Thank you, Mr. Chairman. Earlier this morning we received new data on orders and shipments of durable goods, and we’ve distributed a single page chart that I’ll refer to in a moment as I review those data. I should also note at the outset that this single-page chart replaces one of the panels on page 5 of your chart show package, which was produced before we had the data. The top-line figure in this morning’s data release showed that new orders for total durable goods edged down 0.3 percent in May. As you know, within this aggregate we focus on the series for nondefense capital goods excluding aircraft to get a read on business equipment spending. Orders for this grouping of goods declined about ½ percent in May, and shipments were off a tad more. Although these numbers sound weak, they were actually a little better than we had expected and would cause us to nudge up our forecast for equipment and software purchases in the current quarter. In addition, as you can see from the chart we handed out, orders (the solid line) have moved above the level of shipments (the dashed line), providing some support for the moderate near-term increase in capital goods outlays that we have assumed for this projection.
Turning to your regular package of charts, the data I just reviewed plus the stronger defense spending that we reported last Friday lift our estimate of real GDP growth this quarter to 1¾ percent at an annual rate from the 1½ percent figure shown on line 1 of the table. We are projecting a marked step-up from this pace during the second half of the year, largely on the basis of the policy stimulus—both monetary and fiscal—now in train. This acceleration continues into 2004, when we expect real GDP to advance more than 5 percent. As you can see by comparing lines 1 and 2, the first half of this year turned out to be weaker than we had expected in January, and we now project a sharper acceleration going forward. We anticipate that much of this pickup initially will take the form of stronger household expenditures. As shown on line 3, the growth contribution from consumer outlays is projected to start moving up next quarter, as lower withholding rates and rebate checks begin showing through to spending. With household demand firming, the caution that has pervaded the business sector should gradually recede, boosting outlays on equipment and software (line 4) in 2004. We also expect a sizable growth contribution next year from inventory investment (line 5), as firms build stocks to accommodate the advance in final sales. The faster growth in 2004 reduces the unemployment rate (line 6) to 5.4 percent by year-end, the same level we had projected in January
The incoming data provide some faint signs of the anticipated transition to faster growth. As shown in the middle left panel, private payrolls were essentially flat in April and May, suggesting that labor demand may be turning a corner after declining for two years. Industrial production, not shown, edged up in May after recording sizable declines in March and April, and we are looking for a modest rise in June. This outlook is consistent with the indexes for new orders from the various purchasing managers’ surveys, which—as shown to the right—have moved up since April. Among the recent indicators of spending, real consumer outlays on goods other than motor vehicles bounced back in May, as indicated in the lower left panel, and appear on track to post a moderate gain for the quarter as a whole. As shown by the barbell in the lower right panel, the automakers’ forecasts of light motor vehicle sales in June are centered near the sales pace of recent months.
Although these data are still too mixed to conclude that activity is firming, we believe that the foundation is in place for a substantial pickup, as discussed in your next chart. An important part of that foundation is a heavy dose of fiscal stimulus, including the newly enacted tax law. As noted in the top panel, we had anticipated many provisions of the new law, including the pull-forward of cuts in marginal tax rates, marriage-penalty relief, and the boost in the child tax credit. But the law also contained provisions we hadn’t anticipated in the April Greenbook—notably, the dividend and capital gains tax cuts, an increase in the partial-expensing allowance for equipment investment, and some grants to state governments. Moreover, the personal tax reductions are occurring sooner than we had expected. Taking account of the new tax law plus the continuing effects of earlier tax cuts and the large increase in defense spending, we estimate that fiscal impetus at the federal level (shown by the black line in the middle left panel) will be very large this year and next. Indeed, the cumulative amount of stimulus now in train well exceeds that provided by the tax cuts and the defense buildup during the Reagan Administration. Only a small part of this stimulus is expected to be offset by restraint at the state and local level, shown by the red line.
Financial conditions are also conductive to growth—and have become more so since the last forecast round. Given the rally in stock and bond markets, we have revised up our assumed path for the Wilshire 5000 (the middle right panel) about 10 percent. We have also taken on board the substantial decline in a wide array of long-term interest rates, including the mortgage rate displayed in the bottom left panel. As shown to the right, we have incorporated the further depreciation of the dollar since the last Greenbook.
Your next chart takes a look at financial conditions in the household sector. On the whole, we think households are in good financial shape, though there are pockets of stress. As shown in the top left panel, the household bankruptcy rate has continued to rise, no doubt boosted by the still soft conditions in the labor market. However, the bankruptcy rate focuses on the worst tail of the distribution and does not tell us much about typical households. Broader measures of loan performance have been sending a more positive signal. As shown by the red line in the panel to the right, the delinquency rate on all household loans at commercial banks continued to trend down in the first quarter. At the same time, the delinquency rate on auto loans at finance companies (the black line) has ticked up but remains near the bottom of its range over the past decade.
