The U.S. Economy is on a Solid Path

Richard Clarida, Assistant Secretary of the Treasury
Before the Treasury Borrowing Advisory Committee of the Bond Market Association

As prepared for delivery.
In the text "billion" means 1,000 million.

In the three months since we last met, the U.S. economy has, by all indications, experienced continued solid growth. While in the second quarter the pace of activity seems to have tapered off from the unsustainably rapid rate of growth in the first, the real economy appears poised to continue a healthy expansion as we enter the third quarter.

At the same time, equity markets (both here and abroad) have been highly volatile. The drop in valuations has caused us in Treasury to put our "real time" economic tools to work, making phone call to expert industry contacts, and updating on a daily basis our tracking model of gross domestic product, final sales, and investment. Our view, shared by most private forecasters, is that the economy is on a solid growth path and the recovery is proceeding as expected.

The first half of the year is now history, and our focus is currently directed toward the future. A number of indicators suggest a solid start to the third quarter. Average weekly earnings rose 0.6% in real terms in June and were up 2.8% over the past 12 months. Both auto and non-auto retail sales closed the second quarter on a high note. Evidence for July suggests that consumers responded enthusiastically to the revival of the auto industry's zero-percent financing programs. In June, new home sales broached the one-million mark for the first time in history, and industrial output rose 0.85, a sixth straight increase and the largest gain since October 1999. Inventory-sales ratios remain historically low, pointing to future increases in industrial output.

The news on labor markets is also becoming more encouraging. Payroll employment rose for a second straight month in June and we are heartened by a drop in initial claims for unemployment insurance in mid July to the lowest level since before the recession.

In addition, productivity and inflation data are extremely positive. Productivity has surged by 4.2% over the past year, helping to reduce unit costs, boost wages, and restore growth in corporate profits. I note in particular that, as of last week, more than 85% of Standard and Poor's 500 companies reporting earnings met or beat expectations in the second quarter. These indicators all suggest to me an economy on solid ground.

Finally, the unparalleled flexibility and resilience of U.S. capital markets was and is one of the important sources of the economy's durability. After September 11, the Federal Reserve continued to cut short-term interest rates. Then, long-term bond yields fell, reflecting a flight to quality in response to increased uncertainty and financial volatility. Mortgage rates came down, triggering a wave of refinancings that put billions of dollars into the hands of households. In this low interest rate environment, auto companies were able to offer 0% financing which boosted sales to near record levels.

It is important to note that a similar development is taking place today. In fact, in recent weeks as stock prices have adjusted downward in the face concerns about corporate accounting and earnings reports, the government bond market has rallied sharply. Domestic and foreign funds previously held in equities appear to be flowing into U.S. government bonds, pushing long-term rates lower. Last week, conventional 30-year mortgage rates reached a 30-year low of 6.3%. Applications for home equity loans shot upward, providing additional support for consumption going forward.

All in all, it appears that the economy is well positioned to meet the Administration's current forecast of 2.6% real growth this year. That forecast, released two weeks ago as part of the Mid-Session Budget Review, was much higher than expected in the February Budget but still below private-sector forecasts. With the latest Budget Review, however, we found ourselves in the unusual position of both announcing much stronger real growth expectations and a deeper deficit. The estimate for the Federal deficit for FY-2002 was raised from $106 billion to $165 billion, which represents a deficit of 1.6% GDP. As we discuss in our Mid Session Review released July 15th:

• The reason for the wider deficit is that last year's recession and stock market weakness took a much heavier toll on Federal revenues than previously thought. Non-withheld incomes and capital gains realizations were reduced substantially.

• The considerable change in circumstances from surpluses previously estimated to deficit is largely the result of the recession. We estimate that it accounts for two-thirds of the shift. Another 19% reduction was attributable to the vital needs of homeland security and the war effort. Finally, the tax cuts enacted last year account for only 14% of the budget deterioration.

• Even without the tax cut, the budget would still have been in deficit.

• The combination of sustained economic growth and strong fiscal discipline can restore the budget to balance by 2005. If we make the tough choices to slow spending in later years, we project a return to growing unified surpluses thereafter.

The broad array of economic indicators that I regularly examine suggests to me that the economy is on a path to sustained growth. The fundamentals (high productivity, low inflation, low inventories) set the stage for a future of extended expansion. I am convinced that when investors are able to return their attention to the economic fundamentals, those fundamentals will be judged positively.

Washington, D.C.
July 30, 2002