[Economic Report of the President (1996)]
[Administration of William J. Clinton]
[Online through the Government Publishing Office, www.gpo.gov]

[DOCID: f:erp_c2._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 104-161
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]

CHAPTER 2

Macroeconomic Policy and Performance

ECONOMIC PERFORMANCE DURING the past 3 years has been exceptional.
The economy has grown fast enough to create nearly 8 million new jobs
and reduce the unemployment rate sharply. Long-term interest rates have
declined and remain relatively low. And inflation, at its lowest average
level since the Kennedy Administration, is no longer the factor it once
was in economic decisions. This strong performance has been helped by
macroeconomic policies conducive to sustainable economic expansion.
A major part of this Administration's macroeconomic strategy has
been its effort to reduce the Federal budget deficit. Reducing the
deficit is important because government borrowing to finance budget
deficits raises real interest rates, crowding out business investment
that is vital for raising productivity and economic growth. And to the
extent that budget deficits spill over into current account deficits,
they lead to a transfer of national wealth abroad.
But reducing the deficit is not an end in itself. Rather, it is a
way to create economic conditions favorable to this Administration's
ultimate goal of raising economic growth and thus the standard of living
of all Americans. Once we recognize that deficit reduction is a means to
achieving higher living standards, it becomes apparent that how we
reduce the deficit is important. This Administration has supported
responsible deficit reduction that preserves and enhances investments in
people, businesses, and the environment.
Thus far during the Administration's tenure, the reduction in the
Federal budget deficit has been impressive. For the first time since the
Truman Administration the deficit has declined for 3 years in a row. The
deficit for the past 2 calendar years has been less than the interest
paid on the national debt, so that, except for interest payments, the
budget has been in surplus. And the structural budget deficit--the
deficit adjusted for the effects of the business cycle--has declined
since 1993. This reflects a sharp break with the failed attempts to
reduce the budget deficit during the 1980s. The commitment to balance
the budget over the next 7 years represents a continuation of efforts to
get the government's fiscal house in order.
This chapter first considers the role the government plays in
setting macroeconomic policy. It next reviews macroeconomic developments
during 1995 and argues that all signs point to the current expansion
continuing into the foreseeable future. The chapter then considers the
effects on the economy and the implications for monetary policy of the
move to a balanced budget over the next 7 years. The chapter ends with a
brief analysis of the outlook for the economy and presents the
Administration's forecast for the 1996-2002 period.

THE TWIN ROLES OF MACROECONOMIC POLICY

Since the end of World War II, the Federal Government has played an
important role in stabilizing fluctuations in the economy in the short
run and in fostering a climate for maximum economic growth with low
unemployment over the long run.
The government supports sound macroeconomic performance in two broad
ways. First, its macroeconomic policies cushion the economy from the
short-term ups and downs of the business cycle, helping to keep economic
expansions from faltering. Both monetary policy and fiscal policy are
important elements of these short-run stabilization efforts. Monetary
policy stabilizes the economy through the adjustment of credit
conditions, as reflected in interest rates and credit availability.
Fiscal policy, in principle, can use changes in discretionary spending
or the tax code to stabilize the economy, but in practice the time lags
involved in legislating and implementing such changes tend to reduce
their usefulness. Furthermore, in present circumstances, the commitment
to eliminate the budget deficit limits any potential for using
discretionary fiscal policy. As a result, the ability of fiscal policy
to dampen economic fluctuations depends largely on its role as an
``automatic stabilizer'' whereby outlays and tax revenues change in a
way that reduces the amplitude of the business cycle.
Second, the government's macroeconomic policies help lay the
groundwork for the private sector to generate long-term growth with low
unemployment. Policies that encourage businesses to invest can raise
productivity, increasing the economy's potential output. As discussed
below, the Administration's success at bringing down the deficit has
helped redress the investment shortfall that developed during the 1980s.
As the budget moves toward balance over the next 7 years and the
government reduces its drain on national saving, real interest rates
should fall and investment and growth should rise. Box 2-1 discusses how
microeconomic policies designed to address market failures also can
enhance long-run macroeconomic performance.

Box 2-1.--Microeconomic Policies Can Improve Long-Run Macroeconomic
Performance

Microeconomic policies can reinforce macroeconomic policies.
Policies that support research and development, along with policies that
encourage education and training, complement increased capital
investment in raising potential output. Indeed, as noted elsewhere in
this Report, public expenditures on research and development are
complementary to private expenditures, so that these expenditures can
actually induce increased private investments. Targeted tax policies--
such as the research and experimentation tax credit and the targeted
capital gains tax cut for small and emerging businesses included in the
Administration's 1993 budget--can encourage research and development
expenditures and increase the flow of capital to new enterprises.
Other microeconomic policies designed to make the labor market
work more efficiently--such as training programs, the school-to-work
program, and, more broadly, the Administration's reemployment policies--
can help reduce frictional unemployment (unemployment caused by workers
moving from job to job) and thereby lower the rate of unemployment
associated with stable inflation. Accordingly, microeconomic policies
have payoffs in terms of macroeconomic performance.
These twin roles are often complementary. For instance,
macroeconomic policies that keep the economy on an even keel in the
short run can also spur the economy's growth in the long run by creating
an environment in which businesses and individuals are more certain
about the future. Freed from having to worry about how to insulate
themselves from short-term economic fluctuations, businesses and
individuals can plan for the long term. They are thus more likely to
make the investments that lead to increased productivity and higher
output.

IMPLICATIONS OF THE POLICY MIX

In pursuing these goals of short-run macroeconomic stabilization and
long-run maximum growth, fiscal and monetary policy need to act in
concert. Monetary policy must reflect changes in aggregate demand
relative to the economy's potential output. For example, a shift to a
more expansionary fiscal policy when the economy already is operating at
full employment and full capacity would require monetary policy to
offset the effects of the fiscal expansion. Should it fail to do so, the
prospect of an overheated economy and rising inflation is likely to
trigger an increase in long-term interest rates, as financial markets
react to the change in the economic outlook. In either case, the shift
in fiscal policy will be met with a financial market response that
generally cushions its effects on aggregate demand. But without
deliberate monetary tightening, changes in interest rates may not be
sufficient to stem a rise in inflation.
Although monetary policy can offset the effects on aggregate demand
from a shift in fiscal policy, changes in the mix of fiscal and monetary
policies will invariably alter the composition of output and its
potential level in the long run. During the early 1980s, changes in
fiscal policy put the country on a path to large and rising budget
deficits (over and above what would have been expected given the
cyclical weakness of the economy) and left the Federal Reserve little
choice but to restrain the overheating economy by further tightening
monetary policy.
The high real interest rates that resulted from the burgeoning
deficits and tight money of the early 1980s were in large part
responsible for skewing the composition of output away from fixed
investment. Private fixed investment as a share of gross domestic
product (GDP) fell from over 18 percent in 1979 to under 15 percent by
1989 (to compare 2 years when the economy was operating close to
capacity). The relative decline in private fixed investment net of
depreciation was even sharper, from about 8 percent to about 5 percent
of GDP. At the same time, personal consumption expenditures increased as
a share of GDP from 62 percent in 1979 to 66 percent in 1989. The
effects on investment of the increase in the budget deficit likely would
have been somewhat less marked if private saving over this period had
risen so as to offset the decline in public saving. But instead both
personal and business saving as a share of GDP fell over the 1980s,
exacerbating the effects of deficits on interest rates and thus on
investment.
High real interest rates during the early 1980s also contributed to
a sharp rise in the value of the dollar as foreign investors, attracted
by high yields, bought dollar-denominated assets. The appreciation of
the dollar in turn caused a rapid swing of the current account balance
into substantial deficit. Growing current account deficits quickly
transformed the United States from the world's largest creditor country
into the world's largest debtor by the late 1980s. Although access to
foreign capital moderated the rise in interest rates and the decline in
investment, the resulting buildup in our international indebtedness
required that a portion of the economy's output be used to service the
foreign debt. In addition, the appreciation of the dollar, combined with
the decline in investment's share of output, had strong adverse effects
on U.S. international competitiveness.
Today, with this Administration committed to eliminating the budget
deficit--and with substantial deficit reduction already achieved over
the past 3 years--the environment is vastly different from that of the
1980s. The imbalances that resulted from the fiscal extremism of that
decade can now be corrected. In contrast with earlier policies that
raised interest rates, restrained investment, and impeded our
international competitiveness, our progress in reducing the budget
deficit has lowered interest rates, increased investment, and improved
our competitiveness. As discussed later in this chapter, further deficit
reduction over the next several years quite possibly will require
monetary policy once again to stabilize short-run movements in the
economy, this time to prevent a tightening fiscal stance from pushing
the economy's growth rate below its potential. Such an accommodative
stance of monetary policy should, in concert with deficit reduction,
further enhance the climate for private investment and ensure that the
economy remains on a healthier growth path over the long term.

