[Economic Report of the President (2007)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]



 
CHAPTER 1



The Year in Review and the Years Ahead

The expansion of the U.S economy continued for the fifth consecutive
year in 2006. Economic growth was strong, with real gross domestic
product (GDP) growing at 3.4 percent during the four quarters of 2006.
This strong economic growth comes in the face of numerous headwinds
and resulted from the inherent strengths of the U.S. economy and
pro-growth policies such as tax relief, regulatory restraint, and
opening foreign markets to U.S. goods and services. Growth in the
first quarter rebounded from the effects of the 2005 hurricanes,
including a recovery in consumer confidence and consumer spending,
and the rebuilding of oil and natural gas infrastructure in the Gulf
of Mexico. Although growth slowed in the middle two quarters of the
year, the overall pace of real activity was strong in the face of
near-record inflation-adjusted prices of crude oil and a sharp
decline in home construction. On the inflation front, energy prices
fell substantially towards the end of the year, allowing overall
consumer price inflation to moderate in 2006; however, price inflation
increased for goods and services other than food and energy. In
response to these output and inflation developments, the Federal
Reserve continued raising the federal funds rate through June, and
then held it constant for the rest of the year. The Administration
forecast calls for the economic expansion to continue in 2007, but
we must continue to pursue pro-growth policies such as those designed
to keep tax relief in place, restrain government spending, slow the
rate of health care inflation, enhance national energy security, and
expand free and fair trade.
This chapter reviews the economic developments of 2006 and discusses
the Administrationï¿½s forecast for the years ahead. The key points of
this chapter are:
Real GDP posted strong 3.4 percent growth in 2006, up from
the  3.1 percent 2005 pace. The composition of aggregate
demand changed from preceding years. More growth came from
exports and business structures investment, while residential
investment flipped from contributing to GDP growth in 2005 to
subtracting from it in 2006.
Labor markets continued to strengthen, with the unemployment
rate descending to 41/2 percent in the fourth quarter , and
payroll job growth averaging 187,000 per month.
Energy prices, which rose through August and then declined,
dominated the movement of overall inflation in the consumer
price index. Core inflation (which excludes food and energy
inflation) moved up from 2.2 percent during the 12 months of
2005 to 2.6 percent in   2006, with much of this upward trend
due to an  acceleration in the amount that renters pay for
apartments and other rental properties and the estimated rent
on owner-occupied housing. Energy prices fell sharply from
September through October, and core inflation fell toward the
end of the year.
Real average hourly earnings accelerated to a 1.7 percent
increase during the 12 months of 2006, reflecting solid labor
markets combined with tamer energy prices.
The Administration's forecast calls for the economic expansion
to continue in 2007 and beyond, although the pace of
expansion is projected to slow somewhat from the stronger
growth of recent years. The unemployment rate is projected to
edge up slightly in 2007, while remaining below 5 percent.
Real GDP growth is projected to continue at around 3 percent
in 2008 and thereafter, while the unemployment rate is
projected to remain stable and below  5 percent.

Developments in 2006 and the Near-Term Outlook
The economy went through a period of rebalancing during 2006, with
faster growth in business structures investment and exports partially
offsetting pronounced declines in homebuilding. At the same time,
consumer spending continued to grow.

Consumer Spending and Saving
Consumer spending sustained its strong growth during the four
quarters of 2006 (rising 3.7 percent in real terms), continuing its
15-year pattern of rising faster than disposable income. Several
factors helped to keep spending elevated, and as a result, kept
saving down (according to the official definition in the national
income and product accounts (NIPA)). These factors included rising
energy costs (through the third quarter), rising wealth, and falling
unemployment rates. As a result, the personal saving rate fell to a
negative 1.0 percent for the year as a wholeï¿½its lowest annual level
during the post-World War II era. Despite the negative saving rate,
Americans continue to build wealth in the form of capital gains
(the rise in asset prices), which are not included in the definition
of saving in the NIPAs. The declining saving rate continues a
long-term trend which began in the 1980s.

Energy Expenditures
World demand for crude oil increased from 79.74 million barrels per
day in 2003 to 84.18 million barrels per day during the first three
quarters of 2006. The United States accounted for about one-eighth
(0.5 million barrels per day) of this higher
(4.4 million barrel per day) pace of crude oil consumption. Most
of this increase in world
demand was accounted for by non-OECD countries (up 4.1 million
barrels per day). Consumption of the non-U.S. OECD coun-tries fell
0.2 million barrels per day. In the face of this increase in world
oil demand, the supply available to U.S. consumers was restrained,
and consumers paid higher prices to maintain their consumption.
With the rise in energy prices, nominal energy purchases rose sharply.
That consumers altered their spending patterns only slightly
contributed to the fall in the saving rate. Consumer energy prices
increased 29 percent relative to nonenergy prices (according to the
NIPA price indexes) from the fourth quarter of 2003 to the fourth
quarter of 2006, while real consumption of energy per household fell
only slightly, by 2.1 percent. Between 2004 and 2006, consumers
appear to have maintained both energy and nonenergy consumption by
reducing their saving. Consumersï¿½ response to persistently high
energy prices is likely to emerge gradually, as consumers economize
on energy consumption and possibly on nonenergy consumption.

