best single indicator of current labor market
                                  conditions.”2 While this may well be true historically, we do not believe that it is true at

                                  The reason is that the unemployment rate is increasingly distorted by the decline in labor
                                  force participation. Our analysis suggests that most of this decline—or at least the portion
                                  of the decline that is unrelated to the easily quantifiable effects of population aging—is a
                                  cyclical consequence of the 2007-2009 economic downturn that is still percolating through
                                  the labor market but would probably reverse in a stronger labor demand environment.
                                  This raises the question of whether—and how—the FOMC might want to adjust the 6.5%

                                  Structural Forces Seem Confined to Population Aging
                                  Labor force participation has fallen by 2.7 percentage points since the start of the 2007-
                                  2009 recession. Some of this decline is clearly related to the aging of the US population.
                                  Population aging shifts the composition of the over-16 population—which forms the
                                  denominator of the participation rate and which the Labor Department somewhat
                                  confusingly calls the “working-age” population—toward older age groups whose
                                  participation rates are lower, and thereby pushes down the overall participation rate.

                                  To isolate the role of population aging from other factors, Exhibit 1 plots the overall labor
                                  force participation rate against an adjusted rate that holds the composition of the over-16
                                  population constant across detailed age and gender categories at their December 2007
                                  levels. The chart shows that changes in the composition of the population account for 1.2
                                  percentage points of the decline in labor force participation. This decline is clearly

                                      See Michael Woodford, “Methods of Monetary Policy Accommodation at the Interest-Rate Lower
                                      Bound,” paper presented at the 2012 Jackson Hole Symposium, August 20, 2012.
                                      See Vice Chair Janet Yellen’s speech “Challenges Confronting Monetary Policy” on March 4, 2013.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                  2
May 3, 2013                                                                                                                 US Economics Analyst

                                  structural, and it will continue at an estimated pace of about 0.2 percentage points per year
                                  for the foreseeable future.

                                  Exhibit 1: Population Aging Only Accounts for Part of the Decline

                                   Percent                                                                                          Percent
                                  68                                                                                                      68

                                  67                                                                                                       67

                                  66                                                                                                       66
                                                                                                                        decline due
                                                                                                                        to other
                                  65                                                                                    factors: 1.5       65
                                             Labor Force Participation Rate:
                                  64                 Actual                                                             decline due to     64
                                                                                                                        aging: 1.2
                                  63                                                                                                       63
                                    1996     1998       2000     2002    2004     2006     2008     2010    2012     2014    2016      2018

                                  Source: Department of Labor. Goldman Sachs Global ECS Research.

                                  But it is much harder to attribute the remaining 1.5-point decline to structural factors.
                                  Exhibit 2 plots the composition-adjusted participation rate against a linear trend that
                                  connects the years 1997 and 2007. We choose these years because they represent
                                  comparable points in the business cycle, as the unemployment rate stood just under 5%
                                  and the CBO’s output gap estimate around 0% in both years. The chart shows that the
                                  trend in the composition-adjusted participation rate was flat before the crisis, except for
                                  some modest up-and-down moves that seem related to the business cycle. This is difficult
                                  to square with a story that attributes a significant portion of the post-2008 decline to
                                  structural forces. Such forces should presumably play out over many years and should not
                                  have suddenly appeared after the biggest economic downturn in decades. It is much
                                  easier to square Exhibit 2 with a story in which the post-2007 decline is, at least at a broad
                                  level, a consequence of the deterioration in macroeconomic performance.

                                  Exhibit 2: The Composition-Adjusted Participation Rate Was Untrended Before 2007

                                   Percent                                                                                          Percent
                                  67.0                                                                                                  67.0

                                  66.5                                                                                                   66.5

                                  66.0                                                                                                   66.0

                                  65.5                                                                                                   65.5

                                  65.0                                                                                                   65.0
                                                           Composition-adjusted Participation Rate
                                  64.5                     1997-2007 Trend                                                               64.5

                                  64.0                                                                                                  64.0
                                      1996       1998         2000      2002     2004      2006      2008     2010      2012        2014

                                  Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                               3
May 3, 2013                                                                                                          US Economics Analyst

                                  The United States Is Not Europe
                                  Even if the participation decline is a consequence of the post-2007 downturn in labor
                                  demand, it might still have long-term effects. One specific concern is that we are now
                                  seeing a US version of the increase in European structural unemployment following the
                                  1980-1982 recession. This increase established the term “hysteresis”—an extreme form of
                                  persistence in which a labor market shock is never reversed—in the lexicon of economics.