OVERVIEW OF 1995:
RETURNING TO POTENTIAL GROWTH

Economic growth decelerated considerably in the first half of 1995
before regaining momentum in the third quarter. Some moderation in
growth was anticipated because the robust expansion of the preceding 2
years had greatly reduced the slack in the economy. Between January 1993
and December 1994, the civilian unemployment rate fell from 7.1 to 5.4
percent, and capacity utilization in the industrial sector rose from
81.3 to 85.1 percent. Even after accounting for the economy's tightening
capacity constraints, however, the moderation in growth was greater than
expected. Following the rebound in the third quarter, evidence suggested
that the economy was once again growing at its potential rate. This
moderate pace of growth was fully reflected in the path of the
unemployment rate, which, after falling by more than a percentage point
over the course of 1994, remained virtually unchanged during 1995.
The moderate growth and reduced pace of job creation during 1995
were evidence that the economy had entered a new phase: it had moved
from recovery following the 1990-91 recession to sustained growth. Thus,
with the economy operating near full capacity by late 1994,
significantly higher growth in the short term probably could not have
been accommodated without a rise in inflation. The increase in short-
term interest rates over the course of 1994 and early 1995 represented
an attempt to restrain demand pressures and hold growth close to its
long-run potential.

EXPLAINING THE MODERATION IN GROWTH DURING THE FIRST HALF OF 1995

The moderation in economic growth during the first half of 1995 was
to a large degree the consequence of the rise in interest rates during
1994 and, to a lesser extent, the result of the crisis in Mexico that
began in December 1994. Higher interest rates caused a weakening in
interest-sensitive spending and an associated buildup in inventory that
led producers to restrain output. The economic crisis in Mexico induced
a sharp deterioration in the U.S.-Mexico trade balance, further
moderating growth.
At the beginning of 1994, and increasingly over the course of the
year, many observers believed that the slack in the economy that had
emerged during the recession of 1990-91 had disappeared. As already
noted, this led to concern that continued growth at anywhere near the
heated pace of 1993 would lead to an increase in inflation. These
concerns were evident in rising yields on long-maturity bonds beginning
late in 1993 and continuing through most of 1994. The Federal Reserve
responded by raising the Federal funds rate by 3 percentage points
between February 1994 and February 1995.
Despite these rate increases, the economy continued to grow at a
rapid pace through the end of 1994, while the unemployment rate dropped
another three-quarters of a percentage point in the last half of the
year. Housing starts, one of the more interest-sensitive indicators, did
not peak until December 1994. Similarly, motor vehicle sales continued
at a rapid pace through year's end, and, anticipating continued
strength, automakers boosted production in the first quarter of 1995.
Higher interest rates did not affect economic growth until the
beginning of 1995, and then their impact was reinforced by the economic
crisis in Mexico. The slackening economy was evident as housing starts
dropped in the first 3 months of the year. Although housing activity
stabilized and then moved higher over the balance of 1995, the fall in
starts translated into declines in residential investment during both
the first and the second quarter. Motor vehicle sales also weakened,
resulting in a buildup of inventory that reached uncomfortable levels by
the end of the first quarter. In response, automakers cut production
sharply in the second quarter, restraining GDP growth by almost 1
percentage point at an annual rate.
The magnitude of the moderation during the first half of the year
seems clear in retrospect but was harder to read at the time. The
advance estimate of first-quarter GDP showed a 2.1 percent (chain-
weighted) annual rate of growth--a decline from the pace of 1994, but
not a dramatic one. First-quarter growth was not revised down to its
current estimate of a 0.6 percent annual rate until the benchmark
revisions of January 1996. (Box 2-2 presents an overview of the recently
released benchmark revisions of the national income and product
accounts.) Although scattered indications of weakness, such as the
declines in motor vehicle sales and housing starts, were beginning to
accumulate early in the year, the first solid evidence was the May
employment report (published in June), which showed the first
substantial drop in payroll employment in over 3 years.
Partly as a result of the moderation in growth, interest rates fell
steadily throughout the year. In response, the housing and automobile
sectors retraced much of their decline during the second half of 1995.
By the end of the third quarter, reduced automobile production and a
pickup in sales had worked off much of the inventory overhang. Home
sales and housing starts also had returned to stronger levels.
A review of economic performance sector by sector provides a more
detailed picture of the economy as the expansion continued during 1995.

CONSUMPTION EXPENDITURES

During the first quarter of 1995, consumption expenditures grew by
0.8 percent at an annual rate, after averaging 3.0 percent during 1994.
The drop in spending growth was concentrated in durable goods, which
fell by nearly 9 percent at an annual rate, with weakening demand for
automobiles fueling the decline. Higher interest rates, as discussed
above, are likely to have been the primary reason for the retrenchment
by consumers. Spending on durables recovered sharply in the second and
third quarters, offsetting some weakening in spending on nondurable
goods and pushing overall consumption growth back to a solid pace of
about 3 percent at an annual rate for the second and third quarters of
1995.
As the year progressed, households continued to take on debt at a
rapid rate, raising concerns that they might soon have to reduce their
spending in order to meet debt obligations. Rising delinquency rates on
consumer loans, especially credit card lending, suggested that an
increasing number of households were encountering difficulties managing
their debts. Household debt (consumer and mortgage debt) grew faster
than disposable personal income, continuing the pattern of the past
several years. The burden of this debt, as measured by debt service as a
share of disposable personal income, also rose during the year, although
it remained below the value reached during the late 1980s. The rise in
the debt-service ratio during 1995 occurred despite a general decline in
interest rates over the year, and reflected mainly the sharp rise in the
overall debt level. As debt contracts are adjusted or renewed, however,
the recent decline in interest rates should moderate the rise in debt
service. Furthermore, consumption expenditures in the long term

