[Economic Report of the President (2000)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]


[[Page 49]]

 
CHAPTER 2
Macroeconomic Policy and Performance



The evolution of the stock market illustrates how dramatically tech-
nology   has changed the way we do things and the things we are able
to do. At the  start of the 20th century, the purchase of stock was a
lengthy and labor-intensive process. After a trade, messengers would
hand-deliver the stock certificates, which were then carried to a vault
for safekeeping. Today, computers and instant global communications
have made the trading of stocks anywhere in the world just a mouse click
away.


THE U.S. ECONOMY PERFORMED very well in 1999. The economic expansion is on
the verge of shattering the all-time endurance record, set during the 1960s,
of 106 months. Real (inflation-adjusted) output increased a robust 4.2
percent over the four quarters of 1999, on a par with the energetic pace set
over the preceding 6 years of this Administration. An additional 2.7 million
nonagricultural jobs were created during the year, bringing the total created
during this expansion to nearly 22 million (20.6 million during the 7 years
of this Administration). The unemployment rate dropped to 4.2 percent for the
year as a whole, its lowest level in 30 years (Chart 2-1). The consumer price
index rose by 2.7 percent over the 12

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months of 1999, a pickup from the previous year's 1.6 percent rate (Chart
2-2). A sharp rise in energy prices, following 2 years of declines, accounted
for more than the entire acceleration in consumer prices in 1999. Consumer
prices excluding energy and food prices were up only 1.9 percent over all of
1999, the smallest December-to-December percentage increase since 1965. Over
the first three quarters of 1999, productivity (output per hour) in the
nonfarm business sector increased at an annual rate of 2.8 percent, marking
the fourth straight year of strong productivity growth.

These statistics portray a vibrant economy ending the 20th century on a
strong note, with robust growth, high employment, and low and stable
inflation. A key factor in the recent remarkable performance of the economy
has been an acceleration in productivity. In the long run, productivity
growth sets the pace for improvements in the quality of life. Rising
productivity over most of the last 100 years has dramatically changed the
face of the American economy in terms of living standards, the affordability
of life's basic goods, and the range of goods and services Americans can buy.

As American workers became more productive, average nominal wages rose from
15 cents an hour at the turn of the century to about $14 by 1999. Of course,
in general prices have also risen over that time. But the gains in wages have
far outpaced the rise in prices for the goods and services we buy. For
instance, a candy bar that cost a nickel in 1900 might cost about 50 cents
today, but today it takes the average worker just 2 minutes to earn that 50
cents, whereas in 1900 it took nearly 20 minutes of work to earn a nickel.
Other goods are not only cheaper but of better quality as well. For example,
in 1916 a refrigerator with 9 cubic feet of storage cost $800, the equivalent
of over 3,000 hours of wages for the average worker. Today a refrigerator
with more than twice the capacity, and with features not available 80 years
ago such as an icemaker or an automatic defroster, costs about $900, or about
65 hours of work at the average wage. But the computer industry offers the
most dramatic example of our increased buying power. In 1970 a
state-of-the-art computer cost about $4.7 million, an amount equal to 15 times
the lifetime wages of the average worker. In 1999 a personal computer with
more than 10 times as much computing power cost only $1,000, or less than 2
weeks of the average worker's pay, and this figure is likely to fall to just
1 day's pay in the next decade or so.

This record of long-term productivity growth and the resulting dramatic
changes in the quality of life are the result of investments, both public and
private, in education, science and technology, business capital, and
infrastructure. These and other causes and consequences of economic growth in
the past, and the outlook for continued growth in the future, are a recurring
theme of this chapter. Of course, the transformation and expansion of the
U.S. economy have not always been smooth: periods of growth were often

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interrupted by recession, and in the 1930s by the Great Depression. Thus a
second theme of this chapter is how changes in the economy and in government
policy have contributed to the macroeconomic performance we now enjoy: solid
growth, high employment, and stable low inflation.

As discussed in the other chapters of this Report, public policy has
provided a strong foundation for the robust health of today's economy. One
key to the outstanding macroeconomic performance of the last 7 years has been
the reemergence of fiscal discipline, starting with the Omnibus Budget
Reconciliation Act of 1993 (OBRA 93), continuing with the Balanced Budget Act
of 1997, and including the President's veto of proposed massive tax cuts in
1999. The Federal Government is once again a net saver. That is, the Federal
Government is now a source of funds for private investments in education,
housing, and business; this is in contrast to the preceding 28 years, when it
was a net borrower, competing with households and businesses seeking funds
for investment. In fiscal 1999 alone this return to fiscal discipline freed
over $120 billion that can be used for private investment_investment that
provides jobs and will improve future productivity and real wages. This
contrasts sharply with the record $290 billion deficit of fiscal 1992.
Although the strong economy accounts for some of the improvement, the
Congressional Budget Office's standardized-employment budget (which attempts
to control for cyclical and special factors) shows the same pattern of a
large deficit in fiscal 1992 and a surplus in 1999. Monetary policy likewise
has contributed to supporting long-term growth: by keeping inflation low and
stable, it has reduced the distortions to investment decisions associated
with high and variable inflation.

With the economy running strong, it is vital that fiscal policy continue to
be disciplined and directed at paying down the national debt. By adding to
national saving, Federal surpluses lower interest rates, lowering the cost of
consumer debt and home mortgages to households as well as the cost of
investment in technology and capital to businesses. Such investments boost
productivity and raise living standards. Federal spending needs to be
targeted at top national priorities such as encouraging saving and
investments in people and technology, health care, families, and the
environment. Likewise, tax cuts should be moderate and targeted to areas
where they can do the most good. Looking ahead, paying down the debt now is
the best way to prepare for the looming retirement of the baby-boom
generation and the consequent demands on Social Security and Medicare, as
well as for other needs we cannot today anticipate.

The first section of this chapter reviews the course of the U.S. economy
during 1999. The second examines patterns of national saving and investment in
recent decades and how government deficits and surpluses have affected
national saving. The third section examines how the nature of the

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business cycle has changed over the past century. The fourth and final section
takes up the near-term outlook and the Administration's long-run forecast,
paying particular attention to the effects of changes in productivity trends
on growth and inflation.

The Year in Review

Real gross domestic product (GDP) increased 4.2 percent between the fourth
quarter of 1998 and the fourth quarter of 1999 (Table 2-1). Even in the ninth
year of the expansion, real output growth remained strikingly robust. The
breakdown of the contributions to growth by major category in 1999 was
similar to that over the whole expansion to date. Household spending and
business investment in equipment once again provided the main contributions
to growth. Government spending provided somewhat more impetus to growth than
in previous years of the expansion, owing to increased spending by the
Federal Government and by State and local governments. The drag exerted by
the fact that imports grew faster than exports weighed in heavier than in the
previous year.



Components of Spending

Real GDP growth was strong in each quarter except the second, when it dipped
to a 1.9 percent annual rate. The quarter-to-quarter movements in

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GDP were exaggerated by swings in inventory investment (discussed further
below), which slumped in the second quarter before rebounding in the third
quarter and then surging in the fourth. In contrast, growth in real final
sales, which excludes inventory accumulation, fell only modestly in the
second quarter. Real final sales increased 4.3 percent over the four quarters
of 1999.

Household Spending

Real personal consumption expenditures (PCE) raced ahead at a 5.4 percent
annual rate over the four quarters of 1999, besting the 5.1 percent pace set
in 1998. Consumption growth contributed 3.6 percentage points to overall
growth over the year as a whole. Real purchases of new motor vehicles
increased about 5 percent over the four quarters of 1999; this was off the 14
percent pace of 1998. Total sales of automobiles and light trucks reached a
record 16.8 million vehicles in 1999. Demand for housing also continued
strong in 1999. Single-family housing starts topped 1998's record figure, as
did sales of new and existing single-family homes. The share of American
households who own their own homes was 67 percent in 1999. This figure
surpassed the record high annual level set in 1998. Growth in several housing
indicators stalled in the second half of the year, however, as the effects of
higher mortgage rates began to take hold. Still, housing markets remained
strong, and measures of construction activity were at historically high
levels.

Favorable economic performance continued to drive this robust growth in
household spending, and consumer confidence continued to run strong,
according to household surveys. Real disposable personal income (deflated by
the PCE chain-weighted price index) recorded impressive growth of about 3.7
percent at an annual rate over the four quarters of 1999. The strong stock
market and a pickup in the value of homes further boosted household wealth,
on top of sizable gains in each of the preceding 4 years. As a result,
household net worth nearly reached the level of six times annual personal
income (Chart 2-3). With wealth continuing to grow faster than income,
households have been willing to spend a larger share of their disposable
income (which, in the measurement concept used in the national income and
product accounts, does not include capital gains). Hence the personal
consumption rate rose for the seventh straight year, and the personal saving
rate correspondingly fell.

Business Investment

Real business fixed investment continued to boom last year. Real business
investment in equipment and software increased 11 percent at an annual rate
during 1999. Spending on information processing equipment and software was
the main contributor to the expansion in business investment. Adjusted for
quality improvements, prices for many of these goods declined sharply in
1999. Real outlays on computers and peripheral equipment were up 39 per-

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cent over the four quarters of 1999, while real business spending on software
increased about 13 percent, and real spending on other information processing
equipment (which includes communications equipment) increased 18 percent. As
in the previous year, the brisk pace of computer-related investment resulted
in part from the updating and replacement of older systems in preparation for
the century date change (better known as the year-2000 or Y2K problem).
Investment in transportation equipment also showed solid gains; however,
other categories of equipment investment were nearly flat.


Real spending on nonresidential structures declined about 5 percent over the
four quarters of 1999, as growth in earlier years (4.8 percent in 1997 and
2.9 percent in 1998) appears to have satisfied demand for new space for a
while.

Business inventories increased modestly through the first half of 1999. The
pace of inventory accumulation strengthened in the third quarter. However,
brisk sales brought inventory stocks down to lean levels relative to sales
through the first three quarters of 1999 (Chart 2-4). Toward the end of the
year, businesses apparently built up inventory stocks in anticipation of
potential Y2K disruptions, but sales continued to keep pace.

