Thank you, Mr. Chairman. Karen and I will attempt to be brief this morning. We suspect that this may be an occasion where we may have an easier time explaining our economic outlook to you than you will have figuring out how to explain your economic outlook to others. As a consequence, we intend to yield back the balance of our time to Vincent Reinhart.
In a nutshell, things have been going very well for the U.S. economy in recent weeks. The data have been coming in almost uniformly stronger than we had expected six weeks ago. The latest piece of news fitting that pattern was this morning’s release of the September report on new orders and shipments of nondefense capital goods. New orders outside of aircraft were up nearly 4 percent last month, after having been about flat in August. Shipments of nondefense capital goods excluding aircraft were up 2.5 percent in September, more than reversing the decline in August. The figures are a bit stronger than we had expected and would probably lead us to add about 1 percentage point to the projected growth of equipment spending in both the third and the fourth quarters, bringing the increases to 13 percent and 12 percent, respectively. However, the report also showed manufacturers’ durable inventories liquidating even faster than we expected.
On balance, the data that we have received since the close of the Greenbook would leave unaltered our estimate of the increase in real GDP in the third quarter of 6¼ percent at an annual rate, a figure nearly 2 percentage points above that in the September Greenbook. All of that upward revision reflects stronger readings on final sales, with notable positive innovations in consumption, housing, government outlays, and net exports. No doubt, some of the burst in spending last quarter was simply borrowed from the future. Most notable in that regard, we are interpreting some of the unexplained strength in consumption as reflecting a more rapid response than we had anticipated to this summer’s reduction in personal income taxes. As a consequence, we lowered our projected increase in real PCE in the fourth quarter to offset some of the third-quarter surprise.
But in other areas, the data appear to be signaling greater underlying strength in demand. Housing stands out as the most prominent example. Starts, permits, and sales have all been phenomenal of late. As a consequence, we marked up our forecast of residential investment across the projection period. Yesterday’s release on sales of new and existing homes for September certainly supports that decision. New home sales maintained their recent robust pace of about 1.15 million units; and existing sales clocked in at 6.7 million units, establishing yet another record for the series.
Netting areas of payback against those of greater momentum, we revised down the projected increase in real GDP in the fourth quarter by ¼ percentage point to just under 4½ percent. Needless to say, that is only a small offset to the sizable third- quarter surprise. This morning’s orders figures suggest that we may be undoing even that small downward revision. When coupled with some slight further upward revision to growth in 2004 and 2005—largely reflecting the weaker exchange value of the dollar in this forecast—these revisions imply a level of real GDP about ½ percent above that in the September Greenbook throughout the projection period.
That said, I see the changes that we have made to this projection as largely being ones of degree. The basic forces that we had earlier expected to be at work in the economy now appear to be showing through in the data. Low interest rates and a surge of disposable income generated by tax cuts have provided a powerful stimulus to household spending, especially on durable goods and housing. Moreover, low interest rates, together with a waning aversion to risk, sharp gains in corporate profitability, rising sales, and the partial-expensing tax provisions appear to be creating a considerably more hospitable climate for business investment. While the pattern has been choppy, outlays for defense have also been providing a sizable boost to activity in recent months.
Perhaps even more encouraging, some of the areas that gave us, and probably many of you, greatest pause about our forecast in mid-September have shown some tentative signs of improvement in recent weeks. Industrial production has firmed a bit of late, with notable strength in the production of high-tech goods, especially computers and semiconductors. The national and regional purchasing managers’ indexes suggest that further increases are in train this month. There are also signs of a nascent recovery in labor markets. Private payrolls expanded by 72,000 in September, and the July and August figures were revised to show smaller declines. Initial claims have been averaging close to 390,000 this month, and insured unemployment has moved lower—suggesting that layoffs may have abated some and that hiring may be turning the corner.
Could the surprising strength of such a broad array of economic indicators be signaling the start of an even more vigorous expansion than we are projecting? The answer, of course, is “yes.” Much of the strength in private spending has been in interest-sensitive areas such as autos, other consumer durables, housing, and capital equipment. It is certainly conceivable that we are underestimating the potency of zero real interest rates. The recent weakening of the dollar might be another indication that the current stance of policy is delivering greater stimulus to activity than we have been projecting. Another explanation for the recent pickup in activity could be that business caution is in the process of fading. As you know, we expect the unusual restraint on business spending and hiring to have largely dissipated by the middle of next year. If business sentiment were to improve more rapidly than we are anticipating, the accompanying step-up in the pace of hiring, capital spending, and inventory investment could make the next few quarters look a lot more like a normal business cycle recovery than we currently expect.
