January 23, 2007, Ph.D., Vice President of Economic and Tax Policy and Chief Economist, U. S. Chamber of Commerce, Martin Regalia,

House Committee on Ways and Means

Statement of Martin Regalia, Ph.D., Vice President of Economic and Tax Policy and Chief Economist, U. S. Chamber of Commerce

Testimony Before the Full Committee
of the House Committee on Ways and Means

January 23, 2007

Chairman Rangel and Ranking Member McCrery, members of the Committee, I am Dr. Martin Regalia, Vice President of Economic & Tax Policy and Chief Economist of the U.S. Chamber of Commerce. I am pleased to be able to submit the following testimony for the record on behalf of the U.S. Chamber of Commerce. The U.S. Chamber of Commerce is the world’s largest business federation, representing more than three million businesses and organizations of every size, sector and region. Over ninety-six percent of the Chamber members are small businesses with fewer than 100 employees. I commend the Committee for its interest in having this hearing on the current state of the U.S. economy.

The economy closed 2006 with solid, if not spectacular, economic growth and employment, and slowing inflation. The economy grew 2.0 percent in the third quarter of last year, down from 2.6 percent in the second quarter and well below the 5.6 percent pace of the first quarter of 2006 as the lagging effects of higher energy prices and Fed-engineered interest rate increases continued to impact economic growth. With energy prices down sharply from their peaks reached earlier this year and the Fed tightening now on hold for the last four FOMC meetings, we are projecting an up-tick in GDP growth to about 3.0 percent for the final quarter of 2006 and continued moderate growth in the first half of 2007.

Looking at the labor market, the economy produced 407,000 net new jobs in the fourth quarter of 2006, down from a total of 556,000 in the third quarter, which was the strongest of the year. Although job creation decelerated in the fourth quarter, it nonetheless remains on solid footing with December’s 167,000 net new jobs bringing the year’s total to over 1.8 million. The unemployment rate was 4.5% in both November and December, up slightly from the 4.4% level seen in October. Given the expectation for modest GDP growth, we expect the unemployment rate to climb slightly from this point through the middle of the year, peaking at about 5%. Thus far in 2007, the labor market is improving with the initial claims for unemployment falling to 308,000 on a 4-week moving average basis.

Despite the projected rise in the unemployment rate, job and wage growth are expected to be sufficient to ensure continued consumer spending. Last year, consumers increased their spending pace to 2.8 percent in the third quarter, up from 2.6 percent in the second quarter. The increase came as gasoline prices retreated from summer peaks and freed up some discretionary income. Continued moderation in energy prices coupled with modest growth in real disposable income should keep consumer spending reasonably robust. Recent increases in equity markets have largely offset weakness in home equity wealth. Additionally, consumer debt levels, while high by historical standards, are trending down, helping to improve consumer balance sheets.

The government deficit has become a source of anxiety in recent years. However, in fiscal year 2006 the deficit was $248 billion, down from $318 billion in 2005 and well below the $400+ billion estimate made in early 2006. The improvement in the deficit came primarily from a surge in tax revenues, which were propelled by a rise in receipts from taxes on corporations as well as individuals’ investment profits. Government outlays jumped 28% between 2000 and 2004, while government receipts fell 7% over the same period. However, with strong economic growth over the last two years, revenues grew 28% while expenditures increased 16%.

Interestingly, political factors may actually help to ameliorate the deficit problem in the short run. With the arrival of the new Congress, potential gridlock may actually produce a positive result in the Federal budget. The last time we had a similar situation was in the latter half of the 1990s, when Democrats controlled the Administration and Republicans held the Congress. Back then, the combination of solid economic growth and political gridlock increased Federal revenue growth while slowing the growth in Federal spending. As a result, the budget deficit plummeted, turning into a surplus between 1998 and 2001. While there’s no guarantee that a divided government will produce similar results this time, it is certainly a possibility. Nevertheless, sustainable deficit reductions will likely remain a challenge in the longer-run.