Wealth Effects on Consumption and Saving
The rise in household wealth has also played a role in the decline
of the saving rate. During the late 1990s and again during the past
3 years, a strong rise in household net worth coincided with a
sizeable increase in consumer spending relative to disposable
personal income (see Chart 1-1).




Despite the negative saving rate during 2006, Americans continued
to build wealth because of capital gains. During the four quarters
ending in the third quarter of 2006, the household wealth-to-income
ratio increased 0.04 years, to 5.63 years of income. (The units of
the wealth-to-income ratio are years because wealth is measured in
dollars while income is measured in dollars per year. That is, total
household wealth in the third quarter of 2006 represents the
equivalent of 5.63 years of accumulated income.) More than half of
the increase during these four quarters was accounted for by an
increase in stock market wealth. Housing wealth (net of mortgage
debt) also edged up relative to income over these four quarters, but
by much less than its increases during the preceding 2 years. By the
third quarter of 2006, the overall wealth-to-income ratio was well
above the ratio over most of the past 50 years.

Personal and National Saving
Consumer responses to the rise in energy prices and increases in
the wealth-to-income ratio lowered the personal saving rate to
negative 1.0 percent in 2006. The personal saving rate, the rate at
which households save, has been declining since the mid-1980s.
Corporate net saving takes the form of retained earnings which are
not paid out to shareholders. (Net saving excludes funds used to
replace worn out capital goods.) Retained earnings add to the wealth
of corporate shareholders and supply funds for new investment.
Corporate net saving rose to 3.8 percent of gross domestic income
(GDI) during the first three quarters of 2006, its highest level
since the 1960s. (GDI is the economy-wide sum of all sources of
income and differs from GDP only by measurement error.) But even with
these high levels of net corporate saving, net private saving
(the sum of personal and corporate saving) was only 3.1 percent of
GDI during the first three quarters of 2006, near its lowest level
in the post-war period.
A still broader measure of net saving-net national saving-is the
sum of government and private (personal plus corporate) net saving.
When the Federal government runs a deficit (spends more than it
collects in tax revenue), Federal saving is negative, as it was in
2006. Because the Federal deficit declined substantially in 2006,
and because corporate saving rose, net national saving (which was
negligible in 2005) rose to 2.0 percent of GDI during the first
three quarters of 2006, its highest level since early 2002. Gross
national saving, which includes funds for replacing worn out capital
goods, is higher than net saving (13.8 percent versus 2.0 percent
during the first three quarters of 2006), but shows similar
historical fluctuations.
Projected Consumer Spending
Looking ahead, real consumer spending during the four quarters of
2007 is expected to grow less than 3 percent, down from an average
of 3.5 percent during the past 3 years. This projected rate is
slightly less than the projected 2007 growth of real disposable
personal income (household income less taxes, adjusted for
inflation), and so the saving rate is forecasted to edge up. During
the longer term, real consumption is projected to increase at about
the same pace as real GDP and real income.

Housing Prices
Nationally, housing prices increased less in 2006 than in 2005. An
inflation-adjusted version of the housing price index (the nominal
version of which is compiled by the Office of Federal Housing
Enterprise Oversight from new home sales and appraisals during
refinancing) increased at an average annual rate of 6.4 percent from
2000 to 2005, and then slowed to a 2.6 percent annual rate of increase
in the first three quarters of 2006. (These inflation-adjusted
prices are deflated by the consumer price index.) Looking back, the
cumulative increase in inflation-adjusted housing prices during the
6 years from 1999 to 2005 is one of the largest on record, exceeded
only by the period immediately following the Second World War. Since
1929, periods of rising real prices have been linked to increases in
the share of the gross national product allocated to home construction
(see Chart 1-2). The 6.4 percent annual rate of increase in the
relative price of housing from 2000 to 2005 was associated with an
increase in the residential construction share of GDP from 4.6
percent to 6.2 percent.



