[Economic Report of the President (1999)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]




CHAPTER 2
Macroeconomic Policyand Performance

The U.S. economy performed very well in 1998. Real output increased
3.7 percent at an annual rate over the first three quarters of the year,
once again exceeding the predictions of most forecasters.
Nonagricultural jobs increased by about 2.9 million during the year, and
the average unemployment rate for the year dropped to 4.5 percent, its
lowest level since 1969 (Chart 2-1). The consumer price index rose by
only 1.6 percent, its second smallest increase since 1964 (Chart 2-2),
and other measures of inflation were even more muted
Yet the turmoil in foreign economies that began in the summer of
1997 did not leave the U.S. economy unscathed. Net exports declined
sharply during 1998, as a result of slow or negative economic growth in
a number of the United States' trading partners and a substantial rise
in the foreign exchange value of the dollar since early 1997. Moreover,
during the late summer and fall, domestic financial conditions, which
had been highly conducive to economic growth for several years, became
much less favorable. Investors' sudden flight from risky assets reduced
some businesses' access to capital and raised the cost of borrowing for
others.
Despite these dampening forces, the economic expansion maintained
considerable momentum. A significant factor underlying this strong
performance was the continued practice of responsible fiscal policy:
1998 will be remembered as the year the Federal Government recorded its
first unified budget surplus since 1969. The surplus contributed to the
low level of interest rates during the year, increased the capital
available for private investment, and provided a more stable backdrop
for private economic decisions. Monetary policy also provided an
important boost to the economy. The Federal Reserve held overnight
interest rates steady for much of the year, but it reduced rates three
times in quick succession when the financial environment deteriorated in
the fall. Following the Federal Reserve's actions, financial stresses in
the United States abated considerably, with risk premiums in interest
rates declining once again and the issuance of corporate debt picking
up.
The first section of this chapter reviews the course of the U.S.
economy during 1998. The next section focuses on developments in
domestic financial markets, which were exceptionally turbulent last
year.

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Then the chapter explores two other macroeconomic topics that have
received a lot of attention recently: the boom in business equipment
investment during the past several years, and the ``year 2000'' problem
involving computers. The final section of the chapter analyzes the
outlook for the U.S. economy. When the economic expansion continued
through December, it became the longest recorded peacetime expansion.
The Administration expects the expansion to continue during 1999, albeit
at a more moderate pace.

THE YEAR IN REVIEW

Real gross domestic product (GDP) increased 3.7 percent at an annual
rate between the fourth quarter of 1997 and the third quarter of 1998
(the latest period for which data were available when this Report went
to press). Preliminary data suggest that GDP growth likely remained in
this neighborhood in the fourth quarter, bringing growth for the year as
a whole close to that recorded in 1996 and 1997. Once again, business
investment in equipment made a substantial contribution to GDP growth,
while a larger drag from net exports was offset by a stepup in household
spending on goods, services, and housing from its already robust pace of
the previous several years.

THE STANCE OF MACROECONOMIC POLICY

Both fiscal policy and monetary policy made vital contributions to
the excellent performance of the U.S. economy during 1998.

Fiscal Policy

The passage of the Omnibus Budget Reconciliation Act of 1993 marked
the beginning of a significant shift toward fiscal restraint by the
Federal Government. The Balanced Budget Act of 1997 put in place the
additional policies needed to bring the budget into sustained balance.
In fiscal 1998 (October 1997 through September 1998), the Federal
Government capped 6 years of dramatic budget improvement by recording
the first budget surplus since 1969. The $69 billion surplus was the
largest as a share of GDP since 1957. The goal of eliminating the budget
deficit by 2002 was accomplished 4 years ahead of schedule. Net interest
payments--the fiscal burden imposed by the large deficits of the past--
remain substantial, however, at 15 percent of total expenditures and 3
percent of GDP in fiscal 1998. Excluding these payments, the ``primary''
budget balance, the difference between tax revenue and expenditures for
current needs, reached a surplus of more than $300 billion.
Although the attainment of a budget surplus marks a major fiscal
milestone, the case for continued fiscal responsibility remains strong.
Demographic trends point to an aging of the population that will

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significantly increase expenditures on Social Security and government
health programs over the next several decades. The emergence of a budget
surplus offers the opportunity to prepare for this challenge. Indeed,
the unified budget surplus includes the current excess of receipts over
benefit payments in the Social Security system, which amounted to $99
billion in fiscal 1998. (Apart from the Social Security system, the
Federal Government had a deficit of $30 billion in 1998, producing the
unified surplus of $69 billion.) The Administration has stated that none
of the unified surplus should be used until the future solvency of
Social Security is assured. The President has repeatedly reaffirmed this
commitment to ``save Social Security first,'' and he presented a
specific proposal for Social Security reform in his recent State of the
Union address.

Monetary Policy

In conducting monetary policy during 1998, the main focus of the
Federal Reserve's concerns shifted from a potential reversal of the
favorable trend of inflation to a potential weakening of economic
activity. When the year began, the target Federal funds rate--the rate
banks charge each other for overnight loans--stood at 5.5 percent, where
it had been for the preceding 9 months. However, the surge in economic
growth during the first several months of the year heightened the
concern of the Federal Open Market Committee (FOMC, the Federal
Reserve's principal monetary policy decisionmaking body) that
intensifying use of the economy's resources might lead to a buildup of
inflationary pressures. The FOMC did not adjust the Federal funds rate
in response, but it noted in March that a tightening of monetary policy
was more likely than an easing in the months ahead.
Despite a slowing of growth in the second quarter, the FOMC believed
that the balance of risks still pointed to the possibility of rising
inflation over time. It therefore maintained a bias toward future
monetary tightening. Indeed, labor costs accelerated during 1998 in a
very tight labor market. However, the rapid deterioration in financial
conditions in the late summer and fall persuaded the Federal Reserve
that a much less restrictive monetary policy was appropriate. The FOMC
dropped its bias toward tightening at its August meeting, cut the
Federal funds rate by 25 basis points (0.25 percentage point) at its
September meeting, did so again in mid-October in an unusual between-
meeting move, and lowered the funds rate yet again at its November
meeting. In both October and November the Federal Reserve Board also cut
the discount rate--the rate it charges banks to borrow from the Fed--by
25 basis points, to maintain the discount rate's traditional position
below the funds rate. The easing of monetary policy was not a reaction
to any observed weakness of economic activity but rather a preemptive or
forward-looking action intended to sustain the expansion. The cumulative
75-basis-point reduction in the

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target Federal funds rate brought that rate to 4.75 percent, its lowest
value in 4 years.

TURMOIL IN FINANCIAL MARKETS

The past year was a tumultuous one in U.S. financial markets. The
first half of the year witnessed an extension of the highly favorable
conditions that had prevailed over the previous several years. Yields on
intermediate- and long-term Treasury securities moved in a fairly narrow
band that was centered a little below the levels that had prevailed
during the latter part of 1997. Most households and firms enjoyed ample
access to credit on good terms. Meanwhile equity prices rose sharply,
with most major indexes hitting record highs in July that ranged from 17
to 28 percent above their values at the beginning of the year.
Financial conditions during the second half of the year were less
favorable. In mid-August Russia devalued the ruble and effectively
defaulted on its domestic debt, marking a new round of the financial
crisis in emerging markets that had begun in Southeast Asia a year
earlier. As the international financial turmoil worsened, investors'
desire to shift their portfolios away from emerging market economies--a
trend that had been apparent over the previous year--intensified, and
they began to shy away from all but the safest and most liquid assets in
the markets of the industrial countries. (Chapter 6 discusses
developments in international financial markets at length.) Among U.S.
assets, the shift of investor preferences away from private securities
and toward government securities caused the difference, or spread,
between private and Treasury yields to spike upward. Yields on higher
quality corporate debt were little changed (although the spread between
these yields and Treasury yields widened as the latter fell), but
businesses with lower credit ratings faced much higher costs of
borrowing. Moreover, issuance of corporate debt slowed sharply, banks
tightened terms and standards on business loans (although the volume of
lending actually increased significantly), and stock prices dropped
steeply.
Financial conditions improved markedly after mid-October, partly in
response to the Federal Reserve's interest rate reductions. Risk spreads
narrowed, debt issuance accelerated, and stock markets rebounded to new
highs. Nevertheless, some American businesses apparently faced more
limited access to credit and a higher cost of borrowing at the end of
1998 than at the beginning of the year.

COMPONENTS OF SPENDING

As already noted, real GDP increased at an annual rate of 3.7
percent between the fourth quarter of 1997 and the third quarter of 1998
(Table 2-1), close to the pace of the previous 2 years. Quarterly output

[[Page 48]]


during 1998 was quite erratic: after surging at a 5.5 percent annual
rate in the first quarter, real output growth slowed to 1.8 percent in
the second quarter, and then picked up to 3.7 percent in the third
quarter. This irregular pattern was strongly influenced by sharp swings
in inventory investment (discussed below). Final sales, which increased
by about 3H percent during 1997, rose at a fairly steady 4H percent
annual rate during the first half of 1998, grew at a much slower pace in
the third quarter, and apparently accelerated a little at the end of the
year. Among the components of final sales, net exports exerted a
substantial drag during the first half of the year but less during the
third quarter, as their rate of decline eased. Meanwhile private
domestic final sales--consumption, housing, and business fixed
investment--increased less rapidly in the third quarter than during the
first half of the year.

Household Spending

Real personal consumption expenditures (PCE) surged during the first
half of 1998, increasing at roughly a 6 percent annual rate. PCE growth
downshifted during the third quarter to about a 4 percent pace (which
still exceeded its growth rate for the four quarters of 1997) and
remained strong in the fourth quarter, according to the partial data
available.
Demand for homes was also very strong. Although real residential
investment represents less than 5 percent of GDP, its growth during the
first three quarters of 1998 accounted for over 10 percent of GDP
growth. Single-family housing starts were the highest since 1978, and
new and existing single-family home sales reached record levels. The
percentage of Americans who own their own home reached an all-time

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high of 66.8 percent in the third quarter (the latest period for which
data are available). Growth in homeownership was especially fast for
groups that have been underrepresented in the past, such as blacks and
Hispanics.
This robust growth in household spending during 1998 occurred
against a backdrop of extremely favorable fundamentals. First, real
disposable income maintained its solid upward trend, rising about 3G
percent at an annual rate over the first three quarters (based on the
PCE chain-weighted price index). Second, household wealth soared to an
extraordinary level--almost six times income--as a result of the
dramatic runup in stock prices (Chart 2-3). This expansion in household

resources permitted spending to grow significantly faster than
disposable income. Indeed, the personal saving rate--measured by the
difference between disposable income and consumer outlays, as a
percentage of disposable income--fell sharply again during 1998. After
averaging roughly 4.5 percent between 1992 and 1994, this rate dropped
to about 3 percent in 1996, about 2 percent in 1997, and about H percent
in the first three quarters of last year. (Last summer's revision of the
measured saving rate is discussed later in this chapter.)
Household spending was also spurred by low interest rates and a
ready availability of credit. In particular, housing affordability
soared, as interest rates on 30-year fixed rate mortgages averaged more
than H percentage point below their 1997 values. Indeed, mortgage credit

[[Page 50]]

expanded more rapidly during the first three quarters of 1998 (the
latest available data) than in any year since 1990. Over the same
period, consumer credit grew at a somewhat faster rate than in 1997 but
well below the torrid pace of 1994 and 1995. Total household debt
appears to have increased faster than disposable income in 1998 for the
sixth year in a row. Nevertheless, delinquency rates on consumer loans
remained close to their 1997 values, and delinquency rates on mortgages
stayed quite low. Personal bankruptcy filings reached a new record high
in the third quarter of 1998, but the rate of increase over the
preceding year was well below the pace recorded between 1995 and mid-
1997.
Last year's Economic Report of the President included an extended
discussion of the long-term upward trend in the bankruptcy rate. During
1998 the Congress considered various proposals to reform the bankruptcy
law, and both the House and the Senate passed reform bills; however, the
two houses were unable to agree on a compromise bill that incorporated
the Administration's key principles for bankruptcy reform. The
Administration supports reform of the bankruptcy law that would require
both debtors and creditors to act more responsibly: troubled debtors who
can repay a portion of their debts should do so, but creditors should
treat debtors fairly, in keeping with the creditors' superior expertise
and bargaining power.
Consumer sentiment was buoyant during 1998, probably reflecting both
the favorable fundamentals and expectations for continued economic
growth. The consumer sentiment index of the Survey Research Center at
the University of Michigan posted its highest reading in more than 30
years in early 1998. This optimism waned somewhat in the fall, but the
Michigan index finished the year near the top of its historical range.

