FROM THE OFFICE OF PUBLIC AFFAIRS

May 2, 2005
JS-2415

Assistant Secretary of the Office of Economic Policy
Mark J. Warshawsky
Statement for the Treasury Borrowing Advisory Committee
of the Bond Market Association
May 2, 2005

The U.S. economy remains on a solid growth track. Real GDP rose at a 3.1 percent annual rate in the first quarter, about in line with our estimate of trend growth, following a gain of 3.8 percent in the fourth quarter. The deceleration largely reflected a slower pace of business investment after double-digit rates of growth last year.

Investment in equipment and software rose by 6.9 percent at an annual rate in the first quarter, following an increase of 14.5 percent during all of 2004. Although data are not yet available by which to evaluate the impact of the bonus expensing provision of the Jobs and Growth Tax Relief Reconciliation Act, the expiration of the provision at the end of last year may have contributed to the pullback. Investment in structures, which has been slower to recover from the 2001 downturn, declined at a 2.6 percent annual rate. Overall, business fixed investment increased by 4.7 percent in the first quarter after rising by 11.0 percent over the four quarters of last year. Inventory investment made a substantial positive contribution to first-quarter growth, adding 1.2 percentage points to the increase in real GDP on top of a 0.5 point addition in the previous three-month period.

Personal consumption expenditures moderated in the first quarter to a 3.5 percent annual rate from a brisk 4.7 percent pace during the second half of 2004. A drop in purchases of motor vehicles and parts accounted for most of the slowdown. The fundamentals of the household sector nonetheless remain sound. Nearly half a million jobs were added to nonfarm payrolls during the first quarter, bringing the increase since the May 2003 employment trough to 3.1 million. The unemployment rate continued to recede and in March stood at 5.2 percent, 1.1 percentage points below the June 2003 peak.

There has been some concern of late about recent declines in real wages. However, these declines followed unusual strength of real wages during the recession and early recovery period. Measured from the March 2001 business cycle peak, the performance of real average hourly earnings of production and other nonsupervisory workers in the current cycle is the second strongest on record. Rising benefit costs have been an important factor constraining wage growth recently. The Employment Cost Index showed that hourly compensation costs in private industry rose by a moderate 3.4 percent in nominal terms over the year ending in March – a small gain in real terms. Because of a rapid 5.8 percent increase in benefit costs, however, growth of wages and salaries was held to only 2.4 percent. We nonetheless are encouraged by the deceleration in benefit costs over the past year from growth in the 7 percent range a year ago. As the labor market continues to firm, real wages are expected to strengthen. In the meantime, consumer balance sheets appear to be on solid ground. Debt service payments do not appear to be problematic, consumer loan performance has improved notably in the past few years, and household net worth relative to disposable income is higher than at any time prior to the late 1990s, when the runup in equity markets boosted the wealth ratio to record levels.

Real residential investment picked up to a 5.7 percent pace in the first quarter from the fourth quarter's 3.4 percent annual rate increase. The housing market has been exceptionally vibrant the past few years. A number of records were broken in 2004 and in March new home sales shattered previous highs. On the other hand, housing starts fell sharply in March and building permits have tilted lower in recent months, possibly signaling the sector's return to a more normal and sustainable pace.

The trade deficit widened further in the first quarter, acting as a brake on growth for the sixth consecutive quarter. Imports climbed by 14.7 percent, more than offsetting a 7.0 percent increase in exports. This boosted the trade gap by $42.1 billion in real terms to $663.2 billion and shaved 1.5 percentage points off the first-quarter advance in real GDP. The strong performance of the U.S. economy compared to its major trading partners is partly responsible for the growing deficit.

Inflation has shaded higher over the past year, boosted in part by rising oil prices. The consumer price index rose by 3.1 percent over the year ending in March, up from a 1.7 percent increase in the year-earlier period. Core inflation has also accelerated modestly but remains contained at 2.3 percent.

The rise in energy prices has affected the U.S. economy in other dimensions as well. The one-month futures price of West Texas Intermediate crude oil spiked to a new monthly high of $54.63 per barrel in March, up more than $6.50 from the prior month's average, and on the first day of April soared to a record $57.27 per barrel. Retail gasoline prices averaged close to $2.25 per gallon in April, an all-time high that exceeded year-ago levels by about 45 cents. By cutting into real wages, weighing on consumer confidence, and heightening business uncertainty, energy prices have exerted a drag on economic activity that became visible at the end of the first quarter. So far, the economy has shown considerable resilience in the face of an approximate doubling of oil prices over the past 2-1/2 years but some tempering of growth is consistent with both modeling results and past experience.

Persistently high fuel prices highlight the need to implement the Administration's proposals to bolster domestic energy supplies and adopt technologies to use energy more efficiently, particularly in light of the rise in energy demand from the developing world. Strong growth in consumption among emerging economies is one of the factors that is putting considerable upward pressure on energy prices. It is therefore imperative that we assist rapidly growing countries like China and India in developing cleaner, more efficient technologies to reduce their own demand. By sharing our knowledge, we will contribute to the conservation of energy resources, helping to restrain prices and preserve the environment.

Unless oil prices surge sharply higher, the economy appears well-equipped to weather any loss in momentum we may be experiencing currently. The unemployment rate is low, inflation remains contained, and productivity continues to rise. The strength of these underlying fundamentals suggests that the economy is poised to grow at a healthy rate for the remainder of the year.

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