Box 2-2.--The Comprehensive Revision of the National Income and Product
Accounts

Early in 1996, the Bureau of Economic Analysis released new
estimates of the national income and product accounts. These
comprehensive revisions have been done about once every 5 years and
incorporate definitional changes, statistical changes, and updated
source data in an effort to portray the evolving U.S. economy more
accurately. The latest revision incorporates three major improvements:
  Measures of real output and prices are estimated using
``chained dollars,'' which more accurately account for the
shifting mix of products purchased and sold in the economy (see
Economic Report of the President 1995 for a detailed discussion
of chain-weighted GDP).
 Government investment is estimated separately from
government consumption expenditures, allowing a more accurate
description of government activities and improving the overall
measurement of gross investment and national saving.
 Depreciation of fixed capital is estimated using a new
methodology that better reflects the service lives of different
types of assets.
 The revised estimates of real GDP show average annual
growth of 3.2 percent over the period 1959 to 1994, 0.2
percentage point higher than had previously been reported using
fixed (1987) weights. Between 1959 and 1987 growth averaged 3.4
percent per year, 0.3 percentage point higher than reported
earlier, whereas between 1987 and 1994 it averaged 2.3 percent,
0.1 percentage point lower than reported earlier. Most of the
change in growth rates for real GDP, as well as that of its
components, is attributable to the shift from fixed weights to
chain weights. Boxes 2-3 and 2-6 discuss other aspects of the
revised data.
are related to overall net worth as well as to consumer indebtedness.
Hence the stock market gain of over 30 percent during 1995 should help
sustain consumer spending into 1996.

BUSINESS FIXED INVESTMENT

Business fixed investment grew solidly during the first three
quarters of 1995. The growth rate of business equipment investment fell
back only slightly from its torrid pace in 1994 and was sustained by
rapid investment in computers, which grew even faster during the first
three quarters of 1995 than in 1994. Investment in structures continued
its recovery from the recession of 1990-91, and grew almost as fast as
equipment investment in 1995 (Chart 2-1). The extremely slow recovery of
structures investment following the recession appears to have been due
in part to the oversupply of office buildings and retail space that
characterized the runup and subsequent collapse of the real estate
market during the late 1980s and early 1990s. The vacancy rate for
office space has fallen for 3 years and is now at its lowest point in 8
years.



It has long been recognized that reported measures of gross
investment for the U.S. economy understate actual gross investment
because government investment in equipment and structures has always
been treated in the same fashion as government consumption, with both
reported together as government purchases. The recently revised national
income and product accounts now report government investment separately
from government consumption and thus provide a more complete view of
investment in the economy (Box 2-3).

INVENTORIES

The buildup of excess inventories during the first quarter of 1995
led some producers to cut back output in the second quarter so as

Box 2-3.--New Measures of Government Investment

The Bureau of Economic Analysis now measures government
expenditures for equipment and structures as investment, similar to the
treatment of such expenditures by the private sector. Previously,
government expenditures for fixed assets were considered to be ``current
account'' purchases. This treatment understated gross investment and
saving for the economy and ignored the service flow (or ``output'') of
these assets over their lifetimes. The new approach is more consistent
with international standards and will permit more accurate comparison of
U.S. data with those of other countries.
The new treatment of government investment has three important
effects. First, it increases the share of GDP accounted for by gross
investment expenditures. Second, it reduces the government deficit
measured on a current account basis and thus increases measured saving
of the public sector. Because of these effects, gross domestic
investment and national saving as a share of GDP each are reported about
3 percentage points higher compared with the earlier approach, to 18
percent and 15 percent, respectively, over the period 1970 to 1995.
Finally, the new approach partly accounts for services provided by the
government capital stock and thus raises the measured output of the
government sector and the economy. For recent years, GDP is about 1.8
percent higher, due to the service flow of the government capital stock.
A rough way of measuring the importance of government investment
is to compare it to total investment. Between 1959 and 1994, total
government investment as a share of private nonresidential fixed
investment plus government investment fluctuated between 20 and 40
percent, while government nondefense investment varied between 14 and 23
percent. Thus, even leaving aside investment for defense purposes, the
earlier approach to measuring the economy's fixed investment
misclassified a significant portion of spending aimed at augmenting and
maintaining the Nation's productive capacity.
The new approach does not measure government investment in human
capital or the environment. Investments in education or a cleaner
environment are hard to measure, but also yield returns over time just
as certain as those from investments in highways and office buildings.
to reduce inventories relative to sales. Producers continued to pare
inventories, especially in the automotive sector, during the third
quarter. By late in the year much of the earlier overhang had been
worked off. By year's end, however, automobile industry data showed the
inventory-to-sales ratio moving back up, although it remained below the
levels reached earlier in the year.

RESIDENTIAL INVESTMENT

As alluded to above, a decline in residential investment during the
first half of the year was a major factor in slowing the rate of
economic growth. The rise in mortgage interest rates in 1994 had a
lagged effect on the housing market, which began to lose its footing in
early 1995 as housing starts and home sales both fell during the first
quarter. Residential investment, which had shown hints of weakness
toward the end of 1994, declined abruptly during the first half of 1995.
By June, however, declining mortgage rates had revived the housing
sector, as both starts and sales regained some ground. The improvement
held firm over the summer and was reflected in a bounceback in
residential investment during the third quarter.

NET EXPORTS

After declining during the last quarter of 1994, the net export
deficit (imports minus exports of goods and services) rose sharply
during the first half of 1995. The rise was due in part to the severe
contraction of the Mexican economy that began at the end of 1994
following the peso crisis, and which resulted in a sharp fall in U.S.
exports to Mexico. The U.S. merchandise trade balance with Mexico
deteriorated from a surplus of about $1 billion in 1994 to a deficit
over the first half of the year of about $8 billion.
By the latter part of the year, however, other factors, notably
strong U.S. competitiveness and the lagged effects of earlier movements
in exchange rates reestablished the trend toward a shrinking external
deficit (see Chapter 8 for further discussion of exchange rates and the
current account balance). By the third quarter, exports of goods and
services were once again growing briskly, outpacing a slowing rate of
growth for imports of goods and services. As a result, net exports
contributed importantly to growth during the third quarter.

INFLATION

Inflation remained remarkably low and stable during 1995 (Table 2-
1). The consumer price index (CPI) increased by 2.5 percent over the 12
months of 1995--down 0.2 percentage point from its year-earlier pace.
Inflation as measured by the CPI has now run at less than 3 percent per
year for the past 4 years, for the first time since the 1960s. This
impressive record suggests that a regime change has taken place, whereby
households and businesses have come to expect low inflation for the
foreseeable future.

Table 2-1.--Measures of Inflation
------------------------------------------------------------------------
Measure                          1994       1995
------------------------------------------------------------------------
.........
Percent change

---------------------
GDP chain-type price index........................        2.3    \1\ 2.7

Non-oil import prices.............................        3.8        2.3

CPI-U:
All items.......................................        2.7        2.5
All items less food and energy..................        2.6        3.0

PPI:
Finished goods..................................        1.7        2.2
Finished goods less food and energy.............        1.6        2.5
Intermediate materials less food and energy.....        5.2        3.1
Crude materials.................................        -.5        4.1

Employment cost index: \2\
Total compensation..............................        3.3        2.6
Wages and salaries............................        2.9        2.8
Benefits......................................        4.0        2.1
------------------------------------------------------------------------
\1\Preliminary.
\2\For private industry workers.
Note.--Inflation as measured by the GDP price index and the employment
cost index is computed from third quarter to third quarter; by non-oil
import prices, from November to November; and by the CPI-U and PPI,
from December to December.

Sources: Department of Commerce and Department of Labor.