Business Investment

Real business fixed investment grew extremely rapidly during the
first half of 1998, increasing over 15 percent at an annual rate, and
then rose at a slower pace, on average, in the second half of the year.
Sharp gains in purchases of producers' durable equipment (PDE) accounted
for more than the total advance in business fixed investment during the
first three quarters. Real PDE investment increased about 16 percent at
an annualized rate over that period, exceeding its robust average annual
growth rate over the preceding 3 years of 11 percent. Among its
components, spending on computers and peripheral equipment surged 75
percent in real terms over the first three quarters of 1998
(annualized), and real spending on communications equipment jumped about
20 percent (annualized). (The causes and consequences of the recent boom
in equipment investment are discussed further below.) Real PDE was
little changed in the third quarter but apparently increased strongly
again in the fourth quarter. Both

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the third-quarter deceleration and the fourth-quarter pickup likely
reflected fluctuations in motor vehicle sales.
Business investment in structures fell a bit in real terms during
the first three quarters of 1998. Office construction was boosted by low
and declining vacancy rates, but other commercial construction was
sluggish, and industrial construction was held down by ample factory
capacity. Spending in this category may also have been dampened by a
tightening in available financing during the third quarter, although
conditions in the commercial mortgage-backed securities market improved
noticeably by the end of the year.
Investment in business inventories varied dramatically across the
first three quarters of 1998. Inventories increased $91 billion in real
terms at an annual rate in the first quarter, and the stepup in
inventory investment relative to the fourth quarter of 1997 contributed
over 1 percentage point to the annualized increase in first-quarter GDP.
However, several quarters of strong inventory growth apparently
persuaded businesses to reduce their rate of stockpiling in the second
quarter; in addition, a strike at the Nation's largest automaker led to
a decline in motor vehicle inventories. All told, the sharply lower rate
of inventory accumulation in the second quarter subtracted over 2H
percentage points from second-quarter GDP growth. Inventory accumulation
ran at a moderate pace during the third quarter.

Government

Federal Government consumption expenditures and gross investment
contracted in real terms over the first three quarters of 1998,
following a real decline during 1997. This measure of government
spending, which is included in GDP, differs from unified budget outlays
in a number of ways. Among the most important differences are that the
GDP measure includes the depreciation of government capital and does not
include transfer payments, interest, or grants to State and local
governments. Defense purchases represent about two-thirds of Federal
consumption expenditures and gross investment. During the first three
quarters of last year, a roughly 2 percent annualized decrease in
defense spending more than offset a roughly 1 percent annualized
increase in the smaller category of nondefense spending.
Consumption expenditures and gross investment by State and local
governments moved up over 2 percent at an annual rate over the same
period, just below the average pace of the previous several years.
Strong growth of household income boosted income tax collections
considerably, and most State governments today appear to be in good
financial condition.

International Influences

In 1998 the Federal Reserve Board replaced its traditional index of
the foreign exchange value of the dollar with several new ones. New

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indexes have been developed for three currency groups: a group of major
currencies that are traded heavily outside of their home markets, a
group of currencies of other important U.S. trading partners, and the
aggregate of these two groups, labeled the ``broad index.'' For each
group the Federal Reserve calculates both nominal and price-adjusted
indexes; all are defined such that a rise indicates a strengthening of
the dollar. Because the indexes are designed primarily to measure U.S.
competitiveness in world markets, the weights of the various currencies
are based on market shares of U.S. goods in foreign markets and of
foreign goods in U.S. and third-country markets, and these weights vary
over time. Still, the new nominal index for the major currencies, when
calculated retrospectively over the past 20 years, tracks the Federal
Reserve's previous index fairly closely.
The foreign exchange value of the dollar continued its advance
during 1997 into the third quarter of 1998, but then fell back. All
three real indexes peaked in August or September and then declined
sharply, ending at or below their values at the end of 1997. The nominal
major currency index behaved similarly to the corresponding real index,
but the nominal broad index and the nominal index relative to other
important trading partners both increased, on net, over the year.
Real net exports (exports minus imports of goods and services)
dropped roughly $100 billion over the first three quarters of 1998,
holding down the growth rate of GDP (assuming the other components of
GDP were unchanged) by about 1H percentage points. The negative
contribution of this category was considerably smaller in the third
quarter than in the first half of the year. The current account balance
(which includes international transactions in investment income and
transfers, as well as trade in goods and services) deteriorated during
1998 as well, owing to both the drop in net exports and an increase in
net payments of investment income to foreigners.
The decline in net exports stemmed from a combination of falling
exports and rising imports. Real exports declined by about 4 percent at
an annual rate during the first three quarters of 1998, following a 10
percent runup during 1997. This deterioration was attributable to weaker
activity in a number of foreign economies, especially in Asia, as well
as the higher value of the dollar (which itself was related to the
contrast between foreign economic developments and U.S. economic
strength). Real imports posted a 9 percent annualized advance during the
first three quarters of 1998, below their increase during 1997, despite
a sharper decline in import prices.

THE LABOR MARKET AND INFLATION

American labor markets enjoyed another excellent year in 1998, with
both employment and real wages rising at impressive rates. (Chapter 3
includes a more extensive discussion of employment and compensation
patterns and trends.) Meanwhile core consumer prices

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(that is, excluding food and energy prices) increased at their slowest
pace since the 1960s.

Employment

Nonfarm payroll employment expanded by about 2.9 million jobs during
1998. The number of manufacturing jobs slipped a bit, following small
increases during 1996 and 1997. Weakness in this sector was probably
linked to declining exports of goods. However, jobs in the services
sector, which accounts for about 30 percent of nonfarm employment,
posted another impressive gain. Nonfarm payrolls rose to 127 million by
the end of the year, an increase of nearly 17.7 million jobs since
January 1993. (Over this period, the increase in employment reported by
firms significantly exceeds that reported by households. Part of this
difference can be traced to differences in methodology between the
payroll and household surveys, but the explanation for the remaining
discrepancy is unclear.) Over 90 percent of the increase in jobs since
1993 has been in the private sector.
The unemployment rate averaged 4.5 percent in 1998, down from 4.9
percent in 1997. After falling for 6 straight years, the unemployment
rate now stands about 3 percentage points below its January 1993 level.
Indeed, the 4.3 percent rate in April and December of last year was the
lowest since February 1970. Another measure of available workers is the
sum of those who are looking for work (the official definition of
unemployment) and those who would accept a job but have not been looking
(so-called marginally attached workers, which include discouraged
workers). In 1998 this combined group accounted for only 5.4 percent of
the civilian labor force plus marginally attached workers, down from 5.9
percent in 1997 and 7.4 percent in 1994. The labor force participation
rate--the percentage of the population over age 16 that is either
employed or looking for work--leveled off in 1998 at 67.1 percent, after
trending up between 1995 and 1997. The upward trend resulted from a
marked increase in labor force participation by adult women and a
respite from the previous slide in participation among adult men. In
1998 the participation rate for women was just below 60 percent, and
that for men was almost 75 percent. The employment-to-population ratio--
the proportion of the civilian population age 16 and older with jobs--
averaged a record 64.1 percent last year.

Productivity and Compensation

Labor productivity in the nonfarm business sector increased by about
2.1 percent on an annual basis during the first three quarters of 1998,
somewhat above the 1.7 percent gain of 1997. Measured productivity has
risen much faster over the past 3 years than it did between the
business-cycle peaks of 1973 and 1990, but much of the measured surge
may be attributable to methodological changes and to output

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growth that was above the economy's long-run potential. (Recent
developments in productivity are discussed at greater length below.)
Compensation rose significantly during 1998. The employment cost
index (ECI, a measure of wages, salaries, and employer costs for
employee benefits) for workers in private industry moved up 3.6 percent
(annualized) during the first three quarters of the year (according to
the latest available data), continuing its acceleration of the previous
several years. Wages and salaries increased 4.1 percent at an annual
rate, while benefits climbed 2.4 percent. For the 12-month period ending
in September 1998, compensation growth in construction and manufacturing
was quite close to that during the previous 12-month period, but
compensation growth in the service-producing industries picked up
sharply. The acceleration in compensation was especially pronounced in
the finance, insurance, and real estate sector, likely reflecting
bonuses and commissions associated with higher volumes of stock trading,
mortgage refinancing, and other financial sector activity.
Other measures of compensation also showed substantial gains during
1998. For example, average hourly earnings increased 3.8 percent over
the year. Unlike the ECI, this series excludes benefits and covers only
production and nonsupervisory workers, among other differences.
Because consumer prices increased so little during 1998, these
nominal compensation gains translated into appreciable advances in real
compensation. The increase in the ECI less the increase in the consumer
price index (CPI) was 2.1 percent during the first three quarters of
1998, compared with the solid 1.7 percent gain during 1997. The increase
in real average hourly earnings during the year was 2.4 percent,
slightly above the 1997 growth rate, which was the fastest in more than
two decades.

Prices

Inflation fell again in 1998 from its already subdued 1997 pace. The
CPI increased by only 1.6 percent last year, just below its 1.7 percent
rise during 1997 and well below its 3.3 percent rise during 1996. The
chain-weighted price indexes for GDP and PCE both edged up less than 1
percent on an annualized basis during the first three quarters of 1998,
well below their increases during the previous several years. The CPI
rose at its slowest rate since 1986 and its second-slowest since 1964;
the GDP price index rose at its slowest rate since 1961.
Much of the 1998 decline in inflation can be attributed to a
significant slide in crude oil prices. Weak demand for oil in Asia
together with plentiful worldwide supply helped push down CPI energy
prices by almost 9 percent for the year as a whole. The so-called core
CPI, which excludes the volatile food and energy components of the
broader index, increased 2.4 percent during 1998, a little above the
previous year's mark of 2.2 percent. However, in January 1998 certain
methodological adjustments were made to the way the CPI is calculated;
otherwise the core CPI

[[Page 55]]

probably would have increased by about 2.6 percent last year, almost H
percentage point faster than during 1997. On the other hand, core prices
as measured by the chain-weighted price index for PCE excluding food and
energy decelerated during 1998; this index increased by only 1.2 percent
at an annual rate in the first three quarters of the year, compared with
a 1.6 percent rise during 1997. The CPI and PCE price indexes differ in
both coverage and methodology (as discussed later in this chapter). But
by either measure, core inflation has dropped, on net, over the past
several years. Indeed, core inflation has been lower during the past few
years than at any time since the mid-1960s.
Several factors have helped to hold down core inflation despite the
strong growth of aggregate demand and very tight labor markets. (The
forecast section of this chapter further explores the reasons for recent
low inflation.) Part of the reason why wage increases have not put more
pressure on prices has been rapid productivity growth. In addition,
corporate profits stand at roughly their largest share of national
income during the past 30 years, and some wage increases have been
offset by reduced profit growth of late. Another important contribution
to low inflation has been declining prices of nonoil imports, as excess
capacity in Asia and depreciating foreign currencies have encouraged
foreign producers to reduce the dollar prices of their goods. Beyond
their direct impact on the prices paid for imports, these overseas
developments have discouraged domestic producers from raising their
prices as much as they might have otherwise. Inflation has probably also
been restrained by the strong increase in industrial capacity in the
United States during this expansion. Although the unemployment rate was
at a 29-year low in 1998, the average rate of capacity utilization in
industry during the year was about equal to its long-term average.
Low inflation readings in 1998 were reinforced by a continued slide
in expected inflation. Actual inflation depends on expectations of
inflation, because the wage and price increases sought by workers and
firms are influenced by the prices they expect to pay for other goods.
According to the University of Michigan's survey of households, the
median expectation for annual inflation over the next 5 to 10 years was
about 2.8 percent in the fourth quarter of 1998, slightly below the
late-1997 figure of 3.1 percent and well below the 3.6 percent reading
of 6 years ago. Long-term inflation expectations of professional
forecasters are even lower, according to the survey conducted by the
Federal Reserve Bank of Philadelphia, but have fallen by a similar
amount in recent years.

