[Economic Report of the President (1998)]
[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. 105-176
[From the online service of the the U.S. Government Printing Office]
[wais.access.gpo.gov]



CHAPTER 2 -- Macroeconomic Policy and Performance

Macroeconomic performance over the past 5 years has been excellent,
and the record in 1997 was truly remarkable. In general, the behavior
of the economy last year bore out the analysis of macroeconomic
conditions presented in last year's Economic Report of the President,
which was confident that the economy would continue to grow without
rising inflation. What was not anticipated fully at that time,
however, was how rapidly the economy would grow or how strong the pace
of job creation would be--or that inflation would actually decline.

Last year the Administration forecast 2-percent growth during 1997
with an average unemployment rate of 5.3 percent. This forecast was
not meant as an assessment of the best the economy could do. Rather,
it represented a conservative and credible set of economic assumptions
to be used for forecasting Federal revenues, outlays, and deficits in
the preparation of the budget. Last year's Report recognized that the
actual outcome could be even better. And it was, with growth at nearly
4 percent and the unemployment rate averaging only 4.9 percent. More
jobs were created in 1997 than in either of the 2 previous years. Yet
inflation remained subdued, with the consumer price index (CPI) rising
just 1.7 percent during the year.

This chapter's analysis of macroeconomic policy and performance
concludes that the economy should continue to grow with low inflation
in 1998. The chapter begins with a review of macroeconomic performance
and policy in 1997, to show in some detail where the year's growth
came from and how inflation remained so tame. The second section
examines the important question of whether our understanding of
inflation and our ability to predict it have changed in significant
ways. This question is part of a broader inquiry into whether the
economy has changed in such fundamental ways that standard analyses of
how fast it can grow without inflation need to be replaced with a new
view. The conclusion reached here is that no sea change has occurred
that would justify ignoring the threat of inflation when the labor
market is as tight as it is now; however, the unemployment rate at
which rising inflation becomes a serious threat appears to be lower
than it was in the 1980s, and the rate of growth of potential output
may be higher.

Prudence dictates keeping a wary eye on inflationary pressures, but,
as discussed in Chapter 1, the economy remains remarkably free of the
kinds of imbalances that often appear at the end of expansions. For
example, the analysis in the third section of this chapter indicates
that the financial condition of households remains fundamentally
sound, even though they took on considerable debt in 1997. Two
cautionary notes are introduced. First, the rise in the stock market
over the first 7 months of 1997 put price-earnings ratios and other
measures of stock market valuation near historical highs. Second,
households are continuing to consume a very high proportion of their
disposable income and are saving little. The implications of this low
saving rate for long-term growth are explored in the fourth section of
the chapter, which also assesses the positive contribution of deficit
reduction. The chapter concludes with the Administration's forecast
and outlook.

OVERVIEW OF 1997: A BURST OF GROWTH

Economic growth exceeded expectations in 1997, and the unemployment
rate declined to a 24-year low. Households and firms both increased
their spending at robust rates as continued low inflation, low
unemployment, declining costs of business equipment, and lower
long-term interest rates contributed to a favorable economic
environment for both consumers and producers. Federal Government
purchases of goods and services declined in real terms, and purchases
by State and local governments increased only modestly. Net exports
continued to be a restraining influence on growth.

Strong investment in new productive capacity in the past few years has
helped the economy accommodate higher spending without rising
inflation. But inflation has also been held in check by several other
favorable developments that have kept prices from accelerating even as
wage growth has picked up. Chief among these have been the rise in the
value of the dollar on foreign exchange markets (which makes imports
cheaper), unusually steep declines in prices for computers, and
continued moderation in employer costs of health insurance.

Late in 1996 the economy was already operating near the consensus
estimate of its noninflationary potential. Continued robust economic
growth in the latter part of 1996 and early 1997 promised to increase
resource utilization rates even further, raising concerns that
inflationary pressures would build, and the Federal Reserve raised
short-term interest rates in March. With inflation low and stable--and
in light of the turmoil in Asian financial markets that began to
emerge in mid-1997--the Federal Reserve made no further interest rate
moves.

AGGREGATE SPENDING IN 1997

An accounting of the sectoral contributions to growth in 1997 shows
that increases in private domestic spending for consumption and
investment combined exceeded growth in gross domestic product (GDP;
Table 2-1). Modest increases in State and local government
expenditures accounted for the increase in total government spending.
Net exports became more negative.


TABLE 2-1.~--Components of GDP and Growth in GDP, 1997
----------------------------------------------------------------------------
Item               Billions    Percent       Contribution to growth
of        of GDP    Percentage       Percent of
dollars                 points        total change
----------------------------------------------------------------------------
Personal consumption
e~xpenditures. . . . .     5,488.6     67.9          2.5              65.2  Gross private domestic
investment . . . . . .     1,237.6     15.3          1.5              38.4
Fixed investment. . .     1,173.0     14.5          1.1              27.3
Nonresidential . . .       845.4     10.5           .8              21.3
Structures. . . . .       230.2      2.8          -.0               -.6
Producers' durable
equipment  . . . .       615.2      7.6           .9              21.9
Residential . . . .       327.5      4.1           .2               6.0
Change in business
inventories. . . . .        64.6       .8           .4               10.9
Net exports of goods and
services. . . . . . .       -96.7     -1.2          -.4              -10.0
Exports . . . . . . .       958.8     11.9          1.2               31.7
Imports . . . . . . .     1,055.5     13.1         -1.6              -41.9
Government consumption
expenditures and
~gross investment. . .     1,453.9     18.0           .2                6.1
Federal. . . . . . .       524.8      6.5          -.0                -.0
State and local. . .       929.1     11.5           .2                6.1
GROSS DOMESTIC PRODUCT  8,083.4    100.0          3.9              100.0
MEMORANDUM: FINAL
SALES . . . . . . .     8,018.8     99.2          3.5               89.1
---------------------------------------------------------------------------
Note.-Data are preliminary estimates. Contribution to growth is measured
fourth quarter to fourth quarter.
Sources: Department of Commerce (Bureau of Economic Analysis) and Council of
Economic Advisers.


Private Domestic Spending

The factors traditionally thought to determine household spending are
household income, consumer sentiment, and household net worth in the
current and recent years. Signals were favorable for all of these
fundamentals through most of 1997: real disposable personal income
grew 3.7 percent over the four quarters of the year, consumer
sentiment remained at or near record highs for most of the year, and
year-end stock market values were up about 30 percent from a year
earlier.  Outlays grew even faster than income, and as a result, the
personal saving rate edged down.

Although consumption was robust over the past year, it was not smooth.
Real consumption grew in excess of a 5-percent annual rate in the
first and third quarters, but at only a 0.9-percent annual rate in the
second. No reason for this volatility is apparent; neither fluctuating
income, changes in consumer confidence, nor ups and downs in the stock
market explain it. Although the stock market dipped in April after the
Federal Reserve's interest rate hike, it had fully recovered by
mid-May. At the same time, consumer sentiment continued to rise. Most
of the volatility was in goods consumption; services consumption grew
at around a 4- to 5-percent annual rate in each quarter. Durable
goods, which rose at double-digit annual rates in the first and third
quarters but fell at a 5-percent annual rate in the second, accounted
for much of the quarter-to-quarter fluctuations in growth. Light motor
vehicle sales of roughly 15 million units in 1997 were about the same
as in each of the past 3 years; over this 4-year period, sales of
light motor vehicles were just shy of the record 4-year pace set in
the mid-1980s.

Like those for consumption, the signals for the traditional
determinants of business investment--lagged GDP growth, cash flow
growth, and the cost of capital--were strongly favorable throughout
1997. Several special factors added further impetus to investment
spending. Business equipment grew 12 percent over the four quarters of
the year, with strong demand for most types of equipment. Industrial
equipment grew a healthy 7 percent over the year, and transportation
equipment advanced 10 percent, with particularly rapid growth in
aircraft purchases.

The standout categories of business equipment investment in 1997 were
office and computing equipment and telecommunications equipment.
Growth in real computer spending was fueled in part by price declines
that were even sharper than normal (32 percent over the past year).
Real spending on telecommunications equipment increased 10 percent.
One factor possibly boosting sales in this industry is the rapidly
expanding capacity and availability of cellular telephone and other
wireless services. Although nominal spending on computers and
telecommunications equipment represents about 25 percent of investment
in equipment, measured relative declines in computer prices have been
rapid, so that these categories now account for a rising fraction of
real equipment purchases.

In contrast to the strength in equipment spending, investment in
nonresidential structures was about flat last year, following solid
gains in 1996. Construction of new office buildings made solid gains,
as the strength in the economy allowed the sector to grow out from
under an overhang of empty office buildings at the beginning of the
decade. These gains were offset by small declines in the construction
of industrial, utility, and mining structures.

A pickup in inventory investment added 0.4 percentage point to real
GDP growth over the four quarters of 1997, with an especially large
buildup in the first quarter. The demand for inventories was probably
a result of strong final sales, which increased faster than
inventories over the first three quarters of the year. As a result,
stocks remained lean in relation to sales.

Residential construction increased 6 percent over the four quarters of
1997, with much of that growth occurring in the fourth quarter. The
pickup toward the end of year reflected in part the pattern of
mortgage rates, which after rising through April, fell more than 1
percentage point later in the year.  Falling mortgage rates, together
with strong real income growth, resulted in an increase in housing
affordability in the second half of the year. In addition to new home
construction, real estate commissions moved up over the year, as sales
of existing homes grew by 3 percent over 1997 as a whole to their
highest level ever.

When consumption and investment are combined, real private domestic
demand grew 4.8 percent over the four quarters of 1997; this was
somewhat faster than plausible estimates of the sustainable long-run
growth rate of the economy. The impact of this surge of private
spending was muted, however, by an erosion in net exports, a
continuing decline in real Federal Government spending, and slow
growth in spending by State and local governments.

Government Spending and Fiscal Policy

Government expenditures made only a modest contribution to growth in
real GDP in 1997--and all of that came from expenditures by State and
local governments. Real Federal Government expenditures were lower
last year than in 1996. Fiscal policy was tight in 1997, with the
adjusted structural budget deficit (the deficit measured at a
standardized level of economic activity) declining by $54 billion in
fiscal 1997 from $112 billion in fiscal 1996.

These developments reflected ongoing efforts to restore Federal fiscal
responsibility, which culminated in the Balanced Budget Act of 1997.
The Federal Government's unified budget deficit for fiscal 1997 was
$22 billion, a reduction of $86 billion from 1996. The Federal budget
position has now improved in each of the last 5 years, the longest
unbroken period of improvement since 1948. Last year's unified deficit
was just 0.3 percent of GDP, the smallest by this measure since 1970.
Relative to the size of the economy, last year's general-government
deficit (the combined deficit of all levels of government) is
estimated to have been smaller than that of any other large industrial
country except Canada. Moreover, last year's primary Federal surplus
(defined as revenues less outlays other than net interest) was $221
billion; as a share of GDP this was the largest since the 1950s. It
reveals that the overall budget would have shown a substantial surplus
last year were it not for the interest obligations on debt run up
during the period of large deficits.

