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The following is an analysis of The Economic Outlook section of the January 2001 CBO Budget and Economic Outlook.  The text in *RED are comments included by the website host.

 

The Budget and Economic Outlook: Fiscal Years 2002-2011
January 2001
Section 4 of 15

 


Chapter Two

The Economic Outlook

The growth of economic activity--as measured by real (inflation-adjusted) gross domestic product--is likely to slow from its rapid pace of recent years to about 2½ percent this calendar year and 3½ percent next year (see Table 2-1 and Figure 2-1). Spending by consumers and investment by businesses slowed late last year in response to higher interest rates in 1999 and early 2000 * CBO assumption that interest rates were the cause and lower expectations about future business conditions (reflected in last year's drop in stock prices * CBO is now assuming why the stock market went down and tightening of standards and terms for borrowing by businesses). Although in early January the Federal Reserve Board responded to the slowdown in growth by lowering the federal funds interest rate, spending by consumers and businesses is likely to remain weak this year. However, lower interest rates will set the stage for spending to grow more quickly next year.
 

Table 2-1.
CBO's Economic Projections for Calendar Years 2001-2011

 

Estimated
2000

Forecast

 

Projected Annual Average

 

2001

2002

 

2003-2006

2007-2011

Nominal GDP (Billions of dollars)

9,974

 

10,446

 

11,029

 

 

13,439

a

17,132

b

 

Nominal GDP (Percentage change)

7.3

 

4.7

 

5.6

 

 

5.1

 

5.0

 

 

Real GDP (Percentage change)

5.1

 

2.4

 

3.4

 

 

3.1

 

3.1

 

 

GDP Price Index (Percentage change)

2.1

 

2.3

 

2.1

 

 

1.9

 

1.9

 

 

Consumer Price Indexc (Percentage change)

3.4

 

2.8

 

2.8

 

 

2.6

 

2.5

 

 

Unemployment Rate (Percent)

4.0

 

4.4

 

4.5

 

 

4.7

 

5.2

 

 

Three-Month Treasury Bill Rate (Percent)

5.8

 

4.8

 

4.9

 

 

4.9

 

4.9

 

 

Ten-Year Treasury Note Rate (Percent)

6.0

 

4.9

 

5.3

 

 

5.6

 

5.8

 

 

Tax Bases (Percentage of GDP)

 

 

Corporate profitsd

9.4

 

8.9

 

8.5

 

 

8.2

 

8.0

 

 

Wages and salaries

47.8

 

48.2

 

48.2

 

 

48.2

 

48.0

 

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

NOTES: Percentage changes are year over year.

Annual economic projections for calendar years 2001 through 2011 appear in Appendix E.

a. Level of GDP in 2006.

b. Level of GDP in 2011.

c. The consumer price index for all urban consumers.

d. Corporate profits are book profits.

 

 

The rate of inflation, as measured by the growth of the consumer price index (CPI), is expected to decline from 3.4 percent in 2000 to around 2.8 percent in 2001. That projected decrease reflects the Congressional Budget Office's view that oil prices will fall somewhat from last year's level, although underlying inflationary pressures from the tight labor market will remain. * CBO is assuming a tight labor market is inflationary.

Significant uncertainty surrounds that short-term forecast. For various reasons, economic conditions in the next two years could be much worse or better than CBO anticipates:  * CBO is now stating economic forecasting is difficult, in spite of previous statements cited above.

