Acting Assistant Secretary for Economic Policy
Although the pace of expansion slowed in the first quarter, the recovery remains on firm footing. Consumer spending continued to grow at a healthy rate in the first three months of 2011, and business investment in equipment and software strengthened. Job growth has accelerated in recent months, and factory output is rising at a rapid rate. These developments, along with generally positive business survey data, suggest the underlying trend in economic activity is solid. Even so, risks remain. The unemployment rate remains very high at 8.8 percent, and the housing sector continues to be a point of weakness. Home sales and residential construction are being held back by a number of factors, including excess supply, the larger number of underwater borrowers, tight lending standards, uncertainty about future house prices, and the high level of unemployment. The recent run-up in oil prices is also a concern, as higher fuel prices reduce consumer purchasing power and increase business costs. The federal budget deficit is expected to increase in FY2011, in part because of the December 2010 tax cut agreement, but it will narrow significantly thereafter. Despite these risks, the outlook for the remainder of 2011 is positive. Private forecasters expect a return to growth in the 3 to 3-1/2 percent range in the second quarter. Real GDP growth is projected to stay in that range for the rest of the year, and private payrolls are expected to grow.
According to the advance estimate, real GDP growth moderated from a 3.1 percent annual rate at the end of 2010 to a 1.8 percent annual rate in the first quarter of 2011 – the seventh straight quarter of growth since the economy emerged from recession in mid 2009. The slowdown appears to have been driven in part by temporary factors, including severe winter weather early in the quarter that curtailed construction spending. Business investment in structures fell sharply, extending a trend that began in mid 2008 and pulling business construction spending to its lowest level since 1978. Residential investment also edged down in the first quarter and is now at a 28-year low. Government spending fell sharply, cutting a little over 1 percentage point off of the first-quarter increase in real GDP. A large drop in Federal defense spending accounted for nearly three-quarters of the decrease in government outlays. In addition, the trade deficit widened slightly as imports rose faster than exports. This shaved 0.1 percentage point off of first-quarter real GDP growth, a dramatic shift from the fourth quarter, when trade boosted growth by more than 3 percentage points.
On the plus side, business investment in equipment and software accelerated to a solid 11.6 percent annual rate in the first quarter, the eighth straight quarter of growth. Firms accumulated inventories at a faster pace, boosting real GDP growth by 0.9 percentage point. While the steep run-up in gas prices during the first few months of the year likely cut into consumer spending, real personal consumption expenditures continued to grow at a healthy 2.7 percent annual rate in the first quarter. Private domestic final demand (the sum of private fixed investment and consumer spending) rose almost 2½ percent in the first three months of 2011. That was substantially less than the 4.4 percent increase in late 2010 but still suggests that there is considerable forward momentum coming from sustainable sources of private demand.
The near-term outlook is favorable. Improving job and income prospects are expected to support a healthy pace of consumer spending – which accounts for more than two-thirds of economic activity in the United States – and should help soften the impact of higher fuel prices going forward. Recent improvements in household balance sheets will also lend support. According to the Federal Reserve’s Flow of Funds data, household net worth has risen by a little over $8 trillion from the low recorded in 2009, reflecting the strong performance of equity markets and reduced debt holdings. With these recent gains, households have recovered roughly half of the $17 trillion in wealth lost during the recession. Personal saving has also risen over the past two years as households have sought to rebuild wealth, and the United States appears to have returned to a more sustainable pattern of saving than has prevailed in recent years. In March, the personal saving rate stood at 5.5 percent, well above the 2000-2007 average of 2.7 percent.
Business indicators released in the past few months have been generally upbeat. Manufacturing production accelerated sharply in the first quarter, growing by more than 9 percent at an annual rate – the strongest quarterly gain since late 1997. Capacity utilization, though still well below its long-term average, has risen to its highest level since mid 2008. Business survey data have also been positive. The Institute for Supply Management’s composite manufacturing index has signaled expansion for 20 straight months, and their non-manufacturing index has indicated expansion in the services sector for 16 straight months.
The labor market recovery has strengthened a great deal over the past several months. Payroll job growth accelerated in the first quarter, with private firms adding an average of 188,000 jobs per month – the most in five years. Private-sector businesses have added workers to their payrolls for 13 straight months, with roughly 1.8 million jobs created since February 2010. The unemployment rate has fallen by a full percentage point since November and in March stood at 8.8 percent. The drop in the unemployment rate – the largest 4-month decline since 1984 – was due in large part to strong employment growth. The labor force participation rate fell from 64.5 percent in November to a 27-year low of 64.2 percent in January, but has held steady at that level through March.
