[Economic Report of the President (2008)]
[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 a sixth consecutive
year in 2007.  Economic growth was solid at 2.5 percent during the four
quarters of the year, slightly below the pace during 2006. Payroll job
growth set a record for continuous growth, eclipsing the previous
record of 48 months. This economic growth came despite a reorientation
of the U.S. economy away from housing investment and toward exports and
investment in business structures. The persistent tumble in housing
investment subtracted roughly a percentage point from real Gross
Domestic Product (GDP) growth during the four quarters of the year.
Although the quarterly pattern of real GDP was uneven, with strong
growth in the second and third quarters and weak growth in the first
and fourth quarters, much of the quarter-to-quarter variation can be
attributed to net exports, a volatile component of GDP. In the wake of
mounting problems with the performance of subprime (defined as higher
risk) mortgages, financial markets from August onward were unsettled
because of concerns about the risk entailed in holding some types of
mortgage-backed securities, as well as fears about the financial
health of some firms and the possibility of contagion to the
nonfinancial economy. To insure against the downside risks from these
financial and housing-related developments, the President called for an
economic growth package to boost consumption, business investment, and
labor demand.

The core CPI (consumer prices excluding food and energy) as well as
the price index for GDP (covering everything produced in the United
States) suggested that inflation had moved lower and into the moderate
range by the end of 2007. Food price inflation climbed, however, while
energy prices jumped toward the end of the year. In response to these
output and inflation developments, the Federal Reserve held the Federal
funds rate flat through August. The Federal Reserve then lowered its
policy rate by a percentage point from September through December and
another 11/4 percentage point in January to ease liquidity concerns in
financial markets disturbed by the mortgage market tumble, and to
bolster real activity. The Federal Reserve also took other
liquidity-enhancing measures, including cutting the discount rate at
which it lends to banks, and initiating a new auction approach to
provide collateralized loans to banks.

This chapter reviews the economic developments of 2007 and discusses
the Administration's forecast for the years ahead. The key points of
this chapter are:

 Real GDP posted solid 2.5 percent growth during the four
quarters of 2007, similar to the pace of a year earlier. The
reorientation of aggregate demand that began in 2006 continued in
2007. Compared with the preceding years of the expansion, this
reorientation included more growth from exports and business fixed
investment, while residential investment flipped from contributing
positively to GDP growth from 2003 to 2005 to subtracting from it in
2006 and 2007.

 Labor markets were tight in the first half of 2007 with job
growth averaging 107,000 per month and the jobless rate at 4.5 percent.
Labor market conditions slackened somewhat in the second half, with job
growth slowing to 82,000 per month and the unemployment rate edging up
to 4.7 percent in the third quarter and to 5.0 percent by December.
Energy prices, which tend to be volatile, dominated the
movement of overall inflation in the consumer price index (CPI), with
large increases toward the end of the year. Core consumer inflation
(which excludes food and energy inflation) moved down from 2.6 percent
during the 12 months of 2006 to 2.4 percent in 2007. Food prices rose
appreciably faster than core prices.

Nominal wage gains of 3.7 percent for production workers were
offset by the unexpected rise in energy prices. These nominal gains,
however, exceeded measures of expected price inflation such as those
from the market for the Department of Treasury's inflation-protected
securities, about 2.2 percent. As a consequence, the pace of nominal
wage increases implies an expectation of real wage gains during the
next several years.  In the long run, real wages tend to increase with
labor productivity.

The Administration's forecast calls for the economic expansion
to continue in 2008, but at a slower pace than in the earlier years of
this expansion. Slower growth is anticipated for the first half of the
year, and the average unemployment rate for 2008 is projected to move
up from the 2007 level. In 2009 and 2010 real GDP growth is projected
at 3 percent, thereafter slowing, while the unemployment rate is
projected to remain stable and below 5 percent in the 2009-10 period.

The contraction of the secondary market for some mortgage
securities and the ensuing write-downs at major financial
intermediaries are a new downside risk to this expansion. As of the end
of 2007, however, these developments had not greatly affected the
nonfinancial economy outside of the housing sector (which had already
been in decline for a year or so before the onset of the mortgage
financing problems).

To insure against the downside risks from these new financial
developments, the President proposed tax relief and changes to
depreciation schedules that reduce the cost of business investment. The
policy changes are expected to boost real GDP growth and job creation.

Developments in 2007 and the
Near-Term Outlook

The economy went through a period of rebalancing that began in 2006 and
extended into 2007, with faster growth in business structures
investment and exports offsetting pronounced declines in homebuilding,
while consumer spending growth edged lower.

