[Economic Report of the President (2009)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 1

The Year in Review and the Years Ahead

Following 6 consecutive years of expansion of the U.S economy, the
pace of real GDP expansion slowed in the first half of 2008 and turned
negative in the second half. Payroll jobs began to decline in January,
following a record 52 months of continuous growth. The observed
pattern of output, employment, and other key indicators led the
Business Cycle Dating Committee of the National Bureau of Economic
Research to declare that the economy peaked in December of 2007,
beginning a recession that continued throughout 2008. The
reorientation of the U.S. economy-which had been underway in
2006 and 2007-away from housing investment and consumer spending
and toward exports and investment in business structures continued
through the first three quarters of 2008. However, the reorientation
was neither smooth nor graceful, as falling house prices initiated a
cascade of problems beginning with mortgage delinquencies and falling
prices of mortgage-backed securities. This eventually threatened the
solvency of several major financial institutions and ultimately
resulted in several failures and forced mergers along with a major
decline in the stock market beginning in late September. To respond to
these problems, policy makers have undertaken a wide range of actions
during the year, including: personal tax rebates and bonus
depreciation allowances for business (the Economic Stimulus Act of
2008, enacted in February); support for the housing market (the
Housing and Economic Recovery Act of 2008 in July); large-scale
investment in financial assets (the Emergency Economic Stabilization
Act of 2008 in October); a reduction in the Federal funds rate from
5 1/4 percent in August 2007 to almost zero by December 2008; and
the implementation of a variety of programs by the Treasury, the
Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and
other agencies to provide liquidity to financial institutions and to
mitigate strains impairing the functioning of the overall financial
system.
In the wake of mounting problems with the performance of subprime
(higher risk) mortgages, financial markets became stressed beginning
about August 2007 and became substantially more stressed after mid-
September 2008. After a slight decline in real gross domestic product
(real GDP, the total value of all goods and services produced in the
United States after adjusting for inflation) in the fourth quarter of
2007, policy actions- including the enactment of a fiscal
stimulus program and the initial round of Federal Reserve rate
cuts-helped maintain positive real GDP growth in the first half
of 2008. These actions likely delayed the downturn in output but were
not sufficient to prevent the steep falloff in employment, production,
and aggregate spending that appears to have begun in mid-September.
After the mid-September failure of Lehman Brothers (an investment
bank), the emergency loans to AIG (an insurance company with extensive
involvement in insuring mortgage-related securities), and the takeover
of Washington Mutual (a savings bank with extensive mortgage-related
assets), the global financial markets showed a sharp increase in
perceived risk, and the stock market tumbled.
Inflation figures were mixed, with notable rises through mid-year in
indexes that included food and imported energy products such as the
consumer price index (CPI) and the price index for gross domestic
purchases. A sharp decline in petroleum prices brought these prices
down substantially by the end of the year. In contrast, inflation was
less volatile for the broadest index of the goods and services
produced in the United States (the GDP price index) and for most
measures of wages and hourly compensation.
This chapter reviews the economic developments of 2008 and
discusses the Administration's forecast for the years ahead. The key
points of this chapter are:
 Real GDP likely declined over the four quarters of 2008,
ending a 6-year run of positive growth, as the slow growth in the
first half of the year was eclipsed by what appears to be a sharp
decline in thefourth quarter.
 Financial distress,which first became evident	in
mid-2007 in the market for mortgage-backed securities (MBS),
continued through 2008 and affected a variety of markets. In the
wake of the failure and near- failure of several major financial
institutions in September 2008, financial stresses increased
sharply to levels not seen during the post-World War II era.
 Payroll jobs declined during 2008, having peaked in
December of 2007. Employment losses averaged 82,000-per-month
during the first 8 months of 2008 before accelerating to a 420,000-
per-month pace during the next 3 months. The unemployment rate was
at 5 percent though April-a low rate by historical standards-but
increased to 6.7 percent in November. Initial and continued claims
for unemployment insurance moved up sharply over the course of the
year.
 Energy prices dominated the movement of overall inflation
in the consumer price index (CPI), with large increases through
July, followed by a sharp decline during the latter part of the
year. Core consumer inflation (which excludes food and energy
inflation) edged down from 2.4 percent during the 12 months of
2007 to a 1.9 percent annual rate during the first 11 months of
2008. Food prices rose appreciably faster than core prices.
 Nominal hourly compensation increased 2.8 percent during
the 12 months through September 2008 (according to the employment
cost index), a gain that was undermined by the rise in food and
energy prices, so that real hourly compensation fell 2 percent.
In the long run, real hourly compensation tends to increase with
labor productivity, although the correlation can be very loose
over shorter intervals. Nonfarm business productivity has grown
at an average annual rate of 2.6 percent since the business-cycle
peak in 2001.
 An economic stimulus	package	was proposed by	the President
in January and passed by Congress in February, authorizing about
$113 billion in tax rebate checks to low- and middle-income
taxpayers and allowing 50 percent expensing for business
equipment investment. The stimulus likely boosted GDP growth in
the second and third quarters above what it might have been
otherwise, but its influence faded by the end of the year.
 The Administration's forecast calls for real GDP to
continue to fall in the first half of 2009, with the major
declines projected to be concentrated in the fourth quarter of
2008 and the first quarter of 2009. An active monetary policy and
Treasury's injection of assets into financial institutions are
expected to ease financial stress and to lead to a rebound in the
interest-sensitive sectors of the economy in the second half of
2009. Also supporting growth during 2009 is the substantial recent
drop in petroleum prices, which offsets some of the effects of the
recent decline in household wealth. The unemployment rate is
expected to increase to an average of 7.7 percent for 2009. The
expansion in 2010-11 is projected to be vigorous, bringing
the unemployment rate down to 5 percent by 2012.

Developments in 2008 and the Near-Term Outlook

During the first three quarters of 2008, the economy continued the
rebalancing that began in 2006, with strong growth in business
structures investment and exports offsetting pronounced declines in
homebuilding, while consumer spending edged lower by 0.6 percent at an
annual rate. By the fourth quarter of 2008, however, most major
indicators became sharply negative.