For the decade of the 1990s as a whole, the overall inventory-to-sales ratio
showed a downward trend. This ratio for the manufacturing sector was falling
for most of the decade, and more recently the retail inventory-to-sales ratio
also has fallen. This downward trend in inventories is likely related to the
adoption of just-in-time inventory management as well as to the use of new

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information technologies that enable businesses to manage with leaner
inventories (as discussed in Chapter 3).

Government

Real Federal Government consumption expenditures and gross investment
increased 5.3 percent on a national income and product accounts (NIPA) basis
over the four quarters of 1999. Real defense spending rose 5.4 percent during
that period, reversing a downward trend that saw this spending category fall
nearly 2.6 percent per year on average over the preceding decade. Real
nondefense spending was up 5.0 percent over 1999 as a whole. Federal
purchases of equipment and software were an important contributor to the
pickup in real Federal purchases.

The Federal Government surplus on a unified budget basis for fiscal 1999
(which ended in September) was $124 billion, compared with $69 billion in
fiscal 1998. The last time the Federal Government recorded two consecutive
budget surpluses was over 40 years ago. And at 1.4 percent of GDP, the fiscal
1999 surplus was the largest relative to the size of the economy in nearly 50
years (Chart 2-5). The challenge for the future is to maintain the
hard-earned fiscal discipline of recent years, so that the economy continues
to reap the rewards of greater investment and growth. In support of this
goal, the President rejected a congressional proposal for large-scale tax
cuts that threatened the prospects for continued fiscal discipline; instead
he has proposed a budget


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framework that continues to pay down the national debt while providing for
critical needs and moderate tax cuts.

State and local governments increased real spending on consumption and gross
investment by 4.5 percent over the four quarters of the year. This pace of
spending represents a pickup from the average 3.2 percent annual increase
recorded over the previous 3 years. The strong economy has boosted State tax
revenues, so that most State governments today appear to be in excellent
financial condition. At the end of fiscal 1999, over two-thirds of the States
surveyed had surpluses equal to 5 percent or more of general fund
expenditures (Wall Street's benchmark for financial solidity), and one in
three had balances equaling 10 percent of expenditures.

International Influences

International developments in 1999 posed a challenge to the continued strong
performance of the U.S. economy. Foreign growth rebounded in 1999, but its
past weakness kept demand for U.S. exports subdued during the first half of
the year. Export growth picked up in the second half of the year. Real
purchases of U.S. exports increased 4.0 percent over the four quarters of
1999. Meanwhile, strong income growth in the United States and low relative
prices for imported goods fueled increased U.S. purchases of imported goods
and services for another year: real spending on imports increased 13 percent
dur-

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ing 1999. In tandem, anemic export growth and the surge in imports caused the
trade deficit to widen markedly in 1999, to about 2.8 percent of GDP.

Labor Markets and Inflation

The U.S. work force enjoyed another year of solid job growth and rising real
wages in 1999. The unemployment rate in each of the final 3 months of the
year was 4.1 percent, the lowest since January 1970. Real wages increased for
the fifth straight year. Despite the tight labor market, core consumer
prices, which exclude food and energy prices, increased by 1.9 percent, their
slowest pace in nearly 35 years, although a sharp rise in the price of oil
sent energy prices up and caused overall consumer price inflation to move
upward. At the aggregate level, these statistics paint a rosy picture indeed.
Chapters 4 and 5, however, discuss the ongoing challenge of making sure that
the gains from this prosperity are shared as widely as possible.

Employment

Nonfarm payroll employment expanded by about 2.7 million jobs during 1999.
Employment in the service sector grew rapidly in 1999, and employment in the
government sector posted its strongest gain in 9 years, which was entirely
due to growth at the State and local levels. Since January 1993, Federal
employment (excluding the postal service) has declined by 18 percent, while
private nonfarm employment has increased by 21 percent. The number of
manufacturing jobs, however, fell by 248,000 last year; this marked the
second straight year of declines for this sector, which was particularly hard
hit by the slowdown in export demand. Manufacturing employment had been
increasing by 154,000 per year on average over 1993-97. But trends in this
sector appeared to improve over the year. Manufacturing production increased
more than 5 percent in 1999, and the pace of job reductions in the sector
slowed in the latter part of the year.

The unemployment rate averaged 4.2 percent in 1999, down from 4.5 percent in
1998. The average annual unemployment rate has fallen for 7 straight years
now, and in 1999 unemployment stood at its lowest annual rate since 1969. The
benefits of the decline in unemployment have been widely spread. The
unemployment rate for nonwhites, for example, fell to 7.0 percent, its lowest
annual rate in 30 years. This excellent performance also extends to other
labor market measures. The official definition of unemployment counts as
unemployed only those who are looking for work. If one adds to the standard
definition those who currently want a job but have not been looking
(so-called marginally attached workers), the jobless rate of this combined
group was 5.0 percent in 1999, down from 5.4 percent in 1998. Indeed, the
number of persons desiring a job but not looking has declined in each of the
5 years since these statistics were first collected.

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The labor force participation rate_the percentage of the population over age
16 that is either employed or looking for work_remained at 67.1 percent in
1999 for a third straight year. In the early 1990s the participation rate
appeared to have plateaued, ending an upward trend from the mid-1960s through
1990 that saw this rate rise from about 59 percent to 66.5 percent. This
long-term trend was driven by an increase in the participation rate of women
that more than offset a small decline in that of men. In the second half of
the 1990s the overall participation rate rose again, reflecting the expansion
of the Earned Income Tax Credit and welfare reform. Today participation
stands at its highest annual rate ever recorded. With the participation rate
stable and the unemployment rate down, the employment-to-population ratio_the
proportion of the civilian population aged 16 and older with jobs_rose to
64.3 percent last year, topping the record set in 1998.

Productivity and Compensation

Labor productivity in the nonfarm business sector increased by 2.8 percent
on an annual basis during the first three quarters of 1999. This marks the
fourth consecutive year of strong productivity growth. The recent surge in
productivity follows on the heels of more than two decades of relatively slow
productivity growth (1.4 percent on average over 1973-95). For comparison,
the average annual rate of productivity growth over this century has been
about 2 percent. We examine in detail the causes and consequences of shifts
in productivity trends below.

Compensation per hour in the nonfarm business sector increased 4.6 percent
at an annual rate during the first three quarters of 1999. The strong housing
market helped boost compensation in the construction industry, while a
slowdown in mortgage refinancing likely was behind the dropoff in
compensation growth in the finance, insurance, and real estate sector,
relative to the rate in 1998. Not only has compensation growth been strong,
but a larger share of it is going into the pocketbooks of workers in the form
of higher wages and salaries. According to the employment cost index, growth
in benefit costs has been remarkably subdued on average over the last 5
years, in large part because of a sharp slowing in the growth of medical
insurance costs.  Previously, growth in benefits, especially health
insurance, had caused the benefit  share of employment costs to rise. Medical
insurance costs began to rise again in 1999, however: the 12-month change was
5.8 percent compared with 2.5 percent in 1998.

The real consumption wage_compensation per hour deflated by the CPI-U-RS, an
index published by the Bureau of Labor Statistics that provides a more
consistent measure of inflation than the standard consumer price index (Box
2-1)_increased 2.0 percent at an annual rate over the first three quarters of
1999. This gain in real wages is below the brisk rates of the last 2 years
but well above the 1.4 percent annual average increase over 1960-98
(Chart 2-6).



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Box 2-1. The CPI-U-RS, a Consumer Price Index with More

Consistent Methodology

As noted in previous editions of the Economic Report of the President,
some of the recent deceleration in measured consumer prices is
attributable to a series of changes in the methods used to compute
the CPI. When making changes to its methods of computing the CPI, the
Bureau of Labor Statistics does not revise past official CPI data
using the newer method. In 1999, however, the agency produced a
research version of the CPI, called the CPI-U-RS (the RS stands for
``research series''), in which 14 methodological revisions adopted
since 1978 and still in use today are applied back to that year.
Throughout this edition we use the CPI-U-RS rather than the CPI-U
as a deflator when appropriate. (The text and chart footnotes
indicate which series is being used.)
The new measure shows CPI inflation to have been lower than the official
estimate over 1977-98 by an average 0.45 percentage point (see table).
The difference is a percentage point over the 1977-82 period; revised
methods of measuring the cost of home ownership account for most of
the difference. In 1983 the BLS replaced a measure of home ownership
costs based on purchase price and mortgage interest rates with a
measure based on rental equivalence--roughly, what the homeowner
would pay to rent the same house.
A second important change, in 1999, was the switch to geometric rather
than arithmetic (fixed-weight) aggregation of price measurements
within the lowest-level subcategories in the market basket. This
revision, which applies to low-level categories comprising 61 percent
of consumer expenditures, resolved two problems: the ``functional
form bias'' in rotating new stores into the sample, and the assumption


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Box 2-1.--continued
of no substitution between competing products within most categories.
The effect of applying this geometric aggregation is largest before
1995, when both problems affected the official series. The
functional form bias was eliminated in 1995 for food and in 1996
for other products, and so the effect of geometric aggregation on
the discrepancy between the series diminishes. The effect of this
formula change is lumped together with a few other formula changes
in the second line of the table.
The BLS has omitted a few hard-to-measure methodological changes from
the CPI-U-RS, albeit with small effects. Among these are the new
procedures for hospital prices (implemented in 1997) and the switch to
a new method of sampling (which began to be implemented in 1999) that
may allow new products to enter the CPI earlier in their life cycle.
The CPI-U-RS includes methodological improvements but not the periodic
updates of the CPI market basket designed to take account of changing
spending habits. In 1998, for example, the 1982-84 market basket was
replaced with the 1993-95 basket. This change lowered CPI inflation
by roughly 0.2 percentage point relative to a CPI weighted by the
earlier market basket. Beginning in 2002, the BLS plans to update
the market basket every 2 years rather than approximately once every
decade.
Taken together, the methodological improvements instituted beginning
in 1995, combined with the recent update of the market basket, are
estimated to result in roughly a 0.6-percentage-point slower annual
increase in the CPI in 1999 compared with the methodologies and
market basket used in 1994.