The increase in the CPI during 1995 was held down by a decline in
energy prices and a slowing in the rise of food prices, which increased
almost a percentage point less than a year earlier. Core inflation, as
measured by the CPI excluding food and energy, increased at a 3.0
percent annual rate over the 12 months of 1995, up 0.4 percentage point
from the year-earlier rate. Inflation seemed to be proceeding at a
faster pace during the first 5 months of the year but eased off
thereafter. The early runup and the subsequent moderation largely
reflected the pattern of used car prices, airfares, and automobile
finance charges.
Hourly compensation in the private sector, as measured by the
employment cost index, increased 2.6 percent in the year ending in the
third quarter, versus a 3.3 percent increase during the year-earlier
period. A slowdown in benefit costs--especially for health insurance and
retirement programs--accounted for almost all of the deceleration. The
increase in wages and salaries, in contrast, was little changed from its
year-earlier pace. Overall, the evidence suggested an absence of any
wage pressures as the expansion continued. The absence of significant
acceleration in inflation, either for prices or for wages, especially as
the unemployment rate remained around 5.6 percent for the year, led some
observers to suggest that the unemployment rate consistent with stable
inflation had fallen (Box 2-4). A possible decline in the sustainable
unemployment rate raises important challenges for macroeconomic
policymaking (Box 2-5).

Box 2-4.--Has the Sustainable Rate of Unemployment Fallen?

As the economic expansion continued during 1995, and unemployment
remained well below 6 percent without sparking a rise in inflation, some
economists suggested that the minimum sustainable unemployment rate or
so-called NAIRU (Non-Accelerating-Inflation Rate of Unemployment) has
declined.
During the 1980s, the core rate of inflation increased when the
unemployment rate was below 6 percent and decreased when it was above 6
percent (Chart 2-2). In contrast, for over a year now the unemployment
rate has fluctuated narrowly around 5.6 percent, yet the core rate of
inflation has remained roughly stable rather than risen. (Wage
inflation, as measured by the employment cost index, also has remained
stable.) This recent evidence strongly argues that the sustainable rate
of unemployment has fallen below 6 percent, perhaps to the range of 5.5
to 5.7 percent. The Administration's forecast falls on the conservative
end of this range by projecting the unemployment rate at 5.7 percent
over the near term.
Explanations for why the sustainable rate of unemployment may have
fallen generally focus on structural changes in the U.S. economy that
may have restrained increases in wages and prices. For example,
increased domestic and international competition, a decline in
unionization, and increased concern about job security are possible
reasons why, at current levels of unemployment, wage and price pressures
have been so subdued. In addition, since the sustainable unemployment
rate is related to frictional unemployment, and since such job mobility
is high among young workers, the recent fall in the labor-force share of
young workers may have contributed to the possible decline in the
sustainable rate, just as the increase in young workers during the 1970s
contributed to its rise.

EMPLOYMENT AND PRODUCTIVITY

During 1995, the economy managed to create enough jobs not only to
replace those lost as a result of corporate restructuring and
downsizing, but also to provide employment for new entrants. As a
result, the unemployment rate remained roughly constant.
A deceleration in the pace of job creation accompanied the economy's
move from economic recovery to sustained economic expansion. Growth in
payroll employment dropped to 146,000 per month



in 1995--down from 294,000 per month a year earlier. Coming on the heels
of a strong fourth quarter of 1994, job gains remained solid in the
first quarter, slowed in the second, and then averaged 138,000 per month
during the third and fourth quarters. The moderate pace of job growth in
the second half is about what can be expected as the economy grows at
its potential rate.
Official statistics show that 7.7 million jobs have been created
since this Administration took office, but the best estimate is
considerably stronger. Analysis of forthcoming revisions to estimates of
payroll employment indicates that the job gains between March 1994 and
March 1995 were stronger than currently estimated. As a result, after
the revisions are announced this June, measured job growth through the
end of 1995 should exceed 8 million. Over 50 percent of job growth in
the private sector during 1995 occurred in ``high wage'' industries--
those with an average wage above an employment-weighted median for all
industries in 1993. For the past 3 years, the share of employment growth
concentrated in these industries has continually risen.
The unemployment rate fluctuated in a narrow band around 5.6 percent
during 1995, as increases in the number of jobs fully absorbed increases
in the labor force. The growth rate of the labor force from 1994 to 1995
differed little from the growth rate of the population--a pattern that
has persisted since 1989. Over this pe-

Box 2-5. Macroeconomic Policy and the Sustainable Unemployment Rate

A controversial issue in macroeconomic policy is whether the
benefits from further reducing the unemployment rate when the economy is
operating near full capacity outweigh the costs of possibly increasing
the inflation rate. This controversy centers on how the sacrifice ratio
(the change in unemployment associated with a given change in inflation)
varies as inflation is reduced or increased. For example, in terms of
output and unemployment, is the loss from reducing inflation by 1
percentage greater than the benefit from increasing inflation by 1
percentage?
The view that the unemployment rate must change by more when
inflation is reduced than when it is increased, and the related view
that a small increase in inflation may spark runaway inflation, have
been used as a basis for cautious policy. For instance, some economists
urge waiting until the evidence is overwhelming that the sustainable
rate of unemployment has fallen before allowing an additional decline in
the actual unemployment rate. The argument is that the cost of returning
to the initial low rate of inflation if the sustainable rate has not
changed vastly outweighs the benefit of learning whether it has in fact
changed.
Much empirical work suggests, however, that for small changes,
increases and decreases in inflation exhibit the same sacrifice ratio.
And, small increases in inflation historically have not triggered
runaway inflation. Thus, if policymakers reduced unemployment in the
belief that the sustainable rate had fallen but were wrong and inflation
increased, inflation is unlikely to ``take off,'' and the cost of
returning inflation to its earlier level would roughly equal the benefit
of having temporarily lowered the unemployment rate. The gain, of
course, if policymakers were right and the sustainable rate had fallen
would be lower unemployment with unchanged inflation.
Furthermore, the sustainable rate itself is determined, in part,
by institutional arrangements that result from the overall economic
environment. As the economy gradually moves to lower inflation,
arrangements that tend to amplify wage and price movements, such as
cost-of-living clauses, become less common. In such an environment,
gradual reductions in the unemployment rate that cause little change in
inflation can actually reinforce market participants' views that the
sustainable rate has fallen.
riod the labor force participation rate has remained virtually flat, in
sharp contrast to rising participation rates during the 1970s and 1980s
(Chart 2-3). Because the participation rate is cyclical, rising toward
the end of an expansion, one might have expected the earlier trend to
reassert itself as the current expansion matured. Instead, the stagnant
participation rate has been one of the more enduring features of this
expansion.