Consumer Spending and Saving

Real consumer spending slowed to a 2.5 percent growth rate during the
four quarters of 2007, somewhat below the growth rates during the
preceding 4 years of expansion and below the average rates of the
preceding 30 years. Nominal consumer spending (that is consumer
spending without adjusting for inflation) pulled back from its 16-year
pattern of rising faster than disposable income, and the personal
saving rate for the year as a whole ticked up from 0.4 to 0.5 percent.
Factors that had pushed down the saving rate during recent years
shifted into neutral: the wealth-to-income ratio plateaued and the
unemployment rate (which is related to consumer confidence) stopped
falling. Energy costs rose rapidly, but consumers continued to purchase
similar quantities of energy, which kept the personal saving rate low.
The general decline in the personal saving rate during the past 5 years
(despite the uptick in 2007) continued a long-term trend that began in
the 1980s.

Energy Expenditures

World demand for crude oil increased by 5.5 million barrels per day to
85 million barrels per day between 2003 and the first three quarters of
2007. The United States accounted for only a fraction (0.7 million
barrels per day) of this increase, while demand in other OECD countries
generally fell. (The OECD, or Organization for Economic Cooperation and
Development, comprises 30 key developed economies.) The increase in
non-OECD demand totaled 5.3 million barrels per day, with China's
per-day consumption alone growing by 2.0 million barrels. In the face
of this increase in world oil demand, consumers paid higher prices to
maintain their consumption.

Crude oil prices rose again in 2007. The spot price for West Texas
Intermediate (a benchmark variety of crude oil) rose to an average of
$91 per barrel in the fourth quarter from an average of $66 per barrel
in 2006.
The price of natural gas, which rose sharply in 2005, then fell during 2006,
was little changed on balance in 2007, while electricity prices continued
their upward trend.

With the rise in energy prices, the share of energy in total purchases
rose sharply. From 2003 to 2007, consumer energy prices increased 41
percent relative to non-energy prices, while real consumption of energy
per household fell only 3 percent (according to data from the National
Income and Product Accounts). As a result, energy expenditures, which
were about 5 percent of consumer purchases in 2003, rose to 6 percent
of consumer purchases in 2006 and 2007. Between 2004 and 2006,
consumers appear to have maintained both energy and nonenergy
consumption by reducing their personal saving, which by 2007 (although
up from 2006) averaged only 0.5 percent of disposable personal income.
This continued rapid rise in energy prices suggests that consumers'
adaptation to these prices remains unfinished. Consumers have chosen to
respond to the energy-price shock by using savings to buffer some of
its effects, but this response is probably temporary.

Wealth Effects on Consumption and Saving

Household wealth rose rapidly relative to disposable personal income
from 2002 through the second quarter of 2007, supporting the growth of
consumption and a decline in the saving rate. Over the 2002-07 period,
the ratio of household wealth to annual-income increased 0.7 years, to
5.7 years of accumulated income (that is, consumers collectively
accumulated an extra 70 percent of a years' income). During the late
1990s and again during 2004-06, a strong rise in household net worth
coincided with a sizable increase in consumer spending relative to
disposable personal income (Chart 1-1).



Unlike recent years, however, the 2007 gains did not reflect large
increases in housing wealth (net of mortgage debt), which
peaked-relative to income-in the first half of 2006, and has edged
lower since (see Chart 1-1). The housing price rise of 1.8 percent
during the year that ended with the third quarter of 2007 was a
substantial deceleration from the 11 percent annual rate during the 3
preceding years and was less than the growth of income. Stock-market
wealth rose during the four quarters through the third quarter of 2007
(the most recent wealth data) and accounted for all of the four-quarter
gain. By the third quarter of 2007, the overall wealth-to-income ratio
was well above its 50-year average.

Projected Consumer Spending

Looking ahead, the path of consumer spending is projected to reflect the
recent flattening of the wealth-to-income ratio. Real consumer spending
during the four quarters of 2008 is expected to grow 2.1 percent, down
from an average of about 3 percent during the past 3 years. This
projected rate is less than the projected 2008 growth of real
disposable personal income (household income less taxes, adjusted for
inflation), and so the saving rate is forecasted to continue edging up
in 2008. After that, real consumption is projected to increase at about
the same pace as real GDP and real income.

