2008 Economic Report of The President

8/8/2019 2008 Economic Report of The President

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Transmitted to the Congress February 2008

Together with the Annual Report

of the Council of Economic Advisers

Economic

Reportof thePresident


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Economic Report

of the President

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: (866) 512-1800; DC area (202) 512-1800

ISBN 978-0-16-079822-1

Transmitted to the CongressFebruary 2008

together withTHE ANNUAL REPORT

of the

COUNCIL OF ECONOMIC ADVISERS

UNITED STATES GOVERNMENT PRINTING OFFICE

WASHINGTON : 2008

Fax: (202) 512-2104 Mail Stop: IDCC, Washington, DC 20402-0001


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C O N T E N T S

ECONOMIC REPORT OF THE PRESIDENT .............................................

ANNUAL REPORT OF THE COUNCIL OF ECONOMIC ADVISERS* ...

CHAPTER . THE YEAR IN REVIEW AND THE YEARS AHEAD ...........

CHAPTER . CREDIT AND HOUSING MARKETS ..................................

CHAPTER . THE CAUSES AND CONSEQUENCES OF EXPORTGROWTH ........................................................................................................

CHAPTER . THE IMPORTANCE OF HEALTH AND HEALTHCARE ................................................................................................................

CHAPTER . TAX POLICY ...........................................................................

CHAPTER . THE NATIONS INFRASTRUCTURE ..................................

CHAPTER . SEARCHING FOR ALTERNATIVE ENERGYSOLUTIONS ....................................................................................................

CHAPTER . IMPROVING ECONOMIC STATISTICS ............................

APPENDIX A. REPORT TO THE PRESIDENT ON THE ACTIVITIESOF THE COUNCIL OF ECONOMIC ADVISERS DURING 00 .............

APPENDIX B. STATISTICAL TABLES RELATING TO INCOME,EMPLOYMENT, AND PRODUCTION ........................................................

9

9

0

* For a detailed table of contents of the Councils Report, see page 11

Page

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ECONOMIC REPORT

OF THE PRESIDENT


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ECONOMIC REPORT OF THE PRESIDENT

To the Congress of the United States:

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THE ANNUAL REPORT

OF THE

COUNCIL OF ECONOMIC ADVISERS


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LETTER OF TRANSMITTAL

Council of Economic Advisers Washington, D.C., February 12, 2008Mr. President:

T C E A b 00 AR E A 9 b F E B G A 9.

S,

E P. LzC


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overview .............................................................................................

chapter 1. the year in review and the years ahead ...................... D 00 N-T O .....................

C S S ............................................... H P ......................................................................... 9

R I ............................................................. 0B F I ........................................................ B I ................................................................. G P ............................................................. E I ................................................................. E ............................................................................. P .............................................................................. P W ...................................................................... 0

F M ..................................................................... T L-T O T 0....................................... G GDP L T ...................................... T C I L T ...................

C.....................................................................................

chapter 2. credit and housing markets ......................................... W C M? ..............................................................

R D M M .................................. C M D 00 ...............................................

C M L M............................................. F Q ...................................................................... C A-B C P M .... S M A A ................................... E M ......................................................................... I I ........................................................

P R C M D .............................. P R H M C ............................

A C C................................................. S M M F ..................

M I ......................................................... C.....................................................................................

C O N T E N T S

P


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chapter 3. the causes and consequences of export growth ....... 9T C R E G ........................................... 0

F I G ...........................................................

G D P .............................................. E R ......................................................................... T C B ..........................................................

E F D I ......................................... M T ......................................................... 90

T B T E E M .................. 9T Lb M .............................................................. 9C..................................................................................... 9

chapter 4. the importance of health and health care ............... 9H D H C ...................................... 9

D H .................................................................. 9T P H ........................................................ 9T H S ...................................................... 00T L E ........................................................ 0T H I C ...................................... 0

A C H C S ......................... 0M Hz C C .............................................. 0C C T C I M .... 0I Q C T I

Rb ...................................................................... P H B ....................................................

C.....................................................................................

chapter 5. tax policy ........................................................................ T Sz G: A H V ..................................

E 00 00 T C .............................. A M T ........................................................ 9R B C ................................................................... 9W T-D A ............................... 0

T I R T R ..........................................

Lb S ............................................................................ S I ............................................................. C F P G ............................. S T C I .................................... E B L T ...........................................

T S B T .................................................... C.....................................................................................


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C |

chapter 6. the nations infrastructure ......................................... T B C I P ................................. C S N I .................................. 0

R ....................................................................................... 0B ..................................................................................... R ................................................................................... C P ........................................................................ A .................................................................................... 9T E G ................................................................... T ................................................................

I P....................................................................... H S I B P F? .................................. H S G S P I

Pj? ................................................................................. W S G R P

I? ........................................................................ 9W A P R S F

G? .......................................................................... C.....................................................................................

chapter 7. searching for alternative energy solutions .............. E S ............................................................................... F F ............................................................................... T N T D ............................................................

A E P ....................................................... 0A G E ...................................... 0A T .................................................

T R F .........................................................................

P T ............................................................................. C E ......................................................................... C.....................................................................................

chapter 8. improving economic statistics ..................................... A O U.S. S S ..........................................

T I S S ............................................ 9K U C E ........................................ 9

I V E S D ........................... 9C..................................................................................... 0


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appendixesA. R P A C

E A D 00 .............................................. 0B. S Tb R I, E,

P .........................................................................

list of tales-. A E F ........................................... -. S-S C R GDP G, 9-0 ... -. A L-Y D R M S

C, US b D, 90-000 () .......................... 0-. C M T R C C

U T I T P ......................................... -. E Db E 00-00 T C

00 ..................................................................................... -. E M T R I ............................ -. E A Lz C (00 $/)

P E S 0 ................................................

list of charts

-. C N W R DbP I (DPI) .............................................................

-. N Db I .................................................................... - O H N B S ................... 9-. C P I ......................................................... 0-. P M 90 D P D I P

F ............................................................................... -. C Jb M R, 0-Y F R

M ................................................................................. 0-. T- L Ib O R R

-M T B ............................................................ -. S B C B Y R 0-Y

T N ......................................................................... -. C P O ............................................... -. V A M A D ................. -. M FHA M E ...................................

-. L S .................................................................... -. U.S. E A S G D P ................ 0-. A Az G U.S. E T

P, 00-00 ................................................................. -. R G U.S. E F G D

P.....................................................................................