The stalling of the rise in the overall labor force participation
rate is due mainly to a deceleration in the participation rate for
women; the participation rate for men has fallen no faster than in
earlier years. The flattening out of the female participation rate is
probably the result of long-term demographic trends. As Chart 2-4 shows,
the ratio of children per woman aged 20 to 54 fell between the late
1960s and the early 1980s, echoing the earlier pattern in the birth
rate. The decline in this ratio allowed an increasing fraction of women
to enter the labor force between the mid-1970s and mid-1980s, but its
subsequent flattening in the late 1980s has limited further increases in
participation.
While the increase in the overall labor force participation rate has
slowed since the late 1980s, productivity growth appears to be little
changed. Labor productivity has grown at an estimated 1.1 percent annual
rate since the last business cycle peak in the second




quarter of 1990, about the same as the trend rate during the entire
post-1973 period (Chart 2-5). The figures discussed here are new
estimates of productivity using the recently revised GDP data. See Box
2-6 for details about these estimates and Box 2-7 for a discussion of
the relationship between productivity and real wages.
Table 2-2 shows the relative contributions of productivity and labor
force growth to output growth, both over the past few decades and as
projected for the next several years. In the past, the relative
importance of these determinants of long-run growth have varied
substantially across time periods. During the 1960-73 period, output
growth was fueled by a rapid increase in both the working-age population
and productivity. Productivity growth slowed dramatically after 1973,
but was partially offset in the mid- and late 1970s by an increasing
rate of labor force participation. From 1981 to 1995, the growth rate of
the working-age population slowed dramatically, but was countered by
stabilization in the length of the workweek and other factors. The
Administration forecast of 2.3 percent average GDP growth for the next 7
years reflects projections of 1.2 percent average growth in productivity
and 1.1 percent average growth in the labor force. Measured productivity
is expected to grow a bit faster than in the recent past as further
deficit reduction boosts investment, and planned adjustments to the CPI,
which affect productivity measures, are implemented.

Table 2-2.--Accounting for Growth in Real GDP, 1960-2002
[Average annual percent change]
------------------------------------------------------------------------
1960 II    1973 IV    1981 III
Item               to  1973   to  1981   to  1995   1995 III
IV        III        III      to  2002
------------------------------------------------------------------------

1) Civilian
2) PLUS:   Civilian labor
force participation rate
\1\........................         .2         .5         .3         .1

3) EQUALS: Civilian labor
force \1\..................        2.0        2.4        1.4        1.1
4) PLUS:   Civilian
employment rate \1\........         .0        -.4         .1         .0

5) EQUALS: Civilian
employment \1\.............        2.0        2.0        1.5        1.1
6) PLUS:   Nonfarm business
employment as a share of
civilian employment \1\ \2\         .1         .1         .1         .1

7) EQUALS: Nonfarm business
employment.................        2.1        2.1        1.7        1.2
8) PLUS:   Average weekly
hours (nonfarm business
sector)....................        -.5        -.7         .0         .0

9) EQUALS: Hours of all
persons (nonfarm business).        1.6        1.3        1.6        1.2
10) PLUS:   Output per hour
(productivity, nonfarm
business)..................        2.9        1.1        1.1        1.2

11) EQUALS: Nonfarm business
output.....................        4.5        2.5        2.8        2.4
12) LESS:   Nonfarm business
output as a share of real
GDP \3\....................        -.3         .0        -.2        -.1

13) EQUALS: Real GDP........        4.2        2.5        2.5       2.3
------------------------------------------------------------------------
\1\Adjusted for 1994 revision of the Current Population Survey.
\2\Line 6 translates the civilian employment growth rate into the
nonfarm business employment growth rate.

\3\Line 12 translates nonfarm business output back into output for all
sectors (GDP), which includes the output of farms and general
government.

Note.--Data may not sum to totals due to rounding.
Except for 1995, time periods are from business-cycle peak to business-
cycle peak to avoid cyclical variation.

Sources: Council of Economic Advisers, Department of Commerce, and
Department of Labor.



Box 2-6. New Productivity Estimates

The estimates of productivity in Chart 2-5 use the new, chain-
weighted measure of output and data from the product side rather than
the income side of the national income accounts. The new estimates avoid
the biases inherent in a fixed-weight measure of output. The previous
fixed-weight measure biased productivity growth downward before the base
year (1987) and upward thereafter, with larger biases in years further
from the base year. These biases produce the illusion that productivity
growth had improved from the 1970s to the 1980s and improved again to
the 1990s. Still, many problems remain. For example, quality
improvements often go unrecognized, especially in the service sector,
biasing estimates of service-sector output downward. Although it is not
clear that mismeasurement in services is more important today than in
past decades, the increasing size of the service sector raises the
suspicion that these problems are now relatively larger (see Economic
Report of the President 1995 for a discussion of the problems associated
with measuring productivity).

INCOMES

Income growth during the first three quarters of 1995 moderated a
bit from its pace during 1994, reflecting mainly the deceleration in
employment growth. Real disposable income increased at an annual rate of
2.4 percent for the first three quarters, just below the 2.6 percent
rate over 1994. The slight decline from the year-earlier pace was due to
a pause in income growth during the second quarter, which accompanied
the overall moderation in economic growth.
Corporate profits increased in 1995, at about the same pace as 1994.
The pattern over the year followed that of overall economic growth, with
profits softening during the first half and rebounding strongly during
the third quarter. Other components of national income likewise
increased at more moderate rates during 1995, with the exception of
rental income which declined through the third quarter.

MONETARY POLICY AND INTEREST RATES IN 1995

Monetary policy changed little during 1995. After raising the
Federal funds rate by half a percentage point (to 6.0 percent) in
February, the Federal Reserve held it constant until July, when it
lowered the rate by a quarter of a percentage point. In late December,
the Federal Reserve cut the rate another quarter percentage point, so
that 1995 ended with the Federal funds rate at 5.5 percent, exactly
where it had begun the year. In line with the relative

Box 2-7. Productivity and the Real Wage

Do employees benefit on average, either directly through an
increase in compensation or indirectly through lower prices, from
increases in their productivity? Conventional economic theory says that
they should, at least over long periods. Historically, the evidence has
borne this out. During the past few years, however, questions
increasingly have been raised about whether the benefits of recent
productivity gains have indeed gone to employees.
Some observers point out that hourly compensation (wages plus
benefits) adjusted for changes in consumption prices has not kept pace
with productivity in recent years. This ``real consumption wage,''
however, is not the appropriate measure for assessing whether firms are
remunerating employees for increases in productivity. Because firms hire
an additional employee only if the cost of doing so is less than or
equal to the value of that employee's output, a more appropriate measure
to compare with productivity is compensation adjusted for output prices.
This ``real product wage'' has tracked productivity in recent years
(Chart 2-6).
The real consumption wage has risen recently by less than the real
product wage because prices for goods and services that employees
consume have risen by more than prices for goods and services they
produce. A large part of this divergence likely is due to computer
prices, which have fallen relative to most other prices. Because
spending on computers represents a smaller share of personal consumption
expenditures than computer production does of aggregate output, the
decline in their price has restrained output prices by more than it has
consumption prices.
Although the divergence between consumption and output prices
explains much of the gap between productivity and the real consumption
wage, pre-benchmark data also had shown a small gap between productivity
and the real product wage. The new GDP data eliminate this gap.
Employees, of course, care more about the purchasing power of
their wages (the real consumption wage) than about any ``wage-
productivity gap.'' And the stagnation of wages over the past two
decades, particularly for the lower part of the income distribution, is
cause for concern. Ultimately, however, the only way in the long run to
raise real wages is to raise productivity.



