The Congressional Budget Office expects solid growth in overall economic output over the next two years. Overall demand is now rising fast enough to spur producers to expand their productive capacity by investing in new capital (equipment and structures) and hiring more workers. As a result, the economy has passed into a more balanced stage of growth than that immediately following the 2001 recession. During the rest of calendar year 2004 and in 2005, large gains in investment by businesses are likely to lead that expansion. CBO forecasts that real (inflation-adjusted) gross domestic product will expand by 4.5 percent in 2004 and 4.1 percent in 2005 and then grow at an average annual rate of 2.8 percent over the medium term--from 2006 to 2014. Over the entire 2004-2014 period, growth is expected to average 0.1 percentage point more than in CBO's January 2004 forecast.

At present, the productive capacity of the economy is not being fully employed. Unusually large gains in productivity allowed real GDP to expand rapidly over the past year without taking up much of the "slack"--underutilized labor and capital--that developed in the 2001 recession and its slow-growth aftermath in 2002 and early 2003. But if productivity growth settles into a more moderate pace in the future, as it is expected to do, the rapid expansion of GDP that CBO forecasts for the near term will eliminate any remaining underused capacity in the economy by the end of 2005. The removal of that slack would be accompanied by a reduction in the unemployment rate and a rise in interest rates. Inflation, by comparison, would probably remain modest; CBO views some of the pickup in inflation earlier this year as temporary.

A variety of factors could produce outcomes that differed from CBO's best estimates of the economic conditions likely to prevail over the next two years. Further increases in oil prices would reduce real consumer incomes and worsen the trade balance, although they would be unlikely to derail the recovery. A loss of confidence by businesses or investors because of those higher oil prices or some other adverse factor could result in less investment by businesses than CBO expects. A decline in foreigners' demand for U.S. assets that led to an abrupt drop in the dollar could have mixed effects, ultimately helping net exports but hurting interest-sensitive sectors of the economy such as housing (by raising interest rates) and producing temporarily higher inflation (by boosting prices for imports). A large drop in the prices of homes in some regions of the country could hold down consumer spending, and growth in foreign economies that was weaker than expected would hurt exports, slowing the growth of GDP. Yet many of those factors could also improve more than CBO expects, which would lead to an even stronger two-year outlook.

Over the medium term, the factor that most affects the accuracy of CBO's projections is the rate of growth of productivity. That growth could remain unusually fast-paced, adding to the expansion of output, or it could drop to below-average rates, causing the growth of GDP to be slower than CBO anticipates.
 

Overview of the Outlook

In CBO's estimation, the economy has entered a phase of investment-led growth in which the number of jobs is rising and real GDP is expanding faster than its trend rate. Indeed, CBO expects real GDP to grow so strongly during 2004 and 2005 that the current excess capacity in the economy will be eliminated by the end of 2005 (see Table 2-1). But whether that expectation is fulfilled depends in large part on how lasting the recent surge in productivity turns out to be. The amount of slack that remains in the economy, and thus the room it has for growth before excess capacity is eliminated, are highly uncertain (see Box 2-1). Overall, however, CBO's forecast is similar to the one published in its January 2004 report The Budget and Economic Outlook: Fiscal Years 2005 to 2014; the only significant change since then is that CBO now foresees a more rapid rise in inflation.

Table 2-1.

Box 2-1. How Much Slack Is Left in the Economy? A key factor in determining how fast gross domestic product (GDP) can expand over the next two years is the amount of "slack"--underutilized capital and labor--that remains in the economy. With more underutilized resources, the economy faces fewer bottlenecks to growth, and the Federal Reserve can follow a more stimulative monetary policy. Thus, the more slack the economy has, the more rapid the growth of GDP is likely to be. The reverse is also true--with less slack, GDP is likely to grow more slowly. Available evidence from a variety of sources suggests a wide range of answers to the question of how much slack there now is. The Congressional Budget Office's (CBO's) estimate falls in the middle of that range. Data from the labor market, for example, generally indicate that at least some underused economic capacity remains, but different measures offer different views of how much. By July 2004, the unemployment rate was not far from its projected long-run level, implying little additional room for gains in employment resulting purely from the typical ups and downs of the business cycle. At the same time, the ratio of employment (the number of people working) to the working-age population was still well below its values prior to the recession, suggesting that employment could rise significantly if that ratio returned to its level before the downturn. CBO takes a middle view: it expects that the labor force participation rate (the share of the population ages 16 and older who are either employed or actively looking for work) will partially rebound and the unemployment rate will improve by less than half a percentage point. The range reflected in estimates of the utilization rate of manufacturing capacity by the Federal Reserve Board and the Institute for Supply Management (ISM) is even broader than the range for the labor market. The Federal Reserve's more widely used measure of manufacturing capacity utilization has remained well below its historical average; in contrast, the ISM's measure jumped above its average during the first half of 2004 (see the figure). Although it is difficult to infer conditions in the overall economy from a measure that applies only to manufacturing, the Federal Reserve's estimate implies more room for growth in the economy than the ISM's estimate does.   Measures of Capacity Utilization in Manufacturing (Percent) Sources: Congressional Budget Office; Federal Reserve Board; Institute for Supply Management. Note: The ISM collects data only for May and December. Data for other months were interpolated by CBO. Measures of slack in the labor market and in manufacturing each focus on a single component of the total amount of underutilized economic resources. In contrast, CBO uses a summary measure of underemployed capacity: the gap between its estimate of potential GDP and actual GDP. That so-called GDP gap was about 1.3 percent at the beginning of 2004, CBO estimates--an indication that a moderate amount of slack remained. (By comparison, the GDP gap reached 3.1 percent in early 2003.) CBO's projection of potential GDP and thus its estimate of the GDP gap depend not only on trends in labor hours and the capital stock but also on its estimate of total factor productivity, or TFP (defined as the average real output per unit of combined labor and capital inputs). The higher the level of TFP, the more the amount of GDP that can be produced from a given level of labor and capital and thus the greater the slack remaining in the economy for a given level of actual GDP. TFP has grown rapidly over the past four years, much faster than might be expected on the basis of historical patterns. As a result, potential TFP, and hence potential GDP and the GDP gap, are more uncertain than usual. Were TFP to revert to its historical trend through below-average growth in productivity, potential GDP would be lower than CBO estimated, and the remaining gap between actual and potential GDP would soon disappear. In that case, the likely outcomes would be slower growth or higher inflation than CBO expected, or a combination of both. By contrast, if TFP continued to grow at a typical or above-average rate from its currently high level, potential GDP would be greater than CBO estimated. Given that circumstance, real (inflation-adjusted) GDP would probably grow more rapidly than CBO anticipated, and inflationary pressures would be more muted.