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C |

-. G U.S. G E F T AP, 00-00 .................................................................

-. I U R, 90-00 ................... 9-. N H E A S G D

P..................................................................................... 00-. L E B A .................................... 0-. H I C b S: 9 00 .............. 0-. F R ........................................................................ -. F R Pj ..................................................... -. R P D I ............................................... -. F O Pj ...................................................... 0-. V M T L-M R U.S.,

90-00 ................................................................................ -. A D P-P T, b Ub A Sz,

9-00 ................................................................................ -. C U.S. H B, 99-00 ..................... -. Db U.S. F S b M .................... -. C T U.S. M P ..................................... -. A T T, N Y (LGA) A (ATL)

9-00 ................................................................................ 0-. H-S I L U S b T

C, 999-00 ........................................................... -. W C I U.S.,

9-00 ................................................................................ -. U.S. E C P (00) .................. -. U.S. E C b S S (00) .......... -. U.S. CO E C (00) ........... 9-. B A P S A, F

Y 00 ................................................................................. 9

-. R F A E S ................ 90-. F S A - 0- Y

C ................................................................................... 9

list of oxes-. I E H S ...................................... 0-. M E W O P I A I

b F D ................................................................. -. A P Lb F P ................. -. D S M T ...................................... -. C R A ............................................................. -. G V H M ............................. -. Sz S F ...................................... 0


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-. M L T ......................................................... 9-. T S ...................................................................... -. T C A D ................................................... -. O I U S ................................... 9-. H E Jb P ........................................... 99-. G H C P ......................................... 0-. M P B ............................................................ 9-. E C R R ........................... -. T I H S ................................................ -. D N Y C A ............................................ -. O P .................................................................................. -. T B W ........................................................................ 9-. H R D S I:

I S C P I............... 9-. T C I P S

E A (CIPSEA) .......................................................... 99


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O

T U.S. , . T 00, ( C ). E 00. M 00, b . T b bb , b P . Rz

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T U S

; b ( C). L b b b b b ( C ). T b b - , b , ,

( C , , , ). A .I b b ( C ).


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| E R P

C : T Y R Y A

E 00.

T , , . S U.S. b, - . Pj 00 - b , , P C - . C A . T : RealGDPpostedsolid2.5percentgrowthduringthe fourquartersof

00, . C , b , b GDP 00 00 b 00 00.

Labor markets were tight in the first half of 2007, but conditions , jb .

.0 b Db. Energy prices dominated the movement of overall inflation in the

(CPI), . C ( ) . 00 . 00. F b .

Nominalwagegainsof3.7percentforproductionworkerswereoffsetb . T , ,

. The Administrations forecast calls for the economic expansion to

00, b . S , 00 j 00 . I 009 00, GDP j , j b b .

Thecontractionof the secondarymarketforsomemortgagesecurities - j . A 00, , .


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O | 9

C : C H M

I 00, U.S. b .

C , b b . T : Risingdelinquenciesinsubprimemortgagesrevealedanapparentunder-

b , b b .

TheFederalReserveprovidedliquidityand tookmeasures tosupport b

. TheAdministrationfocuseditsresponseonhousingmarketsandhelping , b b jb- .

Participants in the credit and housingmarkets are actively addressing 00. M b ; , .

Financialinnovationsinthemortgageandcreditmarketshaveprovided b, b . O , b .

Themacroeconomiceffectsof thedownturn inhousingandthecredit , , , b .


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0 | E R P

C : T C C E G

O b

U.S. . T b - , .C - .M b, b . T : TheUnitedStatesistheworldslargestexporter,with$1.5trillioningoods

00. T U S , b G.

In recent years, factors that have likely contributed to the growth in , U S, . O U.S. 00 00.

Overtime,fallingtariffsandtransportandcommunicationcostshave

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Open trade and investment policies have increased access to export U.S. . I b b U.S. .

GreaterexportopportunitiesgiveU.S.producersincentivestoinnovate . I bz

U.S. z. Nearly all economists agree that growth in the volume and value of , b b b . T A b .


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O |

C : T I H H C

T A

b , - . T b, b b , , , A. C . T : Healthcanbeimprovednotonlythroughtheappropriateconsumption

, b b

, , .

Healthcarehasenhancedthehealthofourpopulation;greaterefficiency , , A .

Rapidgrowthinhealthcarecostsandaccesstohealthinsurancecontinue .

Administration policies focus on reducing cost growth, improving

, -b .

C : T P

E b . T b

- , b b . T : TheratiooffederaltaxationintheUnitedStatestogrossdomesticproduct

(GDP) . 0 ; P 00 00 , . 00, b 0- . U ,

b .


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Tax reductions in 2001 and 2003 have considerably lowered the b b . M - .

In addition to contributing to growth, the tax cuts of 2003 also b b .

Thebusinesstax structure intheUnitedStatesstillcreatessubstantial. T b , U S b b b , .

C : T N I

O , ,, . A , b.C j, , . T : Infrastructuretypicallyrequires largecapital investments tobuildand

. O b, , . T b b b G- , , b G .

DemandsontheU.S.infrastructuregrowastheeconomyexpands,andG . P b b .

Thepricepeople pay for using infrastructure should reflect the extra . T , b .

Theprivatesectorplaysan important roleinprovidinginfrastructure.H, b , G . T G .


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O |

C : S AE S

E : -

, , , b b. E - . C : . T : Thecurrentsuiteofavailablealternativeenergysourcesisanimportant

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b . There are several promising, but currently unproven, methods of

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Appropriate and limited government action can play a useful role in z .

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Robuststatisticalsystemsproduceproductsthatareimportanttounder- . B , , bb .

Statistical measures must keep up with the changing nature of the b . F , ( - ) b (

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Moreeffectivestatisticalusecanbemadeofexistingdata.Inparticular, b C I P S E A(CIPSEA) F .


