Skip Navigation

The Economic and Budget Outlook: An Update September 1997

After growing at a healthy pace for all of 1996, the U.S. economy grew at an even faster clip during the first half of 1997. Although vigorous on average, growth for the first half of 1997 has been uneven, with real (inflation-adjusted) gross domestic product (GDP) growing at an annual rate of 4.9 percent in the first quarter and then slowing to less than half that rate in the second quarter. Despite those quarterly swings, fundamental economic conditions remain strong entering the second half of 1997, and the Congressional Budget Office (CBO) expects that strength to carry the economy through 1998 without a recession.

Robust economic conditions such as those in the United States over the past few years typically signal higher inflation. However, according to most measures, inflation is lower now than it was in late 1994. One possibility is that temporary factors have masked inflation. Alternatively, some analysts suggest that the economy has changed in a way that allows it to withstand pressures of greater demand without producing an increase in inflation. Whatever the reason, the recent weakness of inflation raises an uncertainty as to how to interpret conventional measures of inflationary pressures. Reflecting that uncertainty, CBO expects inflation to rise but predicts only a mild increase.

The Federal Reserve, expressing concern about incipient inflation, responded to the robust performance of the economy early in the year by raising the target for the federal funds rate at its March meeting. During the second quarter of 1997, as the economy showed signs of cooling, the Federal Reserve held the target for the federal funds rate steady. Entering the second half of 1997, however, economic growth is expected to be sturdy enough to again raise concerns about inflation and rekindle the possibility of further increases in short-term interest rates through mid-1998.

CBO forecasts that real GDP will grow 3.0 percent from the fourth quarter of 1996 to the fourth quarter of 1997 and 1.8 percent over the four quarters of 1998 (see Table 1 and Figure 1). The unemployment rate is expected to be 5.0 percent in 1997--the lowest annual unemployment rate since 1973--and to rise only slightly in 1998 to 5.1 percent. Inflation as measured by the consumer price index (CPI) has eased over the past year. CBO expects inflation to be 2.1 percent over the four quarters of 1997 and to rise to 3.0 percent over the four quarters of 1998. On a calendar year basis, the CPI will grow 2.4 percent in 1997 and 2.7 percent in 1998. Short-term interest rates will increase from their 1996 level of 5.0 percent to 5.2 percent in 1997 and 5.4 percent in 1998. Long-term interest rates will remain unchanged at 6.4 percent in 1997 and then dip to 6.2 percent in 1998.
 

Figure 1.  The Economic Forecast and Projection

SOURCES: Congressional Budget Office; Department of Labor, Bureau of Labor Statistics; Department of Commerce, Bureau of Economic Analysis; Federal Reserve Board.    NOTE: All data are annual values; growth rates are year over year.    a. Consumer price index for all urban consumers (CPI). The treatment of home ownership in the official CPI changed in 1983. The inflation series in the figure uses a consistent definition throughout.    b. NAIRU is CBO's estimate of the nonaccelerating inflation rate of unemployment.

CBO does not forecast cyclical developments in the economy beyond the calendar year following the current budget year. After 1998, therefore, the economy is as-sumed to return to its long-run path, with growth in real GDP averaging 2.3 percent, inflation averaging 3.1 percent, and the unemployment rate averaging 5.9 percent through 2007. Interest rates decline, with short-term rates averaging 4.4 percent and long-term interest rates averaging 5.7 percent for the period from 1999 through 2007.

The current CBO forecast differs from the January baseline forecast in several respects. CBO has revised its forecast for economic growth upward in 1997 and downward in 1998. Interest rates are generally higher than in the January baseline forecast, whereas the un-employment rate is lower. The inflation rate is higher in 1997 and lower in 1998.
 

The State of the Economy

The performance of the U.S. economy over the past several quarters has been stunning. Economic growth has increased, and the unemployment rate has dipped to a 24-year low. Yet inflation has ebbed despite the mounting evidence of inflationary pressures.

The Buildup of Inflationary Pressures Over the Past Year

The benign behavior of inflation over the past year is puzzling. Conventional measures of inflationary pressures from both the product and labor markets suggested an increase in the underlying rate of inflation in late 1996 or early 1997. Several temporary masking factors may account for much of the "missing inflation." Alternatively, some analysts suggest that the economy has changed in a way that makes inflation less responsive to pressures from a buildup of demand. Un-fortunately, uncertainty surrounds both the measures of demand pressures and the estimated size and timing of the inflationary response to those pressures. As a result, determining the precise reason why inflation has been so subdued is extremely difficult.

Inflationary Pressures in the Product Market. One conventional measure of inflationary pressure is the tightness of the product market, otherwise known as the GDP gap--the percentage difference between actual output and the estimated level of potential or sustainable output. When the economy operates above potential, demand for inputs such as labor, capital, and raw materials is strong, thereby generating upward pressure on prices. CBO estimates that the U.S. economy has been operating above potential since the second quarter of 1996 and that the recent surge in growth pushed the economy significantly above potential in early 1997 (see Figure 2). Although inflation usually begins to climb after the economy exceeds its potential, the timing and the magnitude of the increase is uncertain and, as is the case with any estimate, subject to error. Nevertheless, CBO estimates that the inflationary pressure indicated by the GDP gap should have increased the growth of the GDP price index by roughly 0.2 percentage points over the past two years. Instead, growth of the GDP price index is roughly 0.3 percentage points below what it was in 1994.
 

