For the Treasury Borrowing Advisory Committee of the Bond Market Association
The economy continued to expand at a favorable pace in the second quarter of this year. Real GDP rose at a 3.4 percent annual rate, but would have been stronger were it not for a sharp decline in private inventory investment. Real final sales surged at a 5.8 percent rate, the biggest increase since the third quarter of 2003, reflecting particular strength in business and residential investment, and a sizable narrowing in the foreign trade deficit.
Personal consumption expenditures expanded at a solid 3.3 percent pace in the second quarter, lifted by purchases of motor vehicles as consumers took advantage of employee discounts on many vehicles. Personal income growth is solid and real household net worth has reached a record high. With consumer balance sheets in good shape and further expansion in payroll jobs likely, consumer spending is primed to continue to bolster the economy going forward.
Real residential investment remained strong in the second quarter, growing at a 9.8 percent annual rate, in line with the 9.5 percent pace posted in the first quarter. Indicators of housing activity, such as a 4 percent jump in new single-family home sales to a record level in June, continue to signal strength. Rising employment and income and low mortgage rates will likely support housing demand in the near term.
Business confidence remains firmly positive as well. The latest survey of the National Association for Business Economics found that the share of respondents reporting that capital spending was rising in the second quarter reached it highest reading in more than seven years, and gains in capital spending are expected to continue over the next year.
The expectation of second-quarter gains in investment was borne out as actual capital spending for equipment and software accelerated to an 11.0 percent annual rate in that quarter from an upwardly-revised 8.3 percent pace in the first quarter. Investment in business structures rose at a 3.1 percent rate in the second quarter, more than reversing a decline in the first quarter. Falling vacancy rates for both offices and industrial buildings suggest investment in structures may be poised to strengthen further.
The narrowing of the foreign trade deficit made a positive contribution to growth in the second quarter for the first time since the fall of 2003. Imports declined by 2.0 percent, while export growth accelerated to a 12.6 percent pace. The resulting $44 billion decrease in the net export deficit added 1.6 percentage points to second-quarter growth.
The largest drag on real GDP growth in the second quarter came from a decline in private inventories. The inventory drawdown slashed 2.3 percentage points from the real GDP growth rate, the sharpest negative contribution in more than five years. The latest drop in inventories combined with strong growth of final demand may set the stage for a lift to real GDP from a rebound in inventory accumulation in the third quarter.
An improving labor market with large job gains and low unemployment has contributed to the economy's strength, helping to support consumer spending. Since the employment trough in May 2003, the economy has created 3.7 million payroll jobs. Through the first half of this year payroll increases have averaged 181,000 per month, similar to last year's 183,000 monthly pace. The unemployment rate dropped to 5.0 percent in June, its lowest level since September 2001. The employment-population ratio moved up from 62.4 percent in the first quarter to 62.7 percent in the second; the number of people unemployed for 15 weeks or more has been declining and dropped 9.5 percent in the second quarter.
The expanding economy has been accompanied by benign inflation. Consumer prices in June were just 2.5 percent higher than a year earlier, having decelerated from the recent high for twelve-month growth of 3.5 percent reached last November. Much of the improvement can be traced to a slowing in the year-to-year increase in energy costs from just over 19 percent in November to 7.3 percent in June. Core inflation (excluding energy and food) slowed to a moderate 2.0 percent over the twelve months ending in June from 2.2 percent in November.
One of the important features of recent economic activity is the strong growth of the income side of the national accounts. Not only have corporate profits been rising rapidly but data on wages and salaries have been revised much higher. Wages and salaries rose by 7.5 percent in nominal terms over the past four quarters, equivalent to nearly a 5 percent increase in real terms. These developments represent the reward of a stronger economy that resulted from the tax relief measures enacted from 2001 through 2004.
The buoyant income growth that has accompanied the expanding economy has generated a fiscal dividend. Federal tax receipts have improved dramatically, sharply reducing the budget deficit. Tax receipts in FY2005 are on track to grow 14 percent--the largest such year-over-year increase in nearly 25 years. As a result, the budget deficit is forecast to fall from $412 billion or 3.6 percent of GDP in FY2004 to $333 billion or 2.7 percent of GDP in FY2005. That is $94 billion lower than the Administration's February forecast.
The ongoing strength of economic growth will continue to generate the tax receipts necessary to reduce the deficit, resulting in lower outlays for debt service than previously anticipated. The Mid-Session Review of the Budget now projects net interest costs to be $122.8 billion lower over the 5-year forecast period than expected in the February Budget, with roughly half of the reduction resulting from the lower debt levels and half from lower assumed interest rates. Under Administration policies, including tight controls on growth in discretionary spending unrelated to defense and homeland security, the budget deficit is forecast to continue to fall to $162 billion in 2009 or 1.1 percent of GDP. That would be less than the 1.5 percent projected in February and well below the 40-year average of 2.3 percent of GDP.
Over the long term, the greatest fiscal threats stem from the unfunded obligations in major entitlement programs -- Social Security, Medicare, and Medicaid -- as the population ages and the use and cost of health care grows. The President has proposed reforms to Social Security that would include voluntary personal retirement accounts to protect the system's surplus and to ensure that the necessary prefunding of our future retirement incomes is not spent in excessive government expenditures. His proposal would also address long-term insolvency by slowing the rate of benefit growth in a progressive manner so that low-income workers would be unaffected. We are encouraged by the work ongoing in Congress on the design of personal retirement accounts and on the long-term solvency issues.