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25

C H A P T E R 1

Th Yr in Rviw nd th Yrs Ahd

Th xpnsion of th U.S conomy continud for sixth conscutivyr in 2007. Economic growth ws soid t 2.5 prcnt during thfour qurtrs of th yr, sighty ow th pc during 2006. Pyro jogrowth st rcord for continuous growth, cipsing th prvious rcord of48 months. This conomic growth cm dspit rorinttion of th U.S.conomy wy from housing invstmnt nd towrd xports nd invstmntin usinss structurs. Th prsistnt tum in housing invstmnt sutrctd

roughy prcntg point from r Gross Domstic Product (GDP) growthduring th four qurtrs of th yr. Athough th qurtry pttrn of rGDP ws unvn, with strong growth in th scond nd third qurtrs ndwk growth in th first nd fourth qurtrs, much of th qurtr-to-qurtrvrition cn ttriutd to nt xports, voti componnt of GDP. Inth wk of mounting proms with th prformnc of subprime(dfinds highr risk) mortggs, finnci mrkts from August onwrd wrunsttd cus of concrns out th risk ntid in hoding som typs

of mortgg-ckd scuritis, s w s frs out th finnci hth ofsom firms nd th possiiity of contgion to th nonfinnci conomy. Toinsur ginst th downsid risks from ths finnci nd housing-rtddvopmnts, th Prsidnt cd for n conomic growth pckg to oostconsumption, usinss invstmnt, nd or dmnd.

Th cor CPI (consumr prics xcuding food nd nrgy) s w s th price indexfor GDP (covring vrything producd in th Unitd Stts)suggstd tht inftion hd movd owr nd into th modrt rng y

th nd of 2007. Food pric inftion cimd, howvr, whi nrgy pricsjumpd towrd th nd of th yr. In rspons to ths output nd inftiondvopmnts, th Fdr Rsrv hd th Fdr funds rt ft through August. Th Fdr Rsrv thn owrd its poicy rt y prcntgpoint from Sptmr through Dcmr nd nothr 1 prcntg pointin Jnury to s iquidity concrns in finnci mrkts disturd y thmortgg mrkt tum, nd to ostr r ctivity. Th Fdr Rsrv sotook othr iquidity-nhncing msurs, incuding cutting th discount rtt which it nds to nks, nd inititing nw uction pproch to providcotrizd ons to nks.

This chptr rviws th conomic dvopmnts of 2007 nd discusssth Administrtions forcst for th yrs hd. Th ky points of thischptr r:


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26 | Economic Rport of th Prsidnt

R GDP postd soid 2.5 prcnt growth during th four qurtrs of2007, simir to th pc of yr rir. Th rorinttion of ggr-gt dmnd tht gn in 2006 continud in 2007. Comprd withth prcding yrs of th xpnsion, this rorinttion incudd morgrowth from xports nd usinss fixd invstmnt, whi rsidntiinvstmnt fippd from contriuting positivy to GDP growth from2003 to 2005 to sutrcting from it in 2006 nd 2007.

Lor mrkts wr tight in th first hf of 2007 with jo growthvrging 107,000 pr month nd th joss rt t 4.5 prcnt. Lormrkt conditions scknd somwht in th scond hf, with jogrowth sowing to 82,000 pr month nd th unmpoymnt rt dgingup to 4.7 prcnt in th third qurtr nd to 5.0 prcnt y Dcmr.

Enrgy prics, which tnd to voti, domintd th movmnt of

ovr inftion in th consumr pric indx (CPI), with rg incrsstowrd th nd of th yr. Cor consumr inftion (which xcudsfood nd nrgy inftion) movd down from 2.6 prcnt during th12 months of 2006 to 2.4 prcnt in 2007. Food prics ros pprciyfstr thn cor prics.

Nomin wg gins of 3.7 prcnt for production workrs wr offsty th unxpctd ris in nrgy prics. Ths nomin gins, howvr,xcdd msurs of xpctd pric inftion such s thos from th

mrkt for th Dprtmnt of Trsurys inftion-protctd scuritis,out 2.2 prcnt. As consqunc, th pc of nomin wg incrssimpis n xpcttion of r wg gins during th nxt svr yrs.In th ong run, r wgs tnd to incrs with or productivity.

Th Administrtions forcst cs for th conomic xpnsion tocontinu in 2008, ut t sowr pc thn in th rir yrs of thisxpnsion. Sowr growth is nticiptd for th first hf of th yr,nd th vrg unmpoymnt rt for 2008 is projctd to mov up

from th 2007 v. In 2009 nd 2010 r GDP growth is projctd t3 prcnt, thrftr sowing, whi th unmpoymnt rt is projctdto rmin st nd ow 5 prcnt in th 200910 priod.

Th contrction of th scondry mrkt for som mortgg scuritisnd th nsuing writ-downs t mjor finnci intrmdiris r nwdownsid risk to this xpnsion. As of th nd of 2007, howvr, thsdvopmnts hd not grty ffctd th nonfinnci conomy outsidof th housing sctor (which hd rdy n in dcin for yr or so

for th onst of th mortgg finncing proms). To insur ginst th downsid risks from ths nw finnci dvop-mnts, th Prsidnt proposd tx rif nd chngs to dprcitionschdus tht rduc th cost of usinss invstmnt. Th poicychngs r xpctd to oost r GDP growth nd jo crtion.


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Chptr 1 | 27

Dvopmnts in 2007 nd thNr-Trm Outook

Th conomy wnt through priod of rncing tht gn in 2006

nd xtndd into 2007, with fstr growth in usinss structurs invstmntnd xports offstting pronouncd dcins in homuiding, whi consumrspnding growth dgd owr.

Consumr Spnding nd SvingR consumr spnding sowd to 2.5 prcnt growth rt during th

four qurtrs of 2007, somwht ow th growth rts during th prcding4 yrs of xpnsion nd ow th vrg rts of th prcding 30 yrs.Nomin consumr spnding (tht is consumr spnding without djustingfor inftion) pud ck from its 16-yr pttrn of rising fstr thn disposincom, nd th prson sving rt for th yr s who tickd upfrom 0.4 to 0.5 prcnt. Fctors tht hd pushd down th sving rt duringrcnt yrs shiftd into nutr: th wth-to-incom rtio ptud ndth unmpoymnt rt (which is rtd to consumr confidnc) stoppdfing. Enrgy costs ros rpidy, ut consumrs continud to purchssimir quntitis of nrgy, which kpt th prson sving rt ow. Thgnr dcin in th prson sving rt during th pst 5 yrs (dspit thuptick in 2007) continud ong-trm trnd tht gn in th 1980s.

Energy ExpendituresWord dmnd for crud oi incrsd y 5.5 miion rrs pr dy to

85 miion rrs pr dy twn 2003 nd th first thr qurtrs of 2007.Th Unitd Stts ccountd for ony frction (0.7 miion rrs pr dy)of this incrs, whi dmnd in othr OECD countris gnry f. (Th

OECD, or Orgniztion for Economic Cooprtion nd Dvopmnt,compriss 30 ky dvopd conomis.) Th incrs in non-OECDdmnd totd 5.3 miion rrs pr dy, with Chins pr-dy consump-tion on growing y 2.0 miion rrs. In th fc of this incrs in wordoi dmnd, consumrs pid highr prics to mintin thir consumption.