                                  Most economists agree that the relatively easy availability of long-term jobless benefits
                                  was one key reason for the European hysteresis problem of the 1980s.3 So it is not
                                  surprising that the more pessimistic commentators on the US labor market outlook have
                                  focused on the Social Security Disability Insurance (SSDI) system as a potential analog to
                                  the European unemployment benefit issue. Since 2007, the number of SSDI disabled
                                  worker recipients has risen by 1¾ million, or 0.7% of the over-16 population. We have also
                                  found that higher unemployment statistically boosts the growth in SSDI benefit recipients
                                  at the state level, consistent with the idea that SSDI applications and enrollment do not
                                  depend purely on objective health criteria but also on the state of the economy.4 Few SSDI
                                  recipients ever reenter the labor force, so any cycle-induced increase in disability probably
                                  does cause a permanent reduction in labor supply. On the surface, all this suggests that
                                  disability might account for a sizable share of the drop in participation.

                                  But a closer look shows that that these concerns are probably overblown. Most of the
                                  growth in SSDI beneficiaries seems to be due to a larger and older population, not the
                                  lagged effects of a weaker labor market. As shown in Exhibit 3, the growth in SSDI
                                  beneficiaries has only outstripped the pre-crisis projection of the Social Security
                                  Administration by 0.2-0.3 percentage points—not a trivial number, but still small relative to
                                  the drop in the labor force participation rate we have seen in recent years. One reason is
                                  probably that SSDI admission criteria are quite stringent, resulting in a rejection rate of
                                  over 50% historically.

                                  More broadly, it seems clear that the US labor market is much more flexible than the
                                  European labor market of the 1980s and therefore less susceptible to hysteresis. Hiring
                                  and firing restrictions are less prevalent, unionization rates are lower, unemployment
                                  benefits are less generous, and regional mobility is higher. There is no question that the
                                  US system comes with advantages and disadvantages. One disadvantage is that it
                                  exposes workers to more uncertainty and income volatility. But one important advantage
                                  is that it reduces the risk that cyclical labor market shocks turn structural.

                                  One way of seeing the fluidity of the US labor market is to focus on the gross flows
                                  between unemployment and inactivity. Exhibit 4 shows that about 2.5-3 million workers
                                  move each month from unemployment into inactivity and vice versa.5 This is an amazing
                                  amount of movement which reduces the prima facie plausibility of a story in which large
                                  numbers of workers “get stuck” in inactivity without ever transitioning back into the labor
                                  force. And it marks an important difference versus Europe, where worker flows between

                                      See Richard Layard, Stephen Nickell, and Richard Jackman, Unemployment: Macroeconomic
                                      Performance and the Labour Market, Oxford University Press, 1991.
                                      See David Mericle, “Disability Insurance: A Minor Contributor to Reduced Participation,” US Daily,
                                      May 1, 2013.
                                      Some researchers have voiced concern about overstatement of the gross flows because
                                      unemployed workers are sometimes misclassified as inactive and inactive workers as unemployed.
                                      A standard way of adjusting for possible misclassification leads to a reduction in the estimated
                                      gross flows by 20%-30%, and thus still leaves the flows very large. See Michael Elsby, Bart Hobijn,
                                      and Aysegul Sahin, “On the Importance of the Participation Margin for Labor Market Fluctuations,”
                                      mimeo. February 2013.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                      4
May 3, 2013                                                                                                                     US Economics Analyst

                                  employment, unemployment, and inactivity are much lower.6 So while we would not rule
                                  out a certain amount of hysteresis, we expect it to fall far short of the European experience.

