The Economic Outlook

The economy has been buffeted recently by several interlinked shocks, and the risk of recession is significantly elevated compared with what it is during normal economic conditions. The pace of economic growth slowed in 2007, and there are strong indications that it will slacken further in 2008. In the Congressional Budget Office’s view, the ongoing problems in the financial and housing markets and the high price of oil will curb spending by households and businesses this year and trim the growth of gross domestic product. In contrast, the relative economic strength of the United States’ major trading partners—in particular, the robustness of emerging economies—when combined with the dollar’s decline will stimulate net exports, thus partially offsetting the sluggishness in domestic demand anticipated this year. Although recent data suggest that a recession in 2008 has become more likely, CBO does not expect the slowdown in economic growth to be large enough to register as a recession.¹ For 2009, CBO forecasts that the economy will rebound, as the negative effects of the turmoil in the housing and financial markets fade.

Specifically, CBO forecasts that GDP will increase in 2008 by 1.7 percent in real terms (after an adjustment for inflation) and rebound in 2009 to 2.8 percent (see Table 2-1). Given the prospect of weak domestic demand this year, CBO expects inflation to be contained over the next two years. Employment growth, which slowed during 2007, is likely to slow further in 2008, and unemployment, in CBO’s estimation, will average 5.1 percent this year. Interest rates on Treasury securities will remain low in 2008 and increase in 2009, CBO forecasts, as the economy works through and emerges from its current difficulties.

		Estimated	Forecast		Projected Annual Average
		2007	2008	2009	2010 to 2013		2014 to 2018


		Year to Year (Percentage change)

Nominal GDP (Billions of dollars)		13,828	14,330	14,997	18,243	^a	22,593	^b
Nominal GDP		4.8	3.6	4.7	5.0		4.4
Real GDP		2.2	1.7	2.8	3.1		2.5
GDP Price Index		2.5	1.9	1.8	1.9		1.9
PCE Price Index^c		2.5	2.6	1.8	1.9		1.9
Core PCE Price Index^d		2.1	1.9	1.9	1.9		1.9
Consumer Price Index^e		2.8	2.9	2.3	2.2		2.2
Core Consumer Price Index^f		2.3	2.2	2.2	2.2		2.2

		Calendar Year Average (Percent)

Unemployment Rate		4.6	5.1	5.4	4.9		4.8
Three-Month Treasury Bill Rate		4.4	3.2	4.2	4.6		4.7
Ten-Year Treasury Note Rate		4.6	4.2	4.9	5.2		5.2
Tax Bases (Billions of dollars)
	Economic profits	1,599	1,620	1,649	1,842	^a	2,320	^b
	Wages and salaries	6,368	6,615	6,913	8,401	^a	10,354	^b
Tax Bases (Percentage of GDP)
	Economic profits	11.6	11.3	11.0	10.3		10.1
	Wages and salaries	46.0	46.2	46.1	46.1		45.9

		Fourth Quarter to Fourth Quarter (Percentage change)

Nominal GDP		4.7	3.7	5.1	5.0		4.4
Real GDP		2.5	1.5	3.3	3.0		2.4
GDP Price Index		2.2	2.1	1.8	1.9		1.9
PCE Price Index^c		3.2	2.1	1.9	1.9		1.9
Core PCE Price Index^d		2.0	1.9	1.9	1.9		1.9
Consumer Price Index^e		3.8	2.5	2.2	2.2		2.2
Core Consumer Price Index^f		2.2	2.2	2.2	2.2		2.2

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

The economic outlook this year is particularly vulnerable to uncertainty about the degree to which the problems in the housing and financial markets will spill over to affect other sectors of the economy. Growth in 2008 could be weaker than CBO expects if the turmoil in the financial markets leads to a more severe economywide curtailment of lending than CBO anticipates. Growth could also be slower if crude oil prices, which jumped sharply late last year, rise even higher and further undercut spending by consumers and businesses.

Alternatively, growth in 2008 could be stronger than CBO is currently forecasting. In particular, financial institutions may be able to absorb mortgage-related losses without triggering significant repercussions in the broader economy. Also, unrelated sectors of the economy (that is, nonhousing and nonfinancial sectors) may continue to support the growth in employment and income necessary to sustain consumer spending.

For the medium-term period (2010 through 2018), CBO projects that real growth will average 2.7 percent and inflation will average 2.2 percent. Those estimates rest on CBO’s assumption that the economy will grow at a pace faster than its potential rate of 2.5 percent during the years after 2009 to close the projected gap between GDP and potential GDP at the end of 2009. (Potential GDP is a level of output that corresponds to a high level of resource—labor and capital—use.) CBO also projects that the unemployment rate will average 4.8 percent and interest rates on 3-month Treasury bills and 10-year Treasury notes will average 4.7 percent and 5.2 percent, respectively, during the latter years of the period.

Compared with its August 2007 estimates, CBO’s current forecast for the near term—that is, the next two years—indicates much slower growth, significantly higher inflation in 2008, lower interest rates, and a smaller share of GDP attributable to firms’ profits. The weakness in the housing sector, the turbulence in the financial markets, and the rise in energy prices now appear to be undercutting the growth of GDP to a greater degree than CBO envisioned last summer. The less expansive outlook for the near term also results in lower interest rates on Treasury securities in 2008 than CBO had expected in August. Inflation as measured by the consumer price index for all urban consumers (CPI-U) during the last few months of 2007 was much higher than anticipated—prices for motor fuel shot up unexpectedly—and that growth has boosted the year-over-year rise in prices that CBO expects in 2008. However, the measure of inflation that excludes food and energy—core inflation—grew only slightly more than CBO anticipated last August, and consequently, the outlook for core inflation is essentially unchanged.

The nation’s financial markets have been buffeted by events stemming from the downturn in the housing sector and the losses associated with subprime mortgage loans—that is, loans extended to borrowers who have low credit ratings and a high risk of default. The ultimate magnitude of the subprime-related losses is highly uncertain, in part because it depends on how the economy evolves over the next few years and how far house prices fall. However, rough estimates by some financial analysts suggest that the losses are in the range of $200 billion to $500 billion.² Moreover, because most subprime loans have been pooled into mortgage-backed securities, rather than held by their originators, and those securities have subsequently been restructured as parts of other complex investment securities, who will actually bear those losses is unclear. The uncertainty among investors about their exposure to subprime-related losses has led many of them to reassess the creditworthiness of a wide variety of financial instruments.

Increased aversion to risk in the nation’s financial markets, which marks a shift from an unusually high level of tolerance for risk taking in recent years, could threaten to slow economic activity above and beyond the direct effects of the subprime losses. The availability of credit has become severely restricted for some borrowers, especially those seeking money for risky mortgages and businesses. In addition, borrowing costs have increased not only for subprime residential mortgages but also for some consumer and business loans. The troubles in the U.S. subprime mortgage market have also affected financial markets in other industrialized countries, threatening to slow economic growth there as well. Consequently, policymakers in the United States and abroad have worked to reduce the turmoil in the markets.

CBO does not expect that turmoil to balloon into a severe, economywide credit crunch. The pullback from risk in the financial markets, though, is likely to contribute to the continued tightness of credit, especially for housing and the riskier ventures among businesses’ investments. If a severe credit crunch did occur, it would drive the economy into recession by significantly curbing financial activity and consumer spending. However, CBO assumes in its forecast that the Federal Reserve will implement policies to prevent such a crunch and that the financial sector is capable of absorbing most of the losses it faces. In fact, despite their current financial stresses, some banks that have suffered large losses from their subprime-related investments have thus far survived those setbacks and are now successfully raising needed capital. Moreover, most prime borrowers—those whose credit ratings are solid—are unlikely to encounter major difficulties in funding their investments.

The recent turbulence in the financial markets originated with subprime mortgage lending, especially on subprime adjustable-rate mortgages, or ARMs.³ The number of subprime mortgages has grown rapidly in recent years: In 2005 and 2006, such loans made up about one-fifth of all originations of home mortgages (in dollar terms); they accounted for about 13 percent of all home mortgages at the end of that latter year.⁴ Although the expansion of subprime mortgage lending allowed more people to buy homes, that outcome was achieved in large part by significantly lowering credit standards and offering terms on such lending that were more favorable than had been seen in the past. For example, lenders sometimes made loans to borrowers who would not be able to make their scheduled future payments after their very low introductory interest rates (known as "teaser rates") expired. The fall in housing prices that has occurred over the past year combined with a tightening of lending standards has greatly diminished borrowers’ ability to sell their homes or refinance their mortgage loans, leaving many of them with repayment problems.

As a result, the number of delinquencies and foreclosures on subprime ARMs began to rise dramatically after 2005. By the third quarter of 2007, almost 19 percent of subprime ARMs were considered delinquent, up from a recent low of 10 percent in the second quarter of 2005 (see Figure 2-1). In addition, the share of subprime ARMs entering foreclosure more than tripled, rising from an average of 1.5 percent in 2004 and 2005 to 4.7 percent in the third quarter of 2007. Although the share of delinquent fixed-rate subprime loans has also grown, it is still smaller and has grown more slowly than the share of delinquent subprime ARMs.

The very high rates of delinquency on recent subprime mortgage loans surprised investors, and lenders have virtually stopped making new subprime loans. Trading of existing subprime mortgage-backed securities (MBSs) has diminished, and their prices have fallen sharply, to as low as 14 cents on the dollar for the riskiest of those securities, because of uncertainty about their value, particularly in view of investors’ loss of confidence in the securities’ credit ratings. The price declines were steepest for subprime MBSs that had been issued more recently, suggesting that lenders have significantly lowered their standards for making loans in the past few years.