Crud oi prics ros gin in 2007. Th spot pric for Wst TxsIntrmdit ( nchmrk vrity of crud oi) ros to n vrg of $91pr rr in th fourth qurtr from n vrg of $66 pr rr in 2006.

Th pric of ntur gs, which ros shrpy in 2005, thn f during 2006,ws itt chngd on nc in 2007, whi ctricity prics continud thirupwrd trnd.

With th ris in nrgy prics, th shr of nrgy in tot purchss rosshrpy. From 2003 to 2007, consumr nrgy prics incrsd 41 prcnt


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rtiv to non-nrgy prics, whi r consumption of nrgy pr houshodf ony 3 prcnt (ccording to dt from th Ntion Incom nd ProductAccounts). As rsut, nrgy xpnditurs, which wr out 5 prcnt ofconsumr purchss in 2003, ros to 6 prcnt of consumr purchss in 2006nd 2007. Btwn 2004 nd 2006, consumrs ppr to hv mintindoth nrgy nd nonnrgy consumption y rducing thir prson sving,which y 2007 (though up from 2006) vrgd ony 0.5 prcnt of dispos- prson incom. This continud rpid ris in nrgy prics suggsts thtconsumrs dpttion to ths prics rmins unfinishd. Consumrs hvchosn to rspond to th nrgy-pric shock y using svings to uffr somof its ffcts, ut this rspons is proy tmporry.

Wealth Effects on Consumption and Saving

Houshod wth ros rpidy rtiv to dispos prson incomfrom 2002 through th scond qurtr of 2007, supporting th growth ofconsumption nd dcin in th sving rt. Ovr th 200207 priod, thrtio of houshod wth to nnu-incom incrsd 0.7 yrs, to 5.7 yrs ofccumutd incom (tht is, consumrs coctivy ccumutd n xtr 70prcnt of yrs incom). During th t 1990s nd gin during 200406, strong ris in houshod nt worth coincidd with siz incrs inconsumr spnding rtiv to dispos prson incom (Chrt 1-1).


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Chptr 1 | 29

Unik rcnt yrs, howvr, th 2007 gins did not rfct rg incrssin housing wth (nt of mortgg dt), which pkdrtiv toincomin th first hf of 2006, nd hs dgd owr sinc (s Chrt1-1). Th housing pric ris of 1.8 prcnt during th yr tht ndd withth third qurtr of 2007 ws sustnti dcrtion from th 11 prcntnnu rt during th 3 prcding yrs nd ws ss thn th growth ofincom. Stock-mrkt wth ros during th four qurtrs through th thirdqurtr of 2007 (th most rcnt wth dt) nd ccountd for of thfour-qurtr gin. By th third qurtr of 2007, th ovr wth-to-incomrtio ws w ov its 50-yr vrg.

Projected Consumer SpendingLooking hd, th pth of consumr spnding is projctd to rfct th

rcnt fttning of th wth-to-incom rtio. R consumr spndingduring th four qurtrs of 2008 is xpctd to grow 2.1 prcnt, downfrom n vrg of out 3 prcnt during th pst 3 yrs. This projctdrt is ss thn th projctd 2008 growth ofreal disposable personal income(houshod incom ss txs, djustd for inftion), nd so th sving rtis forcstd to continu dging up in 2008. Aftr tht, r consumption isprojctd to incrs t out th sm pc s r GDP nd r incom.

Housing PricsNtiony, nomin hous pric pprcition sowd to crw in 2007,

nd hous prics f whn corrctd for inftion. An inftion-djustdvrsion of th housing pric indx (th nomin vrsion of which is compidy th Offic of Fdr Housing Entrpris Ovrsight (OFHEO) from homss nd ppriss during rfinncing) incrsd t n vrg nnu rt of6.3 prcnt from 2000 to 2005. It thn sowd to 4.0 prcnt during th fourqurtrs of 2006, nd dcind t 3.2 prcnt nnu rt during th firstthr qurtrs of 2007. (Ths inftion-djustd prics r dftd y thconsumr pric indx.) Th homs covrd y this OFHEO-crtd housingpric indx r thos which r finncd or rfinncd y on of th govrn-mnt-sponsord housing ntrpriss nd must thrfor hv mortggsow th conforming on imit (currnty $417,000). Anothr rvntmsur of hom prics (th S&P/Cs-Shir Indx), hs fn 6.7 prcntin r trms during th yr tht ndd with th third qurtr of 2007; thisindx covrs smr portion of th country thn th OFHEO msur utis mor comprhnsiv with rgrd to homs with rg mortggs.

Th dcrtion of housing prics ong with fing stndrds forsuprim mortggs in 2005 nd 2006 hs d to rising dinquncy rt forsuprim djust-rt mortggs (whr th rt on th mortggs rstsftr n initi priod), which svry disruptd th scondry mrkt for


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nonconforming mortggs in 2007. In contrst, th mrkt for conformingmortggs continud to function w. (Conforming ons must mt crtinon-to-vu nd documnttion rquirmnts in ddition to ing owth conforming on imit.) S Chptr 2, Crdit nd Housing Mrktsfor mor xtnsiv nysis.

Rsidnti InvstmntEvry mjor msur of housing ctivity droppd shrpy during 2006 nd

2007, nd th drop in r rsidnti construction ws stpr thn ntici-ptd in st yrs Report. Housing strts (th initition of homuidingprojct), nw uiding prmits, nd nw hom ss hv fn mor thn40 prcnt sinc thir nnu pks in 2005. Th drop in hom-construction

ctivity sutrctd n vrg of most 1 prcntg point t n nnu rtfrom r GDP growth during th st thr qurtrs of 2006 nd th fourqurtrs of 2007. Furthrmor, vn if housing strts v off t thir currntpc, gs twn th ginning nd comption of construction projctimpy tht rsidnti invstmnt wi sutrct from GDP growth during thfirst hf of 2008.

During 2007, s in 2006, mpoymnt in rsidnti construction f, sdid production of construction mtris nd products ssocitd with nw

hom ss (such s furnitur, rg ppincs, nd crpting). Yt dspitths housing sctor dcins, th ovr conomy continud to xpnd (sBox 1-1).