Housing Prices

Nationally, nominal house price appreciation slowed to a crawl in 2007,
and house prices fell when corrected for inflation. An
inflation-adjusted version of the housing price index (the nominal
version of which is compiled by the Office of Federal Housing
Enterprise Oversight (OFHEO) from home sales and appraisals during
refinancing) increased at an average annual rate of 6.3 percent from
2000 to 2005. It then slowed to 4.0 percent during the four quarters of
2006, and declined at a 3.2 percent annual rate during the first three
quarters of 2007. (These inflation-adjusted prices are deflated by the
consumer price index.) The homes covered by this OFHEO-created housing
price index are those which are financed or refinanced by one of the
government-sponsored housing enterprises and must therefore have
mortgages below the conforming loan limit (currently $417,000). Another
relevant measure of home prices (the S&P/Case-Shiller Index), has
fallen 6.7 percent in real terms during the year that ended with the
third quarter of 2007; this index covers a smaller portion of the
country than the OFHEO measure but is more comprehensive with regard
to homes with large mortgages.

The deceleration of housing prices along with falling standards for
subprime mortgages in 2005 and 2006 has led to a rising delinquency
rate for subprime adjustable-rate mortgages (where the rate on the
mortgages resets after an initial period), which severely disrupted the
secondary market for nonconforming mortgages in 2007. In contrast, the
market for conforming mortgages continued to function well. (Conforming
loans must meet certain loan-to-value and documentation requirements in
addition to being below the conforming loan limit.) See Chapter 2,
"Credit and Housing Markets" for a more extensive analysis.

Residential Investment

Every major measure of housing activity dropped sharply during 2006 and
2007, and the drop in real residential construction was steeper than
anticipated in last year's Report. Housing starts (the initiation of a
homebuilding project), new building permits, and new home sales have
fallen more than 40 percent since their annual peaks in 2005. The drop
in home-construction activity subtracted an average of almost 1
percentage point at an annual rate from real GDP growth during the last
three quarters of 2006 and the four quarters of 2007. Furthermore, even
if housing starts level off at their current pace, lags between the
beginning and completion of a construction project imply that
residential investment will subtract from GDP growth during the first
half of 2008.

During 2007, as in 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 not prevented robust
activity outside of the housing sector. Employment fell in sectors
related to new home construction and housing sales. Despite these
repercussions, overall payroll employment continued to increase, and
real consumer spending continued to move upward through the end of
2007. The unemployment rate, however, increased, by 0.6 percentage
point during the 12 months of the year.

Although residential investment fell sharply, real GDP growth during
2007 was sustained by increases in other forms of investment. As
shown in the chart below, private and public nominal nonresidential
construction (that is, construction of office buildings, shopping
centers, factories, and other business structures) grew rapidly during
the year.

Nonresidential construction draws from some of the same resources
(such as construction labor and materials) as the residential
construction 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 2000ï¿½2005 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. In contrast, gains in
housing wealth came to a virtual halt during 2007.
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 1.8- or 1.9-million
unit annual pace of housing starts that would be consistent with some
demographic models for a decade-long period, leading to an excess
supply of houses on the market. More recently, the 1.2 million unit
pace during the fourth quarter of 2007 is well below this long-term
demographic target. The pace of homebuilding has now been below this
level for long enough that the above-trend production of 2004 and 2005
has been offset by the more recent below-trend production. Yet the
construction of new homes continued to fall rapidly through year-end
2007, with the undershooting possibly reflecting uncertain prospects
for house prices as well as elevated inventories of unsold new and
existing homes. Once prices become firm and inventories return to
normal levels, home construction should rebound, but it is difficult to
pinpoint when this will occur. The residential sector is not expected
to make positive contributions to real GDP growth until 2009.

Business Fixed Investment

During the four quarters of 2007 real business investment in equipment
and software (that is, measured at constant prices) grew 3.7 percent, a
bit faster than the 2006 pace but notably slower than the 8 percent
average pace during the 3 preceding years. Its fastest-growing
components during 2007 included computers, software, and communication
equipment while investment in industrial equipment grew slowly.
Transportation equipment, however, fell substantially due to
environmental regulations (on particulate matter emissions issued in
2000 but effective in 2007) that raised truck prices in 2007 and led
trucking firms to advance heavy truck purchases into 2006 from 2007.

In contrast to residential investment, real business investment in
nonresidential structures grew at a strong 16 percent annual rate over
the four quarters of 2007.  The gains during 2007 were the second
consecutive year of strong growth, which was a marked reversal from the
declines during the period from 2001 to 2005.  Nearly 70 percent of
total growth in nonresidential structures was accounted for by office
buildings, lodging facilities, power facilities, and petroleum and
natural gas exploration and wells. This sector maintained its ability
to borrow funds needed for construction, as net borrowing for
nonfinancial corporate commercial mortgages rose 6.5 percent at an
annual rate during the first three quarters of 2007.