Figure 2.  Inflation and Tightening in the Product Market and Labor Market

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics.   a. Price index for GDP.   b. The degree of tightness in product markets is measured by the percentage difference between real GDP and CBO's estimate of potential output. When positive, that difference indicates inflationary pressure.   c. The degree of tightness in the labor market is measured by the difference between CBO's estimate of the nonaccelerating inflation rate of unemployment (NAIRU) and the actual unemployment rate. When positive, that difference indicates inflationary pressure.

A rule of thumb is that for each year the unemployment rate is below the NAIRU by 1 percentage point, inflation will increase by about half a percentage point over the next two years. According to that rule of thumb, inflation (measured by the GDP price index) should have increased by roughly 0.7 percentage points since 1994.

Despite the slowing of price inflation, the recent tightness of the labor market has begun to show up in an increase in employment costs. For the year ending in the second quarter of 1995, the employment cost index for wages and salaries grew 2.9 percent. For the year ending in the second quarter of 1997, that index grew 3.3 percent. The growth of the employment cost index for total compensation has also risen. However, it remains roughly half a percentage point lower than the measure of growth in money wages and salaries (see Figure 3).
 

Figure 3.  Growth in Wages and Compensation in the Private Sector

SOURCES: Congressional Budget Office; Department of Labor, Bureau of Labor Statistics.

The unemployment gap and the GDP gap indicate different amounts of inflationary pressure, but both signal an increase in inflation. Thus, some increase in the amount of inflation was expected to occur between 1996 and the second quarter of 1997 regardless of the measure employed. The surprising decrease in inflation over that period therefore raises the question of whether temporary factors are masking inflationary pressures or the economy has actually changed in a way that makes it less susceptible to inflationary pressures when growth is high and the unemployment rate is low.

Temporary Factors Masking Inflation. Through the first half of 1997, a number of temporary factors have appeared that can account for most of the discrepancy between the actual inflation rate--measured by the GDP price index--and the inflation rate predicted by the unemployment rate and GDP gaps.

Technical adjustments to the CPI in January 1995 and mid-1996 have reduced growth in the CPI by roughly 0.2 to 0.3 percentage points (see Appendix B for more details). The technical adjustments to the CPI reduced the growth of the GDP price index by a smaller 0.1 to 0.2 percentage points, because the CPI represents only a portion of the GDP price index.

In addition, unusual weakness in some key prices may be holding down overall inflation measures. The strong dollar has suppressed import prices since early 1995 (see Figure 4). That factor directly accounts for about 0.4 percentage points of the discrepancy. Low import prices may also have contributed to holding down domestic inflation through their indirect impact on import-competing industries, but that effect is difficult to quantify. Computer prices have tumbled dramatically, and inflation in the price of medical care has declined over the past two years. Those factors ac-count for an additional 0.2 to 0.3 percentage points of the discrepancy, though some of the weakness in computer prices may reflect the strength in the dollar.
 

Figure 4.  Inflation in Imports, Computers, and Medical Care

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.   a. Price index for imports.   b. Price index for business investment in computers.   c. Price index for medical care.

Other Explanations for the "Missing Inflation." Although temporary masking factors may account for the bulk of the discrepancy between actual and predicted inflation, other explanations for this puzzling missing inflation exist. The response of inflation to demand pressures could be operating with a longer lag than was true in the past for a variety of reasons. For example, the credibility of the Federal Reserve as an inflation fighter may have grown as a result of a good inflation record. Consequently, workers and firms may have ex-pected the monetary authorities to reduce the inflationary pressures before inflation actually rose.

Some analysts have suggested that the short-run relationship between demand pressures and inflation may have changed in a more permanent way. One way the response of inflation might have fallen is if domestic firms have begun resorting to underused production facilities abroad when domestic facilities or labor supplies are strained to capacity. That move could reduce the inflationary response to tight labor markets in the United States.

Alternatively, because of changes in the structure of the economy or in the composition of the labor force, the NAIRU may have declined below the 5.8 percent that CBO currently estimates.

So far, the mystery of the missing inflation has not been resolved. The presence of temporary masking factors suggests that inflation is likely to rise once those factors have run their course. Because inflation has not yet increased, however, it is difficult to ignore the possibility that traditional measures of demand pressures may overstate true inflationary pressures and that the relationship between inflation and demand pressures has changed.

The Prospect for Near-Term Growth

Despite the brief slowdown in economic activity in the second quarter of 1997, fundamental economic conditions remain strong, and CBO expects that strength to continue through the second half of 1997. The economy should then slow to a more moderate pace next year under the Federal Reserve's continued policy of mild monetary restraint.

Households. Brisk employment, growth in income, rising consumer confidence, and a booming stock market--combined with unusually warm weather during the winter months--have spurred consumer spending over the past three quarters. Real expenditures for consumption grew at an average annual rate of 4.3 percent during the last quarter of 1996 and the first quarter of 1997--the highest two-quarter average in almost five years. In the second quarter of 1997, consumer spending weakened considerably, partly as consumers took a breather from their earlier spending pace and reacted to temporary factors such as colder-than-usual weather and labor strikes in the auto industry. Even with a weak second quarter, the average growth rate of expenditures for consumption for the three-quarter period ending in the second quarter of 1997 was still a robust 3.1 percent. Given the healthy growth in employment and earnings, growth of consumption will probably remain solid through the end of 1998.