Much of the long-term progress on the deficit can be traced to the
effects of the Omnibus Budget Reconciliation Act of 1993. However,
last year's improvement in the deficit was considerably greater than
had been anticipated; as recently as February 1997 the projected
deficit for fiscal 1997 was $126 billion.

The continuing vigor of the economy is clearly responsible for part of
this progress toward a balanced budget. Of course, sound
policies--including a credible commitment to deficit reduction--have
nurtured the expansion. About $30 billion of the improvement in the
deficit resulted from lower-than-expected expenditures. Robust
economic growth also was responsible for some of the $76 billion in
unanticipated revenues collected by the Treasury. However, revenues
increased even more than would have been predicted on the basis of
observed economic growth (Box 2-1).

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Box 2-1.--Accounting for the Deficit Surprise During Fiscal 1997

In last year's budget the current-services deficit for fiscal 1997 was
projected at $127.7 billion. (The current-services deficit assumes no
change in law. The President's budget, which includes policy
proposals, was projected at $125.6 billion.) The actual budget deficit
was $21.9 billion--or $105.8 billion lower than the current-services
projection. Although a full accounting for this deficit surprise will
not be possible for several years, the table below summarizes what is
now known.
Of the $105.8 billion difference between the actual and the
current-services deficit, $30.3 billion was accounted for by
lower-than-expected outlays. About one-quarter of these savings were
in income security programs such as food stamps, unemployment
insurance, and family support programs; spending on all of these
programs is typically linked to economic performance.
The remaining $75.5 billion of the difference was attributable to
unexpectedly high revenues. Only $12.3 billion of this revenue
surprise was accounted for by higher-than-expected collections of
corporate, social insurance, excise, and other taxes. Most
($63.2 billion) of the unanticipated revenues came from individual
income taxes. A large portion of the unanticipated individual income
tax revenue, $28.2 billion, came in as payments on 1997 obligations. A
full accounting of this surprise will have to wait until 1997 tax
returns are processed, but a large share of the unanticipated
collections on 1997 liabilities is likely related to
better-than-expected economic growth in 1997. Approximately $6.0
billion in additional individual tax receipts came from payment of
back taxes or from taxes on trusts.
Another $29.0 billion of the revenue surprise arrived in the form of
higher-than-anticipated final payments and lower-than-anticipated
refunds on 1996 individual income tax liabilities. The largest
identifiable contributing factor was higher-than-anticipated tax
liability on capital gain realizations, which accounted for $20.1
billion of the $29.0 billion in unanticipated

Box 2-1.--continued

payments on 1996 obligations. The remaining $8.9 billion came from
higher-than-expected tax liabilities on pensions, dividends,
distributions from Individual Retirement Accounts, interest payments,
and wages and salaries, which were partially offset by
higher-than-anticipated deductions.
----------------------------------------------------------------------------

In national income accounting terms, the slowdown in the growth of
government expenditures and the improving general-government budget
balance have exerted a moderating influence on overall aggregate
demand that has partly offset the robust stimulus coming from private
consumption and investment. Nevertheless, the combined impetus from
private and government spending exceeded the increase in domestic
aggregate production, so that net exports declined further.

Net Exports and the Current Account

U.S. exporters had a good year in 1997, as real exports rose 10.9
percent. However, robust growth in domestic demand pushed real imports
up by 13.3 percent. Real net exports fell by $35.8 billion over the
course of the year, and their contribution to growth in real GDP was
-0.4 percentage point.

One useful perspective on the performance of real net exports comes
from looking at the pattern of growth in the global economy. At least
four major locomotives matter for global economic growth: North
America, Europe, Japan, and--in the past decade--the East Asian
industrializing economies. Expectations at the end of 1996 were that

----------------------------------------------------------------------------
Box 2-2.--Turmoil in Asian Economies

The outbreak of financial crisis in Asia was one of the most
notable--and troubling--developments in the global economy during 1997.
Events began in midyear as a currency crisis and intensified over the
rest of the year, spilling over to the real sectors of the affected
economies as well as to the rest of the world.
By May 1997 Thailand was in the throes of the fourth speculative
attack on its currency, the baht, since August 1996. By then the
buildup of financial difficulties and balance of payments pressures
had reached such a point that efforts to defend the baht could not be
sustained. Pressures soon spilled over to other emerging Asian
economies (especially Indonesia, Malaysia, and South Korea), most of
which also had some balance of payments weaknesses, as well as to
Eastern Europe. These countries' difficulties shook financial market
confidence elsewhere in Asia and in emerging markets around the world,
even those with sounder policies and economic fundamentals, in a
contagion effect.
Since June, four of the countries in the region (Indonesia, the
Philippines, South Korea, and Thailand) have requested and received
assistance from the International Monetary Fund (IMF). In each
instance the adjustment programs developed by the domestic authorities
and the IMF have included a heavy emphasis on financial and structural
adjustment measures (for example, to reform bank lending practices and
further liberalize the economy), as well as the more traditional
macroeconomic adjustments necessary to restore financial market
stability. For each of the affected economies, the question of when
their financial and balance of payments situations will stabilize
depends, first and foremost, on whether and how aggressively they
implement their policy commitments, and second, on the easing of the
contagion effect from those economies that continue to experience
difficulties. In the medium term the return of these economies' strong
growth performance will depend significantly upon the degree to which
structural and financial sector reforms are implemented.
-----------------------------------------------------------------------------

growth would slow in the United States and that the other regions
(except Japan) would easily outpace it. Instead, the United States
(and Canada) saw higher growth rates in 1997 (about 4 percent each),
while growth among our trading partners in the other regions slowed.
In Japan the recovery from the recession of the early 1990s came to a
standstill. In Europe growth continued in 1997, especially in a
northern tier composed of the British Isles and the Nordic countries.
In the developing economies of East Asia, slowing growth turned to
financial crisis in the second half of the year (Box 2-2).

Growth rates in the United States and its trading partners, along with
exchange rates, are major determinants of short-run fluctuations in
real net exports. The fact that income increased more rapidly here in
1997 than it did in most other advanced industrial economies worked to
increase U.S. imports from those economies more rapidly than their
imports from the United States. The negative effects of the East Asian
crunch on U.S. net exports to developing countries had barely begun to
materialize at the end of the year.

In analyzing the components of real growth, it is appropriate to look
at real net exports. But the focus generally shifts to nominal imports
and exports when examining current income flows between the United
States and the rest of the world. The comprehensive measure of such
flows is the current account balance, which comprises not only the
trade balance in goods and services but also net investment income and
transfers.

In a fundamental sense, trends in the current account balance reflect
movements in saving and investment. When the demand for investment in
the United States exceeds the pool of national saving, the difference
is made up by borrowing from foreigners. Conversely, when saving
exceeds investment, the surplus is invested abroad. The United States
first experienced large current account deficits during the mid-1980s,
when net investment fell as a share of national income and net
national saving fell even faster. The deficit shrank briefly as
investment collapsed in the 1990-91 recession, but it has reemerged in
the current expansion. The good news in this expansion is that
investment has been booming. But saving does not appear to have kept
pace. (The interpretation of current trends in saving, investment, and
the current account is complicated by the statistical discrepancy
between GDP measured as the sum of all spending on output and GDP
measured as the sum of all income generated in producing that output.)

The current account deficit for the first 9 months of 1997 was about
$8.7 billion greater than in the comparable period in 1996, and the
deficit for the year is likely to be moderately higher than the $148
billion (1.9 percent of GDP) recorded in 1996. Much of the increase
reflects the emergence of a deficit in the balance on investment
income. As a result of past deficits, foreign holdings of U.S. assets
are now sufficiently large that the investment income paid to
foreigners now exceeds investment income earned on U.S. holdings of
foreign assets. The balance on all goods and services may show little
change at all from last year's $111 billion. The modest size of the
increase in the trade deficit last year is probably related to changes
in the exchange rate of the dollar.

The effect of exchange rates on the nominal trade balance last year is
complicated. The trade-weighted exchange rate of the dollar rose about
3 percent during the first quarter of the year (that is, the dollar
strengthened against a weighted average of the currencies of our
trading partners). In the long run the effect of a stronger dollar is
to slow exports and probably raise spending on imports, thereby
depressing the trade balance. But in the short run the effects on the
nominal trade balance may go the other way. This is because, with a
stronger dollar, importers do not have to pay out as many dollars to
obtain the foreign currency they need to pay for previous quantities
of imports (in what is called a valuation effect), and because it
takes time for the quantity demanded to adjust. There can be a lag of
2 years or more before price changes have their full effect on trade
volumes, but when they do they dominate the valuation effect. (This
pattern of response is often called the J-curve, because the dollar
value of imports at first declines with a stronger dollar but later
rises.) The difficulty in interpreting what happened in 1997 is due to
the fact that in 1996, before the most recent appreciation, the dollar
had also increased in value. Thus the lagged effects from that earlier
appreciation may have partly canceled out the immediate effects from
the 1997 appreciation. The delayed effects of the dollar's
appreciation, together with the other effects of the East Asian
financial crisis, are likely to show up in a more marked increase in
the trade deficit, by all measures, in 1998.

MONETARY POLICY AND FINANCIAL MARKETS

The Federal Reserve raised its target Federal funds rate by 25 basis
points in March, to 5.5 percent. The proximate cause of the rate
increase was the perception that strong demand would boost utilization
rates, which were already approaching levels that in the past had been
associated with rising inflation. The mild deceleration in GDP prices
in the second half of the year translated into a slight upward drift
in the real Federal funds rate as 1997 came to a close, putting the
real rate slightly above its mid-1995 peak. Moreover, the rise in the
real short-term rate did not appear to feed through to intermediate-
and long-term real rates, which remained essentially unchanged--or, by
some measures, even declined--in the second half of the year.

Short-term interest rates fluctuated within a narrow range over the
course of the year, whereas long-term rates rose slightly early in the
year but then declined, finishing the year roughly 50 basis points
(half a percentage point) lower. Long-term interest rates remain very
low. The yield on 10-year Treasury notes remained within 50 basis
points of its 30-year low, while the 30-year Treasury yield stood near
its lowest level since that bond's introduction in 1977. This largely
reflects two related factors: continued progress in deficit reduction,
which lowers nominal interest rates by reducing expected future real
rates, and market participants' expectations of low future inflation,
which act to reduce nominal rates. In addition, turmoil in foreign
asset markets in the second half of the year helped make U.S.
securities more attractive to investors; this ``flight to quality''
probably boosted demand for U.S. assets, putting additional downward
pressure on nominal interest rates. The net result was a flattening of
the yield curve, with the spread (the difference in interest rates)
between 3-month Treasury bills and 10-year Treasury notes falling to
roughly 60 basis points by the end of 1997. This spread is now well
below its historical average of 135 basis points and is roughly equal
to the level that prevailed during the 1960s.

The risk premium on corporate debt--measured as the spread between the
yield on Baa-rated corporate bonds and the 30-year Treasury bond
yield--averaged roughly 125 basis points in 1997 (a Baa rating denotes
bonds of intermediate credit quality); this spread remains quite
narrow by historical standards. The spread between riskier, high-yield
corporate debt (``junk'' bonds) and 10-year Treasury securities also
remained narrow in 1997 but began to rise toward the end of the year.
Taken as a whole, these low risk premiums suggest that market
participants perceive the financial and business sectors to be quite
healthy; most relevant statistics provide support for this view. In
the banking sector, business loan charge-offs and delinquency rates
remained low, while bank capital ratios remained high. Although
business failures increased in 1997, a large portion of this increase
appears to reflect special, one-time factors, not a permanent change
in trend.