CBO does not attempt to forecast the ups and downs of the business cycle after 2005. Instead, its medium-term projection (through 2014) reflects where GDP is likely to be, on average, during future cycles. As a result, CBO's projection of the growth of GDP keeps pace roughly with its estimate of the trend growth of the economy--that is, potential GDP.⁽¹⁾ Real GDP growth will average 3.0 percent from 2006 to 2009 and 2.6 percent from 2010 to 2014, CBO estimates. The slower growth projected for the latter half of the period stems primarily from slower growth of the labor force, as the baby boomers begin to retire.

CBO's forecast incorporates the likely macroeconomic effects of baseline fiscal policy. In particular, it takes into account the impact of portions of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, including the laws' influence on the supply of labor hours and saving.⁽²⁾ One of the assumptions on which CBO's estimates of such effects rests is that businesses and households will behave as if they believed that the "sunsets" (scheduled expirations of tax cuts) contained in EGTRRA would, indeed, occur. CBO's forecast also incorporates the revisions to the national income and product accounts (NIPAs) published in July 2004.

The rate of unemployment in CBO's two-year forecast and medium-term projection is related to CBO's estimate of the gap between GDP and potential GDP. As that gap closes over the next two years, CBO expects the unemployment rate to fall to 5.6 percent in 2004 and 5.2 percent in 2005. The rate will then average 5.2 percent from 2006 to 2014, in CBO's estimation.

Inflation will rise at a faster pace in 2004 than in 2003, CBO forecasts, primarily as a result of more rapid growth in core prices earlier this year. (Core prices exclude food and energy.) Yet even after the acceleration in inflation thus far in 2004, price increases remain low by post-World War II standards. For 2005, inflation is projected to ease somewhat, as energy prices first fall and then grow at more normal rates. Consumer price inflation, according to CBO's two-year estimates, will rise from 2.3 percent in 2003 to 2.6 percent in 2004 but then fall to 2.0 percent in 2005. CBO projects that consumer prices will increase at an average annual rate of 2.2 percent from 2006 to 2014.

Interest rates, especially short-term interest rates, are expected to climb as the economy continues to grow, but they are also likely to remain low by historical standards. The interest rate on three-month Treasury bills is forecast to increase from an average of just 1.0 percent in 2003 to 1.3 percent in 2004 and 2.6 percent in 2005; it is then expected to average 4.5 percent from 2006 to 2014. Yields on 10-year Treasury notes will rise by a smaller cumulative amount, CBO expects, from an average of 4.0 percent in 2003 to 4.6 percent in 2004, 5.4 percent in 2005, and 5.5 percent, on average, from 2006 to 2014.

In CBO's forecast, both fiscal and monetary policy shift course during 2004 and 2005 relative to their paths in recent years. As projected under current law, the effect of fiscal policy on the short-term growth of demand in 2004 will be more modest than it was in 2003; in 2005, it will restrain such growth. The additional demand in 2004 derives from JGTRRA as well as from an increase in defense spending. In 2005, the expiration of certain provisions of JGTRRA and smaller refunds of personal taxes (the taxes on income received by individuals) are expected to reverse some of the fiscal policy influence present in 2004. Similarly, growth in private-sector demand is likely to permit the unusually easy stance of current monetary policy to gradually give way to a more neutral posture during 2004 and 2005.⁽³⁾
 

CBO's Two-Year Forecast

In CBO's outlook for 2004 and 2005, the economy remains in the current phase of its cyclical expansion (see Table 2-2). That phase is characterized by a self-reinforcing cycle of healthy growth in demand and a corresponding need for businesses to employ more workers and capital--which in turn fuels more demand. In the two-year forecast, interest rates rise gradually from their unusually low current levels. Inflation, however, after temporarily climbing in 2004, is forecast to recede, growing slightly more slowly in 2005 than in 2003.

Table 2-2.

The Labor Market

After more than two years of sustained losses in payroll employment, the labor market has begun to rebound and by so doing provide the underpinnings of further growth. From 2001 to 2003, firms more than met the slow growth of demand for goods and services by gains in productivity, which allowed them to let go of more workers than they hired. As a result, the number of nonfarm payroll employees fell by 2.7 million between its peak in March 2001 and August 2003 (see Figure 2-1). Since last August, firms have added to their workforces as the growth of demand accelerated. The number of nonfarm workers rose by about 500,000 between August 2003 and February 2004, and by another 1.0 million between February 2004 and July 2004.

Figure 2-1.

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

Those changes in employment were also reflected in the unemployment rate, which rose from 4.3 percent in March 2001 to a peak of 6.3 percent in June 2003. The rise would have been larger but for the fall in the rate of labor force participation--from 67.1 percent to 66.5 percent--over the same period.⁽⁴⁾ As businesses expanded their workforces during the past year, the unemployment rate fell to 5.5 percent in July 2004--although the rate of labor force participation also dropped, to 66.2 percent, in that month. The additional fall in the participation rate since mid-2003 means that the decline in the unemployment rate does not fully reflect the overall condition of the labor market.

With the growth of overall demand likely to continue outpacing the growth of potential GDP over the next two years, businesses will add workers to meet that extra demand, CBO forecasts. As a result, employment will grow at above-average rates, and the unemployment rate will fall from 6.0 percent in 2003 to 5.6 percent in 2004 and 5.2 percent in 2005. That decline in the unemployment rate will be tempered, in CBO's view, by a rebound in labor force participation (since many new jobs will be taken by people who are not currently in the labor force).

