FROM THE OFFICE OF PUBLIC AFFAIRS

Since the last meeting of the Advisory Committee three months ago, growth in the U.S. economy has dramatically picked up steam.  Last week the Commerce Department reported that the pace of economic activity increased to a stunning 7.2 percent annual rate in the third quarter, well above expectations and the largest increase since the first quarter of 1984.  While some slowdown from that elevated pace is to be expected, there is little doubt that the economy is now firmly on an upward path.

After growing at a slow 1.4 percent pace late last year and early this year, positive signs of improvement began to build through the spring.  The swift conclusion of the war in Iraq lifted the consumer mood.  Attractive auto incentives and the extraction of home equity through a surge in mortgage refinancing also contributed to an acceleration of personal consumption expenditures in the second quarter.  Indicators of investment demand such as new orders and shipments of nondefense capital goods perked up as well, and the nascent recovery in real equipment and software investment that we witnessed in the last three quarters of 2002 resumed in the second quarter of 2003 after a decline in the first.  The firmer tone to investment and consumption helped raise real GDP growth to a 3.3 percent annual rate in the second quarter.

The passage of the Jobs and Growth Tax Relief Reconciliation Act in May provided almost immediate additional support for the economy.  By July, withholding tables reflected reduced marginal tax rates on individual income, and the child tax credit checks began to be delivered to households.  The increase in bonus depreciation and quadrupling of the expensing limit for small businesses encouraged business investment.  The reduction in taxes increased households’ cash flow by an estimated $35 billion and spurred businesses to take advantage of enhanced capital expensing.

The impact was substantial.  Total consumer spending grew at a 6.6 percent rate in the third quarter, the largest gain since a rise of the same amount in the third quarter of 1997, and equipment and software investment surged at a 15.4 percent pace, the fastest since the first quarter of 2000.  Production responded to the pickup in final demand in the last two quarters, and manufacturing output rose at almost a 3 percent annual rate in the third quarter.

More recently, there has been additional evidence of a recovery in the manufacturing sector.  The Institute for Supply Management’s purchasing managers index jumped sharply in October to 57.0 – the highest since January 2000 and the fourth consecutive reading above the 50-percent breakeven point that signals expansion in manufacturing activity. 

Many of the strengths that were evident going into the third quarter are likely to continue to provide support to the economy going forward.  Productivity growth has been exceptional.  The 3.9 percent annual rate of advance in nonfarm productivity since the fourth quarter of 2000 – a period that includes both a recession and recovery – is the strongest of any two-and-a-half year period in 30 years.  Based on the 9.0 percent increase in nonfarm business output indicated by last week’s GDP data and virtually no growth in worker hours, it appears likely that another large productivity gain is in store for the third quarter when results are released later this week.

Businesses are beginning to reap the benefits of those productivity improvements.  Profits and cash flow are rising and unit costs have been held in check, paving the way for further gains in investment.  Small business optimism recently reached a record high level, according to the National Federation of Independent Business, and the Conference Board reported that confidence among large-company CEOs was the strongest in 11 years.  Improved business optimism is a first step in the revitalization of labor markets. 

Equity prices have climbed about 30 percent since mid-March, improving financing conditions for business, as well as adding to household net worth.  Boosted by the tax cuts, real disposable personal income is rising, up at a 3.8 percent annual rate through the first three quarters of the year.  Household and business balance sheets benefited from low interest rates over the past few years, leaving those sectors in a good position to continue to spend.  Rates are still quite low and yield spreads are narrowing, enhancing prospects for investment.

The housing sector has been an engine of growth throughout the recession and recovery and the homeownership rate has risen to a record 68.2 percent.  Housing continued to expand through the third quarter and construction starts and permits point to further growth in residential investment ahead, a development supported by the highest level in four years of homebuilder optimism regarding the six-month outlook, according to the National Association of Home Builders.

The prospects for overall economic growth going forward are positive.  Overseas economies appear to be improving and providing a growing market for U.S. exports, which rose 9.3 percent at an annual rate in real terms in the third quarter for the first quarterly gain in a year.  Production related to replenishing inventories should also contribute to growth.  Through the past few quarters inventories have been trimmed to very low levels as businesses met a relatively large portion of demand out of existing stockpiles.  That is expected to turn around with the revival of strong demand.

The latest Blue Chip consensus forecast expects real GDP growth to ease in the fourth quarter to 3.7 percent and maintain that pace through next year.  That rate is above the estimated potential rate of growth of the economy, and the sustained trend above potential should lead to a pickup in employment.

We have already seen signs of a budding upturn in labor markets, with payroll jobs growing by 57,000 in September -- the first job increase in eight months.  Unemployment claims appear to be moving lower and layoffs are declining.  The Conference Board’s latest consumer confidence survey found their assessment of both current and future employment conditions was more upbeat, contributing to a 4-percentage point increase in the confidence index in October.   

Consumers’ opinions on job conditions seem to have aligned with those of professional forecasters, many of whom expect that the acceleration in real growth in the third quarter and over the following four quarters will lead to a sizable increase in employment.  Private sector estimates are converging on a job gain of 2.1 million over the four quarters ending in the third quarter of 2004.

Though positive signs are emerging and the outlook is favorable, we have seen during the latest recession and recovery how sensitive labor markets have become compared to the experience of previous cycles.  It appears to be taking longer for labor markets to respond to an upturn in economic activity.  Since creating new jobs is a top priority of the Administration, in addition to the stimulus packages already at work, the President recently unveiled a six-point plan to reduce barriers and uncertainties that may be impeding businesses from hiring additional workers.  The plan includes a series of measures to help the economy operate more efficiently, such as tort reform, providing an affordable energy supply, streamlining regulation, opening new markets for U.S. products, making tax cuts permanent, and improving the affordability of health care.

The substantial rise in health care costs has strapped the budgets of families, businesses, and government, acting as a deterrent to hiring.  After a period of relatively slow health spending growth in the late 1990s, growth has accelerated with the retreat of managed care.  Health spending now makes up over 14 percent of the economy.  The Bureau of Labor Statistics’ Employment Cost Index for health benefits has risen 10.1 percent over the past year, following an 11.2 percent increase the previous year.  Employers are struggling to control health care costs without reducing or dropping coverage, because private-sector efforts to improve value and efficiency in health care spending are in their nascence and are not well developed.  Sustained health care cost increases are preventing firms from hiring new workers, while some workers may be reluctant to change jobs for fear of losing health insurance coverage. 

The increasing strain of high and fast-growing health care costs not only impedes the flexibility of U.S. labor markets but also puts a growing burden on the federal budget.  Already, one-quarter of federal outlays are dedicated to health care expenses.  A mere one percentage point decrease in the anticipated rate of growth of health care spending would reduce the national debt by more than $600 billion over the next 10 years.  This Administration is committed to rooting out the causes of wasteful care while preserving the incentives to sustain the miraculous technological progress we have witnessed in this sector.

 In sum, growth in the economy appears to be firmly established and the outlook going forward is bright.  The Administration will continue to work to increase the rate of job growth and to reduce any inefficiencies and barriers that may inhibit the economy from maximizing its growth potential.