MID-SESSION REVIEW - ECONOMIC ASSUMPTIONS

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MID-SESSION REVIEW - ECONOMIC ASSUMPTIONS

ECONOMIC ASSUMPTIONS

Introduction

For the past year, economic growth has been sluggish, restrained by slower growth of domestic and foreign demand. After a period of unsustainably rapid growth, slower growth was widely expected. The extent of the slowdown, however, has been greater than most forecasters anticipated.

Nonetheless, the economy appears poised to recover. Most forecasters, including the Administration, expect a return soon to solid, sustainable growth. Monetary and fiscal policy are acting in concert to provide a powerful stimulus to growth in the coming months. During the first six months of this year, the Federal Reserve cut the federal funds rate by 2-3/4 percentage points, the largest reduction in such a short period since 1984. Given the lags between changes in monetary policy and its effects on the real economy, interest-sensitive sectors are likely to strengthen during the second half of this year.

The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 is likely to provide a boost to consumer spending during the second half of this year and into 2002. In the current quarter, households will receive $38 billion in rebate checks reflecting the lower tax liabilities associated with the new, 10 percent tax bracket. Beginning next January, these lower liabilities will be permanently reflected in lower income tax withholding from paychecks. In addition, income tax withholding schedules were lowered July 1st to reflect the first installment of the phase-in of permanently lower marginal income tax rates for those currently in the 28 percent bracket and higher. This change is estimated to boost take-home pay by $5 billion during the second half of this year. With the prospect of permanently lowered income taxes, consumers are likely to spend a significant part of this addition to their disposable income.

While the economy has been battered by a series of negative shocks, recent months have seen some positive developments. Inventory liquidation during the first half of this year has helped reduce the excess stocks that accumulated when sales slowed unexpectedly. When stocks have been cut enough, increases in demand will require increases in production. In addition, energy prices have declined recently, after rising sharply in 1999 and 2000. Lower energy prices reduce overall inflation, increase the purchasing power of consumers, and boost the profits of most industries. Finally, the stock market, which fell sharply between March 2000 and April 2001, has recovered from its earlier lows.

The long-term economic outlook continues to appear bright. The technological innovations and business practice changes that helped propel productivity growth to a new higher trend during the last half of the 1990s are likely to sustain strong productivity growth into the future. Even during the current slowdown, productivity growth remains healthy. Inflation remains low and under control, which will enable businesses and households to plan and invest for the long haul.

Moreover, the reductions in marginal tax rates enacted this year are likely to have important positive effects in coming years on the supply of labor and saving, which will benefit long-term growth. In the interest of cautious budgeting, however, the Administration has not built these long-term supply-side effects into its long-term economic assumptions, choosing instead to remain close to consensus forecasts.

Recent Developments

Real Gross Domestic Product (GDP) is estimated to have grown at only a 0.7 percent annual rate in the second quarter. According to the initial estimate released at the end of July, the principal restraint on growth was weak business investment in equipment and software, which fell at a 14.5 percent annual rate in the second quarter. Faced with unexpectedly sluggish demand, excess capacity, falling profits, and a more difficult equity-financing environment, businesses have had to cut back or postpone capital spending, especially for high-tech equipment.

In contrast to business investment, consumer spending has held up well, increasing at a 2.1 percent annual rate in the second quarter. This is slower than consumption was growing prior to the slowdown, but unlike business investment, consumption continues to expand, with especially strong spending on consumer durables. Because the consumer accounts for two-thirds of GDP, the willingness of households to continue spending despite the stock market correction and recent job losses has been key to maintaining positive overall growth in recent quarters.

Residential investment, after adjustment for inflation, also has supported overall growth this year, rising at a 7.4 percent rate in the second quarter, following a similar advance in the first quarter. The swing from falling residential investment in the second half of last year to positive growth this year reflects the upturn in housing starts. Homebuilding has been stimulated by relatively low mortgage interest rates. During the first six months of this year, the fixed rate 30-year mortgage averaged just over 7 percent, more than one percentage point below the rate a year earlier, and almost one percentage point below the average rate during the 1990s.