Consumer Spending and Saving
Real consumer spending stagnated in the first half of 2008 and then
fell sharply in the third quarter in what was the largest quarterly
decline since 1980. This was a major deceleration after the 2.8
percent average annual rate during the 2001-07 expansion. During
these three quarters, motor vehicle purchases fell to 12.9 million
units at an annual rate, a drop of 19 percent at an annual rate,
having fluctuated around a 16-17 million unit average annual pace
during the expansion. Energy purchases (which had edged up at a 0.7
percent annual rate) declined at a 9 percent annual rate, finally
reacting to the enormous increase in energy prices (relative to the
price of the overall consumer basket) during the preceding 3 years.
Other consumer spending (that is, outside of motor vehicles and
energy) slowed to only a 1 percent annual rate of growth following a 3
percent average rate of growth during the preceding expansion.
Consumer spending has continued to fall in the fourth quarter. key
factors influencing the evolution of consumer spending during the past
year were the response to the multiyear increase in energy prices, the
February stimulus package (see Box 1-1), and most importantly, the
decline in household wealth during 2008.
-----------------------------------------------------------------

Box 1-1: The Economic Stimulus Act of 2008

Policymakers moved quickly to address the slowing economy early in
the year.  The Federal Reserve cut the target Federal funds rate by
1 1/4 percentage points in January (following 1 percentage point of
earlier cuts from August through December of 2007).  The economic
effects of monetary policy emerge more gradually then those of tax
rebates, and so some fiscal stimulus from rebates was judged to be
useful in supporting the economy in the short term.  The Congress
passed and the President signed the Economic Stimulus Act of 2008
in early February, only a few weeks after the President proposed
it.  The Act was designed to place money in the hands of those
individuals and households who were most likely to spend it.  The
amount to be dispensed was about $113 billion, or about 0.8ï¿½percent
of GDP.  Most of the money was dispensed between late April and
early July, with the bulk of the disbursements ($78 billion) in the
second quarter.
Under this Act, the Treasury mailed checks ranging between $300 and
$600 to taxpayers filing as individuals.  Individuals who earned
$3,000 (the minimum amount under this Act) received a $300 check;
those who earned between $3,000 and $75,000 received a check for up
to $600. The formula phased out the payments at a rate of $50 for
every $1000 of income in excess of $75,000.  (The figures for those
filing as married couples were doubled.)  Social Security and
veterans payments were counted as earned income.  The Act also
included an allowance of $300 for each child (under the age of 17
as of the end of 2007).  Those who did not qualify for payments
based on their 2007 income could qualify based on their 2008
income, with the benefit to be paid in early 2009.
Some academic studies, however, suggest that individuals would
realize that these checks were a one-time event and that they would
choose to spend this windfall over many years.  Other studies
suggest that individuals, especially those who were credit-
constrained, would spend most of the money as it came in.  A
macroeconomic model simulated the expected boost to the profile of
real GDP on the estimate that about 70 percent of the funds would
be considered temporary income (to be spent over a long time) and
the remaining funds would be regarded as immediately spendable.
The profile from that simulation, which also showed the boost from
bonus depreciation (discussed below), is shown in chart 1-1.  The
model simulation suggests a 2 1/4 percentage point boost to the annual
rate of real GDP growth in the second quarter.  Because many of the
rebate checks were delivered late in the second quarter, however,
some of the second-quarter stimulus shown in the chart was
considered likely to spill over into the third quarter.



The Act also authorized businesses to deduct 50 percent of the cost
of investment equipment installed during 2008 from their 2008
taxes, a policy that is often referred to as bonus depreciation.
The Act also expanded the limits for small business expensing, a
policy that was expected to boost real GDP growth by about 0.2
percentage point during 2008. Bonus depreciation is valuable only
to firms with positive profits, however, and so the fourth-quarter
plunge in output will likely reduce the ability of firms to take
advantage of this program.
Whether or not the fiscal stimulus produced the intended effect
cannot be determined from observed macroeconomic data alone because
the path that GDP would have taken without the stimulus remains
unknown.  However, a recent study that examined the nondurable
purchases of a large sample of consumers found that the spending of
individuals rose at the time rebate checks were received.  The
study concluded that the stimulus checks had a significant effect
on purchases and that these effects were more pronounced among low-
income consumers.
--------------------------------------------------------------------

Energy Expenditures

Real energy consumption (that is, adjusted for increases in prices)
increased slightly (4 percent) from 2001 through 2007, despite a
cumulative 66 percent increase in the relative price of energy. The
resulting increase in nominal energy spending through 2007 was not
offset by a decline in nonenergy spending, and was one force that
lowered the personal saving rate during these 6 years. As the relative
price of energy increased another 15 percent during the first three
quarters of 2008, real energy consumption finally fell 7 percent.
Oil prices skyrocketed to a peak monthly average of $134 per barrel
in June for West Texas Intermediate (WTI) (a benchmark grade of crude
oil), almost double the price of a year earlier. The sharp rise in the
price of oil (see Chart 1-1) reflected roughly unchanged world oil
production in the face of rapid global economic growth. More than half
of the increase in world oil demand over the past 5 years is accounted
for by China. Over that period, production increases in Brazil, China,
Canada, the Sudan, and the former Soviet Union were mostly offset by a
large decline in North Sea production and reductions in U.S. and
Mexican production. By December the price of WTI oil had fallen to
about $41 per barrel.
Because the U.S. imports about 3.7 billion barrels of oil per year,
each $10-per-barrel increase adds about $37 billion to the national
oil import bill. However, the economic consequences of the higher oil
import bill during 2003-07 (when the price of WTI crude oil
increased from a $31-per-barrel annual average to a $72-per-barrel
annual average) were partially offset by an increase in demand for our
exports (which grew at an average of 9 percent per year over this
period). This increase in exports was partly a consequence of the same
rise in foreign economic growth that caused the price of oil to
increase. The additional $66-per-barrel increase in the price of oil
from June

[GRAPHIC(S) NOT AVAILABLE IF TIFF FORMAT]

2007 to June 2008 was larger than the entire increase during
the preceding 4 years and added roughly $245 billion to the national
import bill. This rise in cost was reversed by an even larger decline
from June through December, with the price decline attributable to the
drop in energy demand due to a worldwide decline in economic activity.