Although relative housing prices (that is relative to the consumer
price index (CPI)) increased in almost all metropolitan areas during
the 5 years from 2000 to 2005, the increases were concentrated in a
few high-profile markets; increases in most areas were only modest.
For example, real prices in Los Angeles increased at a 14.3 percent
annual rate, but real price increases in 71 percent of metropolitan
areas were less than the 6.4 percent national average. Most house
price changes reflect local conditions (such as local economic and
population growth, tastes, and geographic and zoning limitations on
construction). In areas with restricted supply, small changes in
demand may translate into large price changes.
Although house-price increases during these 5 years were
concentrated in a few markets, the decline in mortgage rates from
2000 to 2005 was one common factor that may have helped raise home
prices across the nation. Because of the drop in mortgage rates,
prices could increase 4.4 percent per year during this period
without raising the monthly mortgage payment.

Residential Investment
Every major measure of housing activity dropped sharply during 2006,
and the drop in real residential construction was steeper than
anticipated in last yearï¿½s Report. New home sales fell 27 percent
from a peak in October 2005 through July 2006, a period when rates
on conventional mortgages moved up about 70 basis points. (A basis
point is one one-hundredth of a percentage point.) Sales then edged
up during the 5 months from August through December, when mortgage
rates dipped lower. Builders reacted sharply to the early-2006 drop
in sales so that housing starts, which peaked at an annual rate of
2.27 million units in the beginning of the year, fell to slightly
more than 1.6 million units by the end of the year. The drop in home
construction activity subtracted roughly 0.7 percentage point from
the annual rate of real GDP growth in the second quarter, and 1.2
percentage points in the second half of the year. Furthermore, even
if housing starts level off at their current pace, normal lags
between the beginning and completion of a construction project imply
that residential investment will subtract from GDP growth during the
first half of 2007.
During 2006, employment in residential construction fell, as did
production of construction materials and products associated with
new home sales (such as furniture, large appliances, and carpeting).
Yet despite these housing sector declines, the overall economy
continued to expand (see Box 1-1).


---------------------------------------------------------------------
Box 1-1: Indirect Effects of the Housing Sector

Thus far, the sharp drop in homebuilding has had few consequences
for the rest of the economy. Employment fell in sectors related to
new home construction and housing sales. Despite these repercussions,
overall payroll employment continued to increase, the unemployment
rate continued to fall, and real consumer spending continued to move
upward through the end of 2006.
Although residential investment fell sharply, real GDP growth during
2006 was sustained by increases in other forms of investment. As can
be seen in the chart below, private nominal nonresidential
construction (that is, business construction of office buildings,
shopping centers, factories, and other business structures) grew
rapidly in the first three quarters of the year and moved up a bit
further in the fourth quarter. Nonresidential construction draws
from some of the same resources (such as construction labor and
materials) as the residential construc-tion sector. The high level of
residential investment during the past couple of years may have
limited the growth of investment in nonresidential structures. While
the case for housing crowding out other sectors is strongest for
nonresidential investment, residential investment competes with all
other sectors of production in credit and labor markets.  A drop in
the share of the economy engaged in housing could provide some room
for other sectors to grow.




The housing market could also affect the rest of the economy through
the wealth channel. That is, declines in housing prices could reduce
household net worth and thereby reduce consumption. The increase in
housing prices during 2000-2005 contributed noticeably to the gain
in the ratio of household wealth to income (shown earlier in chart
1-1) and supported growth in consumer spending. Some of this support
may have been facilitated by homeowners taking out larger mortgages
after their homes appreciated in value. In contrast, housing wealth
decelerated in the second and third quarters of 2006, while the stock
market accounted for most of the gain in the wealth-to-income ratio.
Thus far, national measures of housing prices have not declined, and
negative effects through the wealth channel have not occurred.
----------------------------------------------------------------------
In addition to incomes and mortgage rates, the number of homes built
is underpinned by demographics. Homebuilding during 2004 and 2005
averaged about 2.0 million units per year, in excess of the roughly
1.8-to-1.9-million unit annual pace of starts that is consistent with
the pace of household formation implied by demographic models. As a
result, the pace of homebuilding will tend to be drawn below this
level for long enough so that the above-trend production of 2004 and
2005 will be offset by below-trend production. The construction of
new homes has fallen rapidly, however, and this offset may well be
complete sometime during 2007. Looking further ahead, the
residential sector is not expected to make noticeable positive
contributions to real GDP growth until 2008 and beyond.

Business Fixed Investment
During 2006, real business investment in equipment and software
grew 5 percent, slower than the 7 percent average pace during the 3
previous years. Its fastest-growing components included computers,
as well as machinery in the agricultural and service sectors.
Investment in mining and oil field machinery was also strong, likely
in response to elevated crude oil prices, and to the need to replace
Gulf of Mexico facilities damaged by the 2005 hurricanes. Investment
in heavy trucks has been solid throughout 2006 as trucking firms have
been buying in advance of new environmental regulations
(on particulate matter emissions issued in 2000 that became effective
in 2007), which will raise heavy truck prices in 2007. Aircraft
investment, however, declined sharply for the second consecutive
year. Software investment posted a strong 7.9 percent gain in 2006,
but since 2000, it has grown at only a 3.7 percent annual rate, a
noticeable deceleration from the roughly 16 percent annual rate of
growth during the 1990s.