Mortgage delinquencies and foreclosures could be a problem for the economy and the financial markets for several years. In the case of subprime ARMs, rates for some loans have already been reset, but those on an additional 1.7 million mortgages will be reset during 2008 and 2009.⁵ Those changes, plus the ones occurring in later years (most before the end of 2010), could eventually add about $40 billion to borrowers’ annual payments.⁶ Although that increase is not large relative to households’ total after-tax income ($10 trillion), many households will be hard-pressed to make the higher payments, and some will default on their mortgages and go into foreclosure. The risk of a sharp increase in foreclosures has led to various actions and proposals to help the market cope with the repayment problems among borrowers with subprime ARMs.⁷

The problems of the subprime mortgage market have undermined the confidence of many investors and caused them to reduce their holdings of mortgage loans and of other asset-backed securities associated with particularly risky lending to businesses and consumers. That contagion effect has been intensified by the lack of transparency about which financial instruments and institutions face losses from defaults on subprime mortgages, forcing investors and financial institutions to reevaluate the risk of their investments in a wide range of financial assets. That reassessment has subsequently lessened investors’ willingness to bear such risk and driven down the value of suspect assets, some of which were once thought to have little possibility of default.

Some of that reassessment can be seen as a correction to the underpricing of risk that had occurred in recent years and that contributed to the current turmoil in the financial markets. For example, because the revaluation of risk led to what the markets term a "flight to quality" (that is, a shift from riskier investments to such instruments as U.S. Treasury securities, which investors consider safe), interest rates on prime mortgage loans have actually declined in recent months. To date, the market for conforming mortgages (mortgages that are no greater than $417,000), which make up the bulk of all mortgage loans, has seen no significant adverse effects from the subprime mortgage troubles (see Box 2-1).⁸ Some people fear, however, that the reassessment will go too far and jeopardize economic growth by indiscriminately reducing funding for profitable investments.

Box 2-1.

Conforming Mortgages and the Role of Fannie Mae and Freddie Mac

The problems in the subprime mortgage market have not affected the availability of conforming mortgages— that is, mortgages that are eligible to be purchased on the secondary mortgage market by Fannie Mae and Freddie Mac. In fact, mortgage rates in the latter market have fallen because investors have bid up the price of the mortgage-backed securities (MBSs) offered by those two government-sponsored enterprises, or GSEs. GSEs are private financial institutions chartered by the federal government to promote the flow of credit for targeted uses—in this case, housing. To do that, they raise funds in the capital markets partly on the strength of an implied federal guarantee against the risk of default (which reduces their borrowing costs and enables them to hold less capital than other borrowers and yet still borrow large sums).

Although losses resulting from the subprime troubles have affected the potential of the GSEs to hold loans, they are unlikely to affect Fannie’s and Freddie’s ability to guarantee MBSs. The two GSEs’ concentration in the prime mortgage market helps insulate them from losses, but as of fall 2007, they still held about $230 billion in subprime and Alt-A mortgages.¹ (In terms of their level of risk, Alt-A mortgages carry a higher rating than do subprime mortgages but a lower rating than prime mortgages.) Because of their subprime-related losses, the GSEs’ capital cushion in the third quarter of 2007 had dropped to just about $3 billion—on top, that is, of the $73 billion in capital that current laws and regulations require to safeguard the $1.6 trillion in assets carried on their balance sheets and the $3.3 trillion in off-balance-sheet guarantees of MBSs for which they are responsible.² That modest cushion of $3 billion left little capacity to absorb further losses.

Consequently, Fannie Mae and Freddie Mac have raised $13 billion in new capital and cut their dividends. However, even if they had chosen not to raise more capital, the GSEs could have continued to guarantee returns on MBSs as long as they reduced their portfolios of mortgages—because the capital they are required to maintain for the mortgages held on their balance sheets is about five times higher than the capital required for their guarantees. Because the implicit federal backing that the GSEs’ guarantees carry is the source of the lower costs for borrowing that they obtain in the conforming mortgage market, any problems that the GSEs encounter will probably not affect that market but could affect their ability to buy more subprime and Alt-A mortgages.

Fannie Mae and Freddie Mac have announced riskbased increases in some of their fees, which will probably be passed on to most borrowers—in the form of higher origination costs—beginning in March 2008. For some borrowers who have low credit scores and small down payments, the additional amounts they will have to pay could be several thousand dollars. For other borrowers who appear more creditworthy and make bigger down payments, the amounts will be much smaller.

Pending legislation would raise the conforming loan limits to assist borrowers in regions of the country (such as the West Coast) where home prices are high. Other proposals would increase the assistance that the GSEs provide to the subprime market. However, unless those initiatives are accompanied by higher capital requirements and regulatory reform, the implicit risk for the GSEs’ operations that is borne by taxpayers will increase.

1. Alt-A mortgage loans, which share many of the same problems as subprime mortgage loans, were often made on the basis of undocumented income. Recently, Alt-A mortgages have included low-down-payment loans, interest-only loans, and loans whose balances rise over time. Those loans are defaulting at sharply rising rates.

2. For more information, see Congressional Budget Office, Measuring the Capital Position of Fannie Mae and Freddie Mac (June 2006).

Jumbo Mortgages. In the mortgage markets, the spillover from subprime defaults has been most pronounced for jumbo mortgages—those in amounts greater than those for conforming loans. The availability of funds in the market for existing jumbo loans (a so-called secondary market that resells such loans in the form of securities) has sharply declined; consequently, rates on new jumbo loans in the (primary) market have risen. Borrowers now pay roughly one percentage point more for jumbo loans than for conforming loans (see Figure 2-2). Relatively few new jumbo loans are now securitized.⁹

Sources: Congressional Budget Office; Federal Reserve Board; Bloomberg; Wall Street Journal.

Corporate Bonds. Spillovers from the troubles in the mortgage markets have also raised the cost of borrowing for businesses that have low credit ratings. In the corporate sector, interest rates on high-yield or speculative-grade bonds—those whose risk of default is judged to be high—jumped last summer when the subprime market’s problems emerged, and the rates remain elevated. By contrast, the average interest rate on investment-grade bonds (those with a low risk of default) was essentially the same last year as in 2006. Nevertheless, the difference between the interest rate on investment-grade bonds and that on 10-year Treasury notes, an indication of the riskiness of those bonds, has risen compared with what it was last year, suggesting that repricing of risk has occurred even in the market for the safest corporate debt.

Commercial Paper. The market for commercial paper, a kind of loan that plays a key role in providing short-term credit to both financial and nonfinancial businesses, has been especially affected by losses in the subprime mortgage market. In particular, those losses have severely curtailed the asset-backed segment of the commercial paper market, which has provided financing for structured investment vehicles (SIVs) and other investment funds (or conduits) sponsored by banks (see Box 2-2). The total amount of outstanding commercial paper has dropped sharply since the summer of 2007, which indicates that businesses’ access to short-term credit has been constricted. That constriction is primarily due to the decline in the amount of asset-backed commercial paper; other commercial paper markets have not been as significantly affected by the subprime losses (see Figure 2-3).

Box 2-2.

Structured Investment Vehicles

Structured investment vehicles (SIVs) are entities that issue short-term commercial paper as well as medium-term notes to finance the purchase of longer-maturity, higher-yielding assets. (Such assets include asset-backed securities, which are made up of bank loans, mortgage-backed securities, and debt obligations backed by credit card receivables, automobile and other loans, and, in some cases, subprime mortgages.) Estimates are that in the summer of 2007, SIVs represented about $400 billion. However, the recent difficulties that those entities have encountered as a result of the subprime-related turmoil in the financial markets have caused a steady decline in that amount, to less than $150 billion as of early December 2007.¹

Because the maturities of their assets are longer than the maturities of their liabilities, SIVs periodically need to roll over, or "re-fund," their debt (that is, pay off their old debt with new debt). That re-funding requires that lenders be willing to take on the risks associated with a SIV’s investment portfolio. However, when markets are disrupted and the value of such a portfolio becomes difficult to establish, refunding also becomes difficult—or impossible. In that case, a SIV may have to sell its most marketable assets to pay off its commercial paper and debt—as many SIVs may have done in recent months.

SIVs are known as off-balance-sheet entities because they are legally separate from the banks (or other institutions) that have created them and typically are not carried on the banks’ balance sheets. Although such banks may have backup agreements with the SIVs to extend credit if requested, they have no legal obligation to cover the SIVs’ losses. They may choose to do so, though, to protect their reputations. As long as the SIV does not appear on the bank’s balance sheet, it has little or no effect on the bank’s capital requirements. Those requirements, promulgated by bank regulators, stipulate (as a ratio) the amount of equity that a bank must hold in relation to the amount of assets on its balance sheet and the riskiness of those assets.

SIVs are often required to start selling their assets if their losses exceed certain threshold percentages of their capital or if they violate provisions that specify the liquidity (broadly, the available funds) they must maintain. Those involuntary sales may then push down the prices of the SIVs’ assets, which could cause losses in the value of similar types of assets held by other SIVs and force those SIVs into such involuntary sales as well. The losses could also trigger defaults on commercial paper already issued by the SIVs and further impede their ability to borrow money.

Recent actions by some large banks to resolve the troubles of their sponsored SIVs have included bringing the SIVs’ assets—and losses—back onto the banks’ balance sheets. Those actions reduce a bank’s capital ratio and absorb some of the bank’s lending capacity—because the assets become either a loan or an investment of the bank, potentially crowding out other loans or investments.

1. Those estimates were drawn from "Remarks by Treasury Secretary Henry M. Paulson Jr. on housing and capital markets before the New York Society of Securities Analysts" (January 7, 2008), available at www.treasury.gov/press/releases/ hp757.htm.

Bank Loans. Some banks have been hit hard by their exposure to subprime mortgage lending, both directly and indirectly through the activities of SIVs, raising concerns that banks might substantially restrict their lending. Banks are an important conduit for channeling credit to businesses and consumers, acting variously as originators of loans, securitizers, providers of backup credit lines to issuers of commercial paper, and investors in bonds. Although no one yet knows the share of subprime-related losses that banks will ultimately have to absorb, the losses announced to date have been significant. Those losses have reduced banks’ capital and forced banks to tighten their credit terms on business and consumer loans. That tightening could curb the growth of the overall economy if many banks cannot easily raise additional capital to fund new lending.

Banks’ capacity to lend to businesses and consumers might already be under stress. Commercial and industrial loans have increased sharply since the turmoil began last summer (see Figure 2-4). That increase probably in large part reflects lending that the banks are committed to make when backup credit lines are activated by failed asset-backed commercial paper programs. At the same time, banks’ investment in securities has increased, as they have brought some of the assets of their sponsored SIVs back onto their balance sheets, displacing other loans they might have made.

