FROM THE OFFICE OF PUBLIC AFFAIRS
The U.S. economy continued to grow at a solid pace in the months since the last meeting of the Advisory Committee. Real GDP expanded at a 3.0 percent annual rate in the second quarter, following an exceptionally strong performance in the previous four quarters when the economy grew 5.0 percent * the largest such gain in nearly twenty years. We expect improved activity in the second half of the year, based on expanding labor markets, strong investment and export demand, and rising business and consumer confidence.
Personal consumption expenditures (PCE) more than accounted for the slowdown in overall growth in the second quarter. Real PCE rose at a 1.0 percent rate compared to an increase now placed at 4.1 percent in the first quarter. Several factors contributed to the diminished pace, some of which could be considered transitory. A surge in energy prices was one such factor, with the retail price of gasoline climbing 16 percent above the first quarter average. Mortgage refinancings have helped support growth in consumption expenditures in the past few years through lower payments and cash-out features. However, refinancings shrank 40 percent in the second quarter as mortgage interest rates moved higher.
The fundamentals of the household sector nonetheless remain strong. Aggregate wage growth has been revitalized by improving labor markets. As a result, real disposable personal income has risen at approximately a 3 percent annual rate in each of the past two quarters. It might also be noted that state and local income taxes paid by individuals have been steady as a share of personal income, rather than rising as had been widely expected. Household wealth continues to rise due to higher home values, with net worth hitting a record $45.2 trillion in the first quarter. Consumer balance sheets are in good shape, with interest rates still historically low, monthly financial obligations and debt service payments in relation to disposable personal income diminishing, and delinquency and loan charge-off rates on consumer borrowing moving down.
Activity in the business sector of the economy in the second quarter remained quite strong. Powered by a 10 percent gain in equipment and software and a 5.2 percent increase in investment in structures, business fixed investment increased at an 8.9 percent annual rate * double the pace of the first quarter. Inventory investment also added to growth in the second quarter, contributing 0.3 percentage point. The healthy pickup in business demand for goods, as a well as a 14.6 percent surge in goods exports in the second quarter, contributed to a 7.1 percent annual rate increase in manufacturing production in the quarter, the largest gain since 1999. Exports have been rising at a rapid pace in the past four quarters, reflecting the fact that the desired improvement in economic activity abroad is finally underway. In the second quarter, exports grew at a faster rate than imports. As a result, the trade deficit shaved just 0.1 percentage point off real GDP growth after having reduced growth by 0.8 point in the first quarter.
Strong profits growth, low risk spreads, and renewed business optimism about the strength and sustainability of aggregate demand have been the key drivers of the ongoing rise in business investment, supported as well by tax incentives. Corporate profits as measured in the GDP accounts (which states inventories and depreciation on a replacement-cost basis) were nearly 28 percent higher in the first quarter than a year earlier, pushing the profit margin (in relation to gross domestic income) up to 10.2 percent - the highest since 1997. Surveys of business confidence and capital spending intentions have been very favorable and inventories are lean, suggesting business investment is poised for further growth.
Higher profits and cash flow have also allowed businesses to increase hiring. Monthly job growth accelerated sharply at the end of the first quarter and remained at high levels through the first two months of the second quarter, averaging 304,000 per month from March to May before slowing to a still-solid 112,000 increase in June. The economy has now added 1.5 million new payroll jobs since last August. This growth in large measure reflects the response to the Jobs and Growth tax relief act which went into effect in the second quarter of 2003.
The outlook for the economy in the remainder of the year is quite favorable as the factors holding growth down in the second quarter dissipate. Energy prices are expected to stabilize, removing much of the upward pressure on inflation. In addition, more generous motor vehicle incentives may boost consumer auto purchases after a poor performance in the second quarter. Labor market indicators point to continued job growth, providing a lift to aggregate wages. Both the Conference Board and University of Michigan measures of consumer confidence suggest an increasingly optimistic attitude on the part of consumers.
Overall, the economy is generally expected to expand at more than a 4 percent annual rate in the third and fourth quarters. Recent statistical readings, some of them forward-looking, provide additional perspective on current conditions and the near-term outlook, and most seem to point to an improving economy. A few examples include:
- Leading indicators, which were 3.4 percent higher in the second quarter than the first, continuing to reflect economic strength.
- Unfilled orders for durable goods, which have soared by 8 percent over the past year, pointing to ongoing need for factory production.
- Permits for new home construction remain above new home starts, suggesting sustained strength in residential investment in the near-term - a view confirmed by a high level of home builder optimism.
- Continuing claims for unemployment insurance are extending their downtrend. In the past two weeks, the four-week moving average has been the lowest in three years, suggesting a strengthening labor market.
- Manpower's Employment Outlook Survey measure of net hiring strength in the third quarter remained at the highest level since the first quarter of 2001.
- The latest quarterly industry survey of the National Association of Business Economics found that the share of respondents reporting that demand was rising was 52 percent on net -- the highest in four years.
- Regional measures of industrial activity confirm ongoing strength and good prospects for growth in capital investment. The Business Outlook Survey of the Philadelphia Federal Reserve Bank reported that the index measuring the 6-month outlook for capital expenditures jumped to 28 in July from 18.6 in June.
- Finally, the Institute for Supply Management's manufacturing index rose to 62 in July. The index has now been above 60 for nine consecutive months, the longest period of such strength in more than thirty years. (Readings above 50 are generally consistent with expanding activity in the manufacturing sector.)