[Economic Report of the President (2006)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 1


The expansion of the U.S. economy--having gathered momentum in 2003
and 2004--continued for its fourth full year in 2005. Economic growth
was solid, with real gross domestic product (GDP) growing 3.1 percent
during the four quarters of 2005 and 3.5 percent for the year as a
whole. Near-record prices of energy and damage from several powerful
hurricanes threatened to derail the expansion, but growth was well
maintained in the face of these shocks and a long series of rate hikes
by the Federal Reserve. Productivity growth remained well above its
historical average.
This chapter reviews the economic developments of 2005 and discusses
the Administration's forecast for the years ahead. The key points of
this chapter are:

 Real GDP grew strongly during 2005. Most components of
demand that accounted for growth in 2004 continued to do
so in 2005: consumer spending, business investment in
equipment and software, and exports.
 Labor markets continued to strengthen. The unemployment
rate continued to decline, and employers created another
2 million jobs.
 Inflation rose substantially at mid-year, but came down by
year-end reflecting the movement of energy prices. In
contrast, inflation in the core consumer price index (CPI)
(which excludes food and energy prices) has remained in the
moderate 2-percent range, and inflation expectations for
the period beyond a one-year horizon remain moderate and
stable.
 The Administration's forecast calls for the economic
expansion to continue in 2006, with real GDP growth close
to its post-World War II average rate and the unemployment
rate stable at about its current level. This is expected
to continue in subsequent years.


Developments in 2005 and the
Near-Term Outlook

Despite the impacts of rising energy prices and a devastating
hurricane season (see Box 1-1), the U.S. economy continued to
expand at a solid pace in 2005 and inflation pressures remained
contained.

Consumer Spending and Saving
Consumer spending continued its strong growth in 2005, rising faster
than disposable income over the past decade and a half. As a result,
the personal

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Box 1-1: Economic Impact of the 2005 Hurricanes
In addition to the tragic loss of life and the massive destruction of
personal property, the two major hurricanes (Katrina on August 29 and
Rita on September 24) damaged the productive capacity of the American
economy. Hurricane Wilma (October 24) also caused sizable losses to
life and property, but the damage to the economy as a whole was much
less. Both Hurricane Katrina and Hurricane Rita passed through offshore
areas where oil and natural gas platforms are concentrated and then
struck on-shore areas where petroleum is refined and natural gas is
processed. In addition to the damage to equipment and structures, the
hurricanes separated at least 782,000 workers from their jobs (and
displaced many more from their homes).
The direct damage to the capital stock and the displacement of labor
probably cut real GDP growth by about 0.7 percentage point at an annual
rate in the third quarter. Most of this GDP loss was the direct result
of destruction of oil and natural gas operations. Although rebuilding
of petroleum and natural gas operations was well under way in the
fourth quarter, the continuing disruptions likely subtracted about
0.5 percentage point from the annual rate of real GDP growth in that
quarter. Hurricane Katrina shut down about 1.4 million barrels per
day of oil extraction and 8.8 billion cubic feet per day of natural
gas production when it passed through on August 29. Those operations
were well on their way to recovery when Hurricane Rita came along for
a second strike on September 24, erasing the recovery efforts up to
that date (see the chart below). From Katrina's approach through the
Gulf of Mexico until the end of the third quarter, oil extraction was
cut by an average of 1.08 million barrels per day below normal levels
and by an average of 0.7 million barrels per day during the fourth
quarter. Similarly, natural gas production was reduced by an average of
5.4 billion cubic feet per day (roughly 10 percent of U.S. output) from
Katrina's approach through the end of the third quarter and by an average
of 4.0 billion cubic feet per day in the fourth quarter. Damage to
refineries cut output by an average of about 2 million barrels per day
during September and forced the demand for refined petroleum products
to be met by higher imports and a liquidation of inventories. Most refinery
output was restored by early-November, however. (Recent energy developments
are discussed further in Chapter 11.)
About 782,000 workers filed claims for unemployment insurance
(UI) benefits because of the hurricanes (604,000 under the regular UI
program and another 178,000 under the Disaster Unemployment Assistance
program). The lost production from these workers also subtracted from
real GDP growth in the third quarter (after making an allowance to avoid
double counting the lost production of