The severity of subprime-related losses and their effect on banks’ lending capacity are open questions and likely to remain so throughout 2008, but expectations are that the banking system as a whole will not be imperiled. Thus far, some major financial institutions have been able to raise new capital; also, the tightening of credit standards to date has been less extreme than the tightening that occurred during the banking crisis of the early 1990s. Furthermore, because assets backed by subprime mortgages are widely held, other financial institutions besides banks—including hedge funds, pension funds, and other investment funds—as well as financial institutions in the rest of the world will also absorb some portion of the subprime-related losses.

Since its actions in August, when the turbulence in the financial markets began, the Federal Reserve has taken additional steps to increase the availability of credit and keep the economy growing. In August, it injected temporary reserves into the banking system—which moved the federal funds rate (the interest rate that financial institutions charge each other for overnight loans of their monetary reserves held at the central bank) below its target—and it lowered the discount rate (the interest rate that the Federal Reserve charges on a loan it makes to a bank). With conditions in financial markets still turbulent in the fall of 2007, the central bank cut its target rate, ending the year at 4.25 percent.

Late last year, the Federal Reserve took additional action to lessen the persistent stress on the money markets and announced a new policy instrument called the term auction facility, or TAF. In December, the TAF auctioned $40 billion in short-term financing to depository institutions that are eligible to borrow from the Federal Reserve’s discount window; by the end of January, it will have auctioned another $60 billion (see Box 2-3).

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Box 2-3.

The Federal Reserve’s Term Auction Facility

On December 12, the Federal Reserve introduced a new policy tool, the term auction facility (TAF), to supply funds to financial institutions. The TAF was designed to address the wider-than-normal spread, or difference, that the subprime-related problems in the financial markets induced between the markets’ expectations about the federal funds rate (the rate that financial institutions charge for overnight loans of their monetary reserves) and the dollar LIBOR, or London Interbank Offered Rate (which banks charge each other for short-term loans and which is widely used as a reference rate for financial instruments). Similar discrepancies occurred in LIBOR markets for other currencies.

The TAF has elements of two other mechanisms that have long been part of the Federal Reserve’s monetary policymaking apparatus: open market operations and discount window lending. In its open market operations, which constitute the central bank’s main tool for implementing monetary policy, the Federal Reserve buys and sells U.S. Treasury and federal agency securities through an auction involving representatives of member institutions (known as primary securities dealers). In that way, the Federal Reserve adjusts the supply of monetary reserves in the banking system in order to influence the federal funds rate. (The Federal Reserve’s Open Market Committee establishes a target for that rate.)

In contrast, at the discount window, the Federal Reserve accepts requests for short-term loans by commercial banks and other depository institutions that have short-term liquidity needs or that face severe financial difficulties. For most banks, the discount rate is set as a spread (a certain number of basis points, or hundredths of a percentage point) above the target federal funds rate.¹ The rate that the Federal Reserve charges banks that are in good financial shape is lower than the rate it charges other banks. In times of financial market stress, however, banks have sometimes been reluctant to borrow through the discount window for fear of being stigmatized as weak and thus losing access to private sources of funds (such as other banks).

The TAF, which was designed to overcome that hesitation, is similar to open market operations in that funds are supplied through an auction. However, it differs in that under the TAF, the Federal Reserve announces the amount of funds that will be supplied and the auction determines the interest rate that will be paid by successful bidders, which in effect pushes that set amount of funds into the credit markets. (In contrast, in open market operations, the amount supplied and the interest rate that successful bidders pay are closely connected to the target for the federal funds rate.) Another difference between open market operations and the TAF is that the Federal Reserve will accept a broader range of securities in payment for TAF-supplied funds than it does for funds supplied through open market operations (for which only U.S. Treasury and government agency securities are accepted). Securities eligible under the TAF are the same as those eligible as collateral for the central bank’s discount window lending. However, the open market-type auction of the TAF may eliminate the perceived stigma of using discount window borrowing in times of financial stress and make banks more willing to bid for funds to enhance their liquidity.

The interest rate on TAF-supplied funds in December was between the federal funds rate and the discount window lending rate, but the rate on the funds auctioned on January 14 was below the federal funds target. The two TAF auctions, on December 17 and December 20, each added $20 billion in liquidity to the banking system at respective rates of 4.65 percent and 4.67 percent (compared with a federal funds target rate of 4.25 percent and a discount window rate of 4.75 percent). The auction on January 14 supplied $30 billion at a rate of 3.95 percent. Another auction on January 28 is scheduled to add another $30 billion.

In addition to the implementation of the TAF, the Federal Reserve set up reciprocal currency swap lines with the central banks of the European Community and Switzerland. The swaps, in which the Federal Reserve temporarily exchanges dollars for the respective central banks’ currencies, have facilitated dollardenominated borrowing by those banks’ member institutions.

As a result of the TAF, the swap lines, and other actions, the spread of the dollar LIBOR over the expected federal funds rate has narrowed significantly.

1. Small banks in agricultural or resort communities pay a rate that is an average of selected market rates.

Short-term credit markets have benefited significantly from the Federal Reserve’s actions and its assurances of support for financial institutions. The international interbank market and the domestic commercial paper market—the short-term markets most affected by the subprime problems—have recovered from the summer’s upsets (although in the case of asset-backed commercial paper, spreads, or differences, between borrowing rates and the federal funds rate are still larger than normal, and the number of transactions is smaller than usual.)

CBO expects that the Federal Reserve will further reduce the federal funds rate to prevent credit shortages in 2008 from retarding the growth of the economy and to counter the negative effects arising from a fragile housing market and high oil prices. In CBO’s forecast, the target federal funds rate falls to 3.5 percent by the middle of 2008 and holds at that level for the rest of the year. As the economy recovers, the rate will gradually rise to 4.75 percent in early 2010, CBO anticipates.

CBO’s assumptions about monetary policy and the economy underpin its forecast for interest rates on Treasury bills and notes. CBO estimates that the rate on 3-month Treasury bills will average 3.2 percent in 2008, reflecting the lower federal funds rate and the heightened demand for Treasury securities arising from the subprime-related troubles in the commercial paper market. CBO expects the rate to move higher, to 4.2 percent, in 2009 as the economy recovers and financial market problems ease. For many of the same reasons, CBO forecasts that the rate on 10-year Treasury notes will climb from an average of 4.2 percent in 2008 to 4.9 percent in 2009. That estimate for the 10-year note incorporates the assumption that investors will remain confident that the Federal Reserve is committed to keeping inflation low.

The troubles in the U.S. subprime mortgage market have directly affected financial institutions in other industrialized countries, particularly those that had invested heavily in U.S. securities backed by subprime mortgages or those that were relying on short-term interbank financing for longer-term loans. The international interbank market facilitates domestic and international transactions and provides payment and settlement services to businesses, consumers, and governments. A measure of perceptions of risk among banks in that market is the spread of the three-month dollar interbank rate—known as the dollar LIBOR rate—relative to the expected federal funds rate over that interval.¹⁰ That LIBOR spread jumped during last summer’s turmoil and again in November and early December. Spreads also increased between LIBOR rates for other major currencies and the expected policy rates of the corresponding central banks. A key factor in those hikes was concern about the adequacy of the capital held by banks that have had to absorb subprime-related losses—concern fueled by uncertainty about how much larger those losses might turn out to be.

The European Central Bank, the Bank of Canada, and the Bank of England have each injected substantial amounts of cash into their countries’ financial markets to contain the credit crisis and bolster liquidity. Besides liquidity injections, the Bank of England cut its policy interest rate (similar to the federal funds rate) by 25 basis points on December 6 (a basis point is one-hundredth of a percentage point), acknowledging that the deterioration in financial conditions and the subsequent tightening of credit had increased the risk that economic growth might slow. (So far, other central banks have held off on previously planned hikes in interest rates.) As a result of those and other policy actions, the spread between the three-month dollar LIBOR rate and the expected federal funds rate (like the corresponding spreads in other currencies) has now narrowed but remains high relative to its normal level.

As in the United States, housing prices in many other parts of the world have soared, but the financial disturbances here are unlikely to trigger a collapse in housing markets abroad. Most countries do not have subprime mortgage markets like those in the United States; also, they do not have an oversupply of housing, as this country does, because land is more limited and mortgage financing standards are more conservative. Nevertheless, shortages of credit in some countries may require action by those nations’ central banks.

The pace of economic growth slowed in late 2007, and CBO anticipates additional slackening in 2008. Chief causes of that slowdown are the problems in the housing and financial markets and high oil prices. If those factors continue to worsen, they could further weaken consumers’ and businesses’ confidence about the future, which might constrain economic activity even more than CBO now anticipates. Indeed, some indicators imply that the risk of a recession is high (see Box 2-4). However, the stronger growth of the nation’s major trading partners combined with the dollar’s decline will partially offset weak domestic demand and support growth by increasing U.S. exports.

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Box 2-4.

Recession Signals

Two relatively reliable indicators of a recession, one based on the unemployment rate and the other on a relationship between long- and short-term interest rates, imply that a recession in 2008 is likely. The first such indicator is the change in the three-month moving average of the unemployment rate. Whenever the change in the average from the previous year has been 0.4 percentage points or more, the economy has been in a recession (see the first figure). For all recessions since 1975, the 0.4 percentage-point signal came within one to three months of the onset of the recession.

Changes in the Unemployment Rate

(Percentage points)

Sources: Congressional Budget Office; Department of Labor, Bureau of Labor Statistics.

Note: Changes are from the previous year in the three-month moving average of the civilian unemployment rate. Data are plotted through December 2007.

