Thank you, Mr. Chairman. By virtually all measures, the economy has been humming along at a very solid pace in recent months. We are estimating that real GDP expanded at a 4¼ percent annual rate in the fourth quarter of last year and is likely to grow at about that pace in the first quarter of this year.
The contributors to the expansion have remained much the same. The household sector has, to date, shown no signs of flagging. Consumer spending has been moving up smartly, and housing activity continues to be very strong. Meanwhile, equipment spending by businesses remains on a steep uptrend. And we have even seen some signs of improvement in nonresidential construction, though most of that improvement has been centered in the upswing in drilling activity that has accompanied the jump in energy prices. Inventory investment and hiring—the last major areas in which we could detect the cautious business behavior that had been such a prominent feature of this episode—now appear to be tracing more normal cyclical patterns.
Although the pace of the expansion in real activity is much the same as that of a year ago, the character of the expansion now feels different. While I can easily imagine looking back on these words with regret [laughter], the persistent and widespread improvements that we are now witnessing certainly leave the impression that the expansion is more firmly established and less fragile with respect to adverse shocks than it was in early 2004.
As you know from reading the Greenbook, we think that the recent greater momentum in real GDP will carry forward for a while. That greater momentum in activity and heightened upward pressures on inflation led us to raise the assumed path of the federal funds rate by 50 basis points beyond the very near term. As in past forecasts, tighter monetary policy, diminished impetus from rising equity values and house prices, and fading fiscal stimulus are expected to gradually put a brake on the pace of activity. In our projection, the economy reaches the end of next year with the funds rate in the neighborhood of neutral, output close to potential, and core inflation running around 1½ percent. Were it to occur, such an outcome would be very pleasant indeed.
Of course, we know that our point forecast, like any point forecast, will occur with probability zero. So what should we worrying about? While my colleagues who attend our lengthy forecast meetings were not exactly thrilled by it, the removal of my arm from its sling in the past few weeks has allowed me, once again, to bring my principal value added to the forecasting process, and that is copious amounts of hand- wringing. [Laughter]
In the remainder of my remarks, I=d like to focus on three difficult questions with which we had to wrestle in assembling this forecast: First, what should we make of the recent strength in capital spending and what are its implications for the outlook? Second, how should we balance some powerful crosscurrents at work on the supply side of the economy? And third, what is happening with inflation? I=ll take them each in turn, although there are some common threads that tie them together.
Let me begin with the changes that we have made to the projection for equipment spending. Our last hope for evidence supporting the partial-expensing pothole in the first quarter of this year largely evaporated with the January data. Domestic shipments of capital equipment were up across the board, and imports of capital goods were strong as well. Likewise, new bookings for capital equipment rose at a brisk pace early this quarter, and the backlog of unfilled orders has continued to mount. To be sure, we are projecting some deceleration in E&S spending in the first quarter, but most of that deceleration reflects a drop in purchases of light motor vehicles, and we don=t see the expiration of the tax incentive as the major factor here. Indeed, much of the upward revision to our projection of capital outlays in the first quarter has occurred among long-lived assets—the types of capital equipment that we thought would have been weakest early this year.
So, little remains of our elegant story. Our calibrated vintage capital models failed us, and clearly finger-crossing has not proven a terribly robust forecasting technique. We even tried an approach gently suggested to us by Governor Olson at the time of our last forecast—you know, had we thought about trying common sense? [Laughter] We tried, but even that didn=t seem to work. In a conversation with our colleagues at Treasury that they asked remain confidential, they indicated having been surprised that an appreciable number of firms with taxable income have simply not taken advantage of partial expensing. Moreover, some firms have taken it for purchases of longer-lived assets, but not for shorter-lived assets. This pattern of behavior might suggest that administrative complexity may have loomed larger as a discouraging factor than we or others imagined. But the facts are likely to remain obscure for a long time, while the IRS tabulates the corporate income tax forms for recent years. For now, we=re raising the white flag of surrender and chalking it up as a defeat for models, luck, and logic.
I wouldn=t drag you through this discussion if it were just a sideshow in the forecast. But the changes that we made here were of policy significance. We revised up the growth in real equipment spending by 10 percentage points in the current quarter, from a decline of 5 percent at an annual rate to an increase of 5 percent. Moreover, we had previously interpreted some of last year=s strength in capital spending as resulting from firms pulling forward outlays to take advantage of the tax break. If that was not the case, then underlying demand was likely stronger than we had previously recognized. As a consequence, we are projecting some of that additional strength to carry over into the first half of this year.
After accounting for follow-on multiplier–accelerator effects, the revisions to our forecast of equipment spending boosted growth of real GDP by nearly 2 percentage point this year and by ¼ percentage point next year. These adjustments more than offset the downward revisions to our projection that were necessitated by the higher expected path of oil prices, which we estimate will trim about ¼ percentage point off the growth in real GDP in each of the next two years.
The faster pace of capital spending incorporated in this projection also had implications for aggregate supply through its contribution to capital deepening. But that was just one of a number of changes we made on the supply side of our projection. As I noted earlier, we have had to contend with two strong crosscurrents in this aspect of our forecast: faster-than-expected growth of labor productivity, on the one hand, and slower-than-expected growth of the labor force, on the other.
With regard to productivity, we appear to be starting this year with another large upside surprise. Our estimate of the growth of output per hour in the first quarter has been revised up by 2 percentage points since the last Greenbook to a 3½ percent annual pace.