workers in the petroleum and natural gas industries noted earlier).
Data from the Current Population Survey indicate the unemployment rate
among evacuees was about 12 percent by year end.
According to a Red Cross damage assessment, the three hurricanes
destroyed an estimated 213,000 housing units; most of this damage was
done by Katrina. Furthermore, 169,000 units suffered major damage
(enough to make them uninhabitable), 220,000 had minor damage, and
another 235,000 had extremely minor damage. The Bureau of Economic
Analysis estimates the loss of residential capital stock at about
$67 billion--about $37 billion of which was insured. The insured
structures are likely to be rebuilt (although not necessarily in the
same location), and many of the uninsured structures may be rebuilt
as well. The pace of reconstruction is uncertain but is likely to take
place over a period of three years or so.
In the aftermath of the hurricanes, the President and Congress worked
together to provide disaster relief for the affected areas. Two emergency
spending bills provided for $62 billion of disaster relief, including
transfer payments to persons and businesses in the affected areas, direct
government purchases of goods and services, and grants to State and local
governments. These bills also included funding for the Defense Department
and the Corps of Engineers to rebuild military  facilities and levees in
New Orleans and the Gulf Coast. Additional legislation authorized a
reallocation of about $6 billion from other programs to disaster relief,
established $17 billion of additional borrowing authority for Federal
flood insurance programs, and provided about $15 billion of tax relief
for the affected areas.
In the fourth quarter, the Federal disaster spending together with
private rebuilding may have partially offset the still-negative effects
of petroleum and natural gas operations. By the first quarter of 2006,
these post-hurricane effects are expected to combine to produce a clearly
positive contribution to real GDP growth.
----------------------------------------------------------------------


saving rate fell to a postwar low this year, turning
negative in the second quarter and remaining negative through the
fourth quarter. A number of factors contributed to growth in consumer
spending in 2005; the most important was the increase in energy
prices including the transitory post-Katrina surge. Other factors with
sizable effects in particular quarters were motor vehicle incentive
programs and the loss of rental income from the hurricanes. Rising
household net worth during the late 1990s and again over the past
two years has provided a more-persistent boost to consumer outlays
relative to after-tax income.

Energy Expenditures
Consumer budgets continued to be stretched by higher energy prices
in 2005. Consumer energy prices increased about 21 percent during
the four quarters of 2005, following an 18-percent increase in
2004 (as measured by the consumption price index in the national
income and product accounts). Real consumption of energy was fairly
flat in 2005, but because of the higher prices, the share of
household income allocated to energy purchases increased sharply.
Spending on energy goods and services jumped from 4.2 percent of
disposable personal income in 2002 to about 6 percent in October
and November of 2005 as the average household's energy budget rose
by about $700 during 2005.


Light Vehicle Expenditures
While annual average sales of cars and light trucks have been
remarkably stable over the past six years, much of the
quarter-to-quarter volatility in consumer spending generally comes
from motor vehicle purchases. Quarter-to-quarter variability in
light vehicle sales was particularly evident in 2005. In July,
when General Motors, Ford, and Chrysler each introduced incentive
programs on 2005 models, the sales of light vehicles peaked at
20.7 million units at an annual rate. However, motor vehicle
sales dropped off in the fourth quarter to 15.8 million units
at an annual rate with the removal of the incentive programs.
Light vehicle sales for the year as a whole averaged 16.9 million
units, however, almost identical to the average pace during the
2000-to-2004 period.

Personal and National Saving
Meanwhile, real purchases outside of energy and motor vehicles grew
at their long-standing trend of about 3 1/2-percent growth per year.
With energy prices up and other consumption on an unaltered
trajectory, most of the funds for these higher-cost energy purchases
came from reducing saving. The personal saving rate, which had
been generally falling during the preceding 15 years, fell to
-0.5 percent for 2005.
Personal saving is only one part of national saving. The personal
saving rate does not include corporate saving in the form of
retained earnings; but corporate saving adds to the wealth of
corporate shareholders and supplies funds for investment. Net
private saving, which includes corporate saving as well as
household saving, was 4.3 percent of net national income in the
first half of 2005, down from 7.4 percent in the 1990s. A still
broader measure of saving, national saving, subtracts dissaving
by Federal, state, and local governments (in the form of government
budget deficits) from private (public plus corporate) saving. The
national saving rate was 1.7 percent in the first half of 2005.
(Personal and national saving are discussed further in Chapter 3,
Saving for Retirement; the international aspects of saving are
discussed in Chapter 6, The U.S. Capital Account Surplus.)

Wealth Effects on Consumption and Saving
A strong rise in household net worth during the late 1990s and again
during the past two years coincided with a sizable increase in
consumer spending relative to disposable personal income (Chart 1-1).
From 1995 through 2000, in large part because of a booming stock
market, the wealth-to-income ratio rose well above its historical
range, eventually reaching 6.15 years of disposable income, and
the fraction of disposable income spent by consumers rose to new
heights as well. The wealth-to-income ratio fell sharply in 2001
and 2002 due to the stock market decline. Since its low point in
the third quarter of 2002, the wealth-to-income ratio has again
risen sharply. By the third quarter of 2005, it had recovered to
about 5.6 years of disposable income, well above the historical
average of 4.8. Gains in the stock market accounted for about half
of the recovery while increases in net housing wealth accounted for
another third.


Looking ahead, real consumption growth during the four quarters
of 2006 is expected to be somewhere around the 31ï¿½2-percent trend
rate measured during the past three years. Over the near term, the
personal saving rate is expected to increase. If energy prices
decline in 2006, consumer spending should decline relative to
income; to the extent that energy prices remain high, consumer
spending may still decline relative to income as consumers reduce
energy use and substitute energy alternatives.


