Thank you, Mr. Chairman. The data that we have received since the August Greenbook support our view that an acceleration of activity is under way. A pickup in the second half of this year has been a feature of our forecast since last January. But for the first time we can say that the expected improvement in the economy is based on some fact and is not just forecast. If anything, the data have, on net, been stronger than we had expected. Looking back, the economy was not so weak in the second quarter as was previously estimated; and looking forward, surprisingly strong readings on private spending have led us to revise up projected growth of real GDP in the second half of this year from 4 percent to 4½ percent. Even the components of the projected step-up in activity are roughly in line with our story. Consumers appear to be spending out of the considerable slug of disposable income that has been delivered through personal tax cuts; low interest rates are providing support to housing activity; and capital spending is poised to post a second large quarterly increase.
The skeptical among you could certainly be forgiven for asking, “Haven’t we heard this before? Is this any different from 2002?” But there is an important difference. Nearly half the growth of real GDP that we experienced over the first three quarters of 2002 resulted from efforts by firms to stem the rapid liquidation of their inventories; improvement in the pace of final sales in that period was minimal. By contrast, the acceleration of activity this year has been more than accounted for by larger increases in final sales. Indeed, inventories have been drawn down sharply as spending has picked up. Needless to say, this is a more auspicious configuration for future activity than occurred in 2002.
Obviously, the congruence of recent developments with our long-standing forecast of a second-half acceleration is heartening. But we aren’t declaring victory yet. It’s more like being pleased that your luggage has arrived with you on the plane to Katmandu for your trip to climb Mt. Everest. To be sure, the trip is off to a good start, but you probably shouldn’t conclude yet that you will reach the summit. We are simply too early in the process to know whether we are on the front edge of a powerful expansion that will begin to erode the margin of excess productive capacity that has built up in the economy over the past three years.
There are basically four elements central to our projection that we will achieve and sustain above-trend growth over the next two years. First, monetary and fiscal policies provide a positive impulse to the growth of spending. Second, that impulse to spending boosts income, which feeds back to more spending through the multiplier effect. Third, the combination of more spending and higher output raises the demand for capital and, through the accelerator effect, boosts the growth of investment spending. Fourth, as the signs of sustainable growth become more convincing, there is a gradual improvement of business sentiment and some lifting of the restraint that we have seen on hiring and spending. Because all these factors operate simultaneously, no simple accounting of these influences is possible. But let me offer some impressions.
As I noted earlier, we are seeing clear signs that fiscal and monetary policy are providing a boost to growth. Although the pattern has been choppy, defense spending has contributed importantly to the growth of real GDP this year. Reductions in marginal income tax rates and advance-refund checks for the child tax credit no doubt help to explain the strength of consumer spending. Meanwhile, favorable financing conditions and improved balance sheets have supported interest-sensitive outlays in the household and business sectors.
But moving beyond this policy-induced push on spending, the picture is considerably murkier. For example, gauging current business sentiment is not easy. Judging from reports in the Beige Book and from our business contacts, the mood seems to have improved marginally. In 2002, many business people said that they simply didn’t see any signs of improvement in underlying economic conditions, and they were quite emphatic in stating that the economists were crazy. While I wouldn’t want to endorse that particular psychiatric evaluation of the profession, I’d have to admit that they were right about business conditions. The prevalent mood now seems to run between skepticism and guarded optimism, with less outright hostility to the view that conditions are improving. Still, it is clear that businesses remain cautious and are behaving accordingly. Inventories are under tight control, and firms have continued to be reluctant to add to their payrolls.
We may, however, be seeing some evidence of a greater willingness to engage in capital spending. Real spending on equipment and software was up about 8 percent at an annual rate in the second quarter, and the data in hand suggest to us an even stronger 16 percent gain in the current quarter. This may reflect some brightening of sentiment, but the fundamentals have been improving as well. In addition to the drop in borrowing rates, the partial-expensing provision is holding down the cost of capital. Moreover, business output, final sales, and cash flow have accelerated this year, and that also is likely supporting capital outlays.
However, to move more firmly onto a sustained path of above-trend growth, we will eventually need some help from the labor market. In our forecast, as the impetus to incomes from tax cuts fades, faster growth of employment and labor income more than fill the gap, sustaining relatively rapid growth of consumer spending. This part of the process is not yet in evidence. The biggest surprise we have experienced over the intermeeting period has been the weakness of the labor market. Private payrolls declined again in August, and initial claims for unemployment insurance have edged back up over 400,000 during the past two weeks. As a consequence, we have pushed off again the time at which we expect to see an upturn in hiring.