Box 1-1: Indirect Effects of the Housing Sector

Thus far, the sharp drop in homebuilding has not prevented robust

activity outside of the housing sector. Employment fell in sectors related

to new home construction and housing sales. Despite these repercus-

sions, overall payroll employment continued to increase, and real

consumer spending continued to move upward through the end of 2007.

The unemployment rate, however, increased, by 0.6 percentage point

during the 12 months of the year.

Although residential investment fell sharply, real GDP growth during

2007 was sustained by increases in other forms of investment. As

shown in the chart below, private and public nominal nonresidential

construction (that is, construction of office buildings, shopping centers,factories, and other business structures) grew rapidly during the year.

continued on the next page


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Chptr 1 | 31

Nonresidential construction draws from some of the same resources

(such as construction labor and materials) as the residential construction

sector. The high level of residential investment during the past couple of

years may have limited the growth of investment in nonresidential struc-

tures. While the case for housing crowding out other sectors is strongest

for nonresidential investment, residential investment competes with all

other sectors of production in credit and labor markets. A drop in the

share of the economy engaged in housing could provide some room for

other sectors to grow.

The housing market could also affect the rest of the economy through

the wealth channel. That is, declines in housing prices could reduce

household net worth and thereby reduce consumption. The increase in

housing prices during 20002005 contributed noticeably to the gain in

the ratio of household wealth to income (shown earlier in Chart 1-1) andsupported growth in consumer spending. In contrast, gains in housing

wealth came to a virtual halt during 2007.

Box 1-1 continued


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In ddition to incoms nd mortgg rts, th numr of homs uit isundrpinnd y dmogrphics. Homuiding during 2004 nd 2005 vr-gd out 2.0 miion units pr yr, in xcss of th 1.8- or 1.9-miionunit nnu pc of housing strts tht woud consistnt with somdmogrphic mods for dcd-ong priod, ding to n xcss suppy ofhouss on th mrkt. Mor rcnty, th 1.2 miion unit pc during thfourth qurtr of 2007 is w ow this ong-trm dmogrphic trgt. Thpc of homuiding hs now n ow this v for ong nough tht thov-trnd production of 2004 nd 2005 hs n offst y th mor rcntow-trnd production. Yt th construction of nw homs continud to frpidy through yr-nd 2007, with th undrshooting possiy rfctinguncrtin prospcts for hous prics s w s vtd invntoris of unsodnw nd xisting homs. Onc prics com firm nd invntoris rturn

to norm vs, hom construction shoud round, ut it is difficut topinpoint whn this wi occur. Th rsidnti sctor is not xpctd to mkpositiv contriutions to r GDP growth unti 2009.

Businss Fixd InvstmntDuring th four qurtrs of 2007 r usinss invstmnt in quipmnt

nd softwr (tht is, msurd t constnt prics) grw 3.7 prcnt, it

fstr thn th 2006 pc ut noty sowr thn th 8 prcnt vrgpc during th 3 prcding yrs. Its fstst-growing componnts during2007 incudd computrs, softwr, nd communiction quipmnt whiinvstmnt in industri quipmnt grw sowy. Trnsporttion quipmnt,howvr, f sustntiy du to nvironmnt rgutions (on prticutmttr missions issud in 2000 ut ffctiv in 2007) tht risd truck pricsin 2007 nd d trucking firms to dvnc hvy truck purchss into 2006from 2007.

In contrst to rsidnti invstmnt, r usinss invstmnt in nonrsi-dnti structurs grw t strong 16 prcnt nnu rt ovr th fourqurtrs of 2007. Th gins during 2007 wr th scond conscutiv yrof strong growth, which ws mrkd rvrs from th dcins during thpriod from 2001 to 2005. Nry 70 prcnt of tot growth in nonrsi-dnti structurs ws ccountd for y offic uidings, odging fciitis,powr fciitis, nd ptroum nd ntur gs xportion nd ws. Thissctor mintind its iity to orrow funds ndd for construction, s ntorrowing for nonfinnci corport commrci mortggs ros 6.5 prcntt n nnu rt during th first thr qurtrs of 2007.

On risk to th nr-trm invstmnt forcst is tht th rcnt turmoi inth mrkt for mortgg-ckd scuritis my somhow rduc th fundsvi for usinss invstmnt. Most nw invstmntt st for thcorport sctor s whois ing finncd with intrny gnrtd funds


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Chptr 1 | 33

for nw invstmnt (undistriutd profits pus dprcition, so known scash flow) which wr t norm vs through th third qurtr of 2007. Asfor th mount tht nonfinnci firms must orrow to finnc invstmnt(th finncing gp), th fows showd no shortf, t st through th thirdqurtr of 2007 (Chrt 1-2). A shortg of invstmnt funds, though possi,pprs uniky. Corportions hv n to finnc invstmnt dirctythrough th ond mrkt without pnty s intrst rts on 10-yr high-grd corport onds in th scond hf of 2007 wr itt diffrnt fromth first hf of th yr. Nvrthss th mrkt for invstmnt funds mritscos ttntion s yids on owr-grd corport onds hv dgd up, thnumr of nwy nnouncd vrgd uyouts hv fn shrpy, nd thOctor survy of snior on officrs rportd tightr nding stndrds forons to rg nd sm compnis.

Businss invstmnt growth is projctd to rmin soid in 2008, thoughproy ow th 7 prcnt growth rt during th four qurtrs of2007. Continud growth in output comind with tight or mrkt isxpctd to mintin strong dmnd for nw cpit. In th ongr run, rusinss invstmnt is projctd to grow sighty ov th growth rt ofr GDP.


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Businss InvntorisInvntory invstmnt ws voti during th pst yr or so nd hd

notic infunc on qurtr-to-qurtr fuctutions in r GDP, sp-ciy th wknss in th first nd fourth qurtrs nd th strngth in th

third qurtr. Invntoris of motor vhics on dr ots nd in trnsit wrn importnt contriutor to ths fuctutions s thy wr iquidtd duringth first hf of 2007, nd uit up in th third qurtr for ing iquidtdgin in th fourth qurtr. R nonfrm invntoris grw t ony n vrg0.2 prcnt nnu pc during 2007, growth rt tht is w ow th pcof r GDP growth ovr th sm priod. Coming off ong-trm dcin,th invntory-to-ss rtio for mnufcturing nd trd (in currnt dors)ros in t 2006 for ing rducd shrpy in 2007.