The turnaround in investment in business structures (that is,
nonresidential construction) during 2006 has been dramatic, with
growth at 12 percent, up from an anemic 2 percent gain during 2005.
Growth in 2006 was strongest for office buildings, multi-merchandise
centers, lodging facilities, and recreational structures. Investment
in petroleum and natural gas structures also grew rapidly,
reflecting high petroleum and natural gas prices and the
reconstruction of the Gulf of Mexico capacity. Investment continued
to fall, however, in air transportation structures and medical
buildings.
Business investment growth is projected to remain strong in 2007,
somewhere in the neighborhood of the 9 percent annual rate of growth
during the first three quarters of 2006. Continued growth in output
combined with a tight labor market are expected to maintain strong
demand for new capital equipment at the same time as corporations
are flush with funds for these investments. The financial environment
for these investments is favorable. Cash flow (the internally
generated funds that are available for corporate investment) was at
a record 10.3 percent average share of GDP in the first three
quarters of 2006, while nonresidential investment (at 10.5 percent
of GDP) was close to its historical average. In the longer run,
business investment is projected to grow only slightly above the
growth rate of real GDP.

Business Inventories
Inventory investment was fairly steady during 2006, and had only a
minor influence on quarter-to-quarter fluctuations. Real nonfarm
inventories grew at an average $44 billion annual pace during 2006,
a 3.0 percent rate of growth that is roughly in line with the pace
of real GDP growth over the same period. Coming off a long-term
decline, the inventory-to-sales ratio for manufacturing and trade
(in current dollars) remained relatively flat during the first half
of the year, but began to pick up in August.
Inventory investment is projected to be approximately stable during
the next several years, as is generally the case for periods of
stable growth. The overall inventory-to-sales ratio is expected to
continue trending lower.

Government Purchases
Real Federal consumption and gross investment grew 2.4 percent
during 2006. This was the third consecutive year of growth at
roughly 2 percent. Defense spending accounted for all of the increase
during the four-quarter period, while nondefense purchases fell. The
quarterly pattern of these Federal purchases has been volatile with
sizeable increases in the first and fourth quarters of the year.
Most of the first-quarter surge was in defense components.
Federal outlays (which include purchases, investment, and transfers
such as Social Security) were boosted by a $111 billion appropriation
in fiscal year

(FY) 2006 for reconstruction and relief efforts arising from the 2005
hurricanes. In addition, the supplemental defense spending package
for on-going operations in Afghanistan and Iraq was $70 billion for
FY 2006 and was passed in mid-June. An additional $70 billion
emergency funding was provided in the regular defense appropriation
act passed at the end of September 2006. Another supplemental
appropriation for defense is likely for FY 2007.
Nominal Federal revenues grew 15 percent in FY 2005 and 12 percent
in FY 2006. These rapid growth rates exceeded growth in outlays and
GDP as a whole, and the U.S. fiscal deficit as a share of GDP shrank
from 3.6 percent in FY 2004 to 2.6 percent in FY 2005 to 1.9 percent
in FY 2006.
State and local government purchases rose 3 percent during 2006, up
noticeably from rates below 1 percent during each of the 3 previous
years. In the wake of the 2001 recession, this sector fell sharply
into deficit in 2002. Revenues began to recover in 2003, and by the
first half of 2006 the sector was out of deficit, allowing for an
increase in state and local consumption and investment. This pattern
of delayed response to downturns resembles the past several
business-cycle recoveries.

Exports and Imports
Real exports of goods and services grew 9.2 percent during 2006, up
from the 6.7 percent export growth over the four quarters of 2005.
This accelera-tion reflects rapid growth among our trading partners.
Real GDP among our OECD trading partners grew 2.9 percent during the
four quarters of 2005, and is estimated to have grown at the same
pace in 2006. In addition, the economies of some of our major
non-OECD trading partners such as China, Singapore, and India are
growing at rates of 7 to 10 percent per year, although these
countries comprise only about 7 percent of our exports.
The fastest growth in U.S. goods and services exports was to India,
but exports to China, Africa, and Latin America also grew rapidly.
Despite the rapid export growth to these emerging economies, the
European Union (EU) remains the major export destination, consuming
nearly 25 percent of our exports. Within the EU, Great Britain's
imports of American goods and services grew at a notable 18 percent
annual rate during the first three quarters of 2006.
Real imports grew 3.1 percent in 2006, a slower pace than the 5.2
percent increase over the four quarters of 2005. Petroleum imports,
which grew strongly in the fourth quarter of 2005 to replace
production losses after the hurricanes, declined 10 percent during
the four quarters of 2006. Real imports of nonpetroleum goods grew
5.3 percent over the same period, down slightly from the year-earlier
pace.