But the growth in real wages in 1997 and 1998 was boosted by the effect
of declining energy prices on CPI inflation. Arguably, deflating compen-
sation by the core CPI provides a clearer picture of underlying real
consumption wage trends. If energy and food prices are removed from the
equation, the real consumption wage increased 2.7 percent at an annual
rate over the first three quarters of 1999, slightly surpassing the 2.6
percent annual average increase over 1996-98.

Prices

Inflation picked up in 1999 from its very low 1998 pace. The CPI
increased 2.7 percent over the 12 months of 1999, after rising 1.6 per-
cent during 1998. The chain-weighted price indexes for GDP and PCE
increased 1.6 and 2.0 percent, respectively, over the four quarters of
the year. These inflation rates were also up from their 1998 levels.
More than the total increase in consumer price inflation can be attri-
buted to energy prices, which

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started to rise in March and continued to do so over the course of the
year, reversing a 2-year slide. Oil prices were a main factor in the
down-and-up pattern of energy prices. The price of West Texas Intermed-
iate (WTI), a standard benchmark for oil prices, stood at year's end at
about $26 per barrel, a bit above its level at the end of 1996, but well
above that of a year ago, when WTI cost about $11 per barrel.

Core inflation, in contrast, has remained subdued. On a consistently measured basis, the core CPI-U-RS increased only 1.9 percent over the 12
months of 1999, slightly below the previous year's 2.2 percent increase.
By comparison, core CPI-U-RS inflation has averaged 2.3 percent over the
last 7 years. Core PCE prices, which also exclude the food and energy
components,  increased by only 1.5 percent over 1999 as a whole, after
rising 1.4 percent in 1998. Since the fourth quarter of 1992, core PCE
prices have risen only 1.9 percent per year on average. The CPI and the
PCE price index differ in the goods and services they cover and in their
method of computation, but by either measure core inflation has remained
remarkably stable and low throughout this expansion.

A number of factors have helped keep core inflation in check despite
another year of strong output growth and tight labor markets. First,
prices for nonpetroleum imported goods were little changed over the year,
after declining more than 3 percent over 1998. The market basket on
which the CPI is based includes imported goods, so that changes in the
prices of these goods


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feed directly into the index. Moreover, falling prices of imported goods
discourage domestic producers from raising their prices as much as they
otherwise might. A second factor that restrained inflation is the
existence of spare capacity in the manufacturing sector (Chart 2-7).
Although labor markets have been tight, capacity utilization in
manufacturing remained below its historical average, reflecting weak
manufacturing growth in 1998 and rapid increases in capacity. Purchasing
managers' lead times have been stable for most of the past 2 years,
suggesting an absence of production bottlenecks, but lead times began
to lengthen in 1999.


A third reason for the moderation seen in price increases is that
gains in labor productivity have partly offset increases in compensation.
As noted,







compensation per hour increased 4.6 percent at an annual rate over the
first three quarters of 1999. Over the same period, output per hour
increased 2.8 percent at an annual rate. The growth rate of unit labor
costs_the difference between the growth rates of compensation per hour
and of output per hour_was 1.8 percent at an annual rate over the first
three quarters, slightly below the 2.1 percent rate recorded in both
1997 and 1998. Even with labor markets tight, large increases in product-
ivity have played an important role in counteracting the wage part of
the wage-price spiral typically associated with a high-employment
economy. A more extensive discussion of the relationships among
import prices, productivity, and inflation is provided below.

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Inflation expectations remained low and stable throughout the year,
supporting restraint in wage and price setting. According to the Michigan
Survey of Consumers, the median expectation over the next 5 to 10 years
is for inflation under 3 percent; that figure changed little over the
year. Similarly, professional forecasters' expectations of long-term
inflation continue to be low and stable, according to a survey
conducted by the Federal Reserve Bank of Philadelphia.

Financial Markets

By comparison with the tumultuous events of the preceding year, 1999
was a relatively tranquil year for financial markets. Even the looming
century date change and the potential it posed for Y2K-related
disruptions did not seem to unsettle the markets (Box 2-2). The
Federal Reserve raised the target Federal

Box 2-2. Economic Impact of Y2K Preparations

One of the most anticipated events of the past year was the roll-
over from the year 1999 to 2000. The public and the private sectors
in the United States and abroad devoted enormous resources to ensure
that the Y2K bug did not spoil the new year. Moreover, anecdotal
evidence suggests that businesses and households stocked up near
the end of the year as a precaution against supply shortages. In the
end these preparations paid off, and only minor Y2K-related glitches
were reported.

Potential Y2K disruptions involving information systems in the
financial sector both in the United States and abroad had been a
central concern well before the century date change. The smooth
and efficient operation of financial markets and the banking sector
relies on the extensive use of computers for record keeping, data
exchange, and electronic transactions. The Federal Reserve and the
President's Council on Year 2000 Conversion tracked efforts by fin-
ancial institutions to ensure that records would be accurately
maintained and that operations would continue running smoothly over
the transition to the new millennium.

To allay concerns about a year-end shortage of liquid assets, the
Federal Reserve took steps to assure markets that adequate liquidity
would be available. The Fed also acted to ensure that sufficient
quantities of cash would be available to the public at year's end.
It was widely believed that many people intended to withdraw abnormally
large amounts of cash near the end of the year, as a precaution against
Y2K-related glitches at banks and automatic tellers. In anticipation
of this rise in demand for cash, the Federal Reserve increased its order
for currency through September by over 50 percent from the previous
year. The Fed also implemented measures making it easier for banks to
order and take delivery of cash. Public cash holdings rose by about 5
percent in December, an amount easily accommodated.

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funds rate (the interest rate that banks charge one another for over-
night borrowing) by 75 basis points in three steps, fully reversing
the rate cuts it had instituted in the second half of 1998 during the
global financial crisis. The yield on 30-year Treasury bonds rose more
than 1G percentage points over the course of the year, reflecting a
number of factors in addition to the Fed rate hikes. These included
a rebalancing of international portfolios as the financial crisis receded,
and concerns that continued strength in the U.S. economy would cause
the Federal Reserve to further increase the Federal funds rate.

The stock market recorded another year of strong gains, with the
S&P 500 index of stock prices rising 20 percent in 1999 (Chart 2-8).
But the overall strength of the stock market in 1999 masks a sizable
disparity in performance among stocks. In 1999 fewer than half of the
stocks in the S&P 500 index rose in value. In contrast, despite similar
overall growth, during the first 4 years of the bull market over 70
percent of those stocks rose in any one year. Stock gains were
concentrated in a few sectors, mostly those associated with high
technology. In the mid-1990s the technology-heavy NASDAQ index grew
at about the same rate as the broader S&P 500, but its growth rate has
been about triple that of the S&P 500 in the last 2 years. Even more
impressive is a popular average of Internet-related stocks, which
increased about 160 percent per year over the past 2 years.

[Chart 2-8]




[[Page 66]]

The Calm Following the Storm

The year 1998 had been an especially stormy one for financial
markets. The Asian crisis in 1997 and the Russian debt default in
August 1998 had precipitated a series of dramatic events in U.S.
financial markets. Investors, including foreigners, had sought to
reduce exposure to risk by selling high-risk investments and buying
Treasury securities. This ``flight to quality'' had in turn bid up
prices of Treasury securities, driving Treasury yields down (Chart 2-9).
Corporate bond premiums (the spread between the yield on corporate bonds
and Treasury securities), especially those on high-yield bonds, had risen
sharply. New issuance of private debt had dried up, and debt markets
became less liquid. For a time in the late summer of 1998, even the
previously imperturbable bull market in stocks had turned bearish. Owing
in part to concerns that financial markets were freezing up and that a
credit crunch might follow, the Federal Reserve had cut the Fed funds
rate three times, in September, October, and November 1998, from 5.5
percent to 4.75 percent.


With the economy continuing to surge ahead and the unemployment rate
dropping to nearly 4 percent, the 30-year Treasury yield ended the year
about 125 basis points above its level at the end of 1998. Premiums on
investment-grade corporate bonds fell back to levels somewhat above
those prevailing before the Russian crisis. Premiums on high-yield
bonds stayed elevated relative to early-1998 levels, reflecting in part
the high default rate among busi


[[Page 67]]

nesses with below-investment-grade bond ratings. Liquidity flowed freely
again, with new debt issuance rebounding. Overall, markets appear to
have returned to a state of relative normalcy, but with a renewed
appreciation of the risks associated with investments of all kinds.

Financial Modernization

Last year witnessed a watershed event that will change the way
financial institutions meet the needs of the American people. The
Gramm-Leach-Bliley Act (GLB), which the President signed into law in
November 1999, updates the rules that have governed the financial
services industry since the Great Depression. Prior to GLB, the Glass- Steagall Act of 1933 and the Bank Holding Company Act of 1956 had
largely prohibited banks from being affiliated with firms involved
in underwriting securities or insurance. The financial services industry
had been undergoing rapid change for several decades; affiliations
among banks, security firms, and insurance companies have already
occurred in the marketplace. By repealing those prohibitions and
allowing banks to merge with other financial institutions, the new law
will stimulate competition, increase consumer choice, and reduce costs
for consumers, communities, and businesses while still providing an
appropriate statutory framework for community reinvestment and privacy
protection.

GLB preserves the important role of the Community Reinvestment
Act, guaranteeing that banking institutions will continue to meet the
needs of potentially underserved communities. No bank may take
advantage of the new opportunities that GLB provides unless it shows
that it is satisfactorily meeting the credit needs of its community
in general, and low- and moderate-income neighborhoods in particular.
GLB also provides some protection for the privacy of consumers by giving
them the right to know whether their financial institution intends to
share their financial data with others, and the right to stop that release
of private information to unaffiliated third parties.