Mnufcturing nd trd invntoris ppr to roughy in in withss s of Novmr 2007 nd do not ppr to rquir drmtic swings inproduction. Invntory invstmnt is projctd to firy st during thnxt svr yrs, s is gnry th cs for priods of st growth. Thovr invntory-to-ss rtio is xpctd to continu trnding owr.

Govrnmnt PurchssR Fdr consumption nd gross invstmnt grw 1.6 prcnt during

2007, sowdown from th 2006 pc. Qurtry fuctutions in thisspnding ctgory wr considr, with nry th votiity du to thdfns componnt. Dfns spnding pungd in th first qurtr of 2007ut grw rpidy during th scond nd third qurtrs of th yr.

Th dfns ppropritions ct for fisc yr (FY) 2007 providd$70 iion for oprtions in Afghnistn nd Irq. Th FY 2007 supp-mnt pproprition for dfns providd n ddition $107 iion forongoing oprtions in Afghnistn nd Irq. Anothr $70 iion in mr-

gncy funding for FY 2008 ws providd in th consoidtd ppropritionsct. Th first continuing rsoution for FY 2008 nd th dfns ppropri-tions ct for FY 2008 providd $17 iion for min-rsistnt vhics ndothr funding for Afghnistn nd Irq. Anothr suppmnt ppropritionfor oprtions in Afghnistn nd Irq is iky for FY 2008.

Nomin Fdr rvnus grw 12 prcnt in FY 2006 nd 7 prcnt inFY 2007. Ths rpid growth rts xcdd growth in outys nd GDP s who, nd th U.S. fisc dficit s shr of GDP shrnk from 3.6 prcnt

in FY 2004, to 1.9 prcnt in FY 2006, to 1.2 prcnt in FY 2007.R Stt nd oc govrnmnt purchss ros 3 prcnt during 2007,th scond conscutiv yr of modrt growth. This foowd 3 yrs ofitt chng. In th wk of th 2001 rcssion, this sctor f shrpy intodficit in 2002. Rvnus gn to rcovr in 2003, nd th sctor ws out ofdficit y 2005, owing for n incrs in stt nd oc consumption nd


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Chptr 1 | 35

invstmnt in 2006 nd 2007. This pttrn of dyd rspons to downturnsrsms th pttrn during th usinss-cyc rcovry of th 1990s.

Th Stt nd oc govrnmnt sctor sippd into sm dficit ovrth first thr qurtrs of 2007 rfcting strong growth in outys tht wrnot mtchd y n incrs in rvnus. In 2008, ony sow growth cn nticiptd for this sctors consumption nd gross invstmnt cus ofdcrting housing prics nd thir ffcts on proprty tx rciptswhichcompris out 20 prcnt of this sctors rvnus.

Exports nd ImportsR xports of goods nd srvics grw 8 prcnt during th four qurtrs

2007, th fourth yr of nnu growth in xcss of 7 prcnt. Th pc of

xport xpnsion rfcts rpid growth mong our trding prtnrs, xpndddomstic production cpcity, nd chngs in th trms of trd ssocitdwith xchng rt trnds twn 2002 nd 2006 tht md Amricn goodschpr rtiv to thos of som othr countris (Chptr 3 nyzs rcntxport growth in grtr dti). R GDP mong our dvncd-conomytrding prtnrs (tht is, th othr 29 mmr countris of th OECD) isstimtd to hv grown t rts of 3.3 nd 2.7 prcnt during th fourqurtrs of 2006 nd 2007, rspctivy, ftr growing t n vrg pc of

2.4 prcnt during th prcding 3 yrs. In ddition, th conomis of somof our mjor mrging-mrkt trding prtnrs such s Chin, Singpor,nd Indi r growing t rts of 8 to 11 prcnt pr yr, though thscountris rciv ony out 8 prcnt of our xports. Th OECD projctstht r GDP mong our dvncd-conomy trding prtnrs wi sow to sti-soid 2.4 prcnt growth rt during th four qurtrs of 2008. ThIntrntion Montry Fund projcts tht r GDP mong th group ofmrging mrkt conomis wi sow to sti-strong 7.4 prcnt growth rtfor 2008 s who.

Th fstst growth in U.S. goods nd srvics xports ws to Indi, utxports to Chin, Afric, nd th Midd Est so grw rpidy. Dspitth rpid growth of xports to ths mrging conomis, th EuropnUnion (EU) rmins th mjor ovrss xport dstintion, consuming ovr25 prcnt of our xports. By country, Cnd ccounts for th rgst shrof U.S. xports, t ovr 19 prcnt.

R imports grw 1.4 prcnt nnu rt during 2007, th sowst pcsinc 2001. R imports of nonptroum goods grw 1.2 prcnt during2007, so th sowst rt of incrs sinc 2001. R ptroum importshv dgd up 2.5 prcnt during 2007, whi nomin imports surgd49 prcnt du to rising oi prics. Th ris in oi prics hs n ss of drgon th U.S. conomy thn simir riss hv n cus it hs n offsty th strong growth in forign conomis, which hs oostd U.S. xports.


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Indd, th growth in forign conomis is wht hs rgy inducd thmuti-yr incrs in oi prics (Box 1-2).

Box 1-2: Macroeconomic Effects When Oil Price Increases AreInduced by Foreign Demand

The cost of imported crude oil increased nearly $40 per barrel from

2003 to 2007, the largest dollar increase on record. Earlier price increases

in 1973, 1979, and 1990 were followed by recessions, a development

that has not occurred during the current episode. What has happened

recently that has allowed the United States to maintain strong growth in

the face of this price surge?

Economic growth outside the United States increased about 2.1

percentage points from the 3.5 percent annual growth rate during the

15 years from 1989 to 2003 to a 5.6 percent annual rate during the 4

years from 2004 to 2007 according to estimates from the International

Monetary Fund. The increase in real GDP growth among our trading

partners probably caused an increase in both the demand for oil and the

price of oil, and also an increase in U.S. exports to our trading partners.

Rapidly growing countries (China, Russia, India, and Thailand) accounted

for much of the increase in oil demand during the 4 years from 2002 to



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Chptr 1 | 37

Th current account deficit (th xcss of imports nd incom fowsto forignrs ovr xports nd forign incom of Amricns) vrgd5.5 prcnt of GDP during th first thr qurtrs of 2007, down fromits 2006 vrg of ovr 6 prcnt. Th dcin in th currnt ccountdficit rfcts strong xport growth nd modrt import growth, though

domstic invstmnt continus to xcd domstic sving, with forignrsfinncing th gp twn th two.