The current account deficit (the excess of imports and income flows
to foreigners over exports and foreign income of Americans) jumped
to 7.0 percent of GDP in the fourth quarter of 2005, partly due to
petroleum imports that replaced lost Gulf of Mexico production. The
current account deficit then retraced some of its earlier increase in
the first three quarters of 2006, when oil imports declined. It
appears to have fallen further in the fourth quarter, reflecting the
drop in prices of imported crude oil. Current account deficits mean
that domestic investment continues to exceed domestic saving, with
foreigners financing the gap between the two.

Employment
Nonfarm payroll employment increased 2.2 million during the 12
months of 2006, an average pace of about 187,000 jobs per month. The
unemployment rate declined by 0.4 percentage point during the 12
months of the year to 4.5 percent. The average unemployment rate in
2006 (4.6 percent) was below the averages of the 1970s, the 1980s,
and the 1990s.
Job gains were spread broadly across major sectors in 2006, with
the natural resource and mining sector (which includes oil and
natural gas extraction) experiencing the fastest growth rate
(8.1 percent), likely due to increased demand for energy products.
The service-providing sector accounted for 95 percent of job growth
during the 12 months of 2006, a slightly larger contribution than
would be suggested by its 83-percent share of overall employment.
Within the service-providing sector, 24 percent of job growth was in
professional and business service jobs. As noted, the service-
providing sector accounted for almost all of the 2006 job gains.
The goods-producing sector accounted for the remaining 5 percent of
the gains (notably weaker than its 17-percent share of overall
employment), a continuation of the long-term trend under which the
goods-producing share of total employment has fallen in each of the
past five decades. Within the goods-producing sector, employment
growth during 2006 was concentrated in mining and construction,
while manufacturing employment decreased for the ninth consecutive
year.
Jobless rates fell among most major demographic segments of the
population during the 12 months of 2006. The unemployment rate
dropped for each of the four educational-attainment groups (less
than high school, high school, some college, and college graduates).
For the second consecutive year, the drop in the unemployment rate
was most pronounced among those without a high school degree. After
falling 0.8 percentage point during 2005 (when the overall rate fell
0.5 percentage point), the jobless rate in this group fell another
0.7 percentage point during the 12 months of 2006 (when the overall
unemployment rate fell 0.4 percentage point). By race and ethnicity,
the unemployment rate fell the most during 2006 among Asians,
Hispanics and blacks (1.4, 1.1 and 0.9 percentage points), in
contrast to 0.2 percentage point for whites. By age, the jobless rate
fell most among workers 25 to 34 years old. By sex, the jobless rate
fell more among adult women than adult men.
Furthermore, the median duration of unemployment, an indicator that
typically follows the business cycle with a substantial lag, declined
from its December 2005 level of 8.5 weeks to a December 2006 level
of 7.3 weeks, close to its historical average. The number of
long-term unemployed (those out of work for more than 26 weeks)
fell by 263,000 during the year.
The Administration projects that employment will increase at a pace
of 129,000 jobs per month on average during the four quarters of
2007. In the long run the pace of employment growth will slow,
reflecting the aging of the population and the diminishing rates of
labor force growth. The Administration also projects the unemployment
rate will average 4.6 percent over 2007, before edging up to 4.8
percent in 2008 and beyond.

Productivity
Labor productivity growth usually increases during the early stage
of a business-cycle recovery but then falls somewhat as the cycle
matures. Early in this most recent expansion, productivity grew at a
remarkable 3.9 percent annual rate for the years 2002 and 2003 and
then slowed to a 2.6 percent annual rate for the years 2004 and 2005.
Overall productivity has grown at a vigorous 3.1 percent annual rate
from the business-cycle peak in the first quarter of 2001 until the
third quarter of 2006.
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 3.1
percent annual rate of growth during 2001 to 2006 is striking,
especially given a flat or diminished contribution from capital
deepening (the increase in capital services per hour worked). (The
time periods referred to are those shown in Table 1-2 later in this
chapter.) The 1995-2001 acceleration may be plausibly accounted for
by a pickup in capital deepening 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
does not explain any of the post-2001 increase in productivity growth.
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 business practices. (See Chapter 2, Productivity Growth for an
extended discussion of this.)
Rather than assuming 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 that the 3.1-percent
pace of productivity growth since 2001. Productivity growth is
projected to average
2.6 percent per year during the 6-year span of the budget projection-
roughly equal to the average annual pace during the past decade.