The recent strength in consumer spending has lowered the personal saving rate (see Figure 5). During the first half of 1997, the four-quarter average of the personal saving rate was 4.1 percent--the lowest in almost 50 years. Some analysts maintain that the recent decline in the saving rate is a product of the increase in the value of the stock market. Such an increase in wealth encourages households to consume a larger portion of their disposable income, thus lowering the saving rate.
 

Figure 5.  The Personal Saving Rate

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.    NOTE: Average, over four quarters, of personal saving as a percentage of disposable personal income.

The value of the financial assets of households has been rising faster than debt. Moreover, the ratio of net financial assets to disposable personal income averaged 3 percent during the fourth quarter of 1996 and the first quarter of 1997 (the latest data available). At 3 percent, that ratio is the highest it has been since 1968. In addition, current delinquencies on consumer loans remain below the rates that prevailed through the latter half of the 1980s. Also, the growth of debt has slackened recently as creditors have tightened lending standards and consumers have reduced their appetite for debt. Thus, even if debt problems were holding back growth in consumption, that effect would appear to be waning.

After weakening in late 1996, the housing sector rebounded somewhat during the first half of 1997 but is likely to weaken modestly in the second half. The unusually warm weather in February probably sparked much of the first-quarter surge in housing starts, which pushed total housing starts up to a 15.5 million annual pace--the largest monthly figure since March 1994.

In addition to the warm weather, economic conditions have been favorable for the housing sector. Spurred by strong growth in income and employment, as well as a slight rise in housing affordability, new home sales increased at a brisk pace for the first quarter of 1997. The surge in new home sales was strong enough to push down the ratio of new houses for sale to new houses sold to a 26-year low in the first half of 1997. Thus, even if home sales return to a more sustainable level in the later half of 1997, housing starts are not likely to plummet as builders replenish their stocks.

The long-term factors that should limit future housing demand remain in place, however. Consequently, this year's strength is unlikely to prevail in 1998 and subsequent years. Slower rates of household formation and a decline in the portion of the population most likely to be first-time home buyers (people 25 to 34 years old) are expected to weaken housing construction in the late 1990s (see Figure 6).
 

Figure 6.  The Population That Is 25 to 34 Years Old

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of the Census.   NOTE: Census projections were spliced into historical data available through 1997.

Firms are now operating at a high level of capacity, and if anything are likely to augment capacity. In addition, although overall demand for goods is expected to dwindle slightly, it should remain solid enough to encourage a modest expansion of capacity.

The financial health of business is splendid. The gross cash flow for firms has been generally climbing since 1992 (see Figure 7). Interest costs as a share of net cash flow have fallen since the late 1980s and are now at a 20-year low (see Figure 8). Part of the reason for that decline is that interest rates are lower now than during the late 1980s. In addition, firms are not relying heavily on debt financing given the recent boom in the stock market.
 

Figure 7.  Gross After-Tax Corporate Cash Flow as a Percentage of Potential Output

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

Figure 8.  Interest Payments by Business as a Percentage of Cash Flow

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

The growth in spending on real producers' durable equipment rebounded slightly in the first half of 1997 from its 10.9 percent rate in 1996. Increased expenditures on computers account for most of the growth in spending on business capital. Real business purchases of computers grew at a 33 percent annual rate during the first half of 1997.

Growth in expenditures on capital equipment should moderate further through 1998. Orders for nondefense capital goods, a leading indicator of capital expenditures, have trended downward since mid-1995 (see Figure 9). Although large orders for civilian aircraft in early 1996 are expected to boost spending in the latter half of 1997, they will partially mask the fall expected to occur as a result of the drop in shipments from other industries.
 

Figure 9.  New Orders for Nondefense Capital Goods and Investment in Producers' Durable Equipment

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis, and Bureau of the Census.

Figure 10.  The U.S. Trade Deficit as a Percentage of GDP

SOURCES: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

In the meanwhile, the vitality of the U.S. economy maintains a healthy appetite for imports. Moreover, since U.S. imports are already significantly greater than exports, exports must grow faster than imports just to keep the trade deficit from widening further. When combined, those conditions indicate that the external sector will remain a modest drag on the U.S. economy over the near term.

The overall economic conditions of U.S. trading partners are expected to improve. But improvements are varied both among and within regions of the world. The recovery has been most notable in North and South America. The recoveries in Canada and Mexico, which have recently benefited from strong growth in exports, are expected to gain a more firm footing as domestic demand solidifies. Of course, given the Mexican peso's recent history and current strength, the outlook of overly brisk Mexican domestic demand--carrying the potential of a trade deficit by 1998--may by itself be somewhat worrisome. Fortunately, the peso has remained steady throughout a tumultuous midterm election campaign for Mexico's Congress and despite the ruling party's loss of the majority. The recovery in South America has benefited greatly from increases in capital inflows, declines in inflation, and lower domestic nominal interest rates.

Although the Japanese economy strongly rebounded in 1996, the overall growth in Asia has wound down in 1996 and is expected to edge even lower in 1997. Japan posted a 3.6 percent growth rate in 1996--the highest since 1991. The effect of a tax hike in April and other measures of fiscal restraint should limit Japan's economic growth, however, so even a near-zero interest rate will support only a modest pace of recovery. Spurred by the weak yen, foreign trade seems set to be Japan's primary source of strength in the near term.

The brisk growth rates of the newly industrialized economies of Asia have unmistakably tapered, though they are still at around 6 percent. The region's financial and regulatory infrastructures badly need to be improved, as indicated by the fallout following the recent devaluation of the Thai baht, but the region's economy does have the potential of surging ahead in the future.