EmpoymntNonfrm pyro mpoymnt incrsd y 1.14 miion jos during 2007,

n vrg pc of out 95,000 jos pr month. Th unmpoymnt rtros sighty ovr th sm priod, ticking up 0.6 prcntg point to 5.0prcnt. Th vrg unmpoymnt rt in 2007 ws 4.6 prcnt, qu to

th 2006 vrg. Both th 2007 vrg nd th Dcmr 2007 v ofth unmpoymnt rt wr ow th prviing rts in ch of th thrdcds of th 1970s, 1980s, nd 1990s.

Th srvic-providing sctor ccountd for of th yrs jo gins, sconstruction mpoymnt f du to continud wknss in th housingmrkt nd mnufcturing mpoymnt continud its downtrnd for thtnth conscutiv yr. (Dspit th jo osss, mnufcturing outputcontinus to incrs cus of rpid productivity growth.) Empoymnt in

mining (which incuds oi driing) ros 5.5 prcnt during 2007. Th goods-producing sctor hs ccountd for diminishing shr of tot mpoymntin ch of th pst fiv dcds. Eduction nd hth srvics (whichconstitutd 13 prcnt of mpoymnt t th nd of 2007) ddd th rgstnumr of jos, ccounting for 47 prcnt of tot jo growth.

2006 as shown in the chart. Countries showing the largest increases in oil

consumption tended to be those showing the largest growth rates during

the past 4 years. In addition, U.S. exports grew rapidly to those countriesthat have recently signed and implemented free trade agreements with

the United States (as discussed in Chapter 3).

An increase in real output growth among our trading partners of about

1 percent can be expected to increase our exports by about 1 percent as

well. The cumulative 9 percent higher growth among our trading part-

ners (2.1 percent for each of 4 years) could thus have generated as much

as $120 billion per year of exports. In comparison, the $40-per-barrel oil

price increase added about $150 billion per year to the Nations bill for

oil imports (at 3.7 billion barrels of oil per year).

Box 1-2 continued


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During th 12 months of 2007, th unmpoymnt rt for th mjorduction groups dgd up; it incrsd 0.3 prcntg point for thoshoding t st chors dgr, 0.4 prcntg point for thos whosduction ndd with high schoo dgr or thos with som cog, nd1.0 prcntg point mong thos who did not finish high schoo. By rc ndthnicity, th unmpoymnt rt for ck Amricns ros y 0.7 prcntgpoint, nd ws out 4 prcntg points ov th rt for whits, smrmrgin thn during most of th pst 35 yrs. Unmpoymnt rts mongwhits ros 0.4 prcntg point, nd mong Hispnics ros 1.4 prcntgpoints. By sx, th joss rt for oth dut mn nd dut womn incrsd0.5 prcntg point to 4.4 prcnt in Dcmr 2007.

Th mdin durtion of unmpoymnt dgd up from 7.5 to 8.4 wksduring th 12 months of 2007, foowing sustnti dcin during th

prcding 2 yrs. Th numr of ong-trm unmpoyd (thos whor joss for 15 wks or mor) ros y 426,000 ovr th sm priod. Athough this is not wcom dvopmnt, incrss in unmpoymntrts (nd impicity incrss in durtion s w) wr uit into st yrsAdministrtion forcst s th ow joss rts t th nd of 2006 wr notjudgd to sustin in th ong run.

Th Administrtion projcts tht mpoymnt wi incrs t n vrgpc of 109,000 jos pr month during th four qurtrs of 2008, for

picking up to 129,000 jos pr month in 2009. In th ongr run, thpc of mpoymnt growth wi sow, rfcting diminishing rts of orforc growth du to th rtirmnt of th y-oom gnrtion. ThAdministrtion so projcts tht th unmpoymnt rt wi dg up from2007 to 2008 s who, for rturning to 4.8 prcnt in 2010, th middof th rng consistnt with st inftion in th ong run.

ProductivityProductivity growth hs stndrd cycic pttrn. It usuy fs during

rcssion, grows rpidy during th ry stgs of rcovry, ut thn sowss th rcovry mturs. Th currnt usinss cyc gn on n unusunot, with strong productivity growth of 4.6 prcnt t n nnu rt (rthrthn th usu dcin) during th thr qurtrs of th 2001 rcssion. Aftrtht, th pttrn of productivity foowd mor-usu usinss-cyc pttrnwith strong (3.1 prcnt nnu rt) growth during th first 3 yrs of thxpnsion, foowd y sowing to 1 prcnt nnu rt during thmost rcnt 3-yr priod. Avrging cross th ntir 6-yr priod sincth usinss-cyc pk in th first qurtr of 2001, or productivity hsincrsd t 2.7 prcnt nnu rt. This pc is not significnty diffrntfrom th pc twn 1995 nd 2001. As cn sn in Chrt 1-3, trnd


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Chptr 1 | 39

in with 2.6 prcnt nnu rt of growth from 1995 to 2007 cptursmost of th movmnt of productivity ovr this priod.

Th continution of this roughy 2.6 prcnt growth in or produc-tivity is striking, givn ft or diminishd contriution from capitaldeepening (th incrs in cpit srvics pr hour workd). Th 1995 to2001 ccrtion my pusiy ccountd for y pickup in cpit dp-ning nd y incrss in orgniztion cpit (th invstmnts usinsssmk to rorgniz nd rstructur thmsvs, in this instnc in rsponsto nwy instd informtion tchnoogy). Aftr 2001, rducd rt ofcpit dpningon its ownwoud hv suggstd sowing in th rtof productivity growth. Productivity growth in th rcnt priod thrforpprs to supportd y fctors tht r mor difficut to msur thn thquntity of cpit, such s intngi invstmnts in tchnoogy nd usinssprctics.

Productivity growth is projctd to vrg 2.5 prcnt pr yr during

th 6-yr spn of th udgt projction (T 1-2, tr in this chptr),which is out th sm s th vrg nnu pc sinc 1995. Th projctdgrowth rt is sighty ow th 2.6 prcnt nnu pc discussd in styrs Report, nd rfcts th downwrd rvisions to r GDP nd othr


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output msurs nnouncd in th nnu rvisions to th Ntion Incomnd Product Accounts in Juy 2006 nd Juy 2007.