Nevertheless, there is still significant room for improvement. The number of private payroll jobs is still 7 million lower than at the start of the recession in December 2007, and the unemployment rate is almost 4 percentage points higher. In addition, the share of the unemployed out of work for 27 weeks or more remains very high at 45.5 percent – just a shade below its May 2010 peak of 45.6 percent.
The housing sector remains depressed. The pace of new residential construction picked up in the first quarter, but remained close to the record low level posted two years earlier. New single-family home sales declined slightly, dipping back to a historically low level. Sales of existing homes (single-family as well as condos and co-ops) have trended up since last summer, when they plunged following the expiration of the home buyer tax credit. However, they dropped sharply in February and, despite a partial rebound in March, are still about 12 percent below the levels recorded in the spring of 2010, when the tax credit boosted housing demand. Mortgage rates have risen from the record low levels recorded last fall but remain attractive: Freddie Mac’s benchmark rate for a 30-year fixed-rate mortgage remained in a narrow band between 4¾ and 5 percent during the first 4 months of 2011. Nevertheless, mortgage market activity remains subdued.
A number of factors are weighing on housing demand, including the large stock of homes currently on the market. At the end of March there was a 7.3-month supply of new homes on the market and an 8.4-month supply of existing homes. The average prior to the housing bubble (2000-2004) was around 4 months for new homes and 4½ months for existing homes. The shadow inventory, which includes homes that are delinquent or in foreclosure, is estimated to be much larger than the number of homes currently for sale. This large inventory overhang will likely contribute to the imbalance between supply and demand for many months to come. Uncertainty about the path of house prices is also thought to be hampering housing market activity. After several months of improvement, house prices started to fall again in late 2010 and declines have accelerated recently. In February, the S&P/Case-Shiller 20-city house price index was 3.3 percent below its year-earlier level. That was the largest 12-month decline since late 2009. Similarly, the FHFA house price index fell 5.7 percent over the year ending in February, the biggest 12-month drop since May 2009.
Energy prices have risen sharply since the beginning of the year. The front-month futures contract for West Texas Intermediate crude oil surged from around $85 per barrel in mid February to an average of $109 per barrel in the first half of April. The jump in oil prices reflected concerns about supply disruptions in the Middle East and North Africa. U.S. consumers and businesses faced sharply higher fuel costs as a result: between mid February and the end of April, the U.S. average retail price for regular gasoline climbed 74 cents (or 24 percent) to $3.88 per gallon.
Rising energy prices and a pickup in food price inflation have pushed headline inflation measures higher. However, core inflation remained subdued, reflecting the large degree of slack in labor markets and low level of capacity utilization. The consumer price index rose 2.7 percent over the year ended in March, up from a 2.3 percent increase during the year ended in March 2010. Core consumer prices (excluding food and energy) rose 1.2 percent over the year ended in March 2011, little changed from a year earlier.
Over the longer term, the fiscal situation is a serious concern. The Federal budget deficit is expected to increase in FY2011, in part because of the December 2010 tax cut, but it will narrow significantly thereafter, as the economy recovers and provisions of the Recovery Act and the December tax legislation expire. Even so, projected deficits will still be too high, and our debt will continue to grow relative to the size of our economy. In mid April, President Obama proposed a plan to reduce the budget deficit by $4 trillion over the next 12 years and put the debt on a declining path by the second half of the decade. Deficit reduction in the President’s plan is phased in over time to protect and strengthen our economic recovery and the labor market. The President also proposed a debt “fail-safe” that would trigger across-the-board spending reductions (both in direct spending and in tax expenditures) if, by 2014, the projected debt-to-GDP ratio is not declining toward the end of the decade.
Despite headwinds in the labor and housing markets, rising energy prices, and concerns about the long-term fiscal situation, the near-term outlook remains positive. The recovery is expected to strengthen this year, spurring further gains in private payrolls, although the unemployment rate – which is typically slow to decline – will likely remain elevated in the near term. Continued improvement in the economy will also lead to smaller near-term government deficits, but significant policy changes will be required to put the federal budget on a sustainable path in the medium to long run.