The Chinese economy grew at a 10 percent rate in 1996, little changed from its 11 percent rate in 1994. In addition, the inflation rate fell--from 24 percent in 1994 to 8 percent in 1996--which paves the way for sustainable growth. The financial markets' positive reaction to the recent handover of Hong Kong to China also indicates that the economic vibrancy of both regions is unlikely to be interrupted by that important change.

The export-led recovery in European economies has acquired a much brighter outlook than previously expected, thanks to low rates of interest and weak currencies. The cloud of uncertainty over the European Monetary Union (EMU), which has lowered the deutsche mark against the dollar noticeably in recent months, is likely to continue to depress the currencies of Continental Europe. The weakening in European currencies will no doubt help to boost recovery there further. However, overall growth is likely to be constrained by two main factors limiting recovery in domestic demand--fiscal restraints imposed by the EMU's criteria for convergence, and stubbornly high unemployment rates.

Fiscal Policy. Helped mainly by an unexpected surge in tax revenues, the U.S. budget deficit for the current fiscal year will fall to $34 billion, according to CBO's estimate. That is the smallest deficit since 1974--less than a third as large as the numbers projected for 1997 in CBO's January and March reports. About a third of the surge in revenues stems from stronger-than- expected economic growth. The rest reflects factors that have raised revenues relative to the income reported in the national income and product accounts (see Chapter 2 for details). CBO projects a rise in the deficit to $57 billion for 1998.

To measure the short-term impact of fiscal policy, CBO usually uses the standardized-employment deficit, which excludes from the actual deficit the effects of the business cycle. It also excludes factors that have little if any current economic effect, such as outlays for deposit insurance, spectrum auction receipts, and timing adjustments for certain federal payments and receipts. But it does not make adjustments for other factors, such as those that may have caused the recent surge in revenues relative to reported income. Such factors can distort CBO's measure of fiscal policy.

The standardized-employment deficit is expected to decline from 1.7 percent of potential GDP in 1996 to 1.2 percent in 1997 and 1.1 percent in 1998 (see Figure 11 and Table 2). Ordinarily, CBO would view the decline in 1997 as somewhat restrictive. But some of the factors that might explain the unexpected rise in revenues do not restrain the economy--for example, increased realizations of capital gains or possible upward revisions to national income. If adjustments were made for such factors, the standardized-employment deficit might not decline as much and might indicate an essentially neutral fiscal policy through 1998. The importance of those factors, however, cannot yet be determined because the needed data are not available.
 

Figure 11.  The Standardized-Employment Deficit (By fiscal year, on a unified budget basis)

SOURCE: Congressional Budget Office.

Most of the deficit reduction in the next five years from the budget agreement would be realized in 2002. The legislation calls for gross tax reductions amounting to $141 billion over five years, but it more than pays for them by cutting spending and raising revenues from other sources. The main features of the tax reductions include tax credits for children under 17, tax subsidies for education and saving, a lower tax rate on capital gains, and an increase in the amount of wealth exempt from the estate tax. The main features of the spending reductions are cuts in Medicare and discretionary outlays. Spectrum auction receipts will generate additional savings, especially in 2002. But those savings are partially offset by additional spending to provide increased health insurance coverage for children and to ameliorate some of the effects of last year's welfare legislation.

CBO's forecast of the budget deficit includes the reduction in interest rates from deficit reduction. The recently legislated changes in federal spending and taxes also affect the economic forecast by providing incentives and some disincentives for individuals to work and save and for firms to hire and invest. Though few of those effects can be estimated with precision, on balance, the net effects are likely to be very small (see Box 1).
 