The Growth of Demand

The same factor that is now spurring a rise in employment--the need to add productive resources to satisfy more demand--will also lead businesses to purchase new structures and equipment and to rebuild their inventories. As a result, growth in the economy during the rest of 2004 and in 2005 will be led by businesses' investment--the sector that declined the most during the 2001 recession and its aftermath. That growth continues a pattern: over the last two business cycles, investment by the private sector, including residential construction, has accounted for most of the movement in output as a percentage of potential GDP (see Figure 2-2).

Figure 2-2.

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

In previous business cycles, the contributions to growth made by other components of GDP rose and fell. However, since the late 1980s, the sum of those components has stayed roughly flat relative to potential GDP, and CBO expects that pattern to continue through 2005, with those components together growing at about the same rate as potential GDP. Personal consumption is likely to rise at a healthy pace but not as fast as GDP, in CBO's estimation. Exports are expected to contribute to the expansion, aided by robust growth in many overseas economies and a continued depreciation of the dollar. At the same time, however, rising demand in the United States will increase imports, resulting in a slight reduction in real net exports in 2004 and only a modest gain in 2005. Consumption and investment by the federal government will expand at about the same rate as GDP; however, overall government spending (including expenditures by state and local governments) and residential construction will add little to the growth of demand. Notwithstanding those factors, demand growth in the private sector--led by business investment--is projected to continue the recovery and permit less stimulative fiscal and monetary policy.

The Business Sector. CBO forecasts that a recovery in investment by businesses will be a key force in the ongoing economic upturn. Even so, business investment will remain a smaller share of GDP than it has been in past expansions. Thus, the rapid growth that CBO expects in business fixed investment (purchases of equipment, software, and structures) and inventory investment is best thought of as regaining ground after investment's sharp drop during the recession rather than rising to an unusually high level.

Business Fixed Investment. Between the fourth quarter of 2000 and the first quarter of 2003, business fixed investment suffered an unusually steep and long-lasting decline, falling from 12.7 percent of potential GDP to just 9.4 percent (see Figure 2-3). Real business fixed investment fell at an average annual rate of 7.0 percent during that period after increasing by 5.7 percent annually, on average, during the previous 40 years. The most important factor in the decline was that demand for businesses' output grew more slowly than their ability to produce it with their existing capital and labor. Thus, in general, firms cut their payrolls and reduced investment below the levels needed to fully replace all of their depreciating equipment and structures. In addition, the cost of capital--the "hurdle" rate that the expected return from a new investment must exceed in order for that investment to be considered profitable--increased, as stock prices declined and investors demanded higher risk premiums on corporate securities.⁽⁵⁾ Another reason for the drop in fixed investment was that the high rate of firms' spending during the late 1990s for certain types of information technology (particularly telecommunications equipment) apparently was unsustainable.

Figure 2-3.

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

Those adverse conditions have improved, causing fixed investment to grow in recent quarters. Demand is now outpacing businesses' ability to supply it with their present capital and workforce, as demonstrated by the rising level of employment over the past year. Between October 2002 and July 2004, stock prices climbed by 29 percent while risk premiums on corporate debt fell--both of which reduced the cost of capital. And investment in telecommunications equipment has begun to bounce back. As a result, real investment in equipment and software grew at an average annual rate of 12 percent between the first quarter of 2003 and the second quarter of 2004. The prospect of further growth in spending for equipment is indicated by unfilled orders for nondefense capital goods excluding aircraft, which in June 2004 reached their highest level since September 2001. Nonresidential construction has lagged behind investment in equipment, but it appears to be rebounding as well, with positive real growth reported for the second quarter of 2004.

Changes in the tax code that were enacted in 2002 and 2003 are also contributing to the upturn in investment. The Job Creation and Worker Assistance Act of 2002 (JCWAA) contained incentives to bolster businesses' spending on equipment and structures by temporarily increasing the fraction of new investment that firms can "expense" (deduct from their taxable income immediately rather than over time). JGTRRA expanded those incentives by allowing firms, through the end of 2004, to expense 50 percent of the value of new equipment and of some structures in the tax year in which the property is acquired. In addition, it increased, through 2005, the limit on small businesses' expensing of new depreciable assets. Those incentives will boost investment in equipment by at least 3 percent in 2004, CBO estimates, both by reducing the cost of such investment and by inducing some firms to shift some investment from 2005 to 2004, to take advantage of the expensing provision before it expires.

In CBO's estimation, the growth of business fixed investment is likely to continue at a brisk clip. Many businesses need to expand their capacity to meet a greater demand for their products or to invest in new capacity to replace equipment and structures that are depreciating in value. Yet investment could be weaker than CBO expects if the growth of other components of demand was unexpectedly lackluster or if businesses and investors lost confidence in the prospects for future profitability.

The strong growth of demand over the past year is likely to boost business fixed investment in the future since such spending responds only gradually to greater demand. The importance of past growth is especially significant for construction, where the lags between demand and investment are longer than for other types of capital. In the past, nonresidential construction excluding mining and farming has responded to upturns in employment during the prior four years. According to CBO's forecast, the rate of employment as measured in four-year intervals is beginning to rise and will climb even more rapidly in 2005. Also suggesting a boost in future construction are a drop in the vacancy rate for offices in the second quarter of 2004 and a rise in the level of billings and customer inquiries reported by members of the American Institute of Architects.

Inventory Investment. Businesses' spending on inventories, like their fixed investment, is benefiting from an end to the sluggishness in demand that was responsible for the slump in such spending in recent years. The strong growth in demand forecast for 2004 and 2005, combined with firms' currently lean inventory stocks (even after accounting for the historical downward trend in the ratio of inventories to sales), is likely to trigger significant accumulation of inventories. Businesses restocked their shelves during the second quarter of 2004 at the highest rate seen since 2000, and CBO forecasts that the swing from drawing down inventories to rebuilding them will add significantly to the growth of GDP in 2004 and 2005.