                                  Exhibit 3: SSDI Beneficiary Rolls Have Grown Only Modestly More than 2008 Projections

                                    Percent of 16+ population                                                         Percent of 16+ population
                                  4.0                                                                                                         4.0

                                               Disabled Workers:
                                  3.5                     Actual                                                                              3.5

                                                          2008 Social Security Trustees Report Projection
                                  3.0                                                                                                         3.0

                                  2.5                                                                                                         2.5

                                  2.0                                                                                                         2.0

                                  1.5                                                                                                         1.5
                                     1990      1992    1994      1996    1998     2000     2002     2004       2006   2008   2010    2012

                                  Source: Social Security Administration. Goldman Sachs Global ECS Research.

                                  Exhibit 4: Flows between Unemployment and Inactivity Are Huge

                                    Millions                                                                                            Millions
                                  3.5                                                                                                          3.5

                                  3.0                    Flow from Unemployment into Inactivity                                               3.0
                                                         Flow from Inactivity into Unemployment
                                  2.5                                                                                                         2.5

                                  2.0                                                                                                         2.0

                                  1.5                                                                                                         1.5

                                  1.0                                                                                                         1.0

                                  0.5                                                                                                         0.5

                                  0.0                                                                                                        0.0
                                     1990      1992   1994       1996   1998    2000     2002     2004     2006   2008   2010    2012    2014

                                  Source: Department of Labor.

                                  A Protracted Cycle, but Still a Cycle
                                  But the bare fact remains that workers continue to leave the labor force. Is it really
                                  plausible to argue that this could still be a cyclical phenomenon? With three years of
                                  nonfarm payroll gains under our belt, isn’t it time to conclude that something other than
                                  cyclical labor market weakness must be at work?

                                      For example, work by Olivier Blanchard—now the chief economist of the IMF—has shown that
                                      gross worker flows in the US are more than three times larger than in Portugal. See Olivier
                                      Blanchard and Pedro Portugal, “What Hides Behind an Unemployment Rate: Comparing
                                      Portuguese and U.S. Unemployment,” American Economic Review, Vol. 91, No. 1, March 2001.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                                    5
May 3, 2013                                                                                                            US Economics Analyst

                                  A recent study by Fed economists Christopher Erceg and Andrew Levin suggests that the
                                  answer is no. They present a theoretical model in which households face significant
                                  “switching costs” in their decision to allocate time between job search and other activities
                                  (such as schooling or housework).7 Depending on the size of these costs, the lag between
                                  a hit to labor demand and the resulting decline in the participation rate can be quite long.
                                  They also present evidence from a two-variable vector autoregression (VAR) model
                                  estimated using data for the 1948-2007 period that a shock to the detrended unemployment
                                  rate only gradually shows up in a reduction in detrended labor force participation.

                                  In order to investigate the cyclical behavior of participation, we build on Erceg and Levin’s
                                  analysis using a substantially expanded data set. Specifically, we estimate a three-variable
                                  VAR model using quarterly data on labor force participation, unemployment, and initial
                                  jobless claims for all 50 US states.8 This large dataset allows us to limit our analysis to the
                                  period since 1995. The advantage of this shorter sample period is that it allows us to focus
                                  on the period after the secular increase in female labor force participation had ended.
                                  Unlike Erceg and Levin, we therefore do not need to detrend our data prior to estimating
                                  the model. We believe this is an advantage. Since our analysis is designed to distinguish
                                  between short-term cyclical and long-term structural changes in participation, it is
                                  preferable not to impose particular assumptions about this split a priori.9

                                  Our model shows that labor demand shocks have large effects on both unemployment and
                                  labor force participation, but the effect on participation is much longer-lasting. Exhibit 5
                                  plots the impulse responses to a typical state-level labor market shock. The unemployment
                                  rate jumps quickly and peaks about a year after the shock, before reversing the increase
                                  over the next three years. The participation rate falls more gradually and only starts to
                                  recover from the third year after the shock.