Housing Prices
During the past five years, home prices have risen at an annual
rate of 9.2 percent. This increase was largely supported by two
factors: first, an increase in housing demand, driven by a rise in
nominal per capita disposable income of 3.4 percent per year; second,
a decline in the cost of financing house purchases, due to a drop
in the monthly payment on 30-year fixed-rate mortgages of 4.3 percent
per year. Housing demand was also boosted by increased household
formation and a strengthening job market. Supply constraints, due to
limits on the supply of buildable land in some areas, also contributed
to rising prices over the past five years. After falling during 2004,
mortgage rates were roughly flat at 53ï¿½4 percent in the first three
quarters of 2005, and then edged up along with other long-term
interest rates in the fourth quarter. As a result, a well known
measure of housing affordability has now fallen to about its average
level over its 34-year history.
To gauge the extent to which house price increases have reflected
fundamentals, some studies compare housing prices to rents. The
rent-to-price ratio is a real rate of return on housing assets in the
same way that the earnings-to-price ratio measures the real rate of
return on corporate stocks. Viewed as an asset, a home should bear
a real return similar to the real return available on alternative
assets, such as stocks and bonds. As real interest rates have fallen
in the United States and in most other Organization for Economic
Cooperation and Development (OECD) countries, the rent-to-price
ratio for housing has likewise fallen across a broad range of OECD
countries. A recent OECD paper concluded that the decline in the
rent-to-price ratio in the United States from 2000 through 2004
was roughly consistent with the decline in interest rates over
the same period.

Residential Investment
In response to strong demand and the consequent rise in prices,
builders began construction on more than 2 million new homes during
2005, one of the highest rates of homebuilding on record. Similarly,
residential investment, at 6 percent of GDP in 2005, was at its
highest level since 1955. During 2005, growth of residential
construction contributed about half a percentage point to real GDP
growth. Homebuilding in 2005 was slightly in excess of the pace of
about 1.9 million starts per year that some economists have estimated
is compatible in the long run with U.S. rates of household formation
and other demographic influences.
During the next five years, the Administration expects the pace of
homebuilding to decrease gradually because of demographic trends and
slowly rising long-term interest rates. A gradual slowing of
homebuilding appears more likely than a sharp drop because the
elevated level of house prices will sustain homebuilding as a
profitable enterprise for some time. On balance, residential
investment is not projected to contribute to real GDP growth during
the four quarters of 2006; in subsequent years, it is expected to
subtract a bit from overall growth.


Business Fixed Investment
Real business investment in equipment and software grew 8 percent
during the four quarters of 2005. This growth is down from the
14-percent year-earlier pace, which was boosted by the end-of-2004
termination of the bonus depreciation provisions of the Jobs and
Growth Tax Reconciliation Act. Equipment purchases grew rapidly
in mining and oilfield machinery (18 percent) in response to higher
prices for oil and natural gas and the need to replace
hurricane-damaged rigs in the Gulf of Mexico. Equipment investment
also grew rapidly in the high-tech fields of computers, software,
and communications equipment. Investment in industrial and
construction equipment grew only moderately (6 percent and
4 percent, respectively). Investment in light trucks was strong
through the third quarter, but fell back in the fourth.
In contrast to equipment and software, investment in structures was
weak, growing only 1 percent during 2005, after 2.8-percent growth
in 2004.  Strong growth in the construction of hospitals, shopping
centers, and mines (including oil and natural gas rigs) has been
offset by declines in the building of electrical power stations,
hotels and motels, and amusement and recreation facilities. Office
construction fell for the fifth year in a row; however, the 2005
decline was smaller than previous years as office occupancy rates
have begun to increase.
The accumulation of internal funds has been more than sufficient
to finance business investment during this expansion (Chart 1-2).
These funds, also known as cash flow, are the sum of undistributed
after-tax profits and depreciation. In general, funds for business
investment can be generated through borrowing (typically from the
bond market, commercial paper market, or banks), issuing new stock,
the drawdown of liquid assets, or tapping into cash flow.
Historically, business investment has been about 21 percent higher
than cash flow, with firms raising most of the extra funds in
credit markets. In contrast, business investment during this
expansion has not kept pace with cash flow.  As a consequence,
corporate liquid assets have now built up to levels that are
well above any that have been seen during the past decade and
a half. This buildup in liquid assets implies that financing for
future investment should be readily available. However, the buildup
may reflect greater overall caution among business executives and
owners, a shift in sentiment that could dampen future investment.
During the next couple of years, investment in equipment and software
is likely to maintain the same rapid growth as in 2005, as output
continues to grow and businesses remain flush with cash. Investment
in business structures is projected to accelerate as new oil and gas
rigs are built and as continued declines in vacancy rates support
the construction of new office buildings.