Wealth Effects on Consumption and Saving

The decline in value for housing wealth and, even more importantly,
stock-market wealth were among the most important influences on
consumer behavior during 2008. Changes in real wealth and real
consumer spending are correlated, as can be seen in Chart 1-2. The
interrelationship between wealth and consumer spending is far from
perfect (at least in part because many other factors influence
spending). The relationship is nevertheless statistically significant
whether or not other related factors such as income and lagged values
are included. Household wealth peaked in the second quarter of 2007,
when it reached a level that was worth 6.3 years of disposable income.
Housing and stock market wealth fell over the next five quarters; by
the end of the third quarter of 2008 (the most recent official data
available), the wealth-to-income ratio had fallen by 1.0 year of
income. The continued stock market declines in October and November,
together with the downward trend in house prices, suggest that the
wealth-to-income ratio dropped a further 0.5 year in the fourth
quarter. As a result, the cumulative decline in the wealth-to-income
ratio now appears to be about 1.5 years of income.
Most of the drop in household wealth is related to the stock market
decline. In dollar terms, household net worth fell about $7 trillion
between the second quarter of 2007 and the third quarter of 2008. Most
of this decline was accounted for by the stock market, while the
erosion of housing wealth was about one-half as large as that of the
stock market. Other components of wealth (a category that includes
consumer durables, credit market instruments, and equity in
nonfinancial business, among others) were roughly unchanged over this
five-quarter period.

Projected Consumer Spending

Consumer spending tends to rise and fall along with wealth (as
illustrated in chart 1-2). A statistical analysis of the relationship
between consumer spending, income, wealth, and other variables
suggests that about 5 percent of wealth is spent every year. If this
is so, the recent decline in the wealth-to-income ratio (of about 1.5
years of income) appears likely to reduce the consumption-to-income
ratio and to raise the saving rate by roughly 7 percentage points over
time. During the three years from 2005 to 2007, the saving rate
averaged 0.5 percent, and so it appears that the saving rate will

[GRAPHIC(S) NOT AVAILABLE IN TIF FORMAT]

probably move up gradually towards 7 percent-barring any sizable
recovery in the stock market. A saving rate at this level would return
the saving rate to the same level as for the 10-year period through
1985 (that is, before the run-up in the stock market in the late
1990s). To get there from the third quarter saving rate of 1.1
percent, however, would require substantially slower growth in
consumer spending than in income. Thus, it seems likely that real
consumer spending will continue to fall during the fourth quarter of
2008 and early in 2009. A rebound in the stock market would, of
course, make this adjustment easier, as the saving rate would not have
to rise by the full 7 percentage points. If a stock market rebound
does not occur, consumption growth will likely remain weak into 2010.

Residential Investment

Residential investment continued into its third year of decline in
2008. Major measures of housing activity moved lower over the course
of the year, with housing starts falling to an average annual rate of
740,000 units during the three months through November, a huge decline
from the 2.1 million unit annual rate at its peak in the first quarter
of 2006. The drop in home construction now appears to have subtracted
an average of 0.75 percentage point from the annual rate of growth of
real GDP, similar to the subtraction during 2006 and 2007.
Housing prices peaked in the second quarter of 2007, as measured by
the purchase-only index published by the Federal Housing Finance
Authority (FHFA, formerly the Office of Federal Housing Enterprise
Oversight). From that peak through the latest available data (the
third quarter of 2008), housing prices have declined 6.5 percent (see
Chart 1-3). According to the S&P/Case-Shiller index, which peaked
earlier (in the second quarter of 2006) and subsequently declined 21
percent, the recent decline, as well as the earlier run-up, is more
accentuated. (See Box 1-2 on the relative merits of the two house
price indexes).
Further declines in home construction seem likely through at least the
first half of 2009, as builders' confidence has fallen to the
lowest level on record and the secondary market for housing-related
securities continues to be thin. The Administration forecasts a steady
uptrend in housing starts during the next 5 years, with the annual
rate of starts gradually increasing so that by 2013 starts would reach
1.8 million units. This reflects, among other factors, a return to
steady income growth, an easing of lending standards, and improved
credit availability. The pace of the expected housing recovery has
some upside risk. The number of unsold new houses has fallen to about
400,000 units, about the level of 2003 and 2004, even though the ratio
of unsold new homes to the current selling pace remains near its
record high. If and when aggregate demand accelerates, housing starts
would easily be pulled upward.



--------------------------------------------------------------------

Box 1-2: Different Measures of House Prices
Both the FHFA purchase-only index and the S&P/Case-Shiller index
have merit and use similar methods, but they cover different types
of mortgages and have different regional coverage.  As a result,
each may have advantages in different contexts.  Both are based on
a methodology of observing pairs of sales of the same house over a
span of years.  The FHFA index is limited to homes purchased with
conforming mortgages (that is, mortgages that conform to the
maximum size and minimum downpayment standards set by Fannie Mae or
Freddie Mac).  In contrast, the S&P/Case-Shiller index collects
data from a sample of homes that includes nonconforming as well as
conforming mortgages.  Each house gets an equal weight in the FHFA
index, while more expensive houses are assigned larger weights in
the S&P/Case-Shiller index.  Of the two indexes, the FHFA index has
the broadest national geographic distribution, while the Case-
Shiller index has no data for 13 States and incomplete data for
another 29 States.
The contrasting path of house prices as measured by these two
indexes during the past decade is informative.  By relying on
conforming mortgages only, the FHFA index may provide a more stable
picture of house prices during a period when the mix of mortgages
changed toward the nonconforming types (subprime and jumbo, for
example) and then back again.  (This may be relevant if the type of
mortgage is correlated with the price of the house.)  On the other
hand, the S&P/Case-Shiller index better illustrates the price path
of all houses regardless of mortgage type and mortgage size.  The
contrast between the two indexes suggests that the runup in housing
prices may have been larger for homes purchased with nonconforming
mortgages and perhaps with jumbo mortgages.  As the share of
nonconforming mortgages fell sharply over the past 2 years, the two
indexes are likely relying on more similar samples in 2008, and as
a result, the recent larger decline in the S&P/Case-Shiller index
may partly reflect a falling back to earth after having been
temporarily elevated by higher prices for homes purchased with
nonconforming mortgages.  One study suggests that the inclusion of
subprime mortgages in the S&P/Case-Shiller index accounts for a
substantial share of the index's deeper decline.  The larger
increase and subsequently larger decline in the S&P/Case-Shiller
index may also reflect larger price movements among more expensive
homes.
--------------------------------------------------------------------
Business Fixed Investment

