Recent economic developments

2. While industrial production and employment continued to decline in June, and global growth prospects weakened further in recent weeks, data released on a variety of indicators point toward improving prospects for U.S. economic activity in coming months. Industrial production fell by 0.7 percent in June, led by a further large decline in manufacturing activity, especially production of business equipment, reflecting the slump in capital investment. Employment in June declined by 171,000 workers, following declines of 251,000 and 425,00 in April and May, respectively; the unemployment rate, however, remained largely unchanged since March at 4.5 percent. In contrast, suggesting stronger future growth, the index of leading indicators rose in June for the third consecutive month and consumer confidence increased for the second month in a row. The National Association of Purchasing Managers’ (NAPM) index of business activity in the manufacturing sector increased in June to 44.7 from 42.1 in May. While an index number less than 50 indicates declining activity in the sector, the index’s recent behavior suggests that the rate of decline in manufacturing has diminished substantially, primarily owing to improving new orders. Other data indicate that orders for durable goods increased in May, with a significant increase in orders for semiconductors. The NAPM index for nonmanufacturing rose from 46.6 in May to 52.1 in June, indicating that activity was increasing in this sector. Activity in the housing sector remained strong, with new housing starts rising to nearly 1.7 million units (annual rate) in June, a 6¼ percent increase over the level of starts in June 2000. The international trade deficit on goods and services narrowed sharply in May to $28.3 billion, reflecting a 2.4 percent decline in imports and a 0.9 percent rise in exports. According to First Call, current expectations are for corporate earnings to decline by 9 percent in the third quarter, before increasing by 2½ percent in the fourth quarter, and strengthening to 12 percent in 2002 and to 18 percent through 2006. Since the end of June, stock prices moved lower with the S&P 500 index down by about 4 percent, and the NASDAQ decreasing by 9 percent.

Chairman Greenspan’s testimony

3. In his Congressional testimony on the Federal Reserve’s Semiannual Report on Monetary Policy on July 18, Chairman Greenspan explained that the Federal Reserve’s aggressive easing in monetary policy since the beginning of 2001 was aimed at supporting demand and helping to lay the groundwork for the economy to achieve maximum sustainable growth over the longer term. The rapid and sizable easing in monetary policy was possible because of quiescent inflation pressures reflecting well anchored inflation expectations and a general lack of pricing power in product markets. Mr. Greenspan noted that, given the difficulties associated with accurately forecasting economic developments, the policy making process at times might require substantial swings in the federal funds rate to help stabilize economic activity, as for example, when recurring waves of consumer and business optimism and pessimism were affecting the economy. With regard to the behavior of asset prices and monetary policy, Mr. Greenspan said that the only realistic monetary policy response to a speculative bubble was to lean against the economic pressures that may accompany a rise in asset prices, bubble or not, and address forcefully the consequences of a sharp deflation of asset prices should they occur. Mr. Greenspan acknowledged the difficulty that monetary policy makers have in anticipating and acting on asset price bubbles, and he noted that expectations about future economic developments inevitably play a crucial role in policy formulation.

4. Mr. Greenspan indicated that the risks to the outlook remain tilted toward weakness in the economy. In his view, the period of below trend economic growth was not yet over, and a risk remained that economic weakness could turn out to be greater than expected and require a further easing in monetary policy. He said that the front-loaded easing in monetary policy this year coupled with the tax cuts underway should be increasingly stimulating economic activity as the year progresses. Mr. Greenspan noted that at present with energy prices headed lower and lessening labor market tightness, which should dampen wage increases, overall price pressures are likely to remain well contained in the period ahead.

5. While underscoring the downside risk to the Federal Reserve Board’s current forecast, Mr. Greenspan anticipated a slight strengthening in real activity in the second half of 2001, with real GDP growth over the four quarters of 2001 likely to be in the range of 1¼ to 2 percent, and reaching 3 to 3¼ percent in 2002 (staff estimates of real GDP growth lie toward the lower end of these ranges). He expected that the easing of pressures in product and labor markets would result in personal consumption expenditure price inflation of 2 to 2½ percent over the four quarters of this year and 1¾ to 2½ percent next year.

Budget outlook

6. In recent congressional testimony, OMB Director Daniels said that the unified federal budget surplus for FY 2001 was likely to be lower than previously thought, largely owing to a more negative than expected impact of the economic slowdown on tax revenues, particularly tax payments by corporations. He estimated that the surplus for FY 2001 would be in the range of $160 to $190 billion, with the surplus possibly coming in at the bottom of that range. Previously, the Administration had projected a surplus of around $197 billion, roughly in line with staff estimates. A complete set of revised fiscal projections will be available in the mid-session review of the budget, which is expected to be released in early August.

Social Security Commission

7. The Social Security Commission appointed by the President in May 2001 released an interim report last week. The report highlights the weaknesses of the existing Social Security system and the criteria by which any reform proposals would be evaluated. The report argues that the existing Social Security system provides inadequate incentives for raising personal (and national) saving rates and provides relatively low rates of return to the most economically vulnerable population groups. The report suggests that the introduction of voluntary personal retirement accounts would help address both of these problems, although no details are provided. The Commission at the outset was advised that its recommendations should adhere to certain guidelines, notably that: the Social Security surplus is dedicated to Social Security only; payroll tax increases are avoided; the benefits of current and near retirees are not reduced; and voluntary individual accounts are included. The report contains criteria against which reform proposals should be judged which are consistent with these guidelines and include: ensuring equity of lifetime Social Security taxes and benefits, both between and within generations; encouraging personal and national saving; moving the Social Security system toward a fiscally sustainable course that can withstand unforeseen economic and demographic changes; and analyzing all necessary sources of tax revenue and benefits (including from the traditional system and from personal accounts). The Commission expects that a final report will be issued later this year, and will include specific recommendations to reform and revitalize the Social Security System.