For equity markets 1997 was a noteworthy year. The rise in stock
prices was checked only slightly following the Federal Reserve's March
tightening, and even sharp declines in some foreign stock markets were
unable to do more than temporarily slow the market's advance. All
three major stock price indexes--the Dow Jones Industrial Average, the
Standard & Poor's (S&P) 500, and the NASDAQ composite--shattered
previous records; the S&P 500, for example, peaked in October at
983.12, a record high and 40 percent above its October 1996 average.
The runup in stock prices appeared to be fueled by continued high
profitability in the corporate sector and forecasts of strong future
earnings growth, and it pushed aggregate price-earnings ratios up
sharply. By some measures price-earnings ratios are at levels not seen
in decades.

Declines in foreign stock markets spread to domestic markets later in
the year, causing them to retreat from these record highs. On October
27th the Dow posted a 554-point decline--the 12th-largest in percentage
terms in its history. The drop was steep enough to cause the New York
Stock Exchange's system of ``circuit breakers'' to suspend trading
temporarily for the first time ever (Box 2-3). The day after the
plunge saw the volume of shares traded on the New York Stock Exchange
reach a record high of 1.2 billion (the market made up much of its
previous day's decline that day). The stock market rebounded quickly
following its October losses, with the S&P 500 index and the Dow
finishing 1997 near their highs for the year. Turmoil in East Asia
apparently continued to be a source of downward pressure on stock
prices for the remainder of the year.

The rise in stock prices in 1997 represents the continuation of a
trend that has seen major indexes more than double over the past 3
years. One explanatory factor is market expectations of strong future
corporate earnings. Another possible factor is a reduction of the
premium that investors require to hold stocks in lieu of less risky
assets. Such a reduction could occur if the perception has become more
widespread that stocks represent an attractive, high-return asset, or
if investors' interest in longer term investments for retirement has
grown. Still other possible explanations are a reduction in investors'
expectations of future inflation or of future real interest rates, or
the effect of financial innovations in channeling a larger share of
savings into the stock market by way of mutual funds and pension
funds.

There is some scattered evidence that investors have come to view
stocks as a less risky investment: for example, a survey of
individuals' attitudes toward the stock market shows a marked decline
in the perceived riskiness of stocks since 1994. Similarly,
participants in the largest private retirement savings plan in the
United States have directed an increasing fraction of their retirement
saving contributions to equities since 1986; however, it is unclear
how much this reflects a reduction in participants' tolerance for
risk, a change in their perception of the riskiness of the stock
market, or other factors. If the risk premium on stocks has declined,
this could explain why price-earnings ratios are at historically high
levels; a simple calculation indicates that even a relatively small
change in the risk premium is sufficient to raise price-earnings
ratios sharply. Nevertheless, the possibility exists that
price-earnings ratios will eventually return to more normal levels,
given that periods in which price-earnings ratios are high tend to be
followed by slower future growth in stock prices.

INFLATION AND THE LABOR MARKET

Inflation remained remarkably subdued in 1997. Both GDP and core CPI
inflation (a measure of inflation that excludes the volatile food and
energy components) fell over the course of the year, continuing a
decline that began in 1995. Surprisingly, this deceleration of prices
occurred in an economic environment that was characterized by
extremely low unemployment: as 1997 came to a close, the unemployment
rate had been at or below 5.5 percent for almost 2 years, and at or
below 5 per-

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Box 2-3.--Circuit Breakers

``Circuit breakers'' are rules that automatically halt trading on a
securities exchange when prices move by a given amount. The boards of
a number of major exchanges, including the New York Stock Exchange
(NYSE) and the Chicago Mercantile Exchange, set up circuit breakers in
the wake of the 1987 stock market crash. The NYSE circuit breakers
provide a good example of how such rules operate. Before the October
27th stock market decline, the circuit breakers were set to halt
trading for 30 minutes if the Dow Jones Industrial Average declined
more than 350 points from its morning opening price, and for another
hour if the Dow were to fall an additional 200 points. Both of these
limits were hit on October 27th, and the circuit breakers operated as
designed and closed the market twice (the second event occurred less
than an hour before the closing bell and thus ended trading for the
day).
When they were introduced, it was argued that circuit breakers would
reduce the chance of a major market disruption in three ways: by
preventing an overload of the exchanges' trading systems during
periods of extraordinary price movements; by reducing the possibility
that sharp (and possibly unchecked) declines in stock prices would
leave market participants unable to make good on their trading
commitments; and by providing a forced pause in trading--a chance for
market participants to ``take a deep breath.''
Many observers and market participants criticized the role that the
circuit breakers actually played on October 27th. The trigger limits
had only been adjusted once since 1988, and the percentage declines in
the Dow that they reflected were only about a third as large as they
were when the triggers were  set up in 1988. Furthermore, the
securities exchanges now have enormously greater capacity to process
trades than they did in 1987; by all accounts the record trading
volumes on October 27th and 28th did not remotely threaten to overload
the system. And concerns about fulfillment of trading commitments
appear to have been at least partially allayed, because traders now
have greater access to emergency credit. The ``deep breath'' argument
is more difficultto assess, because nobody knows what would have
happened had the markets not closed early on October 27th. But some
critics argue that circuit breakers can add to market volatility by
causing a race to the exit--a sharp selloff in shares--as stock prices
approach the threshold for a trading halt. Indeed, many traders argue
that that is just what happened when the NYSE reopened after the first
of its two shutdowns on October 27th.  The NYSE has announced that it
will propose modifications to the rule in 1998.
------------------------------------------------------------------------------

cent for 9 months. The unemployment rate fell from
5.3 percent in the fourth quarter of 1996 to 4.7 percent in the fourth
quarter of 1997; all major demographic groups participated, with
declines of 1.0 percentage point among blacks, 0.6 percentage point
among whites, and 0.6 percentage point among Hispanics.

The pace of job creation was quite rapid. More than 3.2 million jobs
were created in 1997, for an average of 267,000 new jobs per month--a
substantially faster rate than in either of the 2 preceding years.
Factory employment rose significantly, by 230,000 new jobs, while
employment at construction sites rose by 210,000 jobs following a
slightly larger gain in 1996. Among the service-producing industries
growth was particularly rapid in computers and data processing (which
increased 13 percent) and engineering and management services (which
increased 7 percent).

These hiring gains were matched by large increases in industrial
capacity. Nevertheless, tightness in labor markets was reflected in a
continued acceleration of wages during the year. Hourly wages as
measured by the employment cost index (ECI) rose by 3.9 percent in
1997, 0.5 percentage point faster than in 1996. The ECI for total
hourly compensation accelerated by a slightly smaller amount, and
continued slow growth in the cost of benefits--particularly health
insurance--kept the growth rate of total hourly compensation 0.5
percentage point lower than that for hourly wages. Trend unit labor
costs (defined as compensation growth relative to trend productivity
growth) continued to rise moderately through the year, while overall
price inflation fell slightly (Chart 2-1).



PRODUCTIVITY

Growth in output per hour worked picked up sharply in 1997: over the
first three quarters of the year the official measure of productivity
in the nonfarm business sector rose at an average annual rate of 2.6
percent. This measure has exceeded its trend rate of growth in all but
one of the past eight quarters. These recent gains were sufficient to
offset the earlier weak performance of this product-side measure of
productivity, bringing it back to its post-1973 trend. (Trend growth
in productivity is discussed in the ``Forecast and Outlook'' section of
this chapter.) Part of the surge in productivity probably reflected
special factors: productivity growth in the third quarter of 1997 was
boosted in part by a decline in hours worked by self-employed workers;
these data tend to be more volatile and somewhat less reliable than
measures of hours worked by employees. However, even when
self-employed workers are excluded, measured productivity growth in
the third quarter remains over twice as fast as its trend rate. The
pickup in productivity growth is significant because it occurred at
the same time that hourly compensation showed some signs of
accelerating. This has kept growth in unit labor costs from rising by
as much as compensation, thus eliminating a potential source of
inflationary pressure.

EXPLAINING RECENT INFLATION PERFORMANCE

Inflation continued to moderate in 1997 even as the unemployment rate
reached a 24-year low. To what extent can recent inflation performance
be explained with the traditional tools of macroeconomic forecasting
and analysis?

RECENT INFLATION PERFORMANCE AND THE NAIRU

The present combination of low and declining inflation and sustained
low unemployment would appear to pose a challenge to models of price
inflation based on the concept of a NAIRU, or
nonaccelerating-inflation rate of unemployment. As discussed in the
1997 Economic Report of the President, historical experience indicates
that the chances are high that inflation will rise in periods when the
unemployment rate is very low, and fall when unemployment is unusually
high. The NAIRU can therefore be defined as the unemployment rate at
which--absent special factors--the odds of falling and rising inflation
are roughly balanced. Although a specific value of the NAIRU
represents a forecaster's best estimate of the rate of unemployment
that can be sustained on average without causing an increase in
inflation, any estimate of the NAIRU is subject to some degree of
imprecision, inasmuch as there will be periods when inflation is
falling even though unemployment is below the NAIRU, and vice versa.
In addition, the NAIRU itself is not invariant over time, but is
instead affected by such factors as the demographic composition of the
labor force and changes in the structure of labor and product markets.

The 1997 Report indicated that reasonable estimates for the NAIRU lie
between 5 and 6 percent, with a midpoint of 5.5 percent. In 1997 the
unemployment rate averaged 4.9 percent, about one-half percentage
point below the midrange estimate of the NAIRU. A forecasting model
built around a NAIRU of 5.5 percent would therefore have predicted
some acceleration in prices over the course of 1997; one reasonable
estimate would have been a 0.3-percentage-point increase in core CPI
inflation. Instead, core CPI inflation finished the year roughly 0.4
percentage point below its year-earlier rate, although 0.1 percentage
point of this deceleration can be accounted for by methodological
changes introduced into the calculation of the CPI.

The observed decline in inflation is consistent with the view that
changes in inflation are influenced by other factors besides labor
market slack (measured here by the gap between the actual unemployment
rate and the NAIRU). A number of factors did in fact help mitigate
inflationary pressure in 1997. First, the costs of providing workers
with nonwage compensation (such as health insurance) continued to rise
at a very low rate; as mentioned above, this helped keep growth in
labor costs from adding to inflation. Second, also as noted above,
computer prices have recently declined at a faster-than-average rate;
without this decline, overall inflation would have risen steadily
since early 1994 (Chart 2-2). Although it is always possible to find
components of GDP whose prices are growing faster or slower than the
average, relative price changes for computers are particularly
noteworthy in that they are largely driven by technological change, as
opposed to cyclical forces such as shortages in raw materials,
bottlenecks in production, or rising labor costs.



Overall price inflation has been further reduced by sharp declines in
the relative price of imported goods, particularly non-oil merchandise
imports. Since the second quarter of 1995 the relative price of all
imported goods has fallen by 14 percent, and the relative price of
non-oil merchandise imports has declined by 15 percent. In part this
decline in import prices reflects two interrelated factors:
significant excess capacity--and hence low rates of inflation--abroad,
and the dollar's appreciation against other major currencies. It is
difficult to determine precisely what effect this has had on overall
inflation, but some estimates indicate that this factor could have
reversed much if not all of the increase in inflation that would have
been predicted solely from the gap between the actual unemployment
rate and the estimated NAIRU.