During the first three quarters of 2008, real business investment in
equipment and software fell 4.4 percent at an annual rate, down from
2.8 percent growth in 2007. Growing categories included software (2.4
percent), communication equipment (5.2 percent), and agricultural
equipment (27 percent), while investment in industrial equipment fell
4.0 percent. Investment in transportation equipment (which includes
motor vehicles and aircraft) was particularly weak, falling 37 percent
at an annual rate through the third quarter, with the sharpest drop
seen in the light trucks category.
In contrast to residential investment, real business investment in
nonresidential structures grew at a strong 12 percent annual rate
through the third quarter of 2008. The gains during 2008 made it the
third consecutive year of strong growth, which was a marked reversal
from the weakness during the period from 2001 to 2005. Nearly 65
percent of total growth in nonresidential structures was accounted for
by manufacturing structures and petroleum and natural gas exploration
and wells.
Access to the credit markets to support investment became more
difficult for nonfinancial corporations during 2008. The flow of new
external funds (credit market instruments such as bond issues,
commercial paper, and bank loans) in the fourth quarter of 2007 was
about $1.9 trillion (the positive bars in Chart 1-4); it then fell by
$1.3 trillion by the third quarter of 2008. Despite this drop in the
flow of external funds, firms were able maintain solid investment by
cutting back on programs to buy stock in their own company (by $700
billion, the negative bars in Chart 1-4) so that the total funds
raised in all capital markets fell only $600 billion (the solid line
in Chart 1-4). These share buyback programs had reached record levels
during the period from 2004 through 2007. However, by the third
quarter of 2008-when the major financial stress
began-share buybacks had diminished to only $410 billion, so
that this `source`` of internal funds had been mostly
exhausted.
Business investment growth is projected to decline in 2009, a
projection that is based partially on the high level of interest rates
on corporate bonds. It is also partially based on the pattern of
business investment reacting to the change in output growth. That is,
following the decline in output in late 2008, investment in 2009 is
likely to fall. Later, the expected acceleration of real GDP in late
2009 and 2010 is expected to result in rapid growth of business
investment. In the longer run, real business investment is projected
to grow at about the same rate as real GDP.



Business Inventories

Inventory investment fell during the first three quarters of 2008 and
had a noticeable influence on quarter-to-quarter fluctuations in real
GDP, subtracting 1 1/2 percentage points from growth in the second
quarter. Inventories of motor vehicles on dealer lots were an
important contributor to these fluctuations as these inventories were
liquidated during the first half of 2008 and were increased slightly
in the third quarter. Inventories of other goods outside of the motor
vehicle sector were liquidated in each of the first three quarters of
the year.
The overall ratio of inventories to sales has come down substantially
since 2001. The inventory-to-sales ratio for manufacturing and trade
(in current dollars) fell in the first half of 2008 before rising
during the 3 months through October. Firms could soon find themselves
with more inventory than they need if (as expected) sales continue to
fall over the next few months. As a consequence, inventories are
likely to be liquidated in the near term. Even so, a drop in inventory
investment is not likely to be as dominant in the current downturn as
it was in most of the post-World War II recessions because of
the fairly lean inventory position relative to sales at the outset of
this recession. In the long term, inventory investment is projected to
be fairly stable, and the overall inventory-to-sales ratio is expected
to continue to trend lower.

Government Purchases

Nominal Federal revenues (that is, in current dollars) fell 2 percent
in fiscal year (FY) 2008, following 7 percent growth in FY 2007. The
decline in revenues can be attributed partly to slowing economic
growth (a key determinant of tax receipts), as well as reduced Federal
tax revenues due to the tax rebate provisions of the Economic Stimulus
Act of 2008. Coupled with declining revenues, a 9 percent increase in
outlays resulted in an increase in the Federal budget deficit to 3.2
percent of GDP in FY 2008, up from 1.2 percent in FY 2007.
Through several appropriations acts, the Congress provided a total of
$192 billion for the wars in Iraq and Afghanistan in FY 2008. One of
these acts, the Supplemental Appropriations Act of 2008, also provided
$68 billion in bridge funding for FY 2009.
Real State and local government purchases rose at a 1.2 percent
annual  rate during the first three quarters of 2008, down from 2.4
percent in 2007. State and local tax revenues slowed in 2008, as
receipts from personal income taxes, sales taxes, and property taxes
decelerated, while corporate tax receipts fell. Notably, property
tax revenue, which had grown at a 6 percent annual rate each year
in 2004, 2005, and 2006, slowed to a 2.6 percent annual rate of
growth through the third quarter of 2008. Over the same period,
receipts from sales taxes edged up only 0.1 percent at an annual rate.
The State and local government sector fell into deficit during 2008,
reaching $109 billion or 0.8 percent of GDP, by the third quarter,
the largest operating deficit on record. On average, State and local
government operating budgets have been in surplus during the
post-World War II period. In 2009 and 2010, only slow
growth-if any-can be anticipated for this sector's
consumption and gross investment. This decline results from the
deterioration in their tax base, as reflected in falling home prices,
declining consumer spending, and slowing growth in personal income.
Property tax receipts and sales tax revenues each represent slightly
more than 20 percent of State and local government revenues: Federal
grants constitute another 20 percent; personal income tax receipts
account for about 15 percent, while corporate tax collections
constitute only 3 percent. A variety of fees, transfers, and incomes
account for the remaining 18 percent.