One risk to the near-term investment forecast is that the recent
turmoil in the market for mortgage-backed securities may somehow reduce
the funds available for business investment. Most new investment-at
least for the corporate sector as a whole-is being financed with
internally generated funds for new investment (undistributed profits
plus depreciation, also known as cash flow) which were at normal levels
through the third quarter of 2007. As for the amount that nonfinancial
firms must borrow to finance investment (the financing gap), the flows
showed no shortfall, at least through the third quarter of 2007
(Chart 1-2). A shortage of investment funds, though possible, appears
unlikely. Corporations have been able to finance investment directly
through the bond market without penalty as interest rates on 10-year
high-grade corporate bonds in the second half of 2007 were little
different from the first half of the year. Nevertheless the market for
investment funds merits close attention as yields on lower-grade
corporate bonds have edged up, the number of newly announced
leveraged buyouts have fallen sharply, and the October survey of senior
loan officers reported tighter lending standards for loans to large and
small companies.

Business investment growth is projected to remain solid in 2008,
although probably below the 71/2 percent growth rate during the four
quarters of 2007. Continued growth in output combined with a tight
labor market is expected to maintain strong demand for new capital. In
the longer run, real business investment is projected to grow slightly
above the growth rate of real GDP.



Business Inventories

Inventory investment was volatile during the past year or so and had a
noticeable influence on quarter-to-quarter fluctuations in real GDP,
especially the weakness in the first and fourth quarters and the
strength in the third quarter. Inventories of motor vehicles on dealer
lots and in transit were an important contributor to these fluctuations
as they were liquidated during the first half of 2007, and built up in
the third quarter before being liquidated again in the fourth quarter.
Real nonfarm inventories grew at only an average 0.2 percent annual
pace during 2007, a growth rate that is well below 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) rose in late 2006 before being reduced sharply in 2007.

Manufacturing and trade inventories appear to be roughly in line with
sales as of November 2007 and do not appear to require dramatic swings
in production. Inventory investment is projected to be fairly 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 1.6 percent during
2007, a slowdown from the 2006 pace. Quarterly fluctuations in this
spending category were considerable, with nearly all the volatility due
to the defense component. Defense spending plunged in the first quarter
of 2007 but grew rapidly during the second and third quarters of the
year.

The defense appropriations act for fiscal year (FY) 2007 provided $70
billion for operations in Afghanistan and Iraq. The FY 2007
supplemental appropriation for defense provided an additional $107
billion for ongoing operations in Afghanistan and Iraq. Another $70
billion in emergency funding for FY 2008 was provided in the
consolidated appropriations act. The first continuing resolution for FY
2008 and the defense appropriations act for FY 2008 provided $17
billion for mine-resistant vehicles and other funding for Afghanistan
and Iraq. Another supplemental appropriation for operations in
Afghanistan and Iraq is likely for FY 2008.

Nominal Federal revenues grew 12 percent in FY 2006 and 7 percent in FY
2007. 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 1.9 percent in FY 2006, to 1.2 percent in FY
2007.

Real State and local government purchases rose 3 percent during 2007,
the second consecutive year of moderate growth. This followed 3 years
of little change. In the wake of the 2001 recession, this sector fell
sharply into deficit in 2002. Revenues began to recover in 2003, and
the sector was out of deficit by 2005, allowing for an increase in
state and local consumption and investment in 2006 and 2007. This
pattern of delayed response to downturns resembles the pattern during
the business-cycle recovery of the 1990s.

The State and local government sector slipped into a small deficit over
the first three quarters of 2007 reflecting strong growth in outlays
that were not matched by an increase in revenues. In 2008, only slow
growth can be anticipated for this sector's consumption and gross
investment because of decelerating housing prices and their effects on
property tax receipts-which comprise about 20 percent of this sector's
revenues.

Exports and Imports

Real exports of goods and services grew 8 percent during the four
quarters 2007, the fourth year of annual growth in excess of 7 percent.
The pace of export expansion reflects rapid growth among our trading
partners, expanded domestic production capacity, and changes in the
terms of trade associated with exchange rate trends between 2002 and
2006 that made American goods cheaper relative to those of some other
countries (Chapter 3 analyzes recent export growth in greater detail).
Real GDP among our advanced-economy trading partners (that is, the
other 29 member countries of the OECD) is estimated to have grown at
rates of 3.3 and 2.7 percent during the four quarters of 2006 and 2007,
respectively, after growing at an average pace of 2.4 percent during
the preceding 3 years. In addition, the economies of some of our major
emerging-market trading partners such as China, Singapore, and India
are growing at rates of 8 to 11 percent per year, although these
countries receive only about 8 percent of our exports. The OECD
projects that real GDP among our advanced-economy trading partners
will slow to a still-solid 2.4 percent growth rate during the four
quarters of 2008. The International Monetary Fund projects that real
GDP among the group of emerging market economies will slow to a
still-strong 7.4 percent growth rate for 2008 as a whole.