The Stock Market Boom

Stock market performance in the 1990s was truly exceptional. An
investment of $100 in December 1989, with all dividends reinvested,
would have been worth nearly $500 at the end of 1999, for a total return
of close to 400 percent. Adjusted for inflation, the real return would
still have been well over 250 percent. The bull market of the last 5
years has been particularly impressive, with a total real return of
nearly 200 percent, or 24 percent per year on average. This total return
makes the current bull market already the strongest since that of the
1930s and the sixth best ever (Chart 2-10). (We define a bull market
as persisting in a given year so long as the real return to stocks is
positive over the year.) Interestingly, whereas the bull market of the
1930s represented a recovery from the 1929 market crash, the gains of the
last 5 years

[[Page 68]]


have built on top of strong stock market performance in the 1980s and
early 1990s. Many economists profess surprise at the remarkable bull
market of the 1990s; others offer explanations for the sustained run,
including a decline in the risk premium that investors demand in return
for holding stocks, and a rise in expected corporate productivity and
profits.

The first step in evaluating the performance of the stock market
is to consider what determines the price of an asset (such as a share
in a corporation) that yields a risky return. A share of common stock
provides the owner with a claim on a portion of the issuing corporation's
future profits. Hence the share price should equal the present
discounted value of the corporation's net profits (that is, after payments
to employees, suppliers, bondholders, and other creditors) divided by
the number of outstanding shares. The discounting of future profits
reflects two factors: the opportunity cost associated with waiting for
those future profits, and a premium related to the uncertainty about
whether those profits will materialize. The opportunity cost of receiving
a dollar next year equals the interest an investor would receive by buying
a risk-free bond instead of the share of stock. Because a stock can be a
risky investment, investors demand a rate of return on stocks that is
above that on a relatively safe bond.

Changes in fundamentals such as corporate profits and interest rates
appear to explain some but not all of the dramatic runup in stock prices.
Corporate profits grew impressively over the 1990s, but not by as much
as stock prices.

[[Page 69]]

From 1989 to 1999, corporate earnings more than doubled, and forecasts
of future earnings were strong, on average, at the end of 1999. The
inflation-adjusted yield on Treasury bonds, meanwhile, is little changed
from its level of 10 years ago and thus has provided only a slight impetus
to stock prices over the decade as a whole. The extraordinary rise in
stock prices relative to actual profits has therefore led economists
to hypothesize that changes have occurred beyond those measured by
these fundamentals. One proposed explanation is that investors have
reduced the premium that they demand for holding stocks. A second is that
the outlook for future profits is brighter than commonly thought and
that stock prices today more accurately reflect the true productivity
and profitability of American businesses. We consider each hypothesis in
turn.

The Equity Premium

From 1989 to 1999 the average annual real stock market return was
over 14 percent, about 8H percentage points higher than the average
annual real return on long-term government securities. Although this
level of return on stocks has been extraordinary, the fact that it has
far exceeded the return on government bonds is nothing new. In fact,
the excess return of stocks over bonds_the equity premium_has averaged
about 4 percentage points over the last two centuries. The equity premium
has also varied considerably over time, and over the second half of this
century it has averaged about 7.3 percentage points (Chart 2-11).




(Chart 2-11)

[[Page 70]]

The additional riskiness of stock returns over that of bond returns
does not appear large enough to justify an equity premium of over 7
percentage points, unless investors are extraordinarily risk-averse or
their investment horizon is very short. For this reason, economists have
long been puzzled by the large excess returns that the stock market has
historically offered.

One explanation for the recent runup in stock prices is that investors
may have been responding to the fact that stocks have historically
yielded much higher returns than bonds over the long haul. In this view,
the stock market was simply undervalued in the past, and the recent runup
in prices was necessary to bring valuations in line with the fundamentals.
Two developments may have spurred this behavior. First, the cost of
owning a diversified portfolio of stocks has fallen with the creation
of a growing number of low-cost mutual funds. Diversification reduces
the risks associated with holding stocks and therefore should reduce
the equity premium that investors demand as compensation for risk.

A second development is that a new generation of investors is now
in the market, and the aversion of older investors to the risks of
equity investing may have diminished. Investors may have had lingering
memories of the bear market of the late 1960s and early 1970s, when the
Dow Jones Industrial Average (adjusted for inflation) fell by more than
60 percent over 6 years. Some perhaps even remembered the Great Crash of
1929, when the Dow fell 64 percent in real terms over 3 years. Investors'
attitudes toward the stock market, and their tolerance for risk, may have
only recently recovered from these painful episodes. Meanwhile many from
the baby-boom generation and later, who know bear markets only from
history books, have become stock investors. Indeed, the older generation's
recoil from stock investing may have been more emotional than rational.
Even an unlucky investor who had invested in the stock market on the eve
of the 1929 crash still would have realized a real return of nearly 6
percent a year, on average, over the next 30 years. In sum, both  the low
cost of diversification and changing attitudes toward the riskiness of
stocks suggest reasons that may have led investors to bid up stock prices
in the 1990s.


Intangible Capital

A second explanation for the bull market may be that investors have
higher expectations for future corporate profits than they used to. In
theory, the stock market value of a company should be closely related to
the replacement value of its assets. For example, if a company owns only
one asset, a factory that cost $10 million to build, the market value of
that company should be $10 million (abstracting from other factors that
affect its profitability).

One possible explanation for the rise in the stock market over the
last decade is that U.S. businesses have accumulated large quantities
of intangible capital in addition to physical capital (plant and equipment). Intangible cap-


[[Page 71]]


ital includes the value of intellectual property (including patents
from research and development investments), organizational structure,
management expertise, and past investments in job training. These assets
are not included in the national accounts' measure of physical capital
but do raise the productive capacity of firms. In this view, stock market
values_which should incorporate information about investments in tangible
and intangible capital_should provide a better yardstick for capital than
standard measures based on past investments in plant and equipment alone,
which may understate the true productive potential of firms.


According to this explanation, the dramatic rise in the stock market
value of corporate businesses during the 1990s derives from a large
increase in their intangible capital stock, in addition to the increase
implied by investments in plant and equipment. The implied surge in
investment in intangible capital could have resulted from businesses'
intensified efforts to increase efficiency and productivity. In addition,
the explosion in information technologies and the Internet may have led
to a surge in intangible capital investment, including the creation of
new products and services and the redesign of production processes and
management.


One implication of this hypothesis is that labor productivity growth
should have increased sharply over the last few years, because workers
now have more productive capital_both tangible and intangible_at their
disposal. Although productivity growth has in fact increased, there is
still too little evidence to support or reject the notion that the
true productive capital stock has grown as rapidly as current stock
market valuations imply.


It is inherently difficult to measure and evaluate the different
variables, including perceptions of risk and profitability, that factor
into stock market prices. The proper valuation of technology stocks_the
group that has driven much of the market's growth in the last 2 years_is
particularly tricky. Some of these stocks currently have low or even
negative earnings but hold the potential for strong profits in the
future. Because these companies lack the proven track record of long-
term growth that more established firms usually have, their stock prices
may in principle be more prone to volatility as investors revise their
forecasts of future profits. Experts have a mixed record of perceiving
the underlying determinants of stock values. As already noted, some
were puzzled by the strength of the bull market in the late 1990s, yet
the market continued to soar. On the other hand, Irving Fisher, one of
the founders of financial economics, famously claimed just 2 weeks before
the 1929 crash that ``Stock prices have reached what looks like a
permanently high plateau.'' In the final analysis, it is likely that
neither of the two hypotheses described here will prove completely
correct, and that several factors, perhaps including an overoptimistic
view of future corporate profitability, have combined to propel the
stock market upward.

[[Page 72]]
Saving and Investment

Investment is the economic bridge linking the present to the future.
By deferring consumption today, we make available resources for
investment, which increases our ability to produce and consume in the
future. Over the last two decades, net domestic investment (gross
investment minus capital consumption) has generally exceeded net
national saving, and the difference has been made up by foreigners
(Chart 2-12). Moreover, the share of GDP that was saved had been very
low through much of the 1980s and early 1990s. This low rate of saving
and its shortfall relative to domestic investment have led some to
conclude that the United States is not ``saving enough,'' especially in
light of the upcoming retirement of the baby-boomers. The picture is not
quite as clear, however, as these simple figures would suggest.

Trends in Saving

The ratio of net national saving to GDP has risen about 3 percentage
points over the last 7 years. Despite this sizable improvement, this
ratio remains low relative to its levels of the 1960s and 1970s. Indeed,
if the national saving-GDP ratio were equal today to its levels in those
decades, it would suffice to cover domestic investment.

The recent upward trend in net national saving is the net result of
changes in the saving patterns of households, businesses, and governments.
The ratio




(Chart 2-12)


[[Page 73]]

of gross personal saving to GDP has declined nearly 5 percentage points
over the last 7 years. However, over the same period, the gross national
saving rate_the sum of personal, business, and government saving_has
increased by 3 percentage points (Chart 2-13). The source of this
difference lies in the reversal of the role played by the Federal
Government, which has transformed itself from a major borrower into a
major saver. In addition, State and local governments have increased
their saving as a share of GDP. Corporate saving has also been on a
gradual upward trend through the 1990s. Yet as already noted, despite
these positive developments in government and business saving, the
national saving rate remains low relative to its 1960s and 1970s levels.
There are, however, reasons to believe that the measured national saving
rate does not accurately portray the accumulation of assets capable of
supporting future consumption.

Saving and Asset Accumulation

Although national saving is not as high today as in past periods,
Americans have nevertheless been accumulating vast quantities of assets.
The ultimate purpose of saving and investing is to provide resources
for future consumption. To paraphrase Adam Smith, consumption is the
sole end and purpose of all saving. In considering the ability to consume
in the future, it makes sense




(Chart 2-13)

[[Page 74]]

to look at not only how much we save, but also at how that saving is
invested and how productive that investment is.