Judged from the perspective of a NAIRU model, therefore, it seems
possible that the economy is currently operating at an unemployment
rate that is inconsistent with stable inflation over the long run, but
that the influence of special, possibly transitory factors has
prevented prices and labor costs from accelerating. Although this is a
plausible explanation for recent inflation performance, it is
certainly not the only one; an alternative hypothesis is that
structural changes in labor and product markets have led to further
declines in the NAIRU. If true, this would imply that at least some
portion of the recent decline in the unemployment rate can be
sustained without an eventual increase in inflation.

The rate of unemployment consistent with stable inflation would be
expected to vary over time in response to such factors as shifts in
labor force demographics, changes in the relation between workers'
real wage demands and their productivity, and structural shifts that
alter the degree of mismatch between workers and jobs (both sectorally
and regionally). For a number of reasons, however, it is difficult at
present to justify a large additional reduction in the estimated NAIRU
on the basis of recent experience. First, the presence of fortuitous
supply shocks clouds the inflation picture significantly; although it
is evident that these shocks have contributed to lower inflation, the
exact extent of this contribution cannot be perfectly gauged. Second,
although inflation in goods and services prices has not risen as
unemployment has fallen below 5.5 percent, some acceleration in wages
has occurred (Chart 2-3), which might reflect labor market tightness.
Finally, the unemployment rate has been below 5.5 percent for too
short a time to allow any certainty that the risk of a gradual buildup
of inflationary pressure is entirely absent.

However, a small downward revision to the estimated range of the NAIRU
is indeed justifiable. A portion of recent inflation performance
cannot be explained by special factors; moreover, the fact that prices
have not accelerated as the unemployment rate has fallen below 5.5
percent suggests that the estimated range should be shifted down. A
model that accounts for supply shocks such as recent declines in
relative import prices and that allows the NAIRU to vary over time
indicates that a reasonable range for the NAIRU now has a midpoint of
5.4 percent, 0.1 percentage point lower than in previous estimates.
The Administration's budget forecast has been revised to reflect this
slightly lower estimated midpoint of the NAIRU's range.



ALTERNATIVE MEASURES OF UTILIZATION AND CAPACITY

The unemployment rate is a useful predictor of future inflation in
that it can directly indicate the potential for rising inflationary
pressure on the cost side, as excess demand in the labor market tends
to raise nominal wages and thus nominal labor costs. The unemployment
rate can also proxy for the state of aggregate demand in the economy,
and thus help assess the degree of excess demand in product markets.
However, the unemployment rate is not the only indicator of resource
utilization and demand (even for the labor market), nor does it
necessarily provide the best forecast of future inflation. It is
therefore of interest to consider what other measures of resource
utilization and labor market tightness suggest about the current
degree of inflationary pressure in the economy.

Several plausible indicators--such as the State insured unemployment
rate, the demographically adjusted unemployment rate, and the
unemployment rate for men of prime working age--imply a degree of labor
market tightness that exceeds that which has historically been
associated with stable inflation. In addition, an index of help-wanted
advertising (which can be considered a proxy for the job vacancy rate)
fails to reveal a large degree of slack in the labor market at
present; earlier in the expansion some observers argued that this
measure indicated a weaker labor market than did the unemployment
rate. The picture painted by these labor market variables is therefore
one in which the potential for inflationary pressure is relatively
high.

The effects of a tight labor market on wages may have been muted by
the presence of widespread worker insecurity, which has been evident
since the 1990-91 recession. Despite a strong job market and a high
level of consumer confidence, surveys indicate that workers' fears of
job loss remain high relative to the level that prevailed before the
recession. Quit rates are low as well, which could reflect workers'
unwillingness to leave their current jobs in the hope of ``trading up''
to better jobs. And strike activity is at a low ebb, although this is
related at least in part to declines in unionization rates. These
factors suggest that workers may be relatively unwilling to press for
the wage gains that they could normally command in a labor market as
tight as that of today.

One indicator that tempers somewhat the general conclusion that labor
and product markets are tight is the rate of capacity utilization
(both in the manufacturing sector alone and for all industry).
Capacity utilization remains below its peak for this expansion and is
roughly at the level historically associated with stable inflation. It
is also noteworthy that core producer price inflation, which more
closely reflects the output price measure that is relevant to
manufacturing capacity utilization, has declined rapidly since the end
of 1995. This suggests that industry has not yet reached the point
where production bottlenecks or other capacity constraints are putting
upward pressure on inflation. Gains in capacity, which have followed
an increase in real private investment growth, have helped keep
capacity utilization in the noninflationary zone; measured capacity
growth increased sharply after 1993 and has stayed high as real
business fixed investment growth has remained strong. In fact, recent
revisions to the capacity utilization data indicate that the economy
had more industrial capacity over the past 4 years than was previously
thought (Box 2-4), making the recent declines in core producer price
inflation somewhat less of a mystery. However, manufacturing
represents only about 20 percent of total output, and although total
goods output (which includes manufacturing as well as trade and
mining) accounts for a larger fraction (40 percent), it is still less
than half of the economy. The possibility of overheating in the
economy as a whole, therefore, should not be dismissed.

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

Box 2-4.--Recent Revisions to Capacity and Utilization

In December the Federal Reserve revised its estimates of capacity and
industrial production, on the basis of improved source data.  For the
preceding 2 years estimates of industrial capacity and utilization had
largely been extrapolated from national accounts data on real
investment. The recent revision incorporates direct estimates of
utilization based on survey data and industry reports, as well as more
comprehensive data on physical output and labor and other inputs.
The new data indicate that industrial capacity has been growing about
1 percentage point faster than previously estimated. Over the past 3
years capacity has grown at an average annual rate of 4.7 percent. In
each of the past 3 years average annual capacity growth has exceeded
every previous growth rate since 1968. Similarly, recent estimates of
the rate of capacity utilization were revised downward by more than a
percentage point. Currently, production as a share of total capacity
is about 83 percent; this is only slightly higher than the series'
long-term average.
------------------------------------------------------------------------------

A NEW ERA FOR THE ECONOMY?

To summarize the chapter thus far, the past few years have seen rapid
growth in output with stable inflation, gradual declines in the NAIRU,
strong growth in profits and stock prices, and a pickup in
productivity that, if sustained, would herald a significant departure
from past productivity trends. Indeed, economic performance in recent
years has been so extraordinary that some have wondered whether it
reflects fundamental structural change in the economy--change so great
that a ``new paradigm'' is needed to describe an economy that is in a
``new era.''

Many such assessments are extreme and unsupportable. In particular,
any claim that the business cycle has been vanquished must be viewed
with considerable skepticism. Nevertheless, it is possible to identify
a number of areas in which fundamental changes are probably
influencing the economy's current performance, in many cases
favorably.

First, U.S. producers face increased foreign and domestic competition.
Exports and imports today play a greater role in the U.S. economy than
at any other time in history. And here at home, deregulation has taken
place or is under way in a number of industries, including
telecommunications, transportation, electricity, and banking.
Increased competition and more open markets contribute to greater
efficiency, thus helping raise the level of output. But it is possible
that greater competition also fosters a faster pace of innovation,
inducing long-run improvements in productivity and thus a higher rate
of output growth.

Labor and product markets have also changed in significant ways. Since
the early 1980s the unionization rate has dropped by nearly half,
continuing a decline in union membership that began in the late 1960s.
In addition, the use of temporary and contingent employees is much
higher than it was 15 years ago. Although this has probably made labor
markets more flexible, it might also have contributed to an increase
in worker anxiety. Information technology might prove as revolutionary
as the steam engine or the automobile. Adoption of just-in-time
inventory management by manufacturers also represents a significant
development, since changes in inventories have often been an important
source of business-cycle fluctuations. Whether just-in-time
inventories will be able to dampen future business cycles, however,
remains to be seen.

Even the public sector has been transformed in recent years. Our
system of social welfare has been changed to help welfare recipients
make the transition to employment. The end of the Cold War saw a vast
amount of defense-related resources freed up for civilian uses. The
government itself is being reinvented to make it more efficient and
responsive. Perhaps most important, deficit reduction has increased
private sector investment; this recent expansion in capital investment
raises productivity by providing workers with more modern and
efficient workplaces.

Not all of these changes represent unalloyed boons. Nor is it possible
to quantify the effects of these changes on the economy or on specific
groups or sectors with any degree of precision (although these factors
would have to be very large to reverse the post-1973 productivity
slowdown to any significant degree). And even if these changes are
having a significant influence on recent economic performance, it may
imply not that a new model of the economy is needed, but rather that
certain key parameters of the current model, such as the NAIRU or
trend productivity growth, have changed. Hence one cannot declare with
any certainty that the old rules no longer apply. But the factors just
described suggest that the economy may be experiencing some important
structural changes that will shape our economic analysis and forecasts
in the years ahead.

THE ECONOMIC CONDITION OF HOUSEHOLDS

Both aggregate statistics and consumer surveys painted an
exceptionally favorable picture of the economic circumstances of
American households in 1997. The tight labor market that led to a
24-year-low in the unemployment rate also lured enough new workers
into the labor market to set an all-time record for the labor force
participation rate. The combination of healthy wage growth and
increasing employment helped push real disposable personal income up a
solid 3 percent over the year. Despite the stock market volatility
witnessed in the second half of the year, at year's end all major
market indexes remained sharply above their levels at the end of 1996,
representing a substantial boost to household net worth. Largely
reflecting this combination of favorable circumstances and the low
inflation rate, consumer sentiment reached record highs in early
summer and remained near those levels for the rest of the year.
Growing income and wealth together with buoyant sentiment led to a
3.8-percent rate of spending growth over the four quarters of
1997--outpacing even the robust growth of disposable income.

Against this backdrop of general prosperity only a few potentially
worrisome trends were discernible. The first was the drop in the
personal saving rate implied by the excess of consumption growth over
income growth. A temporary shortfall in personal saving would not
necessarily be a problem, but the personal saving rate has remained
low for about a decade now, raising questions about whether American
households are preparing adequately for the future. A second
persistent concern has been the ongoing buildup of household debt.
Upon analysis, however, this growth in debt does not appear very
menacing, both because household assets have risen even faster, and
because households still appear to be able to service their rising
debt loads comfortably. A final potential concern has been the
continuing rise in personal bankruptcies despite the robust economy,
which might seem to suggest an increase in the number of households
experiencing sudden financial shocks. However, the bankruptcy rate has
been trending upward for about 20 years now, and the available
evidence suggests that the uptrend is attributable to a complex mix of
economic, legal, and social developments rather than a dramatic
worsening of the economic shocks hitting households.

