For the Treasury Borrowing Advisory Committee of the Bond Market Association
In the three months since the Committee last met, economic growth has continued to moderate. Following three years of above-trend increases, real GDP growth has averaged 2.1 percent at an annual rate in the middle two quarters of 2006. With the moderation, however, economic fundamentals remain strong. There is good news on the inflation front, real wages are rising, the unemployment rate is low, and the job market continues to be solid.
According to the advance figures from the Bureau of Economic Analysis (BEA), real GDP grew 1.6 percent at an annual rate in the third quarter. This followed a 2.6 percent pace of growth in the second quarter and a 5.6 percent pace in the first quarter of 2006. A decline in residential building is a key reason the economy has slowed. In the third quarter, residential building fell more than 17 percent at an annual rate, and reduced overall GDP growth by slightly more than a percentage point. The third quarter overall figure was also held down by rising imports, which grew nearly 8 percent. Although exports grew 6.5 percent, real net exports lowered real GDP growth by an additional 0.6 percentage point.
Despite the slowing in the top-line GDP figure, spending outside of residential building remains firm. Slowing in housing – down for four straight quarters – has not spilled over to consumer spending, which grew at a 3.1 percent rate in the third quarter. Solid employment growth, rising real income, and strong gains in corporate equity prices that have occurred in the second half of this year are all lending support to consumer spending and should keep spending growth strong going forward.
Business fixed investment has also been offsetting the weakness in residential building. In particular, business spending on new buildings jumped 14 percent in the third quarter. The outlook for continued improvement in business investment is good. Corporate balance sheets appear strong as the corporate financing gap – capital investment less internally-generated funds – is low. This suggests there are few, if any, financing constraints on the corporate sector. In addition, corporate income continued to be strong. Corporate profits remain high as a share of gross domestic income, at just above 10 percent in
the second quarter (latest available), their highest level since 1968. These profits represent not only the
potential for future capacity expansion, but also the potential for future hiring, suggesting solid employment growth will continue for the next several quarters. That is the historical pattern. From 1994 through 1997 the profit share rose just under two percentage points to about 9.4 percent of GDI; at this time, the highest level since 1969. Job growth was strong in 1998-2000.
The unemployment rate during the third quarter averaged 4.7 percent, little changed this year, but down about 0.3 percentage point from last year. Payroll job growth averaged 121,000 a month in the third quarter, down from about 145,000 in the first half of 2006. However, upcoming official revisions to the payroll job numbers will add about 800,000 to the level of payrolls for March 2006, according to an announcement by the Bureau of Labor Statistics (BLS). The BLS revision, which was unusually large, suggests payroll job growth was much better than had been thought through early 2006, adding about 67,000 a month to payrolls. Including the revisions, since the low point for jobs in August 2003, the economy has gained 6.6 million jobs, and over the year ending in September, the payroll job gain was 2.2 million. Solid job gains will help to keep incomes up, which will continue to support expansion.
Inflation subsided in the third quarter, aided by large declines in crude oil and gasoline prices. Consumer prices were up 2.1 percent from year-earlier levels in September, the lowest year-to-year rate since early 2004. The September consumer price report was dominated by a large decline in oil and gasoline prices. The price of a barrel of West Texas Intermediate crude was about $75 per barrel at the end of July, while through mid-October it had fallen to about $58 per barrel. Gasoline prices fell from just above $3.00 in early August to just about $2.20 in mid-October. Falling petroleum product prices have dragged down the headline inflation figure. If they can be maintained, lower oil prices will help boost the economy going forward. Outside of food and energy prices, consumer price inflation slipped to 2.7 percent in the third quarter, down from 3.6 percent in the second.
With a reasonably strong economy and a slowdown in inflation, real wages have begun to bounce back. In the past three months, real average hourly earnings were up at a 3 percent annual rate. Real median weekly income in the third quarter of 2006 was 0.8 percent higher than a year earlier, the first year-over-year gain since mid-2004.
Since the Committee last met we have finished fiscal year 2006, and our closing figures for the year are much better than had been predicted only a few months ago. In July the Administration projected the deficit for FY2006 would come in at just below $300 billion. However, the budget deficit in FY2006 was $248 billion, nearly $50 billion below the July prediction and $71 billion below the FY2005 actual. The FY2006 deficit is 1.9 percent of GDP, 0.4 percentage point below the 40-year average of 2.3 percent. Receipts growth was strong -- up 11.8 percent in FY2006 – with net corporate receipts rising $75 billion (or 27 percent).
In sum, despite recent slowing in GDP growth, the outlook for the economy remains good, buoyed by solid job growth, rising real wages, and an emerging slowdown in inflation. The ever-present potential for a sharp reversal in oil prices, however, reminds us of the considerable uncertainty surrounding any economic prediction.