The Household Sector. Spending by the household sector will contribute to economic growth during 2004 and 2005 but will follow the overall economy rather than lead it. During the recent recession and the early part of the recovery, stimulative fiscal and monetary policies contributed to both consumer spending and residential investment, keeping the growth of those sectors positive (in contrast to the contractions they experienced in most previous recessions; see Figure 2-4). That relative strength during the cyclical downturn in 2001 also suggests less of a cyclical rebound in those sectors than in previous recoveries. Under current law, tax provisions will tighten somewhat in 2005; at the same time, CBO forecasts, interest rates will rise. As a result, consumer spending will grow more slowly than GDP over the remainder of 2004 and 2005, whereas real residential investment is likely to decline--although it will remain at a high level.

Figure 2-4.

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

Income. Expansionary fiscal policy accounted for much of the growth in disposable (after-tax) income over the past three years, but during the next two years, the main engines of income expansion are expected to be the rise in real GDP and in labor's share of output. Between 2001 and 2003, tax cuts and expanded government transfer payments sharply boosted disposable income. EGTRRA and JGTRRA each reduced individual income taxes, and JCWAA and subsequent extensions provided additional unemployment benefits. Those measures helped disposable income grow at a solid pace despite the slow growth of personal income. Between the second quarter of 2001 and the third quarter of 2003, when most of the fiscal legislation took effect, disposable income grew at an average annual rate of 5.0 percent. By comparison, personal income excluding transfers grew at an average annual rate of 1.9 percent.

A moderate tightening of fiscal policy will remove some of that positive impact on disposable income in 2005. Provisions of JGTRRA will hold down income growth by temporarily reducing a few tax benefits--the child tax credit, the expanded 15 percent bracket and standard deduction ("marriage penalty relief"), and the expanded 10 percent bracket--and by eliminating the increase in the exemption under the alternative minimum tax. Also dampening income in 2005 relative to 2004 is a likely reduction in tax refunds. Certain tax cuts enacted in 2003 in JGTRRA were retroactive to the beginning of that year, but the government's withholding of taxes for 2003 did not fully account for it. That led to bigger refunds and smaller final payments in 2004--outcomes that CBO does not expect will recur in 2005. Together, the changes under JGTRRA and the reduction in refunds are likely to reduce disposable income in fiscal year 2005 by 0.3 percent of personal income, or about $34 billion.

Nonetheless, in CBO's estimation, two other factors will keep both personal income and disposable income growing at a healthy rate in 2004 and 2005. First, rapid GDP growth will contribute to growth in the income of the people who produce that output, and second, income from labor will grow more rapidly than GDP. Since the onset of the recession in 2001, the share of gross domestic income going to workers has fallen, at least partly because of the weak demand for labor (see Figure 2-5). That decline in labor's share helped hold down growth in pretax income--which partially blunted the effect of lower tax rates on disposable income. CBO expects that stronger demand for labor will reverse some of that decline over the next few years.

Figure 2-5.

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

Households' Finances. Households' finances have improved since the recession and are unlikely to impede consumption in 2004 and 2005, according to CBO's estimates. By the first quarter of 2004, delinquency rates at commercial banks on credit cards, other consumer loans, and residential real estate had each fallen well below the levels they reached during the 2001 recession. The ratio of households' financial obligations to disposable income had also fallen slightly below its recession peak. (Nevertheless, it remains high.) Thus, although households' finances are still vulnerable to a downturn in the economy, they are not likely to precipitate one.

Consumption. CBO expects that solid growth in households' income will enable real consumption to post sturdy gains during the remainder of 2004 and in 2005. Those gains will be somewhat larger than the rise in consumption during the past three years, as stronger GDP growth fuels a more rapid expansion of pretax income and falling oil prices (in 2005) add to real income growth. Nonetheless, consumption will not grow as fast as overall GDP, CBO forecasts, because of the effect on disposable income of tighter fiscal policy in 2005.

On the one hand, a number of factors could lead to slower growth of real consumption than CBO anticipates--for example, a slower pace of income growth, a decline in households' wealth owing to lower prices for houses or corporate equities, a sharp worsening of consumers' finances, or a steep upsurge in oil prices resulting from disruptions in supply. On the other hand, consumption could be stronger than CBO forecasts if those factors became more favorable than expected.

Housing. With construction and sales of homes already at record highs and mortgage rates likely to rise further, residential investment during the remainder of 2004 and in 2005 is expected to curb the growth of demand. The lowest mortgage rates in more than 30 years led to home sales in 2003 that surpassed all other years', giving a big boost to construction. Although mortgage rates have since risen, the low level of rates relative to those in the past, the anticipation of further rate increases, and the growth of employment have kept home buying strong. CBO foresees further hikes in mortgage rates and, as they occur, a slowdown in housing activity from its current level. That slowdown could be worse than anticipated if purchasers of homes today have unrealistic expectations about how much their homes will appreciate and potential buyers revise those expectations downward.

Exports and Imports. Overall, the international sector will slightly lessen the growth of GDP in 2004 and slightly add to it in 2005, CBO estimates. In 2004, the fast pace of U.S. economic growth will raise imports more than solid economic growth abroad will increase exports. Yet a gradual slowing of the rate at which foreigners want to add to their holdings of U.S. assets will result in a decline in the dollar, CBO forecasts, and in 2005, the United States' enhanced competitiveness--a result of that weaker dollar--will tip the balance toward greater growth of exports than of imports.

Changes in CBO's outlook for the foreign sector could substantially influence the accuracy of its entire forecast because events and conditions in that sector directly affect exports and imports and indirectly affect other parts of the economy. A further unexpected rise in world oil prices would reduce real consumer spending, whereas a sharp fall in oil prices would bolster it. Unexpectedly weak growth abroad could lead to a lower level of exports than CBO forecasts, whereas unexpectedly strong growth could lead to a higher level. A sudden lessening of foreigners' willingness to add to their holdings of U.S. assets would reduce the value of the dollar, ultimately aiding the trade balance. But it would also reduce the flow of foreign funds to interest-sensitive sectors, such as housing and business fixed investment, because interest rates would rise.

