[Economic Report of the President (1997)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c2._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-002
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]


CHAPTER 2--Macroeconomic Policy and Performance

MACROECONOMIC PERFORMANCE over the past 4 years has demonstrated the
soundness of this Administration's policies. It has also confirmed the
economic analysis presented in the past three Economic Reports of the
President, refuting critics who predicted the Administration's policies
would not work.
In 1993 the President submitted to the Congress a package of
measures to reduce the Federal budget deficit that cut Federal spending
and raised income tax rates for the roughly 1.2 percent of taxpayers
with the highest incomes. At the time, some critics said that these
higher tax rates could hurt the economy by blunting incentives to work
and to save. Adherents of supply-side theory went further, arguing that
a combination of weaker economic performance and increased tax avoidance
would result in little or no additional revenue from these higher tax
rates. The 1994 Report explored this issue and concluded that the
proposed increases in tax rates for high-income taxpayers would increase
tax revenue without adversely affecting the economy. Three years later
this conclusion has been justified. Between 1993 and 1994, households
with adjusted gross incomes of $100,000 or more saw those incomes
increase by an average of 9.0 percent while their income tax liability
increased by 8.9 percent.
Although only a minority of economists shared the specific concerns
of the supply-siders, the more general economic effects of deficit
reduction have been an ongoing issue. Both the 1994 and the 1995 Reports
analyzed the short- and long-run consequences of deficit reduction. They
argued that, in the short run, deficit reduction should not cause growth
to slow, provided the reduction is credible, financial markets are
forward looking, and the Federal Reserve responds with an appropriately
accommodative monetary policy. Under these conditions deficit reduction
should contribute to lower real interest rates, stimulating interest-
sensitive sectors of the economy. Indeed, for the most part, this
prediction has been borne out over the past 4 years, with durable goods
consumption and private nonresidential and residential investment
supporting the expansion. Over the longer run, the Reports argued, this
policy would increase saving and investment, thereby augmenting the
Nation's stock of productive capital.
In 1996, with the economy growing and the deficit coming down, the
question became whether the expansion, then almost 5 years old, was in
danger of coming to a halt. That year's Report analyzed the reasons why
past expansions had ended. It found that expansions do not die of old
age. Instead they are brought to an end by specific (if unpredictable)
factors, such as a runup of inflation followed by tight monetary policy;
weak financial institutions and lack of credit; or a buildup of
inventories. The combination of tame inflation, a healthy financial
system, and lean inventory-to-sales ratios then prevailing augured well
for the expansion to continue--as it did.
This Report continues the analysis of salient macroeconomic issues
that inform current policy decisions. A number of these relate to
inflation. One of the most striking macroeconomic developments of the
last few years is the combination of low unemployment with steady
inflation. We therefore examine whether changes in the structure of the
economy have lowered the unemployment rate that is achievable without
risking a rise in inflation--the so-called nonaccelerating-inflation
rate of unemployment, or NAIRU. Complementing this discussion is an
analysis of the costs of inflation in the current economic environment
of low and stable inflation and its implications for the conduct of
macroeconomic policy.
The chapter then returns to last year's theme of the factors that
cause expansions to end, focusing this time on the financial condition
of households. We conclude that--notwithstanding recent increases in
consumer indebtedness, credit card delinquencies, and personal
bankruptcies--the overall financial condition of households poses no
obvious threat to the current expansion. Households will also be helped
by the recent decision by the Treasury to issue inflation-indexed
government securities, discussed in the following section. This
innovation will allow the private sector to broaden the array of assets
available to households for longer range financial planning, providing
greater financial security in retirement.
Economists' understanding of the economy and policymakers' ability
to make sound economic and budget decisions are greatly affected by the
quality of available economic statistics. This chapter addresses two
important measurement issues: the identification of biases in measuring
inflation, and the difference between income- and product-side measures
of national output. We analyze the extent to which official measures may
overstate inflation while understating growth in output, productivity,
and the Nation's material standard of living.
Drawing on these analyses, the chapter concludes with a review of
the macroeconomic highlights of 1996 and a look ahead, which suggests
that all signs point to continued stable growth. The final section
describes the economic outlook and presents the Administration's
economic forecast.

THE NAIRU AND ITS EVOLUTION

The nonaccelerating-inflation rate of unemployment is a useful
concept for thinking about the state of the macroeconomy. The NAIRU
(also called the natural rate of unemployment) is defined as the rate of
unemployment consistent with a stable inflation rate. Inflationary
pressure tends to increase when unemployment is below the NAIRU, and
decrease when unemployment is above the NAIRU. A number of explanations
for this phenomenon have been proposed, but one plausible story is that,
when unemployment is low, firms have to offer higher wages to attract,
retain, and motivate new workers than they do when unemployment is high.
Nominal wage growth is passed on to purchasers in the form of faster
growth of prices.

PREDICTING CHANGES IN INFLATION

The unemployment rate provides useful information about the future
course of inflation. This can be seen in its simplest form by comparing
the direction of the change in inflation--as measured by the core
consumer price index (CPI), which excludes the volatile food and energy
components--with the demographically adjusted unemployment rate. Some
groups such as new labor market entrants may have higher ``normal''
unemployment rates than others. The demographically adjusted
unemployment rate weights the actual unemployment rates for different
demographic groups by their labor force shares in a given base year, in
this case 1993. Inflation rose in the 12 months following 28 of the 32
quarters since 1958 in which the demographically adjusted unemployment
rate was below 5 percent, and fell in 26 of the 32 quarters when it was
above 7 percent. This empirical regularity is not only strong but also
statistically significant (Box 2-1 and Chart 2-1). It shows that the
NAIRU appears to have been contained between 5 and 7 percent for the
period from 1958 to the present.
More typically, models of the relationship between unemployment and
inflation do not just predict whether inflation will rise or fall, but
also give some indication of the likely magnitude of this change. The
usual result is that the further the unemployment rate is below the
NAIRU, the more inflation tends to rise. In Chart 2-2 the
demographically adjusted unemployment rate at the beginning of the year
is plotted on the horizontal axis, and the change in core inflation over
the course of that year on the vertical axis. The downward-sloping line
(the regression line) in the chart depicts

Box 2-1.--Unemployment and Changes in Inflation

Very few economists have empirically tested the NAIRU hypothesis
itself: that inflation rises when unemployment is below the NAIRU, and
falls when it is above the NAIRU. The advantage of this basic hypothesis
over more structured theories is that it is amenable to tests that are
nonparametric, that is, that do not require as many assumptions about
how the economy functions. These tests are therefore less sensitive to
precise specification.
The relationship between the demographically adjusted unemployment
rate and the probability of a rise in inflation is shown in Chart 2-1.
For a given range of the unemployment rate, the fraction of quarters in
which the core CPI inflation rate rose over the following 12 months is
shown in the solid line. The dashed line is the best statistical fit for
these data, estimated using a procedure called logit. This relationship
supports the simple NAIRU hypothesis: when unemployment is low,
inflation is more likely to rise. Further, inflation is about as likely
to rise as to fall when unemployment is in the middle range of about 5
to 7 percent.


the statistical relationship; it shows that increasing the unemployment
rate by 1 percentage point lowers the rate of inflation by around 0.6
percentage point.


Chart 2-2 illustrates by implication another point: other factors
besides unemployment also affect inflation. If the unemployment rate
were the only factor affecting inflation, all the points would lie
exactly on the regression line (assuming also that this is the correct
specification). Instead, some points represent periods when unemployment
was low but inflation was falling, and others periods when unemployment
was high but inflation was rising. These changes would have escaped any
forecaster relying on the unemployment rate alone to predict inflation.
Three extensions to the approach embodied in Chart 2-2 are helpful.
First, the NAIRU need not be viewed as an unchanging constant, but
instead can be thought of as evolving with changes in the economy. We
need to understand how it evolves in order to determine the current
level of the NAIRU and thus be able to predict future inflation. This
issue is explored in the next section. Second, economic slack is a
general concept that is unlikely to be perfectly captured by any single
measure. Accordingly, it is useful to employ other measures of slack,
such as capacity utilization or job vacancy rates, in conjunction with
the unemployment rate in explaining and predicting changes in inflation.
Third, other factors also affect the inflation rate; these are usually
grouped under the collective heading of supply shocks. For example, the
only two periods of double-digit inflation since the immediate aftermath
of World War II occurred in 1974 and in 1979-81; both coincided with
large increases in the price of oil. An analyst focusing exclusively on
unemployment would not have predicted the severity of these inflations.

CHANGES IN THE NAIRU

The natural rate hypothesis was originally interpreted as implying a
single, unchanging NAIRU. Today, however, it is recognized that the
evidence is more consistent with a NAIRU that evolves over time.
Accepting this time-varying NAIRU raises a number of questions: is it
possible to explain why the NAIRU changed in the past, predict how it
might change in the future, and perhaps even identify policies that
might influence it?
A few years ago, typical estimates of the NAIRU were in the
neighborhood of 6 percent. If the same natural rate prevailed today, the
fact that the economy achieved below-6-percent unemployment from
September 1994 through the end of 1996 should have increased inflation.
To calculate the rough magnitude of the expected increase, assume for
the sake of argument that the NAIRU is 6.0 percent and that a year in
which the unemployment rate is a percentage point below the NAIRU raises
inflation by about \1/2\ percentage point. Then the average unemployment
rate of 5.5 percent over the roughly 2-year period from September 1994
to December 1996 should have led to about a \1/2\-percentage-point
increase in the inflation rate. Instead, inflation, as measured by the
12-month change in the core CPI, fell from 3.0 percent to 2.6 percent.
In contrast to previous experience with unemployment below 6 percent,
inflation has fallen rather than risen.
Through 1995 and 1996, inflationary pressures were milder than in
previous periods when unemployment was this low--a point discussed in
greater detail later in this chapter. Although potentially transitory
factors, such as a slowdown in the rise of employee health benefit costs
and declining import prices, partly explain why inflation is subdued,
the underlying reason is probably that the NAIRU has fallen
substantially. The three main forces driving this decline are the
changing demographics of the labor force, the delayed alignment of
workers' real wage expectations with productivity growth, and increased
competition in labor and product markets.

Changing Demographic Structure

Each demographic group can be thought of as having its own natural
rate of unemployment: higher for teenagers than for adults, higher for
women than for men, and so on. Even if these individual natural rates
were constant, the overall NAIRU would change in response to changes in
the proportions of these different groups in the labor force. If it is
assumed that demographic changes had about the same effect on the NAIRU
as they have had on observed unemployment, then about 0.5 percentage
point of the decline in the NAIRU since the early 1980s can be
attributed to demographic changes. The single most important demographic
change is the aging of the baby-boom generation: the United States now
has a more mature labor force, with smaller representation of age groups
that traditionally have higher unemployment rates.