Box 1. The Economic Effects of the Budget Reconciliation Package The Congressional Budget Office estimates that current policy will eliminate the deficit by fiscal year 2002 and produce small surpluses through 2007 as a result of an improved economic outlook and passage of the budget reconciliation package—the Balanced Budget Act of 1997 and the Taxpayer Relief Act of 1997.  The package cuts the deficit by decreasing the projected growth of spending, even though certain tax reductions offset part of that decrease.  The principal changes in tax law provide lower rates on capital gains, new and expanded individual retirement accounts (IRAs), reduced exposure to the estate tax and the alternative minimum tax, incentives for postsecondary education, and credits for children under the age of 17.  Some tax provisions will raise revenue—mainly by altering and extending the air-line ticket tax through 2007.  Although the legislation may affect most people, its overall impact on the economy in the next 10 years is likely to be very small.  General Considerations  The economic effects of the package will stem largely from lower deficits.  A deficit reduction raises national saving and leads to lower interest rates and higher gross domestic product (GDP).  The deficit cuts under the new legislation, however, are too small relative to the economy to lead to a large increase in national output.  The new legislation may also affect the economy by changing marginal tax rates—those rates that apply to the last dollar earned.  Lower marginal taxes on income from labor or capital are likely to encourage people to work more or consume less.  Some provisions directly change effective marginal rates—for instance, the new law reduces the statutory tax on capital gains.  Other provisions modify marginal rates indirectly by phasing out credits, deductions, or exclusions according to income.  Taxpayers who fall in the phaseout range will pay more tax than otherwise on an extra dollar of income.  Overall, changes in marginal tax rates under the new law should have little effect on work or saving—the changes are individually small and partly offsetting.  People are also likely to change their behavior to the extent that the new legislation entails income gains or losses that occur apart from any changes in marginal tax rates.  Income gains allow people to work less and consume more; losses have the opposite effect.  Many aspects of the reconciliation package provide income gains.  Some provisions reduce taxes and raise income by extending credits, deductions, or exclusions.  For instance, the child credit raises the after-tax income of people with children.  Similarly, the package allows people who would save or go to college even without new IRAs or incentives for education to reduce their taxes without changing their behavior.  Provisions that change tax rates can also provide pure income gains in addition to changing marginal incentives.  For example, the cut in the tax on capital gains enhances the income or wealth of people who have accrued capital gains on previous saving.  Other provisions effectively impose income losses.  The package raises excise taxes, reduces payments to Medicare providers, and increases premiums paid by Medicare beneficiaries.  On balance, the income losses exceed the gains.  Thus, the overall result of those gains and losses will probably be to increase work and decrease consumption, although that net effect again will be small relative to the economy.  Selected Tax Provisions  Under the new legislation, the top rate on capital gains will drop from 28 percent to 20 percent for gains on the sale of assets held at least 18 months and will eventually fall to 18 percent for gains on assets held for at least five years.  Those reductions will raise output slightly by raising the after-tax return on saving, thereby encouraging more saving.  But the increase will be small because the new treatment reduces the overall effective tax rate on capital income by less than 1 percentage point, a much smaller reduction than the drop in the statutory rate on capital gains.  The difference occurs because taxes on capital gains are deferred until an asset is sold and because the tax cut does not apply to about three-quarters of capital income—namely, capital gains held until death (which escape tax altogether), ordinary capital income (for instance, interest or dividends), and capital income paid to tax-exempt investors (such as pension funds).  The tax act raises the income eligibility limit for contributions to traditional IRAs and establishes so-called Roth or backloaded IRAs, under which many people can make taxable contributions but earn tax-free income in the accounts.  The effect of traditional IRAs on saving is controversial:  estimates of the amount of new saving they generate range from zero to over half of total IRA contributions.1  Backloaded IRAs, which account for over half the potential increase in IRA contributions, provide no immediate tax benefit for contributions and are thus unlikely to be as effective in raising saving.  Moreover, published estimates for the response of saving to IRAs are based on traditional rules for withdrawals.  The tax act liberalizes those rules by allowing withdrawals for education expenses and first-time home purchases—provisions that will probably moderate any increase in saving by making IRAs more like ordinary savings accounts.  Even if one-quarter of estimated new IRA contributions represented additional saving, that increase would add less than one-tenth of 1 percent to GDP by 2007.  The tax act also raises the exemption levels that apply to the estate tax and to the alternative minimum tax for small farms and businesses.  For estates or businesses that fall between the old and new levels, the higher exemptions reduce marginal tax rates.  For larger estates or businesses, the act slightly raises after-tax income and has no effect on the marginal tax rate; for smaller estates or businesses, the act has no effect at all.  Even if the provisions did apply at the margin to everyone, they would reduce the overall effective tax rate on capital income by less than one-tenth of a percentage point and therefore could do little to raise national saving and output.  The incentives for education include tax credits for tuition at colleges and vocational schools, exclusions for earnings received from IRAs for education, and tax deductions for interest paid on student loans.  Those provisions apply largely to people (or parents of children) who would go to school anyway—72 percent of recent high school graduates already participate in post-secondary education within two years of graduation.  Nevertheless, the incentives may encourage some of those who attend part time to attend half time or more and some of those who do not attend at all to do so.2  In that case, labor supply will initially fall—more time in school is likely to mean less time at work.  An increase in schooling, however, should eventually raise both productivity of labor and participation in the workforce, although those positive effects would probably remain negligible during the next 10 years.  In sum, the incentives through 2007 will have a small positive effect on enrollment in postsecondary education, a modest positive effect on the intensity of participation in education, and a very small negative effect on total hours worked.  Although the tax credit for children does not affect the statutory tax rate on income, and its primary effect will be tied to gains in income as noted earlier, that tax credit will also change marginal incentives to work and save.3  Marginal incentives will fall for high-income families because the credit is phased out at a rate that is equivalent to imposing an extra 5 percent tax on their income.  The overall effect will be small, however, because the phaseout now applies only to about 1 percent of earners.  Moreover, the adverse impact will be partly offset by an increase in work effort among some low-income parents for whom the credit, which is not fully refundable, effectively raises their after-tax wage rate.  1. For a detailed discussion, see the following articles in Journal of Economic Perspectives, vol. 10, no. 4 (Fall 1996):  James M. Poterba, Steven F. Venti, and David A. Wise, "How Retirement Saving Programs Increase Saving," pp. 91-112; Eric M. Engen, William G. Gale, and John Karl Scholz, "The Illusory Effects of Saving Incentives on Saving," pp. 113-138; and R. Glenn Hubbard and Jonathon S. Skinner, "Assessing the Effectiveness of Saving Incentives," pp. 73-90.  2. For estimates of the increase in school enrollment under the Administration's HOPE scholarship program, which was more generous than the provisions of the Taxpayer Relief Act of 1997, see Steven V. Cameron and James J. Heckman, "Summary of Main Findings" (unpublished paper presented to the Conference on Financing College Tuition hosted by the American Enterprise Institute in Washington, D.C., on May 15, 1997); and Jane Gravelle and Dennis Zimmerman, Tax Subsidies for Higher Education: An Analysis of the Administration's Proposal, CRS Report for Congress, 97-581 E (Congressional Research Service, May 30, 1997).  3. For a review of the evidence on the sensitivity of labor supply to changes in taxes, see Congressional Budget Office, Taxes and Labor Supply, CBO Memorandum (January 1996).