Exports and Imports

Real exports of goods and services grew at a 7 percent annual rate
during the first three quarters of 2008, following solid growth of at
least 7 percent over the preceding 4 years. The rapid pace of export
expansion over the past 5 years coincided with strong foreign growth
from 2003 to 2007, as well as changes in the terms of trade between
2002 and mid-2008 that made American goods cheaper relative to those
of some other countries. Recently, however, economic growth among our
major trading partners has slowed considerably, with the Euro zone,
Japan, and Canada posting negative growth. Because foreign growth and
U.S. exports are closely related, the global economic slowdown will
likely weigh on U.S. exports in the future.
By region, export growth during 2008 was strongest to Latin
American countries, rising at a 24 percent annual rate through the
third quarter. The European Union (EU) remains the major overseas
destination for U.S. products and services, consuming about 25
percent of our exports. By country, Canada accounts for the largest
share of U.S. exports, at about 16 percent. Mexico purchases 10
percent of our exports; Japan, 6 percent; and China, 5 percent.
Real imports fell at a 3.9 percent annual rate during the first
three quarters of 2008; the last year of decline before that was
2001. The decline in real imports was especially pronounced among
petroleum products, which fell 12 percent at an annual rate, pushed
down by high prices and slowing domestic economic activity over this
period. Due to rapidly rising petroleum prices through the first half
of the year,nominal imports of petroleum products rose at a 46
percent annual rate. Oil prices have since receded dramatically, which will greatly reduce growth in nominal petroleum imports in coming quarters.
Nonpetroleum import prices also increased substantially (6.6 percent
during the four quarters through the third quarter of 2008), which may
also have restrained the level of imports.
The current account deficit (the excess of imports and income flows
to foreigners over exports and foreign income of Americans) averaged
5.0 percent of GDP during the first three quarters of 2008, down from
its 2007 average of over 5.3 percent. The decline in the current
account deficit reflects faster growth in exports relative to imports,
although domestic investment continues to exceed domestic saving, with
foreigners financing the gap between the two.

Employment

The employment situation deteriorated during 2008, mirroring weakness
in other sectors. The pace of job growth appears to have had two
phases: a period of moderate job losses, at an average rate of 82,000
per month from January through August, followed by a steeper decline
at an average rate of 420,000 per month in September, October, and
November. Nonfarm payroll employment fell 1.9 million jobs during the
first 11 months of the year. The unemployment rate rose 1.7 percentage
points over the same period, reaching 6.7 percent. Initial claims for
unemployment insurance rose to an average of about 550,000 per week in
December, up from the 2007 average of 320,000 per week.
Job losses during the first 11 months of 2008 were concentrated in
construction, manufacturing, and temporary help services. Although
manufacturing and construction account for only about 15 percent of
total employment, they accounted for nearly 60 percent of the overall
decline in nonfarm jobs during 2008. Construction employment has been
declining as a result of continued weakness in the housing market, and
manufacturing employment has been on a downward trend as a share of
overall employment for the past five decades. Temporary help services,
which account for only 2 percent of employment, accounted for 21
percent of the year's job losses. Retailing also posted a
notable decline. One bright spot in the employment picture has been
education and health services, which added 505,000 jobs through
November.
Changes in unemployment differed by education level, race, and
gender over the year. Through November, the unemployment rate had
risen for workers of all education levels; it increased 0.9
percentage point for those holding at least a bachelor's degree,
1.8 percentage points for those with some college, 2.1 percentage
points for those whose education ended with a high school degree,
and 2.9 percentage points among those who did not finish high school.
By race and ethnicity, the unemployment rate for African Americans
rose by 2.2 percentage points and was about 5 percentage points
above the rate for Caucasians, a smaller margin than during most of
the past 35 years.The unemployment rate among Caucasians rose 1.7
percentage point,among Hispanics rose 2.3 percentage points, and
among Asian Americans rose 1.1 percentage points. By gender, the
jobless rate for adult men rose 2.1 percentage points to 6.5 percent,
and the rate for adult women rose by 1.1 percentage point to 5.5
percent. The median duration of unemployment increased to 10.0 weeks in November from 8.4 weeks at the end of 2007. The number of long-term
unemployed (those who are jobless for 15 weeks or more) rose by 1.4
million over the same period.
The Administration projects that employment will decline during the
four quarters of 2009, with the job losses likely to be largest early
in the year. As the expected recovery strengthens in 2010, job growth
is anticipated to pick up to 222,000 jobs per month. 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 increase from 2008 to a 7.7 percent annual average in 2009
as a whole, before returning to roughly 5 percent in 2012, the middle
of the range consistent with stable long-run inflation.

Productivity

Nonfarm productivity growth has averaged 2.5 percent at an annual
rate since 1995 (see Chart 1-5). The best estimate of the
productivity growth rate over the next 6 years is 2.4 percent, which
is slightly below the 2.5 percent long-term (that is, post-1995)
rate. Different measures of recent productivity growth are discussed
in Box 1-3. Compared with last year's projection, this
projected rate of growth has been revised down 0.1 percentage point.
The downward revision is a consequence of the downward adjustment
to  output and productivity in the annual revision to the national
income and product accounts.

Prices and Wages

Headline inflation rose and then fell during 2008, although key
indicators of inflation trends were fairly stable. As measured by the
overall consumer price index (CPI), the 12-month rate of inflation
moved up to 5.6 percent for the 12 months through July, up from the
4.1 percent during the 12 months of 2007 (Chart 1-6). The acceleration
was due to increases in food and energy price inflation. By November,
however, the 12-month rate of overall CPI inflation had fallen to 1.1
percent. The 12-month change in the core CPI (which excludes the
volatile food and energy components) fluctuated in a more narrow
range, peaking at 2.5 percent during the third quarter, but edging
down to 2.0 percent by November.