In the current business cycle, the 0.4 percentagepoint threshold was reached when the Bureau of Labor Statistics released the December 2007 unemployment data on January 4. Yet the signal is partially undercut by the lack of support from some other labor-market data. For example, in past recessions, the number of layoffs usually increased around the time that the recession began. The most prominent measure of layoffs, the four-week moving average of initial claims for unemployment benefits, has begun to edge upward, but the increase to date is small and does not seem to indicate a recession. Moreover, surveys of employers thus far do not suggest that they plan large future reductions in hiring. Still, such labor-market indicators could deteriorate suddenly, once it became clear that demand was substantially weakening.¹

Another relatively reliable signal of a recession is a negative yield spread, which occurs whenever a shortterm interest rate (such as the rate for one-year Treasury bills) is above a long-term interest rate (such as the rate on 10-year Treasury notes). All but one occurrence of a negative yield spread since 1955 have foreshadowed an upcoming recession (see the second figure). From mid-2006 to mid-2007, the yield spread was continuously negative.

Yield Spread

(Percentage points)

Sources: Congressional Budget Office; Federal Reserve Board.

Note: The spread is calculated as the difference between the rates on the 10-year Treasury note and the 1-year Treasury bill. Data are monthly and are plotted through December 2007.

Again, though, that signal may be misleading this time, for two reasons. First, the yield-spread signal incorporates the assumption that high short-term rates and low long-term rates have the same impact on the probability of a downturn. If high short-term rates are more important, then the degree of monetary restraint normally implied by a negative yield spread may not be present this time.

Second, the long period of relatively mild inflation since 1985 may have caused investors to be more confident than in the past about the ability and commitment of the Federal Reserve to control inflation. If concerns about a possible sustained increase in inflation have ebbed over the years, the long-term interest rate would tend to be closer to the short-term rate even if no recession was in the offing—that is, long-term rates would not have to reflect as large an ’inflation risk premium’ as they have in the past. Less volatility in economic activity can have a similar effect. Therefore, a slight inversion of the yield curve may be less of a recession signal now than in the past.

1. Some economists have argued that patterns of hiring and firing over the course of the business cycle have changed in recent years. See Robert Shimer, Reassessing the Ins and Outs of Unemployment, NBER Working Paper No. 13421 (Cambridge, Mass.: National Bureau of Economic Research, September 2007); and Robert Hall, ’How Much Do We Understand About the Modern Recession?’ (paper prepared for the Brookings Panel on Economic Activity, September 2007).

Although the troubles in the oil, financial, and housing markets pose a serious risk to the nation’s economic health, the economy may navigate those obstacles more successfully than CBO now expects. Despite some adverse shocks, the economy has been naturally resilient during the past 25 years (although part of that resiliency can be attributed to well-functioning financial markets, and their ability to continue to function well is one of the risks of the current situation). Moreover, employers in the nonhousing portion of the business sector have not accumulated excess workers, capital, or inventories in recent years, implying that firms will not need to cut back as much as they would have in the past in response to ebbing demand. In addition, although globalization has increased the risk that the United States’ economic troubles might spill over to other nations, it has also allowed the impact of the decline in U.S. consumer spending to be shared globally, reducing its adverse effects on U.S. producers and workers.

The housing sector will continue to be a drag on the growth of output in the first half of 2008, CBO forecasts, but it will probably have little direct effect on growth in the second half. The slowdown in residential investment has reduced the annual rate of growth of real GDP by about a percentage point in the past year and a half. However, as lower housing prices make home ownership more affordable and lower rates of construction help reduce the inventory of unsold homes, the numbers of housing "starts" (new housing units beginning construction) and of sales of new and existing homes will stop falling late in 2008 and then start growing in 2009.

Housing Construction and Sales. During 2007, the numbers of housing starts and home sales continued to fall. The number of starts dropped by more than 38 percent for the year ending in December 2007, after sinking by 18 percent for the year ending in December 2006. Sales of new single-family homes for the year ending in November 2007 fell by 34 percent and are down by 53 percent from their peak in 2005. The ratio of unsold homes to monthly home sales has risen to the level observed in most recessions in the past: In November, it stood at 9.3 months, slightly higher than its level during the recession of 1990 and 1991, for example. Sales of existing single-family homes have also continued to drop: They fell by 20 percent in the year ending in November 2007 and are down by about 30 percent from their peak in 2005.

CBO expects an upturn in the number of housing starts in 2009, in part because currently they are considerably below the underlying demand for new units (see Figure 2-5). Underlying demand—that is, the need for new housing units—is based on growth in the number of households and estimates of the replacements required to cover the net removal of old units from the stock of usable housing. The number of starts is currently well below the estimate of underlying demand because of the unusually large excess inventory of vacant units. As those vacant units are sold, starts are expected to gradually return to the level of underlying demand.

Sources: Congressional Budget Office; Department of Commerce, Bureau of the Census.

Notes: Housing starts include both single- and multifamily homes. The underlying demand for new housing is based on the growth in the number of households and the depreciation of the housing stock.

Prices and Affordability. House prices have fallen sharply since their peak in the middle of 2006. A number of indexes are available to track prices; each is flawed, but together they give a sense of trends. One measure—the Standard & Poor’s (S&P)/Case-Shiller national price index for single-family homes, originally developed by financial economists Karl Case and Robert Shiller—was down by 5 percent in the third quarter of 2007 from its peak in the second quarter of 2006. (Those are the latest data available for that index.) In real terms, that amounts to an 8 percent drop over the period (see Figure 2-6). Rapid declines in home prices continued in the fourth quarter of 2007: By October, a narrower S&P/Case-Shiller index for just 20 cities (but available monthly) had fallen by 6.5 percent from its peak. Those trends are generally confirmed by a third price index, published by Radar Logic, Incorporated, a real estate and data analysis firm. (Another widely used index, the purchase-only index published by the Office of Federal Housing Enterprise Oversight, or OFHEO, did not begin to decline until the third quarter of 2007. The difference between its movement and that of the other indexes may reflect the fact that the OFHEO index does not include homes with jumbo or subprime mortgages and thus excludes parts of the market that have seen the greatest difficulties in recent months.)¹¹

Sources: Congressional Budget Office; Office of Federal Housing Enterprise Oversight; Standard & Poor’s; Fiserv; MacroMarkets, LLC; Department of Commerce, Bureau of Economic Analysis.

Notes: Both indexes have been adjusted for inflation by dividing them by the chained price index for personal consumption expenditures.

The outlook for home prices is highly uncertain, but they are likely to continue to fall during 2008. Expectations of such a decline are widespread. Futures markets, for example, anticipate large additional drops in house prices ranging from 5 percent to 10 percent for the coming year and 13 percent to 20 percent over the next three years. (Such expectations may not be a reliable guide, though, particularly for longer periods, because futures contracts of this kind do not trade frequently or in large numbers and therefore may not represent a broad consensus of investors.)

Private forecasters and investment firms also expect significant declines in nominal house prices. Macroeconomic Advisers, for its December 2007 forecast, assumed a 6.3 percent fall in prices between the middle of 2007 and the end of 2009. Goldman Sachs projects a total decline of 20 percent to 25 percent before an upturn occurs.

Such price declines will help make buying a home more affordable. According to the affordability index compiled by the National Association of Realtors, affordability increased between 2006 and 2007 but remained considerably below its recent high in 2003.¹² The declines in house prices now occurring will contribute to greater affordability, and eventually the number of house sales is likely to increase as buyers start to expect that prices will no longer fall and that their housing investment will yield a positive return in the future.

The growth of real consumer spending slowed last year, and CBO forecasts that its pace will decline further in 2008. The growth of real disposable personal income, a major determinant of consumer spending, is expected to slacken, given the less vigorous economic activity forecast for this year, and households’ net wealth, another important determinant, is likely to decline in response to the continuing fall in house prices. Stricter lending standards and terms for borrowing may also slow the growth of consumer spending overall, and the high cost of energy—particularly gasoline—could further dampen spending for nonenergy goods and services.

The Effect of Declines in Housing Wealth. Housing wealth supported consumer spending through 2006, but falling home prices are likely to undercut spending over the next few years. Between 2003 and mid-2006, the rapid growth of housing prices increased homeowners’ housing wealth, and many owners made use of that wealth by securing home-equity loans or taking cash out when refinancing their mortgages. The amount of housing equity withdrawn (net of mortgage fees, points, and taxes) totaled an estimated $663 billion in 2005 and $696 billion in 2006, down slightly from a peak of $739 billion in 2004. In 2007, lower prices for houses and stricter lending standards contributed to a slide in the amount of withdrawn equity—those withdrawals were about $550 billion (measured on an annual basis) in the first three quarters of the year. Probably only a small fraction of that amount was used for consumer spending; homeowners used the majority of it for such purposes as home improvements and debt repayment.

CBO expects that by the first quarter of 2009, house prices nationwide will have fallen by about 10 percent from their peak. The decline in housing wealth will lower the growth of real consumer spending in 2008 and 2009 by about 1 percentage point and half a percentage point, respectively.¹³

The Growth of Employment and Household Income. Employment growth declined throughout 2007, and CBO anticipates that its pace will slow further in the near future. Current data show that during 2007, the economy added 111,000 jobs per month—a rate substantially below the 189,000 jobs added monthly during 2006 and the 212,000 jobs per month that were added during 2005.¹⁴ With the slowing of employment growth, the unemployment rate has crept up from an average of 4.5 percent during the first half of 2007 to an average of 4.8 percent during the fourth quarter (with a jump from 4.7 percent to 5.0 percent in December).

Thus far, much of the decline in the growth of employment has been attributed to housing-related industries, such as residential construction and mortgage lending. Since early 2006, employment in residential construction has fallen by about 300,000 jobs (8 percent); about half of that decline occurred during the second half of 2007. However, further large job losses in that sector are quite possible because residential investment has declined much more rapidly than employment over the past two years.¹⁵

Despite the increase in unemployment, layoffs may not rise as much as they did in previous slowdowns. In the past few years, firms apparently did not hire excess workers. Much of the slowing in job growth appears to have taken place because of a drop in hiring rather than a rise in layoffs. Rates of both job creation and job destruction have been lower in the past several years than they were in the 1990s, suggesting that employers will need to shed fewer workers when demand weakens than they did during past episodes of ebbing economic activity. That factor, in turn, could prevent the economy’s initial weakening from turning into a self-reinforcing downward spiral in the growth of spending, output, and employment.

