The story of our longer-term projection should be familiar. Though we believe that there was a little jam yesterday and that there is some jam today, we would have to admit that in the projection it’s still mostly jam tomorrow. The inflation picture also is about unchanged; everything at the dollar store still costs a dollar. With respect to the risks to the outlook, we think we see light at the end of the tunnel, but we’re nervous about the fact that, whatever the light is, it seems to be getting brighter while we are standing still.
I apologize for not citing all of the colorful metaphors that seemed to be guiding your deliberations at the last meeting, and even more so for now returning to my own plodding prose. In fact, there’s not a great deal more to be added. It has been a reasonably tranquil period for the forecast by the standards of the past couple of years. The principal change we made was to incorporate the effects of your easing of monetary policy and to account for our perception that the elections had shifted the political balance in favor of somewhat greater fiscal stimulus.
The incoming data, on balance, have been close to our earlier expectations and have reinforced our impression that we are indeed working through a soft patch in economic activity. The signs of sluggishness have been most evident in the labor market and in the manufacturing sector, especially the motor vehicle industry. Once again, we received an employment report immediately after publication of the Greenbook. Private payroll employment dropped 48,000 in November in contrast to our expectation of a gain of 20,000. Essentially the employment increases that had occurred over the summer have now been reversed. Our largest forecast error occurred for the unemployment rate, where we had expected an increase from 5.7 percent to 5.8 percent and instead saw a jump to 6.0 percent. That said, I would characterize this development as more a “surprise” of timing than magnitude. As you know, we had been puzzled by the failure of the unemployment rate to rise noticeably in recent months, given the weakness in payroll employment. The puzzle now seems to have been resolved in a single month. The only upward surprise in the November labor market report was in hours worked, which increased a bit more than projected in the Greenbook. Taken together, the November data suggest a bit weaker labor market than we had expected but with little material consequence for our forecast. We would probably carry a slightly higher unemployment rate into early next year— on the order of a tenth or so—and leave our GDP forecast unchanged for now.
The labor market, however, was not the only source of weakness. The major contributor to the sharp slowing in activity between the third and fourth quarters has been the motor vehicle industry. Sales of light motor vehicles have dropped back considerably from the torrid pace registered this summer, as the average level of customer incentives has fallen, on net, since August. The slump in sales has led the automakers to trim production in the fourth quarter. So after contributing about 1 percentage point to the growth of real GDP in the third quarter, motor vehicle assemblies are lopping off nearly 1½ percentage points from growth in the fourth quarter. And even those production adjustments have not been sufficient to prevent inventories from having become a bit heavy, so that some combination of further production cutbacks and sweetened incentives likely will be necessary in the months ahead.
More broadly, activity in the factory sector has sagged again in recent months. We now expect manufacturing IP outside of motor vehicles to drop about ¼ percent in November, continuing a pattern of decline that emerged in late summer. In our forecast, we are not looking for any noticeable increases until the spring. The recent weakness stems, in part, from a significantly diminished impetus to activity from inventory investment. A smaller swing in nonauto inventory investment and the cutbacks in motor vehicle production account for essentially all of the slowing in the growth of real GDP in the current quarter.
To date, we have seen few signs that this period of weakness is spreading or cumulating into something more serious. With the exception of motor vehicles, final sales are projected to grow about 2 percent at an annual rate in the current quarter, the same rate as in the third quarter. Moreover, initial claims for unemployment insurance and insured unemployment have both come down in recent weeks. For the most part, nonauto inventories appear to be in reasonable balance. And commodity prices have been relatively firm, suggesting that the recent weakness in factory output is not yet of cyclical dimensions. Instead, this appears to be a particularly soft spot in a generally subdued expansion. We expect subpar economic performance to extend into early next year, with real GDP projected to grow about 2¼ percent at an annual rate in the first quarter—unchanged from our previous projection.
However, beyond the near term, we have made more noticeable adjustments to our forecast, largely to reflect changes in our underlying policy assumptions. Most important, we lowered our assumed path for the federal funds rate 50 basis points in light of your action last month. We assume that the funds rate will stay at 1¼ percent through the middle of 2004 before gradually rising. This more stimulative monetary policy accounts for the bulk of the upward revision that we have made to the forecast.
We have also built in a slightly more stimulative fiscal policy, which provides a small additional boost to growth in 2004. We have assumed a reduction of personal income tax payments of $25 billion in 2004, over and above the next installment of marginal rate reductions. These tax reductions are assumed to be partly offset by about $5 billion of cuts in federal spending. We view these adjustments to our forecast as better balancing the risks in light of last month’s elections. As we noted in the Greenbook, we are largely agnostic about the form in which this stimulus will be delivered. But as an example, a package of this dimension could include pulling forward the child tax credit and marriage penalty relief that are currently scheduled to occur later in the decade.