Business Inventories
The pace of inventory investment in 2005 was below the 2004 pace and
on average subtracted from overall GDP growth during the first three
quarters of the year. As sales grew during the year, the
inventory-to-sales ratio continued to decline. Indeed, the
inventory-to-sales ratio has fallen considerably since the mid-1980s.
In 2005, businesses held inventories equal to about 27 business-days'
worth of sales--about three days' worth of sales less than they held
in 2000, and about seven days' less than in 1985. The trend toward
leaner



inventories has been evident in manufacturing since the
mid-1980s, and has appeared in retailing and wholesaling since at
least 2000. Leaner inventories suggest that new business practices
such as just-in-time inventory control in manufacturing and computer-
and Internet-assisted supply-chain management continue to become more
popular among supply managers.
Inventory investment generally makes little contribution to real
GDP growth when the growth of final sales is roughly stable from
year to year. (In contrast, inventory investment is important in
the early phases of business-cycle recessions and recoveries.) With
the economy in the midst of an ongoing expansion, and the
Administration expecting fairly smooth growth of final sales during
the next several years, inventory investment is not anticipated
to be a major contributor to annual GDP growth. The economy-wide
inventory-to-sales ratio is expected to trend lower over the
projection period.

Government Purchases
Federal Government purchases as well as transfers and grants (such
as Social Security, Medicare, and Medicaid) contributed to real GDP
growth during 2005. Federal purchases contributed 0.2 percentage
point at an annual rate to real GDP growth in the first half of
the year, and about 0.5 percentage point in the third quarter.
Almost all of these contributions were from the defense budget,
largely a by-product of the reconstruction and military operations
in Iraq and Afghanistan. Despite the developments in Iraq and the
hurricane-relief efforts, however, Federal spending in fiscal year
2005 (which runs from October 2004 to September 2005) was $7 billion
below last year's projection in the FY 2006 budget. An additional
$62 billion has been authorized so far for hurricane-disaster
relief. Although these funds were authorized in FY 2005, the hurricanes
struck near the end of the fiscal year, and so most of the funds will
be disbursed in FY 2006 and beyond.
Federal Government purchases and the consumer spending that results
indirectly from Federal transfers will add to real GDP growth in
early 2006. Federal outlays for FY 2006 are likely to increase
largely due to hurricane-disaster relief and because of additional
funds for reconstruction and counterinsurgency in Iraq.
From FY 2007 forward, however, the impact of Federal outlays is
projected to move sharply toward restraint. For example, Federal
outlays are projected to shrink by 0.7 percentage point of GDP in
FY 2007. The shrinking of the Federal Government's claim on resources
should allow private economic activity more room to grow.

Exports and Imports
Real exports grew 5-3/4 percent during the four quarters of 2005,
about the same as export growth in 2004. This reflects the
interaction of two offsetting influences: the somewhat faster growth
of our trading partners in 2005, which tends to increase the demand
for U.S. exports, and the increase in the exchange value of the
dollar, which tends to dampen export demand by making U.S. goods
relatively more expensive. Real GDP growth among our OECD trading
partners picked up a bit to 2.6 percent during the four quarters of
2005 from a 2.1-percent pace in 2004, as computed from the latest
OECD projections. Offsetting the effect of stronger foreign growth
on our exports was a 7-percent rise in the value of the dollar
against major currencies over the 12 months of 2005.
Data on the destination of U.S. exports show the fastest export growth
to the most rapidly developing countries and regions such as Asia
and Africa. Nevertheless, our OECD trading partners still account
for more than two-thirds of our exports.
Growth of our real exports in 2006 and 2007 is likely to be similar
to that in 2005, because economic growth in our export markets is
likely to be about the same as in 2005. The OECD projects that real
GDP growth among our OECD trading partners (2.6 percent during the
four quarters of 2005) will be 2.5 percent and 2.8 percent in 2006
and 2007, respectively. Growth of real exports to rapidly developing
countries in Asia and Africa will likely continue to be healthy over
the next two years as their economic expansion leads them to demand
more goods and services from abroad.
Growth in real imports slowed substantially during the four quarters
of 2005 to 4.6 percent from 10.6 percent in 2004. Imports grew more
slowly than exports during 2005. Import growth was particularly weak
in the second and third quarters and was fairly widespread, affecting
imports of consumer goods, non-auto capital goods, petroleum
products, and services. Imports  picked up in the fourth quarter,
particularly for petroleum products to replace domestic production
lost because of the damage caused by the hurricanes.
The current account deficit (the excess of imports and income flows
to foreigners over exports and foreign income of Americans) averaged
6.4 percent of GDP ($790 billion at an annual rate) during the first
three quarters of 2005, up from 5.7 percent of GDP during 2004.
Recent increases in the deficit reflect faster growth in the
United States than among our trading partners, making our imports
grow faster than our exports. The longer-term trend also reflects
faster growth of domestic investment than domestic saving with
foreign saving filling in the gap in financing.
The United States has been able to buy more goods and services than
it sells because foreigners have been investing in the United States.
The current account deficit of $790 billion also represents the net
increase in foreign holdings of U.S. assets (either financial assets
or direct ownership of corporations) relative to U.S.-owned assets
abroad. In the future, the returns from these foreign-owned U.S.
investments (that is, interest, dividends, and reinvested
earnings) will themselves add to the current account deficit. These
ideas are explored more fully in Chapter 6, The U.S. Capital Account
Surplus.