Another challenging area for the country’s economy is the trade sector. However, it appears that the situation has improved a bit of late. With the dollar finding a comfort zone at a relatively low level and growth abroad turning in a solid performance, U.S. net exports improved noticeably over the second half of 2006 as exports strengthened and imports slowed, the latter due in part to the recent fall in crude oil prices. Despite this short-term improvement, at current levels our trade deficit will become unsustainable in the long term. Thus, we must continue to push for more access to foreign markets and encourage newly emerging players to remove trade barriers and limit currency manipulation. We must also encourage more domestic saving, which will limit our need to borrow in international capital markets.

Turning to the country’s monetary conditions, interest rates seem to have stabilized. At its latest meeting on December 12, the Fed left interest rates unchanged for a fourth straight time. Before its meeting on August 8, the Fed had increased rates 17 consecutive times, each time adding 25 basis points. While the Fed left the possibility open for more interest rate increases in the future depending on “incoming information,” we believe that the Fed is done tightening for this cycle as inflation pressures have moderated.

The rise in overall inflation earlier this year was driven by sharp increases in many commodity prices, and more recent commodity price declines have likewise been responsible for the recent drop in inflation. Nominal crude oil prices set records above $77 a barrel in the summer. However, crude has since dropped back to near $50 a barrel as oil inventories in the U.S. have become more plentiful amid a mild beginning to the winter season on the northern East Coast, the largest heating-oil market in the U.S. In addition, gasoline prices have dropped more than 70 cents from their peak at over $3 per gallon earlier this year, while natural gas prices continue to exhibit a lack of price pressures.

Amid the recent decline in energy prices, the CPI decelerated notably in the third quarter, increasing at only a 2.9% pace. Despite an up-tick in December, the CPI fell 2.2% at an annual rate in the fourth quarter of last year. More importantly, core inflation (net of food and energy) also showed signs of slowing. The core CPI rose only 1.8% at an annual rate in the fourth quarter of 2006, down from 3.0 percent in the previous quarter. The personal consumption deflator (PCE) -- a measure watched closely by the Fed -- increased 0.5 percent in November (the latest data available) and 1.8 percent over the previous three months. Concurrently, market inflation expectations have trended downward since their cyclical peak in early 2005, with the sharpest declines occurring since the summer of this year.

With the Fed expected to remain on hold and inflationary expectations putting downward pressure on longer-term interest rates, we anticipate a flat yield curve for the next few quarters. While the financial markets appear relatively comfortable with both the Fed’s monetary policy and the overall growth prospects for the U.S. economy, the risk spread has risen slightly in the last few months as economic growth has slowed. However, the current risk spread remains near the level in the latter part of the 1990s and well below the levels witnessed during, and immediately following, the last recession.

While the overall economy performed reasonably well last year and, after a slow first half, is expected to pick up a bit toward the end of this year, there were certain sectors that were, and continue to be, clear weak spots. For example, the housing market declined sharply in 2006 after years of stellar performance. Both housing starts and sales began slumping in the summer as rising interest rates and home prices significantly reduced housing affordability and tempered demand. As a result, we experienced a sharp increase in the inventory of unsold homes and noticeable weakness in home prices. The drop in housing production was a definite drag on the overall economy, but the feared decline in household wealth and its negative impact on broader consumer spending has failed to materialize in part because of the equity market rally in the latter part of last year.

While the housing sector will likely continue to experience some malaise for another few months as the existing inventory is worked off, we believe that the market is close to a bottom and, while it may be a protracted bottom, a cessation in both interest rate and price increases, as well as continued income growth, should help to rebuild affordability and stop the negative momentum. We have already seen some positive signs with a small pick-up in sales of new and existing homes in November and modest improvement in starts in both November and December of 2006. Housing affordability has increased four straight months since July.