The fastest growth in U.S. goods and services exports was to India, but
exports to China, Africa, and the Middle East also grew rapidly.
Despite the rapid growth of exports to these emerging economies, the
European Union (EU) remains the major overseas export destination,
consuming over 25 percent of our exports. By country, Canada accounts
for the largest share of U.S. exports, at over 19 percent.

Real imports grew 1.4 percent annual rate during 2007, the slowest pace
since 2001. Real imports of nonpetroleum goods grew 1.2 percent during
2007, also the slowest rate of increase since 2001. Real petroleum
imports have edged up 2.5 percent during 2007, while nominal imports
surged 49 percent due to rising oil prices. The rise in oil prices has
been less of a drag on the U.S. economy than similar rises have been
because it has been offset by the strong growth in foreign economies,
which has boosted U.S. exports. Indeed, the growth in foreign economies
is what has largely induced the multi-year increase in oil prices
(Box 1-2).

Box 1-2: Macroeconomic Effects When Oil Price Increases Are
Induced by Foreign Demand

The cost of imported crude oil increased nearly $40 per barrel from
2003 to 2007, the largest dollar increase on record. Earlier price
increases in 1973, 1979, and 1990 were followed by recessions, a
development that has not occurred during the current episode. What has
happened recently that has allowed the United States to maintain strong
growth in the face of this price surge?

Economic growth outside the United States increased about 2.1
percentage points from the 3.5 percent annual growth rate during the
15 years from 1989 to 2003 to a 5.6 percent annual rate during the 4
years from 2004 to 2007 according to estimates from the International
Monetary Fund. The increase in real GDP growth among our trading
partners probably caused an increase in both the demand for oil and the
price of oil, and also an increase in U.S. exports to our trading
partners. Rapidly growing countries (China, Russia, India, and
Thailand) accounted for much of the increase in oil demand during the 4
years from 2002 to




2006 as shown in the chart. Countries showing the
largest increases in oil consumption tended to be those showing the
largest growth rates during the past 4 years. In addition, U.S. exports
grew rapidly to those countries that have recently signed and
implemented free trade agreements with the United States (as discussed
in Chapter 3).

An increase in real output growth among our trading partners of about
1 percent can be expected to increase our exports by about 1 percent as
well. The cumulative 9 percent higher growth among our trading partners
(2.1 percent for each of 4 years) could thus have generated as much
as $120 billion per year of exports. In comparison, the $40-per-barrel
oil price increase added about $150 billion per year to the Nation's
bill for oil imports (at 3.7 billion barrels of oil per year).



The current account deficit (the excess of imports and income flows to
foreigners over exports and foreign income of Americans) averaged
5.5 percent of GDP during the first three quarters of 2007, down from
its 2006 average of over 6 percent. The decline in the current account
deficit reflects strong export growth and moderate import growth,
although domestic investment continues to exceed domestic saving, with
foreigners financing the gap between the two.

Employment

Nonfarm payroll employment increased by 1.14 million jobs during 2007,
an average pace of about 95,000 jobs per month. The unemployment rate
rose slightly over the same period, ticking up 0.6 percentage point to
5.0 percent. The average unemployment rate in 2007 was 4.6 percent,
equal to the 2006 average. Both the 2007 average and the December 2007
level of the unemployment rate were below the prevailing rates in each
of the three decades of the 1970s, 1980s, and 1990s.

The service-providing sector accounted for all of the year's job gains,
as construction employment fell due to continued weakness in the
housing market and manufacturing employment continued its downtrend for
the tenth consecutive year. (Despite the job losses, manufacturing
output continues to increase because of rapid productivity growth.)
Employment in mining (which includes oil drilling) rose 5.5 percent
during 2007. The goods-producing sector has accounted for a diminishing
share of total employment in each of the past five decades. Education
and health services (which constituted 13 percent of employment at the
end of 2007) added the largest number of jobs, accounting for 47
percent of total job growth.

During the 12 months of 2007, the unemployment rate for the major
education groups edged up; it increased 0.3 percentage point for those
holding at least a bachelor's degree, 0.4 percentage point for those
whose education ended with a high school degree or those with some
college, and 1.0 percentage point among those who did not finish high
school. By race and ethnicity, the unemployment rate for black
Americans rose by 0.7 percentage point, and was about 4 percentage
points above the rate for whites, a smaller margin than during most of
the past 35 years. Unemployment rates among whites rose 0.4 percentage
point, and among Hispanics rose 1.4 percentage points. By sex, the
jobless rate for both adult men and adult women increased 0.5
percentage point to 4.4 percent in December 2007.