THE CONFIDENT CONSUMER

Early in the summer of 1997 the Index of Consumer Sentiment
constructed by the University of Michigan reached an all-time high; it
remained near that record level for the remainder of the year (Chart
2-4). Some observers have suggested that consumers have become overly
optimistic, and that a return to more normal levels of confidence
could have adverse economic consequences. But a major part of the
surge in consumer sentiment in 1997 can be explained by the
simultaneously favorable values of all four of the indicators that
have historically influenced consumer sentiment: the inflation rate,
the unemployment rate, the performance of the stock market, and, to a
lesser extent, the growth rate of household income. Moreover, although
Chart 2-4 shows that the actual level of sentiment in 1997 has been
even higher than would be predicted given the values of these
indicators, the size of the underprediction is not large compared with
typical past prediction errors.

The Michigan index comprises two subindexes: one for current
conditions and one for expected future conditions. Recently, both have
been hovering near record levels. Roughly two-thirds of the increase
in the index of expected conditions over 1997 can be attributed to the
favorable economic environment, and the remaining underprediction is
not large by historical standards. This suggests that consumers are
not unrealistically optimistic about future developments. However,
very little of 1997's increase in the index of current conditions can
be explained by changes in observed aggregate variables. Again, the
magnitude of underprediction is not very large; moreover, there are
good reasons not to attribute this prediction error to irrational
confidence on the part of consumers. Because the current conditions
index largely reflects consumers' answers to questions about their own
individual financial circumstances, a plausible interpretation of the
prediction error is simply that economy-wide variables such as the
inflation rate and the unemployment rate do not fully capture the
complex elements that influence consumers' assessments of their
personal financial situation. It therefore seems more appropriate to
accept consumers' rosy assessments of their personal financial
circumstances at face value. And judging by past episodes when
sentiment has exceeded the predicted value, the danger appears modest
of a sudden sharp plunge in sentiment that would quickly return it to
the level that aggregate indicators would predict.



Other measures of consumer attitudes also reflect optimism. The
Conference Board's Consumer Confidence Index, the main alternative to
the Michigan index, rose to a 28-year record in December; as with the
Michigan index, a large part of the improvement in the Conference
Board index can be attributed to observable economic conditions. Both
the Michigan and the Conference Board surveys contain many questions
that are not incorporated in their overall indexes, and answers to
these other survey questions have also generally been quite favorable.
For example, throughout the year consumers interviewed for the
Michigan survey said they expected low inflation rates to continue and
believed it was a good time to buy automobiles and houses.

THE CONDITION OF HOUSEHOLD BALANCE SHEETS

The exceptional performance of the stock market appears to be one of
the factors contributing to consumers' sanguine assessments of their
financial circumstances. The rise in the stock market boosted total
household net worth by around $2.6 trillion over the course of 1997,
following similarly strong gains in 1995 and 1996. Higher stock prices
lifted the ratio of household net worth to disposable income to record
levels (Chart 2-5).



Despite the recent boost to stock market wealth, the family home is
still the most valuable single asset most American households own. On
this front, too, 1997 brought encouraging news: the rate of
homeownership reached a new all-time record, boosted by robust income
growth and relatively low mortgage interest rates. Another factor that
has likely contributed to the increase in the homeownership rates in
the 1990s is the increasing availability of sub-prime mortgage loans,
which do not meet traditional industry lending guidelines. Such loans
carry a higher interest rate to compensate lenders for the extra risk.
For example, home buyers who put up less than the traditional
20-percent down payment usually have to purchase private mortgage
insurance to guarantee repayment of the loan; the premium for this
insurance rises as the size of the down payment declines. Indeed,
mortgages that require no down payment at all are now available for
consumers willing to pay very high rates.

Home buyers who take advantage of these loans, of course, take on more
debt than was typical of past buyers who put up a traditional down
payment of 20 percent. The relaxation of down payment constraints is
therefore probably part of the explanation for the runup in mortgage
debt depicted in Chart 2-6. Some of this rise, however, is
attributable to the increasing popularity of home equity borrowing. A
substantial part of new home equity borrowing likely reflects the
growing use of home equity loans to buy motor vehicles, to pay for
home repairs and additions, and to finance other large expenses that
might previously have been financed by separate consumer loans. Home
equity loans are an attractive way of financing such expenditures
because their interest is tax deductible, whereas the interest on
traditional consumer loans lost its tax-deductible status with the tax
reform of 1986.



The increasing substitution of mortgage debt for other kinds of debt
suggests that any assessment of the aggregate household balance sheet
needs to look at the value of all debts combined, not just mortgage
debt. As Chart 2-6 shows, the uptrend in overall household debt is
somewhat less dramatic than that for mortgage debt alone; the ratio of
total debt to disposable income increased from 77 percent in 1986 to
92 percent in 1997. Nevertheless, the ratio of overall debt to
disposable personal income has been trending upward since the
mid-1970s, except for pauses around the recessions of the early 1980s
and early 1990s.

The chart does not support the common perception that aggregate credit
card borrowing has soared out of control. Although revolving debt
(which consists mainly of credit card debt) has grown more rapidly
than other kinds of borrowing, it still represents only a modest
fraction of consumers' debt load. Most of the runup in total debt
instead reflects the sharp rise in mortgage debt.



The dominance of mortgage debt in household balance sheets implies
that the mortgage delinquency rate is a particularly important
indicator of the magnitude of debt repayment problems. Chart 2-7 shows
that the mortgage delinquency rate has actually edged down over the
last year and remains well below rates posted in the mid-1980s,
suggesting that comparatively few consumers have found their rising
mortgage debt insupportable. The chart also shows that although
delinquency rates on credit card borrowing and consumer loans have
gone up, they remain below their peak levels of the early 1990s and
appear to have flattened off in the past year or so.

One probable reason why the continuing runup in debt has not caused
greater repayment problems is that interest rates have fallen,
reducing the payments required to service the outstanding stock of
debt (the debt service burden). The debt service burden has also been
lightened by an increase in the average duration of loans. Chart 2-8
shows that although the aggregate debt service burden has risen
substantially since its trough in 1993, it is still below the level
attained in the late 1980s and certainly does not exhibit the
relentless uptrend evident in the ratio of total debt to disposable
income.



On the whole, then, aggregate statistics paint a favorable picture of
the financial condition of households. Although household debt has
risen, the aggregate value of household assets has risen even more,
leading to a net gain in aggregate household net worth. Judging from
mortgage delinquency rates, the recent rise in the debt service burden
does not seem to be causing unusual strain. And although credit card
debt has been growing, this category still represents a relatively
minor fraction of the aggregate debt households owe.

Aggregate statistics, however, can sometimes mask divergent trends
among different subgroups of the population. If, for example, the rise
in household assets were occurring entirely among the affluent, and if
the rise in household debt were concentrated among lower income
households, then the increase in aggregate household net worth would
not provide much reassurance about the ability of the indebted
households to repay their debt. In practice, however, household-level
data do not seem to be telling a story very different from that told
by the aggregate data. Although affluent households still hold
disproportionate amounts of stock, the surging popularity of mutual
funds and the rise of 401(k) and other tax-sheltered retirement plans
have considerably increased the fraction of households who benefit
directly from stock market gains. Indeed, a recent poll found that
roughly half of American families own stock in some form. And as Table
2-2 shows, although the debt service burden for the median household
increased somewhat between 1983 and 1989, by 1995 the combination of
falling interest rates and lengthening debt maturities had reduced the
median household's burden to near its 1983 level; the fraction of
households with high or very high debt service burdens (defined as
debt service payments greater than 30 and 50 percent of income,
respectively) was actually lower in 1995 than in 1983.


~
TABLE 2-2.--Household Debt Service Burden
------------------------------------------------------------------------------
Item                                1983           1989  ~        1995
------------------------------------------------------------------------------
Debt service burden of the median
household (percent of income)ï¿½1A1  . . . .    12.8           15.2          13.1

Percent of households with debt
service burden:

Over 30 percent. . . . . . . . . . . . .   18.8           23.1          16.3
Over 50 percent. . . . . . . . . . . . .    6.4            7.9           5.6
------------------------------------------------------------------------------
1ï¿½1ADebt service burden is required debt service payments as a percent of
income.
Note.--Data are for households whose heads are employed.
Sources: Board of Governors of the Federal Reserve System and calculations of
the Council of Economic Advisers.


THE PERSONAL SAVING RATE

The personal saving rate has been trending downward since the
mid-1980s. According to the preliminary figures currently available,
the personal saving rate in 1997 was only 3.8 percent, down from 4.3
percent in 1996. Given the exuberant level of consumer sentiment and
the large gains in household wealth last year, the fact that there was
a modest decline in the saving rate from 1996 to 1997 is neither
surprising nor disturbing; such modest annual fluctuations are of
little consequence. The longer term decline in personal saving,
however, has aroused considerable concern among academic economists
and policymakers, for at least three reasons. First, because national
saving is the sum of personal, business, and government saving, low
personal saving contributes to a low national saving rate, and low
national saving has a variety of negative consequences, which are
discussed in more detail later in this chapter. Second, the falling
saving rate raises questions about whether many American consumers are
preparing adequately for their retirement. Finally, families with too
little savings may be unprepared to deal successfully with financial
emergencies such as a spell of unemployment or large medical expenses.

Personal Saving and Retirement

One of the most obvious reasons for households to save is to provide
for a comfortable standard of living in retirement. One way to judge
whether personal saving is too low, then, is to ask whether consumers
appear to be saving enough for retirement. Several recent studies have
examined whether the baby-boom generation, in particular, is doing
enough retirement saving. One set of studies has concluded that
typical baby-boomers need to roughly triple their saving rates if they
hope to maintain their living standards in retirement. Another study,
however, asserts that even if they do not change their saving behavior
at all, the majority of boomers probably will not experience a sharp
drop in living standards upon retirement.

These different conclusions largely reflect a difference in approach.
The first set of studies begins by calculating the gap between the
income that baby-boomers can expect to receive from the combination of
Social Security and traditional pensions, and the income that would be
required to maintain their preretirement standard of living. These
studies then calculate the ``target'' saving rates that baby-boomers
would need to achieve to plug that income gap, and show that the
saving rates of typical baby-boom households are only about a third of
the target rates, leading to a ``baby boom retirement adequacy index''
of 33 percent.

Critics point out that this approach can be misleading, in part
because it is not a measure of the consequences if consumers decide
not to increase their saving. In particular, an index value of 33
percent does not imply that retirement spending will have to be
one-third the level of preretirement spending. For example, consider a
household for whom Social Security and pensions will provide
sufficient retirement income to finance spending at 80 percent of
preretirement income, and suppose that the household only needs 85
percent of preretirement income to maintain its accustomed standard of
living. (Spending needs could decline in retirement for several
reasons, notably the decline in commuting and other work-related
expenses.) Such a household could save nothing, and therefore would
have an index value of zero, yet would only experience about a
5-percent decline in its standard of living at retirement.

An alternative way to evaluate the adequacy of retirement saving is to
calculate the ratio of the level of sustainable retirement spending to
the level of spending necessary to maintain standards of living. Using
this measure of retirement adequacy, a recent study calculated that,
under plausible assumptions about the rate of return on savings, and
assuming no changes in saving behavior or in the Social Security
system, almost half of married-couple baby-boomer households in which
the husband works full-time are saving enough to maintain their
standard of living in retirement. (Single baby-boomers are probably
not faring as well, however.) And only about a third of these
married-couple baby-boomer households are projected to suffer large
cuts in their standard of living. These figures improve if home equity
is included in the measure of retirement savings, although there is
some debate whether including home equity is appropriate. The recent
runup in the stock market would improve the picture further, although
most of the improvement would likely be concentrated among the third
of households who are already best prepared for retirement to the
extent that they hold a disproportionate share of equity investments.