  • The primary negative risk is that the current slowdown might turn into a recession. Although forecasters widely anticipated that economic activity would slow, the deceleration has been surprisingly rapid. * Not only is the economy slowing, it is slowing at a surprisingly rapid rate.  Reports of rising loan losses at commercial banks and defaults on high-risk bonds, combined with the drop in stock prices, have heightened fears that financial markets might severely reduce the supply of credit and capital and choke off the economic expansion. In addition, consumers have become less optimistic about the future, in part because of the decline in the stock market. The possibility of further slowing is heightened by the weakness evident in recent economic data, such as those showing slower growth of retail sales and employment. Although those developments must be watched carefully, they do not as yet constitute a strong reason to expect a recession.  * CBO summarizes by stating a recession should not be expected.  The CBO makes no statement about the duration of the slowdown.
  • In the other direction, the economy might continue to grow rapidly without an increase in inflation, rather than slowing as CBO forecasts. In recent years, the unexpected endurance of the expansion has continually surprised analysts and has proved to be the most significant source of error in their economic forecasts. * CBO has been surprised by recent years expansions.  This statement is an indicator of the CBO lack of understanding of the economic conditions.
  • Another source of risk to CBO's short-term forecast is that inflation might rise. Productivity growth--which has been rapid and kept production costs low--could slow more than generally anticipated, and businesses could pass the resulting cost increases on to customers in the form of higher prices. In that case, rising inflation would be coupled with slowing growth. Alternatively, inflation might start to rise because of continued rapid growth of GDP and increasing wage pressures from the labor market, which has been unusually tight. Or the dollar could fall from its current high level, leading the prices of imported goods to rise and temporarily boosting inflation. Whatever the cause, any further rise in inflation increases the possibility that the Federal Reserve will raise short-term interest rates, with the attendant risk of a recession next year.  * The CBO cites more possibilities.  A further indication of the uncertainty surrounding the economic forecasts.

Those risks are less important for the economic outlook over the next 10 years as a whole. CBO anticipates that growth of real GDP will average about 3 percent over the 2001-2011 period. CPI inflation is projected to average 2.6 percent during that period, reflecting CBO's assumption about what level of inflation would be consistent with Federal Reserve policy. Given the projection of continued stable inflation, interest rates are expected to remain at levels similar to those seen in the second half of the 1990s (see Figure 2-1).

The major uncertainty in those medium-term economic projections is the growth rate of potential GDP (defined as the highest level of output that could persist without spurring higher inflation). CBO has raised its projections of both potential and actual GDP over the past few years in response to the investment boom of the late 1990s * CBO has now clearly stated the potential and actual GDP have been raised as a result of the investment boom in the late 1990s.  In other words, the investment boom is anticipated to result in sustainable GDP growth.  A significant assumption , evidence of the economy's faster growth of productivity, and changes in the data used to calculate GDP. That rise parallels changes made by private-sector forecasters and the Clinton Administration (see Table 2-2). Their and CBO's upward revisions were mostly driven by the increasing belief that acceleration in the growth of information technology--which was a major force behind the investment boom of the late 1990s--will continue to stimulate investment over the next decade * CBO is assuming the IT investment boom in the late 1990’s is going to continue.  Another major assumption. However, economists are uncertain about the degree to which information technology will continue to support economic growth over the next 10 years.
 

Table 2-2.
Change in Projections of Growth Over the Past Five Years (By calendar year)

 

Average Annual Growth Rate of Real GDP (Percent)

Date Projection
Was Publisheda

Period Covered
by Projection

CBO

Blue Chip

Clinton
Administration

2001

2001-2010

3.0

3.3

 

3.1

 

2000b

2000-2009

2.8

2.7

 

2.8

 

1999b

1999-2008

2.3

2.4

 

2.3

 

1998

1998-2007

2.2

2.3

 

2.3

 

1997

1997-2006

2.1

2.3

 

2.3

 

SOURCES: Congressional Budget Office; Aspen Publishers, Inc., Blue Chip Economic Indicators; Office of Management and Budget.

a. CBO and Clinton Administration projections were published in January and completed in November or December of the previous year. Blue Chip publishes long-term projections twice a year, in March and October; the projections shown here are those published in October of the previous year.

b. About 0.3 percentage points of the change between these projections stemmed from a benchmark revision to gross domestic product during 1999 that, for the first time, included software in GDP.

 

The Growth of the Economy's Potential to Produce

The performance of the U.S. economy in the past five years has been extraordinary. Real growth, which averaged 2.8 percent a year during the 1974-1995 period, rose to an average of 4.4 percent from mid-1995 to mid-2000. The unemployment rate fell to 30-year lows. And in a departure from historical patterns, inflation eased despite the low unemployment.

That confluence of events stemmed primarily from an unexpected increase in the growth of the economy's underlying ability to produce goods and services. The growth of labor productivity accelerated from a trend rate of 1.5 percent a year during the 1974-1995 period to 2.9 percent (see Figure 2-2). An important factor behind that recent surge was the acceleration of investment in information technology (IT), which appears likely to continue to contribute to the underlying growth rate of the economy in the years ahead. * The IT boom is again cited to contribute to the underlying growth rate of the economy for years ahead.  Therefore, a reduction in IT investment will result in the CBO assumption being invalid.
 