Much saving goes ultimately into business investment, where it raises
future productivity and thus output. The reported nominal national saving
and investment rates conceal an important development, namely, a sharp
decline in the relative price of business equipment, owing in large part
to quality improvements in capital goods. One dollar of saving buys
more business equipment, on a quality-adjusted basis, today than before.
As a result, the increase in productive business assets corresponding to
the average dollar saved by Americans has risen over time.


The recent runup in the stock market, already discussed, allows an
even more optimistic view on asset accumulation. Real household stock
market wealth has more than doubled since 1995. To the extent that this
runup in stock prices reflects an increase in the productive capacity of
U.S. corporations_say, owing to investments in intangible capital or
especially high returns to investments in information technologies_
this increase in wealth augurs a real increase in future sustainable
consumption. On the other hand, rises in share prices resulting from
changes in U.S. investors' willingness to hold stocks or from overly
optimistic views of future earnings do not imply additional resources
available for national consumption.


The upswing in the national saving rate over the last several years
provides an encouraging sign regarding the Nation's preparations for
the future. To the extent that recent saving is more productive than
past saving, so much the better. In any case, the Federal Government
can further advance this favorable trend in national saving by maintain-
ing fiscal discipline, paying down the debt, and thereby raising govern-
ment saving.

The End of the Business Cycle?

Growth has been a defining characteristic of the U.S. economic
experience over the last century, but only when viewed from a long
perspective: employment and income have often deviated, sometimes sharply,
from their rising long-run trends. Time and again the economy has risen
over a period of years to a temporary peak of activity, only to fall back
downward, bottom out at a trough, and from there once again begin to rise.
These peaks and troughs represent turning points of the business cycle;
an expansion is defined as the period that starts from a trough and ends
when a new peak is reached. Although the business cycle has been a
recurring feature of the U.S. economy for as far back as we have reliable
data, some observers have argued that the economy in the 1990s has
fundamentally changed and that the concept of the traditional business
cycle is outdated.

[[Page 75]]

The beginnings and ends of U.S. business cycles are determined well
after the fact by the Business Cycle Dating Committee of the National
Bureau of Economic Research (NBER), a private, nonprofit organization
of professional economists. For instance, the March 1991 trough that
marked the beginning of the present expansion was not announced by the
committee until December 1992. In identifying the monthly dates for peaks
and troughs, the committee looks for across-the-board movements in a
large array of economic indicators such as output, income, and employment.
Using this methodology, the NBER has determined that since 1854 there have
been 31 expansions and 31 recessions, representing 30 peak-to-peak
business cycles, not including today's ongoing expansion. Although they
are called ``cycles,'' these economic fluctuations are neither regular
nor predictable. The longest expansion to date was that of the 1960s,
which lasted 106 months. (The current expansion is expected to pass that
mark in February 2000.) The longest contraction on record lasted over 5
years, from the October 1873 peak to the March 1879 trough, whereas the
shortest lasted only 6 months, from January to July 1980.


The Changing Nature of Business Cycles in the United States


Forty-one years ago a former chairman of the Council of Economic
Advisers predicted that ``The business cycle is unlikely to be as
disturbing or troublesome to our children as it once was to our
fathers.'' Research quantifying the degree to which business cycles
have moderated over time confirms this view. If the severity of
economic fluctuations is measured in terms of the output lost during
a recession, the 14 recessions between 1900 and 1953 cost on average
about three times as much as the 7 recessions since then. Even if the
Great Depression of the 1930s is excluded, recessions in the earlier
period still were on average more than one and a half times as severe as
those in the 1954-99 period.


Other evidence supports the notion that business cycle fluctuations
have diminished over time. From 1982 to 1998, fluctuations in GNP
and unemployment were on average about 20 percent smaller than they were
from 1954 to 1981, and fluctuations in inflation were less than half as
large on average (Chart 2-14). With the caveat that data from the 19th
century and the early 20th century are less reliable than and not
directly comparable to recent data, business cycle fluctuations appear
to have become less severe in the second half of the 20th century than
in earlier periods.


One other way to think about the postwar moderation of the business
cycle is in terms of the length of time that the economy has spent in
recession and the amount of time it has spent in expansion. The
average length of expansions nearly doubled in the second half of the
century, from about 2H years during 1900-53 to about 5 years since then,
and the average length of economic contractions has fallen from about
17 months to less than 11 months.



[[Page 76]]



(Chart 2-14)

Sources of Business Cycle Moderation

One source of moderation in the business cycle is the changing nature
of the U.S. economy. Historically, inventories have been one of the
most volatile components of spending. Businesses now tend to operate with
much leaner inventory stocks than before, and they appear to be better
able to adjust these stocks to changing economic conditions. The
composition of output has also tended to move from more volatile toward
less volatile sectors. Spending on services, which tends to be
relatively insensitive to cyclical fluctuations, made up over half of
GDP in 1999, compared with less than a third in 1950. Conversely, the
cyclically sensitive manufacturing sector makes up a smaller share of
aggregate output and employment than in the past.


The growing role of stabilization policies_fiscal and monetary
policies, which buffer the effects of destabilizing influences on the
economy_may also have contributed to this moderation of the business
cycle. Over the last century, the role of fiscal policy in affecting the
business cycle not only has grown but has indeed changed fundamentally.
At the beginning of the 20th century, the Federal Government's role in
the economy was tiny. In 1900 there was no Federal income tax and no Social
Security, and total Federal receipts equaled a mere 3 percent of GNP.
The Nation's monetary policy was generally one of simple adherence to the
gold standard, which limited the use of monetary policy as a stabilizing
tool.


The Federal Government's role in macroeconomic stabilization grew in
importance following World War II. Although the income tax had been

[[Page 77]]

introduced in 1913 and Social Security in 1937, by 1940 income and pay-
roll taxes equaled only 3 percent of GNP. Income and payroll tax revenue
rose thereafter as a share of GNP and has averaged around 14 percent over
the last 30 years. It amounted to over 16 percent of GNP in 1999. The role
and character of monetary policy likewise underwent a fundamental
transformation during the late 20th century. Recent experience supports
the view that modern monetary policy can achieve the long-run goal of
price stability while aiding in the cause of short-run macroeconomic
stabilization by ``leaning against the wind'' when macroeconomic
imbalances develop.


Do Expansions Die of Old Age?


One question that has intrigued economists is whether each expansion
contains the seeds of its own destruction. Is it true that the longer
an expansion lasts, the more likely it is to end in the next quarter or
the next year? Studies find no compelling evidence that postwar
expansions possess an inherent tendency to die of old age. Instead,
they appear to fall victim to specific events related to economic dis- turbances or government policies. For instance, the Iraqi invasion of
Kuwait, which led to a doubling of oil prices in the fall of 1990,
contributed to the decline in economic activity during the recession of
1990-91. American consumers, having suffered through the tripling of oil
prices in 1973-74 and their subsequent doubling in 1979, anticipated
negative repercussions on the U.S. economy, and consumer confidence
declined sharply and consumption fell.

An example of policy affecting the end of an expansion is the
Federal Reserve's successful disinflation at the end of the 1970s and in
the early 1980s. In 1979 the CPI inflation rate reached 11 percent.
Under a new chairman, the Federal Reserve dedicated itself to a renewed
effort to reduce inflation, which fell 8 percentage points over 4 years,
to about 3 percent by the end of 1983. As a result, the short expansion
that started in July 1980 came to a halt one year later. With the
Federal funds rate peaking at just over 19 percent in June 1981, the
economy fell into a 16-month recession, during which the unemployment
rate rose above 10 percent.


An Expansion Is Only as Old as It Feels, and This One
Still Feels Young


Although the current expansion entered its 105th month in December
1999_what might be considered old age, based on the history of U.S.
business cycles_it still appears young and vibrant when compared to
the later stages of past long expansions. What is noteworthy in today's
economy is the absence of developments that are frequently identified
with the twilight of an expansion. In particular, productivity has
accelerated during the last several

[[Page 78]]

years, rather than stagnated as in other mature expansions, and
price inflation has been on a falling, not a rising, trend.

In the later stages of the two previous long expansions, productivity
growth slowed to just above a 1 percent annual rate (Table 2-2). In
contrast, over the last 2 years, productivity has been growing nearly
3 percent a year, in part owing to rapid business investment. Strong
productivity growth has enabled the economy to grow rapidly and helped
restrain the cost pressures typically associated with a strong economy.


Inflation trends provide a second sign of an expansion's age and
health. Late in the expansions of the 1960s and the 1980s, high rates
of utilization and decelerating productivity contributed to an
acceleration in prices, that is, a rising inflation rate. In the
current expansion, even with unemployment well below 5 percent, the
acceleration in productivity has helped keep inflation stable. In fact,
inflation has fallen relative to the previous 2-year period.  Surveys
of inflation expectations provide a further encouraging sign that
inflation remains in check: these surveys show that both consumers
and professional forecasters expect inflation to stay low over the
next several years. Some have argued that the U.S. economy is now
nearly immune to the business cycle, because of the effects of
increased international competition, rapid innovation and productivity
growth, and improved flexibility of the production and distribution
systems.

(Table 2-2.)

[[Page 79]]

Of course, it is premature to declare the business cycle dead. But
there are reasons to believe that the economy will continue to perform
as well as, if not better than, it has in the recent past, with less of
the roller-coaster ride that characterized the 1970s and early 1980s
(not to mention earlier decades). Unlike in the 1980s and early 1990s,
fiscal discipline is now the order of the day. Projected surpluses can
now be used to pay down the debt and free up capital for investment in
education, business, and technology, spurring faster growth. Likewise,
the Federal Reserve no longer follows the stop-and-go policies of the
1970s, but instead practices a systematic policy that fosters price
stability and long-term growth.


The Economic Outlook

As always, the growth of the supply-side components of GDP
underlies the projection of long-term growth. In particular, the
prospect for continued productivity growth is the key issue in the
economic outlook and the source of many of the upside and downside
risks to the Administration's projection.