Even the optimists, however, acknowledge that current saving rates of
most baby-boom households are not high enough to provide much of a
cushion against the many uncertainties that they face. In particular,
if their retirement savings earn low rates of return, or if rising
medical costs or other unexpected expenses increase their spending
needs in retirement, or if retirement income from sources other than
personal savings falls substantially short of the projections made on
the basis of current pension and social insurance programs, then many
baby-boomers may end up wishing they had saved much more. And even
under optimistic assumptions, it appears likely that unless they boost
their saving, most unmarried boomers will reach normal retirement age
with insufficient assets to fully maintain their preretirement
standard of living.

On the whole, therefore, it does appear that unless their saving rates
rise, a very substantial proportion of the baby-boom generation is at
risk of reaching retirement age with insufficient assets to maintain
their standard of living. One response may be for them to delay
retirement. Since Social Security and many other pension benefits are
adjusted upward for those who delay retirement, some of the boomers
who are not saving enough to retire at the normal retirement age may
nevertheless be able to retire in relative comfort several years
later. Of course, those who have saved little but whose state of
health or line of work prevents them from remaining in the work force
may have no choice but to accept significantly lower living standards
in their retirement years.

Personal Saving and Financial Emergencies

When consumers are asked about their primary reasons for saving, the
most common answer is that saving is important in order to build up
resources that can be drawn upon in case of emergency. Although
precautionary saving of this kind cannot plausibly explain either the
practice of regular payroll deductions for pension plans or the
accumulation of wealth held by the richest few percent of households,
it can account for the consistent finding by consumer surveys that
most households usually have on hand an amount of liquid assets that
corresponds to between a few weeks' and a few months' worth of
spending.

It is difficult to judge whether these liquid assets are enough to
cushion consumers against financial emergencies. Certainly, they alone
would not be enough to fully maintain spending through the worst
possible emergencies such as a long spell of unemployment. But most
households could probably substantially cut their spending during an
extended unemployment spell. Also, in today's economy most consumers
have the option of credit card, home equity, or other kinds of
borrowing to finance emergency spending. Indeed, a potential partial
explanation of the drop in the personal saving rate over the past
decade is that some consumers have decided that credit cards or other
consumer credit sources can help fill the buffer role traditionally
served by liquid assets.

Unquestionably, credit card availability has risen in recent years.
Particularly notable has been the increase in availability of credit
cards to consumers in lower income and wealth brackets: in 1983 only
28 percent of consumers with annual incomes of less than $15,000 (in
1992 dollars) held credit cards, but by 1995 the ownership rate for
that group had increased to 44 percent. In addition, those groups of
consumers who already had credit cards in 1983 have seen a large
increase in their credit limits in recent years: the median total
credit limit among all consumers with cards increased from about
$6,000 in 1989 to over $9,000 in 1995 (both in 1992 dollars).

As might be expected, credit card borrowing has increased as credit
has become more available. But the increases in borrowing have been
fairly modest compared with the increases in credit limits. Table 2-3
shows the distribution of credit balances (the part of the credit card
bill that consumers choose not to pay off at the end of the month) as
a percentage of income for employed working-age consumers in 1983,
1989, and 1995. Whereas the median ratio of credit card balance to
income was close to zero in all 3 years, consumers at the 75th and
95th percentiles of the distribution had increasingly large balances
relative to their incomes. Still, even in 1995 consumers at the 95th
percentile of the distribution had credit card debt equal to only 22
percent of annual income--a substantial but by no means unbearable
burden.



TABLE 2-3.--Household Credit Card Balances as a Percent of Income
---------------------------------------------------------------------------
Point in distributionï¿½1A1                        1983      1989      1995
---------------------------------------------------------------------------
Median household. . . . . . . . . . . . . . . .      0         0         1
Household at 75th percentile. . . . . . . . . .      2         3         6
Household at 95th percentile. . . . . . . . . .      7        14        22
---------------------------------------------------------------------------
1ï¿½1ADistribution is that of households according to credit card balances
as a fraction of income.
Note.--Data are for households whose heads are employed.
Sources: Board of Governors of the Federal Reserve System and calculations
of the Council of Economic Advisers.


The available data are consistent with the idea that the expanding
availability of credit card debt may have somewhat reduced the need
for consumers to hold buffer stocks of liquid assets, and thus may
have contributed at least modestly to the drop in the personal saving
rate. But for most households credit availability appears to have
increased considerably more than credit use, so that there appears to
be little reason to worry that typical households have less capacity
to withstand financial shocks. Even the small subset of consumers who
have run up quite substantial credit card debts could plausibly expect
to be able to repay those debts, if they do not experience a major
disruption to their income or a large unavoidable expenditure. On the
other hand, consumers with large credit card debts who do experience a
major financial blow may be forced into bankruptcy.

THE LONG-TERM UPTREND IN THE BANKRUPTCY RATE

After remaining roughly stable over much of the 1960s and 1970s, the
personal bankruptcy rate began rising sharply sometime around the late
1970s or early 1980s. Some have argued that this uptrend resulted from
passage of the Bankruptcy Act of 1978, which eased some of the burdens
of bankruptcy. Other analysts argue that the approximate
correspondence between passage of that act and the beginning of the
uptrend in bankruptcies is just a coincidence, and that rising
bankruptcy rates reflect other social and economic developments that
would have led to a rising bankruptcy rate even if the law had
remained unchanged.

One intuitively plausible explanation is that the rise in bankruptcies
reflects the increasingly aggressive marketing of credit cards to
high-risk consumers who previously would not have been granted credit
at all. As noted above, it is true that some households have borrowed
increasingly large amounts on credit cards. Some of those highly
indebted individuals presumably end up in bankruptcy if they lose
their jobs or experience other large financial shocks. But there are
reasons to doubt that increased availability of credit cards provides
a full explanation of the rise in bankruptcies. First, some suggestive
evidence indicates that credit card debt is not a large fraction of
the total debt of consumers who declare bankruptcy; consumers who end
up in bankruptcy court must therefore have borrowed heavily from
non-credit card sources. Second, much of the increase in bankruptcy
appears to have come not from low-income consumers who until recently
could not get cards, but from the kinds of middle-income consumers who
have presumably had access to credit cards all along.

If excessive credit card borrowing is not a complete explanation for
the rising bankruptcy rate, what does explain the rise? One
possibility is that an increasing number of consumers are simply
taking on more debt than they can manage, in non-credit card form as
well as with credit cards. On its face, this explanation seems
plausible in light of the large increases in aggregate household debt
over the past 15 years, depicted in Chart 2-6. But as noted above,
although the aggregate debt service burden has climbed recently, it
remains below its late-1980s levels, yet the bankruptcy rate has
continued to rise. And as shown in Table 2-2, the proportion of
households who had either high or very high debt service burdens was
actually lower in 1995 than in 1983. Hence, the available data do not
seem to support the theory that bankruptcy has risen simply because
increasingly large numbers of ordinary consumers have unwisely taken
out so much debt that any financial shock will send them into
bankruptcy.

Unfortunately, the evidence on alternative explanations is scant, and
no consensus has emerged among experts. One researcher points out
that, under the post-1978 bankruptcy law, up to 15 percent of
households could increase their net worth by declaring bankruptcy;
this researcher and others argue that the rise in the bankruptcy rate
over time largely reflects consumers learning about the costs and
benefits of declaring bankruptcy, perhaps partly through advertising
by bankruptcy lawyers. A related hypothesis is that there has been a
decline in the stigma associated with bankruptcy. This theory is
consistent with evidence showing that, controlling for other factors,
people who live in areas where the bankruptcy rate has been high in
the past are more likely to declare bankruptcy.

Other authors have suggested that increasing divorce rates,
skyrocketing medical costs, or large legal judgments or settlements
may have contributed to the rise in the bankruptcy rate. However,
although each of these factors is clearly important in many individual
bankruptcy cases, none appears to be sufficient to explain more than a
small fraction of the increase in bankruptcies. For example, the
divorce rate stabilized in the mid- to late-1980s, yet bankruptcies
have continued to rise. And some evidence indicates that only a modest
fraction of bankrupt consumers have significant amounts of medical
debt or large legal judgments against them.

Whatever is driving the increase in bankruptcies, the rising
bankruptcy rate has focused attention on the bankruptcy system. In
response, in 1994 the Congress established a commission to recommend
reforms in the bankruptcy system. The National Bankruptcy Review
Commission released its final report in October 1997 (Box 2-5).

LONG-TERM GROWTH: BUDGET DEFICITS AND NATIONAL SAVING

Since its first budget proposal in 1993, this Administration has
demonstrated a strong commitment to reducing the Federal budget
deficit. As a result, the deficit has declined from $290 billion in
1992 to only $22 billion in 1997, or from 4.7 percent to 0.3 percent
of GDP.

-----------------------------------------------------------------------------
Box 2-5.--The National Bankruptcy Review Commission

The National Bankruptcy Review Commission, created by Congress in 1994
and charged with recommending bankruptcy reforms, released its final
report in October 1997. The commission's proposals for business
bankruptcy reform are largely uncontroversial. Perhaps partly because
of a lack of compelling evidence, the commissioners were unable to
achieve consensus on what has caused the rise in personal
bankruptcies, and therefore could not agree on a set of final
recommendations for personal bankruptcy reform. Many of the
commission's final recommendations regarding personal bankruptcy were
approved by a bare 5-4 majority of commissioners, and the minority
wrote a series of detailed dissents explaining their objections. The
dissenting commissioners argue that the recommendations of the report
are too lenient toward debtors. For example, the majority's reform
plan does not mandate that consumers with incomes over some threshold
be forced to repay a portion of their debts out of future earnings.
------------------------------------------------------------------------------

In August 1997 the President and the Congress sealed a historic
agreement that was projected to lead to a balanced budget by 2002; the
continuing robust performance of the economy since August has improved
the outlook further, leading the President to propose a balanced
budget for fiscal 1999.

Balancing the budget has been achieved in large part through a
combination of expenditure restraint and increases in income taxes
for the 1 percent of households with the highest incomes. Both budget
cuts and tax increases are difficult and painful measures. Why did the
Administration judge that taking such measures was so important?
Principally because persistent budget deficits as large as those of
the 1980s and early 1990s constitute an unacceptable drain on national
saving.

To see why budget deficits reduce national saving, it is useful to
imagine the private saving of all Americans as flowing into a common
national pool. This pool of saving is then made available to
borrowers. The budget deficit measures how much of this pool of saving
is drawn down by the government; national saving is the amount left in
the pool after the government has borrowed what it needs to pay for
that portion of current expenses that exceed its current revenues.

Because of the reduction in Federal borrowing, net national saving
(gross national saving less depreciation of the private and public
capital stock) has increased from 3.1 percent of GDP in 1992 to 6.4
percent in 1997 (on the basis of incomplete data for the year). But
even this net national saving rate is far below the 10-percent average
over the period 1960-80.