Prices and Wages
As measured by the consumer price index (CPI), overall inflation
fell from 3.4 percent during the 12 months of 2005 to 2.5 percent
during 2006 (Chart 1-3). The drop in overall CPI inflation was almost
entirely due to the deceleration of energy prices from a 17.1-percent
increase in 2005 to a 2.9 percent increase in 2006. Food prices
increased 2.1 percent during 2006, similar to the pace of the
previous year. Core CPI prices (that is, excluding food and energy)
increased 2.6 percent during 2006, up from a 2.2-percent increase a
year earlier.



After rising sharply during 2004 and 2005, prices of petroleum
products slowed to a 6.1 percent increase during the 12 months of
2006, as the sharp rise through August was reversed later in the year.
Prices of natural gas, which had risen sharply during 2005, fell 14
percent during 2006. As of mid-January 2007, prices in futures markets
suggested that crude oil prices will rise modestly during 2007, while
natural gas prices will increase substantially.
The 0.4 percentage point acceleration of core CPI prices was
accounted for primarily by rent of shelter (which consists primarily
of rent paid by renters and by the rent on owner-occupied dwellings),
which accelerated to a 4.3 percent rate of increase during the 12
months of 2006 from 2.7 percent in 2005. Some of the acceleration in
core CPI prices may also have been a delayed reaction to the rapid
increase in energy prices from mid-2003 to mid-2006, as the higher
energy prices were absorbed into the prices of every service and
commodity that requires inputs of energy or transportation.
Econometric estimates (although imprecise) suggest that perhaps a
quarter of a percentage point of the increases in the core CPI during
the past year may be attribut-able to the past increases of these
energy inputs. The Administration projects that the CPI will increase
at a 2.6 percent annual rate during 2007 and 2008, about the same as
the 2006 pace of the core CPI.
Hourly compensation (which is about 61 percent of nonfarm business
output) has increased a bit faster in 2006 than in 2005. Nominal
hourly compensation for workers in private industry increased 3.2
percent in 2006, up from 2.9 percent during the 12 months of 2005
according to the Employment Cost Index (ECI). All of this increase
was from growth in wages and salaries (3.2 percent in 2006 versus 2.5
percent during 2005) while hourly benefits grew more slowly
(3.1 percent versus 4.0 percent).
Another measure of hourly compensation published by the Department
of Labor and derived from the National Income and Product Accounts
has increased somewhat faster (at 4.3 percent) than the 3 percent
increase in the ECI during the four quarters through the third
quarter of 2006.
Unit labor costs have put little-if any-upward pressure on inflation
thus far, and it appears unlikely that they will over the next year.
Unit labor costs have increased at the same pace as the GDP price
index, a 2.9 percent rate during the four quarters through the third
quarter of 2006. The Administration expects the growth rate of
hourly compensation to increase during 2007, as this nation's rapid
productivity gains are shared by workers. But even with this
acceleration in compensation, the expected strong pace of
productivity growth will likely keep unit labor costs from putting
upward pressure on inflation during 2007.
Moderate growth of hourly compensation and solid growth of
productivity together with strong aggregate demand has driven the
profit share of gross domestic income to its highest level since
1966.
Non-supervisory production-worker wages (which cover 82 percent
of the private workforce) increased 4.2 percent (in nominal terms)
during the 12 months through December 2006-an acceleration of 1.1
percentage points from the pace a year earlier. Real hourly wages of
production workers increased 1.7 percent, a 2.1-percentage point
acceleration from the pace a year earlier. The acceleration in real
earnings reflects both the 1.1-percentage point increase in nominal
wages and a 1 percentage point deceleration in consumer prices.
Among the many available measures of inflation, the Administration
forecast focuses on two: the CPI and the price index for the GDP.
The CPI measures prices for a fixed basket of consumer goods and
services. It is widely reported in the press, and is used to index
Social Security, the individual income tax, Federal pensions, and
many private-sector contracts. The GDP price index covers prices of
goods and services produced in the United States including
consumption, investment, and government purchases. In contrast to
the CPI, its weights are not fixed but move to reflect changes in
spending patterns. Of the two indexes, the CPI tends to increase more
rapidly in part because it measures a fixed basket of goods; the GDP
price index increases less rapidly because it allows for households
and businesses to shift their purchases away from items with
increasing relative prices and toward items with decreasing relative
prices. Among the differences, the GDP price index (which includes
investment goods) places a larger weight on computers, which tend to
decline in price (on a quality-adjusted basis). In contrast, the CPI
places a much larger weight on rent and energy.
The ``wedge,'' or difference between the CPI and the GDP measures
of inflation, has implications for Federal budget projections. A
larger wedge (with the CPI rising faster than the GDP price index)
raises the Federal budget deficit because Social Security and Federal
pensions 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 the
brackets at which higher income tax rates apply and affect other
inflation-indexed features of the tax code.
During the 25 years from 1981 to 2005, 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 0.32 percent per year. The wedge was particularly high
during 2005 when the CPI increased 0.6 percentage point faster than
the GDP price index. The wedge during 2005 reflected the 35 percent
increase in crude oil prices, which have a larger weight in consumer
prices (via their effect on refined-petroleum products) than in GDP
as a whole. Because 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. This effect unwound
during the fourth quarter of 2006 when oil prices declined, causing
the wedge to fall to -0.6 percentage point during the four quarters
of 2006. From 2008 forward, the wedge is projected to average 0.3
percentage point.


