The Economic Outlook

An unusual amount of turbulence has continued to beset the U.S. economy since the Congressional Budget Office prepared its previous forecast, which was released in February. As a result, the near-term outlook appears considerably less promising than it did then.¹ Since early 2008, the prices of houses and the rate of home construction have continued to fall, and delinquencies and foreclosures on mortgage loans have surged, threatening continued instability in financial markets. At the same time, prices for energy and agricultural commodities have been unexpectedly high. As a result, spending by consumers and businesses after accounting for inflation is likely to be weaker than CBO had expected earlier this year, in spite of strength in net exports and the short-term boost to the economy provided by increased federal spending and tax rebates.

According to CBO’s updated forecast for the rest of 2008 and for 2009, the economy is about halfway through an extended period of very slow growth. The rise in gross domestic product is estimated to average about 1 percent (measured at an annual rate and adjusted for inflation) from the last quarter of 2007 through the middle of 2009, before picking up during the second half of 2009. The growth of employment will probably remain weak through the middle of next year, keeping the unemployment rate above 6 percent in the near term.

Whether or not that period of slow growth will ultimately be designated a recession is still uncertain. However, the increase in the unemployment rate and the pace of economic growth are similar to conditions during previous mild recessions.²

Specifically, CBO forecasts that GDP will grow by about 1.5 percent in real terms (after an adjustment for inflation) in 2008 and 1.1 percent in 2009 (see Table 2-1).³ Inflation, as measured by the year-to-year change in the consumer price index for all urban consumers (CPI-U), is projected to average 4.7 percent this year but moderate to an average of 3.1 percent in 2009 in the wake of lower commodity prices. As the economy recovers, interest rates on Treasury securities are estimated to rise next year from their current low levels. In CBO’s forecast, interest rates on 3-month Treasury bills average 1.9 percent in 2008 and 2.7 percent in 2009, and rates on 10-year Treasury notes average 3.9 percent in 2008 and 4.4 percent in 2009.

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

Beyond the forecast’s two-year horizon, from 2010 to 2018, CBO projects real growth averaging 2.8 percent and CPI-U inflation averaging 2.2 percent. With very weak growth in real GDP likely for 2008 and the first half of 2009, real GDP will end 2009 considerably below the level at which the economy is fully using its resources—that is, below its estimated potential level. Consequently, CBO assumes that after 2009, real GDP will grow slightly faster than its potential rate, on average, thus closing that gap. Currently, CBO projects that potential GDP will grow by about 2.4 percent during the 2010–2018 period and that the unemployment rate will average 5.0 percent. Interest rates on 3-month Treasury bills will average 4.6 percent, CBO estimates, and rates on 10-year Treasury notes will average 5.4 percent.

Economic forecasts are always subject to a great deal of uncertainty, and CBO’s current outlook is no exception. On the one hand, the unprecedented decline in activity in the housing market, the problems in the financial sector, and the high level of energy prices might mean that the current downturn will be deeper and more protracted than CBO expects and that inflation will be more severe. In addition to those risks, lingering weakness in the housing market could contribute to significantly more losses on mortgages and force lenders to markedly curtail the availability of credit, thereby delaying the economy’s recovery. On the other hand, the economy might rebound sooner than CBO is forecasting if house prices stabilize and oil prices, which have already declined over the past month, are significantly lower than CBO anticipates.

The economy remains fragile. A steep and continuing decline in the prices of houses has contributed to slower growth in consumer spending and a sharp falloff in residential construction. Rising delinquencies and foreclosures on mortgage loans have created large losses for some financial institutions and other holders of mortgage-backed securities, reducing their capital and hence their ability to support new lending. There has also been a general pullback from risky lending in the nation’s mortgage and credit markets; banks have markedly tightened their standards for loans to reduce their exposure to the risk of further losses. In addition, high prices for petroleum and food have slowed economic activity by reducing the growth of real income.

The weakened condition of the nation’s housing markets continues to be a source of concern because of its effects on the stability of the financial system and the economic outlook. The amount of residential construction and the prices of houses continue to drop in response to an excessive inventory of unsold homes. The decline in house prices has shrunk household wealth and, in turn, cut the growth of consumer spending. The number of mortgage delinquencies and foreclosures has surged, as the fall in house prices and the tightening of lending standards diminish the ability of borrowers to sell or refinance their homes.

House Prices and Residential Construction. Housing prices have fallen this year (see Figure 2-1). One measure of such prices, the Standard & Poor’s (S&P)/Case-Shiller national price index for single-family homes, declined over the year ending in the second quarter of 2008 by more than 15 percent. Similarly, a narrower S&P/Case-Shiller index that includes the prices of houses in just 10 cities and is reported monthly declined by 17 percent for the year ending in June. Another widely used index, the purchase-only price index compiled by the Office of Federal Housing Enterprise Oversight (OFHEO), fell by 4.8 percent for the year ending in June.⁴

Sources: Congressional Budget Office; Office of Federal Housing Enterprise Oversight; Standard & Poor’s, Fiserv, and MacroMarkets LLC.

Notes: The index shown for the Office of Federal Housing Enterprise Oversight is its purchase-only house price index.

The pace of home construction—the number of housing starts—has plummeted since early 2006 as housing prices have dropped, mortgage lending has tightened, and vacant units have glutted the market (see Figure 2-2). The construction of housing units peaked in the first quarter of 2006 at more than 2 million (at an annual rate). By the second quarter of 2008, however, construction had fallen to about 1 million units, close to levels observed in past recessions. That decline in residential construction directly subtracted an average of 1 percentage point (measured at an annual rate) from the rate of growth of real GDP each quarter from early 2006 through the middle of this year.

Sources: Congressional Budget Office; Department of Commerce, Bureau of the Census.

It is uncertain when the prices of houses and the pace of new housing starts will reverse their current declines. CBO assumed for its forecast that by the middle of 2009, house prices nationwide (calculated on the basis of the OFHEO purchase-only index) would fall by almost 10 percent from their levels in the second quarter of this year, resulting in a decline of approximately 15 percent from the peak of the index in the second quarter of 2007.⁵ Such a fall in housing prices, the slow growth of household income because of the languishing economy, and an unusually large excess inventory of vacant units are all likely to delay any recovery in housing construction until at least the middle of 2009.

Mortgage Markets. Delinquency rates have increased for both prime and subprime borrowers, particularly those with adjustable-rate mortgages (ARMs).⁶ The delinquency rate among subprime borrowers was 18.8 percent in the first quarter of this year, up from 17.3 percent in the fourth quarter of last year. The delinquency rate among borrowers with subprime ARMs was an even higher 22.1 percent in the first quarter, up from 20 percent in the fourth quarter. Delinquencies on prime loans rose by about 0.5 percentage points, to 3.7 percent in the first quarter, and delinquencies on prime ARMs climbed by about 1¼ percentage points, to 6.8 percent. Foreclosure rates have also continued upward this year: For example, 17.1 percent of subprime ARMs were in foreclosure in the first quarter, up from 13.4 percent in the fourth quarter of 2007.

The rates of delinquency and foreclosure are likely to increase in the near term as the economy remains fragile and the prices of houses continue to fall. However, various federal programs and other initiatives may blunt the pace of foreclosures (see Box 2-1).

Interest rates on mortgage loans have moved up this year and continue to signal a heightened aversion to risk on the part of lenders in the mortgage markets. For example, the interest rate on conforming fixed-rate 30-year mortgages—loans that can be purchased by Fannie Mae and Freddie Mac on the secondary mortgage market—has risen this year, and the rate in July was greater than the average for all of last year (see Figure 2-3). The interest rate on jumbo mortgages (mortgages that are larger than conforming loans) has increased even more—the "spread" (or difference) between the conforming rate and the rate for jumbo mortgages has widened since June 2007.⁷

Notes: Conforming mortgage loans are those that can be purchased by Fannie Mae and Freddie Mac on the secondary loan market. Jumbo mortgage loans are all loans that are larger than conforming loans. (See also footnote 7.)

Stricter standards for mortgage lending have dramatically reduced the availability of loans from private lenders, particularly for risky borrowers. Originations of subprime mortgages have come nearly to a standstill, mirroring the virtual disappearance of the securitization of those loans.⁸ Indeed, the volume of securitized mortgage lending for Alt-A, subprime, and jumbo loans has continued to decline, reaching extremely low levels during the first few months of 2008.⁹

Financial markets remain under stress. Although the federal government has taken a variety of steps to shore them up, the risk of significantly greater losses on loans remains. Concerns about such losses may curb lending to even creditworthy borrowers and delay the economy’s recovery as a result.