Productivity Growth and the Wage Aspiration Effect

The second explanation for the decline of the NAIRU can be called
the wage aspiration effect. Neither the level nor the rate of change in
productivity seems to have any long-run effect on the unemployment rate:
the average unemployment rate in different periods has been
approximately unchanged despite a century of massive productivity growth
and shifts in its trend. Nevertheless, changes in productivity growth
can have temporary effects on the natural rate. Workers' demands for
increased real wages may depend on past increases, possibly because
people get accustomed to a certain rate of increase in their standard of
living. But in the long run, real wage growth tracks productivity
increases. Thus, after a fall in the productivity growth rate, workers
may initially demand wage growth that is faster than increases in
productivity can justify. This puts upward pressure on the inflation
rate and requires a higher level of unemployment to stabilize the rate
of inflation. But this increase in the NAIRU is only temporary, either
because the productivity slowdown itself is temporary, or because
workers eventually moderate their demands in response to permanently
lower productivity growth. Either way, the NAIRU eventually returns to
its level before productivity slowed.
This wage aspiration effect raised the NAIRU after productivity
slowed beginning in 1973, and its level remained elevated for some time.
However, workers have now had time to lower their aspirations for real
wage growth to reflect the slower productivity growth, which has helped
the NAIRU return to its earlier, lower rate. Altogether, estimates of
this effect show it lowering the NAIRU by a meaningful amount since the
early 1980s.

Increased Competition: The Changing Structure of Labor and Product
Markets

Many of the likely suspects for the remaining decline in the NAIRU
fall under the heading of increased competition in product and labor
markets. This is partly the consequence of opening of markets at home
and abroad through regulatory reform and trade agreements. Although
imports meet only a small fraction--around 13 percent--of total demand,
the fact that much of the U.S. manufacturing sector faces potential
import competition may provide significant wage restraint. Changes in
labor market institutions and practices may also have had some salutary
effects on inflation, whatever their other impacts. Quantifying these
general notions of increased competition and the institutional structure
of the labor market is extremely difficult; however, they can plausibly
explain much of the decline in the NAIRU that is not accounted for by
demography or the wage aspiration effect.

Beneficial Effects of Persistently Low Unemployment

It has been argued that Europe's sustained high level of
unemployment has raised the natural rate of unemployment there, in a
process called hysteresis. High and sustained unemployment causes the
skills of the unemployed to atrophy, limiting their ability to compete
for employment. Attempts by the smaller number of employed workers to
maintain their wages reinforce this mechanism, also perpetuating high
unemployment. The opposite phenomenon may be at work in the U.S. labor
market today. With the lower unemployment of the past few years,
previously unemployed workers have acquired new skills from on-the-job
training. Research has not shown that ``reverse'' hysteresis has acted
to lower the NAIRU in the American economy. But if it has, it means that
sustained high unemployment is even more damaging than we thought,
because it can raise the NAIRU, and sustained lower unemployment is even
more beneficial than we thought, because it can reduce the NAIRU.

Future Evolution of the NAIRU

A number of factors may continue to reduce the NAIRU in the future.
Demographic change will probably continue to lower the natural rate of
unemployment as the current bulge of workers in the 25- to 54-year-old
age bracket moves into the 55-plus age bracket, where the unemployment
rate is typically lower. And if hysteresis is operative in the United
States, the current spell of low unemployment may help generate a lower
NAIRU in the next few years. The other two factors affecting the natural
rate are harder to predict, although competition in the economy seems
likely to increase with liberalization of international trade and
continued regulatory reform.

THE ECONOMIC CONSEQUENCES OF INFLATION

If our growing understanding of the empirical relationship between
unemployment and inflation is to inform policy choices--in particular
the appropriate stance of macroeconomic policy--it needs to be combined
with an analysis of the costs and benefits of inflation and
unemployment.
Policies to lower the inflation rate generally cause temporarily
higher unemployment. The costs of this unemployment are straightforward:
involuntary unemployment imposes substantial hardship on individuals
without jobs and represents wasted resources that could be used in
production. According to Okun's law, a well-known empirical regularity
in economics, every percentage-point reduction in the unemployment rate
corresponds to an increase in output relative to potential of about 2
percent. The 2-percentage-point reduction in the unemployment rate since
the end of 1992, for instance, corresponds to an increase in annual
output of about 4 percent--roughly $300 billion in total, or $3,000 for
every American household.
Accounting for the costs imposed by high levels of inflation is less
straightforward. Inflation is often described as if it were inherently
harmful, but this is misleading. People care about the purchasing power
of their wages, not about the price level itself. If, for example, the
dollar value of everything doubled--including goods prices, salaries,
the money in peoples' pockets, bank accounts, and debt--almost no one
would be worse off; everyone could buy just as much as before. This
general doubling of nominal prices and account balances in the economy
would impose one direct cost: the value of the time, effort, and
materials that goes into reprinting catalogs, account statements, menus,
and the like to reflect the new prices. These costs are minor, however.
Instead the potential damage inflation does is for the most part
indirect, through its effect on the level and distribution of output. In
the example just given, if prices and wages doubled but cash and bank
accounts did not, the burst of inflation would redistribute resources
away from people who held wealth and would thus be very costly to them,
whereas debtors would find themselves better off. Inflation also has
complicated links to the level and growth rate of output. Although
``costs of inflation'' is an acceptable shorthand for these links, it is
the consequences of inflation, not inflation itself, that are the real
concern.

THE EFFECT OF INFLATION ON OUTPUT

A number of economists argue that the current relatively low rate of
inflation has substantial adverse effects and that lowering the
inflation rate by approximately 2 percentage points, to achieve a
situation in which the cost of living is constant (on average), would
bring large benefits. One cost they cite is that taxation of nominal
interest income and nominal capital gains distorts saving and investment
decisions in an inflationary environment, although in some cases these
distortions may offset others elsewhere in the tax system. Other
commonly cited costs of inflation, although lower when the level of
inflation is lower, would remain significant, in the view of these
economists. Whenever any inflation exists, people have trouble
distinguishing relative price changes from general inflation; inflation
thus creates noise in the price system, interfering with its role in
allocating resources efficiently. And although higher levels of
inflation are associated with greater variability of inflation, even at
low levels some risks from its variation exist. The welfare of
individuals is lowered, both directly and indirectly, as they take steps
to mitigate these risks. These costs may sound small, but some
economists argue that they can be quite substantial. More important,
even if the gains from eliminating inflation are small for any given
year, they can be large when aggregated over time, provided they are
permanent.
Although all these costs exist in theory, several studies suggest
that, in practice, the benefits of eliminating inflation in a low-
inflation country such as the United States are not likely to be large.
The argument for zero inflation assumes that the elimination of
inefficiencies associated with inflation will raise the level or the
growth rate of gross domestic product (GDP), yet studies mostly find a
weak link, or none, between the level or the rate of growth of GDP and
the level of inflation in low-inflation countries. Because statistical
techniques cannot disentangle the many factors that influence growth,
however, these studies may have failed to detect small but economically
meaningful effects of low inflation. Also, no one doubts that very high
inflation rates adversely affect growth.
On the other hand, maintaining price stability might impose its own
costs. Some intriguing new research suggests that price stability might
lead to a permanent increase in unemployment and a corresponding
decrease in the level of GDP. Some evidence suggests, for example, that
workers are more resistant to nominal wage cuts than to an equivalent
erosion in their real wages due to inflation. If this were the case,
then in a moderate-inflation environment, firms could adjust to shocks
by letting real wages erode without resorting to layoffs. In a zero-
inflation world, layoffs would be more common.
Another potential cost of price stability is that unemployment and
output might fluctuate more over the course of the business cycle. At
low levels of inflation, policymakers' tools for stabilizing demand
would become less effective. For example, zero inflation would preclude
using negative real interest rates (i.e., nominal interest rates below
the rate of inflation) to stimulate the economy out of recession.
Although monetary policy can affect the economy through other channels,
including changing the quantity of credit, establishing a floor under
real interest rates could make stabilization more difficult.

THE EFFECT OF INFLATION ON THE DISTRIBUTION OF INCOME

The distributional consequences of achieving zero inflation are not
widely recognized. The unemployment required to achieve, and possibly
even that to maintain, zero inflation would place a disproportionate
burden on the less well off. The winners from zero inflation are harder
to characterize precisely. The immediate transition to lower inflation
would benefit holders of nominal claims and people on fixed incomes
(e.g., unindexed pensions) while increasing the burden on debtors. In
the long run as the lower inflation becomes built into expectations,
interest rates would fall, and it would have no added effects on debtors
or creditors. Zero inflation would, however, be a permanent boon to
people with large cash holdings--many of whom live abroad or are engaged
in illegal activities. In summary, reaching zero inflation might require
the less advantaged to take on a disproportionate amount of the burden
of achieving benefits whose size and distribution are uncertain.

RISKS IN MACROECONOMIC POLICY

The previous discussion identified the uncertainties associated with
estimating the changing level of the NAIRU. There are also other
uncertainties facing policymakers. This Administration has a record of
forecasting accurately--but conservatively--output, inflation, and
unemployment. But no forecast is without uncertainty. The long and
variable lags in all policies, from the initial decision through
implementation to the realization of the full effects, create
uncertainty about what the right policy should be. Not only do we lack
precise knowledge about where the economy will be in, say, 6 months'
time, when the effects of today's policy decisions may be felt; often it
is hard to know with precision where the economy is today. Good
policymaking recognizes this uncertainty and weighs carefully the risks
of alternative courses of action. An added advantage of the stable
macroeconomic environment achieved over the past 4 years is that those
risks are far smaller than they would be in a more volatile environment.
The preceding discussion of the NAIRU and analyses in recent Reports
set the stage for an evaluation of these risks. On the one hand,
expansionary policies that lead to unemployment below the NAIRU may
result in a slight increase in inflation, with an accompanying risk of
higher unemployment later as the economy returns to its lower inflation
level. On the other hand, policies that lead to unemployment above the
NAIRU result in a decrease in inflation, but also a waste of the
economy's productive potential, slower growth, and unnecessary
suffering, as workers who are able and willing to work cannot find it.
Evaluating the risk of more expansionary policies raises several key
issues. How high are the costs of a slight increase in inflation? Does
the economy stand at a precipice, such that once inflation increases, it
is likely to accelerate quickly? How high is the cost of disinflating
should the economy overshoot?
Recent research lends support to those who advocate a cautiously
expansionary policy: as the preceding discussion suggested, given the
United States' recent history of low and stable inflation, slight
increases in inflation do not seem to be associated with large costs.
And last year's Report indicated that the economy does not stand at a
precipice: at least in today's stable environment, runaway inflation is
not a threat. Moreover, econometric evidence suggests that the
relationship between the level of unemployment and inflation is such
that the ``extra'' cost of disinflating--of wringing out inflation by
temporarily increasing unemployment above the NAIRU--is no greater than
the increased output resulting from the unintended lowering of
unemployment below the NAIRU through cautiously expansionary policies.
Moreover, the earlier discussion suggested that, in the current
environment of low and stable inflation, the benefits of reducing
inflation may be lower and those of reducing unemployment higher than
had previously been thought.

THE FINANCIAL CONDITION OF HOUSEHOLDS

As 1996 ended, economic fundamentals appeared quite strong. Almost
none of the economic symptoms that often precede a downturn, such as
financial imbalances or inflationary pressures, were evident at the end
of the year. The exceptions to this positive outlook were potentially
worrisome trends in consumer indebtedness, credit card delinquencies,
and personal bankruptcies. But upon analysis they do not seem to reflect
dangerous financial imbalances or presage banking sector troubles.
Indeed, at the beginning of 1997 the overall financial condition of
households was sound and the banking system was very healthy.