 
Interest Rates and Monetary Policy. Interest rates rose and then fell over the first half of 1997, mostly paralleling the evolution of views about the implications of robust economic growth for inflation and the likelihood of any monetary policyactions by the Federal Reserve. Lower-than-expected deficits may also have helped bring down long-term rates by midyear.

The rise in interest rates through the first quarter of 1997 was spurred by the rise in real GDP in excess of potential and by the resulting prospect of hikes in the Federal Reserve's target for the federal funds rate. The Federal Reserve decided at the end of March to increase its target for the federal funds rate by a modest 25 basis points to 5.5 percent. Other short-term rates, tending to move closely in tandem with the federal funds rate, increased modestly as well. In contrast, long-term rates rose more sharply, most likely on the expectation that further increases in short-term interest rates would be forthcoming.

During the second quarter of 1997, however, evidence of slowing economic growth and continued weakness in inflation caused interest rates to subside. Expectations that the Federal Reserve would need to make additional hikes in short-term interest rates ebbed. Consequently, long-term rates, which had risen the most, fell back sharply to levels that prevailed at the start of the year.

Lower-than-expected deficits may also have played a role in the decline of long-term rates during the second quarter, though it is difficult to say by how much. The initial move toward declining long-term rates coincided with news of lower-than-expected growth in employment costs, a closely watched indicator of potential inflation. Subsequent declines in long-term rates coincided with other news about near-term growth and inflation. In contrast, most of the good news about the lower-than-expected deficits emerged only gradually. By the end of April, it was fairly clear that the deficit for 1997 would be lower than previously estimated. Since long-term interest rates were still relatively high at that time, attributing their subsequent decline to a lowering of the deficit would be dicey.

During the second half of 1997, when CBO expects the economy to strengthen a bit from its second-quarter pace and the underlying inflation rate to pick up slightly, the Federal Reserve may again modestly raise its target for the federal funds rate. With inflation expected to rise, raising the federal funds rate would help to keep real short-term interest rates from falling below current levels and keep monetary policy modestly restrictive through 1998.

An additional indication that actions by the Federal Reserve may lie ahead comes from the behavior of the money-supply measures known as M2 and M3. They have been growing at or above their upper-monitoring ranges this year, as they did in 1996 (see Figure 12). The Federal Reserve views growth of those monetary aggregates near the upper band of their monitoring ranges as potentially inconsistent with the goal of stable prices and sustained expansion of the economy, as Federal Reserve Board Chairman Alan Greenspan noted in his monetary policy testimony to the Congress in July.
 

Figure 12.  The M2 and M3 Definitions of the Money Supply and Their Monitoring Ranges

SOURCES: Congressional Budget Office; Federal Reserve Board.

The Economic Outlook

CBO expects the economy to grow through the end of 1998 in a pattern that closely resembles a consensus of forecasts. Real GDP growth will be slower in 1998 than in 1997, while inflation and short-term interest rates will be higher. After 1998, CBO's projection includes the economic effects of this year's reconciliation legislation, and consequently shows a higher level of output and lower interest rates than in CBO's projection last January.

The Forecast Through 1998

According to CBO's new forecast, the economy will grow at a robust pace in 1997 and then slow to a moderate pace in 1998. Inflation will begin to rise during the second half of 1997 and continue to climb modestly through 1998. The brisk pace of economic growth in 1997 will push short-term interest rates higher through the first half of 1998.

Output. CBO expects real output to grow at 3.4 percent in 1997 and 2.1 percent in 1998. Growth in actual output should be above CBO's estimate of growth in potential output for the remainder of 1997 and then fall slightly below growth in potential output in 1998. By the end of 1997, output will be roughly 1.3 percent above its potential, whereas by the end of 1998 it will fall to roughly 0.7 percent above potential.

The healthy pace of growth in output in 1997 stems from strong growth in consumption and investment. The growth rates of those components of final demand are expected to decline slightly in 1998 but exceed the growth rate of GDP.

The real trade deficit for goods and services will continue to widen through the second half of 1998. Although the growth of exports is expected to reach an eight-year high of over 10 percent in 1997, growth of imports will be slightly greater.

Inflation and Unemployment. Growth in employment and the labor force should remain firm through 1998. The unemployment rate is expected to average 5.0 percent in 1997--a 24-year low--and 5.1 percent in 1998. CBO's estimate of the NAIRU is 5.8 percent. The fore-cast that unemployment will remain below 5.8 percent implies higher inflation through 1998, as pressures in the labor market work their way through to changes in the price of products. The current forecast shows inflation increasing but by less than would be expected, given the current and forecast unemployment rates relative to CBO's estimate of the NAIRU: the recent subdued behavior of inflation has increased the uncertainty associated with measures of demand pressures in the economy. The growth in the underlying rate of consumer inflation (CPI, less food and energy) will increase from 2.7 percent in 1997 to 3.1 percent in 1998. The growth in the GDP price index is expected to increase from 2.0 percent in 1997 to 2.4 percent in 1998.