Financial Markets
The Wilshire 5000 (a broad stock market index) increased 13.9
percent during 2006, while the Standard and Poor 500 (an index of
the 500 largest corporations) increased 13.6 percent. This was the
fourth consecutive year of stock market gains following 3 years of
declines. The market has now recov-ered most of its losses since the
March 2000 peak, at least in nominal terms.
Despite increases in short-term rates, yields on 10-year notes
remained low, increasing only 9 basis points during the 12 months of
2006. The low level of long-term interest rates was due in part to
low and stable long-run inflation expectations.
The Administration forecast of short term interest rates is roughly
based on financial market data as well as a survey of economic
forecasters. As of November 13, 2006, the date that the economic
forecast was finalized, trading in financial futures suggested that
market participants expected short-term rates to fall over the next
several years, and the Administrationï¿½s interest rate projections
reflect those views. The Administration projects the rate on 91-day
Treasury bills (5.1 percent on November 13 ) to remain flat in 2007
before edging down in 2008 and 2009. The short-term rate is projected
to fall to 4.1 percent by 2012. At that level, the real rate on
91-day Treasury bills would be close to its historical average.
The yield on 10-year Treasury notes on November 13 was 4.61 percent,
48 basis points below the discount rate on the 91-day Treasury
bills-a noticeable reversal of the usual pattern which shows higher
rates for long-term yields. The Administration expects the 10-year
rate to increase above the 91-day rate during 2007, eventually
reaching a more normal spread of about 1.2 percentage points by 2010.
An increase of a similar magnitude appears to be expected by market
participants (as evidenced by higher rates on 20- and 30-year Treasury
notes than on notes with 10-year maturities). As a result, yields on
10-year notes are expected to increase somewhat further, reaching a
plateau at 5.3 percent from 2010 onward.

The Long-Term Outlook Through 2012
Coming off a fifth year of expansion, the U.S. economy is settling
into a period of steady growth. Having reached a high level of
resource utilization by year-end 2006, growth is likely to slow in
2007 and then will expand through 2012 at around 3.0 percent.
Inflation will remain low and is expected to edge a bit lower, 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 sound basis
for the Administration's budget projections.





Growth in GDP over the Long Term
The Administration projects that, following a slight pickup of growth
from 2007 to 2008, real GDP will increase at a slowly diminishing
rate from 2008 through 2012. Indeed, real GDP is projected to
decelerate from a 3.1 percent rate of growth during the four quarters
of 2008 to 2.9 percent by 2012. The average growth rate during this
interval is roughly in line with the consensus of private forecasters
for those years. After 2007, the year-by-year pace is close to the
estimated growth rate of potential real GDP, a measure of the rate of
growth of productive capacity. (An economy is said to be growing at
its potential rate when all of its resources are utilized and
inflation is stable. The supply-side components of potential GDP
growth are presented in Table 1-2 and are discussed below). The
unemployment rate is projected to edge up in 2007 (from its 4.5
percent level in the fourth quarter of 2006) and to plateau at 4.8
percent in 2008. As discussed below, potential GDP growth is expected
to slow in the near term as productivity growth reverts toward its
long-run trend (about 2.6 percent per year), and to slow further
during the 2007-to-2011 period as labor force growth declines due to
the retirement of the baby-boom generation.
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 length of the workweek, and labor productivity. 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. The high rate
of productivity growth
(3.1 percent at an annual rate, shown in line 10) has been partially
offset by the decline in the participation rate (line 2) and the
workweek (line 8). Also notable is the large and puzzling 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 jobs) relative to the more rapid growth of employment as
measured by the household survey (which estimates the number of
employed persons through a sample of households). This disparity
has been reduced somewhat by the just-issued benchmark revision to
payroll employment, but has yet to be satisfactorily explained.
The participation rate fell, on net, from 2001 to 2006 (although
it ticked up in 2006), and is projected to trend lower through 2012.
The recent behavior stands in contrast to the long period of increase
from 1960 through 1996. Looking ahead, the participation rate is
projected to decline, reflecting the aging of the baby-boom cohorts,
leading to more retirements and a likely increase in the share of
people on disability pensions (see Box 1-2).
----------------------------------------------------------------------
Box 1-2: Long-Term Prospects for Labor Force Participation
The overall rate of labor force participation is projected to
decline as the baby-boom cohorts advance into age brackets with much
lower participation rates. Participation in the labor force (by
working or by looking for a job) declines as people age through their
50s and 60s, as can be seen in the following chart.