constancy of the Federal funds rate, other short-term interest rates
declined only modestly during 1995, with the rate on 3-month Treasury
bills dropping just half a percentage point compared with the end of
1994.
In contrast, longer term rates declined sharply over the course of
the year. At the end of 1995, yields on 30-year, 10-year, and 3-year
Treasury securities had fallen more than 2 percentage points from their
peaks in late 1994. As a consequence, the spread between long- and
short-term interest rates narrowed sharply, and the yield curve (which
plots rates of interest for debt of different maturities) was remarkably
flat at the end of 1995 (Chart 2-7).
The flatness of the yield curve is consistent with several
explanations. The most probable is that investors expect short-term
interest rates, including the Federal funds rate, to decline further.
Certainly, evidence from the futures market for Federal funds supports
this hypothesis and suggests that, as of February 5, 1996, investors
expected a decline in the Federal funds rate on the order of half a
percentage point to occur by July 1996 (Chart 2-8).
An expected decline in short-term nominal interest rates could
reflect an expected decline in real interest rates or an expected
decline in future inflation, or both. Real short-term interest rates
might be expected to decline because the tightening stance of fiscal
policy (as the deficit is reduced) increases the probability that eco-



nomic growth will slow in the short run, and thus makes it more likely
that the monetary authorities would have to lower real short-term
interest rates to stabilize output. On the other hand, if output is not
fully stabilized and falls below its potential, the rate of inflation
should decrease. In this case, much of the expected decline in future
nominal interest rates would reflect a drop in the expected premium for
inflation.
The superb performance of the stock market--both the Dow industrial
average and the broader S&P 500 index rose by more than 33 percent
during 1995--seems to favor the view that real short-term interest rates
are expected to fall. In general, equity prices should move positively
with the current level and expected real growth rate of dividends, and
inversely with the real rate of interest. Although dividend growth was
very strong over the year, these gains probably were not sufficient,
even with an associated permanent shift upward in the level of expected
future real dividends, to explain the phenomenal gains in stock prices
during 1995. More likely, investors anticipated that a decline in real
short-term interest rates would be forthcoming.

FISCAL POLICY IN 1995

The budget deficit for fiscal 1995 was $164 billion, substantially
below estimates made earlier in the year. The budget deficit has now
declined for 3 years in a row, for the first time since the 1940s. Were
it not for the interest payments on debt accumulated during past
Administrations, the budget last year would have been in surplus (see
Chart 2-9). The sharp decline in the budget deficit has slowed the rise
in the national debt sufficiently that the ratio of the national debt to
GDP has remained roughly constant for the past 2 fiscal years.
Part of the improvement in the deficit is likely to be associated
with the state of the business cycle. Tax revenues relative to
expenditures tend to rise during an expansion and fall during a
recession. To assess changes in fiscal policy, economists adjust the
budget deficit (or surplus) for economic conditions. On this basis, the
Administration's progress in reducing the deficit also was evident
during 1995, as the cyclically adjusted, or structural, budget deficit
continued to decline (Chart 2-10).
The progress in reducing the deficit was made possible by the
Omnibus Budget Reconciliation Act of 1993, which cut constant-dollar
government purchases of goods and services over the past 2 years.
Furthermore, as part of the ongoing efforts of this Administration to
downsize government, the Federal workforce has been reduced
substantially. Between January 1993 and November 1995, Federal civilian
employment (excluding the Postal Service) has declined by about 215,000,
leaving the Federal workforce smaller



than at any time since the mid-1960s. Moreover, as the next few years
unfold, the drop in employment should approach the target of 272,911
agreed to as part of the Federal Workforce Restructuring Act of 1994.
Two government shutdowns occurred late in the year and temporarily
interrupted the disbursement of some Federal spending. Because most of
this spending was restored once the shutdowns ended, the overall stance
of fiscal policy was largely unaffected. However, the shutdowns did
exact a significant budgetary cost and lowered real GDP growth by
roughly 0.25 to 0.5 percentage point at an annual rate during the fourth
quarter of 1995.
The Congress also failed to pass legislation acceptable to the
Administration for an extended increase in the debt ceiling on Federal
borrowing authority, forcing the Secretary of the Treasury to take
extraordinary actions to ensure that the United States did not default
for the first time in its history. As this Report went to press, the
Congressional leadership had made a commitment in a letter to the
President to pass a mutually acceptable debt limit increase by February
29. Passage of a straightforward long-term extension of the debt ceiling
still is required to avoid a potential future default.

WHAT CAUSES ECONOMIC EXPANSIONS TO END?

The current economic expansion began in March 1991 and, as of
February 1996, had run for 59 months, a little longer than the 50-month
average for expansions since the end of World War II and the third-
longest of the 10 postwar expansions (Chart 2-11). As the expansion
continued past the postwar average, some reports pointed to its age and
raised the possibility that it might soon falter, with the economy
dipping into recession. Expansions, however, do not end simply because
they have somehow reached the end of their ``normal'' life span. Rather,
expansions end because of changes in economic conditions or policies.
The length of postwar economic expansions has varied substantially,
with the shortest one, in 1980-81, lasting only 12 months and the
longest, that of 1961-69, 106 months. Such large differences make the
average length of expansions a relatively uninformative guide to the
life expectancy of the current expansion (Box 2-8). A far better way to
judge whether the expansion is about to end is to assess whether the
economic symptoms that often precede a downturn--rising inflation,
rising interest rates, financial imbalances, banking sector troubles, or
an inventory overhang--have begun to appear, and if so, whether monetary
or fiscal policies could successfully offset these symptoms. In the
early 1960s, for example, the Kennedy and Johnson Administrations ju-



diciously applied tax policy as a tool of aggregate demand management to
abort an impending downturn.

Box 2-8.--Duration Analysis of Business Cycles

Economists have used statistical methods to determine whether the
end of an expansion or a recession becomes more likely the longer it
goes on. Most findings show that, for business cycles since World War
II, expansions are not significantly more likely to end simply because
they get older, whereas recessions are (Chart 2-12). Although this
difference between expansions and recessions is consistent with several
explanations, the most likely reason is that policymakers since World
War II have more actively engaged in countercyclical monetary and fiscal
policies. With policymakers attempting to sustain expansions, events
that precipitate downturns--such as oil price shocks or policy
mistakes--are as likely to occur early as late in an expansion, so the
length of an expansion does not affect the chance that it will soon end.
On the other hand, if the pressure on policymakers to stimulate the
economy grows stronger the longer a recession persists, then a recession
that has lasted a while will be more likely to end in the next month
than a recession that has just begun.



ECONOMIC SYMPTOMS PRECEDING A DOWNTURN

The onset of most recessions since World War II has followed a
sustained increase in the core rate of inflation (Chart 2-13). The rise
in inflation sometimes has been precipitated by external events--such as
foreign crises that have raised oil prices--and sometimes has resulted
from overly stimulative fiscal or monetary policies. In the case of a
foreign price shock, core inflation may rise if the foreign price
increase gets incorporated into the process of setting domestic wages
and prices. In the case of overly stimulative policies, core inflation
may rise if the economy is pushed to operate at a level above full
capacity (the unemployment rate is forced below its sustainable level).
A common pattern is that a sustained increase in the core rate of
inflation eventually triggers an increase in short-term interest rates.
In general, a greater ongoing acceleration of prices can lead to a
sharper subsequent downturn. For example, during the late 1970s,
although the Federal Reserve had begun to tighten policy just prior to
the pickup in core inflation, the bulk of its tightening came only as
inflation was rising rapidly. As a result, the subsequent tightening was
much greater than it might have been if tightening had started somewhat
earlier. Accordingly, one of the most important factors in assessing the
chance that an expansion will end is the recent evidence on the core
rate of inflation.