Given the Nation's favorable recent economic performance even without
a high national saving rate, it might be tempting to conclude that the
low national saving rate does not matter. But such a conclusion would
be a mistake. There are still good reasons to believe that the
benefits of boosting national saving would outweigh the short-term
pain of cutting back on spending.

SAVING IN A CLOSED ECONOMY

One way of thinking about whether more saving would make the Nation
better off is to ask whether the aggregate capital stock is at the
``golden rule'' level--the level that maximizes sustainable per capita
consumption. (Economists call this the golden rule level because every
generation must resist the temptation to consume more than its share
and thereby leave less for future generations.)

Whether an economy is at the golden rule level can be determined by
comparing the net extra output that would be produced by more capital
against the cost of equipping the growing work force with that extra
capital. If the extra output is greater than this cost, then total
national output could be increased by adding to the capital stock. In
the United States, economists estimate that the before-tax rate of
return on additional capital is much higher than the cost of equipping
the work force with extra capital, implying that the Nation's capital
stock is well below the golden rule level.

The golden rule, however, is an imperfect way to judge whether saving
should be higher. The principal problem is that the rule provides no
way to weigh the short-term pain from lower current consumption
against the long-term gain from eventually higher future consumption.
A more flexible framework is provided by the ``modified golden rule,''
which makes explicit assumptions about how current consumption should
be traded off against future consumption. The modified golden rule
assumes that society as a whole is slightly impatient, in the sense of
preferring current consumption to future consumption, and that
consumers prefer gradual changes in the level of consumption and
dislike abrupt changes. But under plausible assumptions about the
before-tax rate of return, the rate of impatience, and the degree to
which one year's consumption is substitutable for another year's, even
the modified golden rule implies that the saving rate is too low.

SAVING IN AN OPEN ECONOMY

In an economy closed to foreign trade and capital, all domestic
investment must be financed by domestic saving. One of the principal
benefits of increasing globalization of trade and capital markets is
that the ability to borrow and lend in foreign markets relaxes the
need to balance national saving with national investment in every
year. If attractive investment opportunities are available at home but
domestic saving is insufficient to pursue them, foreign investors can
step in; the resulting excess of investment over national saving is
manifested in a current account deficit. This aspect of globalization
has been a favorable development for the United States, because it has
allowed the economy recently to invest in capital equipment at high
rates despite the persistently low national saving rate. The high
rates of investment in capital equipment over the past few years have
been critical in preventing the kinds of production bottlenecks that
have often led to rising inflation rates at comparable points in past
business cycles.

But maintaining national investment above national saving over long
periods does come at a price: growing indebtedness to foreign
investors. In the long run, increased foreign indebtedness means that
a portion of the extra future output generated by the extra investment
will be needed to pay a return to foreign lenders. In light of the
demands that will be placed on the economy over the next 30 or 40
years by the retirement of the baby-boom generation, and considering
that countries that are currently lending to us face similar
demographic challenges, there remains a strong argument that it would
be better to finance our high investment rates more through higher
national saving and less by borrowing abroad.

IMPLICATIONS

This Administration has believed from the beginning that the case for
a higher national saving rate is compelling. That conviction led to
the Administration's steadfast commitment to reducing the budget
deficit. But as important as the progress on the budget deficit has
been, the net national saving rate is still too low. One important
priority for the Administration and the Nation is to address the
actuarial imbalance in the Nation's entitlement programs in a way that
increases the national saving rate and thereby increases the resources
available to meet the impending demographic crunch.

FORECAST AND OUTLOOK

THE ADMINISTRATION FORECAST

The Administration projects GDP growth over the long term at about 2.4
percent per year--a figure consistent with the experience so far during
this business cycle as well as with reasonable growth rates of its
supply-side components. From the business-cycle peak in the third
quarter of 1990 until the third quarter of 1997, real output growth
has averaged 2.4 percent per year. This figure is the average of real
growth rates of the product side (gross domestic product, 2.3 percent)
and the income side (gross domestic income,  2.6 percent). Because the
unemployment rate fell by 0.1 percentage point per year over this
period, the empirical regularity known as Okun's law suggests that
these growth rates overstate the growth of trend output by 0.2
percentage point--a calculation that results in a backward-looking
estimate of 2.2-percent growth of potential output.

This estimate is likely understated by about 0.2 percentage point
because of methodological problems with the CPI that have been or will
soon be corrected (Box 2-6). By lowering measured inflation while
leaving nominal GDP unaffected, these methodological changes will
boost measured real output (and better capture its true value).

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

Box 2-6.--Methodological Changes in the Consumer Price Index

The Bureau of Labor Statistics has recently made several
methodological changes that have improved the accuracy of the consumer
price index; a few more changes are planned over the next several
years (Table 2-4). Most of these improvements have  reduced the
measured increase in the CPI, and many of these also will affect the
deflation of nominal output, and therefore will raise the growth rate
of measured real GDP. Changes made   through 1997 include the
substitution of generic drugs when patents expire on proprietary
brands; the correction of a problem in rotating new stores into the
survey through a procedure called ``seasoning'' (a problem that was
corrected first in the food category and later in other categories of
goods); the modification of the formula for measuring increases in
rent; and a change to measuring transaction rather than list prices
for hospital services. Changes scheduled to be made in the next 2
years include a switch to measuring computer prices by their intrinsic
characteristics (``hedonics''); an update of the market basket from
1982-84 to 1993-95; the use of geometric rather than arithmetic means
to address substitution bias within categories; and more frequent
rotation of the items sampled in categories with many new product
introductions.
The changes made through 1997 have a combined effect of lowering the
CPI inflation rate by 0.28 percentage point per year, and raising real
GDP growth by 0.06 percentage point per year. The post-1997 changes
lower CPI inflation by 0.41 percentage point per year and raise real
GDP growth by 0.14 percentage point per year.
------------------------------------------------------------------------------

In addition, continued capital deepening may add a bit to productivity
growth as the net capital stock grows faster than GDP.  This would not
happen in a steady state where capital and output are growing at the
same pace. But the economy is projected not to reach a steady state
during the forecast period, as the relative price of capital is
expected to continue to fall.



TABLE 2-4.--Expected Effects on Changes in the CPI and Real GDP of CPI
Methodological Changes
---------------------------------------------------------------------------
Percentage-point
Year                effect on:
Change in method              introduced        CPI           Real GDP
percent          percent
change          change
---------------------------------------------------------------------------
Pre-1998   ~                                         -0.28            0.06
Generic prescription drugs . . . .   1995           -.01             .00
Food at home seasoning . . . . . .   1995           -.04             .0
Owners' equivalent rent formula. .   1995           -.10             .00
Rent composite estimator . . . . .   1995            .03             .00
General seasoning. . . . . . . . .   1996           -.10             .06
Hospital services index. . . . . .   1997           -.06             .00
1998 and after. . . . . . . . . . .                  -.41             .14
Personal computer hedonics . . . .   1998           -.06             .00
Updated market basket. . . . . . .   1998           -.15             .02
Geometric means. . . . . . . . . .   1999           -.15             .09
Rotation by item . . . . . . . . .   1999           -.05             .03
Total . . . . . . . . . . . . .                  -.69             .20
----------------------------------------------------------------------------
Sources: Department of Labor (Bureau of Labor Statistics) and Council of
Economic Advisers.


COMPONENTS OF LONG-TERM GROWTH

After rising rapidly in the 1970s and 1980s, the labor force
participation rate was relatively flat between 1990 and 1996. But
the participation rate rose 0.3 percentage point to 67.1 percent in
1997--the first year in which it surpassed the 1990 level (after
correcting for the redesign of the Current Population Survey). One
might interpret the pickup in participation in 1997 as a return
toward the rapid growth of earlier decades, but other explanations,
which suggest that the increase in the rate of participation growth
will not endure, are also likely. Given the strong growth of labor
demand, it seems that some of last year's labor force pickup ought to
be interpreted as a cyclical response to a tight labor market.

The welfare reform law passed in the summer of 1996 may also have
boosted labor force participation growth last year and can be expected
to do so for several years to come. The legislation requires that, by
2002, States either reduce their welfare caseloads by 50 percent or
have 50 percent of the caseload either working or engaged in
work-related activities (such as vocational or job skills training),
or some combination or the two (with some exemptions). This
legislation also set a 2-year time limit on any spell of welfare
recipiency and a 5-year lifetime limit, except that 20 percent of a
State's caseload may be exempted from this requirement. Rough
calculations suggest that the requirement for work-related activities
and the 2-year limit on welfare spells together could cause the labor
force participation rate to grow by almost 0.1 percentage point per
year over the next several years.

At the same time, the long-term demographic forces that have
restrained growth in labor force participation in the 1990s are
expected to remain in place. The stalling of the overall participation
rate in the 1990s is accounted for largely by a deceleration in the
participation rate of women; the participation rate for men has
fallen no faster than in earlier years. The child dependency ratio
(the number of children per woman aged 20-54) fell between the late
1960s and the early 1980s, echoing the earlier pattern in the birth
rate. The decline in this ratio allowed an increasing fraction of
women to enter the labor force between the mid-1970s and the 1980s,
but its subsequent flattening in the late 1980s has limited further
increases in participation.

Balancing these influences, the Administration's long-term outlook
includes a 0.1-percent per year increase in the participation rate
through 2007. Together with population growth of 1.0 percent per year
for the working-age population, this implies labor force growth of
1.1 percent per year (Table 2-5).

PRODUCTIVITY

A good way to begin the analysis of productivity growth is by
examining the recent past. Labor productivity (that is, worker output
per hour) can be measured using either the product-side or the
income-side measure of output (Chart 2-9). By the product-side
measure, labor productivity has grown at a 1.1-percent annual rate
since the business-cycle peak in the third quarter of 1990, whereas
the income-side measure shows productivity growth at a more robust
1.5-percent annual rate. Because neither of these two measures is
perfect, an argument can be made for averaging them, to yield an
estimated annual rate of 1.3 percent over this business cycle.

By either measure, productivity growth was particularly rapid over the
first three quarters of 1997, as noted earlier. An acceleration in
productivity is not usually observed in the latter part of an
expansion (Chart 2-10); historically, productivity growth has tended
to slow as the economy returns to full employment. This tendency
could reflect several factors, such as overly optimistic hiring
decisions by firms, or firms' having to hire less productive workers
as the labor  market tightens. Whatever the explanation, the fact that
no such slowdown is now apparent is evidence that none of these
imbalances are currently present, and that the economy is behaving as
if it remains in a mid-expansion phase, rather than an
end-of-expansion phase.