Banks. Losses on loans and a pullback from risk continue to challenge the banking sector. Banks have written down large amounts of past and anticipated losses in the value of their assets (primarily from subprime loans and other credit that was extended to high-risk borrowers) and have suffered drops in the value of their stock. A key indicator of banks’ wariness about current conditions is the spread between the three-month London interbank offered rate (or Libor)—the interest rate that major banks offer to other banks for such short-term loans—and the expected federal funds rate (see Figure 2-4). That spread (which is often thought to be an indicator of credit and liquidity risk) has remained large in part because banks that have funds to lend fear further deterioration in the balance sheets of banks that need to borrow. Those worries have constrained interbank lending despite efforts by the Federal Reserve and foreign central banks to provide liquidity to the interbank market.

Notes: A spread is the difference between two interest rates. The three-month Libor (London interbank offered rate) is the interest rate major banks offer to other banks for those short-term loans. The expected federal funds rate is the three-month overnight index swap rate.

To reduce their risk of losses, many banks have significantly tightened their standards for lending. The Federal Reserve’s July 2008 opinion survey of senior loan officers at banks around the country reports that most banks are tightening standards not only for residential mortgages and consumer loans but also for business loans, such as those for commercial real estate and commercial and industrial (C&I) loans (see Figure 2-5). Those tighter standards are accompanied by larger spreads between, for example, interest rates on C&I loans and benchmark short-term rates—such as the target federal funds rate that the Federal Reserve sets. (That spread increased from 1.9 percentage points in the third quarter of 2007 to 2.5 percentage points in the second quarter of 2008.)

Notes: The figure shows the net percentage of bank respondents reporting tightening lending standards in the Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices. The commercial and industrial loans measured are for loans to large and medium-sized firms.

Data are collected in January, April, July, and October. The final data point represents the July 2008 survey.

At the same time, however, the large reduction in the federal funds rate over that same interval and the slowdown in the demand for loans have meant lower interest costs for firms that can still borrow from banks. The average interest rate on C&I loans from commercial banks fell from 6.9 percent in the fourth quarter of last year to 4.5 percent in the second quarter of this year.

Tighter lending standards and the slowing economy have contributed to a noticeable decline in the growth of bank credit. However, with the exception of mortgages, lending from banks has not yet been severely curtailed. Moreover, lending through revolving home-equity loans, whose rates are linked to short-term interest rates, has grown rapidly this year—despite tightening loan standards and reports that existing lines of credit have been frozen for some homeowners.

So far, despite banks’ loan losses, only a handful of commercial banks and thrift institutions have failed, although one of the closures was very large and many institutions are on the Federal Deposit Insurance Corporation’s watch list. Between the beginning of this year and August, bank regulators closed down 10 banks. The closure of IndyMac—a California-based thrift and mortgage bank with roughly $32 billion in assets and large holdings of Alt-A mortgage loans—was one of the largest bank closures in U.S. history.

Even though the balance sheets of the vast majority of commercial banks, thrift institutions, and credit unions have so far remained relatively healthy, conditions could deteriorate severely or rapidly enough to cause a larger wave of failures.¹⁰ Delinquency rates continue to rise in most sectors of lending. Whether banks and other lending institutions can sustain their current operations thus depends on the magnitude and duration of the economic slowdown. A continued lack of vigor in the economy would lead to more loan delinquencies, which would weaken banks’ balance sheets and cause them to further curtail their lending to consumers and businesses.

Credit Markets. The pullback from risk has also affected the amount and cost of borrowing for corporations, mainly for firms that have a greater chance of default.

The number of new issuances of risky (speculative-grade) corporate bonds has fallen by about half in the first six months of this year as compared with the same period last year, whereas the number of issuances of lower-risk (investment-grade) bonds is about the same. The volume of buying and selling in the secondary market for securitized instruments has dwindled in response to greater aversion to risk in the financial markets. Less liquidity in the secondary market has tamped down demand among investors for new securitizations derived from financial institutions. The number of issuances of new asset-backed securities has fallen this year, particularly for securities backed by home-equity loans and lines of credit.

The Federal Reserve’s monetary policy (discussed later) has pushed down interest rates on short-term borrowing this year. The rate on three-month Treasury bills fell from an average of 3.0 percent in December to 1.7 percent in August. Interest rates on commercial paper (a kind of loan that plays a key role in providing short-term credit to both financial and nonfinancial businesses) have also moved down. However, rates on lower-rated paper have not fallen as much as have rates on the highest-rated paper (because lower-rated paper has a greater risk of default and markets are already charging a higher amount to bear that risk).

Interest rates on long-term borrowing, by contrast, have not all fallen with short-term rates. Early this year, the rate on 10-year Treasury notes had dropped, but by June it had returned to its average of last December before falling again, through mid-August. The rate on Aaa-rated corporate bonds (investment-grade bonds with the highest credit rating) has changed very little this year, on net—at 5.6 percent in mid-August, it equals its average in both 2006 and 2007. Interest rates on lower-rated bonds, however, have moved noticeably higher. The rate on Baa-rated corporate bonds—bonds with the lowest investment-grade rating—has climbed this year from 6.7 percent last December to 7.2 percent in August.

Interest rate spreads, at the same time, have grown as investors continue to avoid what they perceive as risky investments. The spreads between investment-grade corporate bonds (those rated from Aaa to Baa) and 10-year Treasury notes have neared or exceeded levels reached during the last economic downturn, in 2001 (see Figure 2-6). The spread between the rate on Caa-rated (below investment grade) corporate bonds and 10-year Treasury notes has also increased this year, although it is still less than what it was during the 2001 recession.

Notes: Spreads are measured by the difference between interest rates on corporate bonds and rates on 10-year Treasury notes.

Actions by the Federal Reserve. The Federal Reserve has continued to address the liquidity problems of the financial markets. It has used its traditional tools of monetary policy to lower short-term interest rates and expanded its "tool kit" to address the serious problems with liquidity outside of the commercial banking system that threaten the stability of the entire financial sector.

In an aggressive use of its traditional policy tools this year, the central bank lowered the target federal funds rate from 4.25 percent in December to 2.0 percent in April. Concurrently, it lowered the discount rate (the rate that banks pay for borrowing from the Federal Reserve) from 4.75 percent to 2.25 percent, reducing the spread between the target and the discount rate. Among other actions, it also increased the amount and the term of loans that it provides to depository institutions (such as commercial and savings banks) and continued to work with the European Central Bank and the Swiss National Bank to increase liquidity in the interbank loan market.

The Federal Reserve has also expanded the range of options it uses to address problems in the broader financial markets by creating facilities to lend to primary dealers.¹¹ The Primary Dealer Credit Facility (PDCF) provides overnight loans of funds, and the Term Securities Lending Facility (TSLF) lends U.S. Treasury securities held by the Federal Reserve for 28-day terms. All such lending must be secured with collateral. In the case of the PDCF, eligible collateral includes assets such as Treasury securities and riskier investment-grade debt. The range of eligible collateral for TSLF borrowing is broader and potentially riskier—it includes certain mortgage-backed and other asset-backed securities, among others.

Those new facilities have exposed taxpayers to potential losses on that collateral and raised questions about whether the central bank can continue to support the financial markets. Since last year, about 40 percent of the Federal Reserve’s holdings of Treasury securities have been loaned out in exchange for other collateral. Losses could arise if a borrower defaulted on a loan at a time when the prices of the pledged collateral had fallen. The risk of a significant loss is somewhat reduced because the Federal Reserve typically lends less than the collateral’s full value to protect itself against possible declines in those prices. Although the central bank has lent out a significant portion of its portfolio, it still holds a substantial amount—almost $500 billion worth—of Treasury securities.¹²

In addition, the Federal Reserve, in consultation with the Department of the Treasury, facilitated the purchase of the investment bank Bear Stearns by JPMorgan Chase, an investment and commercial bank. The Federal Reserve lent JPMorgan Chase $29 billion against a portfolio of $30 billion of Bear Stearns’s less liquid assets. Many analysts believe that the central bank had to act to reduce the possibility that Bear Stearns’s problems would spread to other financial institutions. That action, however, has exposed taxpayers to possible losses.13 Moreover, some people are concerned that the Federal Reserve’s assistance to Bear Stearns has reinforced an expectation that large financial institutions that experience financial difficulties will receive help—creating a "too big to fail" policy for investment banks. Such a policy could increase future losses for taxpayers by giving financial institutions an incentive to expand with less concern about the risk they are taking on. (If the managers of such institutions believed that taxpayers would bear possible losses for taking on additional risk but that the stockholders and managers would benefit from possible higher returns, the managers might take on more risk than they otherwise would.)