--------------------------------------------------------------------
Box 1-3: Alternate Measures of Productivity Growth
Productivity growth can be projected by extrapolating its behavior
over the recent past. But using which measure? According to the
official index, which measures output from the product-side
(spending) components of GDP, productivity growth picked up
slightly from the 1995-2001 period (2.4 percent) to the 2001-08
period (2.6 percent at an annual rate), as shown in the following
table. In contrast, an alternative measure of nonfarm output,
derived from the income side of the national income and product
accounts, shows a deceleration in productivity between the two
periods to a 2.1 percent annual rate of increase over the period
2001-08.  The income- and product-side measures of GDP differ by
measurement error only, and the truth is likely to be somewhere in
between.  Both measures show a 2.5 percent annual average growth
rate over the entire 1995-2008 interval.
--------------------------------------------------------------------



Energy prices increased rapidly in the second half of 2007 and in
the early part of 2008 before peaking in July, when the 12-month
rate of change reached 29 percent. Among the various energy
products, prices of gasoline and heating oil increased the most
rapidly during this period (reflecting the price of crude oil on
world markets), but prices of electricity and natural gas also moved
up sharply. Energy prices came down sharply during the 4 months
from July to November, when consumer prices of petroleum products
fell 41 percent (not at an annual rate). The rapid decline reflects
the sharp fall in the price of crude oil; prices of West Texas
Intermediate plunged from an average of $134 per barrel in June to
roughly $41 per barrel in December.
Rapidly rising import prices were another factor boosting inflation
early in the year and also holding it down later. Nonpetroleum import
prices rose nearly 8 percent during the twelve months though July,
before falling during the next 4 months. The pattern reflects the
exchange value of the dollar, which depreciated in 2006, 2007, and
during the first 3 months of 2008 before rebounding later in the year.
The effect of import prices appears clear in the contrast between the
rate of inflation for the goods and services that Americans buy and
the rate of inflation for what Americans produce (see Chart 1-7). The
rate of inflation for the goods and services that Americans buy
(measured by the price of gross domestic purchases) moved up from the
year-earlier pace, in contrast to the less volatile rate of inflation
for gross domestic product.



Food prices advanced notably faster than core prices for the second
consecutive year. During the first 10 months of 2008, food prices
increased 6.5 percent at an annual rate following a 5 percent
increase during the 12 months of 2007. The increase was a worldwide
phenomenon and likely reflects several factors, including rapid
growth in developing countries in the first half of 2008, crop
shortages and increased production of biofuels as well as higher
energy prices being passed through to consumers.
Growth in nominal hourly compensation edged down slightly. Private-
sector hourly compensation increased at a 2.6 percent annual rate
during the first 9 months of 2008, down slightly from 3.1 percent
during 2007. Slightly diminished gains in benefits as well as wages
and salaries account for the deceleration. Gains in real hourly wages
of production workers rose 3.4 percent at an annual rate during the
first 11 months of the year, following a 0.7 percent decline during
the 12 months of 2007, when nominal wage gains were undermined by
rapidly rising food and energy prices.
Despite the relative stability of several key measures of inflation
(hourly compensation, the core CPI, and the GDP price index), a
measure of consumers'inflation expectations moved up and down
during the year in a way that suggests that it was influenced by
volatile energy and nonpetroleum import prices. One-year-ahead median
inflation expectations (as measured by the Reuters-University of
Michigan survey) rose from 3.4 percent at the end of 2007 to about 5
percent in midyear, before falling to 1.7 percent in December. Longer-
term inflation expectations were less volatile but also moved up and
then down in a similar fashion in the 2.6 to 3.4 percent range.

Financial Markets

The Wilshire 5000 (a broad stock market index) fell 39 percent
during 2008, and the Standard and Poor (S&P) 500 (an index of the
500 largest corporations) suffered a similar decline. This decline
erased the cumulated increases over the preceding 5 years. The
Wilshire index slipped 16 percent through September 16, but then
tumbled another 40 percent through November 20, before recovering
a bit in late November and December. The S&P index of financial
stocks fell by 57 percent in 2008.
Yields on 10-year Treasury notes ended 2007 at 4.10 percent-at
the low end of the historical range-and fell another 170 or so
basis points during 2008 with much of the decline coming in November
and December. The low level of these long-term interest rates was due
in part to a likely flight to the quality of these secure assets
relative to others in the private and international markets during the
recent market turmoil. Rates also fell toward the end of the year as
market participants revised down the expected path of the Federal
Reserve's target rate.
The Administration's forecast of short-term interest rates
was roughly based on the expected path of Federal funds rates in the
futures market (where participants place ``bets'' on future
rates) as of November 10, the date that the forecast was developed.
The near-term interest rate forecast has been overtaken by more recent
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 3.9 percent
by 2012 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 10 was 3.8 percent.
The decline in this yield during the subsequent month 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. Market participants also appear
to expect an increase in yield as evidenced by the higher-than-
average spread between the rate on 20-year Treasury notes over rates
on notes with 10-year maturities. As a result, yields on 10-year
notes are expected to increase, to 5.1 percent by 2012 and then to
plateau at this rate for the remainder of the forecast.
One measure of increasing financial stress is the premium that
private borrowers have had to pay relative to the rates on 10-year
government notes (see Chart 1-8). This premium began rising around
August of 2007. Rates on the highest-quality corporate bonds have
increased 170 basis points since August 2007. Rates on BAA-rated
corporate borrowers have increased more than 400 basis points, while
rates on high-risk ("junk") bonds have skyrocketed.
Financial stress also became evident in other ways. The rate that
international banks lend to each other (as measured by the London
interbank offered rate, LIBOR) soared to an unprecedented premium over
Treasury rates beginning in September. For 3-month maturities, this
premium that had averaged 114 basis points during the first 8 months
of the year jumped to 273 basis points in the second half of September
and remained high in October and November, but fell to 135 basis
points by year-end. The Federal Reserve's survey of senior loan
officers also shows a tightening of lending standards for all private
borrowers.
One consequence of the rising spreads for corporate debt is that the
sharp drop in the target Federal funds rate (from 5.25 percent in
August 2007 to a range of 0 to 0.25 percent in December 2008) has not
translated into lower rates for corporate borrowers. The rising rates
for corporate bonds and the troubled market for interbank lending
means that two major channels for monetary policy (lower interest
rates to encourage investment and lower rates