This chart shows the estimated average lifetime age-participation
profile for the 13 cohorts born from 1928 to 1940. Men's
participation is high (exceeding 90 percent) from age 24 through age
50, but then declines thereafter, dropping to 83 percent by age 55
and 36 percent by age 65. The rate of labor force exit is particularly
rapid around 62, the age at which one becomes eligible for early
Social Security retirement benefits. In fact, about 40 percent of
those eligible elect to begin collecting Social Security annuities
at age 62, although this does not necessarily mean that they exit
the workforce.
The difference between the age-participation profile of this 1946
cohort (the dotted lines) and those of its elders illustrates how
participation rates have evolved over time. Female participation
rates have moved sharply upward-in a roughly parallel shift. In
contrast, male participation rates have changed little over time,
moving down only slightly.
The current age distribution of the U.S. population is shown by the
bars in the following chart, and the black line shows an estimate of
the age distribution of the population in 2012. The large baby-boom
cohorts (who were born between 1946 and 1964) are now 42 to 60 years
old, and their aging will shift a sizeable fraction of the population
into age brackets with lower participation rates, thus decreasing
the share of the population in the high-participation ages.



----------------------------------------------------------------------
----------------------------------------------------------------------
An extrapolation that moves the participation rate of each cohort
along a path that parallels the 1928-1940 reference cohort and
projects how the aging of the population translates into participation
rates suggests an average participation rate decline of roughly 0.3
percent per year. A decline of this magnitude would alter a wide
range of labor-market behaviors. In response to the emerging shortage
of experienced workers, real wages are likely to increase and
workweeks are likely to lengthen. Labor productivity is likely to
increase as employers invest in labor-saving capital. And more
immigrants may enter the U.S. labor force. The largest effect of the
baby-boom retirements, however, is likely to be an endogenous effect
on the labor force participation rate itself as developments in pay
and pension arrangements evolve to induce higher participation rates
among experienced workers than our extrapolation would suggest.
----------------------------------------------------------------------
The Composition of Income over the Long Term
The Administrationï¿½s economic forecast is used to estimate future
government revenues, a purpose that requires a projection of the
components of taxable income. The income-side projection is based on
the historical stability of labor compensation as a share of gross
domestic income (GDI). During the first half of 2006, the labor
compensation share of GDI was 56.7 percent (according to the
preliminary data available when the projection was finalized),
slightly below its 1963ï¿½2005 average of 58.1 percent. From this
jump-off point, the labor share is projected to slowly rise to 57.8
percent by 2012.
The labor compensation share of GDI consists of wages and salaries
(which are taxable), non-wage compensation (employer contributions to
employee pension and insurance funds-which are not taxable), and
employer contributions for social insurance (which are not taxable).
The Administration forecasts that the wage and salary share of
compensation will be approximately flat between 2007 and 2012.
Employer contributions to defined-benefit pension plans rose by
almost 1 percentage point of total compensation between 2001 and
2002, boosting the growth of non-wage compensation. Contributions
leveled off and then edged lower in subsequent years.
The capital share of GDI is expected to edge down from its currently
high level before eventually reaching its historical average in 2012.
Within the capital share, private depreciation is expected to
increase (as a result of the strong growth of investment during the
past 3 years). Profits during the first three quarters of 2006 were
about 12.2 percent of GDI, well above their post-1959 average of
roughly 9 percent. Book profits (also known in the national income
accounts as profits before tax) are expected to decline as a share
of GDI.
The GDI share of other taxable income (rent, dividends,
proprietor's income, and personal interest income) is projected to
edge up slightly over the next 2 years.


Conclusion
With the rapid-growth period of the expansion fading into the past,
the economy is currently going through a period of rebalancing, where
higher growth of nonresidential investment and exports are offsetting
the lower rates of housing investment. The economy is projected to
settle into a steady state in which real GDP grows at about 3 percent
per year, the unemployment rate creeps up towards a noninflationary
level (of 4.8 percent) and inflation remains moderate and stable
(about 2.2 to 2.6 percent on the CPI). Consumer spending is projected
to grow in line with disposable income, and business investment and
exports are projected to grow a bit faster than GDP as a whole.
Economic forecasts are subject to error, and unforeseen positive and
negative developments will affect the course of the economy over the
next several years. Given the economyï¿½s fundamental strengths,
however, prospects for continued growth in the years ahead remain
good. Nonetheless, much work remains in making our economy as
productive as possible. Later chapters of this Report explore how
pro-growth policies such as tax reform, fiscal restraint, open
commerce, and enhancing our energy security can enhance our economic
performance.