Other Government Actions. Recently, the federal government attempted to stabilize the financial markets in the face of renewed apprehension about the finances of Fannie Mae and Freddie Mac, two of the government-sponsored enterprises (GSEs) for housing. In July, investors feared that Fannie Mae and Freddie Mac, which own or guarantee roughly half of the nation’s mortgages, would fail. To support the markets’ confidence in the GSEs, policymakers included provisions in the Housing and Economic Recovery Act of 2008 that authorize the Treasury to temporarily purchase obligations and securities held by Fannie Mae and Freddie Mac and by the other housing GSE, the Federal Home Loan Banks (see Box 2-1). Nevertheless, the stock prices of Fannie Mae and Freddie Mac fell in mid-August, suggesting that the market again feared that the federal government would be forced to take them over.

Legislation enacted earlier this year, the Ensuring Continued Access to Student Loans Act of 2008 (Public Law 110-227), may help alleviate some of the problems in the market for student loans. All lenders that make such loans, including those that participate exclusively in the Federal Family Education Loan (FFEL) program, have seen their borrowing costs increase dramatically as a result of the ongoing financial turmoil. The new law gives the Department of Education authority to temporarily purchase federally guaranteed loans originated by lenders in the FFEL program, effectively substituting federal funding for private money to help maintain the viability of new lending in the program. The law also helps increase the supply of student loans through the program’s lender-of-last-resort provisions and boosts the limits on unsubsidized loans by $2,000 per year per student. By CBO’s estimates, that expansion of the limit would increase the volume of unsubsidized loans by more than $1 billion in fiscal year 2008 and by nearly $7 billion by fiscal year 2018.

The high prices for petroleum and food seen over the past year have slowed economic growth. The high price of oil in particular has drained purchasing power from the economy. Faced with weak demand and higher costs for production and transportation, businesses have slowed the growth of jobs, wages, and investment in structures and equipment. The rise in prices for agricultural products has had a smaller impact on the economy than the rise in oil prices, but the increased cost of food has nonetheless constrained spending on nonfood items.

Increased demand relative to the supply worldwide of energy and food is the primary reason that the prices of those commodities have risen over the past year, but the upswing in the price of oil has boosted the price of food as well. Moreover, significant disruptions in the supply of food commodities in 2006 and 2007 have raised the prices of those items.

Inflation in both food and energy prices is likely to abate in the near term. The price of oil has fallen quite sharply since July, and reports of good harvests around the world suggest an easing of commodity food prices later this year. Furthermore, the slowing pace of worldwide economic growth foreseen by many analysts is likely to help lower prices for energy and food.

Oil Prices. The nominal price of petroleum—specifically, the price of West Texas Intermediate crude oil—roughly doubled over the 12 months between July 2007 and July 2008 (see Figure 2-7). Since then, however, the price of petroleum has fallen fairly rapidly, reaching $116 per barrel by late August. CBO’s current forecast incorporates the assumption that the price of petroleum will average about $138 per barrel over the next year. That forecast was based on prices in the futures market for petroleum that were available in early July, when CBO completed its current forecast (see Box 2-2).

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

Note: Data are monthly and are plotted through August 2008. The price is for West Texas Intermediate crude oil. Before 1982, it refers to the posted price; for later years, the spot price. The adjustment for inflation is based on the personal consumption expenditure chained price index.

The primary factor in the upswing in prices is the rising demand for crude oil in rapidly developing countries, especially China and India and countries in the Middle East, combined with the comparatively slow growth of supplies. (The use of oil by industrialized countries actually declined in 2007.) Both the International Energy Agency and the United States’ Energy Information Administration project that the global oil supply will—at best—grow modestly during the next two years. Higher prices for petroleum have not yet reduced demand in some developing countries.¹⁴

To a much lesser extent, other factors—such as geopolitical tensions, speculation, and the decline in the exchange value of the dollar—may have contributed to the dramatic rise in the dollar price of oil. Fears of disruptions in supply owing to political tensions in the Middle East, Africa, and South America, for example, may have encouraged producers to maintain larger inventories or to pump less oil. Some analysts also argue that speculative activity may have contributed to the upsurge and subsequent fall in the price of petroleum over the past year (see Box 2-2). Another factor is that the price of oil in most foreign currencies has risen less than it has in dollar terms because of the decline in the value of the dollar. Therefore, the global response of oil supply and demand has been dampened relative to the rise in the dollar price of oil.

Spending in the United States for petroleum imports rose significantly—by $177 billion, or about 1.2 percent of GDP—between the second quarter of 2007 and the second quarter of 2008. As a result, money that would have been spent primarily on domestic goods and services was channeled abroad, reducing, at least temporarily, the demand for U.S.-produced goods. That redirection of resources generally slowed the growth of employment here, although some of the increased expenditures for oil imports will come back to stimulate domestic production—either through other countries’ purchases of more U.S. exports or as more investment in U.S. assets.

Over the longer term, however, high oil prices will force some consumers and producers to find alternative products or services to reduce their dependence on oil, easing some of the prices’ negative impact on growth. Indeed, some consumers have already responded to the price hikes by driving less or by purchasing more fuel-efficient vehicles.

Food Prices. The prices of agricultural products have risen sharply over the past year. Prices for wheat, corn, and soybeans, in particular, set records recently (see Figure 2-8); prices for eggs and milk rose substantially in 2007 as well. High prices for animal feed have led meat producers to cull herds, preventing a short-run increase in meat prices but probably reducing supplies and boosting prices later this year. Similarly, the prices of dairy products are expected to climb further. Increases in prices for grain and soybeans have far outpaced increases in prices for other agricultural commodities.

Figure 2-8.

Prices of Three Major Agricultural Commodities

(Index, 2000 = 1)

Sources: Congressional Budget Office; Wall Street Journal.

Note: Data are monthly and are plotted through July 2008.

The extent of the rise in agricultural prices was quite unexpected. As with oil, the steady surge in global demand has played a key role. In addition, the increase in energy prices seems to have been a factor in the higher retail food prices of the past two years. Higher prices for energy raised the costs of agricultural production and of retail food processing and distribution. Shocks to supplies as a result of poor weather (especially in the case of wheat) and rising demand for biofuel feedstocks (such as corn for ethanol production) also helped boost prices for agricultural commodities. Those shocks, coming at a time when international grain reserves were at historic lows, produced unexpectedly large increases in prices. Some speculative pressures may also have temporarily pushed up agricultural prices earlier this year.

Inflation in food prices is likely to ease by the end of this year as worldwide supply grows. In fact, prices for corn, wheat, and soybeans have already dropped. Futures markets also expect food prices to fall from recent peaks, although prices are expected to remain at historically high levels.

Net Exports and the Federal Government’s Support of Growth

The relative strength of net exports and the stimulus provided by increased federal spending and tax rebates have partially offset the weakness elsewhere in the economy. In particular, the timeliness of the fiscal stimulus package enacted in February may have helped prevent a contraction of economic activity—consumer spending grew in the spring and early summer. CBO expects the strength in real net exports to continue to provide support for the growth of GDP in the near term, although under the assumptions embodied in CBO’s baseline, the support from the federal government will ebb next year. (Chapter 1 presents CBO’s updated baseline projections of federal spending.)

Net Exports

The relative economic strength of the United States’ trading partners—in particular, the strength of emerging economies—and the substantial decline of the dollar over the past several years are likely to support the growth of real net exports in the near term. However, a significant slowdown in global economic growth in recent months has increased the downside risks to that forecast.

Economic Growth of the United States’ Trading Partners. The momentum in the expansion of the world economy has slowed significantly since last year, and the economic outlook in foreign industrialized countries is particularly precarious. In emerging economies, growth has also pulled back from its previously rapid pace but remains faster than in industrialized countries. CBO expects that real GDP among the United States’ major trading partners will grow more slowly but still faster, on average, than real GDP in the United States this year.