Foreign Economic Conditions. Economic growth in the industrialized countries is recovering from its slow pace in 2003. The Blue Chip consensus of roughly 50 private-sector forecasts expects that rising exports to a strengthening global economy will boost real GDP growth in countries that use the euro--rates will climb from 0.4 percent in 2003 to 1.8 percent in 2004 and 2.2 percent in 2005, in the estimation of the consensus. Growth in the United Kingdom is likely to be stronger than that, aided by more robust domestic demand than in the euro area. Japan's recovery, which has been jump-started by exports to China, is strengthening and broadening, and the Canadian economy, stimulated by vigorous U.S. growth and improved economic conditions worldwide, is bouncing back after posting a mediocre rise in output in 2003. In Australia, a pickup in growth is expected as well.

Also expanding, on average, are the economies of the United States' trading partners in the developing world. Economic conditions in Latin American countries are responding to higher prices for commodities, more-competitive currencies, and improved investor confidence. The Blue Chipconsensus expects real GDP in Mexico and Brazil to grow by more than 3 percent annually in 2004 and 2005 after little or no growth in 2003. Although economic growth in China is not expected to accelerate in 2004, any slowdown there is still likely to leave output expanding at a robust rate. Meanwhile, other developing countries in Asia will continue to benefit from growth in China, Japan, and the United States. For the two-year forecast period, the Blue Chip consensus anticipates stronger growth than in 2003 in South Korea, Taiwan, Singapore, and Hong Kong.

The Dollar's Exchange Rate. CBO expects the value of the dollar generally to move downward during the rest of 2004 and in 2005--because the United States' trade deficits remain large and because a growing level of net foreign indebtedness is likely to make overseas investors less willing to increase their U.S. holdings. The dollar had already lost about 13 percent of its value against a broad basket of currencies between its peak in early 2002 and January 2004 (see Figure 2-6). For the most part, the dollar dropped relative to the currencies of industrialized countries; it remained steady against the currencies of many developing countries because those nations intervened decisively in the currency markets to stabilize their exchange rates relative to the dollar. The U.S. currency regained some of its lost value, rebounding by about 5 percent through May of this year, but it fell in June and July. In CBO's estimation, that overall downward trend is likely to continue.

Figure 2-6.

Sources: Congressional Budget Office; Federal Reserve Board.

Note: The real trade-weighted value of the U.S. dollar is a weighted average of the foreign exchange values of the dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares.

Imports, Exports, and the Trade Balance. The U.S. trade deficit has widened since the end of the recession in 2001, partly because the United States' economy has recovered more rapidly than the economies of most of its trading partners and partly because of delayed effects from the rise in the dollar's value during 2000 and 2001. Between the fourth quarter of 2001 and the second quarter of 2004, real imports grew at an average annual rate of 7.8 percent, whereas real exports grew more slowly, at an average annual rate of 5.8 percent. Consequently, net imports rose from $352 billion (calculated as an annual rate) at the end of 2001 to $561 billion in early 2004.

In CBO's forecast, the trade balance gradually improves during the second half of 2004 and in 2005. Real imports and exports will both rise, in CBO's estimation, borne upward by strong growth in both the United States and the rest of the world. A lower dollar will aid the trade balance by further adding to growth in exports and by curbing growth in imports. Yet although the downward movement expected in the dollar is likely eventually to contribute to a substantial improvement in the trade balance, the improvement during the second half of 2004 and in 2005 will be modest, CBO forecasts.

The Government Sector. Under current law, the rate of growth of real federal purchases of goods and services will exceed that of GDP in 2004 and 2005, in CBO's estimation. From 2001 to 2003, real federal consumption and investment grew at an average annual rate of 6.8 percent. That growth will slow to less than 5 percent in 2004, CBO forecasts, but then accelerate slightly in 2005 as a result of higher defense spending. CBO's estimate reflects appropriations already enacted for the Department of Defense and for certain other programs funded in the defense appropriation act.

The growth of real consumption and investment by state and local governments is forecast to accelerate during 2004 and 2005 from its unusually slow rate in 2003. Nevertheless, it will lag behind the rate of growth of overall GDP, in CBO's estimation. Continuous budgetary pressures since the 2001 recession have forced state and local governments to slow the rise in real consumption and investment to an average annual rate of just 0.6 percent during 2003 and the first half of 2004. Those budgets have improved in response to that restraint and because of increased revenues, but their continued weakness will constrain state and local government spending in the near future. CBO thus anticipates slow growth in real state and local purchases during the second half of 2004 and in 2005.

Inflation

The rate of growth of the consumer price index (CPI) accelerated noticeably during the first half of 2004, partly because of a sharp hike in energy prices. The rising global demand for oil, notably by China, and fears that supplies from the Middle East, Russia, and Venezuela would be disrupted caused the price of crude oil to jump by more than $5 per barrel (or almost 20 percent) during the first half of 2004 (see Figure 2-7). The price of gasoline climbed both because of that boost in crude oil prices and because refining and distribution costs per gallon increased. (Although the price of crude oil hit record levels in early August, it remains well below the level of the early 1980s after adjusting for inflation.) In response to rising demand, the price of natural gas in the United States is estimated to have jumped by almost $1 per thousand cubic feet (or about 20 percent) during the first half of 2004 after declining for most of 2003. Thus, the CPI for energy rose at an annual rate of 26 percent during the first half of 2004 after increasing during 2003 at the above-average rate of 7 percent (measured fourth quarter over fourth quarter).

Figure 2-7.

Sources: Congressional Budget Office; Department of Energy, Energy Information Administration.

Notes: Crude oil prices are the refiners' acquisition prices in dollars per barrel. The natural gas price is the wellhead price in dollars per thousand cubic feet.