FINANCIAL MARKETS

Through much of the current expansion, falling interest rates and
rising equity prices have provided important support to real economic
activity. Indeed, the disruptions to foreign financial markets and

[[Page 56]]

institutions that began in 1997 initially improved financial conditions
in the United States, as shifting portfolio preferences helped to
further reduce U.S. interest rates and boost U.S. equity prices. The
resulting strength in domestic consumption and investment offset at
least some of the dampening effect of the drop in net exports. However,
the worsening of international conditions in the summer of 1998 changed
the domestic financial situation dramatically. An intensified ``flight
to quality'' by lenders and investors restricted businesses' access to
credit and raised the average cost of their borrowing. But by the end of
the year a significant easing of monetary policy and somewhat greater
confidence in the international economic outlook had produced a
substantial improvement in financial conditions.

THE EFFECT OF RISK ON INTEREST RATES AND EQUITY PRICES

Many of the developments in financial markets over the past several
years have been linked to changing perceptions of risk. Therefore, to
understand these developments, one must begin with the basic
relationships among risk, interest rates, and equity prices. All
ownership of financial assets involves risk, and because people
generally want to minimize the uncertainty they face, they will hold
riskier assets only if those assets pay higher expected returns. As a
result, changes in perceived risk require adjustments in expected
returns.
Consider debt securities, such as bonds. All bonds are subject to
market risk, or the possibility that current yields, and therefore
prices, will change to reflect changes in market conditions. Because
bondholders generally receive fixed payments, increases in prevailing
interest rates reduce, and decreases raise, the value of outstanding
bonds. Most bonds are also subject to credit risk, or the possibility
that the issuer will default on the bond's interest payments or on
repayment of the bond's face value. Commercial paper--short-term debt
securities issued by corporations--also has credit risk, but because of
its short maturity it faces little market risk. Bank loans often have
repayment terms similar to those of bonds, and therefore banks face both
market risk and credit risk on their loans.
U.S. Treasury securities have essentially no credit risk, because
people believe that the Federal Government will always meet its legal
obligations. All private debt securities do have credit risk, and
therefore the yields on those securities exceed the ``risk-free'' yield
on Treasury debt. Private credit rating agencies assess the likelihood
of default by private borrowers. Higher rated debt is deemed
``investment-grade,'' whereas lower rated debt is called
``speculative,'' ``high-yield,'' or ``junk.'' Changes in perceived
riskiness affect the spreads between yields on these private debt issues
and the risk-free Treasury yield.

[[Page 57]]

Equities clearly involve risk as well. A simple model of equity
pricing sets the price of a share of stock equal to the present
discounted value of future dividends payable on that share. One risk
facing equityholders, therefore, is that of changes in a company's
dividends, which are often related to sustained changes in its earnings.
Decreases in expected earnings growth reduce a stock's price-earnings
ratio, or the price of a share as a multiple of the company's current
earnings. Another risk for equityholders is that of changes in the
discount rate that investors apply to future earnings. One can view the
discount rate as the sum of the risk-free interest rate and a risk
premium; increases in either component reduce the price of a share and
thus the price-earnings ratio.
The average return to owning equity has exceeded the average return
to owning debt securities over most long historical periods in the
United States. Between 1946 and 1995, for example, the extra return from
holding a portfolio of shares that matches the Standard & Poor's (S&P)
500 composite index (an index of share prices of 500 large, publicly
traded U.S. firms) instead of a portfolio of Treasury bills averaged
almost 7 percent per year. Because equity returns are more variable than
bond returns, it is not surprising that equity returns are generally
higher. But the difference in returns--the equity premium--has been
larger on average than can be explained by stocks' greater riskiness and
economists' traditional assumptions about investor behavior. The
explanation for its size remains something of a mystery.

CHANGING RISK PERCEPTIONS AND FINANCIAL MARKET DEVELOPMENTS

The behavior of debt and equity markets during much of the current
expansion suggests a substantial fall in the perceived riskiness of U.S.
financial assets. Although this apparent trend in risk perceptions
abated in the summer of 1997, when financial crises enveloped several
East Asian economies, it did not reverse in significant measure until
the late summer and fall of 1998, when risk premiums increased at an
alarming rate. By the end of the year, risk premiums were declining
again but remained much higher than when the year began.

Setting the Stage: The Reduction in Perceived Risk Prior to Mid-1997

In early 1997 both debt and equity markets reflected a significant
relaxation in investors' concern about the riskiness of financial assets
over the previous several years. Comparing instruments of similar
maturity, the spread between the average yield on Baa-rated corporate
bonds (Baa is the rating of the median corporate bond in terms of
outstanding volume) and the 30-year Treasury yield was little changed
between the first half of 1993 and the first half of 1997. However, the
spread between the yield on high-yield bonds and the 10-year Treasury
yield fell by about 1I percentage points between those two periods,

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and spreads between bank loan rates and the Federal funds rate dropped
as well. Equities also may have benefited from lower risk premiums, as a
tremendous bull market raised price-earnings ratios appreciably between
late 1994 and early 1997. However, isolating the effect of changes in
risk perceptions on equity prices during this period is difficult,
because a surge in stock analysts' forecasts of earnings growth probably
also contributed to the price rise.
The observed reduction in risk premiums could have been caused by
either an increased willingness to bear risk or a reduction in the
amount of perceived risk. Because preferences toward risk probably
adjust slowly, the latter explanation is much more likely. But why did
risk perceptions change in this way? One possibility was growing
speculation that the U.S. economy had entered a ``new era,'' in which
faster trend growth of real output, lower inflation, and business cycles
of smaller amplitude or less frequency would be the norm. Another
possibility was a strengthening belief that countries around the world
would continue to move toward capitalism. Such a move might reduce the
riskiness of certain investments in the United States, by improving
access to overseas markets or limiting the danger of international
conflict. The spread of capitalism might also raise the expected return
to investments in developing countries; indeed, Table 6-1 and Chart 6-1
in Chapter 6 document a substantial increase in the flow of funds to
developing countries before 1997.

A Flight to Quality

In the summer of 1997 perceptions of risk began to change. As
emerging market economies in East Asia faltered, investors' desired
portfolios shifted toward U.S. assets. The actual quantities of domestic
and foreign assets in their portfolios adjusted slowly, because many
commitments are long term, and in any case, international capital flows
must be balanced by trade in goods and services and investment income in
any given year. However, asset prices adjusted quickly, with yields and
exchange rates moving to dampen potential capital flows. Increased
demand for U.S. assets, combined with an improving Federal budget
outlook and downward revisions to expected inflation, pushed U.S.
interest rates down between mid-1997 and mid-1998. In choosing among
domestic assets, investors became a little more cautious, but the
widening of risk spreads was generally quite limited.
Equity prices were little changed, on balance, during the second
half of 1997 but surged again during 1998. The S&P 500 jumped 22 percent
between the beginning of 1998 and mid-July, and the NASDAQ composite (an
index of over-the-counter stocks, including those of many startup and
high-technology companies) rose 28 percent. Many stock valuation
measures moved further beyond their historical ranges. For example, the
ratio of stock price to lagging four-quarter earnings for the S&P 500
reached almost 29 at the end of the second quarter, the

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highest level in at least 40 years and almost double its average value
since 1956. Nor did low interest rates on risk-free securities fully
explain this phenomenon. The gap between the earnings-price ratio (the
inverse of the price-earnings ratio) and the real 10-year Treasury
yield--the latter measured by the difference between the nominal 10-year
rate and long-term inflation expectations in the Philadelphia Federal
Reserve's survey of professional forecasters--was among the smallest in
many years.
The extraordinary valuation of equities may have been partly
attributable to stock analysts' expectations of very fast earnings
growth. However, some market observers worried that these expectations
were unrealistic: national income had been rising more rapidly than many
economists believed was sustainable, and corporate profits already
represented a larger share of national income than usual. Indeed,
accelerating compensation of workers left profits in the third quarter
of 1998 (the latest available data) slightly below their year-earlier
level.

Stresses in U.S. Financial Markets

The flight to quality intensified dramatically during the late
summer and fall of last year. The effective default on Russian
government debt in August made clear that the dangers of financial
turmoil--and the limited ability of international efforts to control
that turmoil--were not confined to East Asia. In particular, the Russian
debacle heightened fears of large-scale capital outflows from Latin
America, where some economies were, like Russia, facing large fiscal
deficits. The resulting uncertainty about future economic and financial
conditions around the world caused a sudden, stunning shift in desired
portfolios toward safer assets.
Between the end of July and mid-October, Treasury yields dropped
sharply and risk premiums on private debt spiked upward (Charts 2-4 and
2-5). The spread between the yield on Baa-rated bonds and the 30-year
Treasury yield rose almost 80 basis points, roughly matching its peak
during the 1990-91 recession. The spread between the yield on high-yield
bonds and the 10-year Treasury yield nearly doubled, moving from 3.7
percent on July 31 to 6.6 percent on October 14. Wider risk spreads were
apparent in the market for short-term debt as well, with the difference
between the average 3-month AA-rated nonfinancial commercial paper yield
and the 90-day Treasury yield rising from 53 to 118 basis points. The
increase in investment-grade bond spreads was more a reflection of
falling Treasury yields than rising investment-grade yields (in fact,
the latter were little changed on net), but businesses with lower credit
ratings faced substantially higher costs of borrowing.
Part of the widening of spreads reflected greater concerns about
credit quality in an economy that appeared to be facing an increasing
risk of a sharp slowdown. Another part of the widening can probably be

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[[Page 61]]

attributed to the lesser liquidity of private issues at a time when
heightened uncertainty created larger liquidity premiums; we return to
this issue shortly. In addition, less risk-averse investors (such as
hedge funds, discussed later in this chapter) faced more cautious
lenders during this period, which reduced their ability to purchase
riskier or less liquid securities.
Market conditions also worsened along several other dimensions.
Issuance of new debt dropped precipitously, with public offerings of
nonfinancial corporate bonds falling roughly by half between July and
September. In the high-yield sector, issuance virtually ceased in August
and September. Dealers were reluctant to manage new offerings into the
fall, probably because of the heightened uncertainty in financial
markets and greater difficulty in placing new securities. Some firms
substituted bank loans for financing in the securities market, and
business lending by banks boomed. However, banks were not immune to the
rising economic uncertainty, and they tightened their business loan
standards and terms.
A further worrisome development was the increasing illiquidity of
debt markets, especially after mid-September. Bid-ask spreads widened
substantially, and dealers were less willing to enter into large
transactions at posted rates. The price of liquidity climbed, too. So-
called on-the-run Treasury securities are the most recently issued of a
given maturity, and they are traded much more actively than off-the-run
securities. Because of this greater liquidity, on-the-run issues usually
offer yields that are a few basis points below off-the-run yields of
similar maturity, but this gap widened considerably for 30-year bonds in
late September. In addition, the yield spread between the Treasury's on-
the-run conventional debt and its less liquid inflation-indexed debt
fell much more sharply during this period than did survey measures of
inflation.
Equity prices slumped as well. Between July 17 and August 31, both
the S&P 500 and the NASDAQ lost about one-fifth of their value, falling
a little below their levels at the beginning of the year. The Russell
2000 index of small-capitalization stocks had lagged behind other major
indexes since the spring, and by the end of August it stood nearly 23
percent below its value at the beginning of the year. Equity issuance by
nonfinancial corporations declined sharply in late summer as well.
These gyrations in financial markets took a toll on financial
institutions. Share prices of money-center banks (which include some of
the largest commercial banks) and investment banks fell much more
sharply than the broad equity indexes, in the face of rising concern
about exposure to emerging markets, the quality of loan portfolios, and
possible losses from securities trading activities. Nevertheless, the
underlying strength of the commercial banking system--which enjoyed
generally high profits, low delinquency and charge-off rates,

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and ample capital--may have helped contain the financial market
deterioration. However, several hedge funds lost large sums of money,
and one very large fund narrowly averted default (as discussed in the
next section).
All of these developments raised fears of a credit crunch that could
have significantly limited firms' access to external financing and
thereby slowed capital investment and GDP growth. (Household borrowing
did not appear to be hampered by market conditions, as mortgage rates
declined and banks reported no change in terms or standards on consumer
loans.) As already noted, the FOMC cut the Federal funds rate by G
percentage point at the end of September, but market participants'
desire for safety and liquidity showed no sign of diminishing. In
response, the FOMC cut the funds rate by a further G point in mid-
October, explaining that ``growing caution by lenders and unsettled
conditions in financial markets more generally are likely to be
restraining aggregate demand in the future.'' The October drop in the
funds rate was the first policy change between regularly scheduled FOMC
meetings since 1994, suggesting to market participants that the Federal
Reserve had taken an aggressive easing posture.