As you know, the surprising strength of productivity over the past few years has required us to take a stand on how much of the recent gains has reflected structural improvements that will persist going forward and how much has reflected the cautious hiring stance of businesses and their ability, at least for a time, to elicit greater effort from their workforces. In other words, we have had to parse these innovations into trend and cycle components. With positive surprises to productivity continuing, the story about caution-induced effort seemed to us to have diminishing plausibility. Both our models and our best judgment suggested raising our estimates of the structural component of productivity in recent years and correspondingly lowering the cyclical component.
In addition to raising the level of structural productivity through the end of last year, we also nudged up our estimate of the growth of structural productivity going forward by about ¼ percentage point per year to about 3 percent per annum. About half of that upward revision reflected the larger contribution from capital deepening that followed from our stronger investment forecast. The other half reflects stronger projected growth of multifactor productivity. Businesses have been making substantial gains in technological and organizational efficiencies in recent years, and we anticipate more of that to continue over the next couple of years than was assumed in our January projection.
While the revisions that we have made to structural productivity, all else equal, would have resulted in a noticeable upward revision to the projected growth of potential output, all else was not equal. Just as we have been surprised to the upside by productivity, we have been consistently surprised to the downside over the past year or so by the weakness in labor force participation. We had been expecting that, as the labor market began to give clearer signs of sustained improvement, more workers would be drawn back into the labor force. We still think that is likely to happen.
But the growing tension between our expectation of an imminent upturn in labor force participation and the reality of its ongoing decline prompted us to overhaul our models in this area, disaggregating age, sex, and cohort efforts at a much more detailed level than we had done in the past. The upshot of that work has been to suggest that more—though certainly not all—of the decline that we have observed in participation over the past few years has been demographic and less has been cyclical than we had earlier thought. At the risk of oversimplifying some complicated interactions, whereas we had earlier thought a continued uptrend in women=s participation would about offset the ongoing decline in the participation rate of men, we now think that women=s participation may be flattening out even as men=s participation continues to decline. All told, we estimate a more noticeable downward tilt to aggregate trend participation, and thus potential labor input is more limited than we had previously projected.
On net, the upward revisions to productivity slightly exceeded the downward revisions to potential labor input, and we revised up the growth of potential output by 0.1 percentage point this year and next. These upward revisions were smaller than those we made to actual GDP, and, as a consequence, the GDP gap is a touch smaller in coming quarters than was the case in our January projection.
A slightly tighter economy has added to a growing list of worries that would make any compulsive hand-wringer proud. That list would also contain higher oil prices, larger increases in non-oil import prices, a steep rise in commodity prices, a reemergence of price pressures from intermediate materials, some deterioration in near-term inflation expectations, and a disappointingly large increase in core PCE [personal consumption expenditures] prices in January. To our relief, this morning=s PPI for February did not add to this list. The increase in core finished goods—at 0.1 percent—and the increase in core intermediate materials—at 0.5 percent—were right in line with the Greenbook projection.
But taken together, price developments over the intermeeting period have been troubling. The effects of higher oil prices are already being felt at the pump, and headline inflation measures will be up noticeably in February and March. Moreover, higher energy and materials prices are adding to business costs, and higher prices for imports are lessening competitive pressures on the pricing decisions of domestic producers. In response to these developments, we have raised the projected increase in core PCE prices to 1¾ percent in 2005 and 1½ percent in 2006—about ¼ percentage point higher than our previous projection in both years. Still, the basic contours of the inflation forecast remain the same. Such a modest revision might lead some to wonder if the staff should be doing a little more hand-wringing if we wish to avoid an eventual neck-wringing!
But at this point, we believe that only a modest revision is warranted. As you know, for the prices of oil and other commodities, we take our cues from futures markets. And, as they have for much of the past year, those markets are suggesting that a flattening out of prices is just around the corner and that declines will occur by next year. Futures markets have not proven to be terribly reliable guides to prices over the past year, but we simply aren=t confident that we can outguess the markets in these areas.
We view the larger increases in core PCE of late as suggesting that the size, pass- through, and persistence of price pressures from energy, imports, and other commodities has been greater than we had earlier expected. But we do not think that we are, as yet, experiencing a broad-based upward push on inflation. One piece of evidence in support of that interpretation is that all of the acceleration in core PCE prices over the past year has occurred among core goods, where the influence of energy, materials, and imports is likely to be largest. Core services have actually decelerated.
Moreover, the labor cost picture remains quite subdued. Growth in hourly labor compensation has basically moved sideways in recent quarters. Our projection incorporates some acceleration in wage inflation in response to higher price inflation this year and a gradual tightening of the labor market. But the faster projected growth of actual and structural labor productivity holds down the overall increase in unit labor costs. Indeed, the combination of slightly higher price inflation and lower unit labor costs resulted in an upward revision to the price markup in this projection, which already was above historical norms. In effect, greater pricing power is implicit in this forecast.
As I see it, the most disquieting development on the inflation front has not been the run-up in energy and commodity prices, but has been the apparent rise in inflation compensation over the next three years—at least as best as we can judge by readings from the inflation swaps market. Should a deterioration in inflation expectations eventually come to be reflected in wage- and price-setting decisions, you would be facing a more substantial, persistent, and ultimately costly acceleration of labor costs and prices. As we showed in an alternative simulation in the Greenbook, those difficulties are amplified if monetary policy is slow to respond to heightened inflation expectations, and real interest rates are inadvertently eased.
On the other hand, the most comforting development on the inflation front has been the continued exceptional performance of productivity. Although we have revised up our forecast for actual and structural productivity, we are still betting on a substantial slowdown of structural multifactor productivity. As we showed in another simulation, if that doesn’t occur, cost pressures could be considerably less than we are currently anticipating and inflation could drop to the low end of your comfort zone.
Karen will continue our presentation.