to boost consumer spending indirectly by raising the value of fixed
income and equity assets) are not working as they have in the past.
Chapter 2 of this Report discusses financial market developments
in greater detail.
In view of how the stress in financial markets has interfered with
the Federal Reserve's primary policy tool (the Federal funds
rate), the Federal Reserve has responded by developing a range of
programs to provide liquidity to support market functioning, thereby
improving credit conditions for businesses and households. These
include programs to provide liquidity directly to nondepository
financial institutions (such as the Primary Dealer Credit Facility
and the Term Securities Lending Facility) and programs to support
the functioning of particular financial markets (such as the Asset-
backed Commercial Paper Money Market Mutual Fund Liquidity Facility,
the Commercial Paper Funding Facility, and the Term Asset-Backed
Securities Loan Facility). These programs are allowed under section
13-3 of the Federal Reserve Act, which authorizes the Federal Reserve
banks to make secured loans to entities under ``unusual and
exigent circumstances,''provided that these entities are not
able to secure funding from other banking institutions. In addition,
the Federal Reserve has announced programs to buy substantial
quantities of securities, including direct obligations of, and
mortgage-backed securities issued by, the housing-related government
-sponsored enterprises (GSEs). The Federal Reserve has also
indicated that it is evaluating the potential benefits of purchasing
longer-term Treasury securities.

The Long-Term Outlook Through 2014

After 6 years, the expansion ended in December 2007, and real GDP
fell in the second half of 2008. Real consumer spending-a sector that
constitutes two-thirds of GDP-is in the process of reacting to
the substantial declines in wealth that began earlier in the year and
cascaded in the fourth quarter. As a result, the Administration
projects that after recording modest growth in the first half of 2008,
real GDP contracted in the second half, with a sharp decline in the
fourth quarter. The contraction is projected to continue into the
first half of 2009, followed by a recovery in the second half of 2009
that is expected to be led by the interest-sensitive sectors of the
economy. The overall decline, from the second-quarter level of GDP to
the quarter with the lowest real GDP, is projected to slightly exceed
the depth of the average post-World War II recession. This
pattern translates into a small decline during the four quarters of
2008, followed by a small increase during 2009 (see Table 1-1).
Reflecting the drop in real GDP, the unemployment rate is projected to
increase to an annual average rate of 7.7 percent in 2009. The higher-
than-normal level of slack is expected to put some downward pressure
on the rate of inflation. Overall CPI inflation is projected at 1.7
percent in 2009 and 2010, a rate that appears plausible in view of the
2.0 percent change for the core CPI over the 12 months through
November. Payroll employment is projected to fall during 2009 before
rebounding in 2010. The 2009 forecasts for real GDP and inflation are
similar to the consensus forecasts for those variables.
Downturns are eventually followed by recoveries, and historically the
strength of a recovery appears to be loosely correlated with the depth
of the preceding recession (see Chart 1-9). Moreover, the slope of the
regression line in the scatter diagram indicates that-to the
extent that a recession is deeper than the average-most of the
excess depth is offset within the first four quarters of the recovery.
During the 2 years following a recession, real GDP growth has averaged
almost 5 percent, similar to the recovery anticipated in the
Administration forecast for 2010 and 2011. The 5 percent growth rates
in 2010 and 2011 would lower the unemployment rate from its projected
2009 peak to 5 percent, the center of the range consistent with stable
inflation, in 2012.

[GRAPHIC(S) NOT AVAILABLE IN TOFF FORMAT]

Growth in GDP over the Long Term

The Administration forecast is based on a projection that sees the
U.S. economy fluctuating around a long-run potential rate of growth of
2.7 percent. (Potential real GDP growth is a measure of the
sustainable rate of growth of productive capacity.) The path of real
GDP growth in the current downturn and projected recovery fluctuates
around this long-term trend.
Over the next 6 1/4 years, real GDP growth is projected to
increase 2.9 percent (see Table 1-2), a growth rate that is faster
than the 2.7 percent long-term rate because the current level of
the unemployment rate has considerable room to fall before the
economy is again operating at its potential. Real GDP growth in 2013
and 2014, at 2.7 percent, is almost identical to the consensus
projection of long-run growth.
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.
Over the next 6 years, the working-age population (line 1) is
projected to grow 1.0 percent, the rate set in the Census
Bureau's newly revised projection. The labor force participation
rate (line 2), which edged down at a 0.2 percent annual rate during
the past 8 years, is expected to decline even faster (0.3 percent per
year) during the projection period. The further projected deceleration
is a consequence of the aging baby-boom generation (born between 1946
and 1962) entering their retirement years. For example, the 1946 birth
cohort reached the early-retirement age of 62 in 2008. Over long
periods of time the employment rate (defined as 100 less the
unemployment rate) is usually stable, but the elevated jump-off level
of the unemployment rate makes room for some growth in this component
(line 4). The ratio of nonfarm business employment to household
employment (line 6), which has accounted for a puzzling subtraction
from real GDP growth since 2001, is projected to edge down only
slightly (0.1 percent per year) over the projection interval. The
workweek (line 8) is projected to edge up slightly, in contrast to its
general decline over the past 50 years. The slight upward tilt is
projected to be a labor market reaction to buffer labor supply against
the projected falling rates of labor force participation. Productivity
growth (line 10) is projected to grow 2.4 percent, our best estimate
of the trend rate of growth during the recent business cycle
(accounting for some measurement issues, as noted earlier). The ratio
of real GDP to nonfarm business (line 12) is expected to continue to
subtract from overall growth as it has over most long periods.