CBO expects that the rate of growth of hourly wages will decline in the near term. Wages have grown rapidly over the past few years, helping to sustain a rise in consumer spending in the face of a reduction in housing wealth. But hourly wage growth has already started to inch downward, possibly reflecting the slowdown in job creation. For its forecast, CBO assumed that the slow growth in hourly wages would continue throughout this year. Expectations are that the tepid rise in wages, when combined with a fall in the growth of the number of hours worked, will reduce the growth of household income and consumer spending in the near term.

The High Price of Energy. The price index for consumer spending on energy goods and services rose during 2007, and the increased prices that such a rise reflects are likely to curtail consumer spending on nonenergy goods and services. Consumers’ expenditures for energy were about $50 billion higher in the second half of 2007 than in the second half of 2006. Although the increase in oil prices does not seem to have affected spending for goods and services thus far, the persistently high level of energy prices is expected to weaken consumer spending this year.

Consumer Expectations. Consumers’ attitudes about their future economic circumstances have deteriorated in the past year. Two commonly used indexes of such attitudes are maintained by the University of Michigan and the Conference Board. Both show that consumer expectations are at their lowest point since the aftermath of the 2005 hurricanes, suggesting that consumer spending is likely to be weak in the near term (see Figure 2-7).

Note: Data are monthly, smoothed using a three-month moving average, and plotted through December 2007.

Slower Growth in Investment by Businesses. Stalling domestic demand and the tightening of credit conditions for businesses are likely to reduce the growth rates of firms’ spending on investment this year. However, the growth of investment, in CBO’s forecast, will improve in 2009, as consumer spending rebounds.

The patterns of growth of the two major categories of business fixed investment have diverged in recent years. The nonresidential-structure component provided solid support for the growth of GDP in 2006 and 2007, but spending for producers’ durable equipment and software has been much less robust (see Figure 2-8). The differences in the growth of the two categories can be explained by their cyclical dynamics. In response to the faster growth of demand in 2003 and 2004, businesses boosted the rate of growth of the capital stock by increasing investment. But firms can shift their investment, particularly investment in structures, only slowly because of the time it takes to make such changes and the cost of those adjustments. Investment in equipment and software did not fully catch up to the higher level of demand until early 2006, and nonresidential construction is only now catching up. Just as the growth of investment in equipment and software slowed in 2006 and 2007, the growth of nonresidential construction will slow in 2008, in CBO’s estimation. Also, investment in producers’ durable equipment and software will remain weak throughout 2008, CBO forecasts.

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

Part of that anticipated weakness stems from the increase, for some businesses, in the cost of financing their investment. As mentioned earlier, the risk premium paid by borrowers with a speculative-grade credit rating has risen sharply. Lending standards for business loans, including commercial real estate and commercial and industrial loans, have been tightened. In addition, although the growth of corporate profits, which provide internal funds and lessen the need for borrowing, has been remarkably strong for several years, it has recently slowed.

Nevertheless, the risk of a collapse in business fixed investment—such as those that occurred in the last two recessions—is small. The situation today is much more favorable than it was in the late 1990s, when after many years of rapid growth, investment was overdue for a downturn. This time, profits of many firms have grown briskly for many years, and many nonfinancial companies have large cash holdings that will partially insulate them from the credit crunch. Buyouts still occur frequently (although those that use private equity occur less often). In addition, the level of the capital stock does not appear excessive in relation to the fundamentals of investment—demand, productivity, and employment—so the slowdown in the growth of demand that CBO anticipates is unlikely to be exacerbated by a major retrenchment in businesses’ investment.

Although the growth of domestic demand will slow in 2008, the growth of domestic output and employment will be partially buoyed, CBO forecasts, by an increase in net exports. The decline in domestic demand growth will reduce U.S. consumers’ spending on imports as well, and relatively strong economic expansion abroad will keep sales of U.S. products there rising. As a result, the trade deficit is forecast to decline (that is, net exports will become less negative), and the current-account deficit is also expected to shrink.¹⁶ CBO forecasts that the rise in net exports will directly boost GDP growth this year by about three-quarters of a percentage point.

Stronger Growth Among the United States’ Trading Partners. CBO expects that despite some slowing, economic growth abroad in the near term will remain more robust than growth in the United States. The outlook for the industrialized economies, in particular, is now subject to a higher degree of uncertainty as a result of the continuing vulnerability of global financial markets to the subprime-related troubles in the United States. Emerging economies, however, are expected to continue their strong economic expansions.

The turmoil in the financial markets will affect foreign economies less than it will affect the U.S. economy. With a few exceptions, foreign countries had not relied on the kinds of subprime financing methods that precipitated the market’s turbulence in the United States. Some foreign banks and other financial institutions invested in, and suffered losses from, U.S. mortgage-backed securities. However, such losses affect a smaller proportion of those countries’ financial institutions than they do in the United States, and thus far, other nations’ central banks have avoided widespread financial difficulties by injecting, as noted earlier, a significant amount of liquidity into their financial markets.

Similarly, the adverse effects of higher energy prices may be more muted abroad. The impact of increased oil prices overseas has been dampened by the rise in the value of foreign currencies relative to the dollar. European economies, moreover, export more goods and services to the oil-exporting countries than the United States does and thus are likely to benefit more from those countries’ spending.

Some analysts fear that a downturn in domestic demand here will trigger much weaker growth abroad because the strength of some of those economies depends heavily on selling goods and services to the United States. It appears, however, that such nations have built up the growth of their own domestic demand over the past few years and have gradually lessened their dependence on exports to the United States. The persistence of rapid foreign growth last year in the face of a reduction in the growth of exports to the United States and a decline in the United States’ real trade deficit indicate that growth abroad has, at least to some degree, been decoupled from the growth of U.S. domestic demand.

The growth of emerging economies, in particular, has been quite strong in recent years, and that momentum will help to soften the global effects of the slowdown in the United States. Financial problems in this country have not caused a credit shortage in emerging economies’ financial markets but instead have channeled capital to those countries (especially to Brazil and India).

The Recent Decline in the Exchange Value of the Dollar. The fall in the value of the dollar as measured against foreign currencies will also tend to reduce the trade deficit by encouraging exports and discouraging imports. The dollar has been on a downward trend since early 2002, but the pace of its decline against the currencies of major trading partners quickened last year (see Figure 2-9).

For its forecast, CBO assumes that, once the financial disturbances have subsided, the exchange rate will return to a more gradually declining path that reflects the United States’ economic relationships with the rest of the world.

Total real purchases (consumption plus investment) by all levels of government grew by about 2 percent in 2007. CBO forecasts that in 2008, purchases will grow at about the same pace but that in 2009, the pace will decline slightly.

The assumptions that CBO makes about the growth of federal spending imply real growth in federal purchases of about 3 percent in fiscal year 2008 and a slowing of that pace by half in fiscal year 2009.¹⁷ Federal appropriations for 2008 so far include only $88 billion for military operations and other activities in Iraq and Afghanistan—more than $80 billion less than the amount policymakers provided last year for such purposes. However, some of last year’s funds remain to be spent this year (and in future years), which will boost the growth of government purchases in 2008. (Similar effects hold for calendar years.) The slowing projected for fiscal year 2009 reflects the current-law assumptions that CBO uses in its budget and economic projections: CBO bases its projections only on the funds provided thus far for 2008 and therefore estimates that the growth of defense outlays in 2009 will be slower than it is in 2008. (The outlook for federal spending is discussed in detail in Chapter 3.) It is likely, however, that policymakers will provide additional funds for military operations in the months ahead, which would increase the growth of defense spending (relative to the rate incorporated in CBO’s baseline projections) both this fiscal year and next.¹⁸

CBO’s forecast assumes that the growth of spending by state and local governments will slow. Purchases of goods and services by states and localities increased by more than 2 percent in calendar year 2007, the fourth year of steady growth, but spending is likely to be trimmed this year because of the weaker revenues associated with a slowdown in general economic activity. In addition, continued declines in property values will tend to lower receipts from property taxes and real estate transactions.

Although CBO anticipates that inflation will be moderate, on average, in 2008 and 2009, increases in the prices of commodities (such as oil and grains) and the fall in the value of the dollar last year heighten the risk that inflation will rise. Core consumer price inflation, which excludes the volatile prices of food and energy, eased last year, and in CBO’s forecast, it remains moderate, given that the feeble pace of economic growth anticipated in 2008 will reduce upward pressure on both wages and prices. In addition, high vacancy rates in the residential housing market imply that the growth of rents for housing, which account for a large portion of core inflation, will be slow in the near term. The outlook for overall inflation is more uncertain than that for core inflation because it takes account of the ups and downs of energy and food prices. However, CBO expects that consumer price inflation for both energy and food will ease by the end of 2008 and that inflation will be moderate in 2009 (see Figure 2-10).

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

Notes: The overall PCE price index is the chained price index for personal consumption expenditures. The core index excludes prices for food and energy.

Traditional measures of the inflationary pressures that stem from resource constraints indicate that core inflation will subside in 2008. The unemployment rate rose over the past year, and the growth of wages slowed. In addition, productivity growth in 2007 remained solid, and the combination of slower wage growth and a relatively sturdy rise in productivity implies that the growth of unit labor costs—the rise in hourly compensation in excess of labor productivity growth—was about 2 percent during 2007. In addition, capacity utilization in the manufacturing sector stayed below the level that suggests a high level of demand for goods that in turn can lead to inflationary pressures.

The outlook for rents reinforces the likelihood that inflation in the near term will be low. Rents, including the imputed rent for owner-occupied homes, are particularly important in considering inflation because they account for substantial portions of the most commonly used measures of underlying inflation in the prices of consumer goods: 38 percent of the core CPI-U and 14 percent of the core personal consumption expenditure (PCE) price index. Rent inflation slowed during 2007 as vacancy rates remained high for traditional rental units and for houses that are usually owner-occupied. Those rates are likely to remain elevated because of a general surplus of housing and the possibility that some people who cannot sell their houses will try to rent them. Also a possibility, though, is that increased demand for rental units as a result of the rising number of foreclosures may partly offset that effect. Although the growth of rents is difficult to predict, CBO expects that high vacancy rates will constrain such growth throughout 2008 and 2009.