                                  The message from Exhibit 5 is that we should not be surprised to see a protracted decline
                                  in the participation rate following a big downturn in labor demand. But the chart actually
                                  still understates the strength of this message because it focuses on a “typical” labor
                                  market shock in which the hit to labor demand reverses relatively quickly. We can see this
                                  in the fact that the unemployment rate in Exhibit 5 has fully reversed its prior increase less
                                  than four years after the shock. The current labor market recovery has been much slower,
                                  as the unemployment rate has reversed less than half the trough-to-peak increase more
                                  than five years after the shock. The reasons are well known—a private debt overhang,
                                  excess supply in the housing market, fiscal headwinds, and spillovers from the financial
                                  instability in Europe.

                                  If we adjust for the weakness of the recovery in labor demand, the message of Exhibit 5
                                  becomes even stronger. To do this, we feed in a series of layoff shocks that are calibrated
                                  to match the actual behavior of the national unemployment rate since 2007 and our
                                  forecast of a further slow decline in future years.10 Exhibit 6 shows that the predicted
                                  decline is very similar to the actual decline in the (composition-adjusted) participation rate
                                  observed from 2007 to 2013. Moreover, the model projects a very gradual increase in
                                  participation starting in 2013-2014. Since the model does not take into account the impact
                                  of population aging, it is better to interpret the projection as a forecast for the composition-
                                  adjusted participation rate. We therefore view the results as broadly consistent with our
                                  forecast for a flat headline participation rate over the next few years.

                                       See Christopher Erceg and Andrew Levin, “Labor Force Participation and Monetary Policy in the
                                       Wake of the Great Recession,” Federal Reserve Bank of Boston Economic Conference, April 9, 2013.
                                       We order the variables with initial jobless claims first, followed by unemployment and participation.
                                       The limitation of our approach relative to Erceg and Levin’s is that we extrapolate from state-level
                                       labor market cycles to the national labor market cycle, which may not be correct.
                                       Since the slow pace of labor market recovery mainly reflects low hiring rather than high layoffs, it
                                       would be more realistic to slow down the decline in the unemployment rate by manipulating the
                                       hiring rate rather than the layoff rate, but hiring data do not exist at the state level.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                         6
May 3, 2013                                                                                                                  US Economics Analyst

                                  Exhibit 5: Labor Demand Shocks Have a Substantial Impact on Participation

                                    Percentage points                                                                     Percentage points
                                   0.4                                                                                                   0.4
                                                               Effect of a One Standard Deviation Shock to Initial Claims on:
                                   0.3                                            Unemployment Rate                                      0.3

                                                                                  Participation Rate
                                   0.2                                                                                                   0.2

                                   0.1                                                                                                   0.1

                                   0.0                                                                                                   0.0

                                  -0.1                                                                                                   -0.1
                                         0       1         2         3         4        5        6         7         8          9
                                                                               Years After Shock

                                  Source: Goldman Sachs Global ECS Research.

                                  Exhibit 6: Our Modified Model Can Account for the Behavior of Participation

                                    Percentage points                                                                    Percentage points
                                   6                                                                                                      6
                                                                                       Actual Unemployment Rate
                                   5                                                   Model-implied Participation Rate                  5
                                                                                       Actual Composition-adjusted Participation Rate
                                   4                                                                                                     4

                                   3                                                                                                     3

                                   2                                                                                                     2
                                   1                                                                                                     1

                                   0                                                                                                     0

                                  -1                                                                                                     -1

                                  -2                                                                                                     -2
                                    2008     2009       2010     2011      2012      2013      2014     2015     2016        2017

                                  Source: Goldman Sachs Global ECS Research.

                                  Depressed Participation Weighs on Wages and Prices
                                  Even if the participation decline ultimately turns out to be cyclical and reversible, one might
                                  worry that the reversal would involve a period of significantly higher wage and price
                                  inflation. Whether this happens depends in part on whether a depressed participation rate
                                  in itself weighs on inflation, perhaps because individuals who have temporarily withdrawn
                                  from the workforce still provide enough potential competition for jobs to dampen wage
                                  and price inflation.

                                  Ultimately, this is an empirical question. But it is difficult to answer it with national data
                                  alone. The limited number of national business cycles, most of which have seen the
                                  unemployment rate move inversely with the participation rate, makes precise estimation of
                                  the effects very difficult. In order to expand the size of our sample, we therefore again turn
                                  to our state-level dataset. We regress nominal wage growth on the unemployment rate,

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                               7
May 3, 2013                                                                                                US Economics Analyst

                                  the participation gap—defined as the difference between participation and a linear state-
                                  specific trend—and a host of control variables.