A Perspective on the Past Eight Years

The past 8 years began with a mild recession and then shifted into a
slow-growth recovery that only gradually gained momentum. Throughout
the first 7 years, consumer spending provided a solid base for
economic growth, and that base was fortified by housing investment. As
residential construction fell in 2006 and 2007, it was replaced by
export growth as a major contributor to overall GDP growth. In 2008,
the combination of falling construction, losses in housing-related
securities, rising oil prices, and a falling stock market eventually
tipped the economy into recession. Inflation as measured by the four-
quarter change in the price index for GDP fluctuated between 1.6 and
3.5 percent, a fairly narrow range in a broad historical context.
The economy showed signs of slowing in 2000: the dot-com bust was
already underway, and GDP growth in the third quarter of 2000 was
negative. In response to the incipient downturn, the Federal Reserve
slashed its target rate early in January 2001. The economy began to
shed jobs steadily in March 2001. The Administration and Congress
responded proactively with EGTRRA (The Economic Growth and Tax Relief
Reconciliation Act of 2001) which delivered about $36 billion of
stimulus checks in 2001 and phased in cuts in marginal tax rates over
several years. The recession of 2001 was particularly severe in
business investment, a demand component that had been particularly
strong in preceding years. Low interest rates during this period
boosted demand for housing and consumer durables, both of which were
substantially stronger than during an average recession. The recession
of 2001 was exacerbated by the terrorist attacks of September 11, and
several widely publicized accounting scandals also contributed to the
economic uncertainty of the time. All told, however, the 2001
recession turned out to be the shallowest of the post-World War
II period (the most that real GDP declined in a single quarter during
the recession was 0.4 percent), with some of the credit attributable
to the quick action of monetary and fiscal policy.
The unemployment rate continued to rise following the official end
of the recession. To address the lagging recovery, the Administration
and Congress instituted JCWAA (the Job Creation and Worker Assistance
Act), which allowed firms to expense 30 percent of their equipment
investment and extended unemployment compensation to laid-off workers,
and JGTRRA (the Jobs and Growth Tax Relief Reconciliation Act), which
boosted the expensing rate on investment to 50 percent and extended
the duration of this provision. JGTRRA also cut the tax rate on
dividends and capital gains. These Acts helped speed up economic
growth soon after their implementation. The relative strength of the
U.S. economy, evident in the demand for imports and in
foreigners'desire to invest in the United States, helped
maintain world demand during this early-recovery period. It also
resulted in a large increase in the U.S. current account deficit.
Late in 2003, the economy shifted from a period of slow recovery
to a period of broad economic expansion, marked by a decline in the
unemployment rate and rapid growth in economic activity. The recovery
was led by robust growth in consumer spending, equipment and software
investment, exports, and residential construction, and coincided with
spectacular house price appreciation. With the benefit of hindsight,
house prices climbed too high. As home prices began to recede
beginning in early 2006, so did the pace of housing starts. Housing
starts continued to decline over the next 2 1/2 years, eventually
reaching an all-time low in November 2008.
During 2006 and 2007, rapid export growth and growth in investment
of nonresidential structures replaced residential investment as the
main drivers of aggregate demand. The economies of our trading
partners, especially those in developing countries, picked up and
boosted the demand for our exports-and also boosted the demand
for petroleum. The rise in petroleum prices, which moved up again
toward the end of 2007, added to the cascade of problems caused by
falling house prices.
Although growth slowed to a crawl in early 2008 and employment edged
down, fiscal stimulus and monetary policy actions held real GDP growth
in generally positive territory through the first half of the year.
The sharp declines in consumer spending in the third quarter and the
stock market drop in September and October finally confirmed that the
decline was a recession.
Until the second half of 2008, the economy was resilient, weathering
many shocks including the 2001 recession, the terrorist attacks of
September 11, some widely publicized accounting scandals, and the 2005
and 2008 hurricanes. The most damaging event was the decline in the
housing market that began in early 2006. Even after the onset of the
housing market decline, however, real GDP growth remained positive
until the fourth quarter of 2007.
The business-cycle expansion lasted 73 months, the fourth longest
post-World War II expansion. The growth rate of real GDP per labor
force participant averaged 1.5 percent at an annual rate from the
business-cycle peak in 2001 to the business-cycle peak in the fourth
quarter of 2007, identical to its average growth over the period from
1953 to 2001.

Conclusion

The economy was weakening as it entered 2008, but was temporarily
sustained at generally positive growth by the 2008 fiscal stimulus
package and monetary policy actions. Consumer spending declined
sharply in the third quarter, and mounting stress in financial markets
reached a crescendo in September, triggering a decline in stock market
wealth that further reduced consumer spending. Because of the large
declines in wealth from September to December, the saving rate is
likely to rise in 2009, which will continue to cause a decline or slow
growth in consumer spending. The large September to December declines
in wealth imply that an upward movement of the saving rate is likely
in 2009, with further constraint on consumer spending as the increase
plays out. The monetary and financial agencies of the Government have
recently been particularly active with the Federal Reserve
implementing a variety of new programs to provide liquidity to
financial institutions and to support the functioning of financial
markets. The Treasury, empowered by the recently passed Emergency
Economic Stabilization Act, has also been active over this period and
has strategically allocated funds to support financial sector solvency
and liquidity (discussed in more detail in Chapter 2). These vigorous
measures are expected to increase confidence in the financial sector
over the next several months, leading to a rebound in output sometime
in 2009.
Beyond the next few years, the economy is projected to settle into a
steady state in which real GDP grows at about 2.7 percent per year,
the unemployment rate stays around the level consistent with stable
inflation (about 5.0 percent) and inflation remains moderate and
stable (about 2.1 percent on the CPI). 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 (that is, free mobility
of labor, relatively low taxes, and openness to trade), prospects
for a resumption of steady growth in the years ahead remain good.
Later chapters of this Report explore how market-based reforms and
pro-growth policies such as tax reform and open commerce can enhance
our economic performance.