After trending downward from its recent peak in 1990, core inflation
has been low and stable over the past 2 years (Chart 2-14). In addition,
during 1995 interest rates fell, especially during the last part of the
year. As they did so, the interest-sensitive housing and automobile
sectors recovered from their slackening earlier in the year. Thus, with
inflation stable and interest rates likely to decline further, the
evidence strongly supports continuing economic expansion.
The 1990-91 recession, however, did not follow the typical pattern
of rising interest rates preceding a downturn (although it did follow
the pattern of a prior increase in core inflation). When that downturn
arrived, some short-term interest rates had been falling for a full
year. But a distinguishing feature of the period preceding that
recession was the weakened condition of financial institutions,
especially savings and loan associations and banks. Unlike in the late
1980s and early 1990s, when savings and loan associations and many banks
were in financial difficulty due in part to the collapse of an
overheated real estate market, banks today are on a more stable footing.
The better financial situation of the banks suggests that the system
should be able to adapt more easily today to any adverse shift in
interest rates or real estate values, thereby limiting the consequences
for the overall economy.



Finally, a sharp rise in inventories can often signal that spending
has unexpectedly fallen, and can lead firms to cut production, possibly
precipitating a recession. After a buildup of inventory during the early
part of last year, the subsequent moderation in production helped to
reduce the overhang. As a result, inventories presently are at more
manageable levels.

SHORT-RUN MACROECONOMIC EFFECTS OF REDUCING THE BUDGET DEFICIT

As the budget moves toward balance over the next 7 years, two
factors will help to ensure that deficit reduction sustains economic
growth in the short run. First, a forward-looking response of financial
markets to deficit reduction can accelerate the decline in real long-
term interest rates, bringing forward the investment dividend associated
with balancing the budget. Second, an accommodative monetary policy can
validate the market's response and reinforce its positive effects on
short-run growth. But such a response by financial markets that is
backed-up by monetary policy ultimately depends on the credibility of
the deficit reduction itself.

The Response of Financial Markets

Cutting the deficit reduces the government's claim on the output of
the economy, either directly through lower purchases of goods and
services or indirectly through reduced transfer payments, freeing up
resources for use by the private sector. Thus, the critical question for
the outlook is whether or not spending by the private sector will rise
and take advantage of the newly available resources, thereby sustaining
growth in the short term. The answer depends largely on whether
financial markets adjust sufficiently in response to deficit reduction
so as to support the level of aggregate spending.
Adjustments in financial markets can stimulate spending in the
economy in two major ways. First, deficit reduction raises private
investment spending, primarily through a decline in real long-term
interest rates, that is, long-term interest rates adjusted for
expectations of future inflation. Second, deficit reduction spurs
international competitiveness, leading to an improvement in the current
account balance. Part of this improvement comes through expansion of
exports to our trading partners and part comes through shifts by
consumers and businesses away from imports and toward more competitive
U.S. products. How much of the stimulus comes through investment and how
much through net exports depends on the response of interest rates and
interactions between interest rates and exchange rates. In the end,
however, the stimulus will depend largely on the magnitude and timing of
the decline in real long-term interest rates.
Some increase in spending could occur purely as a result of a fall
in nominal interest rates that reflects entirely a drop in expectations
about future inflation, leaving real rates unchanged. This might happen,
for example, if qualifying standards for access to mortgage credit are
specified in nominal terms, so that a decline in nominal interest rates
allows more individuals or businesses to borrow even though real
interest rates have not declined. Overall, though, a rise in aggregate
spending due to this effect is likely to be far less important than the
rise in spending accompanying a drop in real interest rates.
Deficit reduction can lower real long-term interest rates through
three channels. First, a shrinking deficit directly lowers real long-
term interest rates through a ``portfolio'' channel, as reduced
government borrowing over time lowers the supply of government bonds
relative to other assets. Second, a shrinking deficit lowers real long-
term interest rates through an ``aggregate demand'' channel, as the
shift to a contractionary fiscal policy weakens aggregate spending and
money demand. Third, a shrinking deficit lowers real long-term interest
rates through a ``term-structure'' channel. More prudent fiscal policy
diminishes the likelihood that monetary policy in the future may have to
restrain an overheating economy and lowers expected real short-term
interest rates. Since long-term interest rates depend on the current and
expected future levels of short-term rates, an expected decline in
future short-term rates will be reflected in a decline in long-term
rates.

The Importance of Forward-Looking Expectations

When market participants are forward-looking and anticipate
(correctly) that the monetary authority will accommodate future credible
deficit reduction, real long-term interest rates fall by more than when
market participants either do not view future deficit reduction as
credible or believe that monetary accommodation will not be forthcoming.
To understand why credible deficit reduction accompanied by appropriate
monetary accommodation leads to greater declines in long-term interest
rates, we have to understand the relationship between short-term and
long-term interest rates. Market participants investing their funds for
say, 10 years, have a choice of buying a 10-year bond, or buying a 1-
year bond, and rolling it over next year into another 1-year bond, and
so forth. Adjusting for the differences in risk, the two investment
strategies should yield the same return. In the absence of risk, this
would mean that the long rate would simply equal the average of expected
short rates over the 10-year period.
Deficit reduction that is viewed as credible and likely to be
accompanied by future monetary accommodation leads investors to expect a
future decline in short-term rates. Because long-term bonds must yield
the same return (up to a risk premium) as a series of successive short-
term bonds, long-term rates also will decline, typically by more than
current short-term rates. In addition, credible deficit reduction that
is accompanied by a more stable and certain fiscal policy, could further
lower real long-term interest rates through a reduction in the ``risk
premium.'' With investors more certain about the future, long-term
investments become less risky and the premium paid on such investments
falls. On the other hand, if market participants believe the deficit
reduction is not credible, then they will not expect additional future
declines in real short-term interest rates and the risk premium will not
fall, so that the decline in current real long-term rates will be less.
In this case, a larger drop in current short-term interest rates would
be necessary to lead to a sufficient decline in long-term rates so as to
sustain aggregate spending and ensure full employment.
The evidence over the past 3 years, which witnessed deficit
reduction combined with economic recovery, shows that interest rate
declines can more than offset the contractionary effects when market
participants are forward looking. In particular, the decrease in long-
term interest rates occurred in anticipation of the deficit reduction,
and had the desired effects of stimulating investment--not only in
offsetting the shift to a contractionary fiscal stance, but in
supporting the economic recovery.
The success thus far of financial markets in ensuring that deficit
reduction does not compromise near-term growth does not mean that
appropriate monetary policy is unimportant. Monetary policy--which
operates with long and variable lags--needs to anticipate both the
pattern of deficit reduction and other events which affect the level of
aggregate economic activity. If monetary policy, for instance, follows a
rule and responds to increases in the unemployment rate above its
sustainable level only after the increases have occurred, then paths of
more rapid deficit reduction would be accompanied by higher average
levels of unemployment. But with a pre-announced schedule of credible
deficit reduction, the shifting fiscal stance could be incorporated into
monetary policymaking, taking account of normal lags. And, with
investors expecting future deficit reduction, the market does much of
the work of accelerating the decline in interest rates, so that
relatively little change may be required in monetary policy to sustain
growth in the short run.
Analysis using macroeconometric model simulations confirm these
patterns. In one simulation, with monetary policy following a feedback
rule (but not fully offsetting the effects of deficit reduction on the
output gap) and with investors perfectly anticipating future changes in
interest rates, long-term interest rates fall much more quickly than
short-term interest rates--mirroring the pattern observed during 1995.
In another simulation, investors are not forward-looking and monetary
policy fails to accommodate the effects of deficit reduction and instead
holds constant the rate of increase in the money supply. Although market
forces lead to a decline in short-term and long-term interest rates and
an associated increase in investment, in this simulation the decline in
rates is not sufficient to sustain the economy at full employment. The
message from this analysis is that the combination of credible deficit
reduction and a well-designed monetary policy that anticipates future
deficit reduction can avoid potential contractionary effects on the
economy.