The more stimulative monetary and fiscal policies give a steeper tilt to the trajectory of growth in this forecast. We now project real GDP to increase 3¼ percent in 2003 and 4¼ percent in 2004—about ¼ and ½ percentage point faster, respectively, than in the October Greenbook. That pace is rapid enough to begin to erode the margin of excess capacity by late next year, and the unemployment rate is now projected fall below 5½ percent by the end of 2004.
As has been the case at several junctures over the past couple of years, our outlook is once again apparently at odds with that of the market. Even after the developments of the past week, market participants are anticipating an earlier and more aggressive tightening of monetary policy than we have incorporated in our baseline projection. In our forecast, growth remains subdued through midyear, weighed down by the continuing adjustment of household spending to the decline in stock market wealth, the playing out of the boost we have been getting from inventory investment, and the lackluster economic performance of our major trading partners. As a consequence, we do not envision the same urgency for tightening as is built into market expectations. Only by late 2003 do the waning effects of the earlier stock market declines and the improving investment picture lift growth in real GDP above that of potential.
We readily admit that we could have this wrong. The markets apparently continue to be looking for something that resembles a more conventional period of economic recovery. And with the real federal funds rate at or below zero for nearly two years, we cannot rule out a period of more-vigorous growth. Those risks are amplified by the possible enactment of a major stimulus package early next year. Certainly the buzz about that possibility has been growing in recent days. Given the uncertainties about the magnitude, timing, and composition, we were dissuaded from building into the forecast a larger and more immediate stimulus package. Instead, we addressed that possibility in an alternative simulation that assumed a combination of a payroll tax holiday and an acceleration of the marginal rate reductions included in the 2001 tax legislation, with those actions taking effect early next year. That package— roughly $115 billion of added stimulus next year—raises growth of real GDP above 4 percent, on average, throughout the projection period. In this alternative scenario, the faster pace of activity pushes the unemployment rate down to 5 percent by the end of 2004, and core PCE inflation levels off at just under 1½ percent. While there are clear upside risks to our projection, we continue to see some sizable counterbalancing risks to the downside. The most obvious risks center on our forecast of capital spending. To be sure, there has been a substantial turnaround in equipment spending from last year to this; steep declines in spending in 2001 have given way to modest increases this year. In our forecast, that process of improvement continues into next year and 2004, with growth in real E&S spending picking up from low single digits this year to low double digits next year. Accelerating output and sales, a low and declining cost of capital, and tax incentives are projected to help propel faster growth of spending over the next two years.
But thus far this year, equipment spending has continued to fall short of the fundamentals, at least those that we are capable of quantifying in our models. That shortfall likely reflects a variety of factors including gloomy business sentiment, a sense of heightened uncertainty about economic and geopolitical conditions, financing difficulties in some sectors, and lingering overhangs of capital. Whatever the sources, the unusual restraint on business spending will need to largely dissipate by the second half of next year in order to get our projected acceleration of business spending. And that still remains a forecast. Although reports on capital spending plans have been mixed of late, I think it’s fair to say that the combination of caution and pessimism still predominates.
There are risks to the consumption outlook as well. We view this quarter’s flattening out as a pause, driven importantly by the drop-off in motor vehicle purchases. If that slump reflects the beginning of a more persistent weakening of overall consumer outlays—one that occurs before the acceleration of business spending—the current soft patch could come to look a lot more like the La Brea tar pits.
A final downside possibility is that financial markets have overreacted to a few pieces of good news in recent weeks. We were impressed by the extent to which the markets moved on the positive surprises in readings on retail sales, durable goods orders, and initial claims—all noisy indicators of activity. Any substantial retracing of these recent gains—and we have seen some of that in the stock market in the last few days—would cause us to revise down our projection for growth, all else being equal. In sum, we feel comfortable with the balance of risks surrounding our projection of real output. But those risks remain considerable.
I have devoted little attention this morning to our inflation projection largely because there has been little news with regard to price inflation or its determinants. Measures of core inflation have generally drifted down over the past year. And, with slack in resource utilization expected to persist over the projection period, we anticipate a further slight reduction in these measures over the next two years. But neither our models nor surveys of inflation expectations suggest any sharp deviation from the recent performance of prices in the period immediately ahead. Karen Johnson will continue our presentation.