TRENDS IN CONSUMER CREDIT

The past few years have been marked by a rapid rise in consumer
credit (which does not include residential mortgage loans) and a
subsequent worsening of some indicators of household financial
condition. The runup in consumer credit had slowed considerably by the
end of 1996, following more than 2 years of double-digit credit growth.
Even in 1996, however, consumer credit appears to have grown faster than
disposable income. Reflecting this rise, total required debt-service
payments of households (including payments on mortgage debt) have also
risen as a share of disposable income.
The largest and fastest-growing type of consumer credit is revolving
credit, which consists primarily of credit card accounts (Table 2-1).
Banks hold the largest share of consumer credit: almost half of the
total outstanding, or about three times the shares held by finance
companies and credit unions. Other holders include savings institutions,
retailers, and gasoline companies. A large and rapidly rising share of
consumer loans is held in securitized pools: loans are packaged by the
originator and securities issued against them, which are then sold to
investors (Box 2-2).

Table 2-1.--Growth in Consumer Credit Outstanding
[Percent change; simple annual rates\1\]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Addendum:
Disposable
Period         Total                                Revolving                          Automobile       Other       personal
income
------------------------------------------------------------------------------------------------------------------------------
1993..                7.5   11.3....................................................           8.8           2.7           3.0
1994..               14.5   18.2....................................................          13.4          11.8           3.6
1995..               14.2   22.0....................................................          10.6           9.3           5.5

1996:I               11.9   16.8....................................................           8.9           9.0           3.5
I
I....                7.2   12.8....................................................          10.2          -2.7           6.7
I
II...                6.9   9.3.....................................................           9.2           1.4           4.4

O
ctobe
r....                6.6   3.7.....................................................           3.2          14.3            .8
N
ovemb
er...                7.5   8.4.....................................................           1.6          12.4           6.0

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

Level, November 1996 (billions of dollars)

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

1,190.6   460.0...................................................         377.7         352.8    \2\5,690.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Calculated from published levels.
\2\ Annual rate.

Note.--Annual percent changes are for December to December; quarterly, for last month in quarter to last month in quarter. Data are seasonally
adjusted.

Sources: Department of Commerce and Board of Governors of the Federal Reserve System.

The rapid growth in consumer debt in recent years reflects both
demand and supply factors. On the demand side, the strong economic
expansion and the consequent decline in unemployment and rise in
consumer confidence are likely to have increased households' willingness
to borrow. Borrowing may also have been boosted by the increases in
household wealth generated primarily by higher stock prices. Refinancing
of residential mortgages has cut household interest burdens, increasing
the amount of consumer debt that households can support. At the same
time, a desired rebound in spending on durable goods following the 1990-
91 recession may well have stimulated the demand for consumer credit.
On the supply side, the recovery of the banking system following the
substantial losses and capital pressures of the late 1980s and early
1990s may have encouraged banks to try to increase lending

Box 2-2.--Securitization of Consumer Loans

In recent years lenders have financed an increasing share of
consumer loans by selling them to investors in the form of asset-backed
securities. These securities allow investors to purchase a claim on the
interest and principal payments generated by a pool of consumer loans.
The first sales of such securities occurred only in 1985, but by 1996
more than 20 percent of outstanding consumer loans had been securitized
and sold. The largest issuers are the finance subsidiaries of automobile
manufacturers, credit card banks, and nonbank credit card issuers. The
structure of consumer loan-backed securities varies, reflecting the
types of loans being securitized and the needs of the seller. The
securities are sold to a variety of investors, including insurance
companies, pension funds, and mutual funds.
Automobile loans were the first type of consumer loans to be
securitized. More recently, however, credit card loans have become the
largest class of securitized consumer loan. In large part this shift
reflects heavy securitization by banks, virtually all of which
represents sales of credit card loans. A recent Federal Reserve survey
of senior loan officers at large banks found two main reasons for the
increase in securitization: rapid growth in credit card lending had
outstripped banks' willingness to hold such loans on their books, and
banks had gained experience in arranging securitizations. In addition,
the banks pointed to the capital market's greater receptiveness to
securitized loans, and the rising costs of carrying loans on their own
balance sheets.
Most securities backed by consumer loans have what are known as
credit enhancements, which can substantially reduce default risk. These
features include third-party guarantees; ``set-asides'' in which either
the lender puts up money at the time of the sale to cover possible
losses, or a portion of the interest paid on the securitized loans is
accumulated in a fund for the same purpose; and the sale of a
subordinated class of securities that are paid only after payments on
the senior securities have been made. As a result, the securities
generally obtain top ratings from independent rating agencies. When
losses on consumer loans were high during and after the 1990-91
recession, these enhancements proved quite robust: none of the
securities missed a payment.
by easing their standards and terms. Simultaneously, three other changes
may have reduced the apparent risk of consumer lending relative to other
types of loans. First, improvements in computerization and credit
scoring may have improved banks' ability to measure and manage consumer
lending risk. Second, the development of a market for securitized
consumer loans, especially credit card loans, allowed banks to shift
some of the risk of these loans to security holders. Third,
consolidation in the banking industry may have improved the geographical
diversification of banks' consumer loans. Reflecting these trends,
Federal Reserve surveys of senior loan officers between 1991 and 1995
consistently showed a net increase in willingness to provide consumer
installment loans.
Other supply and demand factors also contributed to the particularly
rapid growth in revolving credit. On the household side this rise may
reflect, at least in part, increased convenience use of credit cards, as
more nontraditional outlets such as grocery stores began accepting
credit card payments. This sort of card use also reflects supply-side
factors. Card issuers have offered incentives, such as frequent-flyer
miles, to cardholders to encourage them to make purchases with their
cards. In addition, lenders have aggressively pursued new credit card
customers, with extensive promotions including widespread mailings of
preapproved applications, and an increased willingness to provide card
accounts to riskier customers. Data from the 1995 Survey of Consumer
Finances by the Federal Reserve show that the share of lower income
households with credit card debt has increased somewhat in recent years.
However, the survey also shows that the largest increases in consumer
credit use are not among low-income households, but rather among those
with incomes of $50,000 to $100,000. The expansion in bank credit card
activity, in turn, has been driven by the high profitability of credit
card lending.

IMPACT ON HOUSEHOLDS

Measures of consumer loan delinquencies and increased losses on bank
consumer loans, as measured by net charge-offs, suggest that at least
some households are facing significant financial strains. The rise in
the charge-off rate over the past 2 years has brought it back to near
its 1991 peak. Consumer loan delinquency rates, however, remain well
below their previous peak (Chart 2-3).
But both of these patterns need to be put into proper context. In
the case of both delinquencies and charge-offs the recent deterioration
has been more dramatic for credit card loans than for other consumer
loans. For residential mortgages, the other major type of household
loan, delinquency rates have declined recently and are near their lowest
level in almost two decades. The number of non-


business bankruptcies, which reached their highest quarterly level ever
(more than 290,000) in the third quarter of 1996, represents another
possible sign of distress among some households. As discussed in Box 2-
3, however, this rise is probably at least partly the result of such
factors as changes in bankruptcy law and a number of broader societal
changes, which have increased the willingness of households to file for
bankruptcy. Nonetheless, the pickup in bankruptcies has surprised many
lenders.
One problem in assessing the implications of recent movements in
bankruptcies and delinquencies is distinguishing between long-term
trends and normal cyclical variations. Normally, as the economy goes
into an expansion, bankruptcy and delinquency rates might be expected to
decline at first and then rise. Since economic turnarounds are hard to
predict, at the beginning of a recovery a large number of firms and
households will do better than expected. As a result, delinquency rates
will turn out lower than expected. Moreover, the pace of lending
increases during recoveries, which may subsequently depress delinquency
and loss rates because the new loans are unlikely to become delinquent
soon after they are extended. Eventually, however, as banks lower their
lending standards in response to their greater optimism about the
economy and their own improved financial position, delinquencies and
bankruptcies increase.

Box 2-3.--Nonbusiness Bankruptcy: Trends and Causes

The recent rise in nonbusiness bankruptcies is probably the result
of changes in bankruptcy law and a number of broader societal changes,
in addition to economic conditions. Indeed the trend has been evident
for many years. The number of nonbusiness bankruptcy filings was fairly
stable between the late 1960s and the late 1970s, but it has grown
steadily since from about 200,000 a year in the late 1970s to more than
1 million for the 12 months ending in September 1996.
In recent years about two-thirds of nonbusiness bankruptcies have
been filed under Chapter 7 of the U.S. Bankruptcy Code. Under Chapter 7,
assets of the petitioner in excess of the State exemption level (if any)
are liquidated, and the proceeds are distributed to the creditors. In
return, most remaining unsecured debts of the petitioner are
``discharged,'' that is, forgiven. Virtually all other nonbusiness
bankruptcies are filed under Chapter 13. Those filing under Chapter 13
are not required to give up any assets but must instead provide a plan
under which they will repay a portion of their debts from future income,
generally over several years.
Researchers generally attribute much of the increase in
bankruptcies since the late 1970s to effects of the Bankruptcy Reform
Act of 1978. This act increased the protections available to petitioners
and established Federal asset exemption levels that were quite generous
compared with State exemption levels. However, the act also allowed
States to override the Federal exemption levels, and many did so. The
Federal exemption levels were doubled in the Bankruptcy Reform Act of
1994, which may have given further impetus to the rise in bankruptcy
filings in 1995 and 1996.
Other economic and social factors may have contributed to the
recent rise in bankruptcies. Improvements in the supply of consumer
credit likely increased borrowing by households with lower levels of
wealth and income, and such households seem more likely than others to
file for bankruptcy after a financial shock. Bankruptcies may also have
been boosted by a reduction in the social stigma attached to bankruptcy.
The increase in the number of divorces may also have contributed.
Finally, advertising by lawyers, which became legal in 1977, may have
made households more aware of bankruptcy as an option.
As asset quality declines, banks are led to reassess their lending
strategies. Recent Federal Reserve surveys have found that about half
the banks had tightened their standards for approving new credit card
accounts, and a significant share had also tightened some terms on these
accounts. About a quarter of the banks reported having tightened lending
standards for non-credit card consumer loans. More generally, surveys
since the middle of 1996 have indicated that, on balance, banks have
become slightly less willing to extend consumer loans.

