Statement of Martin Regalia, Ph.D., Vice President of Economic and Tax Policy and Chief Economist, U. S. Chamber of Commerce Testimony Before the Full Committee of the House Committee on Ways and Means January 23, 2007 Chairman Rangel and Ranking Member
McCrery, members of the Committee, I am Dr. Martin Regalia, Vice President of
Economic & Tax Policy and Chief Economist of the U.S. Chamber of Commerce. I am
pleased to be able to submit the following testimony for the record on behalf of
the U.S. Chamber of Commerce. The U.S. Chamber of Commerce is the world’s
largest business federation, representing more than three million businesses and
organizations of every size, sector and region. Over ninety-six percent of the
Chamber members are small businesses with fewer than 100 employees. I commend
the Committee for its interest in having this hearing on the current state of
the U.S. economy.
The economy closed 2006 with
solid, if not spectacular, economic growth and employment, and slowing
inflation. The economy grew 2.0 percent in the third quarter of last year, down
from 2.6 percent in the second quarter and well below the 5.6 percent pace of
the first quarter of 2006 as the lagging effects of higher energy prices and
Fed-engineered interest rate increases continued to impact economic growth.
With energy prices down sharply from their peaks reached earlier this year and
the Fed tightening now on hold for the last four FOMC meetings, we are
projecting an up-tick in GDP growth to about 3.0 percent for the final quarter
of 2006 and continued moderate growth in the first half of 2007.
Looking at the
labor market, the economy produced 407,000 net new jobs in the fourth quarter of
2006, down from a total of 556,000 in the third quarter, which was the strongest
of the year. Although job creation decelerated in the fourth quarter, it
nonetheless remains on solid footing with December’s 167,000 net new jobs
bringing the year’s total to over 1.8 million. The unemployment
rate was 4.5% in both November and December, up slightly from the 4.4% level
seen in October. Given the expectation for modest GDP growth, we expect the
unemployment rate to climb slightly from this point through the middle of the
year, peaking at about 5%. Thus far in 2007, the labor market is improving with
the initial claims for unemployment falling to 308,000 on a 4-week moving
average basis.
Despite the projected rise in the
unemployment rate, job and wage growth are expected to be sufficient to ensure
continued consumer spending. Last year, consumers increased their spending pace
to 2.8 percent in the third quarter, up from 2.6 percent in the second quarter.
The increase came as gasoline prices retreated from summer peaks and freed up
some discretionary income. Continued moderation in energy prices coupled with
modest growth in real disposable income should keep consumer spending reasonably
robust. Recent increases in equity markets have largely offset weakness in home
equity wealth. Additionally, consumer debt levels, while high by historical
standards, are trending down, helping to improve consumer balance sheets.
The government deficit has become
a source of anxiety in recent years. However, in fiscal year 2006 the deficit
was $248 billion, down from $318 billion in 2005 and well below the $400+
billion estimate made in early 2006. The improvement in the deficit came
primarily from a surge in tax revenues, which were propelled by a rise in
receipts from taxes on corporations as well as individuals’ investment profits.
Government outlays jumped 28% between 2000 and 2004, while government receipts
fell 7% over the same period. However, with strong economic growth over the
last two years, revenues grew 28% while expenditures increased 16%.
Interestingly, political factors
may actually help to ameliorate the deficit problem in the short run. With the
arrival of the new Congress, potential gridlock may actually produce a positive
result in the Federal budget. The last time we had a similar situation was in
the latter half of the 1990s, when Democrats controlled the Administration and
Republicans held the Congress. Back then, the combination of solid economic
growth and political gridlock increased Federal revenue growth while slowing the
growth in Federal spending. As a result, the budget deficit plummeted, turning
into a surplus between 1998 and 2001. While there’s no guarantee that a divided
government will produce similar results this time, it is certainly a
possibility. Nevertheless, sustainable deficit reductions will likely remain a
challenge in the longer-run.
Another challenging area for the
country’s economy is the trade sector. However, it appears that the situation
has improved a bit of late. With the dollar finding a comfort zone at a
relatively low level and growth abroad turning in a solid performance, U.S. net
exports improved noticeably over the second half of 2006 as exports strengthened
and imports slowed, the latter due in part to the recent fall in crude oil
prices. Despite this short-term improvement, at current levels our trade
deficit will become unsustainable in the long term. Thus, we must continue to
push for more access to foreign markets and encourage newly emerging players to
remove trade barriers and limit currency manipulation. We must also encourage
more domestic saving, which will limit our need to borrow in international
capital markets.