The median duration of unemployment edged up from 7.5 to 8.4 weeks
during the 12 months of 2007, following a substantial decline during
the preceding 2 years.  The number of long-term unemployed (those who
are jobless for 15 weeks or more) rose by 426,000 over the same period.
Although this is not a welcome development, increases in unemployment
rates (and implicitly increases in duration as well) were built into
last year's Administration forecast as the low jobless rates at the end
of 2006 were not judged to be sustainable in the long run.

The Administration projects that employment will increase at an average
pace of 109,000 jobs per month during the four quarters of 2008, before
picking up to 129,000 jobs per month in 2009. In the longer run, the
pace of employment growth will slow, reflecting diminishing rates of
labor force growth due to the retirement of the baby-boom generation.
The Administration also projects that the unemployment rate will edge
up from 2007 to 2008 as a whole, before returning to 4.8 percent in
2010, the middle of the range consistent with stable inflation in the
long run.

Productivity

Productivity growth has a standard cyclical pattern. It usually falls
during a recession, grows rapidly during the early stages of a
recovery, but then slows as the recovery matures. The current business
cycle began on an unusual note, with strong productivity growth of 4.6
percent at an annual rate (rather than the usual decline) during the
three quarters of the 2001 recession. After that, the pattern of
productivity followed a more-usual business-cycle pattern with strong
(3.1 percent annual rate) growth during the first 3 years of the
expansion, followed by a slowing to a 13/4 percent annual rate during
the most recent 3-year period. Averaging across the entire 61/2-year
period since the business-cycle peak in the first quarter of 2001,
labor productivity has increased at a 2.7 percent annual rate. This
pace is not significantly different from the pace between 1995 and
2001. As can be seen in Chart 1-3, a trend



line with a 2.6 percent annual rate of growth from 1995 to 2007
captures most of the movement of productivity over this period.

The continuation of this roughly 2.6 percent growth in labor
productivity is striking, given a flat or diminished contribution from
capital deepening (the increase in capital services per hour worked).
The 1995 to 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). After 2001, a reduced rate of capital deepening-on its
own-would have suggested a slowing in the rate of productivity growth.
Productivity growth in the recent period therefore appears to be
supported by factors that are more difficult to measure than the
quantity of capital, such as intangible investments in technology and
business practices.

Productivity growth is projected to average 2.5 percent per year during
the 6-year span of the budget projection (Table 1-2, later in this
chapter), which is about the same as the average annual pace since
1995. The projected growth rate is slightly below the 2.6 percent
annual pace discussed in last year's Report, and reflects the downward
revisions to real GDP and other output measures announced in the annual
revisions to the National Income and Product Accounts in July 2006 and
July 2007.

Prices and Wages

As measured by the consumer price index (CPI), overall inflation rose
from 2.5 percent during the 12 months of 2006 to 4.1 percent during
2007 (Chart 1-4), with the increase due to an acceleration of food and
energy prices. Energy prices accelerated from a 2.9 percent increase in
2006 to a 17.4 percent increase in 2007. Food prices increased 4.9
percent during 2007, up sharply from the 2.1 percent pace of the
previous year. Core CPI prices (that is, excluding food and energy)
increased 2.4 percent during 2007, down from a 2.6 percent increase a
year earlier.

Prices of petroleum products climbed 29.4 percent during 2007 while
natural gas prices fell slightly. Electricity prices increased 5.2
percent, which was less than the rate of increase a year earlier. As of
late-January 2008, futures prices show that market participants expect
crude oil prices to edge down during 2008 from their current high level
while natural gas prices are expected to rise.

The rapid increase in food prices during 2007 reflects worldwide
agricultural supply and demand conditions, such as the drought in
Australia (a major wheat exporter), the demand for corn-based ethanol,
and short-supply



conditions for dairy herds. The supply constraints during
2007 for wheat and dairy products appear temporary and are expected
to return toward normal during 2008.

The 0.2 percentage point deceleration of core CPI prices was accounted for
primarily by rent of shelter, which slowed to a 3.1 percent rate of
increase from a 4.3 percent rate of increase during the 12 months of 2006.
The Administration projects that the CPI will increase 2.1 percent in
2008, slightly less that the 2.4 percent rate of increase of the core CPI
during 2007; energy and food prices are expected to be little changed in
2008 following their recent large increases.