Employment
Nonfarm payroll employment increased by 2.0 million during the
12 months of 2005, an average pace of 168,000 jobs per month. The
unemployment rate declined by 0.5 percentage point to 4.9 percent
during the 12 months of the year. The average unemployment rate in
2005 (5.1 percent) was below the averages of the 1970s, the 1980s,
and the 1990s. During the first eight months of 2005, employment
growth averaged 196,000 per month, but dropped to only 21,000 per
month in September and October immediately after the hurricanes. The
Bureau of Labor Statistics expects a slight downward revision to
employment growth over the 12 months ended in March 2005.
Job gains were spread broadly across major industry sectors in 2005.
The service-providing sector accounted for 88 percent of job growth
during the 12 months of the year, a slightly larger contribution
than would be suggested by its 83 percent of overall employment. The
goods-producing sector accounted for the remaining 12 percent of the
gains, notably weaker than its 17-percent share of overall
employment. Within the goods-producing sector, over-the-year
employment growth was concentrated in construction and mining,
while manufacturing employment decreased for the seventh time in
the past eight years.
By educational attainment, the drop in the unemployment rate during
2005 was most pronounced among those without a high school degree;
the jobless rate in this group tumbled 0.7 percentage point during
the 12 months of the year. By race and ethnicity, the unemployment
rate fell the most among blacks and Hispanics, (1.5 and 0.5 percentage
points, respectively), in contrast to 0.3 percentage point for whites.
By age, the jobless rate fell most among teenagers 16 to 19 years
old. By sex, the jobless rate fell more among adult men than adult
women. The median duration of unemployment, an indicator that
typically follows the business cycle with a substantial lag, declined
from 9.4 weeks in December 2004 to 8.5 weeks in December 2005. In
general, unemployment rates fell the most in 2005 among those groups
with the highest rates at the end of 2004.
The Administration projects that employment will increase at a pace
of 176,000 per month on average during the 12 months of 2006--roughly
in line with the Philadelphia Federal Reserve Bank's survey of
professional forecasters. The Administration projects the unemployment
rate will remain at about 5.0 percent throughout 2006.

Productivity
Labor productivity growth in the nonfarm business sector has been
exceptionally vigorous, exceeding the forecasts of most economists.
Productivity (real output per hour worked) grew at a 3.4-percent
annual rate during the first three quarters of 2005, following
similar or higher growth rates during the three preceding years.
Since the business-cycle peak in the first quarter of 2001 (a period
that includes a recession and a recovery), productivity has grown
at an average 3.6-percent annual rate, notably higher than during
any comparable 4-1/2-year period since 1948 (Chart 1-3). Although
1995 has been regarded as a watershed year for productivity because
of the acceleration of productivity from a 1.5-percent to a 2.4-percent
annual rate of growth, the further acceleration to a 3.6-percent
annual rate of growth during 2001 to 2005 is even more striking
(the precise time periods are shown in Table 1-2, later in this
chapter). The 1995-2001 acceleration may be plausibly accounted for
by a pickup in capital services per hour worked and by increases
in organizational capital, the investments businesses make to
reorganize and restructure themselves, in this instance in response
to newly installed information technology.
In contrast, capital deepening (the increase in capital services
per hour worked) does not explain any of the post-2001 increase
in productivity; in fact, the growth of capital services per hour
worked appears to have fallen off slightly in this period. The
post-2001 acceleration in productivity, therefore,



appears to be accounted for by factors that are more difficult to
measure than the quantity of capital, such as continuing improvements
in technology and in business practices.
One curious aspect of productivity acceleration has been its limited
spread. Business-sector productivity growth has been higher in the
United States than in any other major industrial economy.
(Business-sector productivity growth has also been rapid in Ireland,
Greece, Korea, Turkey, the Scandinavian countries, and several
transitional east-European countries.) As every industrial economy
has access to the same technology, the strong U.S. performance
suggests that other structural features of the U.S. economy may also
play an important role in productivity growth. Some research suggests
that, all else equal, countries with more-flexible, less-heavily
regulated product and labor markets are better able to translate
technological advances into productivity gains.
Rather than assume that the recent remarkable pace of productivity
growth will continue, the Administration believes it is prudent to
build a budget based on a forecast somewhat lower than the 3.6-percent
pace of productivity growth since 2001. Productivity is projected to
average 2.6 percent per year during the six-year span of the budget
projection--roughly equal to the average annual pace during the past decade.