 

Other important developments also played a role in the economy's outstanding performance over the past five years. Changes in corporate behavior, particularly increased efforts to reduce costs (which were facilitated by the IT revolution), appear to have helped raise the sustainable growth rate of productivity. * CBO states this “appears” to have contributed to the rate of productivity.  The components of productivity are critical to the understanding of what constitutes a change in productivity.  Weakness in many foreign economies, coinciding with a period when inflationary pressures in the U.S. economy were building, kept the prices of imports low, dampening inflation. The weakness abroad also encouraged foreigners to invest in the United States. And massive improvement in the federal budget reduced the government's demand for credit and thus made more funds available for investment.

The Information Technology Boom

Recent progress in information technology has contributed to the increase in productivity growth in various ways. The most visible and clearly quantified way involves the manufacturing of IT equipment itself. The rate of technical change in that sector is reflected in the quality-adjusted price index for computers and related equipment. That index has been declining for many years because of ongoing improvements in productivity, but it fell more rapidly between 1995 and 1999 (see Figure 2-3). Although some of that faster decline stemmed from temporary market developments, CBO anticipates continued rapid productivity gains in the production of IT equipment.  * CBO anticipates productivity gains in the production of IT equipment.
 

 

 

 

Besides those gains, information technology has helped businesses lower their costs of production. Significant cost savings from IT investments are hard to quantify precisely, but numerous anecdotes suggest that savings are greatest in business operations that involve intensive handling, disseminating, or archiving of information or that require constant monitoring of data--operations such as purchasing, delivery, and inventory management.

The unusually large declines in IT prices, combined with the clear benefits of IT investment, resulted in a surge in such investment by businesses. Indeed, the investment boom of the late 1990s was led by higher spending on new software and computing and communications equipment (see Figure 2-4).
 

 

 

* Graph shows the significance of the IT investment in the late 1990’s.  Did the investment continue as assumed by the CBO?

Changes in Corporate Management and Culture

Advances in information technology, coupled with increased globalization, have created a more competitive environment for businesses, causing them to significantly change the way they behave. In particular, increased competition has forced firms to sharpen their focus on controlling production costs. Rather than try to pass on higher costs to consumers or improve their profits by raising prices, companies appear more ready and willing to reduce costs by embracing new technology quickly, undertaking large investments, and making changes in their organizational structures that increase efficiency. Although businesses have always tried to lower costs, the IT revolution appears to have given them both the additional means and the need to focus more attention on cost-cutting innovations.

Weakness in the Rest of the World

Weakness in other countries in the second half of the 1990s helped the U.S. economy, on balance, by providing financial capital and a low-cost source of imports. Many foreign economies--notably Asian ones--were plagued by economic problems during that period. Capital flowed to the United States seeking higher risk-adjusted rates of return, and as a result, the dollar strengthened. That effect was compounded by the flight of capital to U.S. markets in search of a safe haven during the Asian crisis. Those inflows of capital stimulated investment by making more funds available. * Has the inflow of capital to the USA continued?

In addition, the combination of a strong dollar and excess capacity abroad held down prices of imports and overall inflation through 1999. Prices of imported goods (excluding petroleum and computers) fell by an average of 2.3 percent per year between 1996 and 1999 after increasing by an average of 3.0 percent per year in the previous 10 years (see Figure 2-5). Lower import prices reduce overall inflation in two ways: directly through the share of imported goods and services in the price indexes used to measure inflation, and indirectly through increased foreign competition that limits the ability of U.S. producers to raise prices.
 

 

The weakness in world economic activity also reduced prices for commodities (such as grains, metals, and crude oil). Petroleum prices eased for most of the second half of the 1990s before starting their run-up in 1999.

Improvement in the Federal Budget

Another factor that contributed to the favorable economic performance of the past five years was the improvement in the federal budget, which added to national saving, making more funds available for private investment. The budget moved from a $164 billion deficit in 1995 to a $236 billion surplus in 2000. Part of that improvement stemmed from policy changes that increased revenues in the 1990s and restrained spending when surpluses emerged. But the bulk of the improvement occurred because economic developments spurred phenomenal growth in revenues. * CBO states the bulk of the improvement in economic developments spurred phenomenal growth in revenues.  The CBO states part of the improvement stemmed from policy changes.
 