POSSIBLE EFFECTS ON LENDING INSTITUTIONS AND CONSUMER SPENDING

Increased delinquency rates and loan losses could put the financial
position of lending institutions in jeopardy, or they could depress
consumer spending and thus adversely affect the economic expansion.
Neither outcome appears likely at present.
Today, banks are in sound financial condition. Bank capital and
reserve ratios are robust relative to their levels in the mid-1980s, and
bank profitability is near record levels. Moreover, despite the rise in
delinquency and charge-off rates on consumer loans, overall bank asset
quality remains high: measures of business and real estate loan quality
are near their best levels in recent years. Finally, credit card loans,
which have shown the greatest deterioration, account for only about 5
percent of bank assets. Thus, bank regulators can react in a graduated
manner to lending excesses at some banks. Indeed, Federal banking
regulators, while continuing to monitor banks' consumer lending
activities, have not taken any broad regulatory actions.
Households' spending could be adversely affected by their financial
position either directly, because they become unwilling to borrow
further to finance continued purchases, especially purchases of consumer
durables, or indirectly, because banks become unwilling to lend to them.
It seems unlikely that banks will pull back from consumer lending by
enough to affect consumer spending on durable goods substantially.
Because their condition is healthy, banks can respond to higher losses
in a measured way, without drastic reductions in consumer lending. As
already noted, the bulk of the loan quality problem appears to be in the
credit card sector, where some banks may have eased standards
excessively in earlier efforts to gain market share. Nonetheless,
profitability among the largest credit card banks, although not as high
as it was a few years ago, remains high relative to profits at other
banks (Box 2-4).
Banks are also likely to pull back selectively, because rising
delinquencies and losses on credit card loans may reflect the behavior
of a relatively small group of riskier borrowers who have been able to
obtain card accounts in recent years; the fact that other meas-

Box 2-4.--Profitability of Credit Card Operations

The credit card operations of large banks appear to have been far
more profitable than other bank activities in recent years. However,
competitive pressures and higher loan losses have eroded this difference
since the early 1990s.
The profits of the large credit card banks significantly exceeded
those of the banking industry as a whole through the late 1980s and
early 1990s. In 1993 and 1994, before-tax profits at these banks, which
account for about two-thirds of the banking industry's credit card loans
outstanding, were roughly 4 percent of outstanding balances. By
contrast, banking industry profits, before taxes, were only about 1.7
percent of assets in those 2 years. Since then this large gap has
narrowed. Before-tax profits at large credit card banks fell to just 2.7
percent in 1995, and to just 2.1 percent in the first half of 1996. Over
the same period, profits for the industry as a whole have increased
slightly, to more than 1.8 percent of assets. The relative decline in
profits at large credit card banks reflects a rise in loan losses, a
reduction in fee income, and narrower interest spreads. Nonetheless,
because of rising levels of securitization, returns on assets and equity
at these banks remain quite high relative to returns for the industry as
a whole.
ures of household financial strength have not deteriorated to the same
degree supports this notion. Even the rise in the delinquency rate on
non-credit card consumer loans at banks may be an overstatement: these
loans include loans for automobiles, the delinquency rate for which may
have been boosted in recent years by the shift of many relatively low
risk customers to lease financing. Finally, banks may find it difficult
to limit credit card lending in the short run, because unused lines of
credit are currently more than three times the dollar volume of credit
card loans outstanding, and these lines have been growing rapidly.
The high level of indebtedness is also unlikely to affect consumer
spending significantly. Indeed, standard theoretical models of consumer
spending indicate that indebtedness has no independent effect; consumer
spending is determined by income patterns over people's lifetimes. Some
research suggests that high levels of indebtedness may have an adverse
effect. But in the current situation this effect should be offset by
other influences. The ratio of households' net worth to disposable
income is as high now as it has been in three decades. Historically,
high levels of aggregate net worth relative to disposable income have
been associated with high levels of consumer spending. In addition, high
levels of consumer confidence should help to bolster consumer spending.

INFLATION-INDEXED SECURITIES

In September 1996 the Treasury announced that it would issue
inflation-indexed debt securities starting in early 1997. Inflation-
indexed securities provide two main benefits. First, they offer
investors an asset that is protected against unexpected inflation. No
other financial asset offers the same degree of protection against both
credit risk and the risk of inflation. Moreover, financial firms may use
indexed securities to provide other assets valued by households, such as
indexed annuities. Second, since investors should be willing to accept a
lower average yield on securities that provide such a hedge against
inflation, a shift from conventional securities to indexed securities of
the same maturity is likely to reduce the Treasury's average borrowing
costs. Indexed securities offer other benefits as well: the spread that
emerges in the market between rates on indexed and on comparable
conventional securities will provide better information than is now
available about investors' expectations of future inflation, which
should prove useful in formulating monetary policy; and indexed
securities could reduce the sensitivity of the Federal budget to
unexpected fluctuations in real interest rates, by allowing the Treasury
to lock in real financing costs over a relatively long horizon.

HOW INFLATION-INDEXED SECURITIES WORK

The first indexed securities issued carry a 10-year maturity. In the
future the Treasury will issue indexed securities once each quarter. As
with the current 2- and 5-year Treasury notes, the sales are single-
price auctions in which all successful bidders receive the same return.
Investors can make noncompetitive tenders so that they are assured of
receiving securities at the rate determined in the auction. Indexed
securities are available in denominations as small as $1,000, to
encourage demand from small savers. The securities can also be stripped,
that is, the interest component separated from the principal component
to suit the needs of different investors for differing income streams.
The Treasury expects to issue one other maturity of indexed security
within a year. In addition, the Treasury intends to sell, starting in
about a year, inflation-protected savings bonds that pay rates based on
those on marketable indexed securities. Conventional EE savings bonds,
which are not indexed, will continue to be available.
The principal of indexed Treasury securities is protected from
inflation because its value is adjusted periodically (indexed) in line
with changes in the consumer price index. The version of the CPI used
for these calculations is the CPI for all items for urban consumers
(CPI-U), without seasonal adjustment. Investors will receive semiannual
interest (coupon) payments based on the indexed value of the principal.
At maturity the indexed value of the principal or the par value,
whichever is larger, is repaid. Because the coupon payments are based on
the inflation-adjusted principal, both they and the principal of indexed
securities are protected against increases in the general price level.
The fact that the value of the principal can increase before it is
repaid raises special issues of tax treatment, which are discussed in
Box 2-5.

Box 2-5.--Tax Treatment of Indexed Securities

Before the first indexed securities were issued, the Internal
Revenue Service proposed regulations on their tax treatment. Interest
payments on indexed securities will be taxable as current income, as are
those on conventional Treasury securities. However, increases in the
inflation-indexed principal will also be taxable as interest income. If
the CPI-U declines, the resulting reduction in the indexed principal may
be used (subject to some limitations) to offset taxation of interest
payments on the indexed securities.
Because holders of indexed securities receive the increase in the
inflation-indexed principal only at maturity, in periods of high
inflation the income tax they owe on the interest plus that on the
increase in principal could exceed the interest payment received. The
inflation rate at which this occurs depends on the interest rate on the
indexed securities and the investor's marginal tax rate. With a real
interest rate of 3 percent on indexed securities, for a taxpayer in the
28 percent tax bracket, taxes will exceed interest received if inflation
exceeds about 8 percent. Investors in this position could cover the tax
payment by selling a portion of their indexed securities. Holders of
conventional Treasuries do not face this problem because inflation
automatically reduces the real value of their principal.
Of course, many households will invest in indexed securities
through tax-deferred accounts such as individual retirement accounts and
401(k) plans. For these investors the tax treatment of indexed
securities will generally be immaterial unless they make a taxable early
withdrawal. Similarly, holders of inflation-indexed savings bonds (as
opposed to marketable indexed securities) will not pay taxes on interest
received until maturity.

BENEFITS OF INDEXED SECURITIES

Indexed securities provide households with a savings vehicle that
automatically adjusts to compensate for the effects of inflation.
History suggests that the returns on most assets do not fully reflect
changes in the inflation rate. Among financial assets, Treasury bills
have provided the best protection against inflation (Table 2-2). Stocks
and long-term government bonds have not provided such protection.
Investments in new homes, and to an even greater degree in existing
homes, have provided protection against inflation, but real estate
investments are not liquid. Thus, families looking for a flexible and
low-cost way to save for future expenditures such as retirement or a
child's education should find inflation-indexed securities a valuable
new option (Box 2-6). The availability of indexed Treasury securities
may also allow private firms to develop other desirable financial
instruments, such as inflation-indexed mutual funds and annuities, or to
hedge pension liabilities. Indeed, at least one mutual fund manager has
already filed with the Securities and Exchange Commission to offer a
mutual fund investing primarily in indexed securities.

Table 2-2.--Average Increase in Rate of Return When Inflation Rises         by 1 Percentage Point
[Percentage points; annualized]
----------------------------------------------------------------------------------------------------------------
Holding period
Item                               -----------------------------------------------
3 months         1 year          5 years
----------------------------------------------------------------------------------------------------------------

Financial assets:

Equities......................................................           -1.74           -1.34           -0.54
Long-term government bonds....................................            -.97            -.79            -.11
Treasury bills................................................             .53             .65             .69

Nonfinancial assets:

New homes (median sales price)................................             .17             .26             .80
Existing homes (median sales price)...........................             .95             .78            1.16
----------------------------------------------------------------------------------------------------------------
Note.--Data shown are the slope coefficients on the inflation rate taken from regressions of each rate of return
on a constant and CPI inflation over the corresponding holding period.
Returns on financial assets are from Ibbotson Associates; equity returns are for the S&P 500 index.
Data for financial assets begin in 1955; for new home prices, in 1963; and for existing home prices, in 1968.

Sources: Council of Economic Advisers, based on data from Ibbotson Associates, National Association of Realtors,
Department of Commerce, and Department of Labor.

Much of the attention surrounding the introduction of indexed
securities has focused on their likely impact on households, but indexed
securities also raise two important issues for the Treasury. First, many
economists believe that the Treasury now pays an inflation risk premium
on its intermediate- and long-term conventional securities. In other
words, investors require a higher interest rate on these securities to
compensate them for the possibility that higher-than-expected inflation
will erode the real value of future interest payments and principal
repayments received on the security. One recent study concluded that
investor concerns about inflation risk might add as much as \1/2\ to 1
percentage point to the required yield on some Treasury securities.
Thus, by issuing indexed securities, the Treasury may be able to reduce
average borrowing costs.

Box 2-6.--How Indexed Securities Reduce Inflation Risk

The table below illustrates how indexed bonds can reduce the risk
of meeting a future expenditure. In this case the expense is the cost of
a year of college for a child who is 8 years old today and will be
attending college in 10 years. If the cost of a year of college rises at
the same rate as the CPI, an indexed security guarantees the parents
enough money to cover that cost, no matter how high the inflation rate
in the intervening years.
Note that although the indexed security reduces risk, it may
underperform the conventional security. In the example shown, if
inflation turns out to be only 1 percent, the holder of the conventional
security will end up with a larger net return than the holder of the
indexed security. However, if inflation turns out to be 5 percent, the
holder of the conventional security will end up with a smaller net
return and will be unable to meet the cost of college with the security
and its accumulated interest.

Savings Outcomes After 10 Years Under Different Inflation Assumptions
[Initial investment of $10,000; expected inflation of 3 percent]
----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
If inflation
(1)Conventional bond
(1)Indexed bond
turns out to be:
(1)(Subject to inflation risk)
(1)(Not subject to inflation
risk)
----------------------------------------------------------------------------------------------------------------
1 percent                        Investment outcome:     $18,771          Investment outcome:     $14,845
College cost:           14,728           College cost:           14,728
Net:                     4,043           Net:                      117
----------------------------------------------------------------------------------------------------------------
5 percent                        Investment outcome:     $18,771          Investment outcome:     $21,891
College cost:           21,718           College cost:           21,718
Net:                    -2,947           Net:                      173
----------------------------------------------------------------------------------------------------------------
Note: Real rate of return of 3 percent on indexed bond; nominal rate of return of 6.5 percent on conventional
bond (3 percent real rate of return plus 0.5 percent inflation risk premium plus 3 percent expected
inflation); current college cost of $13,333, assumed to grow at the same rate as the CPI; returns are assumed
to accumulate tax free.

Source: Council of Economic Advisers calculations.