The price of natural gas for the second quarter of 2004 is a forecast taken from Energy Information Administration, Short-Term Energy Outlook(August 2004), Table 4. Real prices, which are expressed in 2003 dollars, were computed using the research series of the consumer price index.

Core inflation (excluding food and energy) also accelerated during the first half of 2004 but less quickly than overall inflation. Core consumer prices rose at an annual rate of 2.4 percent during the first half of 2004 after climbing by 1.2 percent in 2003 (measured fourth quarter over fourth quarter). Much of the acceleration in core inflation stemmed from increased growth in the index for shelter, which accounts for about 40 percent of the core CPI-U (the consumer price index for all urban consumers excluding food and energy) and includes apartment rents, imputed rents for owner-occupied homes, and the cost of lodging away from home. The index for shelter grew unusually slowly during 2003 and then rebounded early in 2004--for reasons that are not well understood (see Figure 2-8). CBO assumes that much of the recent acceleration in those prices does not reflect an increase in the underlying trend but is instead temporary and the result, perhaps, of measurement problems. Therefore, some of the rapid growth in core inflation should be considered temporary as well.

Figure 2-8.

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

CBO's forecast assumes that during the second half of 2004 and in 2005, prices will grow more slowly than they did in the first half of this year, as both energy prices and shelter price inflation fall. (When the forecast was completed in July, CBO expected that oil would cost significantly less in mid-2005 than it did in mid-2004.)⁽⁶⁾ CBO projects that the CPI-U will grow by 3.0 percent (measured fourth quarter over fourth quarter) during the whole of 2004, a pace well below the annual rate of 4.0 percent reported for the first half of the year. In 2005, the consumer price index will rise by just 1.8 percent, CBO forecasts.

Moderate growth in unit labor costs (the costs required to produce a unit of output) will help hold inflation in check, in CBO's estimation. Such costs have fallen slightly over the past three years--the longest period with no increase since the early 1960s--which helped keep inflation low during that time. The quiescence of unit labor costs in recent years stems from moderate growth of labor compensation coupled with unusually rapid growth of productivity. Although the cost of benefits--notably, employers' contributions to defined-benefit pension plans and group health insurance--has grown rapidly since the 2001 recession (as measured by the employment cost index for civilian workers), wage growth has slowed, preventing the rate of growth of overall labor compensation from accelerating (see Figure 2-9). Unit labor costs are unlikely to continue shrinking; nevertheless, CBO estimates that productivity will increase at a fast enough pace to keep what it expects will be moderate growth in compensation from boosting inflation.

Figure 2-9.

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

Note: Compensation includes wages and salaries and benefit costs.

Inflation could, of course, turn out to be much different than CBO has foreseen, with energy prices posing the main risk of a substantially different outcome. A terrorist attack or other major disruption to the supply of oil could push energy prices sharply higher and, in turn, boost inflation (as measured by the CPI-U). Alternatively, energy prices could fall more rapidly than expected if the Chinese economy slowed at the same time that members of OPEC (the Organization of Petroleum Exporting Countries) and other oil exporters were boosting supply. Another factor with an uncertain outcome is the very accommodative monetary policy of recent years--some analysts worry that it might push up inflation. A further uncertainty in the inflation outlook is the recent acceleration in the shelter index. If much of that rise is not temporary, as CBO assumed, overall inflation might grow more rapidly than expected. For example, prices that continued to increase at the high rates of early 2004 would almost certainly lead to core CPI-U inflation that was greater than CBO anticipated.

Monetary Policy

Now that the economy is expanding at a solid pace and labor market conditions are showing gradual improvement, CBO expects that the Federal Reserve will move away from the considerably accommodative monetary policy it has pursued over the past year and increase the federal funds rate, its main policy instrument. (The federal funds rate is the interest rate that financial institutions charge each other for overnight loans of their monetary reserves.) At the end of June, the Federal Reserve raised the funds rate--from 1 percent to 1.25 percent--for the first time since May 2000; it raised the rate further, to 1.5 percent, in early August. Additional increases are expected that will return monetary policy to a relatively neutral stance--that is, evenly balanced between supporting the pace of expansion and maintaining low inflation, according to the central bank. In statements accompanying its policy announcements, the Federal Reserve has indicated that the pace of increases in the federal funds rate is expected to be "measured" but that it could quicken "as needed" to maintain low inflation. The consensus among participants in the financial markets when CBO's forecast was completed was that the federal funds rate would climb to 2.25 percent by early 2005 and then move toward 3 percent and above after mid-2005.

CBO's outlook for the rate on three-month Treasury bills is consistent with the markets' consensus view of monetary policy and the federal funds rate: CBO's forecast rises over the next two years as the forecast for the federal funds rate rises. In CBO's estimation, the three-month rate will increase from an average of 1.0 percent in 2003 to 1.3 percent in 2004 and 2.6 percent in 2005 (see Figure 2-10).

Figure 2-10.

Sources: Congressional Budget Office; Federal Reserve Board.

Note: All data are annual values.

Long-term rates have already risen in anticipation of the Federal Reserve's policy tightening and are thus expected to increase by less than short-term rates will. As prospects for economic growth improved over the past year, the yield on 10-year Treasury notes rose from an average of 3.6 percent during the second quarter of 2003 to an average of 4.6 percent during the second quarter of 2004. CBO estimates that the yield on 10-year Treasury notes will average 4.6 percent during 2004 and 5.4 percent during 2005.

A Comparison of Two-Year Forecasts

CBO's assessment of the economy's near-term outlook is moderately more optimistic than those of the Administration and the Blue Chip consensus (see Table 2-3). CBO expects that the rate of growth of real GDP in 2004 will be 0.2 percentage points slower than the pace that the Administration anticipates; however, it expects somewhat stronger growth in 2005 than the Administration does. At the same time, CBO's forecast for slightly faster growth of the GDP price index in 2004 and slightly slower growth in 2005 means that it expects nominal GDP in both years to rise somewhat more quickly than the Administration does. CBO's two-year forecast for the unemployment rate and the rate on three-month Treasury bills is almost the same as the Administration's, but CBO anticipates somewhat higher yields on 10-year Treasury notes for 2005. A further point of difference is that CBO's outlook foresees slightly slower consumer price inflation in 2005 relative to the Administration's.