Labor productivity trended upward at an average annual rate of 1.4
percent from 1973 to 1995 but then accelerated to a 2.9 percent clip
over the past 4 years (Chart 2-15). The unexpected surge in product-
ivity growth has led to several positive developments: it has
restrained inflation, allowing the unemployment rate to fall lower
than it otherwise might; it has increased econom-




(Chart 2-15)


[[Page 80]]

ic growth, with positive effects on the Federal budget balance; and
it has boosted stock market valuations.

Over the past 4 years, the income-side measure of output, gross
domestic income, has grown half a percentage point per year faster
than the product-side measure, gross domestic product. Because
measurement error enters into both, the Council of Economic Advisers
believes that we learn something from each, and therefore the follow-
ing discussion focuses on an average of the two measures in discussing
trend productivity and potential output.


What Has Caused Productivity Growth to Rise?


Because the apparent acceleration in productivity is less than 4
years old, its cause and future continuation remain controversial. A
year ago, available data showed productivity growth to be within the
range of normal cyclical variation. But more recent data, especially
the October benchmark revision to the national accounts (Box 2-3),
place the acceleration on more solid footing. National accounts
revisions result from changes in price measurement and new definitions
as well as the arrival of new data. Abstracting from the first two, the
data-based revision over 1995-98 allows us to advance the start of
the acceleration at least to 1997 and perhaps as early as 1995. And
insofar as the revised data are more accurate, they make the ident-
ification of the acceleration more credible. The Council's analysis
finds that two developments account for half of this acceleration: an
increase in capital_especially computer and software capital_and product- ivity growth in the computer-producing sector.

Labor productivity increases when workers have more capital to work
with. Capital deepening has been a persistent feature of the U.S.
economy since World War II, as capital services per hour has increased
in almost every year. Yet in 1995, business investment as a share of
GDP climbed above its long-term average, and it has continued upward
since. As a result, capital services per hour grew faster after 1995
than before. Estimation using preliminary data and established methods
of growth accounting (that is, weighting the growth rate of capital
services per hour by capital's cost share) finds that capital deepen-
ing accounts for 1.53 percentage points of annual labor productivity
growth during the 1995-99 period. This is up from 1.06 percentage
points during the 1973-95 period (second line in Table 2-3). The
difference between these growth rates shows that capital deepening
accounts for 0.47 percentage point of the 1.47-percentage-point
acceleration in productivity after 1995 (Table 2-3, column 3).
Investment in computers and software accounts for all of this gain
from capital deepening. (Official data on capital services will not
be released until mid-2000, and so these calculations remain tentative.)

This contribution from capital deepening is important, but it is
not the whole story. Although capital deepening contributes to labor
productivity growth in the long run, it has not been a reliable guide to
year-to-year fluctu

[[Page 81]]

Box 2-3. What Did We Learn from the GDP Benchmark Revision?

The Commerce Department's benchmark revision of the GDP statistics,
released by the Bureau of Economic Analysis last October, incorporated
new data from the last full economic census (conducted every 5 years)
and from the benchmark input-output accounts from 1992, as well as from
the revised annual sources that are usually incorporated in the annual
July GDP revision. The benchmark revision also provided an opportunity
to change accounting definitions and to make the pre-1995 accounts
consistent with current methods of deflation.

Spending. Over the 11-year period from 1987 to 1998, revisions raised
the annual rate of growth of real GDP by an average of 0.4 percentage
point. The revisions fall into three main categories (Chart 2-16):
revisions to source data, revisions to the methods used in adjusting
for inflation, and new definitions of spending categories and sub-
categories.

Incorporating new source data from the economic censuses and other
sources added about 0.2 percentage point per year to growth since 1994
but had little impact on earlier years.

Changes in deflation methodology accounted for the largest component
of the benchmark revision for the 1987-94 period. This change reflects
the retrospective application of current CPI methods to the years 1978-94. (These methods were already in use for the post-1994 period.)

Among several new definitions introduced, the most significant is the
inclusion of computer software purchases in investment, which raises the
growth rate of real GDP by an average of 0.18 percentage point per year
over 1987-98. By 1998 the cumulative impact of these definitional changes
was to raise the measured level of nominal GDP by 2.0 percent and the
growth of real GDP since 1959 by 3.5 percent.

Income and saving. In the GDP accounts, pension plans for government
employees were moved from the government to the household sector, so
that employer contributions to (and interest and dividends earned by)
these pension plans are now classified as personal income. On the other
hand, pension benefit payments were removed from the transfer income
component of personal income. This reclassification boosted personal
saving but reduced government saving by an offsetting amount. The
personal saving rate still shows a marked decline over the 1990s but
was no longer negative in 1999 as it was under the old GDP accounts.
New source data boosted measured wages and salaries substantially in
1998, adding to income and saving.
With software now classified as investment, software depreciation is
added to the income side of the accounts. Although the new definition
boosted gross national saving, net saving is changed little.
Productivity. The reclassification of software as investment and
the improvements in deflation methodology boosted measured productivity


[[Page 82]]

Box 2-3.--continued

growth over most of the historical period affected by these revisions
and had been anticipated. In contrast, the changes brought about by
the new source data were unexpected and revealed that productivity
(on a consistently measured basis) had been growing faster than had
been previously believed.

[[Chart 2-16]




ations in productivity. In addition, the power of capital deepening
to explain even long-run changes can be overstated. For example,
capital shallowing accounts for very little of the post-1973 product-
ivity slowdown.

Increasing quality of the work force has been another persistent
feature of U.S. economic growth. The American work force has become
better educated, and since about 1980 the average worker is more
experienced. Nothing dramatically new happened to the index of labor
composition (which measures the effect of education and work experience
on productivity) after 1995, but it may have added an additional
0.05 percentage point to labor productivity growth after 1995 (third
line in Table 2-3).

Besides their role in capital deepening, computers enter GDP directly
as part of consumer durables and business investment. Hence, pro-


[[Page 83]]



(Table 2-3.)


ductivity growth in the production of computers contributes directly
to overall productivity growth. Productivity growth has been
particularly rapid in the computer-producing sector. A measure of
productivity in the computer-producing sector would capture this
direct effect. However, it is impossible to be precise about computer
sector productivity because of the difficulty in measuring the real
inputs (such as engineering and other business services) to this sector
from other sectors. In lieu of a direct productivity measure, the rate
of decline in the relative price of computers tells us something about
quality improvement in the computer sector. The price of computers relative
to that of nonfarm output, which had been falling at an 18 percent
average annual rate before 1995, fell at a 29 percent annual rate there-
after, indicating an acceleration in computer quality after 1995. An
estimation that weights these changes by the share of final sales
of computers in nonfarm output (about 1G percent) finds that improved
computer quality added 0.23 percentage point to the post-1995
acceleration (fourth line of Table 2-3). (These methods and estimates
are, of course, approximate; one study using different methods attributes
most of the acceleration in trend productivity to the computer-
producing sector.)

These three explanations_capital deepening, changing labor composition,
and rising computer quality_may account for half of the post-1995
acceleration in productivity. The other half reflects all the other
factors that affect productivity growth. These may include cyclical
influences and new efficiencies from the use of the Internet, especially
for business-to-business transactions.

[[Page 84]]


The Outlook for Productivity

Can the factors that account for the more rapid pace of labor product-
ivity growth since 1995 be sustained? The data provide a mixed but,
on balance, positive picture.

The trend toward a more educated work force seems likely to continue
with support from the Administration's policy of promoting investment
in education and job training. Moreover, the median age of the work force
will continue to rise through at least 2008, when the leading edge of
the baby-boom generation retires. But these trends are not expected to
shift, and as a result, the contribution of labor composition to product-
ivity is not likely to change much from its historical average of 0.3
percentage point per year.

The decline in the relative price of computers has been particularly
rapid over the past 4 years, and so it is prudent to expect that this
rate will return to its long-term rate of about 20 percent per year. If
that happens, computers' contribution to productivity growth will drop
from about 0.4 to 0.3 percentage point per year.

The growth rate of capital services per hour increased in 4 of the past 5 years, reaching 5.4 percent in 1999_a rate that implies a 2-percentage-
point yearly contribution of capital deepening to labor productivity
growth. For 2000 the pace of capital deepening is likely to increase
further, because the current level of investment is already very high.
(The rate of growth of capital services depends on the level of invest-
ment.) Projections over the longer run are more speculative, but the level
of nominal investment is expected to remain high relative to nominal output.
The President's budget proposal_in which the Federal Government continues
to pay down the Federal debt_also promotes this investment. This
high-investment economy is likely to promote a continued strong pace
of capital deepening and strong productivity growth.

Besides the contributions of labor and capital, cyclical and other
considerations enter the productivity forecast. Most important, the
level of productivity in 1999 was likely above its trend, as hiring
probably has not caught up with the surge in output, and many vacancies
probably remain unfilled. A model that allows labor productivity to
differ from its trend because of these cyclical influences estimates the
trend of labor productivity growth at a 1.8 percent annual rate since 1990,
up from a 1.6 percent annual rate from the peak of the previous business
cycle to 1990. Simulations from this model overestimate the level of
productivity from 1993 through 1997 and underestimate it thereafter.
Although these errors may stem from the lack of a role for capital deep-
ening in the model, this omission has the offsetting benefit that the
estimate of the long-term trend in labor productivity is not overly sen- sitive to cyclical movements in investment spending.

Second, the projection depends on the time horizon. A projection for
the near future extrapolates recent trends, whereas a projection for
the distant

[[Page 85]]

future extrapolates long-term trends. Near-term projections ought to
balance the probable continued role of capital deepening in supporting
strong productivity growth with the likelihood that a lot of job
vacancies will be filled. Weighting these considerations, the Administ-
ration projects the trend rate of increase in labor productivity at
2.2 percent per year for 1999-2002, which is down from the nearly 3
percent pace actually observed over the past few years. The projection
of productivity growth then begins to fade toward its long-term rate,
with growth of 2.0 percent for 2003-05 and then 1.8 percent for 2006-10.
Productivity over the entire 1999-2010 interval is projected to grow at a
2.0 percent average annual rate.