The second issue for the Treasury is the effect of the indexed
securities on the riskiness of Treasury payments: indexed securities
increase the risk to the Treasury of having to meet high interest
payments if inflation is high. This uncertainty, however, is about the
nominal payments that the Treasury will make; indexed securities
actually reduce uncertainty about the real value of those payments.
Fixed real payments on at least a portion of the Treasury's debt may be
desirable, since an increase in inflation would increase nominal
interest costs but would also be expected to increase nominal GDP and
thus tax revenues. This effect of indexed securities on payments made by
the Treasury can be seen in the example of household savings in Box 2-6.
Since indexed securities provide for less variation in the real value of
the household's savings, they must also provide for less variation in
the real value of payments by the Treasury. Thus, indexed securities
reduce real uncertainty not only for investors, but also for the
Treasury.
Indexed securities may also have implications for monetary policy.
Some economists have worried that substantial issuance of indexed
securities could reduce the political pressure on the Federal Reserve to
keep inflation low, because holders of Treasury securities would become,
as a group, less anxious about inflation. On the other hand, indexed
securities may increase the government's incentive to fight inflation,
because it would not be possible to inflate away the value of inflation-
indexed debt.
Whatever the effect on incentives, indexed securities could also
provide the Federal Reserve with useful information about real interest
rates and investors' expectations of future inflation rates. At present
this information can only be inferred from nominal interest rates and
survey data on expected inflation. Once a substantial market for indexed
securities has developed, policymakers will be able to decompose
interest rates for a given maturity into real and inflation-related
components. Changes over time in these components may provide useful
insights into the working of the economy that can be used in formulating
monetary policy.

EXPERIENCE IN OTHER COUNTRIES

A number of other countries already issue indexed securities. The
largest issuer is the United Kingdom, which began issuing nonmarketable
indexed securities in the mid-1970s and marketable ones in 1981.
Currently, indexed securities account for about $60 billion of U.K.
marketable debt, about a sixth of the total. The indexed security market
in Israel accounts for more than 85 percent of that country's marketable
debt, probably because past periods of very high inflation there have
made indexed securities more attractive. Australia issued indexed
securities as early as 1985, as did Canada, New Zealand, and Sweden,
starting in the 1990s. In these countries the share of debt that is
indexed remains well below that in the United Kingdom.
Because the issuance of indexed securities in countries with
financial systems similar to ours is so recent, one cannot yet use these
experiences to evaluate the likely impact of indexed securities in the
United States. The relative real returns on conventional and indexed
securities (and therefore the relative real payments by the government)
depend on the happenstance of inflation, especially unexpected
inflation, following the issuance of the securities. As a result,
relatively long periods are needed to evaluate their relative returns
with any confidence.
Finally, the experience in other countries does suggest that the
market for indexed securities may be relatively illiquid. In the United
Kingdom, where the indexed security market is largest, indexed
securities are traded much less often than conventional securities.
Purchasers, who are often pension funds and insurance companies,
apparently buy these securities to hold in their portfolios rather than
trade them. This pattern suggests that indexed securities satisfy a real
need in the market, but the reduced liquidity might raise the return
demanded by investors concerned about their ability to sell the
securities on short notice at reasonable cost. This ``liquidity
premium'' may offset to some degree the elimination of the inflation
risk premium, at least until the new market becomes well established.

MEASUREMENT ISSUES

The quality of economic statistics affects the assessment of
economic performance and the formulation of economic policy. The issues
of possible bias in the measurement of consumer price inflation and the
difference between income- and product-side measures of national output
provide two important illustrations.

THE CONSUMER PRICE INDEX

Many researchers have argued that the CPI overstates increases in
the cost of living. Much of this research comes from the Bureau of Labor
Statistics (BLS), which produces the CPI. This research has identified
several possible sources of bias; the degree of consensus on the
importance of each varies.

Substitution Bias

The CPI prices a fixed market basket of commodities. Shares of these
commodities in the basket are based on spending patterns observed in a
base period. But consumers do not buy the same basket of goods from year
to year. When the prices of some goods rise more quickly than those of
other goods, consumers often substitute away from those that have become
relatively expensive and toward others that have become relatively
cheap. Increases in the CPI measure how much additional income a typical
consumer would need to buy the base-period market basket at the new
prices. In contrast, a true cost-of-living index would measure how much
more income a consumer needs to maintain the same level of economic
well-being, taking into account the ability to substitute among goods.
By ignoring substitution, the CPI overstates increases in the cost of
living.
Substitution bias takes place at two levels, given the way the CPI
is constructed. At the ``upper'' level, substitution occurs among the
basic categories that make up the CPI's market basket--for example, when
consumers switch from apples to oranges (2 of the 207 categories). But
these 207 categories are themselves made up of numerous individual
items. For example, the apples category consists of a sample of
Delicious, Granny Smith, Macintosh, and other varieties. Thus a second,
``lower'' level of substitution takes place within categories when the
price of, say, Delicious apples rises and consumers shift to other
varieties.
The market basket is divided into categories, and each category's
weight is determined by its share in total consumption as measured by
the Consumer Expenditure Survey. (Data for this survey are collected by
the Bureau of the Census under contract with the BLS.) The current
categorization is based on 1982-84 data; an updated categorization based
on 1993-95 data will go into effect in 1998. The category weights are
fixed for approximately 10 years. Within categories, the component
weights are updated every 5 years on a rolling basis.
Certain other price indexes, called superlative indexes, take into
account consumers' ability to substitute, and hence are not subject to
substitution bias. Unlike fixed-weight indexes, superlative indexes use
information about consumer purchases, both at the beginning and at the
end of the period over which inflation is measured. Using a superlative
index to aggregate the 207 expenditure categories, BLS researchers
calculated that, on average, annual inflation was 0.14 percentage point
per year lower than the change in the official CPI from 1988 to 1995.
Replacement of the CPI with a superlative index might seem an easy
fix. But these indexes cannot be constructed in a timely fashion because
the required data on spending patterns are compiled almost a year after
the corresponding price data. Users would have to accommodate themselves
to the inevitable lag or else accept a provisional forecast, to be
revised when complete data became available. In contrast, one of the
strengths of the current CPI is that it is up-to-date and virtually
never revised. Because price indexes are used for several purposes, such
as macroeconomic management, adjusting tax brackets, and Social Security
payments, it may be desirable to have more than one index: a timely one
that is sufficiently accurate for macroeconomic management, and a more
accurate but less timely one for other purposes.
Substitution bias within categories is parallel to bias between
categories: the current procedure for combining the price increases of
individual items in a category is appropriate only if consumers do not
make substitutions. Unfortunately, superlative indexes can be used
neither to estimate the magnitude of the bias within categories, nor to
redress it, because the necessary data on spending patterns are not
available at the level of individual items. Instead, researchers have
estimated this bias by comparing a geometric index with the fixed-
market-basket index, on the grounds that a geometric index approximates
a cost-of-living index if goods are moderately substitutable. (A
geometric index, like a fixed-market-basket index, requires only
beginning-of-period expenditure shares.) The BLS has estimated that a
geometric index measures about 0.25 percentage point per year less
inflation than the CPI does at the within-category level.
It is open to debate whether all or only part of this 0.25-
percentage-point difference reflects actual substitution patterns,
because the conditions under which a geometric index actually
approximates a cost-of-living index may not hold. These conditions are
likely to apply to the more narrow categories in the CPI, such as apples
and oranges, where consumers can easily shift their purchases. However,
they may not hold for broad categories such as prescription drugs, where
purchases are based on doctor's orders and are little affected by
prices. A similar problem occurs in categories like ``toys, hobbies, and
music equipment,'' which includes dolls, stamps, guitar picks, and grand
pianos--items so different that they cannot plausibly substitute for one
another. Another obstacle to substitution occurs where goods are
normally used together--such as washers and dryers in the laundry
equipment category or carburetors and air filters in the ``other
automobile parts and equipment'' category. For these categories the
fixed-market-basket index may only slightly overstate inflation and thus
come closer to the truth than the geometric mean.
Even for the narrow categories, the bias from using a fixed market
basket may be limited. Within these categories (such as between two
varieties of apples) commodities may be highly substitutable. But some
evidence suggests that for these categories relative price changes are
small.

Quality Adjustment

Measuring inflation properly requires distinguishing between changes
in the underlying price and changes in quality. The BLS measures quality
changes when it can. Some are easy to measure, for example when bakers
double the size of their chocolate chip cookies. Others are more
difficult but straightforward: for example, optional automobile
equipment that later becomes standard, such as air bags or antilock
brakes, can be quality-adjusted by its price when it was sold as an
option. Quality adjustments generally have a significant effect on price
increases as measured by the CPI. For example, the BLS estimates that in
1995 quality adjustment reduced the increase in the CPI by 2 percentage
points compared with what it would have been based on listed prices.
The BLS does not adjust for other, more difficult problems because
the agency cannot make direct quality adjustments in the absence of
quantifiable data. For example, televisions are less likely to need
repair than they were a decade ago, and some surgical procedures are
more likely to be successful today than in the past. But repair rates
for televisions and success rates for surgery cannot be computed until
years after the purchase. Several studies on quality adjustment are
available; most suggest that BLS methods fail to capture a wide range of
quality changes. However, these studies focus on a relatively few
categories of the CPI--possibly those where the quality bias is presumed
largest--making it difficult to assess the magnitude of the overall
quality bias in the CPI.

New Products

New products, such as air conditioners in the 1950s or videocassette
recorders in the 1980s, usually decline sharply in price during the
first years they are available for sale. But these products are not
usually included in the CPI basket until years after their introduction,
and so the CPI never records their initial price declines.

Outlet Substitution

Over time, consumers may change their shopping patterns, shifting
from high-priced to low-priced outlets, where the quality of service is
often lower. Current methods assume that all of the difference in price
between high- and low-priced outlets reflects differences in the quality
of service. To the extent this assumption is not appropriate, current
methods overlook one source of price decline.
To sum up, recent research has identified several possible sources
of bias in the CPI. A commission appointed by the Senate Finance
Committee recently reported on these sources of bias (Box 2-7). The
magnitudes of some of these biases are based on hard estimates around
which there is broad agreement. On the magnitudes of other biases,
however, consensus has yet to emerge.