The price of petroleum—specifically, the price of West Texas Intermediate crude oil—jumped late last year and in December averaged about $92 a barrel. In inflation-adjusted terms, the price surpassed its previous peak in 1980 (see Figure 2-11). Accounting for much of the recent surge in prices is burgeoning demand for crude oil from fast-growing developing countries in combination with the slow growth of supply. But geopolitical tensions and increases in demand as a result of speculative and precautionary purchases have also exerted upward pressure on prices. The rise in the price of crude oil has pushed the price of petroleum products—such as gasoline and heating oil—higher. For example, the national average price of a gallon of gasoline went from $2.31 in December 2006 to $3.02 in December 2007.

Sources: Congressional Budget Office; Wall Street Journal; Department of Commerce, Bureau of Economic Analysis.

Notes: The price is for West Texas intermediate crude oil. Before 1982, it refers to the posted price; for later years, the spot price. The price is adjusted for inflation by dividing it by the chained price index for personal consumption expenditures.

Data are monthly and are plotted through December 2007 (the December value for the price index is an estimate).

For its forecast, CBO has assumed that the price of petroleum will fall during 2008 to about $84 a barrel by year’s end. That assumption was based on prices in the futures market at the time that the forecast was completed, in early December. If that drop does, indeed, occur, the prices paid by consumers for heating oil and gasoline will be lower at the end of the year than they are today (despite the seasonal hike in gasoline prices during the summer), which will dampen the overall growth of consumer prices. The volatility of those prices in recent years, however, suggests that changes in petroleum prices could affect the accuracy—in either direction—of CBO’s forecast for inflation.

Inflation in food prices is expected to fall slightly from the 4½ percent to 5 percent rate of the past year to about 3 percent by the end of 2008. But inventories of grains were small at the end of 2007, and that increases the risk that poor harvests might cause food prices to rise more than CBO anticipates. A large number of prices for foodstuffs (such as corn, wheat, milk, and eggs) rose in 2007, and those increases boosted consumer food price inflation (see Figure 2-12). The prices of various grains are high in part because of continued concerns about small global stocks. In its forecast, CBO assumes that overall food commodity prices will stabilize or ease slightly during the first half of this year, reducing upward pressure on consumer prices by the end of 2008.

Sources: Congressional Budget Office; Commodity Research Bureau; Department of Commerce, Bureau of Economic Analysis.

Notes: The food price inflation measure is the growth of the six-month moving average of the chained price index for personal consumption expenditures on food. The foodstuffs index includes butter, cocoa beans, corn, hogs, lard, soybean oil, steers, sugar, and wheat.

Data are monthly. For food price inflation, they are plotted through November 2007; for the foodstuffs price index, they are plotted through December of that year.

The declining dollar will tend to increase core consumer price inflation, but CBO expects that its overall effect will be muted. Several recent studies indicate that the effect on inflation of changes in exchange rates has been smaller over the past several years than it was in the past. That shift arises mainly because foreign exporters have responded to the dollar’s depreciation by reducing the prices of their goods and services (through increases in productivity or reductions in their profits).¹⁹ Nevertheless, the losses that those exporters can absorb are limited. Given how much and how fast the value of the dollar has declined recently, some of the effects of the drop in the exchange rate may be passed through to consumer prices in the near term. However, in CBO’s forecast, the upward pressure on prices from the dollar’s decline is offset by the moderating effects of slow economic growth.

CBO’s economic projections for the period beyond the next two years, to 2018, do not explicitly incorporate any ups and downs in the business cycle. Instead, they reflect the average effects of typical cycles, thereby including the likelihood that at least one recession will occur in any 10-year interval. The projections for that medium-term period extend historical trends in such underlying factors as the growth of the labor force, the growth of productivity, and the rate of national saving. CBO’s projections for real GDP, inflation, real interest rates, and tax revenues are based on the projections of those underlying factors, including how current fiscal policy might affect the way those factors evolve.

CBO’s projection of growth in real GDP averages 2.7 percent annually during the 2010–2018 period, a pace that exceeds the rate of growth of potential GDP during the same time. Weak growth in 2008 leaves real GDP below its potential level at the end of 2009, even though CBO expects that growth will pick up during that year. Thus, to bring actual and potential GDP back to their average historical relationship, CBO assumes that the rate of growth of the economy will be faster than its potential growth rate during the years after 2009.

CBO’s current projections for inflation, unemployment, and interest rates after 2009 are similar to the ones that it published last August.²⁰ Inflation, as measured by the CPI-U, will average 2.2 percent during the 2010–2018 period, CBO projects, and growth in the PCE price index will average 1.9 percent. For most of the medium term, unemployment rates will average 4.8 percent, and interest rates on Treasury securities will average 4.6 percent for 3-month bills and 5.2 percent for 10-year notes.

In CBO’s projection, potential output grows at an annual rate of 2.6 percent, on average, during the 2008–2018 period, or about eight-tenths of a percentage point slower than its long-run average pace of 3.4 percent (see Table 2-2). Growth will be slower than the historical average, in CBO’s estimation, primarily because of the sharp slowdown expected in the rate of expansion of the potential labor force, as the large cohort of workers born during the postwar baby boom (from 1946 to 1964) begins to reach the traditional age for retirement. In addition, the rate of capital accumulation, which averages 3.5 percent annually in CBO’s 10-year projection, is slower than its average rate of growth since 1950. By contrast, productivity growth rises at a rate that is close to its long-run average. CBO’s projection for the growth of potential GDP has been revised downward since CBO last updated its forecast, in August 2007, largely because revisions to the source data on which CBO bases its economic estimates have revealed a somewhat slower trend in potential total factor productivity, or TFP (average real output per unit of combined labor and capital services).

									Projected Average
			Average Annual Growth						Annual Growth
								Total,			Total,
			1950–	1974–	1982–	1991–	2002–	1950–	2008–	2014–	2008–
			1973	1981	1990	2001	2007	2007	2013	2018	2018


			Overall Economy

Potential Output			3.9	3.2	3.1	3.1	2.8	3.4	2.7	2.5	2.6
Potential Labor Force			1.6	2.5	1.6	1.2	1.1	1.6	0.8	0.5	0.7
Potential Labor Force Productivity^a			2.3	0.7	1.5	1.9	1.6	1.8	1.8	2.0	1.9

			Nonfarm Business Sector

Potential Output			4.0	3.6	3.3	3.5	3.0	3.6	3.0	2.9	2.9
Potential Hours Worked			1.4	2.3	1.7	1.1	1.1	1.5	0.8	0.5	0.7
Capital Input			3.8	4.2	4.1	4.6	2.5	3.9	3.5	3.5	3.5
Potential TFP			1.9	0.7	0.9	1.3	1.5	1.4	1.4	1.4	1.4
	Potential TFP excluding adjustments		1.9	0.7	0.9	1.3	1.3	1.4	1.3	1.3	1.3
	TFP adjustments		0	0	0	0.1	0.2	*	0.1	0.1	0.1
		Price measurement^b	0	0	0	0.1	0.1	*	0.1	0.1	0.1
		Temporary adjustment^c	0	0	0	*	*	*	0	0	0

Contributions to the Growth of Potential
Output (Percentage points)
	Potential hours worked		0.9	1.6	1.2	0.8	0.7	1.0	0.5	0.4	0.5
	Capital input		1.1	1.3	1.2	1.4	0.8	1.2	1.1	1.1	1.1
	Potential TFP		1.9	0.7	0.9	1.3	1.5	1.4	1.4	1.4	1.4

		Total Contributions	4.0	3.6	3.3	3.5	3.0	3.6	3.0	2.8	2.9

Potential Labor Productivity
in the Nonfarm Business Sector^d			2.6	1.3	1.5	2.4	1.9	2.1	2.2	2.3	2.3

CBO now projects that the potential labor force—the labor force after an adjustment for movements in the business cycle—will grow at an average annual rate of 0.7 percent during the 2008–2018 period. That rate, which is almost identical to CBO’s projection in August, is considerably lower than the 1.6 percent rate of growth experienced during the 1950–2007 period. Labor force growth is expected to slow because the rate of labor force participation is likely to decline during the next decade with the baby boomers’ retirement; in addition, the rate of participation by women in the labor force is unlikely to increase during the next 10 years as it did in the past. (After a large surge during the 1960s, 1970s, and 1980s, women’s participation leveled off during the 1990s and has remained flat since then.) In addition to the demographic effects, CBO’s projection for growth of the labor force incorporates a slight slowing because of the increase in marginal personal tax rates scheduled under current law. (Rates increase over the medium term because of the growing reach of the alternative minimum tax, real bracket creep—in which inflation pushes income into higher tax brackets—and the expiration of provisions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001.) CBO assumes that the increase in marginal tax rates will modestly lessen people’s incentive to work.

The average rate of capital accumulation that CBO projects for the 2008–2018 period—3.5 percent—is almost identical to the rate it projected last August, but it is slower than the long-run average rate, largely because of the projected slowdown in labor force growth. One by-product of that slowdown is that firms will not need to increase the stock of capital at the same rate as in the past—because there will be relatively fewer workers to provide with structures, equipment, and software. Hence, firms can maintain the same growth in the amount of capital per worker but with less investment than in other periods.

CBO’s projections show potential TFP growing by 1.4 percent, on average, during the 2008–2018 period. That rate, which is similar to both the historical average and the rate in last August’s projection, results from largely offsetting changes caused by revisions to source data—specifically, the national income and product accounts (NIPAs)—and data that have become newly available.

In August, the Department of Commerce’s Bureau of Economic Analysis (BEA), which maintains the NIPAs, released a set of revisions to the accounts that revealed that the growth of TFP since 2003 was significantly slower than previously thought. According to the data available last summer, before BEA’s revision, TFP grew at an average annual rate of 1.5 percent between the third quarter of 2003 and the first quarter of 2007; according to the most recent, revised data, the growth rate was 1.1 percent (see Figure 2-13). By itself, that change would tend to lower CBO’s projection of potential TFP. However, other data released since August indicate that total factor productivity grew strongly in the second and third quarters of 2007 (4.1 percent at an annual rate). The addition of the latter data improve the outlook for potential TFP and largely offset the effects of BEA’s revisions to the NIPAs.