FORECAST AND OUTLOOK

The economic expansion is forecast to continue throughout 1996, as
the effects of recent declines in long-term rates boost spending. Over
the 7-year forecast horizon, output is projected to track potential
output and the rate of inflation is expected to remain roughly constant
(Table 2-3).
Real GDP is projected to grow at its potential rate of 2.2 percent
during 1996 (on a fourth-quarter-over-fourth-quarter basis), as
investment in both the housing and the business sectors responds to
lower interest rates and as consumption spending is supported by recent
gains in stock market prices. Inflation, as measured by the

Table 2-3.--Administration Forecast
--------------------------------------------------------------------------------------------------------------------------------------------------------
Actual
Item                              --------------------   1996      1997      1998      1999      2000      2001      2002
1994      1995
--------------------------------------------------------------------------------------------------------------------------------------------------------

Percent change, fourth quarter to fourth quarter

-----------------------------------------------------------------------------------------
Nominal GDP...................................................       5.9   \1\ 4.1       5.1       5.1       5.1       5.1       5.1       5.1       5.1

Real GDP (chain-type).........................................       3.5   \1\ 1.5       2.2       2.3       2.3       2.3       2.3       2.3       2.3

GDP price index (chain-type)..................................       2.3   \1\ 2.5       2.8       2.7       2.7       2.7       2.7       2.7       2.7

Consumer price index (CPI-U)..................................       2.6       2.7       3.1       2.9       2.8       2.8       2.8       2.8       2.8

-----------------------------------------------------------------------------------------

Calendar year average

-----------------------------------------------------------------------------------------
Unemployment rate (percent)...................................       6.1       5.6       5.7       5.7       5.7       5.7       5.7       5.7       5.7

Interest rate, 91-day Treasury bills..........................
(percent).....................................................       4.3       5.5       4.9       4.5       4.3       4.2       4.0       4.0       4.0

Interest rate, 10-year Treasury notes (percent)...............       7.1       6.6       5.6       5.3       5.0       5.0       5.0       5.0       5.0

Nonfarm payroll employment (millions).........................     114.0     116.6     118.3     119.8     121.2     122.6     124.1     126.0     127.9
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\Estimates.
Note.--The figures for 1994 and 1995 reflect the benchmark revisions to GDP announced in January 1996 and may differ from those used to prepare the
Administration's 1997 budget.

Sources: Council of Economic Advisers, Department of Labor, Department of the Treasury, and Office of Management and Budget.

CPI, is expected to increase to 3.1 percent in 1996 from 2.7 percent in
1995, as food and energy prices, which had held down the overall rate of
price increase last year, are expected to rise in line with overall
inflation this year. The core rate of inflation is expected to remain
roughly unchanged during 1996, consistent with our forecast that
unemployment is likely to remain relatively unchanged, and that at
current unemployment rates, pressures for increasing inflation are weak
or nonexistent.
Although true inflation is expected to remain constant from 1996
onward, inflation as measured by the CPI is expected to edge lower as
revised procedures gradually remove part of the upward biases in current
CPI inflation figures. CPI inflation is likely to slow by 0.2 percentage
point in 1997, when the Bureau of Labor Statistics (BLS) will implement
procedures to correct for problems associated with bringing new stores
into the survey sample. CPI inflation is expected to slow by another 0.1
percentage point in 1998, when the BLS updates the CPI market basket to
reflect more recent data on expenditure patterns. As a result of these
adjustments, CPI inflation is expected to fall from 3.1 percent in 1996
to 2.8 percent in 1998 and thereafter. Some of these CPI adjustments
pass through to the GDP price index and, given the growth rate of
nominal GDP, raise estimates of real GDP growth. Consequently, real GDP
growth is projected to rise to 2.3 percent from 1997 onward.
The impetus from the decline in interest rates in the second half of
1995 is expected to keep aggregate demand growing at the economy's
potential rate for 1996. Over the medium term, interest rates are
expected to edge lower as projected reductions in the Federal deficit
reduce demands on capital markets. The projected decline in interest
rates is expected to sustain growth at its potential rate as deficit
reduction further restrains Federal spending.
The unemployment rate is projected at 5.7 percent in the near term
and is expected to remain at that level throughout the forecast period.
Economic growth of 2.3 percent over the forecast horizon is expected to
generate enough jobs to employ all the new entrants implied by the
expected 1.1 percent annual growth rate of the labor force. This
unemployment rate is also expected to be consistent with long-term
stability of the inflation rate.
As always, the forecast has risks. A basic assumption is that
monetary policy will be calibrated to offset the ongoing effects of
fiscal contraction. Obviously, monetary policy may not achieve this
goal. Monetary policy has long lags, and so the course of fiscal policy
must be properly anticipated. But fiscal policy depends on budgetary and
other policy decisions of the Congress, and at present future
Congressional action remains uncertain, despite bipartisan consensus
toward achieving a balanced budget.
In the short term, the economy may hit a pothole in the first
quarter of 1996, resulting at least in part from the effects of the
government shutdown and bad weather in the eastern United States during
January. But even if this should come to pass, the economy is expected
to rebound, and the growth rate over the four quarters of 1996 is likely
to be unaffected. The economy also faces the risk that foreign economic
growth may stall, reducing foreign demand for U.S. exports. Still, the
U.S. economy's export performance in 1995, in the face of economic
weakening in three of our major trading partners, was impressive.
Increased exports to strengthening economies in Canada, Japan, and
Mexico would help offset any losses elsewhere.

CONCLUSION

As the year 1995 ended, the economy was fundamentally sound. None of
the imbalances that typically precede a recession were evident. All
signs pointed to continued economic expansion at a sustainable pace.
Unemployment was expected to stay low, the inflation rate was expected
to remain low and stable, and business investment was expected to
continue powering the economy as interest rates declined.
The economy during 1995 made the transition from economic recovery,
during which growth was driven by removing slack from labor and capital
markets, to a period where growth is and will continue to be determined
by expansion of the economy's capacity. Although the transition to
sustained growth was not entirely smooth, the economy rebounded smartly
during the second half of 1995 from the earlier bump in the road and
should continue to expand during 1996.
Perhaps the best news during the year was that inflation remained
low and stable despite an unemployment rate that in the past was
associated with rising inflation. The stability of inflation even as the
unemployment rate was essentially unchanged at about 5.6 percent appears
to signal a shift in the economic environment. The improved economic
environment also was apparent in bond and stock markets, as long-term
interest rates fell and stock prices soared, reflecting in part an
outlook for inflation reminiscent of the early 1960s.
The bipartisan commitment to balance the budget over the next 7
years was the major macroeconomic policy event of the year, and
represents a continuation of Administration efforts to redress the
fiscal imbalance inherited from the past. As the deficit is further
reduced, private investment should increase, helping to raise living
standards. And, deficit reduction that is credible means that the
decline in interest rates needed to sustain growth in the short run is
likely to be forthcoming with only modest accommodation from monetary
policy. A significant portion of the decline in long-term interest rates
during 1995, particularly over the second half of the year, probably
reflected investors' perception that credible further deficit reduction
was on the horizon. The Administration's success in reducing the deficit
over the last 3 years certainly demonstrates the firmness of its
commitment to restoring balance to the Federal budget.