The pace of economic growth in foreign industrialized countries has been buffeted by several headwinds: the decline in those countries’ purchasing power caused by higher prices for oil and food, tighter credit as a result of their exposure to subprime losses in U.S. financial markets, weaker housing markets, the appreciation of their currencies against the dollar, and the slowing U.S. economy. Even though the turmoil arising from the subprime mortgage problem has been less severe and the adverse effects on growth of higher energy prices likely to be more muted in those countries than in the United States, economic activity has slowed more in some foreign industrialized economies than it has here. That slower pace may be due in part to the less accommodative responses by policymakers in those countries and the greater rigidity of their labor markets.¹⁵ Growth in those economies is likely to remain sluggish over the near term.

The outlook for emerging economies is better than the outlook for industrialized ones, even though the former are also showing signs of a significant slackening. Emerging economies in Asia are expected to post a solid rise in output in the near term, although the rate of increase will probably be more moderate than it was last year. Emerging economies in South America are also likely to weather the U.S. slowdown reasonably well—commodity exporters in particular have benefited from higher prices for their products. Nevertheless, inflation looms as a threat to growth in many emerging economies.

The Exchange Value of the Dollar and the U.S. Current Account. The trade-weighted value of the dollar (the value relative to trading partners’ currencies, with the weight of each country’s currency equal to that country’s share of U.S. trade) has been on a downward path since early 2002. From July 2007 through March 2008, the dollar fell at a noticeably faster rate than its average pace of decline since 2002. The dollar’s rapid fall during that recent period was primarily a response to more aggressive easing of monetary policy in the United States than abroad and, to a lesser extent, the Chinese authorities’ decision to allow the country’s currency to appreciate more rapidly against the dollar than it had in the past.¹⁶ Since March of this year, however, the trade-weighted value of the dollar has stayed relatively stable, as the dollar appreciated against some currencies and depreciated against others. The pause in the dollar’s decline may in part reflect the views of investors about the future actions of the Federal Reserve (that it will make no further cuts in the federal funds rate) and of the European Central Bank (that the sharper-than-expected decline in economic growth in the countries that use the euro may force the bank to lower its interest rates soon).

In CBO’s forecast, the exchange value of the dollar falls once the impact of short-term policy effects fades. The expected decline reflects the likelihood that foreign investors will be less willing to continue to add to their large dollar holdings at the same rate as they have in the past. Foreign investors have accumulated a sizable amount of dollar assets (for example, U.S. Treasury securities) in the past 15 years, a period of persistent U.S. current-account deficits.¹⁷ Once those investors have accumulated enough such assets to carry out international transactions and meet their need for reserves, they are likely to slow their purchases of dollar assets.¹⁸ In turn, the exchange value of the dollar will fall, and prices of U.S. assets will appreciate less than they would have if foreign investors had continued to accumulate dollar-denominated assets. Those outcomes will make domestic products relatively cheaper (compared with imports) and the growth of household wealth slower. U.S. residents as a result are likely to spend less on imported goods and to save more and spend less generally, thereby lowering the current-account deficit.

The U.S. current-account deficit as a share of GDP has followed a declining path since the end of 2005, although occasionally that decline has been interrupted by a surge in the price of imported oil. In CBO’s forecast, the current-account deficit resumes its downward adjustment toward a more sustainable level as the value of oil imports stabilizes, domestic demand slows more than the demand for U.S. exports, and the value of the dollar declines.

The Fiscal Stimulus Package and Government Spending

The federal government is supporting growth in the short term through its tax and spending policies and through the automatic stabilizing effects of the federal budget. In February, policymakers enacted the Economic Stimulus Act of 2008. That law provided tax rebates of up to $600 for individual filers and up to $1,200 for couples, as well as $300 per qualified child under the age of 17. The stimulus package also included tax cuts for businesses (in the form of temporarily enhanced depreciation deductions). By mid-July, when the Treasury completed its major rounds of disbursements of the rebate checks, more than 90 percent of the roughly $100 billion in rebates that was expected to be distributed in this calendar year had been sent to qualifying individuals and families. CBO expects that the rebates will boost the rate of economic growth by almost 1½ percentage points (at an annual rate) during the second and third quarters of 2008. (CBO assumes that, on average, roughly 40 cents of each rebate dollar will be spent within six months.) By the last quarter of 2008, however, the rebates and the temporary boost to consumer demand they provide will have peaked, and the growth of household spending is likely to slow.

The federal government is also boosting short-term economic growth through such spending measures as an extension of unemployment benefits, which was enacted in June, and more generally through an increase in its purchases of goods and services. The contribution that those purchases make to growth is projected to shrink next year, however (under the assumptions embodied in CBO’s baseline).

For 2008, CBO expects that real federal purchases will grow by 5 percent (compared with 2 percent in 2007) because of a faster pace of both defense and nondefense spending. That rate is projected to slow to 3 percent in 2009 because, under baseline assumptions, CBO projects that funding for defense programs in that year will grow only with inflation—a pace that would be well below the average annual increases witnessed thus far during the wars in Iraq and Afghanistan. (The outlook for the federal budget is discussed in detail in Chapter 1.)

In addition to the effects of tax and spending policies, the federal budget is supporting growth through the so-called automatic stabilizers, which derive from the impact of the economy on the federal budget deficit. As the economy slows, so does the growth in federal taxes, which helps cushion the slowdown in the growth of disposable income. Also, as the rate of unemployment goes up, so do benefit payments for unemployment insurance (even if policymakers do not extend unemployment benefits), which helps bolster consumer spending.

CBO estimates that in fiscal year 2008, those automatic stabilizers will increase the federal budget deficit by about half a percent of potential GDP, compared with an increase of roughly a quarter percent in 2007. In 2009, the automatic stabilizers will boost the deficit by more than 1 percent of potential GDP, CBO projects.

Spending by Households, Businesses, and State and Local Governments

The recent turbulence in the economy is likely to further dampen spending by households, businesses, and state and local governments. The growth of consumer spending, buoyed by tax rebates during the middle of this year, is forecast to slacken in the near term. Investment by businesses will also probably be sluggish: Companies will feel less need to add to existing capacity, and that reluctance is likely to reduce the growth of real GDP this year. In addition, a sustained fall in the revenues of state and local governments—an effect of the weak economy—is likely to force cutbacks in spending in that sector.

Household Spending

The outlook for growth in household spending has become less favorable since CBO’s previous forecast. Employment this year has persistently contracted; as a result, the growth of household income has slowed and will probably decelerate more in the near term. Surveys show that consumer confidence has deteriorated to a level usually seen during a recession. The continued decline in the prices of both houses and stocks has shrunk households’ net wealth and will further depress spending. In addition, the high cost of energy is likely to reduce real income. Finally, more-stringent lending standards among banks will probably limit the availability of credit for consumers and further curb spending. CBO forecasts that real consumer spending, which was temporarily supported by tax rebates during the middle of this year, will decline later this year and early next year, before recovering during the second half of 2009.

Employment and Household Income. Employment has weakened significantly this year (see Figure 2-9). Current data show that the economy lost an average of 76,000 jobs per month through August, whereas it added an average of roughly 100,000 jobs monthly during the same period last year. With the decline in employment, the unemployment rate has been rising over the past year, climbing from an average of 4.5 percent during the first half of 2007 to 6.1 percent in August of this year.

Figure 2-9.

Total Nonfarm Payroll Employment

(Percentage change from previous year)

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

Note: Data are monthly and are plotted through July 2008.

Not only has the pace of job losses in construction and other housing-related industries quickened this year but losses have spread beyond economic sectors with ties to housing. Employment in residential construction continues to decline and has fallen by more than half a million jobs, or roughly 16 percent, since its peak in early 2006. Employment in nonresidential construction remained solid until late last year, but it has also been declining during 2008. The manufacturing sector continues to shed jobs, although the magnitude of the contraction during this downturn has been somewhat smaller than in previous slowdowns. Among service-providing industries, retail employment as well as employment in temporary-help services shrank significantly during the first half of this year.

CBO’s forecast implies that employment will continue to contract for the rest of this year—with the economy losing an average of roughly 50,000 jobs per month during the second half of 2008—and will grow sluggishly for much of 2009. Although the number of layoffs has been small by comparison with the number seen in previous recessions, layoffs are likely to increase as economic activity remains slack and forces some employers to adjust the size of their workforce. The unemployment rate, according to CBO’s forecast, will remain high during much of next year, averaging 6.2 percent in 2009.