Table 2-3.

Compared with the Blue Chip consensus forecast, CBO's two-year outlook is somewhat more optimistic, with more rapid growth in 2004 and 2005 of both real and nominal GDP. Blue Chip's and CBO's inflation forecasts are similar for 2004, but for 2005, CBO foresees lower rates of increase than Blue Chip does for both the CPI-U and the GDP price index. CBO and the consensus anticipate similar outcomes for the unemployment rate and for long-term interest rates in 2004 and 2005 and for short-term rates in 2004. However, CBO's forecast for short-term rates in 2005 is lower than that of the consensus.

In its midyear report to the Congress, the Federal Reserve presented its economic outlook in the form of ranges known as central tendencies, which are based on forecasts by the members of its board of governors and the presidents of the Federal Reserve banks.⁽⁷⁾ CBO's outlook for the growth of real GDP (measured fourth quarter over fourth quarter) is slightly below the Federal Reserve's central tendency for 2004 but falls within the tendency for 2005. Similarly, CBO expects the unemployment rate at the end of 2004 to be slightly higher than the Federal Reserve's central tendency but to be within it at the end of 2005. However, CBO's forecast for growth of the price index for personal consumption expenditures, excluding food and energy, falls within the central tendency for both 2004 and 2005.
 

The Outlook Beyond 2005

Over the medium term--from 2006 to 2014--real GDP will grow at an average annual rate of 2.8 percent, CBO expects, the same rate as that of potential real GDP during the same period. Inflation, as measured by the CPI-U, will average 2.2 percent during the period, in CBO's estimation, and the rate of unemployment, 5.2 percent. Over the medium term, the rate on three-month Treasury bills will rise to an average of 4.5 percent, and the rate on 10-year Treasury notes will average 5.5 percent.

To develop its medium-term projections, CBO extends historical patterns in the factors that underlie its estimate of the growth of potential GDP, such as the expansion of the labor force, productivity, and the rate of national saving. In doing so, CBO takes into account the possibility of business-cycle fluctuations by basing projected trends on historical averages and growth rates that include periods of expansion and recession. CBO's medium-term projections also reflect the effects on potential output of changes in fiscal policy.

Potential Output

Potential output during the 2004-2014 period will grow at an average annual rate of 2.8 percent, CBO projects--about the same pace as it anticipated in January 2004 (see Table 2-4). That estimate results from roughly offsetting changes in several variables that underlie the projection for potential output, including the potential labor force, the capital stock, and total factor productivity (TFP).⁽⁸⁾

Over the 2004-2014 period, the average annual growth of the potential labor force is projected to be 0.9 percent--about a tenth of a percentage point faster than CBO estimated last January.⁽⁹⁾ To reflect information from the 2000 census, CBO updated its estimates of the U.S. population and used revised historical data on the labor force and employment. Those data suggest a faster trend in labor force growth than CBO assumed in preparing its January estimates.

The growth of capital services--the flow of productive services from existing capital--will average 3.7 percent annually during the period, CBO estimates, or about 0.3 percentage points off the pace projected in January. Two factors explain that slower growth. First, the rate of investment spending by businesses is lower in the current projection, relative to the existing capital stock, than it was in CBO's earlier projection. Second, compared with the January estimate, the mix of investment assumed for the current projection is less heavily weighted toward shorter-lived assets (which provide relatively high levels of capital services per dollar of investment).

Potential total factor productivity in CBO's medium-term projection grows at an average annual rate of 1.4 percent, or nearly 0.1 percentage point faster than in last winter's outlook. That revision results from CBO's re-evaluation of the trend in TFP growth in light of newly revised data from the NIPAs on output and capital stocks and a reassessment of the current amount of slack in the economy. Although CBO's current estimate of trend growth in TFP is higher than its January estimate, there is still a wide gap between actual TFP and its estimated trend at the end of 2003. To partially close that gap, CBO temporarily boosted its estimate of the growth of historical potential TFP--specifically, by an average annual rate of 0.6 percentage points during the 2001-2003 period (see Figure 2-11). That change raised the level of potential TFP at the end of 2003 and in all subsequent years by 1.8 percent.

Figure 2-11.

Source: Congressional Budget Office.

Note: Total factor productivity is the average real output per unit of combined labor and capital inputs.

Unemployment

CBO projects that the unemployment rate will reflect the gap between GDP and potential GDP over the medium term. Thus, with GDP expected to equal potential GDP, on average, the unemployment rate will average 5.2 percent for the entire 2006-2014 period, in CBO's estimation.

Inflation

Over the 2006-2014 period, average annual inflation is expected to match CBO's estimate of core inflation at the end of 2005. Prices will grow, CBO projects, at an average annual rate of about 2.2 percent as measured by the CPI-U and 1.7 percent as measured by the GDP price index. That outlook reflects CBO's view that the Federal Reserve will be able to maintain the rate of CPI-U inflation at between 2.0 percent and 2.5 percent, on average.

The difference that frequently exists between the growth of the CPI-U and that of the GDP price measure affects projections of some portions of the federal budget. Many spending programs and most income tax brackets are indexed to the CPI-U or the CPI-W (the index of consumer prices for urban wage earners and clerical workers). In contrast, the growth of taxable income is more closely related to growth in the GDP price index. Thus, the more that growth in the CPI-U can be expected to exceed growth in the GDP price index, the worse the budget outlook will be. CBO estimates that the wedge between the projected rates of growth of the CPI-U and the GDP price index will average somewhat less than 0.5 percentage points from 2006 to 2014--roughly equaling the average wedge between the two rates during the 1985-2003 period.⁽¹⁰⁾

Interest Rates

CBO's projections of interest rates in the medium term, during which the economy is assumed to grow at trend rates, reflect its estimates of CPI-U inflation and real interest rates, which are based on analyses of historical rate averages and trends in the real return to capital. In CBO's estimation, real rates on three-month Treasury bills and 10-year Treasury notes during the 2006-2014 period will average 2.4 percent and 3.3 percent, respectively. The (nominal) rate on three-month bills will average 4.5 percent, CBO expects, and the rate on 10-year notes will average 5.5 percent.
 

