ECONOMIC ASSUMPTIONS

Introduction

    The U.S. economy has displayed remarkable resilience in the face of unprecedented shocks. The economic slowdown that began in mid-2000 turned into a full-blown recession in March 2001. The disruption to economic activity caused by the September 11th attacks contributed to the brief contraction of economic activity.

    Thanks to timely fiscal and monetary policy responses and the willingness of households and businesses to trust in the future, a recovery in economic activity is underway, making the recent recession the mildest on record. Economic growth resumed in the fourth quarter of last year, accelerated sharply in the first quarter of 2002, and continued in the second quarter, albeit at a slower pace. Growth will continue to be supported by higher after-tax incomes resulting in part from the tax relief enacted last year and by the incentives for business investment in the recently enacted stimulus package.

    The brevity of the contraction and the strength of the subsequent recovery were not anticipated in forecasts made at the turn of the year. Since January, forecasters—including the Administration's—have raised their projections for growth over the near-term. If the upturn in capital spending is delayed or if consumer spending weakens, the balance of the recovery might be weaker than projected. Still, the longer-term economic outlook remains favorable. The recent strong productivity performance, even during the recession, provides encouraging evidence that the improvement in business productivity observed during the last half of the 1990s has become a structural feature of our economy.

    The Administration's economic projections are virtually identical to the consensus of private sector forecasts. They anticipate a healthy but reasonable expansion that will create more private-sector jobs, higher incomes, and growing profits. The Administration's economic policies—providing tax relief, shifting spending to the most effective, high-priority programs, promoting efficient regulation, and freeing resources to be used more effectively in the private sector—will be important factors in achieving a strong, sustained expansion.

    Fiscal Policy: Fiscal policy played a valuable role in enabling the economy to return quickly to sustained, noninflationary growth. In June 2001, the President signed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which provided substantial tax relief to the American people. The goal of the Act was to reduce tax burdens permanently. The Act, however, could not have been better timed from a cyclical perspective.

    Beginning in July 2001, 85 million taxpayers received rebate checks totaling $36 billion reflecting the new, lower 10 percent tax bracket. In addition, income tax withholding schedules were reduced to incorporate the first stage of the lower marginal income tax rates for those in the 28 percent tax bracket and higher. In January 2002, withholding schedules were lowered again to reflect the 10 percent tax bracket. The rebate and lower withholding rates reduced personal income tax liabilities by $44 billion in calendar year 2001 and by $52 billion in 2002. Altogether, EGTRRA reduced taxpayers' 2002 calendar year liabilities by about $70 billion.

    Fiscal policy provided further support to the recovery with the passage in March 2002 of the Job Creation and Worker Assistance Act. The Act provides an incentive for businesses to invest by permitting them to expense 30 percent of the value of qualified new capital assets including equipment and software. The balance is depreciated according to existing schedules. The expensing provisions, which expire in September 2004, reduce the cost of capital and so provide an additional incentive for businesses to invest during the vulnerable initial phase of the expansion. The Act also provides up to 13 weeks of additional unemployment benefits for the long-term unemployed who exhaust regular unemployment insurance benefits.

    Budget Surpluses and Interest Rates: Recent years have featured repeated assertions that large federal surpluses were necessary to keep interest rates low. Although there is no historical correlation between the fiscal net position and interest rates, this view still seems to have its adherents. It is important, therefore, to note that a return to deficits has coincided so far with falling and extraordinarily low interest rates (see next section).

    Monetary Policy: Low inflation has permitted the Federal Reserve to pursue a monetary policy focused on reviving economic activity. During the first eight months of 2001, the Federal Reserve reduced the federal funds rate from 6 1/2 percent to 3 1/2 percent. Then, after September 11th, the rate was cut to just 1 3/4 percent by December, the lowest level since the early 1960s; it has remained at that level during the first half of 2002. Short-term interest rates declined sharply as the Federal Reserve reduced the federal funds rate.

    At the longer end of the maturity spectrum, rates declined significantly in late 2000 and remained close to those levels during 2001 and the first half of 2002. The yield on the 10-year Treasury note was around five percent in late 2001 and the first five months of 2002. Except for a brief period in 1998 and again in early 2001, this was its lowest level in 35 years. The rate on 30-year conventional mortgages was around seven percent in 2001 and the first five months of 2002, also one of the lowest levels since the mid-1960s. In June, long-term rates edged down further.