The rate of growth of household income is likely to decline in the near term as the growth of hourly wages and the number of hours worked slow. Over the past year, the growth of hourly wages has declined, and CBO expects it to slow further throughout 2008 and in 2009, the result of the sluggish pace projected for economic growth. Some households might attempt to maintain their spending by borrowing against their future earnings or their houses, but with the tightening of lending standards, many households will probably be unable to do so. The near-term reduction that CBO foresees in the growth of household income is therefore likely to bring about a significant falloff in the growth of consumer spending.

Consumer Expectations. Consumer expectations have fallen sharply since early 2007 and are now close to or below levels observed during past recessions (see Figure 2-10). Although expectations increased noticeably in August, possibly as a result of lower prices for gasoline, the growth of consumer spending is still likely to deteriorate as the effects of the tax rebates recede.

Figure 2-10.

Index of Consumer Expectations

(Index, 1985 = 100)

Sources: Congressional Budget Office; Conference Board.

Note: Data are monthly and are plotted through August 2008.

Household Wealth. Falling prices for houses and stocks have led to declines in households’ net wealth, which shrank for the first time since 2002 during the final quarter of 2007 and continued to contract during the first quarter of 2008. The decline in wealth is likely to persist as housing prices slide further and the weak economy further depresses stock prices. Less household wealth, in turn, will dampen consumer spending.

Business Spending

The drop in overall demand for goods and services has contributed to much of the deterioration—compared with CBO’s prior forecast—in the outlook for business fixed investment (spending for structures, equipment, and software). A greater-than-expected contraction in employment during the first half of this year suggests less need for additional capital in the near future. In addition, profits from businesses’ domestic operations have been squeezed by tepid domestic demand and higher costs for production-related materials and transportation. Lower stock prices and the pullback from risk in the credit markets are also likely to restrain businesses’ spending in the near term. CBO forecasts that the growth of real business fixed investment will fall substantially during 2008, reaching its slowest rate during the second half of this year before recovering in 2009.

Although the growth of spending for nonresidential structures has remained strong, it has started to show some signs of faltering. (By contrast, investment in producers’ durable equipment had already moderated during 2007.) The relative strength in spending for nonresidential structures was primarily a delayed response to faster growth in employment in prior years. Increased exploration and drilling for petroleum spurred by the soaring price of crude oil played a role as well. Nevertheless, a leading indicator for nonresidential construction—the architectural billings index of the American Institute of Architects—indicates sharply lower billings by architectural firms so far in 2008, which suggests a decline in real nonresidential construction (other than drilling) in the coming months. Tighter lending standards will also tend to depress construction activity in the near future.

State and Local Government Spending

The real growth of spending (that is, consumption plus investment) by state and local governments has measured less than 2 percent (at an annual rate) in each of the past four quarters, and that growth is projected to be even weaker during the rest of this year and next. Real compensation of employees grew by slightly more than 1 percent in the second quarter—the slowest pace since the last quarter of 2005. Although real investment grew by nearly 4 percent in the second quarter of this year, its growth did not offset a decline of nearly 7 percent in the first quarter.

The continued slowing of the growth of state and local governments’ revenues in the near term will worsen their budget outlooks, CBO forecasts, and cause policymakers—despite some help from rainy-day reserves and selective increases in taxes and fees—to trim plans for spending as they cope with balanced-budget requirements. The sluggish economy, the drop in consumers’ purchases of gas as a result of record prices, and the impact of the subprime mortgage problems will continue to curtail collections of income, sales, and property taxes. Fewer revenues are apt to lead in turn to less growth in spending on government personnel and purchases of goods and other services. Moreover, the effects of slower growth in revenues could be exacerbated by higher costs for debt servicing (because in order to borrow, state and local governments might have to raise the interest rates they pay on state and municipal debt).

Inflation and Monetary Policy

Surging prices for food and energy have boosted overall consumer inflation this year, although core consumer inflation, which excludes those prices, has been relatively well contained. Increases in commodity prices plus increases in the prices of noncommodity imports over the past year have raised concerns that inflation will be persistently high in the near term. Yet the recent drop in the price of oil—should it persist—reduces both that risk and the chances that the Federal Reserve will raise interest rates more quickly than CBO anticipates to tamp down inflation. In CBO’s view, overall inflation will ease in the near term as core inflation remains low, the growth of food prices slows, and prices for energy decline. With those conditions in place, the Federal Reserve will start raising its policy interest rate in 2009, CBO forecasts.

Commodity and Import Prices

In addition to commodity prices for energy and food, prices for other commodities (such as nonfood agricultural products, metals, and other industrial materials) have spiked over the past year. The breadth and size of those recent jumps were similar to those observed in the 1972–1975 period, which has kindled fears that inflation will be as stubbornly high in the near future as it was during the 1970s.

The prices of imported goods are also putting upward pressure on domestic inflation. As the exchange value of the dollar has fallen, the growth of import prices, even if commodities are excluded, has increased. Inflation in such prices is likely to remain high both this year and next because of the past decline in the dollar and because of a boost in inflation overseas.

The rapid increases in petroleum and food prices during the year ending in July and, to a lesser extent, the increase in the prices of imports have raised the overall rate of consumer price inflation this year (see Figure 2-11). With the price of crude oil doubling from the middle of 2007 to the middle of 2008, the consumer price index for energy rose by 29 percent during the year ending in July 2008. The prices that consumers paid for food over the same period rose by 6 percent; average rates of growth in food prices for 2006 and 2007 were 2.3 percent and 4 percent, respectively.

Figure 2-11.

Consumer Price Index

(Percentage change from previous year)

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

Notes: The core measure is the consumer price index for all urban consumers (CPI-U) excluding prices for food and energy. The figure uses the research series of the CPI-U, which, approximately, applies current methods of calculating the CPI-U to historical data.

Data are monthly and are plotted through July 2008.

CBO does not expect the recent increase in prices for energy and commodities to lead to persistently high inflation. During the 1970s, large price hikes for commodities and imported goods triggered higher inflation (including core consumer price inflation, which excludes food and energy) by igniting a wage-price spiral, in which an initial price shock sets off higher wage growth, which in turn causes businesses to raise prices, and so on. But measures of current wages and salaries, such as the Bureau of Labor Statistics’ employment cost index, have not yet provided evidence that higher prices for food and energy are boosting wages. Moreover, unlike in the 1970s, the Federal Reserve appears likely to use monetary policies to discourage such a spiral from taking hold. Another development arguing against a wage-price spiral is that the price of oil has recently begun to decline.

Core Inflation

Core consumer price inflation has remained moderate this year despite the pressures generated by rising prices for commodities and imports. Moreover, several indicators, particularly those from the labor market, point to continued moderation in core inflation for the rest of this year:

■	Unemployment has risen steadily over the past year, reaching 6.1 percent in August, and the growth of wages has slowed;

■	The growth of unit labor costs has been modest over the past year (see Figure 2-12); and

■	Capacity utilization in manufacturing is below the level associated in the past with higher inflation.¹⁹

Figure 2-12.

Unit Labor Costs

(Percentage change from previous year)

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

Notes: Unit labor costs are hourly costs for labor divided by output per hour.

Data are quarterly and are plotted through the second quarter of 2008.

Components of the consumer price index, such as housing, medical care, and apparel, also suggest that pressures on core inflation are relatively subdued. Housing rents, including the imputed rent for owner-occupied homes, are particularly important because they compose roughly a third of the overall CPI-U. Inflation in housing rents has continued to ease over the past year with the rise in vacancy rates for both traditional rental units and owner-occupied houses. Those high vacancy rates are likely to persist, and if they do, they will continue to curb inflation in housing rents. As for the smaller components of the CPI-U, inflation in the price of medical care has moderated, and even the rise in prices for apparel, a category heavily dominated by imports, has remained small so far this year.

Monetary Policy

Over the near term, the Federal Reserve will continue to try to alleviate the downturn in economic activity and at the same time keep the chances of persistently higher inflation small. In view of the outlook for weak growth of the economy in 2008 and 2009, as well as the expectation that core inflation will be relatively contained, CBO does not believe that the Federal Reserve will raise short-term interest rates significantly in 2008. But if the risk of higher core inflation increases, the Federal Reserve may boost its short-term policy interest rate (the federal funds rate) to lessen that risk.

As the downward pressures on the economy from the housing and financial sectors fade, however, the Federal Reserve is likely to raise the target federal funds rate throughout 2009 and 2010, in CBO’s estimation, reversing much of the fall in the rate that has taken place over the past year. In CBO’s forecast, the federal funds rate averages 2.3 percent this year and 2.8 percent in 2009. Interest rates on 3-month Treasury bills, which have fallen significantly since last summer, are expected to rise in the near future in concert with the increase in the federal funds rate. CBO projects that the rate on 3-month Treasury bills will average 1.9 percent in 2008 and 2.7 percent in 2009. Similarly, CBO expects that the rate on 10-year Treasury notes will climb from an average of 3.9 percent in 2008 to 4.4 percent in 2009.