Government spending on consumption and investment, primarily at the state and local level, has also added to demand and helped keep real GDP rising. Real state and local consumption and investment purchases rose at a 7.5 percent annual rate in the second quarter; federal purchases increased at a 1.6 percent rate. Changes in inventories and in net exports in the second quarter had very little impact on overall growth.

Inflation, which was already low, has abated further as a consequence of slower growth and falling energy prices. The Consumer Price Index (CPI) rose at a 3.1 percent annual rate in the second quarter, slightly less than the 3.4 increase over the prior year. The core CPI, which excludes food and energy prices, rose at a 2.6 percent rate in the second quarter, close to the pace during the prior year. The GDP chain-weighted price index, a broader measure of inflation than the CPI, rose at a 2.3 percent annual rate in the second quarter, the same pace as during the preceding four quarters.

Sluggish growth during the past year has also begun to affect labor markets. Businesses began to slow the pace of hiring during the second half of last year and continued to do so into the first quarter. During April through July, private sector payrolls were reduced by almost 400,000. The manufacturing sector more than accounted for all of these job losses. Since its recent peak in July 2000, the manufacturing sector has lost 840,000 jobs. The unemployment rate has edged up from 4.0 percent in December to 4.5 percent in June and July, but this rate is still 2 percentage points below the average unemployment rate of the past 25 years.

In financial markets, short-term interest rates have fallen sharply this year in response to the slowing economy and the Federal Reserve's reductions in the federal funds rate. The 3-month Treasury bill rate fell from 5.8 percent in December to 3.5 percent in early August. In contrast, at the longer-end of the maturity spectrum, interest rates have been relatively steady this year. The yield on the 10-year Treasury note was 5.2 percent in early August, the same level as in December and 1.2 percentage points below the average of the prior 10 years. Together, the sharp drop in short-term rates has shifted the yield curve from relatively flat to upward sloping, a signal that investors believe that economic growth will soon pick up.

Equity prices have recovered from their April lows in response to further easing of monetary policy and investors' expectations that the economy and corporate profits are likely to improve. Nonetheless, the major indexes remain well below their levels at the end of last year.

Revised Economic Assumptions

The economic projections for the Mid-Session Review, summarized in Table 5, have been revised from those used in the Administration's 2002 Budget to incorporate recent developments and policy actions, notably the weaker economic growth and profits, the near-term fiscal stimulus from the recently enacted tax package, and the Federal Reserve's easing of monetary policy.²

The Mid-Session Review projections are similar to those of private-sector forecasters and, except for the near term, close to those used for the 2002 Budget. The Administration projects economic growth to slow this year to a greater extent than anticipated earlier, and to recover next year. The long-run sustainable rates of GDP growth and unemployment, which are maintained during the second half of the 10-year projection horizon, are the same as in the budget projections. Beginning with 2002, the inflation projection is nearly identical to that in the Budget. Interest rates, however, are lower than in the Budget assumptions, especially short-term rates.

Real GDP, Potential GDP and Unemployment: The most important revision to the economic assumptions is the lowered real growth projection for this year. By the end of the year and into 2002, however, real growth is expected to increase significantly as the fiscal and monetary stimulus takes hold and as the cutbacks in capital spending wane. During the outyears of the projection period, real GDP is projected to rise 3.1 percent per year, the Administration's estimate of the nation's potential GDP growth during this period. Over the 10 years, 2002-2011, real GDP growth averages 3.2 percent per year, the same as in the April Budget, and slightly below the Blue Chip consensus of private-sector forecasts published in March, the latest consensus long-range projection.

As a consequence of slow growth this year, the unemployment rate is forecasted to edge up slightly. During 2002 and 2003, as economic growth picks up, the unemployment rate is projected to move down again. In 2004 and beyond, the unemployment rate is projected to remain on a plateau of 4.6 percent, the same level as the private sector consensus.