                                  Exhibit 7 shows our results. We find evidence that a depressed participation rate holds
                                  down wage growth at the state level, over and above the effect of an elevated
                                  unemployment rate. However, the size and statistical significance of our results are
                                  somewhat sensitive to whether we include time dummies—that is, whether we focus only
                                  on the relative variation in wage growth and participation across states or also the
                                  aggregate national variation. Our benchmark is the latter, and it suggests that depressed
                                  participation rate holds down wage growth in a way that is qualitatively similar to a high
                                  unemployment rate, though smaller in magnitude.

                                  Exhibit 7: Some Evidence that Depressed Participation Weighs on Wages

                                     Dependent Variable: Wage Growth (%yoy)

                                                                                 (1)               (2)

                                     Unemployment rate (-1)                     -0.17             -0.25
                                                                               (-3.74)           (-4.99)
                                     Participation gap (-1)                     -0.15             -0.06
                                                                               (-2.21)           (-1.18)
                                     State GDP growth (-1)                      0.08              0.01
                                                                               (3.68)            (0.44)
                                     Dependent variable (-1)                    0.14              0.15
                                                                               (3.79)            (4.30)
                                     Fixed effects                             State        State, year
                                     R-squared                                 0.14            0.60

                                     T-statistics are in parentheses under the coefficients.
                                     The regressions are on a panel of annual state data since
                                     1990 using state fixed effects.

                                  Source: Goldman Sachs Global ECS Research.

                                  Implications for the Outlook
                                  The recent data and the analysis above have led us to shave our forecasts for the
                                  unemployment rate. We now expect the rate to fall to 6% by early 2016, 0.3 points lower
                                  than previously. But we have not changed our forecast that the funds rate will stay near
                                  0% until early 2016.

                                  The reason is that the shift of jobless individuals from unemployment into inactivity is
                                  making the unemployment rate a less appropriate measure of broad labor market
                                  conditions. This has important implications for Fed policy because it implies that the
                                  committee might still be quite far from reaching the jobs side of its mandate even once the
                                  unemployment rate is back at 6%. After all, the Federal Reserve Act calls for “maximum
                                  employment”, not “minimum unemployment.” This distinction did not matter much in the
                                  past, but it is becoming increasingly important.

                                  The more immediate implication is that Fed officials may need to revisit their forward
                                  guidance. In principle, we see three options for what they might do, in increasing order of

Goldman Sachs Global Economics, Commodities and Strategy Research                                                            8
May 3, 2013                                                                                                              US Economics Analyst

                                  1.   Emphasize that 6.5% only a threshold. They could emphasize even more that the
                                       6.5% figure is only a necessary but not sufficient condition for a hike. This is the
                                       simplest option because it does not require agreement on a new measure, but it would
                                       make forward guidance a less and less powerful instrument of monetary policy and
                                       thereby violate the principles laid out in Michael Woodford’s 2012 Jackson Hole Paper
                                       on monetary policy accommodation at the zero bound, which seem to enjoy
                                       widespread acceptance among many FOMC members.

                                  2.   Change the number. They could lower the 6.5% threshold while keeping the focus
                                       on the unemployment rate. This would be a pragmatic way of adjusting the current
                                       approach for the participation issue without having to introduce new and less widely
                                       followed labor market indicators into the FOMC statement.

                                  3.   Change the measure. They could directly couch their guidance in terms of the
                                       employment/population ratio (presumably adjusted for the effects of population
                                       aging), our total employment gap shown in Exhibit 8, or a participation-gap adjusted
                                       unemployment rate. This directly addresses the underlying issue, namely that the
                                       unemployment rate has become a less useful statistic. But it would be considerably
                                       more complicated in terms of communication.

