July 22, 2005

1. This note reports on information that has become available since the staff report was issued. The topics covered include the budget outlook, legislative developments, and recent economic and financial market developments. They do not affect the staff appraisal.

Recent economic and financial market developments

2. Recent developments have been favorable, reducing concerns of a soft patch in activity. June payroll employment continued its recent steady progress, rising by 146,000 (1¼ percent on an annualized basis) while the unemployment rate fell 0.1 percentage points to 5 percent. In the same month, industrial production and retail sales increased by a larger-than-anticipated 0.9 percent and 1.7 percent (month-on-month), respectively, and relatively strong export growth as well as the benefit from a temporary dip in oil prices helped reduce the trade deficit to $55.3 billion in May from the previous month’s $56.9 billion. Consumer and producer sentiment have also improved.

3. Inflation pressures appear to be contained. The June 12-month increase in overall and core consumer prices moderated to 2.5 percent and 2.1 percent, respectively, both below market expectations. Similarly, headline and core producer price inflation fell to 3.6 percent and 2.2 percent, respectively, and spreads between conventional and inflation-indexed 10-year bonds declined slightly to around 2¼ percent.

4. These developments have elicited limited financial market responses. Long-term bond yields have increased by about ¼ percentage point to around 4¼ percent on stronger growth prospects. Market expectations about the Federal Reserve’s policy course have remained largely unchanged, with a further 75 basis points of tightening expected by end-2005. Stock prices have strengthened somewhat, and—after some appreciation in early July—the dollar has returned to its June level.

Monetary, fiscal and legislative developments

5. The Federal Reserve’s semi-annual Monetary Policy Report (MPR) was presented to Congress yesterday by Chairman Greenspan. The MPR projects core PCE inflation will remain below 2 percent and economic growth will be sustained at around 3½ percent this year and next, assuming no further oil price spikes. With economic slack diminishing, the Chairman indicated that further monetary tightening would likely be necessary.

6. Recent budget data suggest a more favorable budget outlook for the current year (FY 2005, ending September 30) and beyond. Reflecting strong and broad-based revenue growth through June, the Administration’s Mid-Session Review lowered the projected unified deficit for this year to $333 billion (2¾ percent of GDP), compared with the February estimate of $412 billion (3½ percent of GDP). Stronger revenues have also led to a reduction in anticipated deficits of around ½ percent of GDP in subsequent years. Consequently, after remaining at 2¾ percent of GDP in FY 2006, the unified federal deficit is now projected to fall to almost 1 percent of GDP by FY 2010, even including some costs in FY 2009 and FY 2010 from the assumed introduction of Personal Retirement Accounts.

7. Limited further progress has been made on moving ahead with Social Security reform. A consensus has yet to emerge in Congress on steps to reduce the Social Security system’s actuarial deficit or whether Personal Retirement Accounts (PRAs) should be introduced, and debate on reform options has been postponed until after the August recess.

8. Legislative work on corporate pensions, energy policy, and the Central America Free Trade Agreement continues. A reconciliation of energy bills passed by the two chambers is underway. A corporate pension reform bill that would tighten defined-benefit pension funding requirements is on track for a vote by the full House. The Central America Free Trade Agreement has passed the Senate, but has yet to be voted on in the House.

United States: Unified Budget

(Percent of fiscal year GDP)

Source: Office of Management and Budget.

¹Compared to the FY 2006 budget, this includes an allowance for costs of operations in Iraq and Afghanistan in FY 2006 as well as PRA expenses of $25b in FY 2009 and $50b in FY 2010.

United States: Unified Budget

(Percent of fiscal year GDP)

			FY 2004	FY 2005	FY 2006	FY 2007	FY 2008	FY 2009	FY 2010
FY 2006 Mid-Session Review1
	Outlays		19.8	20.1	20.2	19.5	19.1	19.0	19.1
		Net interest expense	1.4	1.5	1.6	1.7	1.7	1.7	1.8
	Revenue		16.3	17.4	17.5	17.7	17.9	17.9	18.1
	Unified balance		-3.6	-2.7	-2.6	-1.7	-1.1	-1.1	-1.1
FY 2006 Budget
	Outlays		19.8	20.3	19.9	19.5	19.2	19.1	19.0
		Net interest expense	1.4	1.5	1.6	1.8	1.9	1.9	2.0
	Revenue		16.3	16.8	16.9	17.2	17.5	17.5	17.7
	Unified balance		-3.6	-3.5	-3.0	-2.3	-1.7	-1.5	-1.3
Difference
	Outlays			-0.1	0.3	-0.1	-0.2	-0.1	0.1
		Net interest expense		0.0	-0.1	-0.1	-0.2	-0.2	-0.2
	Revenue			0.6	0.7	0.5	0.5	0.4	0.3
	Unified balance			0.8	0.4	0.6	0.6	0.5	0.2

Source: Office of Management and Budget.

¹Compared to the FY 2006 budget, this includes an allowance for costs of operations in Iraq and Afghanistan in FY 2006 as well as PRA expenses of $25b in FY 2009 and $50b in FY 2010.

View Table

United States: Unified Budget

(Percent of fiscal year GDP)

			FY 2004	FY 2005	FY 2006	FY 2007	FY 2008	FY 2009	FY 2010
FY 2006 Mid-Session Review1
	Outlays		19.8	20.1	20.2	19.5	19.1	19.0	19.1
		Net interest expense	1.4	1.5	1.6	1.7	1.7	1.7	1.8
	Revenue		16.3	17.4	17.5	17.7	17.9	17.9	18.1
	Unified balance		-3.6	-2.7	-2.6	-1.7	-1.1	-1.1	-1.1
FY 2006 Budget
	Outlays		19.8	20.3	19.9	19.5	19.2	19.1	19.0
		Net interest expense	1.4	1.5	1.6	1.8	1.9	1.9	2.0
	Revenue		16.3	16.8	16.9	17.2	17.5	17.5	17.7
	Unified balance		-3.6	-3.5	-3.0	-2.3	-1.7	-1.5	-1.3
Difference
	Outlays			-0.1	0.3	-0.1	-0.2	-0.1	0.1
		Net interest expense		0.0	-0.1	-0.1	-0.2	-0.2	-0.2
	Revenue			0.6	0.7	0.5	0.5	0.4	0.3
	Unified balance			0.8	0.4	0.6	0.6	0.5	0.2

Source: Office of Management and Budget.

¹Compared to the FY 2006 budget, this includes an allowance for costs of operations in Iraq and Afghanistan in FY 2006 as well as PRA expenses of $25b in FY 2009 and $50b in FY 2010.