Calm Restored

After this second rate cut, the stresses in financial markets began
to abate. Risk and liquidity premiums fell back a little, and debt
issuance picked up in both the investment-grade and the high-yield
sectors. The FOMC made a third G-point cut in the Federal funds rate at
its November meeting, noting that, despite an improving situation in
financial markets, ``unusual strains'' were still present.
Financial market conditions stabilized further during the remainder
of the year, and growth in bank loans eased as borrowers returned to the
capital markets. Nevertheless, risk spreads remained significantly wider
than when the year began, and Treasury yields stayed low. The yield on
Baa-rated corporate debt was little changed in 1998, but that on high-
yield debt increased by about 1H percentage points. Banks reported a
further tightening of loan terms and standards in November, but average
interest rates on their commercial and industrial loans were lower in
late 1998 than in late 1997.
Equity markets were little changed, on net, between the end of
August and early October, but from there they climbed rapidly to new
highs (Chart 2-6). Between October 8 and year's end, the S&P 500 gained
28 percent and the NASDAQ 55 percent. For the year as a whole the S&P
500 and the NASDAQ were up 27 and 40 percent, respectively, but the
Russell 2000 lost 3 percent. The Wilshire 5000, the broadest index of
U.S. equity prices, finished 1998 roughly 22 percent above its value at
the end of 1997, achieving its fourth consecutive year of double-digit
increases.

[[Page 63]]


The striking changes in financial market conditions over the past
year and a half had--and will continue to have--important effects on
real economic activity in the United States. Before discussing these
effects, however, it is worth examining in greater detail one type of
financial institution that was hit especially hard by the turmoil of
last year.

NEW CONCERNS ABOUT HEDGE FUNDS

In late September a group of large financial institutions urgently
invested $3.5 billion in Long-Term Capital Management (LTCM), a
prominent hedge fund, to prevent its imminent collapse. Representatives
of these firms--which were already LTCM's principal creditors--had been
encouraged to undertake the rescue by the Federal Reserve Bank of New
York, which feared that a sudden failure of the fund could significantly
disrupt financial markets. The New York Federal Reserve Bank did not set
the terms of the rescue or invest public money. Nevertheless, the
episode prompted serious questions about the economic effects of hedge
funds and appropriate public policy toward them.

What Are Hedge Funds?

The label ``hedge fund'' is usually applied to investment companies
that are unregulated because they restrict participation to a relatively
small number of wealthy investors. No precise figures are available, but
the amount invested in hedge funds as of mid-1998 appears to

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have been around $300 billion. Hedge funds follow a variety of
investment strategies, but they often make combinations of transactions
with various counterparties designed to focus their risk exposure on
certain specific outcomes. (Derivative instruments, such as futures and
options, can be an efficient way to structure these transactions, but
are not the only way.) For example, if a fund expects the yield spread
between mortgage-backed securities and U.S. Treasuries to decline, it
can buy the former and sell the latter short (which means selling
securities that the fund has borrowed but does not own). Identical
movements in the yields of the two types of securities will be a wash
for the fund, but a narrowing of the yield spread will make it a profit
by increasing the value of the mortgage-backed securities relative to
the Treasuries. Of course, this focusing of risk does not eliminate
risk, as an unexpected widening of the spread will create a loss for the
fund.
Hedge funds can play a useful economic role by bearing risk that
would otherwise be borne by more risk-averse businesses and individuals.
Hedge funds can also reduce inefficiencies in asset pricing by
exploiting discrepancies in prices relative to economic fundamentals or
historical norms. Their activity causes these discrepancies to narrow,
increasing liquidity by ensuring that other market participants can buy
and sell securities at consistent prices.
LTCM had made a variety of investments all over the world, focused
primarily on the expectation that various financial market spreads and
volatilities would converge to their historical norms. Instead, the
flight to quality in 1998 increased volatility and sharply widened risk
and liquidity spreads in many markets simultaneously, causing many of
LTCM's bets to lose money. Compounding these bad outcomes was the huge
amount of borrowing that LTCM had used to finance its transactions;
through this heavy leveraging of its equity capital, the fund had raised
its return when its investment decisions were correct, but had also
reduced its margin for error. Before its final crisis, LTCM had only $4
billion or so of equity capital, but over $100 billion in assets and
sizable positions in futures contracts, forward contracts, options, and
swaps.
If LTCM had defaulted, its creditors and counterparties could and
probably would have tried to cover their losses by selling the
collateral LTCM had pledged to them. The counterparties would also have
tried to rehedge newly exposed positions, which would have put
additional strains on markets at a time when risk and liquidity premiums
were already rising sharply. Because many of LTCM's investment positions
were quite specialized, or were large relative to the markets in which
they traded, rapid liquidation and rehedging by counterparties would
probably have caused big swings in some market prices. The New York
Federal Reserve Bank was especially concerned not about the direct
losses that creditors and counterparties would have incurred, but

[[Page 65]]

about the potential impact of large price movements on other investments
by these firms and on the investments of the many individuals and
institutions not associated with LTCM.
By investing several billion dollars of new capital in LTCM, its
principal creditors and counterparties prevented the firm's immediate
default. These firms probably saved money as a result, because unwinding
LTCM's portfolio gradually was expected to be much less disruptive to
markets and prices than a sudden liquidation.

Regulation of Hedge Funds

The near collapse of LTCM raised questions about the proper
regulatory stance toward hedge funds and other institutions that
actively trade securities and derivative instruments. Currently, hedge
funds face far less regulatory scrutiny than do many other financial
institutions. No government agency is charged with their direct
supervision. For example, hedge funds are exempt from the Investment
Company Act of 1940 (which provides for regulation of mutual funds)
because of their restrictions on participation. However, hedge funds'
creditors and counterparties provide some degree of ``market
regulation'' by evaluating the funds' collateral, investment positions,
and equity capital before doing business with them. The care exercised
by these creditors and counterparties is, in turn, monitored to some
extent by the government regulators of those institutions. These
regulators include the Federal Reserve Board and the Office of the
Comptroller of the Currency (OCC) for banks, the Securities and Exchange
Commission (SEC) for broker-dealers, and the Commodity Futures Trading
Commission (CFTC) for futures commission merchants.
Of course, lending institutions' techniques for managing their
credit risks are not perfect, and market regulation cannot prevent all
problems arising from hedge funds. Moreover, some financial firms that
are likewise largely unregulated, such as certain broker-dealer
affiliates, also engage in leveraged trading strategies. Following the
near collapse of LTCM, the Secretary of the Treasury called on the
President's Working Group on Financial Markets, which he chairs, to
study the implications of the operations of firms such as LTCM and their
relationships with their creditors. (This working group was established
by executive order in 1988. Its members are the Secretary of the
Treasury, the Chairman of the Board of Governors of the Federal Reserve
System, the Chairman of the SEC, and the Chairperson of the CFTC.
Additional participants are the Federal Deposit Insurance Corporation,
the Office of Thrift Supervision, the New York Federal Reserve Bank, the
OCC, the National Economic Council, and the Council of Economic
Advisers.)
Should there be more government regulation of hedge funds and other
highly leveraged financial institutions? One justification for
regulating financial institutions generally is to reduce systemic risk--
the

[[Page 66]]

chance of a general breakdown in the functioning of financial markets.
This risk arises largely from the asymmetry of information that is
intrinsic to capital markets. Because market participants have
difficulty judging the financial health of institutions, they cannot
fully understand the risk of their investments. Moreover, bad news about
one firm can have a contagion effect on others, reducing their access to
capital as well. This spillover effect may have been exacerbated by
financial innovation, which has linked the fortunes of financial
institutions in ever more complex and subtle ways. Further, when
financial institutions fail, asset prices in illiquid markets may
overshoot their long-run values.
But even if market participants had better information and more
fully understood the risks of their investments, they might take more
risk than is socially desirable. Of course, every firm has an incentive
to restrain its risk taking in order to protect its capital, and firm
managers have an incentive to protect their own investments in the firm.
However, no firm has an incentive to limit its risk taking in order to
reduce the danger of contagion for other firms. In addition, some firms
take more risk because of deposit insurance, which makes it easier for
banks to attract depositors without having to demonstrate financial
soundness. Some very large firms may take additional risk because they
believe that the government views them as ``too big to fail'' and would
step in to prevent their collapse.
The collapse of LTCM might have posed a larger systemic risk than
the collapse of almost any other hedge fund at almost any other time.
Few institutions are as large or as leveraged as LTCM was, and the
market strains that its default would have provoked would have been
especially severe during the extreme worldwide flight to quality and
liquidity that occurred last fall. One can argue that the risk
management practices of both hedge funds themselves and the firms with
which they deal should give more weight to the likelihood of such
unusual events, and indeed the experience of 1998 may have chastened
financial institutions in this regard.
Despite the risks just described, determining the appropriateness of
government regulation of hedge funds and other leveraged institutions is
not straightforward. The study by the President's working group,
expected to be completed early this year, will address a number of
possible regulatory issues, including disclosure and leverage. With
respect to disclosure, it appears that LTCM's creditors lent to the fund
on the basis of insufficient information, or failed to analyze
adequately the information they had. Market participants now appear to
be demanding more disclosure from hedge funds, which is a positive
development. The working group is exploring whether the government
should require additional disclosure to counterparties, creditors,
investors, regulators, or the public.

[[Page 67]]

With respect to leverage, the degree of LTCM's leverage caused the
risks in its portfolio to be transmitted more rapidly to other market
participants. Creditors to hedge funds now appear to be reducing the
amount of leverage they are willing to provide, which is another
positive development. In addition, bank regulators can employ their
existing regulatory tools to induce banks to make more prudent
decisions. The working group is evaluating whether the government should
do more to discourage excessive leverage, and if so, what specific steps
might be appropriate.

FINANCIAL MARKET INFLUENCES ON SPENDING

The financial market developments described in this section have had
a significant impact on household and business spending. This impact has
been felt through several channels, including wealth effects, effects on
interest rates, and effects on the availability of credit to businesses.

Wealth and Consumption

An increase in a person's net worth raises the amount that he or she
can consume, either today or in the future. Statistical evidence
suggests that consumer spending has tended to rise or fall by roughly 2
to 4 cents per year for every dollar that stock market wealth rises or
falls. This wealth effect usually occurs over several years, but much of
the adjustment is seen within 1 year. The effect might be larger today
than in the past because more Americans own stocks: the Survey of
Consumer Finances shows that 41 percent of U.S. families owned stocks
directly or indirectly in 1995, compared with 32 percent in 1989.
However, there is little direct evidence on this point.
The dramatic increase in stock prices over the past few years has
provided a significant impetus to consumer spending. Applying the
historical relationship cited above to the change in total household
wealth (which includes other assets and liabilities as well as stocks),
one could conclude that rising wealth boosted consumption growth by
nearly a percentage point during 1998, after a similar increase during
1997. Robust spending has, in turn, led to a dramatic decline in
households' saving out of income from current production, with the
personal saving rate falling to a historical low of 0.2 percent in the
third quarter of last year. (Net private saving, which combines personal
saving and undistributed corporate profits, has also declined as a share
of national income during the past few years, but less sharply than has
personal saving.)
The sharp decline in household saving in recent years became more
apparent after the annual revision of the national income and product
accounts in July 1998. Prior to the revision, capital gains
distributions by mutual funds had been included in personal income (just
as interest payments are), which bolstered measured personal saving. But

[[Page 68]]

these distributions do not represent income from current production, and
the revised data correctly exclude them from income. The revision
lowered the measured personal saving rate, and by a greater amount in
more recent years because capital gains distributions by mutual funds
were greater. However, the revision had no effect on private saving,
because the markdown of personal saving was automatically offset by an
increase in the measured undistributed profits of the mutual fund
industry.

Interest Rates and Consumption

Changes in interest rates affect household spending through various
channels. Consider a decline in rates. This tends to boost the value of
stocks and bonds, which has a wealth effect on consumption as discussed
above. In addition, lower rates encourage spending on houses,
automobiles, and other durable goods often bought on credit, while
reducing the return on new saving. Moreover, a decline in interest rates
augments homeowners' cash flow by reducing payments on adjustable rate
mortgages and spurring mortgage refinancing. At the same time, however,
lower interest rates work to reduce spending in several ways. Household
cash flow is diminished by a drop in interest income, and people who are
saving to reach a target level of wealth need to save more to reach that
target. On balance, lower rates probably stimulate household spending,
and higher rates probably dampen it, but the magnitude of these effects
is unclear.
Nominal interest rates on Treasury securities reached unusually low
levels last year. For example, for the year as a whole, the average 10-
year Treasury yield was the lowest since 1967, and at the peak of the
financial market stress in early October the 10-year yield touched its
lowest value since 1964. Real Treasury yields (as measured by the
difference between nominal yields and survey measures of inflation
expectations) were also low, although less exceptionally so. Interest
rates facing household borrowers did not fall as sharply as did Treasury
rates last year; for example, interest rates on consumer loans from
commercial banks were only slightly lower in 1998 than in 1997, and
credit card rates were roughly unchanged. But rates on fixed rate
mortgages averaged more than H percentage point lower in 1998 than in
1997.

