FROM THE OFFICE OF PUBLIC AFFAIRS

The U.S. economy weathered a challenging series of storms in the past three years.  Record-high taxes as a share of GDP, the bursting of the stock market bubble, and rising energy prices tipped the economy into recession in early 2001, subsequently exacerbated by the terrorist attacks.  The recession has been determined to have ended in November 2001, but the economy continued to perform in a choppy manner even after that date from the impact of corporate scandals, unease over domestic security, and economic weakness abroad.  Indeed, lingering effects of these headwinds, as well as more recent uncertainties relating to the Iraq war, led to a pace of economic growth late last year and in the first half of this year that was slower than desired and below potential.   

In response, the Administration has worked to implement fiscal policies that stimulate the economy in the short-run and also have long-term payoffs by increasing the potential growth rate of the economy.  Its three major stimulus programs that have been enacted in the past three years have by all accounts prevented the economy from experiencing a deeper recession, fostered the recovery, and will promote long-term growth.  The economic effects of these programs are estimated to be sizable.  If there had been no fiscal stimulus since the beginning of 2001, by the second quarter in 2003 real GDP would have been as much as 2 percent lower; the unemployment rate would have been nearly 1 percentage point higher; and as many as 1.5 million fewer Americans would be working.  By the end of 2004 without the President’s growth measures, real GDP would be as much as 3-1/2 to 4 percent lower; the unemployment rate would be 1.6 percentage points higher; and the economy would have 3 million fewer jobs than is currently projected for the baseline economy including the stimulus actions.

Signs of improvement are becoming apparent.  Consumer confidence has strengthened from the war-depressed levels of February and March and contributed to a pickup in consumer spending.  Unit sales of motor vehicles increased at a 10 percent annual rate in the second quarter; the retail sales components used in the calculation of personal consumption rose more strongly as the quarter progressed; and chain store sales posted strong gains through July.  Healthy increases in consumers’ disposable (after-tax) income are fueling the rise in spending as well, supplemented by the extraction of housing wealth due to mortgage interest rates that have been and still are the lowest that most Americans have ever seen.

Business confidence has also improved as earnings rose, profit expectations are higher and business financial conditions have become more accommodating.  Since the last meeting of the Treasury Borrowing Advisory Committee, equity valuations have risen smartly.  Most major indices are up between 8-1/2 to 11-1/2 percent since the end of April with the exception of the Nasdaq, which is  up almost 20 percent.  We believe these gains reflect not only the successful culmination of the war with Iraq but also a favorable reaction to the reductions in taxes on dividends and capital gains in the recently enacted Jobs and Growth Tax Relief Reconciliation Act (JGTRRA), which favor the use of equity capital.  Indeed, we have seen a significant increase in announced dividend payments since the passage of JGTRRA.  In the two months since the President signed the legislation, over 200 companies announced they would increase their dividend payouts.  For some, the increase would amount to more than 200 percent.

Interest rates hit historic lows during the past three months, and despite some significant swings during the past quarter, the latest readings of the ten-year Treasury yield are up only modestly compared to the end of April.  The low rates allowed businesses to restructure debt, improve balance sheets, and increase cash flow.  Yield spreads narrowed through most of the last three months, and high-yield spreads relative to Treasuries narrowed dramatically to a range not experienced since early 2000.  While the recent back-up in long-term rates may dampen growth in housing refinancings, it should not pose much of a disruption to the sector overall since rates are still very low by historical standards.  While refinancings have eased from May’s peak levels, mortgage applications for home purchase are still very high.

Improved corporate financial conditions and stronger profits are laying the foundation for a solid pickup in investment.  Replacement demand supported gains in real equipment and software investment in the last three quarters of 2002, and a return to growth is expected to have occurred in the second quarter of this year.  That view was reinforced by last week’s report of a strong gain in capital goods shipments in June, especially of computers and related products which surged in nominal terms at a 35 percent annual rate for the second quarter as a whole.   Going forward, the favorable corporate environment, as well as the business equipment expensing provisions of JGTTRA, are expected to lead to accelerated growth in investment and, importantly, hiring.

For now, labor market conditions remain disappointing.  Some firming may be building, as recent figures on initial unemployment claims show a drop of 55,000 in the last two weeks to the lowest level in five months.  While that is a promising sign, seasonal adjustment difficulties in July due to auto plant shutdowns and other vacation closings make caution warranted when interpreting the weekly figures.
 Nonetheless, the outlook for the overall economic climate and for jobs has become much more promising now that the effects of the new stimulus legislation are beginning to take hold.  Rapid productivity growth in the last few years, which in the long-run enhances standards of living, has so far allowed output to grow without the addition of new employees.  Demand is projected to pick up substantially under JGTRRA, however, as the tax rate reductions and the rebates of the increased child credit boost consumer demand and the bonus expensing provision for equipment and software spur investment demand.  In the third quarter alone, consumers will receive an extra $35 billion of spendable funds, according to the Joint Committee on Taxation.

The Administration’s economic policy extends beyond the traditional “macroeconomic” arena.  It also responds to problem “microeconomic” areas quickly as they arise.  Most recently it is seeking to improve the pension security of workers and retirees.  Improvements in disclosure is a goal of pension reform, reducing uncertainties for both beneficiaries and investors.  The development of comprehensive pension reform proposals is underway, but we have put forward to Congress proposals for immediate improvements.  These proposals would provide better information on plan funding levels while easing the funding burden on businesses in the initial years of the reforms, but then transition to more appropriate funding based on accurate measures of pension liabilities.

The principal element of reform that should be adopted is a phased-in plan to discount future benefit payments to today’s dollars using discount rates based on a corporate bond based yield-curve, replacing the current use of the 30-year Treasury bond.  Benefit payments to be made in future years would be discounted correctly by matching the rate on the yield curve appropriate to the time horizon of the pension plan’s expected benefit payments.  Other proposals include reducing the smoothing of interest rates used for discounting by phasing in a 90-day average instead of the current four-year average to better reflect current financial conditions;  the publication of an estimate of how much current assets would cover earned benefits if the plan were terminated; and measures to limit benefit increases in severely underfunded plans sponsored by financially weak or bankrupt companies.

 Overall, we feel the economy is poised for revival.  JGTRRA not only provided tax relief but much needed reform in reducing the double-taxation of dividends and encouraging the use of equity capital.  Our pension proposals will further help set corporate balance sheets on firmer footing.  We believe that real GDP is on course to rise at a pace in excess of 3-1/2 percent in the second half of this year, a view that is corroborated by private-sector forecasters.