Wages and Prices
As measured by the Consumer Price Index (CPI), overall inflation
increased in 2005 to 3.4 percent from 3.3 percent during the 12
months of 2004. Rapid increases in energy prices (16.6 percent and
17.1 percent in 2004 and 2005, respectively) elevated the level of
overall inflation in both years. The four major energy subindexes
(gasoline, fuel oil, natural gas, and electricity) all posted large
increases in 2005, with prices of natural gas and electricity
advancing faster than in the preceding year. Food price inflation,
at 2.3 percent, was moderate and little changed from the year-earlier
pace. Core CPI prices (which exclude the prices of food and energy)
increased 2.2 percent during 2005, substantially below the overall
inflation rate and the same as the year-earlier pace.
Labor costs (which comprise about 62 percent of the costs of nonfarm
business) have been stable, or possibly trending lower. Hourly
compensation for workers in private industry increased at a
3.0-percent annual rate during the 12 months ended in September 2005
down from 3.7 percent during the year-earlier period according to
the Employment Cost Index (ECI), which is compiled from the
National Compensation Survey (NCS). The deceleration occurred in
both wages and salaries (with growth down to 2.2 percent from
2.6 percent in the year-earlier period) and hourly benefits (which
slowed to 4.8 percent from 6.8 percent).  The slowing in hourly
benefits was accounted for primarily by smaller increases in
contributions to defined-benefit pension programs in 2005 than
in 2004 according to other tabulations from the NCS. Hourly benefits
have increased notably faster than hourly wages and salaries in each
of the past four years. Another measure of hourly compensation
published by the Department of Labor and derived from the national
income and product accounts (NIPA) has increased notably faster
than the ECI measure, rising 5.0 percent during the four quarters
ended in the third quarter of 2005. The difference between these
two measures may be partly attributable to the exercise of stock
options which are included in the NIPA-derived measure at the time
they are exercised, but are not recorded by the NCS.
With hourly compensation growing in the 3.0 percent-to-5.0 percent
range (depending on the index) and labor productivity growth at
about 3.0 percent, trend unit labor costs have barely changed, with
increases in the range from 0 percent to 2 percent. Because unit
labor costs have increased by less than the 2.9-percent increase
in the GDP price index during the four quarters through the third
quarter of 2005, labor costs do not appear to be putting upward
pressure on inflation.
An important determinant of inflation during the next year is likely
to be energy prices, whose run-up during the past two years has
been the main reason for the increase in inflation. Futures markets
suggest roughly stable oil and natural gas prices, which (if they
come to pass) will remove some of the upward pressure on the overall
inflation rate.
Although some measures of short-run inflation expectations increased
around the third quarter of 2005, they fell back later in the year.
More importantly, a variety of longer-term measures of inflation
expectations have been approximately stable during the past two
years, including those derived from the market for Treasury
Inflation-Protected Securities (TIPS) and the University of Michigan
consumer survey (Chart 1-5). History suggests that the stability of
inflation expectations promotes stability in actual inflation as
well as in the overall economy.
The Administration expects CPI inflation to stabilize at 2.4 percent
during the next several years, up only slightly from the 2.2 percent
increase in the core CPI during the 12 months through December.
The projected path of inflation as measured by the GDP price index
is similar, but a bit lower.  Inflation by this measure is projected
at 2.2 percent during the four quarters of 2006 and 2007, down from
the 3.0-percent increase during 2005. These inflation projections
are very close to those of a year ago, and are also very close to
those of the consensus of professional forecasters.
The ``wedge,'' or difference, between the CPI and the GDP measures
of inflation has implications for the Federal budget projections. A
larger wedge (with the CPI rising faster than the GDP price index)
raises the Federal budget deficit because cost-of-living programs
rise with the CPI, while Federal revenue tends to increase with the
GDP price index. For a given level



of nominal income, increases in
the CPI also cut Federal revenue because they raise income tax
brackets and affect other inflation-indexed features of the tax code.
Of the two indexes, the CPI tends to increase faster in part because
it measures the price of a fixed basket of goods. In contrast, the
GDP price index increases less rapidly because it allows for
households and businesses shifting their purchases away from items
with increasing relative prices and toward items with decreasing
relative prices. Among other differences, the GDP price index places
a larger weight than does the CPI on computers, which tend to
decline in price (on a quality-adjusted basis).  In addition, the
CPI places a much larger weight on energy.
During the 13 years ended in 2004, the wedge between inflation in the
CPI-U-RS (a historical CPI series designed to be consistent with current
CPI methods) and the rate of change in the GDP price index averaged
0.36 percent per year. The wedge was particularly high during the
first three quarters of 2005 when the CPI increased 1 percentage
point faster than the GDP price index; this difference reflected
the roughly 50-percent annual rate of increase in crude oil prices,
which have a larger weight in consumer prices than in GDP as a whole.
Since domestic production accounts for only about 35 percent of U.S.
oil consumption, the weight of oil prices in GDP is roughly one-third
of its weight in consumption. As this boost from higher oil prices
unwinds over the next couple of years, the wedge between the CPI
and GDP inflation is likely to be lower than average. From 2008,
the wedge is projected to average 0.3 percentage point.