Financial Conditions and Business Investment

For several years through mid-1998, businesses enjoyed ready access
to external funding on favorable terms. This circumstance was one of the
factors encouraging the brisk pace of capital investment, as reported in
the following section. Last year's sudden flight to quality changed this
situation abruptly, raising borrowing costs for some businesses and
limiting others' ability to borrow. However, one should not overstate
the impact of these developments on economic activity. As

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noted earlier, investment-grade borrowers faced essentially the same
cost of long-term debt capital at the end of 1998 as at the beginning,
although riskier borrowers saw their borrowing costs rise. Financial
markets and institutions continued to funnel substantial funds to
businesses. Moreover, most businesses do not face an overwhelming burden
of servicing existing debt. The aggregate debt-service burden for
nonfinancial corporations--measured as the ratio of net interest
payments to cash flow--fell roughly by half between 1990 and 1996 and
then slipped a little further in the following 2 years.

THE INVESTMENT BOOM

Business investment in plant and equipment has grown remarkably
rapidly during the 1990s. Chart 2-7 shows that real business fixed
investment has contributed about one-quarter of real GDP growth during
this expansion, compared with an average of roughly 15 percent during
previous expansions since World War II. Outlays for producers' 

durable equipment have been especially strong, increasing at an average
annual rate of more than 10 percent in real terms and contributing more
than twice as large a share of GDP growth as during previous expansions.
In contrast, real investment in nonresidential structures has barely
changed, on net, contributing almost nothing to output growth during
this period.

[[Page 70]]

CAUSES OF THE BOOM

The pace of investment depends on decisions made by myriad
individual firms, each reacting to a variety of forces. Still, one can
identify at least four general factors that have contributed to the
recent surge in investment.

Rapid Output Growth

One key factor is the rapid growth of output during the past several
years. In a simple model, a firm's desired capital stock depends on its
expected sales, as well as on the cost of capital and other factors. An
increase in expected sales induces an increase in desired capital, which
requires investment. The level of investment thus depends on the change
in sales; if one views sales as the rate at which firms are distributing
their products, the change in sales is an acceleration of that rate, and
this sort of model is therefore called an ``accelerator model.''
A pure accelerator model expresses aggregate investment only as a
function of output growth, typically with several lags built in to
capture both a gradual adjustment of sales expectations and a gradual
adjustment of the capital stock to its desired level. The capital stock
adjusts gradually because firms often choose to install new capital
slowly, in order to reduce the cost of installation. Research using more
elaborate accelerator models shows that they can explain a large share
of the variation in equipment investment over the past several decades,
and a smaller share of the variation in building of nonresidential
structures. Of course, the observed correlation between output growth
and investment reflects not only the influence of the former on the
latter but also the reverse: strong investment also boosts output.
Nevertheless, strong demand outside of the investment sector in recent
years has clearly helped to boost investment demand through this
accelerator effect.

Robust Profits

A second factor underlying strong investment has been robust
corporate profits. Although profit growth waned in 1998, economic
profits (defined as book profits adjusted for changes in inventory
valuation and for capital consumption) represented almost 12 percent of
national income in the first three quarters of 1998, well above the
1980s peak of about 9 percent. (Profits peaked at over 14 percent of
national income in the 1960s.) The increasing share of profits in
national income over the past 5 years is mirrored by a declining share
of net interest payments (Chart 2-8); the sum of these components now
represents roughly the same portion of national income as during the
1980s. Thus, much of the runup in profits has been simply a shift in
capital income from debtholders to equityholders. After-tax profits--
which represent the funds available for payments to stockholders and

[[Page 71]]


for investment--have also made up an unusually large share of national
income in recent years.
Profits can affect investment in two ways. First, high returns to
existing capital may help persuade firms that the return to new capital
investment will be high as well. Second, high profits allow firms to
purchase capital using internally generated funds, which are generally
less expensive to the firm than external funds (the proceeds of
borrowing or the sale of shares). This difference in cost arises because
lenders know less about a firm's investment projects and financial
condition than the firm itself does. Their informational disadvantage
creates so-called agency problems, which include both moral hazard
(firms may alter their behavior in ways that raise their lenders' risk
without the lenders' knowledge or acquiescence) and adverse selection
(firms that seek external funds will tend to be those with riskier
projects). Thus, the information asymmetry between firms and potential
lenders raises the cost--and sometimes restricts the quantity--of funds
raised in financial markets.

Plentiful External Capital

A third reason for the impressive recent pace of investment has been
the ready availability of external funding. In particular, the dramatic
reduction in Federal Government borrowing has left more resources
available for private use. The domestic source of new loanable funds in
the economy is national saving, which equals saving by the Federal

[[Page 72]]

Government plus saving by households, businesses (in the form of
undistributed after-tax profits), and State and local governments. Since
1992, net private and State and local government saving has declined
slightly as a share of GDP, but the surge in Federal receipts relative
to expenditures has more than offset that dip (Chart 2-9). Over this
period, net national saving has more than doubled as a share of GDP,
rising from 3 percent to 6H percent--its highest level since 1984. (Net
saving equals gross saving less the consumption of fixed
capital.)
An alternative approach to evaluating the availability of external
funding is to focus on the price or cost of those funds--the interest
rate--rather than the quantity. Both price and quantity depend on
business investment decisions. A high level of desired investment
creates strong demand for loanable funds, pushing up their cost and
perhaps increasing the quantity of funds supplied by savers. Therefore,
if saving and desired investment for any given interest rate both
increase, the equilibrium interest rate can either rise or fall. This
ambiguity makes movements in the cost of borrowed funds an unreliable
indicator of shifts in the supply of funds. As already noted, however,
the increase in the supply of loanable funds during the past several
years came entirely from a reduction in government dissaving, which is
largely independent of investment demand. (It is not entirely
independent because part of the improvement in government finances

[[Page 73]]

is attributable to the strong economy, which in turn is due partly to
strong investment.)
In addition to national saving, another source of funds for
investment is capital inflows from abroad. In the national income and
product accounts, domestic investment equals national saving (plus a
statistical discrepancy) less net foreign investment, which is the
amount that domestic residents are lending abroad less the amount that
foreigners are lending to us. Net foreign investment has been
significantly negative on average during this decade (that is,
foreigners have been investing more capital in the U.S. economy than
Americans have been investing abroad), as it was during the 1980s,
providing additional resources for domestic investment. As with private
domestic saving, however, the net capital inflow depends partly on the
demand for investment funds, so it cannot be considered an independent
cause of strong investment.

Falling Computer Prices

A fourth factor spurring investment during the past several years
has been a remarkable drop in the price of computers. (Prices have also
fallen for some other capital goods, although less dramatically.)
Continued technological advances pushed down the chain-weighted price
index for business computers and peripheral equipment by about 30
percent at an annual rate during the first three quarters of 1998,
following declines of around 25 percent during both 1996 and 1997. The
combination of falling prices, new products, more innovative
applications of existing technology, and concerns about the year 2000
problem (discussed later in this chapter) has sharply boosted outlays in
this area. Between the end of 1995 and the third quarter of 1998,
nominal computer spending increased roughly 30 percent, and real
computer spending tripled. Nominal computer spending is now roughly
twice what it was at the end of the 1980s, and real computer spending is
about 12 times as large. This exceptional advance in real computer
spending has comprised a significant part of growth in real equipment
investment.

IMPLICATIONS OF THE INVESTMENT BOOM

The 1990s boom in business fixed investment has generated a
significant increase in the Nation's stock of business capital. The
larger capital stock has benefited the economy in two important ways: it
has helped restrain inflation by increasing industrial capacity, and it
has helped raise productivity.

Capacity Utilization and Inflation

When demand for resources in the economy exceeds supply, inflation
usually results. The simplest measure of the utilization of labor
resources is the unemployment rate. Inflation often rises when labor

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markets are tight, because competition for workers among firms puts
upward pressure on wages; if these wage increases are not matched by
increases in productivity, firms face higher costs of production and
raise their prices as a result. Consequently, the unemployment rate is
useful in predicting inflation, although of course the relationship is
far from perfect.
The simplest measure of the utilization of capital resources is the
capacity utilization rate. Inflation often rises when capacity
utilization is high because the marginal cost of production is higher in
those situations, and higher marginal costs can lead to higher prices.
The capacity utilization rate reported by the Federal Reserve Board is
the ratio of the actual level of output to a sustainable maximum level
of output (or capacity), based on a realistic work schedule and normal
downtime. The Federal Reserve produces these numbers for the industrial
sector (manufacturing, mining, and utilities) only, using data from the
Survey of Plant Capacity collected by the Census Bureau. The correlation
between the capacity utilization rate and acceleration of the core CPI
is positive and fairly high, even though capacity utilization data apply
to only a portion of the economy. (Because final demand for services is
more stable over the business cycle than final demand for goods, the
focus of capacity utilization on the goods-producing sector may not
represent a significant obstacle to predicting cyclical pressures for
inflation.) In time-series models, capacity utilization is often an
important predictor of inflation, and several studies have found that
the nonaccelerating-inflation rate of capacity utilization (analogous to
the nonaccelerating-inflation rate of unemployment, or NAIRU) is close
to the mean value of that series.
Despite the historical relationship between the unemployment rate
and inflation, the very low unemployment rate of the past several years
has not produced an increase in inflation. Indeed, core inflation has
dropped, on net, during this period. One factor that may have helped
hold down inflation is the rapid pace of investment, which has caused
total industrial capacity to grow faster in each of the past 4 years
than in any other year since 1967, when the series began. As a result,
capacity utilization has stayed fairly close to its long-run average
since 1996 in spite of substantial output growth and rising utilization
of labor resources.

Productivity

The accumulation of capital boosts the productivity of labor through
capital deepening, or increases in the quantity or quality of capital
per worker. New capital can also embody technological advances or
innovative ways of organizing work that raise the productivity of both
labor and capital, known as multifactor productivity or total factor
productivity.
The Bureau of Labor Statistics breaks down growth in potential
output into changes in the quantity of labor and changes in labor

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productivity; the latter is in turn broken down into changes in labor
quality, changes in the quantity and quality of capital, and changes in
multifactor productivity. Between 1990 and 1996 (the last year for which
the breakdown is officially tabulated), labor productivity in private
business increased at an average rate of 1.1 percentage points per year.
Improvements in labor quality accounted for 0.4 percentage point, and
capital deepening contributed about 0.4 percentage point. (In
comparison, capital deepening contributed 0.7 percentage point to
multifactor productivity growth between 1979 and 1990. Although gross
business fixed investment has increased significantly as a share of GDP
during the past 6 years, it represented a smaller share of GDP on
average between 1990 and 1996 than between 1979 and 1990. Net business
fixed investment, which determines the change in the business capital
stock, was also a smaller share of GDP on average during the later
period.) Gains in multifactor productivity represented the remaining 0.3
percentage point of labor productivity growth, part of which may be
related to capital investment, although such an effect is difficult to
quantify.
Some observers are surprised that the torrid pace of computer
investment has not had a more apparent effect on productivity growth. As
noted earlier, much of the acceleration in measured labor productivity
during the past 3 years may owe to methodological changes and cyclical
dynamics rather than fundamental advances such as the increasing use of
computers. One factor limiting the impact of the information technology
revolution on productivity is the relatively small share of this type of
capital: computers and peripheral equipment still represent less than 5
percent of the total net stock of equipment and less than 2 percent of
net nonresidential fixed capital. And the small base of computer capital
means that many years of brisk investment would be needed before
computers could represent an appreciable part of the capital stock.
Even so, computers could have a large effect on productivity if the
rate of return to computer capital were especially high. In conventional
growth accounting, such as the calculations made by the Bureau of Labor
Statistics, unusually high returns to computers would appear as higher
multifactor productivity. However, measured multifactor productivity has
not increased especially rapidly during the 1990s. Measurement error
could play a role here, as a substantial part of the output of computers
is intangible and may not be captured in the national income accounts.
Yet mismeasurement of output has been a perennial problem for national
income accounting, and whether this problem is worse in the computer age
is not clear.
More fundamentally, the full benefits of the dramatic advance of
computer technology may still lie ahead of us. Economic historian Paul
David has compared the computer revolution to the transition to electric
power in the late 19th and early 20th centuries. He noted that

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the productivity gains from the electrification of manufacturing were
not large at first but became quite substantial several decades after
the opening of the first central power station. Box 2-1 examines the
hypothesis that rising productivity follows major technical innovations
with a considerable lag, and considers whether productivity patterns in
the information age are likely to mirror those that followed the
widespread adoption of electrical power.