Implications of CPI Bias for Other Economic Statistics

The CPI is used as an input for calculating many other economic
statistics, and therefore the potential biases in its measurement have
consequences beyond our view of inflation. The accuracy of many economic
measures is critically dependent on how well we measure price changes.
Most of the individual consumption items used in calculating real GDP
are deflated by component-level price indexes from the CPI. Most of the
biases in the CPI result in an overdeflation of GDP, biasing real output
growth downward. (Between-category substitution, however, is handled
properly in the national income and product accounts.) Productivity is
also calculated from real GDP, so overestimates of CPI inflation would
lead us to underestimate productivity growth. The accuracy of many other
statistics, such as real median household income

Box 2-7.--Estimates and Recommendations of the Advisory Commission to
Study the Consumer Price Index

An advisory commission appointed by the Senate Finance Committee
has estimated that the current CPI overstates inflation by 1.1
percentage points per year. Their estimate of bias is the sum of the
following parts:


------------------------------------------------------------------------
Estimate of bias (percentage
Source of bias                           points)
------------------------------------------------------------------------
Substitution
Upper level (between-category)....                                0.15
Lower level (within-category).....                                 .25
New products and quality change.....                                 .60
Switching to new outlets............                                 .10
Total...............................                                 1.1
Plausible range.....................                              .8-1.6
------------------------------------------------------------------------

The commission made several recommendations based on its findings.
It proposed that the BLS establish a cost-of-living index as its
objective in measuring consumer prices. It recommended that the BLS
develop two indexes: one to be published monthly and the other annually,
with historical revision to the annual index. The annual measure should
use a superlative index for aggregation at the between-category level
and a geometric index at the within-category level. The monthly index
would be called the CPI and should move toward geometric weighting at
both levels, with the weights kept as up to date as possible.
The commission also recommended that the Congress provide
additional resources to expand the surveys upon which the CPI is based.
It further advised that the President and the Congress should reevaluate
the indexing provisions in various Federal programs and features of the
tax code in light of the commission's estimated bias in the CPI.
and real earnings, that are directly converted from nominal values by
the CPI would also be affected.
Although removing CPI bias would change some of the details of our
views of productivity and income trends, it would not radically alter
our views on such fundamental issues as the productivity slowdown that
began around 1973 or the increase in income inequality over the past two
decades. Although bias in the CPI would mean that real growth and
productivity have been higher recently than official measures indicate,
that bias would also apply to longer term measures of growth and
productivity. To explain away the decrease in productivity growth, the
CPI would have to be not merely biased but increasingly biased over
time. It is certainly plausible that the increased share of the service
sector in the economy has made it harder to measure quality, with the
consequence that the approximately 2-percentage-point estimate of the
slowdown in productivity overestimates the true reduction. Yet it would
require an implausibly large increase in CPI bias to explain away the
entire slowdown as an artifact of mismeasurement.
Similarly, CPI bias might be depressing measures of real wages, but
that does not change the fact that real wages today are growing more
slowly than in the 1950s and 1960s. Also, the increase in income
inequality described in Chapter 5 is one widely discussed phenomenon
that is completely unaffected by CPI measurement: inequality is measured
by comparing income between groups; converting to real values is
irrelevant, and in any case any bias in the deflator would affect all of
the groups equally.

INCOME- AND PRODUCT-SIDE MEASURES OF OUTPUT

Another measurement issue that has a large effect on our assessment
of the economy is the difference between two key measures of national
output: gross domestic product and gross domestic income. The size of
the economy can be measured by adding up either all the output produced
(GDP) or all the income generated in producing that output (GDI). In
theory these measures should yield the same result, but in practice they
differ because of measurement error; this difference is called the
statistical discrepancy. Over eight consecutive recent quarters, for
example, measured real GDI grew faster than measured real GDP: 3.1
percent versus 2.1 percent at an annual rate from the third quarter of
1994 to the third quarter of 1996.

Which Is More Accurate?

Measurement problems exist on both sides of the accounts. A
significant share of the published national income and product accounts
estimates consist of extrapolations based on various indicators and
trends until the full annual revision, when most of these projections
are replaced with more complete and consistent source data. The latest
year to have passed through the usual annual revision process is 1994.
The major problem on the output side is the measurement of services
consumption, where about 30 percent of reported output is based on
projections until the annual revision, and State and local purchases,
where the figure is about 25 percent. The measurement problems in
services consumption may be getting worse, as sales in such new and
rapidly growing areas as casino gambling, cellular telephone service,
and on-line services are not fully measured.
On the income side, estimates of several components of nonwage
income, especially proprietors' income, are on shaky ground. Unlike the
projections on the product side, which are for the most part replaced
with more complete source data during the annual revision, the income
projections are replaced only with a very long lag or, in some cases,
never. For example, the problems with proprietors' income may persist,
as such income is chronically underreported, and the correction for
underreporting is based on an out-of-date (1988) taxpayer compliance
study that has been discontinued.
In several ways the recent behavior of the economy is more
consistent with the strength shown on the income side. Several economic
relationships are currently misbehaving. Although the errors in each of
these relationships are within their historical ranges, together they
add up to a suspicion that the product-side measure of GDP is
understating real growth:
 According to Okun's law, the unemployment rate is stable
when GDP is growing at its potential rate, and falls when GDP is
growing faster than its potential. Through the middle of 1994,
potential output appeared to be growing a bit over 2 percent per
year. Thus the 2.1 percent per year growth between the third
quarter of 1994 and the third quarter of 1996 should have
resulted in a stable unemployment rate. Instead, the
unemployment rate dropped almost 0.4 percentage point per year.
The drop in the unemployment rate is, however, perfectly
consistent with the growth rate of real GDI over these 2 years
(3.1 percent).
 Personal income tax payments in 1996 for the 1995 tax year
were far higher than expected by the Treasury or the
Congressional Budget Office, yet these estimates were calibrated
to the relatively high income-side estimates--suggesting that
even more income may have been generated than the official
estimates of the Bureau of Economic Analysis indicate.
 The real product wage (hourly compensation deflated by the
prices received by producers) usually rises at the same rate as
labor productivity growth. But over the last 2 years the real
product wage has grown at a 1.8 percent annual rate--much faster
than the official measure of productivity, which has grown at
only a 0.3 percent annual rate. However, income-side
productivity (discussed below) has grown at a more compatible
1.6 percent annual rate over this period.

Implications for Recent Productivity Growth

Nonfarm business productivity can be measured using either an
income- or a product-side measure of real output. The BLS formerly
measured productivity on the income side (except for the advance
estimate). Then, in February 1996, the agency changed to a product-side
measure, in part to minimize revisions between their advance and their
final estimates.
The recent difference between the two measures of productivity
growth is dramatic. According to the official (product-side) measure,
productivity growth has slowed to only a 0.3 percent annual rate over
the past 2 years. In contrast, the income-side measure shows a 1.6
percent annual rate of growth over the same period. Similarly, over the
6 years since the last business-cycle peak, productivity has grown at a
0.9 percent annual rate by the official measure but at a 1.2 percent
annual rate on the income-side measure.
The difference between the income- and the product-side measures of
output obscures our view of recent productivity growth. The best guess
is that productivity has been trending upward at about a 1.1 percent
annual rate during the current business cycle. This rate is no different
from that measured over the entire post-1973 period (Chart 2-4).


REVIEW AND OUTLOOK

OVERVIEW OF 1996

Economic growth exceeded expectations in 1996. In February 1996 the
Administration had forecast that real GDP would grow 2.2 percent over
the four quarters of 1996. This forecast was in line with private
forecasts at the time. As growth picked up in the first half, that
forecast was revised upward to 2.6 percent in July 1996. The consensus
of private forecasters now indicates that real GDP expanded 2.8 percent
in 1996.
Growth over the last several quarters has been solid, but has
fluctuated. Chart 2-5 shows that real growth was weak in the fourth
quarter of 1995 and recovered slightly in the first quarter of 1996.
Several transitory factors account for that sluggishness: the dispute
between the President and the Congress over the budget, which led to two
partial Federal Government shutdowns in the fall of 1995 and the
following winter; unusually severe weather in January; and a March
strike at a major automobile manufacturer. Much of the strong growth in
the second quarter of 1996 was directly traceable to the rebound from
these factors. Growth moderated in the third quarter to a 2.1 percent
annual rate. However, as discussed above, the product- and income-side
measures of output diverged: whereas real GDP was estimated to have
increased at only a 2.1 percent annual rate in the third quarter, real
GDI grew at a 4.2 percent annual rate. Estimates of fourth-quarter GDP
are unavailable as this Report goes to press, but other data indicate
that growth was robust.


After holding fast at around 5.6 percent for all of 1995, the
unemployment rate edged down about 0.3 percentage point over the 12
months of 1996. As measured by the Current Employment Statistics survey
of the BLS, nonfarm employment grew at a brisk pace of 240,000 per month
during the first 8 months of the year. But reflecting the deceleration
in output in the second half, employment growth moderated to 162,000 per
month over the last 4 months of 1996. Since January 1993, payroll
employment has increased by 11.2 million.
Inflation, as measured by the 12-month change in the CPI, rose in
1996 (Chart 2-6). All of the increase, however, was attributable to the
acceleration in food and energy prices. An acceleration in these prices
was anticipated in the Administration's forecast. The core CPI, which
excludes these volatile components, moved down 0.4 percentage point from
its year-earlier pace to 2.6 percent for the 12 months ending in
December 1996. This deceleration was somewhat surprising given the
decline in the unemployment rate (Chart 2-7) and the strong growth over
the first half of the year. But as the earlier discussion of the NAIRU
showed, the ability of the economy to sustain low unemployment and low
inflation is the best it has been in years.




Solid growth was achieved in 1996 despite a fiscal policy that has
been very restrictive. The standardized-employment deficit (that which
would result if the economy were at full employment) as a share of
potential nominal GDP has fallen in each of the past 4 years, for a
cumulative total of 2.1 percent of potential GDP. As a result, the
Federal budget deficit in the 1996 fiscal year fell to only 1.4 percent
of actual GDP on a unified-budget basis. Both the President and the
Congress are committed to eliminating the deficit; hence fiscal policy
should continue to tighten in the intermediate term. In 1997, however,
the standardized-employment deficit as a share of potential GDP is
expected to rise slightly from 1996.
With inflation contained and the economy expanding at a sustainable
pace, the Federal Reserve kept the Federal funds rate flat after
lowering it in January 1996. Over the course of the year, long-term
interest rates ebbed and flowed with the pace of economic activity,
rising from early in the year through the summer, declining in the fall,
and then rising again toward the end of the year.

Private Domestic Spending

Consumption expenditures grew at a 3.4 percent annual rate in the
first half of 1996, with growth concentrated in durable goods, which
expanded at nearly a 10 percent pace. Purchases of new automobiles grew
rapidly in the first quarter, and expenditures on other durable goods
also picked up substantially in the first half. Spending on durables was
probably stimulated not only by lower interest rates, but also by the
rise in household wealth due in part to the very substantial increase in
stock prices. The high level of mortgage refinancing activity last
winter may also have contributed to the pickup by reducing households'
mortgage payments.
Consumer spending growth slowed substantially in the third quarter.
Again the effect was most dramatic for consumer durable goods, partly
reflecting the effects of higher intermediate- and long-term interest
rates. In addition, higher debt burdens and rising delinquency rates on
consumer loans may have led some households to limit spending and some
banks to tighten lending standards. However, the discussion of the
financial condition of households earlier in this chapter suggests that
concerns about consumer distress may have been exaggerated. Consumer
fundamentals remain positive: consumer confidence is high, income growth
is healthy (real disposable personal income expanded at a better than 3
percent rate over the four quarters ending in the third quarter of
1996), and the growth in household liabilities has been offset by rapid
growth of assets. Moreover, as Chart 2-8 shows, the saving rate tends to
be low when the ratio of net worth to income is high--at least over long
periods; this ratio is at its highest level since 1969. Thus, it is
likely that the third-quarter slowdown in consumption will prove largely
temporary. Indeed, advance retail sales for the fourth quarter indicate
a pickup.
The general soundness of the household sector is affirmed by the
market for new homes. Residential investment expanded rapidly through
the first half of 1996 despite harsh winter weather early in the year
and rising long-term interest rates through the late winter and spring.
In part, the effect of higher rates may have been offset by a
substantial shift of purchasers to adjustable-rate mortgages, which
offer considerable upfront savings. Moreover, despite the rise in rates,
measures of housing affordability were the highest they have been since
the 1970s. Residential investment did fall in the third quarter, perhaps
reflecting the continued rise in interest rates over the summer.
However, residential construction appears to have rebounded in the
fourth quarter: new home sales were well maintained through November,
and inventories of unsold new homes were low relative to sales. Long-
term interest rates declined in the fall, with the rate on conventional
mortgages retracing about half of its rise earlier in the year. Housing
starts, after declining in September and October, increased sharply in
November, although they fell back again in December.
As it has been over most of the expansion, private fixed investment
was a bright spot in 1996. Investment in producers' durable equipment
was particularly robust, growing at a better than 13


percent annual rate through the third quarter, with computer investment
especially strong. In part this strength is likely to have reflected
firms' efforts to upgrade their equipment in a period of increasing
demand, substantial profits, and rapid technological change.
In contrast, business investment in structures rose more modestly in
the first three quarters of 1996, as this sector continued to grow out
from under the large excess supply resulting from overbuilding in the
1980s. Construction in the office segment rebounded in the second and
third quarters following declines in late 1995 and early 1996.
Construction of industrial buildings fell off in early 1996, although it
rebounded late in the year.
Investment in nonfarm business inventories declined in late 1995 as
firms took steps to work off excess stocks. This effort continued into
1996, and with the March auto workers' strike cutting automobile
inventories sharply, overall inventories declined in the first quarter.
Inventory investment remained low in the second quarter, probably
reflecting the unexpected strength in demand and, perhaps, further
efforts by some firms to limit stocks. Inventory investment picked up in
the third quarter, however, as final sales slowed and some firms may
have moved to replenish stocks. Yet despite the third-quarter rise,
inventory-to-sales ratios remained historically lean, suggesting that
the increase should not cause a drag on production into 1997.