Recent Developments

    Real Gross Domestic Product (GDP) grew at a 1.7 percent annual rate in the fourth quarter of 2001, following a 1.3 percent decline in the third quarter. In the first quarter of 2002, growth accelerated to a 6.1 percent pace, the fastest advance in over two years. The recovery in economic activity was led by the household sector, with additional contributions to growth from higher government spending, and a much reduced rate of inventory liquidation. Business capital spending and the foreign sector remained ongoing restraints on growth. Although the growth rate in the second quarter of 2002 will not be announced until the end of July, it appears that the economy continued to expand, although at a more moderate pace than in the first quarter.

    Consumer confidence, and with it consumer spending, fell sharply immediately after the September terrorist attacks, but the successful pursuit of the war on terrorism and some strengthening in the stock market during the closing months of 2001 helped restore consumers' confidence. This confidence was manifested in a new willingness to spend, especially on big-ticket discretionary purchases. In the fourth quarter, motor vehicle sales set a record high, boosted by generous sales incentive programs including zero-percent financing. On average, consumer spending adjusted for inflation increased at a 4 1/2 percent annual rate during the fourth quarter of 2001 and the first quarter of 2002, up from only a 1 3/4 percent rate during the prior half year. Because consumption accounts for two-thirds of GDP, the resurgence of consumer spending was key to restoring economic growth.

    The housing sector also contributed significantly to the turnaround in the economy, boosted by low mortgage rates and restored confidence. During the first five months of 2002, combined new and existing home sales reached the highest level on record and new housing starts reached the highest level in three years. Residential investment adjusted for inflation rose at a rapid 14 1/2 percent annual rate in the first quarter of 2002, the fastest quarterly gain in nearly six years.

    Government spending on consumption and investment also increased. In the fourth quarter, combined federal and State/local spending rose at a 10 percent annual rate, and in the first quarter of this year, at a seven percent pace. At the federal level, defense spending, driven by the war on terrorism, increased sharply. At the State/local level, the spending increase was led by construction.

    In contrast to the household and government sectors, business capital spending continued to restrain overall growth. During the fourth quarter of last year and the first quarter of 2002, investment in business structures declined sharply. Investment in equipment and software continued to fall in the fourth quarter, but at a slower rate, and increased marginally in the first quarter, the first gain in over a year. Forward-looking indicators of equipment spending during the spring suggest that business capital spending is firming.

    A widening of the U.S. net export deficit also restrained GDP growth, especially in the first quarter of 2002. Slow growth in the economies of our trading partners curtailed U.S. exports, while rapid growth of household spending boosted imports. The large monthly trade deficits of the first quarter widened further in April to the highest level on record.

    Inflation remained low even as the expansion got underway. During the first five months of 2002, core inflation in the Consumer Price Index (CPI), which excludes the volatile food and energy components, increased at only a 2.3 percent annual rate. For the first five months of the year, the overall CPI increased at a 3.0 percent annual rate.

    The turnaround in the economy helped improve the labor market. The nation's payrolls expanded in May and June, following 13 consecutive months of declines. In the hard-hit manufacturing sector, job losses in recent months were much smaller than during the prior year and the workweek, a leading indicator of economic growth, lengthened. The unemployment rate in June was 5.9 percent, about the same level as in April and May, but somewhat higher than the 5.6 percent average of the prior six months.

    In financial markets, the 3-month Treasury bill rate was 1.7 percent in June while the yield on the 10-year Treasury note was 4.9 percent, resulting in a steeply upward sloping yield curve. Equity prices fell sharply in the second quarter. By the end of June, major indexes had lost most, or in some cases all, of the gains achieved in the fourth quarter.

Revised Economic Assumptions

    The economic assumptions for the Mid-Session Review, summarized in Table 3, have been revised from those used in the Administration's 2003 Budget to incorporate the unanticipated strength and timing of the recovery, and the passage of the Job Creation and Worker Assistance Act (JCWAA). Real GDP growth this year is now expected to be considerably higher than anticipated in the budget. Private sector forecasters have made a similar upward revision. Over the near- and longer-term, the Mid-Session Review projections are close to the consensus of private sector forecasts. The rates of GDP growth and unemployment during the second half of the projection period are the same as in the budget; inflation and interest rate projections are nearly identical to those in the budget.