MACROECONOMIC IMPLICATIONS OF THE Y2K PROBLEM

It is now less than a year until the widely anticipated arrival of
the year 2000 problem, called Y2K for short (or, more colorfully, the
``millennium bug'' or ``millennium bomb''). Many older computer
programs, including those running on microprocessors embedded in other
electronic products, encode the current year using only the last two
digits. Thus, when January 1, 2000, arrives, they may fail to recognize
``00'' as

Box 2-1.--The Electrical Revolution, the Computer Revolution, and
Productivity

Although the electric dynamo was invented well before the turn of
the century, it did not seem to fuel large gains in productivity until
many years later. One economic historian reports that U.S. productivity
grew more slowly between 1890 and 1913 than previously, but it increased
rapidly between 1919 and 1929, and he attributes half of the
acceleration in manufacturing productivity relative to the preceding
decade to growth in electric motor capacity. Drawing a parallel between
this episode and the spread of computing technology in our own time, he
argues that an extended process of technological diffusion may now be
under way, which may yield large productivity gains in the future.
Others have noted similar lagged productivity effects following the
introduction of steam power and the development of the automobile.
The slow diffusion of electric power may be explained primarily by
the need to build new factories and redesign manufacturing processes in
order to take full advantage of the new technology. Many manufacturers
would have gained little from simply replacing a large steam power unit
with a large electric power unit in the same factory. Substantial cost
savings were available over time from building new factories: electric-
powered factories could be single-story and less sturdy, machinery could
be reconfigured more easily, and the flexibility of wiring meant that
portions of plants could be shut down individually. However, new
construction was generally unprofitable until existing plants had

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the year 2000, mistaking it instead for 1900. The result could be
incorrect output or total system failure. Although it sounds to many at
first like a trivial matter, of interest only to computer engineers and
programmers, in fact the Y2K problem is potentially extremely serious,
given the central role that computer technology has taken in our lives.
Problems caused by the Y2K bug in one company, industry, or sector may
have widespread consequences in others.
There are many conceivable Y2K disaster scenarios. Most involve
disruptions to some critical infrastructure that links the rest of the
economy together, such as transportation systems, power distribution
grids, or telecommunications or financial networks. Such disruptions
would likely have effects that are more than proportionate to the size
of the sector directly affected. Some observers warn that in January
2000 planes may stop flying, telephone traffic may be disconnected,
financial transactions may not go through, power grids may shut down,
and so on. Others have worried that Social Security recipients might not
receive their checks (although, as Box 2-2 notes, the Social

Box 2-1.--continued

depreciated. In addition, a relatively loose industrial labor market
at the turn of the century kept the price of labor low and discouraged
manufacturers from substituting capital for labor. Real wages in the
United States did not rise enough to motivate significant expansion of
the capital stock until immigration from Europe was curtailed during
World War I. Lastly, implementing the new processes throughout the
economy required a considerable supply of specialized talent--electrical
engineers and factory architects experienced in the new designs--which
developed only slowly.
Whether productivity in the information age will follow the path
of productivity in the electric age remains to be seen. The introduction
of computer technology is similar in many ways to the transition to
electric power. Integrating computers into the work environment is not a
straightforward matter: firms are clearly still adapting the
organization of work to take maximum advantage of the new technology. At
the same time, the diffusion of computers differs from the spread of
electricity in important ways. For example, computers have already
spread through the economy much faster than electric power did, at least
in part because of their plunging prices. The historical analogy is
intriguing and has appealing implications, but even its main proponent
warns against taking it too literally. It is simply too soon to know
whether the computer revolution will generate a surge in productivity
growth ahead.

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Box 2-2.--Preparing Federal Systems for the Year 2000

The Federal Government is a sufficiently large player in the
economy that a failure of its own operations due to the Y2K problem
would cause great inconvenience and hardship to many Americans, even if
it did not impact the macroeconomy. The Federal Government operates some
of the largest, most complex computer systems in the world, which
provide services to millions of Americans. At the Social Security
Administration (SSA) alone, information systems track annual earnings
for more than 125 million workers, take 6 million applications for
benefits each year, and make monthly benefit payments to 48 million
Americans. The Federal Government also exchanges vast amounts of
information with the States, which administer key Federal programs such
as the food stamp program, Medicaid, and unemployment insurance.
Preparing Federal systems for the year 2000 is an enormous
challenge, and agencies have mounted aggressive efforts to ensure that
their critical services will not be disrupted. SSA was the first agency
to begin work on the Y2K problem, as long ago as 1989. By 1995 several
agencies had Y2K projects under way and were sharing information with
each other about their efforts. In 1995 the Office of Management and
Budget (OMB) formed an interagency committee, which it asked the SSA to
chair, to coordinate the various Federal efforts. In 1996 the Chief
Information Officers Council was assigned the responsibility of building
on and overseeing the committee's work.
Since early 1997 the OMB has produced quarterly reports on
agencies' progress in assessing, remediating, testing, and implementing
critical systems. The Administration has established a goal of having
all critical systems compliant by March 1999. As of November 15, 1998,
61 percent were already compliant, up from 27 percent a year earlier. A
small percentage of critical systems
Security Administration is already Y2K-compliant) and even that hospital
life-support systems might shut down.
Huge efforts to address the Y2K problem have been under way for some
time, especially in large corporations and financial markets and in the
U.S. Government (see Box 2-2 on Federal Y2K efforts; see also Box 5-3 in
Chapter 5, on the Administration's initiative to encourage Y2K
information sharing among companies). The American economy is large,
diverse, and resilient, and people will find ways around those
disruptions that, despite everyone's best efforts, will inevitably
occur. But it is essential to guard against complacency. Some, in
particular some smaller companies and some State and local governments,
have not yet gotten the message.

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Box 2-2.--continued

are not expected to meet the March goal, and their agencies have
been instructed to produce specific benchmarks showing how they will
complete work on these systems before January 1, 2000, and to create
contingency plans where necessary.
Federal payment systems are of particular concern to the public
and the economy. Social Security and veterans' benefits systems are
already compliant, and the Internal Revenue Service appears well on its
way to being able to collect and process tax returns and issue refunds
in a timely manner. For Medicare, which continues to face major system
challenges, the Health Care Financing Administration is developing
contingency plans to ensure that health care funding is not disrupted.
State-run systems for administering Federal benefit programs play a
critical role in distributing a wide range of benefits, and a few States
are receiving increased attention from Federal agencies.
The OMB also works with agencies to ensure that they have adequate
financial resources to address the problem. In the fall of 1998 the
Congress provided a $3.35 billion emergency fund to ensure that
unanticipated Y2K funding needs are met and that no system will fail for
lack of financial resources.
In February 1998 the President's Council on Year 2000 Conversion
was created to coordinate the Federal Government's Y2K efforts. The
council works with the OMB to ensure that agencies are making the most
effective use of their financial and human resources to prepare their
systems. The council is also concerned with reaching out beyond the
Federal Government to promote action on the problem and to offer support
to Y2K efforts in the private sector, by State, local, and tribal
governments, and by international entities.
Some foreign countries have only recently gotten the message as
well. Thus concern has shifted recently to the international dimension.
Y2K problems can be transmitted not just from one company to another,
but also from one country to another. Australia and Canada are classed
with the United States among those countries relatively far along in
their remedial efforts. But some European countries have been diverted
by another large information processing task, namely, that of converting
their information systems to deal with the new European currency, the
euro, which came into existence in January 1999. In many countries,
preparations are not as far along as they should be. The reassuring
notion that developing countries are not yet as dependent on computers
as are many industrial countries is

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outweighed by the fact that their equipment is likely to be older and
therefore may contain more of the old two-digit coding.
Those companies and countries that only began to address the Y2K
problem in 1998 now find themselves in a race against time. And any that
have still not begun to deal with the problem will probably find their
efforts have come too late. In such cases, business continuity planning
to minimize probable disruptions is particularly necessary.
A few Wall Street forecasters have assigned high odds to the
likelihood that the Y2K problem will lead to a serious global recession.
Such forecasts seem excessively dire. Even if disruptions turn out to be
more serious than most analysts expect, they will most likely show up
primarily as inconveniences and losses in certain sectors. It is less
likely that they would manifest themselves as the sort of economy-wide
macroeconomic disturbances that can lead to a recession. In other words,
aggregate economic statistics such as GDP and employment will probably
not reflect Y2K effects to any noticeable extent. However, it would be
unwise to state categorically that a Y2K recession is not in the cards.
Computer technology is so pervasive in our lives that it is difficult to
predict all the possible sources of danger.
Some effects on the demand side of the economy can reasonably be
predicted--indeed, they are already upon us. First, the need to address
the Y2K problem is already boosting demand for computer hardware and
software, both to retrofit older machines and programs and to purchase
new equipment that is Y2K-compliant. From a review of quarterly 10-K
reports filed by Fortune 500 firms, the Federal Reserve Board has
estimated that these large companies will spend a total of $50 billion
on Y2K fixes. Indeed, this spending probably helps explain why real
investment in computers and peripheral equipment in late 1998 was
running more than 60 percent above its level a year earlier. Sometime
later in 1999, it is likely that a tendency for firms to freeze their
systems, so as not to be caught in midstream when January 1, 2000,
arrives, will work to moderate Y2K spending. Thereafter a second burst
of pent-up computer spending may occur, especially if new Y2K-related
problems are revealed.
The Y2K problem is also increasing demand for the services of
computer programmers. This effect should reverse after 2000, if all goes
well, but it is likely to persist for some time after January 1. Not
only may unanticipated glitches be discovered and need to be fixed, but
companies are also likely to face a backlog of upgrade tasks that they
had postponed in order to divert programming resources to Y2K issues.
Economists at the Federal Reserve Board have pointed out that the
increased demand for computer goods and services may not be showing up
in GDP, to the extent that it takes the form of firms reallocating their
own computer support services to work on the problem. To the contrary,
they point to a negative effect on productivity resulting from the
diversion of resources from what would otherwise be investment in

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new productive capacity, and they estimate a loss to U.S. productivity
due to such diversion of 0.1 to 0.2 percent per year in 1998 and 1999.
Uncertainty over the performance of information and delivery systems
might lead firms to stockpile inventories in the runup to January 2000.
Uncertainty has a positive effect on the demand for inventories at every
stage of production, from raw materials such as oil and other mineral
and agricultural products to retailers' inventories of consumer goods.
The Y2K inventory effect should provide a clear boost to GDP in the
fourth quarter of 1999, offset by a corresponding negative effect in
early 2000. But this possibility implies no particular distortion of
economic activity and calls for no particular policy response. Given the
intrinsic uncertainty created by Y2K, it is rational and sensible, even
optimal, for companies to take the precaution of adding a bit to
inventories ahead of time. There is no reason to presume that this
tendency to stockpile will be greater, or that it will be less, than
what is appropriate.
Disturbances in the financial sector are also possible. The demand
for cash balances, like the demand for inventories, is affected by
uncertainty. Risk-averse people may withdraw more than the usual amount
of money from automatic teller machines on the way to their New Year's
Eve parties this year. As any macroeconomic textbook shows, an increase
in the demand for cash without an increase in its supply can have a
contractionary effect on the economy. Unlike the other factors, however,
this one is easily accommodated. The Federal Reserve has already made
arrangements to ensure that banks have the currency they need to satisfy
a surge in demand. Thus, an increased demand for cash is one part of the
macroeconomic equation that need not be a source of concern.
Effects on the supply side--notably in the infrastructure sectors
mentioned above--are the source of the more alarming scenarios and are
much harder to predict. It is here that the greatest risks lie. There is
no way to evaluate, for example, whether the prospect of Y2K glitches in
the financial sector will stoke irrational end-of-millennium unease to
the point of provoking self-confirming volatility in securities markets.
Banks have reported that Y2K compliance is already an important factor
in their decisions to extend credit in certain foreign countries,
particularly in Asia and Eastern Europe, where countries are thought to
be among the least well prepared for the Y2K problem. A tightening of
bank lending in these regions could accentuate the capital scarcity
arising from the recent flight to quality.
There is no way of knowing the odds that the Y2K problem will lead
to a recession. Even those who issue pessimistic forecasts admit freely
that they are purely subjective judgments. This is not the sort of
problem that lends itself to formal modeling; macroeconomic models
simply are not built to address one-time scenarios such as a Y2K
debacle. Moreover, if one knew enough about all the potential problems
to