International Influences

The Nation's trade deficit expanded in the first three quarters of
1996, riding a combination of strong domestic demand and weaker activity
in foreign markets. In real terms the deficit on trade in goods and
services (on a national accounts basis) reached a 2-year low in the
fourth quarter of 1995. The deficit expanded in each of the three
subsequent quarters. This increase reflected a large rise in imports.
Real imports of goods and services over the first three quarters rose at
a 10.0 percent annual rate, while exports increased at only a 2.2
percent rate. In 1996, slower growth in economic activity in our major
foreign markets negatively affected U.S. exports. Although weak growth
in our trading partners was the main cause of the increased deficit, the
strength of the dollar against the yen and the major continental
European currencies may also have played a small role.
In Canada, our largest export market, growth has been slowing for
the last 2 years: the Organization for Economic Cooperation and
Development estimates growth for 1996 at 1.5 percent, down from 2.3
percent in 1995 and 4.1 percent in 1994. This slowdown, which was partly
due to slower growth in government spending, was partly responsible for
slower growth of U.S. exports to Canada: merchandise exports grew by
only 3 percent in the first half of 1996, down from 11 percent in 1995.
The Canadian economy picked up in the third quarter, and U.S. exports
rose substantially from 1995 levels.
In the European Union, our second-largest export market, GDP growth
slowed to an estimated 1.6 percent in 1996, about a percentage point
lower than in 1995. Among the major EU countries, investment spending
was weak in France and Germany, while government consumption
expenditures contracted in Italy. Low consumer confidence also held back
aggregate demand in Continental Europe. As a result of this weaker
economic performance, growth in U.S. exports to the European Union
slowed sharply in the first 11 months of 1996.
Growth is estimated to have slowed in Singapore and South Korea,
because of oversupply in the market for certain electronic goods, and to
have stayed virtually unchanged in Hong Kong and Taiwan. U.S. exports to
these four markets expanded only 2 percent in the first 11 months of
1996, after growing at a rapid pace in 1995.
Activity in some other key export markets picked up in 1996. Japan
saw substantial growth for the first time since 1991, although it was
concentrated in the first quarter. Growth for all of 1996 is estimated
to have been 3.6 percent, after 4 years of annual growth averaging less
than 1 percent. U.S. exports to Japan expanded by a healthy 6 percent in
the first 11 months of 1996, although this was below the strong pace in
1995. This partially reflects fluctuations in the value of the yen,
which peaked at about 80 to the dollar in April 1995 and has since
depreciated over 40 percent, making imports from the United States more
expensive for Japanese residents.
Mexico pulled out of its severe 1995 recession last year, with
estimated growth of 4.0 percent following a 6.9 percent contraction in
1995. Reflecting this turnaround, U.S. merchandise exports to Mexico
expanded 21 percent in the first 11 months of 1996, after contracting
sharply in 1995.
Although the growth rates of our trading partners have probably been
the more important determinant of our trade balance, the level of the
dollar might have had an influence as well. The dollar, measured against
the currencies of the other major industrialized countries, fell to its
lowest levels in almost 3 years in mid-1995. Since then it has
appreciated by around 33 percent against the yen and around 11 percent
against the deutsche mark. This pattern of depreciation followed by
appreciation may explain part of the slowing in imports in late 1995 and
the increase in 1996. However, exchange-rate movements were probably not
the dominant cause of recent increases in the trade deficit for three
reasons. First, although the dollar has moved against some currencies,
its effective exchange-rate index, when weighted according to trade
shares, has appreciated only 6 percent in real terms since mid-1995.
Second, a lag of 2 or more years generally is seen before an import
price change has its full effect on volumes. Third, the initial effect
of an appreciation is generally to lower import prices, and therefore
lower the dollar value of import spending (the valuation, or J-curve,
effect), not to raise it.

Fiscal Policy

The Federal Government budget deficit for fiscal 1996 was $107
billion, a reduction of $57 billion from 1995. The deficit has now
declined in each of the last 4 years, for the first time since the
1940s. Last year's unified deficit was just 1.4 percent of GDP, the
smallest deficit by this measure since 1974. The U.S. general-government
(combined Federal, State, and local) deficit was the smallest among the
large industrialized countries. Moreover, the budget last year showed a
primary surplus (defined as revenues less outlays other than net
interest) of $134 billion, the largest ever, and the largest as a share
of GDP since the 1950s. Indeed, the budget would have been in balance
last year were it not for the interest due on the debt run up between
1981 and 1992. The low level of the budget deficit in recent years is
reflected in the ratio of publicly held Federal debt to GDP, which has
stabilized since 1993, after nearly doubling over the previous 12 years.
Part of this improvement in the deficit reflects the economic
expansion. As output and employment grow, tax revenues are boosted and
some types of expenditures, especially transfers to low-income
households, decline. But policy changes have been important as well. As
already noted, the standardized-employment deficit, as a share of
potential GDP, which is measured holding the level of economic activity
constant, has fallen for 4 straight years and was lower last year than
it has been since 1974.
The recent progress on the deficit reflects in large part the
increases in revenue and reductions in government spending due to the
Omnibus Budget Reconciliation Act of 1993. The Administration has worked
hard to increase the efficiency of government and has reduced the
Federal workforce substantially. By October 1996, Federal civilian
employment (excluding the Postal Service) had declined by more than
250,000 since January 1993. The Federal workforce is smaller than it has
been in 30 years, and smaller as a share of the total workforce than it
has been since the 1930s.
As a result of disagreements between the White House and the
Congress over the budget, two partial Federal Government shutdowns
occurred in late 1995 and early 1996. Although these closures
temporarily interrupted the disbursement of some Federal spending, the
overall stance of fiscal policy was largely unaffected because most of
the spending was later restored. The shutdowns did, however, have a
small, temporary effect on the level of real GDP because a large
proportion of Federal workers did not work during the shutdowns. A
related disagreement over passage of an extended increase in the debt
ceiling on Federal borrowing authority forced the Secretary of the
Treasury to take a number of extraordinary actions to ensure that the
United States did not default on its debt obligations for the first time
in its history. The debt ceiling bill was not passed until March, and
the final spending bills for fiscal 1996 were not passed until April,
more than 6 months after the start of the fiscal year.

Monetary Policy and Interest Rates

Monetary policy changed little during 1996. The Federal Reserve cut
the Federal funds rate by one-quarter percentage point at the end of
January 1996. This cut, following a similar-size cut in December 1995,
brought the funds rate down to about 5.25 percent, where it remained for
the rest of the year. Other short-term market rates declined with the
Federal funds rate early in the year but drifted slightly higher over
the late spring and summer. Evidently the pickup in economic growth was
seen in the markets as eliminating the possibility of further policy
easing, and later led many investors to expect tighter monetary policy.
Indeed, the minutes of the Federal Open Market Committee meetings held
in the summer and fall show that, although the committee chose to leave
policy unchanged, the members did see the risks as skewed toward an
intensification of inflation pressures, to which they would have had to
react with tighter policy. However, expectations of Federal Reserve
action subsided as economic growth moderated without a change in
monetary policy and as new data continued to show few signs of a pickup
in inflation. As a result, short-term rates retraced some of their
earlier rise. By year's end, expected future Federal funds rates, as
measured by prices in the Federal funds futures market, were about flat,
suggesting that market participants no longer thought that policy was
likely to change in the near term.
Intermediate- and long-term rates followed the same general pattern
as short-term rates over the course of the year, but the movements were
considerably larger (Chart 2-9). By late February, intermediate- and
long-term rates began to rise, and throughout the spring and early
summer stronger-than-expected economic data pushed rates higher. By July
the yield on 30-year Treasury bonds had risen more than a percentage
point from its January low. Later in the year, when economic growth
moderated and concerns about possible Federal Reserve policy action
eased, longer term rates fell; they rebounded, however, to finish 1996
more than half a percentage point higher than at the start of the year.


Rates on corporate bonds followed those on Treasury securities, as
risk spreads remained quite narrow (Chart 2-10). The average spread
between the rate on Baa-rated corporate bonds and that on 30-year
Treasury bonds changed little over the course of the year, ending up at
about 1.35 percentage points, fairly narrow by historical standards. The
spread between rates on the high-yield bonds issued by riskier firms and
those on comparable Treasury securities narrowed considerably in early
1996, following a steady increase in 1995. This spread, which was about
3.5 percentage points at year's end, is also quite narrow by historical
standards. Similarly, spreads between rates on bank loans to businesses
and market rates remained narrow as banks reported heavy competition
from other banks and, to a lesser extent, nonbank lenders.


These narrow spreads suggest that the markets believe the risk of
corporate default to be unusually low, reflecting in part the robust
profits enjoyed by U.S. firms in 1996. Indeed, in contrast to some
measures of household stress, measures of business financial
difficulties remain quiescent. Delinquency and charge-off rates for
business loans at banks are near their recent lows and well below their
levels in the mid-1980s. Similarly, the number of business bankruptcies
remains quite low.
Strong profitability helped boost broad stock market indexes to
successive record highs over the course of the year despite the rise in
longer term interest rates. Indeed, the rise in stock prices outran
corporate profits, so that the ratio of stock prices to recent earnings
was elevated at year's end, but still below its 1992 and 1993 peaks. The
runup in stock prices could reflect a number of factors. Investors may
anticipate further rapid growth in earnings and dividends, or a decline
in real interest rates as further progress is made in reducing the
budget deficit. Investors may also have gradually reduced the
compensation they demand for bearing the risk associated with holding
stocks, because they expect the current, more stable, low-inflation
environment to persist, or because of the influence of well-publicized
research showing that equities have consistently outperformed other
financial investments over long holding periods. The rise in stock
prices may also reflect the impact of financial market innovations that
have led to an unprecedented channeling of savings into the equity
market through pension and mutual funds.