                                  Exhibit 8: The Overall Employment Gap Remains Large

                                    Percent of labor force                                                        Percent of labor force
                                   3                                                                                                    3

                                   2                                                                                                   2

                                   1                                                                                                   1

                                   0                                                                                                   0

                                  -1                                                                                                   -1

                                  -2                                                                                                   -2

                                  -3                                                                                                   -3

                                  -4                          Unemployment Gap                                                         -4

                                  -5                          Participation Gap                                                        -5
                                  -6                                                                                                   -6
                                    1994      1996      1998         2000         2002   2004       2006   2008   2010     2012

                                  Source: Department of Labor. Goldman Sachs Global ECS Research.

                                  The first option is probably the path of least resistance for the time being. Financial
                                  markets continue to expect a very late exit despite the declining unemployment rate, so
                                  Fed officials may not feel much urgency in revamping their forward guidance. But as we
                                  approach 6.5%, a reduction in the threshold or maybe even a new measure may well be

                                  Jan Hatzius
                                  David Mericle

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                           9
May 3, 2013                                                                                                                                                                 US Economics Analyst

The US Economic and Financial Outlook

(% change on previous period, annualized, except where noted)
                                      2011     2012     2013    2014     2015     2016                  2012                                2013                                2014
                                                 (f)      (f)     (f)      (f)      (f)       Q1       Q2    Q3          Q4        Q1      Q2    Q3         Q4       Q1        Q2    Q3          Q4
 Real GDP                                1.8      2.2     1.9      2.9      3.2     3.0        2.0      1.3      3.1      0.4       2.5     1.8      2.0     2.5      3.0       3.5      3.5      3.5
  Consumer Expenditure                   2.5      1.9     2.1      2.5      2.7     2.5        2.4      1.5      1.6      1.8       3.2     1.8      2.0     2.0      2.5       3.0      3.0      3.0
  Residential Fixed Investment          -1.4    12.1    14.2     15.0     13.4    12.5       20.6       8.4    13.6     17.5      12.6    14.8     15.0    15.0     15.0      15.0     15.0     15.0
  Business Fixed Investment              8.6      8.0     5.2      8.8      7.5     5.8        7.5      3.6     -1.8    13.1        2.1     3.8      8.5     9.3      9.3       9.3      9.3      9.3
     Structures                          2.8    10.8      3.8      6.7      5.9     5.0      12.8       0.6      0.0    16.7       -0.2    -0.9      5.0     7.5      7.5       7.5      7.5      7.5
     Equipment & Software              11.0       6.9     5.8      9.7      8.1     6.1        5.4      4.8     -2.6    11.8        3.0     5.8    10.0    10.0     10.0      10.0     10.0     10.0
  Federal Government                    -2.8     -2.2    -6.4     -5.4     -2.5    -1.2       -4.2     -0.2      9.5   -14.8       -8.4    -5.0   -10.0     -5.0     -5.0      -5.0     -4.0     -3.0
  State and Local Government            -3.4     -1.4    -0.4      1.3      1.8     2.0       -2.2     -1.0      0.3     -1.5      -1.2     0.3      1.0     1.0      1.5       1.5      1.5      1.5
  Net Exports ($bn, '05)               -408     -401    -400     -419     -441    -453       -416     -407     -395     -385      -401    -396     -400    -404     -409      -414     -422     -430
  Inventory Investment ($bn, '05)         31      43       50      55       63      63          57       41       60      13        50       51      49       49      49         53       57      59
 Industrial Production, Mfg              3.4      3.9     2.6      2.9      3.7     3.1        8.2      1.4     -0.4      2.4       5.2     2.0      2.0     2.5      3.0       3.0      4.0      4.0
INFLATION (% ch, yr/yr)
 Consumer Price Index (CPI)             3.1      2.1     1.6      1.7      2.0      2.1       2.8      1.9      1.7      1.9       1.7     1.6      1.6     1.5      1.5       1.8      1.7      1.7
 Core CPI                               1.7      2.1     1.8      1.8      1.9      2.1       2.2      2.3      2.0      1.9       1.9     1.8      1.8     1.9      1.8       1.8      1.8      1.8
 Core PCE*                              1.4      1.7     1.2      1.5      1.6      1.8       1.9      1.8      1.6      1.5       1.3     1.1      1.2     1.3      1.4       1.5      1.5      1.5
 Unit Labor Costs                       1.9      0.7     1.4      1.6      1.9      2.3       0.2      0.4      0.1      2.0       0.6     1.2      2.2     1.5      1.8       1.7      1.5      1.5
 Unemployment Rate (%)                  8.9      8.1     7.5      6.9      6.3      5.9       8.2      8.2      8.0      7.8       7.7     7.5      7.4     7.3      7.2       7.0      6.8      6.6
 Federal Funds** (%)                   0.07     0.16    0.13     0.13     0.13     1.25      0.13     0.16     0.14     0.16      0.14    0.13    0.13     0.13     0.13      0.13     0.13     0.13
 3-Month LIBOR (%)                     0.56     0.31    0.30     0.30     0.30     1.50      0.47     0.47     0.39     0.31      0.28    0.30    0.30     0.30     0.30      0.30     0.30     0.30
 Treasury Yield Curve** (%)
  2-Year Note                          0.26     0.26    0.40     0.60     1.50     2.00      0.34     0.29     0.26     0.26      0.26    0.30    0.35     0.40     0.45      0.50     0.55     0.60
  5-Year Note                          0.89     0.70    1.40     1.95     2.60     3.10      1.02     0.71     0.67     0.70      0.82    0.90    1.10     1.40     1.65      1.80     1.90     1.95
  10-Year Note                         1.98     1.72    2.50     3.00     3.25     3.75      2.17     1.62     1.72     1.72      1.96    2.30    2.40     2.50     2.60      2.80     2.90     3.00
  30-Year Bond                         2.98     2.88    3.60     3.90     4.00     4.25      3.28     2.70     2.88     2.88      3.16    3.50    3.60     3.60     3.65      3.70     3.85     3.90
 Current Account (% of GDP)            -3.1     -3.0    -3.0     -3.2     -3.5     -3.8      -3.5     -3.0     -2.8     -2.8      -2.9    -2.9    -3.0     -3.0    -3.1      -3.2     -3.3     -3.4
 Euro ($/€)**                          1.32     1.31    1.40     1.40     1.35     1.25      1.32     1.25     1.29     1.31      1.30    1.36    1.40     1.40    1.40      1.40     1.40     1.40
 Yen (¥/$)**                             78       84     105      110      115     125         82       79       78       84        95    102      105      105    105       106      108      110
* PCE = Personal consumption expenditures. ** Denotes end of period. *** Profits are after taxes as reported in the national income.
 and product accounts (NIPA), adjusted to remove inventory profits and depreciation distortions.
NOTE: Published figures are in bold.