Turning to the country’s monetary
conditions, interest rates seem to have stabilized. At its latest meeting on
December 12, the Fed left interest rates unchanged for a fourth straight time.
Before its meeting on August 8, the Fed had increased rates 17 consecutive
times, each time adding 25 basis points. While the Fed left the possibility open
for more interest rate increases in the future depending on “incoming
information,” we believe that the Fed is done tightening for this cycle as
inflation pressures have moderated.
The rise in overall inflation
earlier this year was driven by sharp increases in many commodity prices, and
more recent commodity price declines have likewise been responsible for the
recent drop in inflation. Nominal crude oil prices set records above $77 a
barrel in the summer. However, crude has since dropped back to near $50 a
barrel as oil inventories in the U.S. have become more plentiful amid a mild
beginning to the winter season on the northern East Coast, the largest
heating-oil market in the U.S. In addition, gasoline prices have dropped more
than 70 cents from their peak at over $3 per gallon earlier this year, while
natural gas prices continue to exhibit a lack of price pressures.
Amid the recent decline in energy
prices, the CPI decelerated notably in the third quarter, increasing at only a
2.9% pace. Despite an up-tick in December, the CPI fell 2.2% at an annual rate
in the fourth quarter of last year. More importantly, core inflation (net of
food and energy) also showed signs of slowing. The core CPI rose only 1.8% at an
annual rate in the fourth quarter of 2006, down from 3.0 percent in the previous
quarter. The personal consumption deflator (PCE) -- a measure watched closely by
the Fed -- increased 0.5 percent in November (the latest data available) and 1.8
percent over the previous three months. Concurrently, market inflation
expectations have trended downward since their cyclical peak in early 2005, with
the sharpest declines occurring since the summer of this year.
With the Fed expected to remain on
hold and inflationary expectations putting downward pressure on longer-term
interest rates, we anticipate a flat yield curve for the next few quarters.
While the financial markets appear relatively comfortable with both the Fed’s
monetary policy and the overall growth prospects for the U.S. economy, the risk
spread has risen slightly in the last few months as economic growth has slowed.
However, the current risk spread remains near the level in the latter part of
the 1990s and well below the levels witnessed during, and immediately following,
the last recession.
While the overall economy
performed reasonably well last year and, after a slow first half, is expected to
pick up a bit toward the end of this year, there were certain sectors that were,
and continue to be, clear weak spots. For example, the housing market declined
sharply in 2006 after years of stellar performance. Both housing starts and
sales began slumping in the summer as rising interest rates and home prices
significantly reduced housing affordability and tempered demand. As a result,
we experienced a sharp increase in the inventory of unsold homes and noticeable
weakness in home prices. The drop in housing production was a definite drag on
the overall economy, but the feared decline in household wealth and its negative
impact on broader consumer spending has failed to materialize in part because of
the equity market rally in the latter part of last year.
While the housing sector will
likely continue to experience some malaise for another few months as the
existing inventory is worked off, we believe that the market is close to a
bottom and, while it may be a protracted bottom, a cessation in both interest
rate and price increases, as well as continued income growth, should help to
rebuild affordability and stop the negative momentum. We have already seen some
positive signs with a small pick-up in sales of new and existing homes in
November and modest improvement in starts in both November and December of 2006.
Housing affordability has increased four straight months since July.
During times such as these, with
overall growth slowing and the composition shifting, top line indicators can be
inconclusive and we can sometimes get a clearer picture by looking at sector
data. One of these underlying sectors is manufacturing. The Institute for
Supply Management’s computes a Purchasing Managers Index (PMI) that is intended
to signal whether this sector is expanding or contracting. A reading above 50
indicates growth while a reading below 50 signals contraction. While a brief
stint below 50 can occur even in relatively good economic times, a prolonged
stay or sharp decline below that level usually means trouble. In November 2006
the PMI dipped slightly below 50 for the first time since April 2003 but quickly
rose back above 50 in December. This brief excursion into negative territory is
more consistent with below-trend growth rather than an impending recession.
Another indicator of industrial
strength is manufacturing new orders, specifically orders of non-defense capital
goods excluding aircraft – a number which is less volatile and more reflective
of the overall trend in industrial demand. These orders have trended up since
2004 and rose 9.6% through November of last year compared with the same period
in 2005.