Risks in the Economic Outlook

Economic growth has slowed substantially since mid-2007, and CBO believes that the economy is now about halfway through an extended period of sluggish growth. This period has not as yet been designated a recession; the National Bureau of Economic Research, or NBER (which by convention determines the starting and ending dates of recessions in the United States) usually waits for more data before making a formal determination, in part because revisions to economic data can sometimes be significant. However, the patterns of some of the key economic indicators that NBER examines (such as employment and real personal income excluding transfers from programs like Social Security) are similar to the patterns that have characterized mild recessions in the past, and many features of CBO’s forecast—in particular, the anticipated rise in the unemployment rate—are similar to those observed in recent downturns.

Concerns remain that the economy’s current challenges—the unprecedented decline in house prices, the problems in the financial markets, and the high price of oil—could cause this downturn to be deeper and more protracted than the last several recessions. Indeed, some analysts have argued that current conditions in the housing and financial markets are the worst since the Great Depression. They contend that the prices of homes will fall by much more, further weakening banks and reducing the credit available for loans, in turn forcing down house prices even more. In the view of some researchers, economic downturns that are associated with housing "busts" and shortages of credit tend to be deeper and longer than other recessions.²⁰ The economic outlook could deteriorate even more if many banks became insolvent or if the current financial crisis in the United States spreads more widely overseas and destabilizes global financial markets.

However, the economic outlook could also improve sooner than CBO is currently forecasting. During the past 25 years, the economy has been resilient in the face of adverse shocks; since 1983, it has experienced only two relatively mild recessions, and inflation has been much more contained than in earlier years. Some economists attribute that long period of relative stability to a number of developments—for example, less economic regulation, greater competition in labor and product markets (including globalization), and more-effective monetary policy. They argue that the economy has become more competitive and more flexible, able to respond to shocks because prices can adjust more quickly to reflect relative scarcities. (According to that view, scarce goods and services can be quickly redirected to their most valued uses, and a price shock’s negative effect on output will be muted.)²¹

The current turbulence in the financial markets is testing that argument, but up to now, the economy has coped with the severe shocks of the past year relatively well. In particular, in a distinct contrast to events following the shocks of the 1970s, the lack of a steady surge in core inflation and unit labor costs, and the degree to which the consumption of petroleum products has declined, indicate an efficient response by businesses and households to skyrocketing oil prices. (For example, initial estimates indicate that the consumption of petroleum products during the second quarter of this year was about 4 percent lower than it was a year ago, even though real GDP was 1.8 percent higher. In contrast to responses to earlier oil price shocks, the reduction in the use of petroleum per unit of GDP has occurred without causing major disruptions.) Moreover, the apparent restraint in core inflation has given the Federal Reserve more latitude to try to mitigate the downturn in the economy. Also, some of the negative effects that the shortage of credit has had on businesses’ investment spending may have been alleviated by the relatively healthy balance sheets of nonfinancial corporations.

CBO’s Economic Projections Through 2018

CBO projects that real GDP will grow at an average annual rate of 2.7 percent during the 2010–2018 period—slightly faster than the estimated growth of potential GDP, which will average 2.4 percent during the same time. CBO’s forecast of a very weak rate of growth for output during 2008 and 2009 leaves a substantial gap between real GDP and its potential level at the end of the latter year (see Figure 2-13). In CBO’s projection, that gap is closed by faster growth during 2010, 2011, and 2012. CBO assumes that after 2012, output will grow, on average, at the same rate as potential GDP, keeping the output gap at an average of zero.

Figure 2-13.

The GDP Gap

(Percentage of potential gross domestic product)

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

Notes: The GDP gap is the difference between real (inflation-adjusted) gross domestic product and its estimated potential level (which corresponds to a high level of resource—labor and capital—use).

Data are quarterly and are plotted through 2018.

CBO expects that inflation, as measured by the CPI-U, will average 2.2 percent from 2013 to 2018 and that the rate of unemployment will average 4.8 percent, the same as CBO’s estimate of the natural rate of unemployment.²² CBO projects that rates on 3-month Treasury bills will average 4.6 percent during the period and rates on 10-year Treasury notes will average 5.4 percent.

To develop its projections for the medium term (that is, 2010 through 2018), CBO projects levels and rates of growth for the factors that underlie potential GDP, such as the growth of the labor force, of capital services (how much the stock of physical capital contributes to the flow of production), and of productivity. In doing so, CBO takes into account the effect that current fiscal policy may have on those variables, but it does not attempt to forecast fluctuations in the business cycle beyond the next two years.

Potential Output

CBO projects that potential output will grow at an average annual rate of 2.4 percent during the 2008–2018 period, or about a tenth of a percentage point slower than the rate that CBO foresaw last February (see Table 2-2). Coming on top of a downward revision to CBO’s estimate of potential GDP for 2007, CBO’s revised projection for potential growth implies that the level of real GDP in 2018 will be roughly 2 percent lower than the level CBO expected last winter. About half of the revision to potential output stems from a slower pace of capital accumulation during the 2008–2018 period; however, part of the change arises from a downward revision to the estimates of potential hours worked during recent years that derives from CBO’s revised interpretation of trends in the labor markets.

Table 2-2.

Key Assumptions in CBO’s Projection of Potential Output

(By calendar year, in percent)

Source: Congressional Budget Office.

Note: TFP = total factor productivity; * = between zero and 0.05 percent.

a. Values as of August 22, 2008.

b. The ratio of potential output to the potential labor force.

c. An adjustment for a conceptual change in the official measure of the gross domestic product chained price index.

d. An adjustment for the unusually rapid growth of TFP between 2001 and 2003.

e. The estimated trend in the ratio of output to hours worked in the nonfarm business sector.

CBO’s current projection for the rate of growth of investment by businesses is lower than its projection of last winter. Real fixed investment by businesses will grow at an average annual rate of 4.4 percent from 2008 through 2018, CBO estimates, down from the 4.6 percent pace projected in February. A weaker outlook for investment by businesses has two primary causes. First, the slower growth of employment projected for the entire 2008–2018 period implies that firms will need to spend less to adequately equip their workers with tools, machines, and other capital goods to maintain their current productivity. Second, in CBO’s baseline, the federal deficit is larger during the 2008–2018 period than CBO anticipated last winter, which implies that national saving and investment by businesses will also be lower than they were in the February projection.²³

CBO has also made a significant downward revision to its estimate of potential hours worked in the nonfarm business sector—the primary labor input underlying CBO’s estimate of potential output—for the period since 2004 and in its projection for the 2008–2018 period. That revision is not the result of a change to CBO’s outlook for the potential labor force, which is largely unaltered since the forecast last February. (In CBO’s current projection, the potential labor force grows at an average annual rate of 0.7 percent during the 2008–2018 period.) Instead, the revision stems from a change in CBO’s interpretation of trends in employment, particularly in the nonfarm business sector.

The growth of nonfarm employment has been much lower, on average, during the business-cycle expansion occurring since 2001 than would have been expected on the basis of past expansions. Employment in the nonfarm business sector did not grow relative to the labor force during the last recovery, as it did during the previous 20 years (see Figure 2-14). It is not entirely clear why that is the case—shifts of jobs to other sectors of the economy explain only part of the slower growth. It seems increasingly likely that nonfarm business employment will merely match the growth of the labor force in the future rather than grow more quickly, as it has since the 1970s.

Figure 2-14.

Nonfarm Business Employment as a Percentage of the Labor Force

(Percent)

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

Note: Data are quarterly and are plotted through the fourth quarter of 2007.

One implication of that interpretation is that the experience of the late 1990s, when the share of the labor force employed in nonfarm businesses was very large, was unusual and may not be repeated. Consequently, CBO is now placing less weight than before on the data from the late 1990s in estimating the level of potential employment in the nonfarm business sector. The net result is a lower level of potential employment during the 1990s and in the decade after 2000.

CBO projects that employment in the nonfarm business sector will grow at an average annual rate of 0.7 percent during the 2008–2018 period—that is, at the same pace as the potential labor force during that time. CBO projects that average weekly hours worked will decline very slightly during the period, so that hours worked in the nonfarm business sector will grow somewhat more slowly, at an average annual rate of 0.6 percent.