Note: Data are quarterly and are plotted through the first quarter of 2007 (for August 2007 TFP) and the third quarter of 2007 (for January 2008 TFP and trend TFP).

CBO’s projections for inflation have changed little since last August. Inflation, as measured by the CPI-U, will average 2.2 percent annually during the 2010–2018 period, CBO now estimates, and growth in the PCE and core PCE price indexes will average 1.9 percent per year. In general, CBO assumes that in the medium term, monetary policy will determine what happens to inflation, and that the Federal Reserve will seek to maintain core inflation in the PCE price index at just under 2 percent, on average. CBO projects that the rate of unemployment will average 4.8 percent during the 2010–2018 period.

CBO’s medium-term projections for interest rates are also quite similar to those it published in August. CBO estimates those rates by adding its projection for inflation to 3-month Treasury bills will average 2.5 percent during the latter years of the projection period, CBO forecasts, and the real rate on 10-year Treasury notes will average 3.0 percent. When combined with the projected rates of CPI-U inflation, those real rates imply nominal rates of 4.7 percent for 3-month Treasury bills and 5.2 percent for 10-year Treasury notes.

CBO’s projections of federal revenues are based on its projections of various categories of income as measured in the NIPAs. The outlook for revenues is most directly affected by projections of wages and salaries, corporate profits, proprietors’ income, and interest and dividend income. However, CBO makes numerous adjustments to the NIPA categories to project the income reported on tax forms for calculating tax liability (see Chapter 4 for details of CBO’s outlook for revenues).

Before-tax profits (which are also known as book profits) required an unusual adjustment for CBO’s current forecast. Corporate tax returns are the primary source of data for the NIPAs’ estimates of profits and book depreciation (the depreciation that the tax code allows businesses to deduct when they calculate their taxable profits), but at the time that BEA released its August revisions, the most recent complete data for those returns were for 2004. BEA, in developing its estimate of depreciation and book profits for 2005, relied on preliminary information from the Internal Revenue Service gathered from corporate tax returns for 2005 and on other data, such as the Bureau of the Census’s surveys on corporate profits for years after that.

Since August, more-complete data for 2005 have become available. As a result, CBO’s estimate of book depreciation for 2005 and subsequent years is higher than BEA’s estimate, and CBO’s estimate of book profits between 2005 and 2007 is lower. Because of that, CBO has used a different historical pattern for book profits in its projections of revenues than the pattern provided by the NIPAs. (See Chapter 4 for additional detail on the effects of profits on CBO’s revenue outlook.) CBO includes only economic profits in its forecast tables this year because that measure is not affected by differences in assumptions about historical book depreciation and is a better measure of profits from current production.

The labor share of GDP has averaged 62.3 percent since 1950. CBO’s measure of labor income consists of the total compensation that employers pay their employees—that is, the sum of wages and salaries and supplemental benefits—and 65 percent of proprietors’ income. Supplements include employers’ payments for health and other insurance premiums, employers’ contributions to pension funds, and the employer’s share of payroll taxes (for Social Security and Medicare). Most stock options are included in the wage and salary component of labor income when they are exercised.²² (Stock options were a factor in the rise in the GDP labor share in the late 1990s.)

Recent data from the NIPAs indicate that the labor income share of GDP over the four quarters ending in the third quarter of 2007 averaged about 61.9 percent, or about half a percentage point less than its long-term average. The relatively low unemployment rate nationwide during 2007 encouraged faster growth of compensation last year, but the slowdown in economic growth that CBO expects this year is likely to suppress the growth of wages. Therefore, CBO projects that labor income will grow only slightly faster this year than the slow growth it has forecast for nominal GDP. However, CBO assumes that the labor share of GDP will return to its long-run average during the 2008–2018 period (see Figure 2-14).

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

The GDP share of domestic capital income is essentially the opposite of the labor share, and so it falls slowly in CBO’s forecast. Capital income consists of domestic corporate profits, depreciation charges, interest and transfer payments made by domestic businesses, rental income, and the remaining 35 percent of proprietors’ income. Within the capital share, CBO’s forecast anticipates a decline in domestic economic profits relative to GDP and an increase in domestic businesses’ interest payments (see Figure 2-15). In the past, the growth of profits has weakened when the growth of GDP slowed, and CBO’s forecast reflects that historical pattern. Profits have been high relative to GDP in recent years, in part because businesses’ interest payments have been unusually low, reflecting both low corporate interest rates and the slower accumulation of debt in the corporate sector compared with past periods. In the latter years of the projection period (2010 to 2018), the shares of domestic profits and interest payments in CBO’s projections are expected to move to levels that are similar to their averages over the past 20 years.

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

Compared with its August projections, CBO’s current forecast for 2008 and 2009 indicates much weaker growth, significantly higher inflation in 2008, lower interest rates, and a smaller GDP share for profits (see Table 2-3). Real growth in the middle of 2007 turned out to be faster than CBO had anticipated in its forecast last summer; also, during the second half of 2007, housing activity declined more than CBO had expected and energy prices rose by much more. In addition, the repercussions from the subprime shock to the financial markets now appear to be more severe than CBO had initially thought they would be. The weaker near-term outlook has also resulted in lower interest rates on Treasury securities in recent months (although interest rates on all low-rated private-sector securities are higher). Given the environment of very slow growth this year, CBO expects that interest rates on Treasury securities will remain lower in 2008 and 2009 than the rates it had forecast last August.

			Estimated	Forecast		Projected Annual Average
			2007	2008	2009	2010 to 2013		2014 to 2017


Nominal GDP (Billions of dollars)
		January 2008	13,828	14,330	14,997	18,243	^a	21,654	^b
		August 2007	13,893	14,575	15,306	18,390	^a	21,829	^b
Nominal GDP (Percentage change)
		January 2008	4.8	3.6	4.7	5.0		4.4
		August 2007	4.9	4.9	5.0	4.7		4.4
Real GDP (Percentage change)
		January 2008	2.2	1.7	2.8	3.1		2.5
		August 2007	2.1	2.9	3.2	2.8		2.5
GDP Price Index (Percentage change)
		January 2008	2.5	1.9	1.8	1.9		1.9
		August 2007	2.7	2.0	1.8	1.8		1.8
Consumer Price Index^c (Percentage change)
		January 2008	2.8	2.9	2.3	2.2		2.2
		August 2007	2.8	2.3	2.2	2.2		2.2
Unemployment Rate (Percent)
		January 2008	4.6	5.1	5.4	4.9		4.8
		August 2007	4.5	4.7	4.8	4.8		4.8
Three-Month Treasury Bill Rate (Percent)
		January 2008	4.4	3.2	4.2	4.6		4.7
		August 2007	4.8	4.8	4.8	4.7		4.7
Ten-Year Treasury Note Rate (Percent)
		January 2008	4.6	4.2	4.9	5.2		5.2
		August 2007	4.9	5.2	5.2	5.2		5.2
Tax Bases (Billions of dollars)
	Economic profits
		January 2008	1,599	1,620	1,649	1,842	^a	2,200	^b
		August 2007	1,702	1,751	1,788	2,004	^a	2,330	^b
	Wages and salaries
		January 2008	6,368	6,615	6,913	8,401	^a	9,936	^b
		August 2007	6,383	6,703	7,046	8,470	^a	10,016	^b
Tax Bases (Percentage of GDP)
	Economic profits
		January 2008	11.6	11.3	11.0	10.3		10.1
		August 2007	12.3	12.0	11.7	11.2		10.7
	Wages and salaries
		January 2008	46.0	46.2	46.1	46.1		46.0
		August 2007	45.9	46.0	46.0	46.0		46.0

Memorandum:
Real Potential GDP (Percentage change)
		January 2008	2.8	2.8	2.7	2.6		2.5
		August 2007	2.8	2.8	2.8	2.7		2.5

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

Notes: GDP = gross domestic product; percentage changes are measured from one year to the next.

CPI-U inflation during the last few months of 2007 was much higher than CBO had anticipated because prices for motor fuel jumped unexpectedly. However, if price hikes for energy are excluded from that measure, inflation grew only slightly more during the last quarter of 2007 than CBO had previously estimated. The current forecast assumes that the large upticks in the prices of food and energy in 2007 were largely transitory; thus, CBO forecasts that growth in the CPI-U after 2008 will be essentially the same as the estimate of growth it published last August.

In the case of CBO’s medium-term projections, the major changes relative to CBO’s last outlook are the slight reduction in projected growth of real GDP and the lower profits share of GDP. Average inflation, the unemployment rate, and interest rates over the medium term are largely unchanged from CBO’s August 2007 projections.

Changes in the economic outlook since last summer have reduced CBO’s projections of revenues significantly, but they have also slightly curbed its projections of spending in the near term. The economic changes have worsened the overall budget outlook for 2008 by $17 billion, and the changes over the 10 years from 2008 to 2017 have increased the projection of the cumulative deficit for that period by $486 billion. The slower real growth of GDP and the lower profits share that CBO projects throughout the period account for the reduction in revenues. The drop in the projected rates on Treasury securities will reduce the government’s net interest payments, CBO forecasts, particularly in 2008 and 2009. (The specific revisions to the budget outlook that can be attributed to changes in the economic forecast are described in more detail in Appendix A.)

CBO’s forecast for real growth in 2008 is significantly more pessimistic than that of the Administration and somewhat more pessimistic than the current Blue Chip consensus forecast (see Table 2-4). (The Blue Chip consensus forecast is based on a survey of about 50 private-sector forecasters.) After 2008, the differences between the forecasts are not large for most categories of estimates, although CBO’s shows markedly higher unemployment and short-term interest rates in 2009 compared with those of the Blue Chip consensus and the Administration.