The positive performance of
manufacturing orders and shipments is reflected by growth in total industrial
production. Although it decelerated a bit in the third quarter, industrial
production growth remains decent and continues to drive investment and support
robust levels of capacity utilization. Moreover, corporate profits continue to
surge and provide a healthy source for internal financing of investment, and
with credit readily available on world-wide credit markets and interest rates
still relatively low, outside financing options are prevalent.
Given the resilience in the
industrial sector, growth in equipment and software investment bounced back from
an annualized rate of -1.4 percent in the second quarter to 7.7 percent in the
third quarter, and helped by a strong 15.6 percent rise in the first quarter
will likely rise by about 7.0 percent in 2006. We expect growth in this
component at a slightly slower 5.7% pace.
In addition, investment in
structures rose 15.7 percent in annualized terms in the third quarter, following
a very brisk pace of 20.3 percent in the second quarter – the highest rate in a
decade. While we expect some easing in this category over the forecast horizon,
the generally strong pace will continue to offset some of the weakness in
residential construction.
Like manufacturing, transportation
has also proven to be a useful leading indicator of overall economic activity,
especially because it includes both domestically produced and imported goods.
The American Trucking Associations (ATA) produces an index of truck tonnage,
which measures the volume of goods moved by trucks throughout the country. The
tonnage index has slumped a bit since early 2006 and through last November was
2.8 percent below the same period in 2005. However, the level of the index
remains well above that seen during the last recession.
Railroad data also suggests some
slowing in the economy. The Association of American Railroads (AAR) publishes
statistics on rail activity. In 2006, AAR’s total carloadings rose 2.8% over
2005, while intermodal carloadings (which are better correlated with
manufacturing activity) gained 5.0%. However, the rate of year-over-year growth
in intermodal carloadings has declined noticeably from the nearly 12% pace in
late 2004.
Financial indicators are another
valuable yardstick to measure economic activity. Growth in the money supply
strengthened noticeably after the 2001 recession, running at an annual rate of
nearly 6% between 2001 and 2004. Since then growth has slowed to about 1% as
the Fed’s monetary policy has become more restrictive. The availability of
credit, however, has shown no sign of slowing, as total bank credit has risen at
an annual rate of 8% in the 2001-2006 period. Moreover, commercial and
industrial loan volume, which had dropped off sharply between 2001 and 2004, has
since picked up, growing at an annual rate of 11% over the 2004-2006 period.
While it appears that both
liquidity and credit are readily available, it is a small consolation if
businesses and individuals cannot service their debt. However, the data suggest
that while delinquencies are up slightly since early 2006, they remain well
below the peaks seen during the last recession. The industrial sector has
actually outperformed the overall spectrum of borrowers, as commercial and
industrial loan delinquency rates have declined significantly from the most
recent peak of 3.9% in the second quarter of 2002 to 1.3% in the third quarter
of 2006.
On balance, both sector statistics
and top line numbers are telling us the same story – despite the current
slowing, the economy still has plenty of momentum and should continue to grow
and create new jobs in the near future. If we are correct, GDP will grow at
about a 3.0% rate in 2006 and slightly less than 3% in 2007. Thus, the economy
remains fundamentally sound and it appears that the Fed has achieved the
proverbial soft landing.
Appendix
Real GDP Outlook
Real Personal Consumption Expenditures
Real Disposable Income Per Capita
Household Wealth
Consumer Debt
Housing Starts
Home Sales
Median Home Prices
Housing Affordability Index
Real Private Investment in Equipment and Software
Real Private Investment - Structure
Real Change in Private Inventories
Industrial Prodcution
Corporate Profits
Purchasing Managers Index
Inventory-to-Sales Ration: Total Business
US Trade Deficit
US Nominal Trade Weighted Exchange Rate
Real GDP Growth of Top Trading Partners
Total Non-Farm Jobs
Household Employment
Initial Unemployment Claims
Unemployment Rate
Consumer Price Index
Core Consumer Price Index
Market Inflation Expectations
West Texas Intermediate Spot Oil Price
Retail Gasoline Price
Spot Market Price Index: Metals
Natural Gas Price: Henry Hub, LA
Interest Rates
Yield Spread: 10-Year Treasury Minus 3-Month Treasury
Risk Spread: Moody's Seasoned Baa Corporate Yield Minus Moody's Seasoned Aaa Corporate Bond Yield
The President Budget
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