Hourly compensation (which was about 62 percent of nonfarm business
output) has increased at roughly the same 3 percent rate in 2007 as during
the preceding 2 years according to the Employment Cost Index (ECI) for the
private sector. The wage and salary index grew 3.3 percent, little changed
from 3.2 percent a year earlier, while growth of hourly benefits slowed to
2.4 percent. Another measure of hourly compensation from the productivity
and cost dataset increased slightly faster than the ECI.

Unit labor costs (labor compensation per unit of output) 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 grew only 0.7 percent
at an annual rate during the first three quarters of 2007 which is less
than the 2.6 percent growth in the GDP price index during the same
interval.

Average hourly earnings of production or non-supervisory workers (who
constitute about 80 percent of total employment on nonfarm payrolls)
increased 3.7 percent (in nominal terms) during the 12 months through
December 2007-somewhat below the pace a year earlier of 4.3 percent. These
nominal hourly earnings were outstripped by the 4.4 percent increase in
the overall CPI for wage earners, and so real earnings fell 0.7 percent
during 2007 (following a 1.8 percent gain in 2006). Even so, the recent
pace of these nominal wage increases is above various measures of expected
price inflation (such as those implied by the market for inflation-indexed
Treasury securities), and suggests that employers and employees expect a
gain in real earnings in 2008. The situation is similar to a year ago, but
during 2007, price inflation was higher than expected because of sharp and
unanticipated increases in food and energy prices. In the long run, real
hourly compensation increases with productivity growth, which is projected
to remain solid.

Among the many available measures of inflation, the Administration
forecast focuses on two: the consumer price index and the price index for
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 benefits, the individual income tax, Federal pensions, and many
private-sector contracts.  The GDP price index covers prices of all final
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 and services; the GDP price index
increases less rapidly because it reflects the shifting of household and
business purchases away from items with increasing relative prices and
toward items with decreasing relative prices. Additionally, 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),
while 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.

Is rising inflation a problem for the United States? Although the CPI
accelerated to a 4.1 percent rate of increase during 2007, the
acceleration was entirely a result of food and energy price increases that
are not likely to be repeated. Nor do market participants expect it to be
repeated, as is evident from the well-anchored long-run consumer price
inflation expectations in the market for inflation-indexed securities.
Furthermore, most of the price increases for petroleum do not reflect
prices charged by workers or firms in the United States because 65 percent
of petroleum is imported. The GDP price index better captures the prices
that Americans are charging for their labor and services, and it
decelerated to a 2.6 percent increase during 2007 from a year-earlier pace
of 2.7 percent. Prices for business investment-which is not captured in
the CPI-slowed noticeably in 2007. In sum, long run inflation expectations
remain stable, and inflation as measured by the broad-based GDP price
index remained moderate in 2007.

Financial Markets

The Wilshire 5000 (a broad stock market index) increased 3.9 percent
during 2007, while the Standard and Poor 500 (an index of the 500 largest
corporations) increased 3.5 percent. This was the fifth consecutive year
of stock market gains, and it followed 3 years of declines.

Yields on 10-year Treasury notes ended 2006 at 4.6 percent-near the low
end of the historical range-and fell another 46 basis points during 2007.
These yield dropped further in January. The low level of these long-term
interest rates was due in part to low and stable long-run inflation
expectations.

The Administration's forecast of short-term interest rates is roughly
based on financial market data as well as a survey of economic forecasters
at the date that the forecast was developed in mid-November. The near-term
forecast has been overtaken by events as interest rates have fallen
notably since the forecast was finalized. Whatever the starting point,
the Administration projects the rate on 91-day Treasury bills to edge up
gradually to 4.1 percent by 2011 and then remain at that level. At that
level, the real rate (that is, the nominal rate less the rate of
inflation) on 91-day Treasury bills would be close to its historical
average.

The yield on 10-year Treasury notes on November 15 (when the forecast was
finalized) was 4.17 percent. The January decline in this yield means that
this near-term forecast has also been overtaken by events. The
Administration expects the 10-year rate to increase, eventually reaching a
normal spread of about 1.2 percentage points over the 91-day Treasury-bill
rate by 2012. An increase in yield also appears to be expected by market
participants (as evidenced by higher rates on 20-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 2012 onward.