Supply-Side Components of GDP

In addition to productivity, the factors on the supply side whose effects
on GDP growth sum to total GDP growth include population, the labor
force participation rate, the employment rate, the workweek, and the
two additional ratios shown in Table 2-4. In line with the latest
projection from the



(Chart 2-4)



[[Page 86]]

Bureau of the Census, the working-age population is projected to grow
at almost 1.1 percent annually through 2007 (a bit faster than projected
last year). In line with the latest projection from the Bureau of
Labor Statistics, the labor force participation rate is projected to
increase by less than 0.1 percent per year. The length of the average
workweek is projected to remain about flat over the entire projection
horizon. In contrast, the employment rate is projected to decline roughly
0.1 percent per year as the unemployment rate edges up to 5.2 percent_
the middle of the range judged consistent with long-run inflation
stability. From 2008 on, growth in the working-age population slows a
bit, and the labor force participation rate begins to fall as the first
wave of the baby-boom cohort reaches the early retirement age of 62.

Budget Effects of a High-Investment Economy

An economy fueled by high investment_especially in computers_will
be characterized by two forces that partly offset the positive effects
on the Federal budget of faster productivity growth: higher depreciation
and a larger wedge between the CPI and the GDP price index.

A high-investment economy is an economy in which a large share of
output is required to replace worn-out capital, simply because more
investment means more capital goods to be depreciated. The share of
nominal business fixed investment in nominal GDP, which had averaged
11 percent since 1959, increased to about 12H percent by the end of 1999
and is likely to increase further in the near term. The 1H-percentage-
point increase in the investment share thus far portends a similar
increase in the share of total gross domestic income claimed by
depreciation. As depreciation claims an increasing share of income, less
room will be available for the taxable components such as profits and
wages and salaries.

The rapid decline in computer prices, together with an increasing
nominal share of computers in GDP, also has negative effects on the
Federal surplus through the ``wedge'' between the CPI and the GDP price
index. A larger wedge reduces the Federal budget surplus because cost-
of-living adjustments for Social Security and other indexed programs
increase with the CPI, whereas Federal revenues increase with the
slower-growing GDP price index. The effect is reinforced by the fact that
the CPI is also used to index income tax brackets and other features of
the tax code.

Rapid declines in computer prices increase the wedge, because
computer prices have a 10 times larger weight in the GDP price index
(1.1 percent) than in the CPI (where the December 1999 relative
importance weight is only 0.11 percent). For example, computer price
declines held down the increase of the GDP price index by 0.23 percent-
age point but reduced CPI inflation by only 0.03 percentage point.

[[Page 87]]

Over the past 6 years, the CPI-U-RS has increased 0.6 percentage
point per year faster than the GDP price index. The projected wedge is
in line with this historical average, as the Administration's inflation
projection flattens out after 2002 at 2.6 percent for the CPI and 2.0
percent for the GDP price index


(Table 2-5).





What Has Held Inflation in Check?

During the past 2H years the key measures of inflation have remained
low and stable despite an unemployment rate below 5 percent. Previous
experience suggests that such a sustained period of low unemployment
would push up the inflation rate. Yet inflation, as measured by the
four-quarter change in the price index for GDP and the core CPI, has
remained remarkably subdued.
In the 1995 and 1996 editions of the Economic Report of the President,
the NAIRU, the unemployment rate consistent with stable inflation,
was estimated to lie in a range centered around 5I percent. There is
growing evidence that the NAIRU has fallen below that level. Indeed,
several studies using statistical methods that allow the NAIRU to change
over time estimate a pronounced drop in the late 1990s. Possible causes
include spare manufacturing capacity, new efficiencies in the labor
market from the expanded use of temporary help workers and Internet job
search resources, higher-than-expected productivity growth, and
declining import prices. Manufacturing capacity was discussed previously;
the other factors are considered below.

[[Page 88]]

The Changing Labor Force

Over the past two decades, the aging of the baby-boom generation has
reduced the proportion of younger workers in the labor force. In the mid-
and late 1970s, young baby-boomers swelled the ranks of the youngest
segment of the labor force: in 1978 nearly 25 percent of American workers
were between the ages of 16 and 24. As the baby-boom generation aged,
this share fell and is now about 16 percent. Because younger workers
are typically more prone to unemployment spells than older workers
(the unemployment rate of workers aged 16-24 is nearly three times that
of workers over 25), this aging of the labor force reduced the overall
NAIRU. According to recent estimates, the changing age profile of
American workers accounts for about 0.7 percentage point of the reduction
in the NAIRU during the 1980s but had no significant further effect in
the 1990s.

Rising education levels may also have brought down the NAIRU. The 1980s
and 1990s were a period of marked increases in the educational attainment
of the U.S. labor force. In 1998, for example, 57 percent of workers had
some college education, up from about one-third in the mid-1970s. Unemploy-
ment rates are consistently lower for groups with more years of schooling.
For instance, the unemployment rate for those with no high school diploma
averages about 4 percentage points higher than for those with a high school
diploma but no college. And the unemployment rate of those with a high
school diploma but no college degree is about 3 percentage points higher
than that for college graduates. These differences in unemployment rates
may also reflect other worker characteristics that are correlated with
education, however, obscuring any causal link between educational
attainment and the NAIRU.

Temporary Help Agencies

The rapid growth of the temporary help industry may also have
contributed to a decline in the NAIRU. Temporary help agencies have
existed since the 1920s, but their role in labor markets expanded
greatly during the 1980s and 1990s. Between 1982 and 1999, total employ-
ment in this industry increased more than sevenfold, and the industry's
share of overall employment has grown from less than 0.5 percent in the
early 1980s to more than 2.3 percent in 1999.
One way the temporary help industry may reduce the NAIRU is by creating
short-term employment opportunities for workers who might otherwise
be unemployed. Businesses in cyclical or volatile industries need flex-
ibility to scale their payrolls up or down as demand fluctuates.
Businesses frequently need temporary employees with specialized skills,
who can substitute for permanent employees on leave. Similarly, the
growing availability of temporary



[[Page 89]]


work enables job hunters to work while they search for a permanent
position and provides opportunities for people who desire to work
intermittently.

Labor market data support the hypothesis that the temporary help
industry creates employment opportunities. Thus far during this expansion,
the temporary help industry has created 1.9 million new jobs, and this
figure does not count those workers who found permanent jobs through
their temporary assignments. Moreover, in 1997, 60 percent of all
temporary workers would have preferred permanent positions, and about a
third of this group were actively seeking permanent employment. This
suggests that a significant proportion of temporary workers would have
been unemployed in the absence of the temporary help industry. In fact,
a recent study found that the unemployment rate in 1997 might have been
up to 0.3 percentage point higher if only half of these ``involuntary'' temporary workers had remained idle while they sought permanent employment.

The Internet Job Market

Yet another partial explanation for the decline in the NAIRU is
improved job matching through the Internet. The new medium has recently
added to its many functions that of providing the virtual space for a
burgeoning labor market. As both job hunters and recruiters discover
its advantages, the Internet job market is rapidly becoming part of
the mainstream job market. According to one study, nearly 60 percent of
human resources managers used online recruiting in 1998, up from 13 percent
in 1996. Moreover, a survey found that large companies are increasing the
resources devoted to Internet recruiting.

A leading Internet jobs clearinghouse is America's Job Bank. Part
of America's Career Kit (see Chapter 4), America's Job Bank is a
partnership between the Department of Labor and the public employment
services operated by the States. Funded by unemployment insurance
tax revenues, America's Job Bank links 1,800 employment service offices
around the country, aggregating information on over 1.5 million job
seekers and a similar number of job opportunities in one convenient,
easily accessible Internet site. Job hunters can post their resumes and
search the job listing data base; firms can post job listings and search
the resume data base. America's Job Bank charges no transaction or usage
fees for either job seekers or employers.


Internet job sites such as America's Job Bank represent a more
efficient mechanism for clearing labor markets than has been available
before. These sites dramatically reduce the cost of the search process
for both job hunters and recruiters, enabling labor market participants
to investigate a greater number of opportunities in less time and at
lower cost. One study found that the cost per hire of Internet advertising
for an opening is about one-eighth that of traditional advertising methods.

Such improvements in efficiency

[[Page 90]]

make it easier and cheaper for job seekers to find suitable openings
and for corporate recruiters to find suitable candidates.

Productivity and the NAIRU

Over long periods, labor productivity and real product wages (hourly
compensation deflated by the price of output) move in tandem,
because businesses can afford to give real wage increases that are
justified by productivity gains, and competition forces them to do
so. Eventually, a change in the rate of productivity growth tends to
be matched by an equal change in the growth of both actual and
anticipated real wages. Breaks in trend productivity growth, however,
are difficult to recognize, and therefore wage and price inflation adjust
only gradually to any change.

A significant break in the trend rate of productivity growth has occurred
once before since accurate statistics have been kept. That break
occurred after 1973. The productivity slowdown at that time elevated the
NAIRU and contributed_along with demographics, oil price increases, and
strong demand_to rising inflation in the late 1970s. During that period,
nominal hourly compensation increased at a rate that would have been
consistent with stable inflation if productivity had still been growing
at its pre-1973 trend. Instead, because productivity growth had fallen,
the higher compensation resulted in rising inflation of unit labor costs
and prices. Making matters worse, many wage setters adjusted to the
higher rate of inflation, creating a wage-price spiral. This process of
rising inflation might have continued had the back-to-back recessions of
1980 and 1981-82 not raised the unemployment rate to 10 percent, well
above the NAIRU. By the mid-1980s inflation was again stable, but gains
in real hourly compensation (deflated by the output price) had settled
down to about 1H percent per year_a drop of almost half from the pace of
the 1960s.