Financial Markets
The Wilshire 5000 (a broad stock price index) increased 4.6 percent
during 2005, the third consecutive year of stock market gains
following three years of declines. The 2005 increase was well below
the gains of the two preceding years.
Short-term interest rates increased during the year as the Federal
Reserve's Open Market Committee raised the target Federal funds rate
by 25 basis points at each of its eight meetings. As a consequence,
rates on 91-day Treasury bills rose 1.7 percentage points during the
year.
Despite the increases in short-term rates, yields on 10-year Treasury
notes remained low, increasing only 24 basis points during the 12
months of 2005 (Chart 1-6). The low level of long-term interest rates
was due, in part, to low and stable long-run inflation expectations.
At the end of 2005 the gap between the yield on 10-year Treasuries
and the rate on 91-day Treasury bills was only about 0.6 percentage
point, noticeably lower than its historical average. (The yield on
longer-term Treasury notes is usually higher than on shorter-term
notes because the market compensates investors for the extra risk
of holding longer-term securities.)


Yields on corporate bonds also remained low and the spread between
yields on corporate bonds (which carry more risk) and the yields
on more-secure obligations of the U.S. Treasury remained small.
Measured relative to Treasury obligations of similar maturities, the
yields on corporate bonds rated ``BAA'' (about average quality) by
Moody's Investor Services remained near their lowest levels over
the past decade (Chart 1-7). This suggests that the perceived default
risk of U.S. corporations remains low.

The Long-Term Outlook Through 2011

The U.S. economy continues to be well positioned for long-term growth.
The Administration projects that real GDP will expand at about its
potential rate (between 3.1 percent and 3.3 percent per year) through
2011, inflation will remain low and stable (with the CPI increasing
at around 2.4 percent per year), and the labor market will remain
firm (Table 1-1). The forecast is based on conservative economic
assumptions that are close to the consensus of professional
forecasters. These assumptions provide a prudent and cautious basis
for the Administration's budget projections.




Growth in GDP over the Long Term
The Administration projects that real GDP will grow at a slowly
diminishing rate from 2005 through 2009, decelerating year by year
from a forecasted 3.5-percent rate during the four quarters of 2005
to 3.1 percent in 2009, roughly in line with the consensus forecast
for those years. The year-by-year pace is close to the estimated
growth rate of potential real GDP growth (a measure of the rate of
growth of productive capacity). The unemployment rate is projected
to remain flat at 5.0 percent. As discussed below, potential GDP
growth is expected to slow in the near term as productivity growth
reverts toward its long-run trend, and potential GDP is expected to
slow further during the 2007-to-2011 period as labor force growth
declines.
The projected growth of potential real GDP, 3-1/4 percent during the
next two years, is in line with recent experience. Potential growth
is the rate of real GDP growth that can be achieved while the
unemployment rate remains stable. For example, during the past
four years (from the third quarter of 2001 to the third quarter of
2005) real GDP growth was 3.22 percent at an annual rate while the
unemployment rate was unchanged--on net--at about 5 percent.
The growth rate of the economy over the long run is determined by
its supply-side components, which include population, labor force
participation, the ratio of nonfarm business employment to
household employment, the workweek, and the growth in output per
hour. The Administration's forecast for the contribution of the
growth rates of different supply-side factors to real GDP growth
is shown in Table 1-2.
As can be seen in the fourth column of the table, the mix of
supply-side factors determining real GDP growth has been unusual
since the business-cycle peak at the beginning of 2001, with the
exceptionally high productivity growth (3.6 percent at an annual
rate) partially offset by declines in the participation rate
(line 2) and the workweek (line 8). Also puzzling is the large
decline in the ratio of nonfarm business employment to household
employment (line 6). This unusual decline reflects the slow growth
of employment



as measured by the payroll survey (which asks employers
to report the number of employees) relative to the more-rapid growth
of employment as measured by the household survey (in which people
report the employment status of their household members)--a disparity
that has not yet been explained.
The participation rate fell from 2001 to 2005, and is projected to
trend lower through 2011. The recent behavior stands in contrast to
the long period of increase from 1960 through 1996 (Chart 1-8). The
participation rate appears to have topped out in 1997-2000 before
declining. The reversal of direction reflects nothing new about
the participation rate for men, which continued a downward trend
that began shortly after the end of World War II. Rather, the new
factor at play is the change in the trend in the female participation
rate, which has edged down on balance since 2000 after having risen
for five decades.
Another factor in the decline in the labor force participation rate
has been the increase in the number of workers collecting insurance
for disability retirement. The 0.5-percentage point increase (as a
share of the working-age population) since 2000 accounts for about
half of the overall decline, and appears to be largely a reflection
of increases in the number of workers entering high-disability ages
(50+ years old).