The Long-Term Outlook Through 2013

During the sixth year of expansion in 2007, the composition of demand was
reshuffled, a process that is likely to continue in 2008. The period of
somewhat slower-than-normal growth that began in 2007 is likely to
continue into 2008. Thereafter, the economy is projected to expand at a
roughly steady rate at or just below 3.0 percent. Having reached a level
of resource utilization consistent with stable inflation by the end of
2007, inflation will remain in the low-to-moderate range currently
suggested by core inflation rates. Payroll job growth is expected to
remain solid while the unemployment rate is expected to be little changed
over the projection interval (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
2008 to 2009, real GDP will increase at a slowly diminishing rate from
2009 through 2013, due to the expected retirement of the baby-boom
generation. Indeed, real GDP is projected to decelerate from a 3.0 percent
growth rate during the four quarters of 2009 to 2.8 percent by 2013. The
average growth rate during this interval is roughly in line with the
consensus of private



forecasters for those years. After 2008, 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 be roughly flat in 2008 and 2009 at around its December 2007 level
before edging back down to 4.8 percent thereafter. As discussed below,
potential GDP growth is expected to slow in the medium term as
productivity growth reverts toward its long-run trend (about 2.5 percent
per year), and to slow further during the periodfrom 2008 to 2011 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.

The labor force participation rate generally fell from 2001 to 2007 and
is projected to trend lower through 2013. The recent behavior stands in
contrast to the long period of increase from 1960 through 1996. Looking




Box 1-3: Aging and the Pattern of Labor Force Participation

The overall labor force participation rate trended up to 67.1 percent
in 1997, and after holding steady between 1997 and 2000, has generally
edged lower during the past 7 years. Men's labor force participation rates
fell fairly steadily through 2004. Women's labor force participation rose
steadily through 1999, and has edged lower since then.



Participation in the labor force (by working or by looking for a job)
declines as people age through their 50s and 60s as is shown for women
in the chart below. As a result, the overall rate of labor force
participation is projected to decline as the baby-boom cohorts (those
born between 1946 and 1964) advance into age brackets with much lower
participation
rates.

Female participation rises rapidly from age 20 to 24, drops off during
the child-rearing years, and then rises again to a maximum in the
40 to 50 age bracket, as shown in the chart above. Looking at how the
shape of this age-participation profile has evolved shows some striking
changes: The participation rates of women in their 40s moved upward
rapidly from the cohorts born in 1928 to those born in 1948, but has not
risen any further in the years since. Also, the dip in participation
during the child-rearing years has become less pronounced. Neither of
these patterns of evolution suggests that the pre-1999 trend of rising
female participation will re-emerge. Although participation of women over
age 55 rose dramatically from the cohort born in 1938 to the cohort born
in 1948, the age-participation profile of the cohort born in 1958
suggests that this trend of rising participation of older women is
unlikely to



continue. This follows because the 1958 cohort shows no
advance in participation at age 49 (their age in 2007) compared with
somewhat older cohorts (such as the 1948 or 1953 cohorts shown in the
chart), hinting that the rising participation rates for older women has
plateaued. Also, the drop in participation during the child-rearing years
has almost vanished, leaving only a little room for further increase
among 25- to-35-year-old women.

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 (Box 1-3).


The Composition of Income over the Long Term

The Administration's 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 2007, the labor compensation share
of GDI was 56.9 percent (according to the preliminary data available when
the projection was finalized), below its 1963-2006 average of 58.0
percent. From this jump-off point, the labor share is projected to slowly
return toward its historical average, reaching 57.7 percent by 2013.
(Another definition of the labor share-including the imputed wages of the
self-employed-is higher, about 62 percent for the nonfarm business
sector.) 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 for social insurance (which are
not taxable). The Administration forecasts that the wage and salary
share of compensation will change little between 2007 and 2013.

As the labor share of GDI increases toward its historical average, the
capital share of GDI is expected to edge down from its currently high
level before eventually reaching its historical average in 2012. Profits
during the first half of 2007 were about 11.6 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, proprietors' income, and personal interest income) is projected
to edge up slightly over the next 2 years.

Conclusion

The economy entered a period of rebalancing in 2006 and 2007, as higher
growth of nonresidential investment and exports offset the lower rates of
housing investment. This rebalancing-and the reduced rate of growth that
goes with it-is projected to continue in 2008. The bipartisan economic
growth package called for by the President would provide insurance against
the near-term risks of any broader economic slowdown related to financial
and housing-related developments by providing a boost to consumption,
business investment, and job creation. The economy is projected to settle
into a steady state in which real GDP grows at about 2.9 percent per year,
the unemployment rate stays around the level consistent with stable
inflation (about 4.8 percent) and inflation remains moderate and stable
(about 2.3 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 economy's
strong basic structure, free mobility of labor, relatively low taxes,
well-balanced capital markets, and openness to trade, prospects for
continued growth in the years ahead remain good. Later chapters of this
Report explore how pro-growth policies such as tax reform, fiscal
restraint, open commerce, and market-based reforms can enhance our
economic performance.