[[Page 82]]

construct an accurate forecasting model, one would also know enough to
go out and fix them. But as always, the unpredictable problems are the
hardest to predict.
One can look to historical precedent--past disruptions of
transportation or power systems due to strikes, weather events, or
technological failures, for example--to see if anything can be learned
about the macroeconomic spillover effects. Such an analysis is
encouraging. Table 2-2 reports over 20 major disasters that occurred in
the United States between 1971 and 1995, most of them weather-related,
together with estimates of their monetary damages. The adverse impacts
on buildings and property, even leaving aside the tremendous human toll,
were often large: over 1 percent of GDP each in the cases of Hurricane
Andrew in 1992 and the Northridge, California, earthquake in 1994. In
economic terms these damages represent a loss in future consumption;
resources must be diverted to replace or repair the capital stock that


[[Page 83]]

has been lost or damaged. Yet in most cases the reduction in the capital
stock had only a limited impact on current sales and production, so that
the disruption did not show up in the national statistics on output,
income, or employment for the year. The same is true of strikes, even
those that affect the communications or transportation infrastructure.
The 1997 strike against the Nation's leading private package delivery
service, for example, in the end had little discernible impact on GDP,
in part because firms and individuals found other ways to ship their
packages. Americans are, after all, very adaptable. Also, output that is
lost in one month is often made up the next.
To be sure, it could be dangerous to generalize from these
precedents. A disruption that affected the entire country, or that
lasted more than a few weeks, would offer less scope for substitution.
But even when a failure of major power cables cut power to the central
business district of New Zealand's largest city for 2 months last year,
the estimated effect on the year's GDP growth was small in the end.
To summarize, even if Y2K disruptions turn out to be on the serious
side, they will most likely show up primarily as inconveniences and
losses in some sectors, and not in noticeable macroeconomic terms. A
survey of 33 professional forecasters reported an average expectation
that the Y2K problem and efforts to address it would add 0.1 percent to
economic growth in 1999 and subtract 0.3 percent in 2000. Given typical
yearly fluctuations in GDP, it would be hard to identify effects of this
magnitude after the fact. The huge efforts now under way, both in the
government and in the corporate sector, should make a truly serious
disruption, let alone a recession, less likely. Again, however, it is
important to avoid complacency. We should all redouble our preventive
efforts, to keep from having to put the adaptability of the economy to
the test.

NEAR-TERM OUTLOOK AND LONG-RUN FORECAST

THE ADMINISTRATION FORECAST

The Administration projects GDP growth over the long term at roughly
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
the economy's supply-side components. One method for estimating the
economy's potential growth is an empirical regularity known as Okun's
law, which can be illustrated by a scatter diagram (Chart 2-10). The
diagram plots the four-quarter change in the unemployment rate against
the four-quarter growth rate for real output. According to Okun's law,
the unemployment rate falls when output grows faster than its potential
rate, and rises when output growth falls short of that rate. The rate of
GDP growth consistent with a stable unemployment rate is interpreted as
the rate of potential growth and

[[Page 84]]

is estimated as the location where the fitted line in Chart 2-10 crosses
the horizontal axis--in this case around 2.5 percent.

COMPONENTS OF LONG-TERM GROWTH

Labor Force

In the long term, the growth rate of the economy is determined
primarily by the growth of its main supply-side components: population,
labor force participation, the workweek, and labor productivity (Table
2-3). Of these, the most easily understood is the civilian working-

age population (the number of Americans aged 16 and over), which has
grown at a 1.0 percent annual rate over the past 8 years. Official
projections by the Bureau of the Census point to a growth rate of 1.0
percent per year through 2008 for this segment of the population.
The labor force participation rate--the percentage of the working-
age population that is working or seeking work--was little changed in
1998, after notable increases in the 2 previous years. Although no
readily apparent explanation emerges for the year-to-year pattern, the
resurgence of strong GDP growth in 1996 (following a slower year), the
expansion of the earned income tax credit, and the welfare reform law
passed in the summer of 1996 probably all contributed to the increase in
participation that year and in 1997. Welfare reform required States to
move more of their public assistance caseload into work or work-related

[[Page 85]]

activities. Most likely, the boost to participation from these efforts
will be spread over the years between 1996 and 2002. Evidence for this
effect is the rapid rise in the participation rate for women who
maintain families. The increase in the participation rate for this
group, which makes up only 6 percent of the labor force, accounts for
half of the increase in the total participation rate over the past 3
years. These labor market issues are discussed further in Chapter 3.
On average, the total participation rate has been little changed
since the last business-cycle peak. Looking ahead, the Administration
expects the participation rate to increase by almost 0.2 percent per
year during the phase-in period of welfare reform (that is, through
2002) and then to slow to 0.1 percent per year thereafter.

Productivity

The official measure of productivity in the nonfarm business sector
has grown at about a 2 percent annual rate over the past 3 years,
substantially faster than the 1.1 percent average annual growth rate
between the business-cycle peaks of 1973 and 1990. To assess whether


[[Page 86]]

the recent surge in productivity represents an increase in long-term
trend growth, several measurement issues must be addressed, as well as
the cyclical behavior of productivity. One such issue concerns the
decision to switch to geometric price indexes for some components of
consumption. This decision, announced by the Bureau of Labor Statistics
for the CPI starting in 1999, was first implemented by the Department of
Commerce with last year's annual revisions to the national income and
product accounts. (The Department of Commerce used the experimental CPI
series that the Bureau of Labor Statistics began releasing in 1997.) The
new methodology raised the measured annual growth rates of real nonfarm
output and productivity by roughly 0.2 percentage point per year for
1995 and subsequent years. The change did not apply to earlier years,
because last year's annual revision did not reach back that far. If the
same methods were applied to earlier years, as they probably will be
with the next benchmark revision, the average annual rate of
productivity growth since 1973 might be 1.3 percent rather than the 1.1
percent officially reported.
A second measurement issue concerns whether real output is best
measured on the product side (the official method) or on the income side
of the national accounts, or by a mixture of the two. Since 1993, the
average annual growth rates of the income-side measures of output and
productivity have been 0.5 percentage point higher than the official
product-side measures. Because both sides of the accounts contain useful
information, the Administration's (unofficial) estimate includes the
information from both these series by averaging them--as has been done
in Chart 2-11.
Other, more fundamental measurement issues exist as well. Box 2-3
discusses attempts to include environmental benefits in measures of
national income, as would be required for a truly comprehensive measure
of economic welfare.
In the long term, productivity increases with training,
technological innovation, and capital accumulation. But productivity
growth also shows considerable variation over the business cycle,
typically falling below its trend during recessions, then growing faster
than trend during the middle of an expansion, and finally falling again
in advance of the business-cycle peak, as it did between the peaks of
1980 and 1990. This cyclical behavior can be captured by a model in
which firms only partially adjust toward their desired level of
employment in any quarter, because hiring and firing are costly. As
shown in Chart 2-11, a simulation from this model shows that the above-
trend growth of productivity in recent years is consistent with strong
output growth and an underlying trend rate of 1.3 percent.
The most straightforward conclusion is that the trend growth of
labor productivity has not changed much during the post-1973 period and
that recent productivity growth reflects primarily cyclical factors.
Since 1994, on the other hand, labor productivity has grown faster

[[Page 87]]


than under the simulation, and it remains possible that the growth rate
of trend labor productivity has risen recently. Weighing these
possibilities, the Administration has projected long-term annual growth
of labor productivity at 1.3 percent, but will closely monitor
productivity data over the next year for further evidence of a stronger
growth rate.

Box 2-3.--Accounting for the Environment

Economists have long realized that GDP is a measure of market
output, not of national welfare. By design, changes in GDP primarily
reflect the value of goods and services as measured in the marketplace,
excluding changes in leisure time, health status, environmental quality,
and other aspects of well-being. Recently, concerns over sustainable
development have sparked interest in expanding the system of national
income accounts to include measures of environmental quality and the
stock of natural resources. Some people worry that economic development
may entail a deterioration of environmental quality and a depletion of
natural resources, causing national well-being to fall even as measured
GDP rises. Proposals for a ``green GDP'' attempt to address this desire
for a more comprehensive scorecard on well-being and environmental
sustainability.
Incorporating environmental and natural resource assets into a
unified system of national income accounts is exceedingly difficult,

[[Page 88]]



Box 2-3.--continued

however. Important aspects of environmental quality must first be
measured in physical units, which then must somehow be translated into a
common economic measure (dollars). There is little agreement about how
to value many aspects of environmental quality, or even on methods for
establishing such values. For example, setting a dollar value on the
health and aesthetic benefits of lowering air pollution raises a host of
difficult philosophical and technical issues.
These problems have led most countries to abandon the quest to
incorporate the environment formally into GDP. An alternative favored by
Eurostat, the statistical office of the European Union, is to report
only physical measures of different aspects of environmental quality.
This approach makes no attempt to aggregate these various estimates into
a common unit of measure, and no attempt to estimate green GDP. Rather,
separate accounts track various measures of environmental quality
individually.
An intermediate approach, used by the United Nations System of
Environmental and Economic Accounting and in prototype accounts
developed by the United States, is a system of satellite accounts to
account for certain important aspects of environmental quality. These
accounts, although developed to be consistent with the system of
national income accounts, are not restricted to the same definitions and
methods. This flexibility allows them to focus on issues of particular
interest and to be tailored to available information. As information and
methods of valuation improve, the system of satellite accounts would
move closer to a unified set of economic and environmental accounts.
The satellite accounts approach allows the system of national
income accounts to address two fundamentally different needs. There will
always be a need for a frequently updated measure of market-based goods
and services for both government and the private sector, which GDP
fulfills. A broader measure of well-being is also needed, even though it
is likely to be less precise and available less frequently, and this the
satellite accounts can provide. Fortunately there is no need to choose
between them.

INFLATION: FLAT OR FALLING?

The key to the longevity of this expansion has been low inflation.
Direct measures of the strain on productive capacity, such as the
unemployment rate and the capacity utilization rate, play a role in
determining whether the economy has reached the limits of its capacity.