Differences between the GDP-based and CPI measures of inflation affect budget forecasts. Indexed budget programs and personal income tax brackets are tied to CPI inflation, whereas projections of overall incomes (and thereby revenues) are most directly influenced by growth in the GDP price index. As a result, for a given rate of inflation in the GDP price index, a rise in the forecast for CPI inflation implies a higher deficit projection. Over the 1986-1996 period, inflation in the CPI exceeded growth in the GDP price index by an average of 0.4 percentage points. CBO's forecast maintains that difference through 1998.

Interest Rates. As a result of solid GDP growth in 1997 and rising inflation, CBO assumes that short-term interest rates will climb. The three-month Treasury bill rate is expected to increase to 5.5 percent by the fourth quarter of 1997--50 basis points above its current level. Long-term rates are expected to fall by 20 basis points from 1997 to 1998.

Comparison with Other Forecasts. For the most part, CBO's forecasts are close to the forecasts produced by the Blue Chip consensus and the Federal Reserve (see Table 3). All of the forecasts expect growth to be strong in 1997 and then recede slightly to a moderate pace in 1998. The 1997 growth rates for real GDP are at the bottom of the Federal Reserve's central-tendency range of 3 percent to 3.25 percent (the central tendency includes the majority of the forecasts of Federal Open Market Committee members and other Federal Reserve Bank presidents). The 1998 forecasts of the growth rate range from a low of 1.8 percent (CBO) to a high of 2.5 percent (the upper limit of the Federal Reserve's central-tendency range).
 

The forecasts for inflation show a decline in 1997 and a rebound in 1998. Forecasts of CPI inflation on a fourth-quarter-to-fourth-quarter basis for 1997 range from a low of 2.1 percent (CBO) to a high of 2.5 percent, which is at the upper end of the Federal Reserve's central-tendency range. The CBO forecast for the growth of the GDP price index is slightly less in 1997 and greater in 1998 than the Blue Chip forecast.

All three forecasters expect the unemployment rate to fall in 1997 from its 1996 level, but CBO and the Blue Chip expect the unemployment rate to rise slightly in 1998, whereas the Federal Reserve indicates no change. Forecasters expect short-term interest rates to rise in 1997 and 1998 but foresee little change in long-term interest rates in 1997 and no change or a slight drop in 1998.

The Projections for 1999 Through 2007

CBO projects that growth in real GDP will average 2.3 percent during the 1999-2007 period, just slightly below the growth rate of potential output for that period (see Tables 4 and 5). The unemployment rate will average 5.9 percent during the same period, while inflation, as measured by the CPI, will average 3.1 percent. Interest rates are roughly constant in CBO's projection for that period; short-term rates average 4.4 percent and long-term rates 5.7 percent.
 

Projections for Growth. CBO's forecast for economic growth leaves real GDP at roughly 0.7 percent above potential GDP by the end of 1998. CBO projects that rising short-term interest rates in 1997 will slow the economy, allowing real GDP to reach its average historical relationship with potential GDP by 2002.

Projections for Inflation. CBO projects that inflation, as measured by the CPI, will average about 3.1 percent from 1999 through 2007, and the GDP price index will advance at an average rate of 2.6 percent. The difference between the growth rates of the CPI and the GDP price index--0.4 percentage points--is similar to the average difference that prevailed between the two measures of inflation during the late 1980s and early 1990s.

Projections for Interest Rates. CBO projects interest rates by combining a projection for real rates with the projection for inflation. Real interest rates are projected to approach their levels of the 1960s, a period when inflation rates and federal deficits were not too different from what CBO now projects. Real long-term interest rates decline through the end of 2001, settling at a rate of about 2.6 percent in 2002 and thereafter. Combined with an inflation rate of 3.1 percent, that level implies a nominal rate of 5.7 percent. The three-month Treasury bill rate averages 4.4 percent during the 1999-2007 period, which implies a real rate of 1.3 percent, the same as its average during the late 1950s and early 1960s.

Projections for Income Shares. CBO projects that the share of GDP that falls into the main taxable income categories--wages and salaries, corporate profits, and other taxable income--will decline steadily from 79.6 percent in 1997 to 76.9 percent in 2007. The primary reason for the projected decline in the taxable share is a projected increase in the share of GDP devoted to depreciation (wear and tear on business equipment and structures), which stems from the recent boom in investment. Since depreciation goes untaxed, an increase in the share of depreciation tends to depress the taxable share of gross income.

Another source of the decline in the taxable share is an increase in the share of GDP composed of fringe benefits--untaxed forms of compensation such as employer-paid health and life insurance, pension benefits, and unemployment compensation. The benefit share of GDP has been falling in recent years, largely because the growth in medical costs has been restrained by a shift among employers toward managed care plans. However, as the proportion of employees covered by managed care increases, the scope for further savings diminishes. As a result, the benefit share of GDP is expected to rise in 1999 and thereafter.

The share of GDP paid in the form of wages and salaries is almost flat in CBO's projection, rising from 48 percent of GDP in 1997 to 48.4 percent in 2007. However, the rise in the benefit share--offset slightly by a decrease in the projection of employer contributions for social insurance--is enough to increase the projection for labor compensation as a share of GDP from 58.2 percent in 1997 to 58.8 percent in 2007.

A Comparison of January's Outlook with the Current Outlook

CBO's current (September 1997) outlook differs from its January baseline (see Table 6). In the September outlook, real GDP growth, the level of nominal GDP, and the tax bases are higher and interest rates after 1998 are lower. In addition, the outlook for the unemployment rate is lower in the current forecast.
 