Households have been restructuring the liability side of their balance sheets through another wave of mortgage refinancing. As shown by the red line in the middle left panel, the “coupon gap,” which measures the difference between current mortgage rates and the average rate on the stock of existing loans, is currently very wide, providing a strong impetus to refinancing activity. We estimate that “refi” volume (the black line) hit yet another record this month, with households extracting a sizable amount of cash through these transactions. Even though mortgage debt has been growing rapidly, the household debt service burden (shown to the right) has been edging down in recent quarters, owing to the decline in interest rates and the lengthening of loan maturities. Going forward, we expect debt burdens to lighten further, as income growth picks up and as households continue to refinance higher- cost debt.
Turning to the asset side of the household balance sheet, some observers have continued to raise concerns about the emergence of a housing price bubble. The lower panel shows that house prices, as measured by the repeat sales index for existing homes, indeed have been growing rapidly in real terms. While we would not entirely dismiss concerns about a bubble, we believe the price increases in recent years largely reflect solid fundamentals—most notably, the sharp reduction in mortgage interest rates. The rate of house-price appreciation has tapered off from its peak in 2001, and looking ahead, we expect the gains to slow quite a bit further. However, outright declines appear unlikely under our forecast of above-trend economic growth and only small increases in mortgage rates.
As shown in the top left panel of your next chart, businesses also have been taking advantage of the drop in long-term interest rates to improve their balance sheets. The corporate sector has been relying heavily on bond financing (the red bars) while paying down bank loans and commercial paper (the hollow bars). This substitution toward longer-maturity debt is now in its third year, and the cumulative effect can be seen in the panel to the right. The red line plots the aggregate ratio of current debt to assets for nonfinancial corporations, where current debt consists of short-term obligations plus the portion of long-term debt due within one year. As you can see, this ratio has fallen to the lowest level in more than a decade, even though the ratio of total debt to assets (the black line) has not changed much on net in recent years.
The combination of lower interest rates and the shift toward longer-maturity debt has reduced the debt service obligation for corporations, as indicated in the middle panel. We have defined this obligation as interest expense plus debt due within one year, expressed as a percent of after-tax cash flow. The debt service obligation for the median investment-grade firm (the black line) has now reversed its entire run-up between 1997 and 2000. For the median speculative-grade firm (the red line), the decline has been less pronounced but this series still has fallen to the lower part of its historical range. These trends are obviously good news about corporate financial positions.
At the same time, many companies are having to cover funding shortfalls in their defined-benefit pension plans. As noted in the bottom left panel, pension contributions by S&P 500 firms tripled in 2002, reaching $45 billion. Although this is a sizable figure, we doubt that the pension situation poses a major threat to the health of the corporate sector. For one thing, the funding gap is highly concentrated among investment-grade firms, which accounted for roughly 90 percent of all contributions last year. Moreover, even for these firms, last year’s pension contributions amounted to only a small part of their total cash flow—about 5 percent by our calculations. Overall, we believe that corporate financial positions have improved a fair bit, and financial markets evidently agree. As shown by the red line to the right, the spread between the yield on ten-year BBB-rated bonds and comparable maturity Treasuries has dropped sharply from its peak recorded last fall. In addition, as shown by the black line, a market-based measure of expected defaults over the coming year has moved lower as well.
Against this backdrop of stronger financial conditions, a key element of our projection is the outlook for business investment, addressed in your next chart. As I noted earlier, the data on nondefense capital goods through May painted a mildly encouraging picture about the demand for business equipment. In contrast, as the top right panel shows, nonresidential construction activity remained quite sluggish through April, our latest reading.
To gather more timely information about the investment outlook, we asked the Reserve Banks to query their business contacts on this topic. As noted in the middle panel, about 35 percent of the respondents plan to increase their capital spending over the next six to twelve months, somewhat outweighing the 20 percent that intend to reduce spending; the rest plan to leave their outlays about unchanged. These responses seem roughly consistent with our forecast of a moderate uptrend in nominal investment spending in coming quarters. Among the firms planning to boost their spending, about two-thirds said that they had already started to place the orders to achieve this increase. We also asked about the major factors driving the reported plans. Few respondents mentioned the cost or availability of external finance, and an equally small fraction cited the partial-expensing provisions as a reason to increase spending over the relatively short horizon on which we focused. Rather, the outlook for sales growth was the factor cited most often—both by firms that plan to increase outlays and by those that don’t. This focus on sales growth accords nicely with a standard accelerator model of investment.
The bottom panel characterizes our outlook for equipment and software spending, using the accelerator framework. This panel shows the historical relationship between the growth in real E&S spending (on the vertical axis) and the acceleration in business output (on the horizontal axis). As you can see from the red dots, spending in both 2001 and 2002 was below the regression line, and we expect 2003 to end up as another weak year. However, our projection for 2004 is considerably brighter. We expect the degree of business caution to fade, which should provide a substantial direct lift to spending and also make firms more willing to take advantage of the tax incentives and low financing costs now available. Karen will now continue our presentation.