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But in the last analysis, it is the direction of inflation that signals
whether or not the capacity limit has been breached. Over the past 2
years, low and stable inflation has allowed decisionmakers, both in
business and in government, to focus primarily on growth rather than on
bottlenecks.
In addition to its importance for policy decisions, the level and
direction of inflation are important variables in long-term economic and
budget projections. In this context it is important to note the gap that
has developed between inflation as measured by the CPI and the measures
of inflation included in the national income accounts. The broadest
measure of inflation for goods and services produced in the United
States is the chain-weighted price index for GDP, which increased only
1.0 percent over the four quarters ending in the third quarter of 1998,
almost a percentage point below its year-earlier pace. In contrast, the
CPI posted a larger increase--and less of a deceleration--over the past
year, despite a much larger weight for petroleum prices, which fell
during the year. The difference becomes striking when one focuses on the
contrast between two price measures that appear to have the same
coverage: the price index from the national income accounts for personal
consumption expenditures excluding food and energy (the core PCE), and
the CPI excluding food and energy (the core CPI). As Chart 2-12 shows,
the core CPI inflation rate has been roughly flat for the past year at
about 2.4 percent, whereas that of the core PCE has slowed to 1.1
percent for the four quarters ending in the third quarter of 1998, from
a 1.9 percent increase during the year-earlier period. Furthermore, the
difference that has opened up between these two series has no historical
precedent. What could cause such a divergence?
More than half of the deceleration in the core PCE over the past
year is accounted for by price imputations. National income accountants
impute prices for components of the consumer market basket for which
there is no nationally collected price measure. These items include
lotteries, insurance, and financial intermediation. One of these imputed
prices (that for ``free'' checking accounts) slowed sharply over the
past year. Because these imputations tell us little about the course of
inflation, it is more useful to focus on an index that excludes
imputations (Chart 2-12).
Excluding imputations, the index for the core PCE still shows lower
inflation than does the core CPI, and a gap between the series has
opened up over the past few years. The major sources of the difference
are in the treatment of medical care and housing. The price index for
medical care in the PCE, which was formerly an aggregation of mostly CPI
components, has now shifted toward an aggregation of components from the
producer price index. Over the four quarters ending in the third quarter
of 1998, medical prices in the PCE index have increased much less (2.2
percent) than the CPI measure of the same

[[Page 90]]


concept (3.5 percent). Although the increase in housing prices is
similar in both indexes (because the PCE housing index uses CPI
sources), housing is twice as important in the CPI as in the PCE price
index. This difference in weight, together with an increase in the price
of housing relative to the overall index, means that housing has also
been a source of the difference between the CPI and PCE inflation
measures. At this time, with no compelling reason to prefer one index to
the other, it is best to keep an eye on both.
In addition to the price index of the core PCE, other price indexes
from the national income accounts are increasing at or below an annual
rate of 1 percent per year. One of these, the price index for nonfarm
business output (which is aggregated from consumption prices as well as
prices of other spending components) increased at only a 0.5 percent
annual rate in the past four quarters. Can this low rate persist?
Whatever the rate of inflation today, in the long run the inflation
of business prices will likely gravitate toward the rate of increase in
trend unit labor costs--that is, the increase in hourly compensation
less the rate of trend productivity growth. Until recently, one measure
of trend unit labor costs (namely, the ECI measure of hourly
compensation, described earlier in the chapter, less the trend in
productivity) has closely matched the rate of price increases in the
nonfarm business sector (Chart 2-13). However, a large gap has opened up
recently, with the ECI-based measure of trend unit labor costs
increasing at a rate of 2.5 percent over the past four quarters (a 3.8
percent increase in

[[Page 91]]

hourly compensation less 1.3 percent trend productivity growth), in
contrast with an increase of 0.5 percent in prices in the nonfarm
business sector. The historical pattern suggests that this gap will
close, and it could do so through either higher price inflation, lower
wage inflation, or higher trend productivity growth. The eventual
outcome may involve some combination of all three, but the inertia in
wages and trend productivity growth suggests that most of the correction
will come from a higher rate of inflation of nonfarm business prices, at
least as measured in the national income accounts. If this price measure
gravitates upward, it will close not only the gap between prices and
trend unit labor costs, but also the gap between the price measures from
the national income accounts and the CPI. Accordingly, the
Administration projects that inflation as measured by the GDP price
index will rise to 2.1 percent by 2000. At the same time, the CPI is
projected to rise at a 2.3 percent annual rate--about the current rate
of increase of the core CPI.

WHAT HAS HELD INFLATION IN CHECK?

Inflation has been steady or falling despite an unemployment rate
that has been below 5 percent since July 1997. A model of inflation that
included only the unemployment rate and inflation expectations would
have predicted a pickup of inflation during this period. Three factors
that have held measured inflation down over this period have been
pressure from the international environment (including low oil prices),

[[Page 92]]

a level of capacity utilization that is low relative to the unemployment
rate, and certain methodological changes in the official measure of
inflation. But even taking these factors into account, the unemployment
rate associated with stable inflation (the nonaccelerating-inflation
rate of unemployment, or NAIRU) has probably edged lower.
Conditions in the international environment have restrained
inflation. The foreign exchange value of the dollar has risen
substantially over most of the past 3 years, both oil and nonoil import
prices have been falling, and exporters of U.S. goods face stiff
competition. On the import side, prices of nonpetroleum goods have
fallen at about a 4 percent annual rate, on average, during the past 3
years (Chart 2-14). 
With the share of nonpetroleum imports at about 15 percent of
consumption, these imports account for about 0.6 percentage point of the
reduction in consumer price inflation. Meanwhile exporters of U.S. goods
have cut prices by about 3H percent per year over the past 3 years,
presumably to match stiff competition abroad. With goods exports at
about 8 percent of GDP, export prices have subtracted about 0.3
percentage point from the inflation rate as measured by the GDP price
index. In recent months the dollar has retraced some of its appreciation
of the 1995-98 period, and so the damping effect on inflation may not be
as forceful over the medium term.
Capacity in manufacturing, mining, and utilities has grown at a 5G
percent annual rate over the past 3 years, outpacing growth in

[[Page 93]]

production at 4I percent. Consequently, the capacity utilization rate
has dropped to a level that is now 1 index point below its long-term
average of 82.1 percent of capacity. This slack in capacity is the
legacy of a sustained high level of industrial investment and stands in
sharp contrast to the tightness in labor markets. Over most of the
postwar era, slack in capacity has moved with the unemployment rate, and
so these two measures usually tell much the same story. However, in
current circumstances the excess industrial capacity offsets some of the
tightness in labor markets.
A final reason for the slowing of reported price indexes has been
methodological changes to both the CPI and the indexes used in the
national income accounts (Box 2-4). In general, these changes have
reduced the measured rate of inflation. For the CPI, methodological
changes made from 1995 through 1998 reduced the rate of CPI inflation by
about 0.44 percentage point. Changes to be introduced in 1999 and 2000
will reduce it by an additional 0.24 percentage point.

Box 2-4.--Methodological Changes to Price Measurement

The Bureau of Labor Statistics (BLS) and the Bureau of Economic
Analysis (BEA) have recently made several methodological changes that
have improved the accuracy of the consumer price index and the price
indexes in the national income accounts. One of these changes goes into
effect this year (Table 2-4). Most of the improvements made by the BLS
have reduced the measured increase in the CPI, and many will also affect
the deflation of nominal output and therefore raise the growth rate of
measured real GDP. Changes made through 1998 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); a modification of the
formula for measuring increases in rent; a change to measuring prices on
hospital bills rather than the prices of hospital inputs; a switch to
measuring computer prices by the computers' intrinsic characteristics
(``hedonics''); and an update of the market basket from one based on the
1982-84 period to one based on 1993-95. A change scheduled for this year
is the use of geometric rather than arithmetic means to address
substitution bias within categories; next year the BLS will bring in the
results of more frequent rotation of the items sampled in categories
with many new product introductions.
The combined effect of the changes made through 1998 has been to
lower the CPI inflation rate by 0.44 percentage point per year.

[[Page 94]]



Box 2-4.--continued

Changes to be implemented in 1999 and 2000 will lower CPI
inflation by a further 0.20 and 0.04 percentage point per year. The BEA
brought the geometric CPI components into the national income accounts
during the annual revision of July 1998. In this revision the books were
open only for the 3 previous years, and so the effect of the geometric
CPIs now begins in 1995. In the benchmark revision scheduled for October
1999, this effect will be taken back farther into the historical record.
The BEA has also recently switched from using the CPI to using the
producer price index (PPI) to deflate physicians' services and the
services of government and for-profit hospitals. These changes, made in
the July 1997 annual revision of the national income accounts, reached
back to 1994. Because the PPI measures of these prices have been
increasing less than the comparable CPIs, the changes reduce the rate of
increase of the chain-weighted price index for GDP and raise real GDP
growth. These changes, in addition to those passed through from the CPI,
will have cumulated to raise the annual growth rate of real GDP by 0.29
percentage point by 2000.

[[Page 95]]


A proper accounting for these changes can explain in part the recent
low inflation in terms of the CPI (although not that in terms of the GDP
price index). The rest can be explained by some combination of low
nonoil import prices, low oil prices, and a downtick in the NAIRU. But
it is as yet impossible to know exactly which combination of these
factors is the right one.

THE NEAR-TERM OUTLOOK

Both supply- and demand-side considerations argue for some
moderation in real GDP growth from its rapid 3.7 percent annual pace of
the past 3 years. On the supply side, the unemployment rate has fallen
by about 0.4 percentage point per year over the past 3 years, and it is
questionable whether a further decline of this magnitude could be
accommodated without inflationary consequences. Labor force growth has
not kept up with demand for labor 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, private consumption and fixed investment are
expected to grow less rapidly in 1999 than they did in 1998.
Consumption, which constitutes two-thirds of demand, rose at more than a
5 percent annual rate during the first three quarters of 1998. Growth of
consumer spending, which was well in excess of the growth rate of
disposable personal income, reflected the remarkable growth of stock
market values. As a consequence, the saving rate fell almost 2
percentage points over the year, finally dropping to near zero by year's
end. Unless the stock market continues to surge, consumption is likely
to grow at a more moderate pace. Continued real income growth is likely
to motivate further, but smaller, consumption gains.
Business equipment investment grew at an extraordinary 26 percent
annual rate in the first half of the year, the fifth consecutive year of
double-digit growth. Business purchases of computers accounted for much
of this growth; the rapid pace of innovation in the computer industry is
driving new investment, and prices have been falling sharply. But
equipment investment decelerated sharply in the third quarter of 1998.
Investment in business structures has been about flat over the past year
and a half. Low capacity utilization may be one factor limiting
investment growth. However, as long as the relative price of equipment
is falling, it is likely that business investment will continue to grow
faster than the economy as a whole.
Strong real income growth, together with the drop in mortgage
interest rates over the past year, is also buoying residential
investment. The 1.62-million-unit pace of housing starts in 1998 was the
highest in a decade. Even if mortgage rates remain around their current
low levels, housing activity and residential investment are likely to
edge down because of demographic factors and the lack of pent-up demand
after several years of strong growth.

[[Page 96]]

Nonfarm manufacturing and trade inventories also grew rapidly in
1998, but no faster than sales. The (nominal) inventory-to-sales ratio
was thus little changed over the year and remains at one of its lowest
levels ever (Chart 2-15). Nevertheless, if the components of final
demand were to decelerate to a more modest rate in 1999, the level of

inventory investment would have to drop in order for this lean inventory
posture to be maintained.
Some restraint is likely to come from the international economy, as
the rise in the dollar over the past 3 years and the continued
restructuring of several Asian economies have already weakened--and will
continue to weaken--demand for American-made products. Because the
direction of trade responds with a lag to changes in the exchange rate,
the appreciation of the dollar over the past 2 years is likely to boost
demand for imports and limit growth of exports in 1999. As a result, net
exports are likely to become more negative in 1999, although they
probably will not decline as much as in 1998.
Up to now, the Asian economic crisis has not had the negative effect
on the U.S. economy that was anticipated a year ago. The consequences of
a larger-than-expected drop in import prices have offset much of the
direct loss of exports. On the one hand, American exports to the Asian
economies most affected by the crisis have fallen about $30 billion (in
nominal dollars) since the second quarter of 1997. On the other hand,
the weakness abroad has been a major factor in

[[Page 97]]

lowering the price of imported crude oil, which has fallen almost $8 per
barrel from precrisis levels. Because the United States purchases about
3H billion barrels of foreign petroleum and petroleum products per year,
the resulting $27 billion saving on the national oil import bill offsets
almost all of the loss in exports to Asia. In addition, the drop in
nonpetroleum import prices and the price discipline imposed on exporters
who compete in international markets have held down inflation by about
half a percentage point, as discussed earlier. Low inflation has in turn
allowed interest rates to be lower, and domestic demand higher, than
they would otherwise be.
A moderation in output growth to 2.0 percent is projected for the
next 3 years--about half a percentage point below the economy's long-
term growth rate, but roughly in line with the consensus of professional
economic forecasters (Table 2-5). Over these 3 years the unemployment

rate is projected to edge up slowly to 5.3 percent--the middle of the
range of unemployment compatible with stable inflation. Thereafter, the
Administration's forecast is built around a growth rate of potential
output of 2.4 percent per year. The Administration does not believe that
2.4 percent annual growth is the best the economy can do; rather, this
projection 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 indeed it

[[Page 98]]

has been for the past 3 years. But the Administration's forecast is used
for a very important purpose: to project Federal revenues and outlays so
that the government can live within its means. For this purpose,
excessive optimism is dangerous and can stand in the way of making
difficult but necessary budget decisions. On the other hand, excessive
pessimism can force difficult decisions where none was required. In the
final analysis, the only worthy objective is the creation of a sound
forecast that points to the eventual outcome using all available
information as fully as possible.
As of December 1998, the current economic expansion, having lasted
93 months, was the longest ever during peacetime and the second longest
on record. There is no apparent reason why this expansion cannot
continue. As the 1996 Economic Report of the President argued,
expansions do not die of old age. Instead, postwar expansions have ended
because of rising inflation, financial imbalances, or inventory
overhangs. None of these conditions exist at present. The most likely
prognosis is therefore the same as last year's: sustained job creation
and continued noninflationary growth.