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                                                                                       10
May 3, 2013                                                                                                            US Economics Analyst

Economic Releases and Other Events

                      Time                                                                                Estimate
Date                  (EST)    Indicator                                                             GS          Consensus     Last Report

Tue      May 07         15:00 Consumer Credit (Mar)                                                       n.a.     +$16.0bn       +$18.1bn
Wed      May 08          8:30 Fed Gov Stein spks on panel at Chicago Fed Conference
Thu      May 09          8:00 Richmond Fed Pres Lacker spks at Council on Foreign Relations
                         8:30 Initial Jobless Claims                                                      n.a.       335,000       324,000
                         8:30 Continuing Claims                                                           n.a.     3,018,000     3,019,000
                        10:00 Wholesale Trade (Mar)                                                       n.a.        +0.1%          +1.7%
                        13:15 Philly Fed Pres Plosser spks on monetary policy at NYC conf
Fri      May 10          8:25 Chicago Fed Pres Evans spks at Chicago Fed Conference
                         9:30 Chairman Bernanke keynotes Chicago Fed annual conference
                        14:00 Federal Budget Balance (Apr)                                                n.a.     -$103.0bn     -$106.5bn
                        14:00 KC Fed Pres George spks on economy to Wyoming Bus Alliance
                               G-7 Finance Ministers and central bank governors meet for a two-day
         May 10/11
                               meeting to discuss global financial issues; UK

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research                                                                            11
May 3, 2013                                                                                                                           US Economics Analyst

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Goldman Sachs Global Economics, Commodities and Strategy Research                                                                                         12

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