Inflation: The CPI and GDP measures of inflation have been raised slightly in 2001 to incorporate recent data. For 2002 and beyond, the inflation projections are virtually the same as in the Budget. For 2002-2011, the Consumer Price Index is projected to rise 2.5 percent per year on average; the GDP chain-weighted price index is projected to increase 2.1 percent yearly. The slower rise in the GDP measure reflects the fixed weighting in the CPI; the higher weights for housing in the CPI combined with a relatively faster rise projected for housing prices; and the lower weight for computers in the CPI combined with a projected decline in computer prices. The 10-year inflation projections are very close to those of the private sector consensus.

Interest Rates: Short-term interest rates this year have fallen significantly below the levels projected in the Budget as a consequence of weaker-than-expected growth and monetary policy actions. The yield on the 10-year Treasury note has also been below the earlier budget projection. The Mid-Session Review assumptions anticipate some rise in the 91-day Treasury bill rate through the end of 2002 as the recovery strengthens. Thereafter, the rate is projected to remain at 4.3 percent. During the last five years of the projection period, this T-bill rate is 0.7 percentage point lower than assumed in the budget. The yield on the 10-year Treasury note is projected to remain at 5.2 percent, consistent with the historical spread between short-term and long-term interest rates.

Table 5. ECONOMIC ASSUMPTIONS ¹

(Calendar years; dollar amounts in billions)