I must admit that, in preparing this briefing, I was struck by how often I was struggling to find synonyms for strength. Over the past three years, I had developed a reasonably complete list of substitutes for weakness. But lest you fear that we have fallen prey to the sin of conviction concerning our forecast of sustained expansion, let me assure you that we remain capable of conjuring dark thoughts about the outlook. Indeed, there are still some very palpable downside risks to our forecast.
For one, neither we nor anyone else should have much confidence in an ability to parse out the effects of this summer’s drop in personal tax rates and the issuance of rebate checks on the time profile of consumer spending. Our calculations rely more on judicious assumption than on hard empirical evidence, so the uncertainty surrounding these estimates is large. Maybe the recent strength in consumer spending has been mainly the consequence of the tax cuts and, because we have experienced little or no growth in labor income, spending will shortly peter out. Some circumstantial evidence could be seen as supporting this hypothesis. Chain store sales—an admittedly poor predictor of broader consumer spending—have dropped back in recent weeks after popping up this summer, and the reports that we hear from the automakers are that sales have dropped from spectacular to merely good in recent weeks.
It is also possible that some of the strength in business spending will prove to be transitory. Before the war began in March, one of the explanations for the so-called soft patch was that, given the enormous uncertainties, businesses were putting capital spending projects on hold. Maybe the noticeable upturn in orders since the spring is a temporary bulge that reflects the implementation of those previously deferred decisions rather than an acceleration in the underlying demand for capital equipment. Such a possibility might square with the limited and guarded guidance that companies have provided for revenues and profits going forward, despite the spectacular gains many have experienced recently.
There are also ample reasons to discount the available signs of improvement in the labor market. We have seen similar periods of false hope over the past couple of years. Private payrolls improved a year ago, only to fall back most of this year. Moreover, both initial claims and insured unemployment dropped to levels comparable to those we are currently observing on three other occasions during the past three years. Obviously, none of those occurrences ultimately proved a precursor to sustained expansion.
False positives were not just a feature of the labor market data. The purchasing managers’ indexes showed improvement similar to that seen recently in early 2002, and industrial production posted a brief period of increase in the middle of that year. With investors apparently pricing in substantial odds that a more vigorous expansion is under way, any perceptible disappointment on that front could feed back negatively through financial markets onto the real economy. That would put at risk our forecast that output will grow rapidly enough to make a dent in the current margin of underutilized capacity.
We have taken some comfort from the greater synchronicity of the positive signals in the current episode relative to those earlier false starts. Moreover, unlike 2002, the pickup in activity to date has been driven by a strengthening of private final demands, which are now increasing more rapidly than at any time since the late 1990s. Still, we will need to see more evidence before we can confidently confirm the sustained above-trend expansion that we have been predicting.
In contrast to the many surprises in the spending and production data, price developments have been unfolding pretty much as we had expected. We continue to believe that the economy has the capacity to grow rapidly over the next two years without putting upward pressure on inflation. Slack in resource utilization diminishes only slowly in our forecast, with the unemployment rate expected to decline to 5½ percent by the end of 2004 and to 5 percent by the end of 2005. Likewise, manufacturing capacity utilization rises from its current level of around 73 percent to only 78 percent at the close of 2004 and just above 80 percent by the end of 2005. In short, available capacity combined with continued strong gains in structural labor productivity should keep a lid on cost pressures. Meanwhile, there have been few signs that inflation expectations have deteriorated in any material manner, and given our benign outlook for prices, we think the odds are low that expectations will become unglued over the next two years. However, as we noted in yesterday’s Board presentation, the confidence band around our forecast for core inflation is quite wide. And the uncertainty surrounding that forecast has more to do with unaccounted-for shocks than it does with our uncertainty about the strength or weakness of the economy over the next two years. Those results imply both that we will almost surely be wrong and that we probably won’t be able to offer you with any confidence good explanations as to why. Karen Johnson will now continue our presentation.