    Real GDP, Potential GDP, and Unemployment: Real GDP growth in the fourth quarter of 2001 and the first quarter of this year was stronger than expected in the budget assumptions. As a result, actual growth last year was 1.2 percent on a year-over-year basis, compared with the 1.0 percent estimated in the budget, and growth this year is projected to be 2.6 percent, compared with 0.7 percent in the budget. Growth during the next few years is projected to be slightly less than anticipated in the budget because the recovery appears to be more front-loaded than expected previously. Growth during 2002–12 averages 3.2 percent per year, the same as in the Blue Chip consensus, an average of 50 private sector forecasts. During 2008–2012, assumed growth is 3.1 percent yearly, the same as in the budget assumptions and the Blue Chip consensus. This is the Administration's estimate of the nation's potential GDP growth rate.

    As in the budget assumptions, the unemployment rate is projected to decline during the next few years to 4.9 percent in 2007 and then remain at that low level. That rate is the Administration's estimate of the long-run unemployment rate that is consistent with stable inflation. It is also the same as the outyear projection of the Blue Chip consensus.

    Inflation: For 2002, the GDP measure of inflation has been reduced 0.7 percentage point compared with the budget projection to 1.3 percent on a year-over-year basis to incorporate recent lower-than-expected data. The CPI measure of inflation is projected to be 1.7 percent, slightly below the budget projection. Thereafter, during 2003–2012, the GDP and CPI inflation projections are nearly identical to those in the budget. The GDP chain-price index is expected to rise just under two percent each year, and the CPI by slightly less than 2 1/2 percent.

    Interest rates: The interest rate projections are very close to those in the budget. Short-term interest rates are assumed to rise as the recovery increases credit demands. The 91-day Treasury bill rate, currently at 1.7 percent, is assumed to increase to 4.3 percent in 2004 and remain at that level. The yield on the 10-year Treasury note is projected to remain steady at 5.2 or 5.3 percent during 2002–2012. The larger gain in short-term rates than in long-term rates is consistent with the interest rate movements that usually occur at this stage of the business cycle.

    Income Shares: The share of taxable income in nominal GDP has been revised from the budget assumptions, primarily because of revisions to corporate profits and wages and salaries. Recent data and the passage of the stimulus bill have affected the projection of corporate profits; information about the annual revision to the National Income and Product Accounts that will be released at the end of July has affected the projection of wages and salaries.

    The projection of corporate book profits before tax during the next few years incorporates two factors that work in opposite directions. Book profits have been raised because recent data reveal that the recovery raised profits more than had been anticipated in the budget assumptions. On the other hand, the temporary 30-percent expensing provision of JCWAA raises corporate book depreciation through September 11, 2004 and accordingly lowers book profits; thereafter, book profits are raised because the remaining depreciation on the investments eligible for expensing will be lower. Taking both of these factors into account, the share of book profits before tax in GDP is projected to be about the same as in the budget assumptions during 2002–2004 and higher than the budget assumptions during the following years. That difference is gradually reduced so that by the end of the projection horizon there is little difference between the two projections.

    Recent information on State personal income reveals that the levels of wages and salaries in the National Income and Product Accounts for 2001 and early 2002 are currently substantially overestimated. These levels will be revised downward officially on July 31st when the Bureau of Economic Analysis releases its annual GDP revision covering the past three years. Starting at a lower level suggests that the wage and salary share in GDP is likely to rise slightly during the projection period, rather than decline as assumed in the budget projections. The projection incorporates this rise.

    A lower level of wages and salaries helps to explain some of the shortfall of individual income tax receipts experienced in 2002. The downward revision in the level of wages and salaries will not affect projections of future budget receipts because the level of current receipts is known and not subject to revision. Projections of the growth in future tax receipts depend on the growth rate in wages and salaries, which edges up as a share of GDP through 2006 as the labor compensation share of GDP returns to its historical average.