OUTLOOK AND FORECAST

One way to project the future is to extrapolate the recent past. For
such a calculation it matters how fast real GDP has grown during the
current expansion. Measured on the product side, real output has grown
at a 2.0 percent annual rate since the business-cycle peak in the third
quarter of 1990, while the income-side measure has grown at a 2.3
percent annual rate (Table 2-3, line 13). As already discussed, it seems
that the truth is likely to be closer to the income-side measure.

Components of Long-Term Growth

It is useful to begin the discussion of the long-term outlook with
the components of aggregate supply. Whether one considers income- or
product-side measurement more accurate, it remains true that real output
has decelerated during the current business cycle from its pace between
the business-cycle peaks in 1973 and 1990. The deceleration is more than
explained by the slowing of both of the two components of labor force
growth, the working-age population and the labor force participation
rate.
Since 1989 the participation rate has been virtually flat, in sharp
contrast to the rising participation rates of the 1970s and 1980s. This
stalling of the overall 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 of
the female participation rate is probably the result of long-term
demographic trends. The child dependency ratio (the number 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.

Table 2-3.--Accounting for Growth in Real GDP, 1960-2003
[Average annual percent change]
----------------------------------------------------------------------------------------------------------------
1960 II    1973 IV
Item                               to  1973   to  1990    1990 III  to     1996 III
IV        III         1996 III       to  2003
----------------------------------------------------------------------------------------------------------------

1) Civilian noninstitutional population aged 16 and over....        1.8        1.5      1.0                 1.0
2) PLUS:   Civilian labor force participation rate\1\.......         .2         .5       .0                  .1

3) EQUALS: Civilian labor force\1\..........................        2.0        2.0      1.0                 1.1
4) PLUS:   Civilian employment rate\1\......................         .0        -.1       .1                  .0

5) EQUALS: Civilian employment\1\...........................        2.0        1.9      1.0                 1.1
6) PLUS:   Nonfarm business employment as a share of
civilian employment\1\ \2\.........................         .1         .1       .3                  .1

7) EQUALS: Nonfarm business employment......................        2.1        2.0      1.3                 1.2
8) PLUS:   Average weekly hours (nonfarm business)..........        -.4        -.3       .1                  .0

9) EQUALS: Hours of all persons (nonfarm business)..........        1.6        1.7      1.4                 1.2
10) PLUS:   Output per hour (productivity, nonfarm business).        2.8        1.1       .9   \3\(1.2)      1.2

11) EQUALS: Nonfarm business output..........................        4.5        2.8      2.3   \3\(2.7)      2.4
12) LESS:   Nonfarm business output as a share of real GDP\4\         .3         .1       .3    \3\(.4)       .1

13) EQUALS: Real GDP.........................................        4.2        2.7      2.0   \3\(2.3)      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\Income-side definition.
\4\Line 12 translates nonfarm business output back into output for all sectors (GDP), which includes the output
of farms and general government.

Note.--Detail may not add to totals because of rounding.
Except for 1996, time periods are from business-cycle peak to business-cycle peak to avoid cyclical variation.

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

The decline in this ratio allowed an increasing fraction of women to
enter the labor force between the mid-1970s and the mid-1980s, but its
subsequent flattening in the late 1980s has limited further increases in
participation.
The participation rate rose 0.15 percentage point in 1996, an
acceleration from its recent stagnation, but below its pace in the 1970s
and 1980s. Both male and female participation rates contributed to the
acceleration in 1996. The male participation rate flattened out, after
years of decline, while female participation rose 0.32 percentage
point--faster than its recent pace but more slowly than in earlier
decades.
Table 2-3 shows the contributions of population, labor force
participation, and productivity growth to output growth, both
historically and as projected. In the past, the contributions of these
supply-side factors have varied substantially across time periods, and
in ways that have tended to be offsetting. During the 1960-73 period,
output growth was fueled by a rapid increase in both the working-age
population and productivity. When productivity slowed after 1973, the
slowdown was partially offset by an increasing rate of labor force
participation. Growth in the working-age population was dramatically
slower after 1990, but this slowdown was partly countered by
stabilization in the length of the workweek.
The last column of Table 2-3 illustrates how the Administration's
forecast of 2.3 percent average annual GDP growth for the next 7 years
is consistent with projections of 1.0 percent growth in population, 0.1
percent growth in participation, and 1.2 percent growth in productivity.
As noted, the participation rate has turned up in the past year and
may even rise faster to the extent that the recently enacted welfare
reform legislation moves greater numbers of former recipients into the
paid labor force. Measured productivity is expected to grow a bit faster
than in the recent past, as further deficit reduction boosts investment,
and as planned adjustments to the CPI, which will affect the measurement
of productivity, are implemented.
As of December 1996 the current expansion had lasted 69 months,
making it the third longest in the postwar record. There is no
foreseeable reason why this expansion cannot continue. As last year's
Report argued, expansions do not die of old age. Rather, most recent
expansions have ended because of rising inflation, financial imbalances,
or inventory overhangs. None of these conditions exists at present. As
discussed earlier in the chapter, the financial condition of households
is sound, inventories remain lean, and inflation remains under control.

Inflation Considerations

The unemployment rate has fallen during the past 6 months, although
it remains within a range that most economists would view as consistent
with stable prices (Chart 2-11). The chart shows the band of uncertainty
about the natural rate, and this band is wide. Despite the recent
decline in unemployment, inflation remains stable, and economists are
gradually revising down their consensus estimate of the natural rate.
Some have pointed to the acceleration in wages and salaries over the
past year as proof that labor markets are tight enough for inflation to
begin rising. However, wages and salaries are only one part of labor
costs; the other component, hourly benefits, has slowed dramatically
over the past few years. Most of the slowing has been in health
insurance premiums. As a result, total hourly compensation for private
industry workers as measured by the employment cost index (ECI)
increased only 2.9 percent during the 12 months ending in September
1996--not much different from its rate during the previous 2 years. This
pace for hourly compensation, less the 1.1 percent trend for
productivity growth, implies that trend unit labor costs are increasing
at a 1.8 percent annual rate. As this is far below the pace of recent
price inflation, labor costs are not putting any upward pressure on
prices (Chart 2-12).
This reduction in the rise of employers' health premiums may be
temporary. Therefore it is worth entertaining the notion that wages and
salaries are the best measure of the trend in compensation. In this
case, trend unit labor costs would increase by the 3.3 percent


rate of ECI wage growth seen recently, less the 1.1 percent trend rate
of productivity growth discussed earlier, resulting in an estimate of
2.2 percent. This differs little from the recent rate of inflation as
measured by the price index for GDP (which is lower than CPI inflation).
Wage increases are thus high enough so that workers share in
productivity increases, but low enough that they do not put upward
pressure on inflation.
But the case against a near-term outbreak of inflation is stronger.
First, as already noted, slow growth in hourly benefits has been holding
down labor costs and may continue to do so. Second, corporate profits
are very high; profits as a share of GDP during the first three quarters
of 1996 were higher than for any three-quarter period since the 1960s.
Thus, profits could be a temporary buffer preventing accelerating wages
from being immediately passed through to accelerating prices. In sum,
with continued growth of productivity, with sustainable wage growth and
with high profits as a buffer, the U.S. economy has room for a sustained
increase in real wages--without rising inflation.
The rate of inflation in 1996 has been elevated by rapid increases
in food and energy prices. These prices are not expected to grow any
faster than other prices over the next year, and so the rate of increase
in the CPI is expected to edge lower. Also holding down measured
inflation over the next 2 years, by about 0.3 percentage point per year,
are methodological changes that are already under way. The BLS estimates
that by fixing a problem encountered when new stores are rotated into
the sample, CPI inflation will be lowered by 0.1 percentage point. (This
fix was completed in July 1996.) The forecast assumes that new
procedures for calculating the hospital services price index will lower
CPI inflation by about another 0.1 percentage point. Beginning in 1997,
the BLS will collect transaction prices where available rather than list
prices for hospital services, and will reorganize their categories so
that inpatient and outpatient surgery might be substitutable. Finally,
in 1998 the BLS will also replace its current market basket, based on
1982-84 data, with one based on 1993-95 data. Usually the items with the
smallest price increases receive the largest increase in weights. The
forecast assumes that the incorporation of the new market basket will
lower CPI inflation by 0.1 percentage point. The importance of
information-processing equipment alone will rise by enough to lower CPI
growth by 0.02 percentage point per year, assuming prices for such goods
continue to fall at a 10 percent annual rate as they have recently.

The Near-Term Outlook

With inflation not a problem, the economy can continue to move
forward at a sustainable rate. Aggregate demand is likely to be
sufficient. Consumption, which is two-thirds of the economy, should be
supported by a combination of high income growth, high consumer
confidence, and a high level of household net worth relative to income.
Business investment in equipment probably will continue to react to the
rapid improvements in technology--especially in computers and
telecommunications equipment. However, it seems likely that equipment
investment will not continue to grow at the torrid rate of the past few
years. The market for business structures should remain on track as
vacancy rates continue to decline. Finally, net exports were a drag on
economic growth in 1996, as growth in many of our trading partners
lagged behind our own. But there are signs that foreign growth is
picking up, and exports should soon reflect this.

Table 2-4.--Administration Forecast
----------------------------------------------------------------------------------------------------------------
Actual
Item             --------------------   1997     1998     1999     2000     2001     2002     2003
1995      1996
----------------------------------------------------------------------------------------------------------------

Percent change, fourth quarter to fourth quarter

----------------------------------------------------------------------------------
Nominal GDP..................        3.8   \1\5.0      4.6      4.7      5.0      5.0      5.0      5.0      5.0

Real GDP (chain-type)........        1.3   \1\2.8      2.0      2.0      2.3      2.3      2.3      2.3      2.3

GDP price index (chain-type).        2.5   \1\2.2      2.5      2.6      2.6      2.6      2.6      2.6      2.6

Consumer price index (CPI-U).        2.7      3.2      2.6      2.7      2.7      2.7      2.7      2.7      2.7

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

Calendar year average

----------------------------------------------------------------------------------
Unemployment rate (percent)..        5.6      5.4      5.3      5.5      5.5      5.5      5.5      5.5      5.5

Interest rate, 91-day
Treasury bills (percent)....        5.5      5.0      5.0      4.7      4.4      4.2      4.0      4.0      4.0

Interest rate, 10-year
Treasury notes (percent)....        6.6      6.4      6.1      5.9      5.5      5.3      5.1      5.1      5.1

Nonfarm payroll employment
(millions)..................      117.2    119.5    121.1    122.4    123.9    125.6    127.4    129.1    130.8

----------------------------------------------------------------------------------------------------------------
\1\Estimates.

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

In 1997 and 1998 the Administration projects a 2.0 percent increase
in output (Table 2-4), slightly below the potential pace, but in line
with the consensus. The balance of the Administration's forecast is
built around a 2.3 percent growth rate of potential output. The
Administration does not think that 2.3 percent real growth in the long
term is the best the United States can do. This projected pace reflects
a conservative estimate of the effects of Administration policies to
promote education and investment and to balance the budget. The outcome
could be even better. But the Administration's forecast is used for a
very important purpose: to project Federal revenues, outlays, and the
Federal deficit. For this purpose the most important virtues are
credibility and conservatism, and the Administration has remained close
to mainstream thinking on these issues. The Administration's forecasting
record is good, and the projections here are close to the consensus of
private forecasters.