Taxable Income

CBO's baseline projections of revenues are closely connected to its projections of national income. Because different categories of income are taxed at different rates, and some are not taxed at all, the projected distribution of income among its various components is a central factor in CBO's budget projections. For example, the average effective tax rate on wages and salaries is currently about 30 percent; the average effective rate on personal monetary interest income is under 10 percent. Shifts of income from interest to wages and salaries thus increase revenues.

CBO expects that the sharp drop over the past three years in the share of total income going to employees will be partially reversed over the next 10 years. However, CBO also believes that much of the projected rise in that income share will be attributable to an increase in benefits rather than to higher wages and salaries. (Those increased benefits will stem primarily from the continued rapid growth of employers' contributions to health insurance premiums and defined-benefit pension plans.) Consequently, the share of GDP accounted for by wages and salaries will remain near historically low levels, dropping from 46.4 percent in 2003 to 45.7 percent in 2004, before rising to 45.8 percent in 2005 and an average of 46.1 percent during the 2006-2014 period (see Figure 2-12). Those figures are all well below the average annual share of 47.3 percent of the past 20 years because the share of GDP claimed by benefits will be larger in the future than it was in the past.

Figure 2-12.

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

Although the NIPAs include various measures of corporate profits, CBO focuses on two of them in preparing its forecast. Book (before-tax) profits is the measure most closely related to the profits on which corporations pay tax and is thus affected by changes in the tax code. The law allows corporations to value inventories and depreciate assets at certain rates, and the book measure of profits is designed to reflect those statutory provisions. By contrast, the economic profits measure is not affected by the tax treatment of inventories and depreciation. Rather, it is designed to reflect the valuation of inventories and the rates of depreciation that more truly represent the worth of goods that businesses have on hand and the current economic usefulness of the capital stock. Except during periods of high inflation, economic profits have generally been larger than book profits.

Book profits and economic profits will differ sharply over the next decade because of statutory provisions that affect how companies can depreciate their assets for tax purposes. The partial-expensing provisions of JCWAA and JGTRRA that expire at the end of 2004 allow firms to depreciate some of their capital stock much more rapidly than the rate at which the economic usefulness of that capital is assumed to deteriorate. Those provisions will lower book profits by about $180 billion in 2004, CBO estimates, because companies can take extra depreciation this year. Conversely, from 2005 on, the provisions are expected to increase book profits by about $100 billion in 2005 and by declining amounts in subsequent years--because the extra depreciation taken from 2002 to 2004 means that less depreciation will be taken in later years.

The robust expansion of GDP, coupled with minimal growth in net interest payments (because of the low amount of corporate borrowing) will push economic profits up from a 9.3 percent share of GDP in 2003 to a 10.8 percent share in 2005, CBO forecasts. After 2005, both higher interest rates and the expanding portion of total GDP claimed by labor compensation will shrink economic profits as a share of GDP. CBO expects that share to average 9.5 percent from 2006 to 2014--which is still well above the average annual rate of 8.4 percent for the 20-year period from 1984 to 2003. The average will remain high in part because lower interest rates are likely to hold businesses' interest expenses to a smaller share of GDP than they claimed during that past period.
 

Changes in the Economic Outlook Since January 2004

The changes that CBO has made in its two-year forecast since January 2004 are relatively small (see Table 2-5). It revised downward the expected growth of real GDP for 2004 by 0.3 percentage points; in addition, growth in 2003 was 0.2 percentage points weaker than it had expected. CBO also reduced its forecast for the unemployment rate, by 0.2 percentage points for 2004 and 0.1 percentage point for 2005, after the rate fell more rapidly than expected in early 2004. The forecast for the interest rate on three-month Treasury bills for 2004 is the same as it was in January; for 2005, it is lower. CBO's estimate of the yield on 10-year Treasury notes for the next two years is unchanged.

Table 2-5.

The most noticeable revision to CBO's current forecast relative to January's is higher expected inflation. Prices for both energy and nonenergy goods and services rose more rapidly during the first half of 2004 than CBO had anticipated. As a result, its forecasts for consumer price inflation during 2004 and 2005 have been boosted by 1.0 and 0.3 percentage points, respectively. Since January 2004, CBO has revised its forecast for growth in the GDP price index by similar upward amounts.

Changes since January in the outlook beyond 2005 are small. Today, CBO expects a slightly faster pace of labor force growth over the medium term than it foresaw in January; accordingly, 0.1 percentage point has been added to its projection of the average annual rate of growth of real GDP. The current outlook for consumer price inflation is about the same as January's, but CBO now projects somewhat slower growth in the GDP price index and thus a slightly larger wedge between its growth rate and that of the CPI-U. Nevertheless, throughout the 2006-2014 interval, the levels of both indexes are projected to remain above the levels that CBO expected last January because they are now forecast to be much higher in 2005.

Compared with its estimates in January, CBO has raised its expectations about wages and salaries and profits, primarily because it now anticipates faster growth in nominal GDP than it did in January. Relative to GDP, wages and salaries grew surprisingly slowly during the first half of 2004, and CBO now projects that they will make up a smaller-than-expected share of output over the 2004-2014 period. In nominal terms, however, the level of wages and salaries will be higher, an estimate based on CBO's expectation of a higher level of nominal GDP, which stems partly from higher projected price inflation and partly from higher estimated growth of real GDP. In the case of profits, several factors led CBO to raise its forecast of their level for 2004 and 2005, including higher projected nominal GDP, a smaller-than-expected GDP share of wages and salaries in early 2004, higher-than-expected economic profits during late 2003 and early 2004, and lower short-term interest rates projected for 2005.