TABLE 2-5.--Accounting for Growth in Real GDP, 1960-2005
[Average annual percent change]
------------------------------------------------------------------------------
1960 II  1973 IV  1990 III   1997 III
Item                           to       to       to         to
1973 IV 1990 III  1997 III     2005
------------------------------------------------------------------------------
1) Civilian noninstitutional population
aged 16 and over . . . . . . . . . .   1.8     1.5       1.0         1.0
2) PLUS: Civilian labor force
participation rateï¿½1A1 . . . . . . . .    .2      .5      .0             .1
3) EQUALS: Civilian labor forceï¿½1A1 . . .   2.0     2.0     1.1            1.1
4) PLUS: Civilian employment rateï¿½1A1 . .    .0     -.1      .1            -.1
5) EQUALS: Civilian employmentï¿½1A1. . . .   2.0     1.9     1.2            1.0
6) PLUS: Nonfarm business employment as
a share of civilian employmentï¿½1A1ï¿½1A2 .    .1      .1      .2             .1
7) EQUALS: Nonfarm business employment ~   2.1     2.0     1.4            1.1
8) PLUS: Average weekly hours
(nonfarm business) . . . . . . . . .   -.5     -.4      .1             .0
9) EQUALS: Hours of all persons
(nonfarm business)~~ . . . . . . . . .   1.6     1.7     1.5            1.1
10) PLUS: Output per hour
(productivity, nonfarm business)~.ï¿½1A .   2.9     1.1     1.1  3(1.5)    1.3
11) EQUALS: Nonfarm business output~. .  .  4.5     2.8     2.7  3(3.0)    2.4
12) LESS: Nonfarm business output as a
share of real GDPï¿½1A4. . . . . . . . .    .3      .1      .4  3( .4)     .1
13) EQUALS: Real GDP . . . . . . . . . .   4.2     2.7     2.3  3(2.6)  5 2.3
------------------------------------------------------------------------------
1ï¿½1AAdjusted for 1994 revision of the Current Population Survey.
2ï¿½1ALine 6 translates the civilian employment growth rate into the nonfarm
business employment growth rate.
3ï¿½1AIncome-side definition.
4ï¿½1ALine 12 translates nonfarm business output back into output for all sectors
(GDP), which includes the output of farms and general government.~
5ï¿½1AGDP growth is projected to fall below its long-term trend (2.4 percent) as
the employment rate is projected to fall 0.1 percent per year over this
period.
Note.--Detail may not add to totals because of rounding.
Except for 1997, time periods are from business-cycle peak to business-cycle
peak to avoid cyclical variation.
Sources: Council of Economic Advisers, Department of Commerce (Bureau of
Economic Analysis), and Department of Labor (Bureau of Labor Statistics).


Because hours worked usually reacts to changes in output with a lag,
hours probably have not caught up with the acceleration in GDP in
1997. As a result, the growth of productivity over the four quarters
ending in the third quarter of 1997 likely exceeded its trend rate, as
it often does midway through an expansion. A better estimate of trend
productivity growth comes from a model that takes this lagged
adjustment into account. This procedure estimates that the trend rate
of productivity thus far in this business cycle has been similar to
the 1.1-percent annual rate that has prevailed since 1973. Looking
ahead, measured productivity can be expected to grow at a 1.3-percent
annual rate because of the 0.2-percentage-point effect that the CPI
methodological adjustments will have on real GDP.





INFLATION CONSIDERATIONS

Continued labor market tightness can be expected to put some up-ward
pressure on inflation. With the relative price of investment goods
continuing to fall, strong growth of investment is expected to keep
industrial capacity relatively more ample than labor supply. And the
future development of inflation will also be affected by the factors
that have thus far suppressed it. The restructuring of the Asian
economies virtually guarantees that the price of imports from these
economies will remain low and may fall further. The relative price of
computers will continue to fall, although the rate of decline is
expected to return to the roughly 15-percent annual rate that has
prevailed over much of the 1990s. Finally, the methodological changes
to the CPI planned to be implemented before 2000 are eventually
expected to lower annual CPI inflation by another 0.4 percentage
point, and the price index for GDP by 0.1 percentage point. With these
considerations in mind, the Administration projects CPI inflation to
creep up by about 0.3 percentage point over the next few years, to 2.3
percent by 2000.

THE DEMAND FOR HOUSING

A surge in the fourth quarter raised residential investment growth
above that of GDP during the past year. New home construction (housing
starts and shipments of mobile homes) was roughly unchanged in 1997
from its year-earlier pace, despite a jump in the fourth quarter.
Demographic trends indicate stable demand for housing during the next
decade.

The current shape of the age distribution reflects the legacy of the
baby boom and the baby bust. Because most new households are formed by
young adults, the passage of the first wave of baby-boomers into the
prime years of household formation in the late 1970s was associated
with a rapid pace of home construction and rising house prices. But
household formation fell to an annual rate of about 1.1 million per
year during the first half of the 1990s as the smaller baby-bust
cohort moved into adulthood. Demographic forecasts project a similar
rate of household formation over the second half of the 1990s.

In addition to growth in the number of households, demand for new
homes is created by the replacement of homes that are scrapped or
destroyed and by the increase in the number of second homes and vacant
homes (Table 2-6).  Replacement demand (which can be estimated over
long periods only) has averaged about 300,000 units per year. The
increase in ``vacant'' homes (which includes second homes) is highly
cyclical and has reflected the general economic strength of recent
years, but tends to average about 200,000 units per year. Altogether,
housing demand has averaged 1.53 million units per year thus far in
the 1990s and, in light of the demographic forecast, is expected to
continue at a similar pace for the next decade.

This projection of the long-run demand for housing is slightly
stronger than what has prevailed thus far in the 1990s, but not quite
as strong as demand in the past 2 years. As Table 2-6 shows, long-run
demand is consistent with a rate of housing starts of roughly 1.40
million units per year, slightly below the 1.48-million-unit pace of
homebuilding in 1997. Of course, economic conditions can push housing
starts away from their demographic fundamentals. Recessions generally
slow the pace of both home construction and household formation as
young people remain longer in their parents' homes--this is what
happened in 1990. In good times, people spend more on larger homes and
second homes. If the current good times continue, homebuilding could
exceed these projections of its demographic determinants.



TABLE 2-6.~--Contribution of Selected Determinants of
Demand and Supply for New Homes
[Millions, annual average]
------------------------------------------------------------------------------
Determinant                1970s      1980s     1999-96    1996-2006
------------------------------------------------------------------------------
Demand:
Household ~growth. . . . . . . . .    1.73       1.26        1.05         1.10
Change in vacancies . . . . . . .     .20        .40         .18          .24
Net removals. . . . . . . . . . .     .30        .30         .30          .30
Total demand . . . . . . . . . .    2.23       1.96        1.53         1.64
~~Supply:~
Single-family homes . . . . . . .    1.14        .99        1.05         1.08~
Multifamily homes . . . . . . . .     .62        .51         .24          .30
Mobile homes. . . . . . . . . . .     .37        .25         .26          .26
Total supply . . . . . . . . . .    2.12       1.75        1.54         1.64
Measurement error . . . . . . . .     .11        .21        -.01          .00
------------------------------------------------------------------------------
Note.--Detail may not add to totals because of rounding.~
Sources: Department of Commerce (Bureau of the Census) and Council of
Economic Advisers.~


THE NEAR-TERM OUTLOOK

Both supply- and demand-side considerations argue for some moderation
in real GDP growth from its rapid 3.6-percent annual pace of the past
2 years (Table 2-7). On the supply side, the unemployment rate has
fallen about a percentage point over the past 2 years, and it is
therefore doubtful whether a further decline of this magnitude could
be accommodated without inflationary consequences. Labor force growth
has not kept up with demand in the past 2 years, nor can it be
expected to keep up with a repetition of that kind of demand growth.

On the demand side, some restraint is likely to come from the
international economy, where the recent rise in the dollar and the
restructuring of several Asian economies may slow the demand for
American-built products. Because the direction of trade responds with
a lag to changes in the exchange rate, the large rise in the dollar
over the past 2 years is likely to boost demand for imports and limit
growth of our exports.  The recent movements of the Asian currencies
are particularly dramatic and will make imports from these economies
less expensive. Even so, the cloud formed by the Asian restructuring
has a silver lining: aggressive competition from foreign producers is
likely to restrain domestic inflation--as it has during the past 2
years.



TABLE 2-7.-Administration Forecast
------------------------------------------------------------------------------
Actual
Item               ---------    1998  1999  2000  2001 2002  2003 2004
1996  1997
------------------------------------------------------------------------------
Percent change, fourth quarter to fourth quarter
---------------------------------------------------
Nominal GDP . . . . . .   5.6  1ï¿½1A5.8   4.0   4.1   4.3 ~  4.6   4.6   4.6   4.7
Real GDP (chain-type) .   3.2  1ï¿½1A3.9   2.0   2.0   2.0   2.3   2.4   2.4   2.4
GDP price index (chain-
type). . . . . . . . .   2.3  1ï¿½1A1.8   2.0   2.1   2.2   2.2   2.2   2.2   2.2
Consumer price index
(CPI-U). . . . . . . . . 3.2~    1.9   2.2   2.2   2.3   2.3   2.3   2.3   2.3
---------------------------------------------------
Calendar year average
---------------------------------------------------
Unemployment rate
(percent). . . . . . . . 5.4    4.9   4.9   5.1   5.3   5.4   5.4   5.4   5.4
Interest rate, 91-day
Treasury bills (percent) 5.0    5.1   5.0   4.9   4.8   4.7   4.7   4.7   4.7
Interest rate, 10-year
Treasury notes (percent) 6.4    6.4   5.9   5.8   5.8   5.7   5.7   5.7   5.7
Nonfarm payroll
employment (millions)  119.5 1ï¿½1A22.3 124.0 125.4 126.8 128.4 130.4 132.5 134.5
------------------------------------------------------------------------------
1ï¿½1APreliminary.
Sources: Council of Economic Advisers, Department of Commerce, Department of Labor, Department of the Treasury, and
Office of Management and Budget. ~
~~~

Other factors also are expected to slow the growth of demand. Business
purchases of capital goods have been growing faster than the overall
economy, and because the relative price of equipment investment is
falling, this trend is expected to continue. However, some moderation
of the recent torrid pace is expected as business demand for capital
goods becomes more sated.  A similar effect may limit expenditures on
consumer durables, where--given the length and strength of this
expansion--pent-up demand has been exhausted.

The rate of inventory investment was particularly strong during the
first half of 1997 and remained high despite tapering off somewhat in
the second half of the year. Because output grew so rapidly,
inventories remain lean with respect to sales, and certainly no
overhang of excess inventories exists at this point. Still, the rate
of inventory growth during 1997, at about 5 percent, is in excess of
what will be needed once demand moderates to its trend. As a result,
inventory investment is also expected to restrain near-term growth in
demand.

As in recent Administration projections, a moderation in output growth
to 2.0 percent is projected in the near term--slightly below the
economy's long-run growth rate, but in line with the consensus of
professional economic forecasters. The balance of the Administration's
forecast is built around a growth rate for potential output of 2.4
percent per year. The Administration does not think that 2.4-percent
annual real growth is the best that the economy can do; rather, this
projected growth 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--as it has been in
the past 2 years. But the Administration's forecast is used for a very
important purpose: to project Federal revenues and outlays and the
Federal budget deficit. For this purpose excessive optimism is
dangerous and can stand in the way of making difficult but necessary
budget decisions. In the final analysis, the most important goal is
the creation of a sound forecast that accurately captures likely
economic trends.

As of December 1997 the current expansion had lasted 81 months, making
it the third longest in the postwar record. There is no foreseeable
reason why this expansion cannot continue. As the 1996 Report argued,
expansions do not die of old age. Instead, recent postwar expansions
have ended because of rising inflation, financial imbalances, or
inventory overhangs. None of these conditions exists at present. The
most likely prognosis is therefore for sustained job creation and
continued noninflationary growth.