FROM THE OFFICE OF PUBLIC AFFAIRS

When you were here three months ago, economic growth was accelerating in the third quarter following a modest pace of activity in the second quarter.  Consumers were responding once again to new auto-sales incentives.  As a result, motor vehicle sales reached an 18.6 million unit annual rate in August, the fifth highest on record.  Indicators of equipment investment were rising, including in the high-tech sector.  We will not have official GDP results for the third quarter until later this week, but private forecasters expect real growth in the 3-1/2 percent annual rate range, considerably faster than the 1.3 percent recorded in the second quarter.

Toward the end of the third quarter, economic indicators began to turn a bit softer.  This was primarily evident in consumer spending and implies a lower platform heading into the fourth quarter.  Even so, we see a number of signs that provide a basis for optimism.  The four-week average of initial claims for unemployment insurance, while still elevated, has been moving lower through the first three weeks of October.  The housing sector continues to escalate beyond expectations, with starts of new single-family homes jumping to their highest level since 1978.  Inventories appear to be very lean in relation to sales, and are poised to make positive contributions to growth as production picks up to rebuild stocks.

In addition, productivity growth remains stellar and inflation is well behaved.  In the second quarter, productivity growth compared to a year earlier hit 4.8 percent in the nonfarm business sector, the largest four-quarter increase in almost 20 years.  Productivity growth in the corporate sector alone is even more striking.  Output per hour in nonfinancial corporations was up 6.0 percent over the past year, a performance not seen since 1976.  The importance of these gains cannot be underestimated.  Productivity advances have combined with modest nominal wage increases to result in year-to-year declines in unit labor costs of about 2 1/2 percent in the nonfarm sector – a development not seen since the early 1960s.  This has led to improved profits and some widening in profit margins. 

The endurance of the “productivity miracle” in a period of moderate growth provides a substantial case for stronger real growth in the future, as costs are contained and profits rebuilt.
 It seems likely that important sectors of our economy have yet to benefit fully from improved productivity growth and that there are further gains to come in such areas as health care, education, and government.  These are areas in which the Administration has, and will continue, to devote considerable effort in both management and policy design.

The inflation and productivity picture are, of course, closely linked, and inflation results this year have been particularly good.  The CPI has risen by just 1 1/2 percent over the past twelve months.  As a result, real wages have been rising – one of the factors that has supported consumption.  Part of the favorable inflation environment reflects lower energy prices relative to a year earlier – a development that is now reversing.  Still, prices for non-energy goods have also been falling and non-energy service prices have been decelerating.  Overall, growth in the nonenergy CPI has been slowing and has risen at just a 2.1 percent annual rate over the latest 12 months.

Low inventories, rapid productivity growth, rising real wages, and benign inflation support the view that solid growth will be maintained going forward, notwithstanding what may be a continued pattern of quarterly fluctuations.  Average growth over the first half of the year was quite favorable at a 3.1 percent annual rate, and even with what might be a slower performance in the fourth quarter, the economy is well-positioned to grow at about a 3 percent pace in the second half. 

Part of the reason for the economy’s speedy and durable, though at times uneven, recovery following the 2001 recession and the terrible shocks of the terrorist attacks, lies with the resiliency and flexibility of our economic system, including our capital markets.  Both last fall and this summer, a portfolio shift to government and agency bonds in the face of heightened volatility and uncertainty in the equity markets lowered long-term interest rates to 40-year lows.  Mortgage rates followed suit, triggering a surge in refinancings that put billions of dollars into the hands of households.  That, and the 0% financing that auto makers were able to offer, helped support consumer spending and the overall economy.

Fiscal and monetary policies also helped return the economy to an upward path.  But the recession in 2001, declines in the stock market, and the necessary spending to combat terrorism have had an effect on Federal finances in fiscal year 2002.  In response to these events, the Federal budget was in deficit by $159 billion in FY2002, although this was less than the $165 billion projected in last summer’s Mid-Session Review.  With renewed economic growth and restraint in discretionary spending, we expect the budget to return to surplus within a few years.

In sum, current economic developments are generally positive, and strong underlying fundamentals will assist a return to stronger growth in 2003.  As Secretary O’Neill has often said, the road to recovery may be bumpy, but we are confident that a sustained economic upturn is underway and growth will accelerate.