					Projected
		Estimated	Forecast		Annual Average,
		2007	2008	2009	2010 to 2013


		Fourth Quarter to Fourth Quarter (Percentage Change)
Nominal GDP
	CBO	4.7	3.7	5.1	5.0
	Administration	5.1	4.8	5.1	4.9
	Blue Chip consensus	5.2	4.2	5.1	n.a.

Real GDP
	CBO	2.5	1.5	3.3	3.0
	Administration	2.7	2.7	3.0	2.9
	Blue Chip consensus	2.6	2.0	2.9	n.a.

GDP Price Index
	CBO	2.2	2.1	1.8	1.9
	Administration	2.3	2.0	2.0	2.0
	Blue Chip consensus	2.6	2.1	2.1	n.a.

Consumer Price Index^a
	CBO	3.8	2.5	2.2	2.2
	Administration	3.9	2.1	2.2	2.3
	Blue Chip consensus	3.9	2.4	2.3	n.a.

		Calendar Year Average (Percent)
Unemployment Rate
	CBO	4.6	5.1	5.4	4.9
	Administration	4.6	4.9	4.9	4.8
	Blue Chip consensus	4.6	5.0	5.0	n.a.

Three-Month Treasury Bill Rate
	CBO	4.4	3.2	4.2	4.6
	Administration	4.4	3.7	3.8	4.1
	Blue Chip consensus	4.4	3.4	3.9	n.a.

Ten-Year Treasury Note Rate
	CBO	4.6	4.2	4.9	5.2
	Administration	4.7	4.6	4.9	5.2
	Blue Chip consensus	4.6	4.3	4.8	n.a.

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of LaborStatistics; Federal Reserve Board; Aspen Publishers, Inc., Blue Chip Economic Indicators (January 10, 2008); Council of Economic Advisers, Department of the Treasury, and Office of Management and Budget, "Administration Economic Forecast" (joint press release, November 29, 2007).

Notes: The Blue Chip consensus is the average of about 50 forecasts by private-sector economists. The latest Blue Chip consensus does not extend past 2009.

The Blue Chip consensus forecast of January 10, 2008, projects a rate of growth for real output in 2008 that is about halfway between the forecasts of the Administration and CBO, but the publishers of the Blue Chip outlook note that their January survey was taken before the weak employment report of December 2007. Hence, they speculate, participants would probably have lowered their forecasts of economic growth for 2008 if they had been aware of those data.

CBO’s lower forecast, relative to the Blue Chip’s, of real output growth in 2008 stems from a view of the growth of household real income and spending that is less robust than the one that the January Blue Chip outlook foresees. However, the two forecasts are nearly identical for CPI-U inflation in 2008 and 2009. Unemployment rates in the two outlooks are about the same for 2008, but that of the consensus shows no additional rise in 2009—whereas CBO’s shows a significant further increase in that year. The consensus view of long-term Treasury rates differs only slightly from CBO’s for both 2008 and 2009, but its outlook for the rates on 3-month Treasury bills follows a different path than CBO’s: The Blue Chip’s average for interest rates on the 3-month Treasury bill is higher in 2008 by 0.2 percentage points and lower in 2009 by 0.3 percentage points than CBO’s forecast for those rates.

Compared with the Administration, CBO expects slower real growth and a higher unemployment rate during 2008 as well as higher CPI-U inflation. CBO projects significantly lower interest rates on 3-month Treasury bills and 10-year Treasury notes during 2008 than does the Administration.

Because the Federal Reserve is now publishing its range of internal forecasts more frequently, CBO can compare the annual economic projections in its outlook with those of the central bank (see Table 2-5). The Federal Reserve’s Federal Open Market Committee compiles and releases its projections four times each year, but there is a delay between the time of the meeting and the actual report. Thus, the comparisons here (which consider CBO’s forecast against the projections prepared for the committee’s meeting last October) may differ substantially from those involving later projections by the FOMC. (The next time the projections will be released will be in February, after the committee’s January meeting.)

		Federal Reserve^a
			Central
		Range	Tendency	CBO


		Calendar Year 2007

Percentage Change, Fourth Quarter to Fourth Quarter
	Real gross domestic product	2.2 to 2.7	2.4 to 2.5	2.5
	PCE price index	2.7 to 3.2	2.9 to 3.0	3.2
	Core PCE price index^b	1.8 to 2.1	1.8 to 1.9	2.0

Average Level, Fourth Quarter (Percent)
	Civilian unemployment rate	4.7 to 4.8	4.7 to 4.8	4.7

		Calendar Year 2008

Percentage Change, Fourth Quarter to Fourth Quarter
	Real gross domestic product	1.6 to 2.6	1.8 to 2.5	1.5
	PCE price index	1.7 to 2.3	1.8 to 2.1	2.1
	Core PCE price index^b	1.7 to 2.0	1.7 to 1.9	1.9

Average Level, Fourth Quarter (Percent)
	Civilian unemployment rate	4.6 to 5.0	4.8 to 4.9	5.3

		Calendar Year 2009

Percentage Change, Fourth Quarter to Fourth Quarter
	Real gross domestic product	2.0 to 2.8	2.3 to 2.7	3.3
	PCE price index	1.5 to 2.2	1.7 to 2.0	1.9
	Core PCE price index^b	1.5 to 2.0	1.7 to 1.9	1.9

Average Level, Fourth Quarter (Percent)
	Civilian unemployment rate	4.6 to 5.0	4.8 to 4.9	5.3

Sources: Congressional Budget Office; Federal Reserve Board of Governors, "Minutes of the Federal Open Market Committee, October 30–31, 2007" (November 20, 2007), available at www.federalreserve.gov/monetarypolicy/files/fomcminutes20071031.pdf.

Relative to the FOMC’s October 2007 projections, CBO foresees real growth of GDP that is below the reported range of the Federal Reserve’s estimates for 2008, whereas it forecasts real GDP growth for 2009 that is above the FOMC’s range of estimates. In addition, CBO estimates that the unemployment rate will be above the range expected by the Federal Reserve for both 2008 and 2009.

CBO’s inflation forecast for 2008 and 2009 is at the upper end of the central tendency for overall inflation reported by the Federal Reserve on the basis of the October FOMC meeting. Similarly, CBO’s forecast for core inflation lies at the top end of the central tendency published by the central bank.

The National Bureau of Economic Research is by convention responsible for dating the peaks and troughs of the business cycle. According to its Business Cycle Dating Committee, a recession is "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real [inflation-adjusted] GDP, real income, employment, industrial production, and wholesale-retail sales." For further discussion, see www.nber.org/cycles/jan08bcdc_memo.html.

The Organisation for Economic Co-operation and Development (OECD) suggests that the ultimate cumulative losses will be in the range of $200 billion to $300 billion (see Adrian Blundell-Wignall, Structured Products: Implications for Financial Markets, Paris, OECD, 2007). Wall Street investment firms project larger losses: Goldman Sachs estimates total losses of around $400 billion (Goldman Sachs, US Daily Financial Market Comment, November 15, 2007), and Merrill Lynch puts them at around $500 billion (David A. Rosenberg, "A Daily Snapshot of Market Moving Developments," Morning Market Memo, New York, Merrill Lynch, December 19, 2007).

Rates on ARMs are subject to change when market interest rates change. (Rates are frequently tied to the rates banks charge each other for short-term loans.) Many subprime ARMs are hybrid products in which rates are fixed for the first two or three years and are reset annually thereafter.

See Christopher L. Cagan, Mortgage Payment Reset: The Issue and the Impact (Santa Ana, Calif.: First American CoreLogic, March 19, 2007).

Securitization is the process by which loans (student loans, mortgages, commercial loans, and automobile loans) and other receivables (credit card payments) are assembled into pools and then their cash flows sold as tradable asset-backed securities that are purchased by different classes of investors who accept different levels of risk.

Measures of home prices differ substantially in their coverage and how they handle changes in quality. The OFHEO index covers all areas of the country and has a relatively sophisticated adjustment for quality—a major issue in measuring home prices—but it is restricted to houses with conforming mortgages, thus missing the parts of the market that have been most affected by the recent turmoil. The S&P/Case-Shiller indexes use the same adjustment for quality and cover fewer markets and only single-family homes. However, they include all such homes in a covered area, whatever their type of mortgage. The Radar Logic composite index covers just 25 metropolitan housing markets and is not intended to represent the national market. It picks up all transactions, including condominiums, and is updated daily. Its only quality adjustment, however, is for the size of the residence.

The index measures the financial ability of households to purchase homes. An index of 100 implies that the median household income is just enough (with a 20 percent down payment) to qualify for a mortgage loan on a median-priced, existing single-family home. Higher values of the index imply greater affordability.

In February 2008, the Bureau of Labor Statistics (BLS) will revise the employment data for nonfarm business establishments for 2006 and 2007. BLS has indicated that it will revise the March 2007 employment level downward by 297,000 jobs, or 0.2 percent. That revision would reduce the average monthly growth in establishment employment in the 12 months through March 2007 by roughly 25,000 jobs. It is also likely that, after BLS incorporates information from its benchmark revisions, it will post additional downward revisions to employment growth for the period since March 2007.

Why a further drop in measured employment in residential construction has not already occurred remains something of a puzzle. One possible explanation is that some establishments classified by BLS as being involved in residential construction may have shifted many of their resources to unrelated activities.

Appendix D discusses the differences in the accounting treatment of federal spending in the federal budget and in the national income and product accounts.

According to CBO’s estimate of the cyclically adjusted budget (the budget minus the effects of the business cycle), federal fiscal policy currently is essentially neutral—neither stimulative nor restrictive. For more discussion, see Congressional Budget Office, The Cyclically Adjusted and Standardized Budget Measures (forthcoming).

See Mario Marazzi and others, Exchange Rate Pass-Through to U.S. Import Prices: Some New Evidence, International Finance Discussion Paper No. 833 (Washington, D.C.: Board of Governors of the Federal Reserve System, April 2005), available at www.federalreserve.gov/pubs/ifdp/2005/833/ifdp833.pdf. See also Mario Marazzi and Nathan Sheets, "Declining Exchange Rate Pass-Through to U.S. Import Prices: The Potential Role of Global Factors," Journal of International Money and Finance, vol. 26, no. 6 (October 2007), pp. 924–947.