In CBO’s projections, potential total factor productivity (TFP) grows by 1.4 percent per year, on average, virtually the same rate assumed for productivity growth in CBO’s February forecast.²⁴ Although total factor productivity grew more slowly than potential TFP during the fourth quarter of 2007 and the first quarter of 2008, it is still very close to its estimated potential level. As a result, the addition of new data released since the previous forecast had little effect on CBO’s estimate of potential TFP.

Inflation, Unemployment, and Interest Rates

CBO’s outlook for inflation during the 2010–2018 period has also changed little since February. CBO projects that inflation, as measured by the CPI-U, will average 2.2 percent annually during the medium term, whereas growth in the personal consumption expenditure (PCE) and core PCE price indexes (the core measure excludes food and energy) will average 1.9 percent annually. (The PCE price index is an alternative to the consumer price index as a measure of inflation.)In general, CBO assumes that during the 2010–2018 period, inflation will be determined by monetary policy and that the Federal Reserve can, on average, maintain core inflation as measured by the PCE price index at just under 2 percent. The rate of unemployment is projected to average 4.8 percent during the latter years of the coming decade.

Compared with CBO’s February estimates, its current projections of long-term interest rates are higher because federal borrowing to finance the deficit is estimated to be greater. Larger amounts of federal borrowing tend to lower the national saving rate, raise interest rates, and reduce investment. CBO’s projection for interest rates on 3-month Treasury bills over the 2008–2018 period (4.6 percent, on average) is the same as it was in February, but its projection for rates on 10-year Treasury notes (5.4 percent, on average) is two-tenths of a percentage point higher. CBO projects interest rates for the medium term by adding expected inflation (as measured by the CPI-U) to its estimate of real interest rates.²⁵

Projections of Income

CBO projects federal revenues (see Chapter 1) on the basis of various categories of income as measured in the national income and product accounts. The outlook for revenues is most directly affected by wages and salaries, domestic corporate profits, proprietors’ income, and interest and dividend income. However, CBO makes numerous adjustments to the NIPA categories to estimate the income reported on tax forms for calculating tax liability.

At the broadest level, GDP can be roughly divided into labor income and domestic capital income.²⁶

Labor Income

CBO’s measure of the labor share of GDP consists of the total compensation that employers pay their employees—that is, the sum of wages and salaries and supplemental benefits—and 65 percent of proprietors’ income. Supplements include employers’ payments for health and other insurance premiums, employers’ contributions for pension funds, and the employer’s share of payroll taxes (for Social Security and Medicare). During the 1950–2007 period, CBO’s measure of the labor share averaged 62.3 percent of GDP, and CBO assumes that during the 2008–2018 period, the labor share of output will gravitate toward that average.

Over the four quarters ending in the second quarter of 2008, the labor share of GDP averaged 61.5 percent, or 0.8 percentage points below the long-term average (see Figure 2-15). CBO anticipates a rise in the labor share during the short run, for several reasons:

Figure 2-15.

Total Labor Income and Wages and Salaries

(Percentage of gross domestic product)

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

Note: Data are quarterly and are plotted through 2018.

■	The share of compensation ordinarily increases temporarily in a slowing economy because the growth of compensation usually does not fall as fast as the growth of GDP;

■	Low interest rates will boost net proprietors’ income, much of which is labor income; and

■	Firms may have to make some catch-up contributions to defined-benefit pension funds because of lower stock prices. Those contributions will come out of profits because they are not related to benefits for current workers.

CBO expects that during the 2010–2018 period, the share will return to its long-run average.

Supplements to wages—in particular, employers’ payments for health insurance premiums—are projected to grow faster than GDP, so the wage and salary share of GDP declines slightly from 2010 to 2018 in CBO’s projection. The rate of decline, however, is slower than the trend over the past 40 years.

Domestic Capital Income

The share of GDP attributable to domestic capital income generally moves in the opposite direction from the labor share, and it falls slightly in the near term in CBO’s projection. Capital income consists of domestic corporate profits, depreciation charges, interest and transfer payments made by domestic businesses, rental income, and the remaining share (35 percent) of proprietors’ income. CBO forecasts that the profits component within the capital share will be small in 2009 and 2010 when compared with that in recent years but profits will increase as the general economic recovery projected for the second half of 2009 takes hold.

As a share of GDP, interest payments by businesses are projected to remain relatively small. Mortgage payments by homeowners are included in that category, and the current low level of housing-related activity, combined with the expectation that housing and the financing of mortgages will recover only slowly, damps down CBO’s projection of business interest payments.

Changes in the Outlook Since February 2008

Compared with its February estimates, CBO’s current forecast indicates a much less favorable outlook, particularly over the next two years. The forecast now indicates weaker growth, significantly higher inflation and unemployment, and slightly higher interest rates for 2008 and 2009. On average, for the entire projection period (2008 to 2018), the forecast suggests slower growth and higher long-term interest rates (see Table 2-3).

Table 2-3.

CBO’s Current and Previous Economic Projections for Calendar Years 2008 to 2018

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

Note: GDP = gross domestic product; percentage changes are measured from one year to the next.

a. Values as of August 22, 2008.

b. Level in 2013.

c. Level in 2018.

d. The consumer price index for all urban consumers.

By far the single largest negative surprise since February has been the rise in energy prices. That spurt in prices had a sizable effect on measures of inflation and the growth of real GDP. The increase in consumer energy prices alone accounted for roughly 60 percent of the 4.7 percent rate of growth in the CPI-U (measured on an annual basis) during the first half of this year. The rise in energy prices was also a major factor in CBO’s downward revision to its forecast for growth, because the surge in spending for imports of petroleum and oil-related products undercut spending for domestically produced goods and services.

The changes that CBO has made in some of its other assumptions about prices have been less significant. Prices for food also rose somewhat more than CBO anticipated in February, but they have had a much smaller effect on inflation and growth than energy prices have had. Moreover, the growth of the core consumer price index was a surprise in the other direction: The index grew slightly more slowly than CBO foresaw in its February forecast.

Other developments during the first half of this year that worsened the near-term outlook for growth (other than the rise in energy prices) included slower housing sales, a weakening in businesses’ investments in structures and equipment, and a decline in the growth of employment (which diminishes future spending by households).

Changes in economic conditions since February have resulted, on balance, in a worse outlook for the federal budget because CBO’s new forecast leads to both a reduction in CBO’s projections of revenues and an increase in its projections of spending. The more-rapid-than-expected growth in inflation in 2008 and 2009 has increased CBO’s projections of spending for programs such as Social Security and Medicare. In addition, the net effect of higher prices and lower real output in the new forecast is a slightly lower projection for nominal GDP after 2008, which results in lower estimated revenues. Changes in the composition of income have a similar effect. (The specific revisions to the budget outlook that can be attributed to changes in the economic forecast are described in more detail in Appendix A.)

How CBO’s Forecast Compares with Those of Other Forecasters

Compared with the estimates of other forecasters, CBO’s estimate of real economic growth in the near term is generally weaker (see Table 2-4).²⁷ CBO’s estimates of the growth of real GDP in 2008 and 2009 are slightly more pessimistic than those of the current Blue Chip consensus forecast;²⁸ however, its forecast of unemployment rates is very similar to that of the consensus, being only slightly lower in 2008 and slightly higher in 2009. The Administration’s forecast for the growth of real GDP—published on July 28—is stronger than CBO’s, especially for 2009. The Administration foresees a slightly lower unemployment rate for 2008 and a much lower rate for 2009, which is consistent with its forecast of faster growth of real GDP. CBO foresees real growth of GDP that is at the lower end of the range of estimates of the Federal Reserve’s Federal Open Market Committee (FOMC) for 2008 and 2009 but higher for 2010 (see Table 2-5).²⁹ In contrast, its forecast for the unemployment rate is at or above the high end of the Federal Reserve’s range throughout the 2008–2010 period.

Table 2-4.

Comparison of Economic Forecasts by CBO, the Administration, and the Blue Chip Consensus for Calendar Years 2008 to 2013

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board; Office of Management and Budget, Mid-Session Review, Fiscal Year 2009 (July 28, 2008); Aspen Publishers, Inc., Blue Chip Economic Indicators (New York: Aspen Publishers, Inc., August 10, 2008).

Notes: The Blue Chip consensus is the average of about 50 forecasts by private-sector economists. The latest Blue Chip consensus does not extend past 2009.