The growth path for real GDP during the 1999-2007 period is also higher than the January baseline--about 0.2 percentage points higher. One reason is that the fiscal outlook has changed in part because of this year's budget reconciliation legislation: the current projection assumes a balanced budget by 2002, whereas the January baseline projection did not.

The growth dividend that stems from assuming a balanced budget accounts for about one-third of the upward revision. Another third of the upward revision stems from revised projections for the growth in hours worked and real investment. The projections for hours and investment were revised upward largely because of newly released data and revised historical data. The remaining third of the upward revision to real GDP is the result of an adjustment made to the growth of potential output to reflect technical adjustments to the CPI and the GDP price index.

The technical adjustments are necessary because the Bureau of Labor Statistics has announced that it will make two changes to its method for calculating the CPI and its component indexes (see Appendix B). Those changes, which will reduce the measured growth of prices, are reflected in CBO's projections for the CPI and the GDP price index. However, such changes will have no effect on the future growth of total expenditures in the economy. Consequently, CBO's projections of nominal GDP should be unaffected by them. To maintain the same projection for nominal GDP in the face of a lower projection for the growth of the GDP price index, the growth of real GDP must be adjusted upward on a one-for-one basis to offset the effects of lower inflation on nominal GDP. CBO's projection for the growth of potential output therefore includes a technical upward adjustment of 0.1 percentage point, beginning in 1999.

The current outlook for the unemployment rate for the 1997-1999 period is significantly lower than the January forecast. Although the January forecast called for a drop in the unemployment rate in 1997, the size of the drop during the first half of 1997 was unexpectedly large. For the later years, however, the projected unemployment rate is the same as in January.

In January, CBO expected interest rates to remain roughly constant through 1998 because economic output was anticipated to remain only slightly above potential. The unexpectedly high growth in the first half of 1997 prompted CBO to raise its forecast for short-term interest rates in 1997 and 1998--but in the projection period, interest rates are lower. The forecast for long-term interest rates was also raised slightly for 1997 but reduced below the previous projection by 1999. Interest rates are lower in the later years largely because of the effect of smaller deficits on interest rates.

Nominal GDP and the tax bases are much higher, particularly in the projection period. The NIPA revision raised the level of nominal GDP in early 1997 by $63 billion, and the effect of that revision carries throughout the forecast and projection years. Also increasing the growth of nominal GDP are the revisions to the growth of real GDP that came from new data on the rise in the number of hours worked and investment in recent years, as well as from the positive effects of deficit reduction.

The NIPA income categories that are most important for projecting revenues--corporate profits and wage and salary disbursements--are much larger in the September outlook than in January. The upward revisions in those income categories largely occured for the same reasons as the higher nominal GDP. In addition, deficit reduction will, by reducing interest rates, tend to increase the share of GDP accounted for by profits. The wage and salary share is larger in the current out-look in part because the rate of growth of nonwage compensation is smaller than projected in January.
 

Risks to the Economic Outlook

CBO's forecast reflects its view of the most likely, but certainly not the only, path for the economy through 1998. Embodied in the current CBO forecast are assumptions that interest rates will rise and that economic growth will slow to a moderate but sustainable pace by the second half of 1998.

A potential risk to the forecast is that economic growth may increase in the second half of 1997 and early 1998, thus putting further upward pressure on inflation. A related risk is that if the temporary factors that CBO believes could be masking inflationary pressures suddenly dissipate, inflation could rise sharply. Alone or in combination, either of those events would probably prompt the Federal Reserve to raise interest rates higher than CBO already expects, thereby increasing the risk of a significant slowdown or recession in the economy by the end of 1998. Monetary restraint has often precipitated recessions in the past.

Another possible risk to the current forecast is that CBO has underestimated the rate of growth of potential output because of a surge in the growth of productivity that has not been accounted for in government statistics on productivity. Should that be the case, the economy could sustain a rate of growth in output higher than CBO assumes without igniting inflation. If that scenario came to pass, CBO's forecast for interest rates and inflation would be too high and its income projections too low.

A third possible risk is that the stock market could decline significantly. Recent rises in the stock market have pushed the earnings yield (earnings as a percentage of price) on the Standard & Poor's 500 index down almost to the yield on short-term safe assets such as Treasury bills. Typically, the earnings yield on stocks exceeds the yield on safe assets. The occasional disappearance or even reversal of that spread is not unprecedented. However, it has usually happened near the end of economic expansions or just before a decline in the stock market.

Although corrections in the stock market of 20 percent to 30 percent are rare, they are not unprecedented. Nevertheless, based on the experience of the 1987 stock market crash, when the Dow Jones industrial average fell by almost 23 percent in one day, corrections of that magnitude by themselves need not severely affect overall economic activity. Therefore, even a severe correction might only slow growth slightly.

Aside from the specific risks mentioned thus far, always a possibility is the risk that the economy will deviate from the path assumed in CBO's forecast and projection. The forecast and projection are estimates, and estimates are subject to error. Those errors occur as unforeseen factors push the economy either above or below the assumed path.

Although the direction and magnitude of the errors are uncertain, the possibility of large errors definitely grows over time. Thus, CBO's projection of the economy in 2002 is much less certain than its forecast of the economy in 1998. The economic and budget outlook should therefore be interpreted in light of those possible deviations. As pointed out in CBO's Economic and Budget Outlook in January, typical-size fluctuations can easily increase or decrease the budget deficit by over $100 billion in a single year.

---