During times such as these, with overall growth slowing and the composition shifting, top line indicators can be inconclusive and we can sometimes get a clearer picture by looking at sector data. One of these underlying sectors is manufacturing. The Institute for Supply Management’s computes a Purchasing Managers Index (PMI) that is intended to signal whether this sector is expanding or contracting. A reading above 50 indicates growth while a reading below 50 signals contraction. While a brief stint below 50 can occur even in relatively good economic times, a prolonged stay or sharp decline below that level usually means trouble. In November 2006 the PMI dipped slightly below 50 for the first time since April 2003 but quickly rose back above 50 in December. This brief excursion into negative territory is more consistent with below-trend growth rather than an impending recession.

Another indicator of industrial strength is manufacturing new orders, specifically orders of non-defense capital goods excluding aircraft – a number which is less volatile and more reflective of the overall trend in industrial demand. These orders have trended up since 2004 and rose 9.6% through November of last year compared with the same period in 2005.

The positive performance of manufacturing orders and shipments is reflected by growth in total industrial production. Although it decelerated a bit in the third quarter, industrial production growth remains decent and continues to drive investment and support robust levels of capacity utilization. Moreover, corporate profits continue to surge and provide a healthy source for internal financing of investment, and with credit readily available on world-wide credit markets and interest rates still relatively low, outside financing options are prevalent.

Given the resilience in the industrial sector, growth in equipment and software investment bounced back from an annualized rate of -1.4 percent in the second quarter to 7.7 percent in the third quarter, and helped by a strong 15.6 percent rise in the first quarter will likely rise by about 7.0 percent in 2006. We expect growth in this component at a slightly slower 5.7% pace.

In addition, investment in structures rose 15.7 percent in annualized terms in the third quarter, following a very brisk pace of 20.3 percent in the second quarter – the highest rate in a decade. While we expect some easing in this category over the forecast horizon, the generally strong pace will continue to offset some of the weakness in residential construction.

Like manufacturing, transportation has also proven to be a useful leading indicator of overall economic activity, especially because it includes both domestically produced and imported goods. The American Trucking Associations (ATA) produces an index of truck tonnage, which measures the volume of goods moved by trucks throughout the country. The tonnage index has slumped a bit since early 2006 and through last November was 2.8 percent below the same period in 2005. However, the level of the index remains well above that seen during the last recession.

Railroad data also suggests some slowing in the economy. The Association of American Railroads (AAR) publishes statistics on rail activity. In 2006, AAR’s total carloadings rose 2.8% over 2005, while intermodal carloadings (which are better correlated with manufacturing activity) gained 5.0%. However, the rate of year-over-year growth in intermodal carloadings has declined noticeably from the nearly 12% pace in late 2004.

Financial indicators are another valuable yardstick to measure economic activity. Growth in the money supply strengthened noticeably after the 2001 recession, running at an annual rate of nearly 6% between 2001 and 2004. Since then growth has slowed to about 1% as the Fed’s monetary policy has become more restrictive. The availability of credit, however, has shown no sign of slowing, as total bank credit has risen at an annual rate of 8% in the 2001-2006 period. Moreover, commercial and industrial loan volume, which had dropped off sharply between 2001 and 2004, has since picked up, growing at an annual rate of 11% over the 2004-2006 period.

While it appears that both liquidity and credit are readily available, it is a small consolation if businesses and individuals cannot service their debt. However, the data suggest that while delinquencies are up slightly since early 2006, they remain well below the peaks seen during the last recession. The industrial sector has actually outperformed the overall spectrum of borrowers, as commercial and industrial loan delinquency rates have declined significantly from the most recent peak of 3.9% in the second quarter of 2002 to 1.3% in the third quarter of 2006.

On balance, both sector statistics and top line numbers are telling us the same story – despite the current slowing, the economy still has plenty of momentum and should continue to grow and create new jobs in the near future. If we are correct, GDP will grow at about a 3.0% rate in 2006 and slightly less than 3% in 2007. Thus, the economy remains fundamentally sound and it appears that the Fed has achieved the proverbial soft landing.

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