Looking ahead, the participation rate is projected to decline slowly,
reflecting the aging of the baby-boom cohorts, leading to more
retirements and a likely increase in the share of disabled workers.
Baby boomers are currently in their forties and fifties, and over
the next several years they will move into older age brackets which
typically have lower participation rates. The decline in the
participation rate may quicken after 2008 when the first baby-boom
cohort reaches Social Security's early retirement age of 62.

Interest Rates over the Near and Long Term
The Administration forecast of interest rates is based on financial
market data as well as results of a survey of economic forecasters.
As of November 15, 2005, the date that the forecast was finalized,
trading in financial futures suggested that market participants
expected short-term interest rates to rise a bit further, and
the Administration's interest-rate projections reflect those views.
Taking its cue from financial futures markets, the Administration
projects the rate on 91-day Treasury bills to increase to about
4.2 percent by 2007 and to about 4.3 percent from 2008 to 2011. At
that level, the real interest rate on 91-day Treasury bills will be
close to its historical average.
The yield on 10-year Treasury notes on November 14 was 4.61 percent,
just 68 basis points above the (discount) rate on 91-day Treasury
bills. This difference was very low relative to its historical
average, and the Administration expects it to increase gradually
during the six-year forecast period. As a result, yields on 10-year
notes are expected to increase somewhat further, reaching a plateau
at 5.6 percent from 2009 onward.


The Composition of Income over the Long Term
A primary purpose of the Administration's economic forecast is to
estimate future government revenues, which requires a projection of
the components of taxable income. The Administration's income-side
projection is based on the historical stability of the long-run
labor compensation and capital share of gross domestic income
(GDI). (GDI is the sum of all income components and differs from GDP
only by measurement error--which can be substantial.)  During the
first three quarters of 2005, the labor compensation share of GDI
was 57.6 percent (according to the advance data available when the
projection was finalized), slightly below its 1963-2004 average of
58.1 percent. From this jump-off point, the labor share is projected
to slowly rise to 58.1 percent by 2011.
The labor compensation share of GDI consists of wages and salaries
(which are taxable), nonwage compensation (employer contributions to
employee pension and insurance funds--which are not taxable), and
employer contributions to social insurance (which are not taxable).
The Administration forecasts that the wage and salary share of
compensation will be roughly stable during the budget window. One
of the main factors boosting nonwage compensation during 2002-2004
was employer contributions to defined-benefit pension plans. As
noted earlier, the National Compensation Survey for 2005 shows a
moderation of these contributions, suggesting that the period of
very rapid catch-up contributions may be behind us.
The capital share of GDI is expected to edge down from its currently
high level before stabilizing near its historical average. Within
the capital share, depreciation is expected to increase (a result
of the strong growth of investment during the past three years).
After adjusting for the temporary effects of the hurricanes, profits
in the third quarter of 2005 were about 11.6 percent of GDI, well
above their post-1959 average.
Book profits (known in the national income and product accounts
as ''profits before tax'') jumped up in the first quarter of 2005
in large part because of the termination of the temporary provision
for expensing of equipment investment under the Job Creation and
Worker Assistance Act of 2002 and the Jobs and Growth Tax Relief
and Reconciliation Act of 2003.  These expensing provisions reduced
taxable profits from the third quarter of 2001 through the fourth
quarter of 2004. The legacy of these expensing provisions increases
book profits from 2005 forward, however, because investment goods
expensed during the three-year expensing window will have less
remaining value to depreciate. The share of other taxable income
(the sum of rent, dividends, proprietors' income, and personal
interest income) is projected to fall in coming years, mainly
because of the delayed effects of past declines in long-term
interest rates, which reduce personal interest income during the
projection period. In addition, rental income has been--and is
projected to continue--trending down as a share of GDI.

Conclusion

The economy has shifted from recovery to sustained expansion,
having absorbed the effects of the third-quarter hurricanes and
large increases in energy prices. The economy is projected to
settle into a steady state in which GDP grows at its potential
rate, the unemployment rate remains flat at a low level, and
inflation remains moderate and stable. Consumer spending remains
strong, businesses are continuing to invest, and exports are
growing faster than domestic production. Having said this, we
must remember that economic forecasting is difficult, and no
doubt unforeseen positive and negative developments will affect
the course of the economy over the next few years. Given the
economy's fundamental strengths, however, prospects remain good
for continued growth in the years ahead. Nevertheless, much work
remains in making our economy as productive as possible. Later
chapters of this Report explore how pro-growth policies, such as
improving incentives in health care, promoting free trade,
reforming our retirement and tax systems, and boosting the
skills of the U.S. workforce can enhance our economic performance.