CBO's Medium-Term Projections

CBO projects that real GDP will grow at an average rate of 3.0 percent in the medium term (defined as the 2001-2011 period). That rate is significantly higher than the 2.7 percent that CBO projected last July.(1) The faster growth rate results from a change in CBO's method of calculating the contribution of capital to growth, an upward revision in the official data on investment for the past three years, and higher projected levels of investment. Inflation in the CPI is projected to average 2.6 percent, and the unemployment rate is expected to average 4.8 percent.   * Based on the significant increase in investment in the past three years, the CBO increased the projected increase in the GDP.  Obviously, a decline in investments in the following years will invalidate the assumption.

Growth of Potential GDP

Potential GDP--the highest level of output that the U.S. economy can produce given its labor force, capital stock, and technology without generating inflationary pressures--is the basis for CBO's medium-term projections of real GDP. Potential GDP is projected to grow at an average rate of 3.3 percent a year through 2011 (see Table 2-3).
 

Table 2-3.
Key Assumptions in CBO's Projection of Potential GDP (By calendar year, in percent)

 

Average Annual Growth Since 1951

 

Projected Average Annual
Growth Through 2011

 

 

1951-
1973

1974-
1981

1982-
1995

1996-
2000

Total,
1951-
2000

 

2001-
2005

2006-
2011

Total,
2001-
2011

Overall Economy

 

Potential Output (GDP)

3.9

3.2

2.9

3.4

3.4

 

3.5

3.2

3.3

Potential Labor Force

1.6

2.5

1.4

1.2

1.7

 

1.1

1.0

1.0

Potential Labor Force Productivitya

2.2

0.7

1.4

2.2

1.8

 

2.4

2.2

2.3

 

Nonfarm Business Sector

 

Potential Output

4.0

3.6

3.1

4.0

3.7

 

4.1

3.6

3.8

Potential Hours Worked

1.3

2.2

1.6

1.4

1.5

 

1.2

1.0

1.1

Capital Input

3.7

4.3

3.1

5.0

3.8

 

5.8

4.8

5.2

Potential Total Factor Productivity

2.0

0.8

1.1

1.5

1.5

 

1.5

1.5

1.5

 

Potential TFP Excluding Adjustments

2.0

0.8

1.1

1.1

1.4

 

1.1

1.1

1.1

 

TFP Adjustments

0

0

0

0.4

0

 

0.4

0.4

0.4

 

 

Computer quality

0

0

0

0.2

0

 

0.2

0.2

0.2

 

 

Price measurement

0

0

0

0.1

0

 

0.2

0.2

0.2

 

 

Temporary adjustmentb

0

0

0

0.1

0

 

0

0

0

 

Contributions to Growth of Potential Output (Percentage points)

 

 

Potential hours worked

0.9

1.5

1.1

1.0

1.1

 

0.9

0.7

0.8

 

Capital input

1.1

1.3

0.9

1.5

1.1

 

1.7

1.4

1.6

 

Potential TFP

2.0

0.8

1.1

1.5

1.5

 

1.5

1.5

1.5

 

 

 

Total Contributions

4.0

3.6

3.1

4.0

3.7

 

4.1

3.6

3.8

 

Memorandum:

 

Potential Labor Productivityc

2.7

1.4

1.5

2.6

2.2

 

2.8

2.6

2.7

SOURCE: Congressional Budget Office.

NOTE: CBO assumes that the growth rate of potential total factor productivity changed after the business-cycle peaks of 1973 and 1981 and again after 1995.

a. Potential GDP divided by the potential labor force.

b. The temporary adjustment raises the growth of potential TFP during the 1996-2000 period to help make the estimate of potential GDP more compatible with the observed weakness of inflation. That adjustment is considered transitory, in the sense that although it has a permanent effect on the estimated level of potential TFP, its effect on the growth rate of TFP is temporary.

c. Estimated trend in the ratio of output to hours worked in the nonfarm business sector.

By CBO's estimate, the annual growth rate of potential GDP increased from 2.9 percent between 1982 and 1995, on average, to about 3.4 percent between 1996 and 2000. Much of that acceleration can be attributed to an increase in the growth of th