GDP = gross domestic product; n.a. = not applicable.

a. Values for CBO incorporate the July 2008 revisions to the national income and product accounts, whereas values for the Administration do not. Historical values for the Blue Chip consensus incorporate the revisions but probably not fully.

b. The consumer price index for all urban consumers.

Table 2-5.

Comparison of Economic Forecasts by the Federal Reserve and CBO for Calendar Years 2008, 2009, and 2010

Sources: Congressional Budget Office; Federal Reserve Board, "Summary of Economic Projections for the Meeting of June 24–25, 2008" (July 15, 2008).

Notes: GDP = gross domestic product.

The range of estimates from the Federal Reserve reflects all views of the members of the Federal Open Market Committee. The central tendency reflects the most common views of the committee’s members.

a. The personal consumption expenditure chained price index.

b. The personal consumption expenditure chained price index excluding prices for food and energy.

Compared with the Blue Chip’s and the Administration’s forecasts, CBO’s near-term estimate of inflation is generally higher for 2008 but similar for 2009. Compared with the view of the Blue Chip consensus, CBO expects higher inflation (on the basis of the consumer price index) in 2008 but slightly lower inflation in 2009. The Administration’s forecast for CPI-U inflation is much lower than CBO’s for 2008 but is the same as CBO’s for 2009. CBO’s forecasts for both overall and core inflation are all within the Federal Reserve’s ranges and within its central tendency for 2008. CBO’s forecasts of interest rates on short- and long-term Treasury securities are similar to the Blue Chip’s and the Administration’s forecasts for 2008 and 2009. (The Federal Reserve does not publish its interest-rate forecasts.)

For CBO’s previous forecast, see Congressional Budget Office, "Update of CBO’s Economic Forecast," letter to the Honorable Kent Conrad (February 15, 2008).

By convention, the National Bureau of Economic Research (NBER) is responsible for dating the peaks and troughs of the business cycle (a recession extends from the peak of a cycle to its trough). According to NBER’s Business Cycle Dating Committee, a recession is a significant broad-based decline in economic activity that lasts more than a few months. To date a recession, the committee examines movements in economic indicators, including real GDP, employment, real personal income excluding transfers, and industrial production, as well as manufacturing, wholesale, and retail sales. For further discussion, see www.nber.org/cycles/jan08bcdc_memo.html.

CBO’s economic outlook was completed in early July, before the release, on July 31, of the Bureau of Economic Analysis’s (BEA’s) annual revisions of the national income and product accounts. (Those revisions incorporate new sources of data, revisions to previously published data, and methodological changes.) Data from 2005 to the first quarter of 2008 were revised. For most of the NIPA data, including the growth rates of real GDP and various price indexes, BEA’s revisions do not suggest the need for material changes in CBO’s economic forecast. CBO will analyze the implications of the revisions more fully in its next outlook, to be published in January 2009, once data associated with the revisions (such as new information on capital stocks) become available. In the meantime, CBO has incorporated the revised history into the forecast presented in this update.

The OFHEO measure covers only homes financed with conforming mortgages, which are low-risk loans up to a certain amount that are eligible to be purchased by Fannie Mae and Freddie Mac (formally, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, respectively). One reason for the discrepancy between the S&P/Case-Shiller and the OFHEO measures is that the latter omits houses that have been financed with higher-risk mortgages—the part of the mortgage market that has experienced the greatest turbulence over the past year.

As of August 13, the futures market price for the composite 10-city S&P/Case-Shiller index indicated a decline of 12 percent between August 2008 and November 2009.

Subprime borrowers are those who have low credit ratings and a high risk of default, whereas prime borrowers are those whose credit ratings are solid. The distinguishing feature of ARMs is that their rates are subject to change when market interest rates rise or fall. (Rates are frequently tied to the rates that banks charge each other for short-term loans.)

The Economic Stimulus Act of 2008 (Public Law 110-185), which was enacted in February, temporarily increased the conforming loan limit—from $417,000 to $729,750—to cover some jumbo mortgages (and create a jumbo conforming limit) in high-cost areas to encourage lenders to continue to offer such loans to consumers who wished to refinance. The recently enacted Housing and Economic Recovery Act of 2008 (Public Law 110-289) permanently sets the jumbo conforming limit in high-cost areas at the lesser of 115 percent of the area’s median house price or $625,500.

Securitization is the process by which such assets as student loans and mortgages are assembled into pools and the rights to the cash flows from the loans sold in the form of securities.

Alt-A mortgage loans, which share many of the same problems that afflict subprime mortgage loans, were often made on the basis of undocumented income.

The potential support provided by the Housing and Economic Recovery Act of 2008 to Fannie Mae and Freddie Mac may help reduce the risk of losses on banks’ portfolios of mortgage-backed securities that are guaranteed by the two firms.

Primary dealers are firms that trade in U.S. government securities with the Federal Reserve System. There are currently 19 primary dealers.

Rather than the composition of its balance sheet, the primary limitation that the Federal Reserve faces in dealing with problems in the financial system is the need to keep inflation and expectations of price hikes in check.

According to the agreement, JPMorgan Chase would be responsible for the first $1 billion in losses, and the Federal Reserve Bank of New York—and, ultimately, taxpayers—would absorb any losses that remained. Taxpayers would be involved because such losses would diminish the amount of the Federal Reserve’s surplus that was turned over to the Treasury and recorded as federal revenues.

Energy subsidies provided by the governments of some developing countries may have prevented the surge in oil prices from damping down consumers’ demand for oil in those nations. However, it is unclear how much of the increase in prices can be explained by such subsidies.

Instead of aggressively lowering interest rates, as the Federal Reserve did, the European Central Bank raised its policy interest rate (similar to the target federal funds rate) by a quarter of a percentage point in early July to combat inflationary pressures stemming from surging energy and food prices. In addition, none of those nations enacted a fiscal stimulus package similar in scope to the Economic Stimulus Act of 2008 in the United States.

China’s currency, the renminbi, appreciated by about 11 percent against the dollar for the 12 months from July 2007 to July 2008. By comparison, the renminbi appreciated by 5 percent over the 12 months ending in July 2007.

The current-account balance of a country is a broad measure of its trade balance that includes goods, services, and unilateral current transfers.

For a detailed discussion, see Congressional Budget Office, Will the U.S. Current Account Have a Hard or Soft Landing? Issue Brief (June 11, 2007).

Capacity utilization is the seasonally adjusted output of the nation’s factories, mines, and electric and gas utilities expressed as a percentage of their capacity to produce output. (A facility’s capacity is the greatest output it could produce if its capacity was fully utilized.)

Stijn Claessens, Ayhan Kose, and Marco Terrones, "What Happens During Recessions, Crunches, and Busts?" (paper presented at the American Enterprise Institute forum "Will the Global Economy Turn Down?" Washington, D.C., July 21, 2008).

See Congressional Budget Office, The Economic Effects of Recent Increases in Energy Prices (July 2006), Chapter 3.

The natural rate of unemployment is the rate arising from all sources except fluctuations in aggregate demand.

National saving equals total saving by all sectors of the economy: personal saving, business saving (corporate after-tax profits not paid as dividends), and government saving (budget surpluses). National saving represents all income not consumed, publicly or privately, during a given period.

Total factor productivity is average real output per unit of combined labor and capital services.

The projected real 10-year rate is determined by the rate of national saving, among other factors. For more information, see Congressional Budget Office, How CBO Projects the Real Rate of Interest on 10-Year Treasury Notes (December 2007).

For more details on CBO’s projection methods, see Congressional Budget Office, How CBO Forecasts Income (August 2006).

For full details of those other forecasts, see Aspen Publishers, Inc., Blue Chip Economic Indicators (New York: Aspen Publishers, Inc., August 10, 2008); Office of Management and Budget, Mid-Session Review, Fiscal Year 2009 (July 28, 2008); and Federal Reserve Board, "Summary of Economic Projections for the Meeting of June 24–25, 2008" (July 15, 2008).

The Blue Chip consensus forecast is based on a survey of 50 private-sector forecasters.

Four times a year, the Federal Reserve’s Federal Open Market Committee compiles the forecasts prepared by members of the Board of Governors of the Federal Reserve System and the presidents of the Federal Reserve banks. Those forecasts are then released in conjunction with the publication of the minutes for the FOMC meetings held in late January, April, June, and October. Table 2-5 compares CBO’s forecast with the projections prepared for the committee’s meeting in June 2008. (The next time the projections will be released will be in November, after the committee’s October meeting.)