The acceleration in productivity after 1995 may have initiated a
similar process, but in reverse, allowing the unemployment rate to fall
lower, with less consequence for inflation, than would have been
possible otherwise. The rate of growth of nominal hourly compensation
has increased during recent years, but these nominal increases have
not resulted in rising price inflation. Businesses have been able to
grant these larger pay increases without raising price inflation, partly
because increases in unit labor costs have remained stable as rising
productivity growth offset the rising compensation gains.

The new, higher trend growth rate of productivity since 1995 could
have temporarily lowered the NAIRU, because it can take many years for
firms and workers to recognize this favorable development and incorporate
it into their wage-setting process. In the meantime, the productivity
surprise can stabilize inflation of unit labor costs and prices even
at unemployment rates below the previous NAIRU. The Phillips curve
estimated from the scatter diagram in


[[Page 91]]


Chart 2-17 shows how this could happen. It assumes that nominal
increases in hourly compensation reflect three factors: a bonus for
tight labor markets, as reflected in a low unemployment rate; a
full adjustment for expected price inflation (with backward-looking
inflation expectations); and a normal increase in real wages (which
here will be called the ``real wage norm''). The real wage norm may
reflect prevailing views of the trend in labor productivity. But little
is known about how the real wage norm is formed, and therefore the
model is estimated on the assumption that the real wage norm reflects
the previous year's increase in real hourly compensation.
With stable productivity growth, and with unemployment equal to the
long-term NAIRU (where the diagonal regression line crosses the x-axis
in the chart), wage and price inflation are stable from one year to the
next. However, a 1-percentage-point positive surprise in productivity
growth has the effect of temporarily lowering the NAIRU by 1G percentage
point. With nominal wage growth unchanged and productivity growth higher,
unit labor costs, and with them price inflation, would fall if the
unemployment rate does not change. Only with a lower employment rate
would unit labor costs and price inflation be stabilized. Hence the
short-term NAIRU is lower.
The effect of the increase in productivity growth on unemployment
probably will not last indefinitely. If productivity growth is maintained
at its current high level, it will cease to be ``unexpected,'' the real
wage norm will eventually rise to that same level, and the short-term
NAIRU will gravitate back to its long-term level.




(Chart 2-17)



[[Page 92]]

Declining Relative Import Prices

A decline in the relative price of imports can affect the short-term
NAIRU in a manner similar to an acceleration of productivity. Competition
from imports restrains the markup of prices over unit labor costs and
thus reduces price inflation for a given rate of wage inflation. (A 1
percent decline in relative import prices lowers the inflation rate by
0.1 percentage point.) The 4 percent annual rate of decline in the price
of nonpetroleum imports relative to U.S. nonfarm business prices during
1997 and 1998 lowered nonfarm price inflation by about 0.4 percentage
point per year. The effect on the short-term NAIRU is similar to that of
a productivity acceleration of the same magnitude and can be argued to
have lowered the NAIRU by about 0.5 percentage point.

World price trends cannot be expected to continue to restrain
inflation as much as they have in recent years. The relative price of
nonpetroleum imports firmed in 1999, and with strength returning to
overseas economies, these prices are likely to increase in 2000. In
addition, the rebound in oil prices in 1999 may exert some upward pressure
on prices of commodities that use oil as an input.

The Unemployment Forecast


The Administration's projection of the unemployment rate roughly follows
its projection of the short-term NAIRU and reflects the factors just
discussed. The short-term NAIRU, which has been centered around 5I
percent over the postwar period and in the mid-1990s, probably fell into
the 4 to 4H percent range through the combination of the temporary help
and Internet innovations to the labor market, the productivity surprise,
falling relative import prices, and perhaps other factors. It is very
difficult to quantify the long-term effects of the temporary help and
Internet innovations to the labor market. For the purpose of its
conservative forecast, the Administration estimates that they account
for roughly a 0.5-percentage-point permanent reduction in the NAIRU from
its historical average, to a range centered around 5.2 percent. In contrast,
the effects of the productivity surprise and falling relative import
prices are temporary and are expected to erode over the next several years.
As a consequence, in the Administration's conservative projection,
the unemployment rate edges up to 5.2 percent by 2003 and remains at
that level thereafter.

The Near-Term Outlook

After growing at a 4.3 percent annual rate over the past 4 years, real GDP is projected to decelerate to an annual growth rate of 2.9 percent over the four quarters of 2000. This rate, which was slightly above the consensus projection

[[Page 93]]

of professional economic forecasters when the GDP projection was finalized
in November, is now a bit on the low side.

Because it constitutes two-thirds of GDP, consumption is expected to
account for much of the expected deceleration. Personal outlays increased
faster than disposable income in each of the past 7 years, and the saving
rate plunged to 2 percent by the end of 1999. Although these consumption
gains are consistent with the rapid rise in stock market wealth, they are
not likely to persist unless the stock market continues to surge. More
likely, real consumption growth will slow from its 5 percent rate over
the past 2 years to rates consistent with the growth of real disposable
income. However, if the stock market performs as well this year as it has
in the recent past, it would present some upside risk to the Administra-
tion's projection.

Real business fixed investment has increased faster than real GDP in
almost every year of this expansion. This pattern is expected to persist
over the projection horizon as technological change boosts demand for
computers and communications equipment. In contrast, real business
purchases of industrial equipment have been nearly flat for the past year,
and real investment in nonresidential structures has declined. If total
demand slows as expected, purchases of these other investment goods and
structures may decline.

Residential investment has been very strong, owing to continued gains
in real disposable income and increases in wealth. With real incomes
continuing to rise, housing starts are expected to remain high. However,
the pace of residential investment is likely to fall back to a rate in
line with the demographics of household growth.
Inventories remain quite lean in relation to sales. In fact, nonfarm
inventories (measured as months of supply) have fallen to the lowest level
on record. These lean stocks militate against any near-term threat to
the expansion from excessive inventories. Nevertheless, as this report goes
to press, there is speculation that firms may have stockpiled a buffer
against Y2K disruptions before the turn of the year, planning to work off
these stocks afterward.

Real exports, which had grown only 2 percent over the four quarters of
1998, grew 4 percent during 1999. The pickup may reflect an economic
rebound among the United States' trading partners, especially those
affected by the Asian economic crises. For example, Korean GDP grew at a
15 percent annual rate in the first three quarters of 1999 after falling
5 percent over the four quarters of 1998. Exports to a group of 10 major
U.S. trading partners in East Asia, which fell $38 billion during the
first year of the crisis (from the second quarter of 1997 to the second
quarter of 1998), have recouped about half of that loss. A pickup is
also evident among the 11 countries that have adopted the euro as their
currency. In these countries GDP has accelerated to a 2.8 percent annual
rate of growth during the first three quarters of 1999, from a 1.9 percent
annual rate during the four quarters of 1998.  The matur-

[[Page 94]]

ing recovery among these trading partners is expected to lead to solid
growth of U.S. exports for the next several years.

Even with this growth in export markets, however, net exports are likely
to fall even further in the near future as U.S. demand for imports
continues to outstrip foreign demand for U.S. exports. Nevertheless,
the current account balance is expected to stabilize after 2001 and
then improve, as foreign output growth boosts export demand while
slower growth in the United States curbs import demand.
Interest rates are expected to remain flat over the entire 11-year
projection span, at 5.2 percent (on a bank discount basis) for 91-day
Treasury bills and 6.1 percent for the 10-year Treasury yield. Real
interest rates, calculated by subtracting the Administration's expected
rate of inflation (2.6 percent in the long term as measured by the CPI)
from projected nominal rates, are projected to be similar to their
historical averages.

On the income side, the Administration's projection is based on the
long-run stability of the labor share of GDP. This share is flat over
the projection period at about 58 percent_its historical long-run average.
Wages as a share of total compensation are expected to erode slightly,
as other labor income, especially medical insurance premiums, is expected
to grow faster than wages. Because the labor share is projected to be flat
and stable, so too is the capital share. However, the division of income
within the capital share is not stable. As noted earlier, a rise in
the depreciation share is a partial offset to the benefits of a
high-investment economy, and this growing depreciation expense is pro-
jected to come at the expense of profits. Profits before tax, which were
9.2 percent of GDP in the third quarter of 1999, are projected to slide
to about 7G percent of GDP by 2006.

A moderation in output growth to 2.5 percent is projected for 2001-03
(Table 2-5), 0.7 percentage point below the economy's potential growth
rate at the beginning of that period. The tightness in labor and product
markets at the beginning of the period is expected to dissipate during
this slow-growth period. Over these 3 years, the unemployment rate is
expected to edge up slowly to 5.2 percent, the middle of the range of
unemployment compatible in the long run with stable inflation. From 2003
to 2007, the Administration's forecast is built around a 3.0 percent
growth rate of potential output. From 2008 to 2010, real GDP slows further
to a 2.6 percent annual rate, reflecting slower population growth and the
anticipated retirement of the first wave of the baby-boom generation.
The Administration does not believe that annual growth of 3 percent is the
best the economy can do; rather this projection reflects a conservative
estimate of the effects of Administration policies to promote education and
to foster a high-investment economy by paying down the national debt.
The outcome could be even better_as indeed it has been for the past 4
years. But the

[[Page 95]]

Administration's forecast is used for a very important
purpose: to project Federal revenue and outlays so that the government
can meet its responsibilities while living within its means. For this
purpose, excessive optimism is dangerous and can stand in the way of
making difficult but necessary budget choices. On the other hand,
excessive pessimism can force difficult and possibly counterproductive
decisions where none is required. In the final analysis, the only
worthy objective is the creation of a sound forecast that uses all
available information as fully as possible.

As of December 1999, the current economic expansion, having lasted
105 months, was the longest ever during peacetime and only a month
shy of the longest on record. There is no apparent reason why this
expansion cannot continue. As already noted, expansions do not die
of old age. It is always difficult to forecast the future of the
economy, but the current situation of low and stable core inflation
and lean inventories reveals no obvious signs of an imminent slowdown.
The most likely prognosis is therefore the same as last year's:
sustained job creation and continued noninflationary growth.