	Actual 2000	Projections

	Actual 2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011

Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars	9,963	10,364	10,937	11,575	12,228	12,880	13,553	14,263	15,009	15,794	16,619	17,488
Real, chained (1996) dollars	9,318	9,474	9,776	10,122	10,468	10,800	11,133	11,476	11,829	12,194	12,569	12,956
Chained price index (1996 = 100), annual average	107.0	109.5	111.9	114.3	116.8	119.2	121.7	124.3	126.9	129.5	132.2	135.0
Percent change, fourth quarter over fourth quarter:
Current dollars	5.8	4.2	6.0	5.8	5.5	5.2	5.2	5.2	5.2	5.2	5.2	5.2
Real, chained (1996) dollars	3.4	1.7	3.7	3.5	3.4	3.1	3.1	3.1	3.1	3.1	3.1	3.1
Chained price index (1996 = 100)	2.3	2.4	2.2	2.2	2.1	2.1	2.1	2.1	2.1	2.1	2.1	2.1
Percent change, year over year:
Current dollars	7.1	4.0	5.5	5.8	5.6	5.3	5.2	5.2	5.2	5.2	5.2	5.2
Real, chained (1996) dollars	5.0	1.7	3.2	3.5	3.4	3.2	3.1	3.1	3.1	3.1	3.1	3.1
Chained price index (1996 = 100)	2.1	2.3	2.2	2.2	2.1	2.1	2.1	2.1	2.1	2.1	2.1	2.1
Incomes, billions of current dollars:
Corporate profits before tax	926	796	969	1,020	1,104	1,164	1,182	1,202	1,224	1,254	1,291	1,337
Wages and salaries	4,769	4,989	5,272	5,621	5,951	6,270	6,572	6,888	7,224	7,589	7,969	8,370
Other taxable income ²	2,281	2,372	2,418	2,507	2,589	2,693	2,788	2,887	2,994	3,107	3,226	3,326
Consumer Price Index (all urban): ³
Level (1982–84 = 100), annual average	172.3	178.0	182.7	187.4	192.0	196.8	201.8	206.8	212.0	217.3	222.7	228.3
Percent change, fourth quarter over fourth quarter	3.4	3.2	2.6	2.5	2.5	2.5	2.5	2.5	2.5	2.5	2.5	2.5
Percent change, year over year	3.4	3.3	2.7	2.5	2.5	2.5	2.5	2.5	2.5	2.5	2.5	2.5
Unemployment rate, civilian, percent:
Fourth quarter level	4.0	4.8	4.7	4.7	4.6	4.6	4.6	4.6	4.6	4.6	4.6	4.6
Annual average	4.0	4.6	4.8	4.7	4.6	4.6	4.6	4.6	4.6	4.6	4.6	4.6
Federal pay raises, January, percent:
Military ⁴	4.8	3.7	4.6	3.9	3.9	3.9	3.9	3.9	3.9	3.9	3.9	3.9
Civilian ⁵	4.8	3.7	3.6	3.9	3.9	3.9	3.9	3.9	3.9	3.9	3.9	3.9
Interest rates, percent:
91-day Treasury bills ⁶	5.8	3.8	3.9	4.3	4.3	4.3	4.3	4.3	4.3	4.3	4.3	4.3
10-year Treasury notes	6.0	5.2	5.2	5.2	5.2	5.2	5.2	5.2	5.2	5.2	5.2	5.2
ADDENDUM: ⁷
Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars	9,873	10,278	10,846	11,479	12,126	12,772	13,440	14,144	14,884	15,662	16,481	17,343
Real, chained (1996) dollars	9,224	9,385	9,685	10,027	10,370	10,699	11,028	11,368	11,719	12,080	12,451	12,835
Chained price index (1996 = 100), annual average	107.0	109.5	111.9	114.4	116.8	119.3	121.8	124.3	126.9	129.5	132.2	135.0
Percent change, fourth quarter over fourth quarter:
Current dollars	5.3	4.2	6.0	5.8	5.5	5.2	5.2	5.2	5.2	5.2	5.2	5.2
Real, chained (1996) dollars	2.8	1.8	3.7	3.5	3.4	3.1	3.1	3.1	3.1	3.1	3.1	3.1
Chained price index (1996 = 100)	2.4	2.4	2.2	2.2	2.1	2.1	2.1	2.1	2.1	2.1	2.1	2.1
Percent change, year over year:
Current dollars	6.5	4.1	5.5	5.8	5.6	5.3	5.2	5.2	5.2	5.2	5.2	5.2
Real, chained (1996) dollars	4.1	1.7	3.2	3.5	3.4	3.2	3.1	3.1	3.1	3.1	3.1	3.1
Chained price index (1996 = 100)	2.3	2.3	2.2	2.2	2.1	2.1	2.1	2.1	2.1	2.1	2.1	2.1
Incomes, billions of current dollars:
Corporate profits before tax	845	714	870	916	991	1,045	1,061	1,079	1,099	1,125	1,159	1,200
Wages and salaries	4,837	5,085	5,374	5,730	6,066	6,391	6,699	7,022	7,363	7,735	8,123	8,532
Other taxable income ²	2,236	2,341	2,387	2,476	2,558	2,661	2,755	2,855	2,961	3,074	3,193	3,293

¹ Based on information available as of June 2001. ² Rent, interest, dividend and proprietor's components of personal income. ³ Seasonally adjusted CPI for all urban consumers. ⁴ Percentages apply to basic pay only; additional rank-specific adjustments are proposed for 2002; adjustments for housing and subsistence allowances will be determined by the Secretary of Defense. ⁵ Overall average increase, including locality pay adjustments. ⁶ Average rate (bank discount basis) on new issues within period. ⁷ Assumptions adjusted to reflect revised historical series for GDP and incomes released by the Bureau of Economic Analysis in July 2001.

² The economic growth assumptions are based on data available as of June, 2001. The Addendum to Table 5 adjusts the levels of the Mid-Session Review assumptions for revisions to the National Income and Product Accounts, released on July 27, covering the period from the first quarter of 1998 through the first quarter of 2001. The effect of these revisions was to restate real and nominal GDP downward; the GDP inflation measure was hardly revised. On the income side, by the first quarter of 2001 the level of corporate profits before tax was lowered while wages and salaries were revised up by a slightly larger amount. Adjusting the MSR assumptions for consistency with the revised historical data does not affect the projections of receipts or outlays because these are based on the economic assumption's projections of growth rates of GDP and incomes, not the projections of levels of these variables.