One should be careful not to exaggerate the extent to which the multiplier process depends on job growth. Large gains in output by definition result in large gains in income. To date, those gains are coming from faster growth of labor productivity and the income is flowing heavily to profits. Corporate earnings are boosting cash flow and likely are helping to finance some of the increases in capital spending. Moreover, heightened corporate profitability has provided a lift to equity prices, which in turn support business spending through a lower cost of capital and household spending through the wealth effect. Indeed, taking all of these channels into account, the propensity to spend out of capital income is only marginally smaller than the propensity to spend out of labor income. So the multiplier effect is attenuated but not eliminated when output gains are generated through faster productivity.
Still, I think that only limited comfort should be taken from that observation, largely because the recent configuration of the growth of output and productivity is not sustainable. Ongoing declines in hours worked and employment will be associated with a rising unemployment rate—a development that could at some point sour consumer attitudes. Even setting aside that possibility, increasing slack will eventually put downward pressure on inflation; with an unchanged funds rate, the accompanying upward pressure on real interest rates will have negative consequences for aggregate demand.
As seems so often to have been the case in recent years, interpreting developments on the supply side of the economy has been just as central to our forecasting enterprise as getting a good fix on aggregate demand. The performance of productivity over the past year has remained phenomenal. Over the year ending in the second quarter, productivity in the nonfarm business sector is estimated to have risen more than 4 percent—a pace that we think is likely to be matched or exceeded in the current quarter. Moreover, the historical revisions to labor productivity released by the BLS after their incorporation of new estimates of hours worked point to larger increases in output per hour in both 2001 and 2002 than previously estimated. In light of these developments, we thought adjustments to our estimates of structural productivity and potential output were needed to better balance the risks to our forecast. In the end, we raised the estimated level of structural labor productivity by a cumulative 2 percent by the end of 2003, after accounting for a break in the series. We also increased the growth rate of structural productivity about ¼ percentage point over 2004 and 2005 to 2½ and 2¾ percent per annum respectively. Owing to a downward revision to the trend in the workweek implied by the revised data, our upward revision to potential output was slightly smaller.
There are several plausible explanations for the exceptional performance of productivity. For one, firms are likely using more fully and effectively technologies and capital that were introduced and installed in the late 1990s. The boom years may have masked inefficiencies that had built up. But in the more difficult circumstances of the past several years, firms have been under intense pressure to cut costs in order to improve the bottom line. Some of the gains may also be coming from developments at the industry level. Many startups and firms that entered new lines of business in the boom period never gained any traction and eventually folded their tents in the intensely competitive environment of the past few years, leaving the most efficient producers with a larger share of the market. Finally, advances in technology and organizational know-how are probably providing a bigger boost than we had previously recognized to the growth, and not just the level, of structural productivity. Hence, we nudged up further our estimates of the growth of multifactor productivity for the next two years.
With the upward adjustments we made to aggregate supply exceeding those we made to aggregate demand, we are forecasting both stronger growth of real GDP and a slightly higher output gap than in our August forecast, a gap that is not expected to be eliminated by the end of 2005.
As you know, current market expectations, as well as those of many professional forecasters, are that you will begin to tighten by the middle of next year. In contrast, we have assumed that the federal funds rate is held at its current level until the middle of 2005. On the surface, it might appear that the staff is assuming not only that the punch bowl will be left on the table after two years of partying but also that the central bank will be ladling out punch faster than fraternity brothers on pledge night! Needless to say, that is not how we view our policy assumption.
In our forecast, we expect the pressures on inflation over the next two years as more likely to be down than up, and thus there will be little urgency to begin the tightening process. The margin of slack in labor and product markets is expected to recede only slowly over the next two years. This reflects both our relatively optimistic outlook for the growth of potential output and our forecast that growth of real GDP will slow in 2005, when fiscal policy swings from a position of considerable stimulus to one of slight restraint. Slack in labor markets should help to keep downward pressure on labor compensation. At the same time, the sustained strong uptrend in structural productivity should then translate those modest gains in labor compensation into minimal increases in structural unit labor costs. Barring some exogenous shock, it is difficult to envision any noticeable deterioration of inflation expectations. To us, these influences, taken together, seem a recipe for subdued inflation. In our forecast, headline CPI inflation declines from 2 percent this year to about 1 percent in 2004 and 2005. Core inflation edges lower over the next two years, and energy prices decline in line with expectations embedded in current futures prices. We believe the risks are comfortably balanced around that projection.
The mean Blue Chip forecast has an unemployment rate of 5¾ percent by the fourth quarter, very similar to ours but with CPI inflation remaining at 2 percent next year. Obviously, it is difficult for us to take a firm stand on the wisdom of our forecast relative to that of the Blue Chip. Their 2 percent CPI forecast is at the upper end of the 70 percent confidence interval around the staff projection—so their forecast is clearly a credible one. Of course, I’d also note that the lower end of the 70 percent confidence interval around our forecast includes a small decline in headline prices in 2004—so that outcome cannot be written off yet either. Karen will now continue our presentation.