Prics nd Wgs

As msurd y th consumr pric indx (CPI), ovr inftion rosfrom 2.5 prcnt during th 12 months of 2006 to 4.1 prcnt during 2007(Chrt 1-4), with th incrs du to n ccrtion of food nd nrgyprics. Enrgy prics ccrtd from 2.9 prcnt incrs in 2006 to 17.4 prcnt incrs in 2007. Food prics incrsd 4.9 prcnt during2007, up shrpy from th 2.1 prcnt pc of th prvious yr. Cor CPIprics (tht is, xcuding food nd nrgy) incrsd 2.4 prcnt during 2007,down from 2.6 prcnt incrs yr rir.

Prics of ptroum products cimd 29.4 prcnt during 2007 whintur gs prics f sighty. Ectricity prics incrsd 5.2 prcnt, which ws ss thn th rt of incrs yr rir. As of t-Jnury 2008,futurs prics show tht mrkt prticipnts xpct crud oi prics to dgdown during 2008 from thir currnt high v whi ntur gs prics rxpctd to ris.

Th rpid incrs in food prics during 2007 rfcts wordwid gri-cutur suppy nd dmnd conditions, such s th drought in Austri (

mjor wht xportr), th dmnd for corn-sd thno, nd short-suppy


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Chptr 1 | 41

conditions for diry hrds. Th suppy constrints during 2007 for wht nddiry products ppr tmporry nd r xpctd to rturn towrd normduring 2008.

Th 0.2 prcntg point dcrtion of cor CPI prics ws ccountdfor primriy y rnt of shtr, which sowd to 3.1 prcnt rt ofincrs from 4.3 prcnt rt of incrs during th 12 months of 2006.Th Administrtion projcts tht th CPI wi incrs 2.1 prcnt in 2008,sighty ss tht th 2.4 prcnt rt of incrs of th cor CPI during 2007;nrgy nd food prics r xpctd to itt chngd in 2008 foowingthir rcnt rg incrss.

Houry compnstion (which ws out 62 prcnt of nonfrm usinssoutput) hs incrsd t roughy th sm 3 prcnt rt in 2007 s duringth prcding 2 yrs ccording to th Empoymnt Cost Indx (ECI) for

th privt sctor. Th wg nd sry indx grw 3.3 prcnt, itt chngdfrom 3.2 prcnt yr rir, whi growth of houry nfits sowd to2.4 prcnt. Anothr msur of houry compnstion from th productivitynd cost dtst incrsd sighty fstr thn th ECI.

Unit or costs (or compnstion pr unit of output) hv put itt, ifny, upwrd prssur on inftion thus fr, nd it pprs uniky tht thywi ovr th nxt yr. Unit or costs grw ony 0.7 prcnt t n nnurt during th first thr qurtrs of 2007 which is ss thn th 2.6 prcnt

growth in th GDP pric indx during th sm intrv.Avrg houry rnings of production or non-suprvisory workrs (who

constitut out 80 prcnt of tot mpoymnt on nonfrm pyros)incrsd 3.7 prcnt (in nomin trms) during th 12 months throughDcmr 2007somwht ow th pc yr rir of 4.3 prcnt.Ths nomin houry rnings wr outstrippd y th 4.4 prcnt incrsin th ovr CPI for wg rnrs, nd so r rnings f 0.7 prcntduring 2007 (foowing 1.8 prcnt gin in 2006). Evn so, th rcnt pc

of ths nomin wg incrss is ov vrious msurs of xpctd pricinftion (such s thos impid y th mrkt for inftion-indxd Trsuryscuritis), nd suggsts tht mpoyrs nd mpoys xpct gin in rrnings in 2008. Th sitution is simir to yr go, ut during 2007,pric inftion ws highr thn xpctd cus of shrp nd unnticiptdincrss in food nd nrgy prics. In th ong run, r houry compnstionincrss with productivity growth, which is projctd to rmin soid.

Among th mny vi msurs of inftion, th Administrtion

forcst focuss on two: th consumr pric indx nd th pric indx forGDP. Th CPI msurs prics for fixd skt of consumr goods ndsrvics. It is widy rportd in th prss, nd is usd to indx Soci Scuritynfits, th individu incom tx, Fdr pnsions, nd mny privt-sctor contrcts. Th GDP pric indx covrs prics of fin goods ndsrvics producd in th Unitd Stts, incuding consumption, invstmnt,


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nd govrnmnt purchss. In contrst to th CPI, its wights r not fixd,ut mov to rfct chngs in spnding pttrns. Of th two indxs, thCPI tnds to incrs mor rpidy, in prt cus it msurs fixd sktof goods nd srvics; th GDP pric indx incrss ss rpidy cus itrfcts th shifting of houshod nd usinss purchss wy from itms with incrsing rtiv prics nd towrd itms with dcrsing rtivprics. Additiony, th GDP pric indx (which incuds invstmnt goods)pcs rgr wight on computrs, which tnd to dcin in pric (on quity-djustd sis), whi th CPI pcs much rgr wight on rntnd nrgy.

Th wdg, or diffrnc twn th CPI nd th GDP msurs ofinftion, hs impictions for Fdr udgt projctions. A rgr wdg(with th CPI rising fstr thn th GDP pric indx) riss th Fdr

udgt dficit cus Soci Scurity nd Fdr pnsions ris with thCPI, whi Fdr rvnu tnds to incrs with th GDP pric indx. For givn v of nomin incom, incrss in th CPI so cut Fdr rvnucus thy ris th rckts t which highr incom tx rts ppy ndffct othr inftion-indxd fturs of th tx cod.

Is rising inftion prom for th Unitd Stts? Athough th CPIccrtd to 4.1 prcnt rt of incrs during 2007, th ccrtion wsntiry rsut of food nd nrgy pric incrss tht r not iky to

rptd. Nor do mrkt prticipnts xpct it to rptd, s is vidntfrom th w-nchord ong-run consumr pric inftion xpcttions inth mrkt for inftion-indxd scuritis. Furthrmor, most of th pricincrss for ptroum do not rfct prics chrgd y workrs or firms inth Unitd Stts cus 65 prcnt of ptroum is importd. Th GDPpric indx ttr cpturs th prics tht Amricns r chrging for thiror nd srvics, nd it dcrtd to 2.6 prcnt incrs during 2007from yr-rir pc of 2.7 prcnt. Prics for usinss invstmntwhich

is not cpturd in th CPIsowd noticy in 2007. In sum, ong runinftion xpcttions rmin st, nd inftion s msurd y th rod-sd GDP pric indx rmind modrt in 2007.

Finnci MrktsTh Wishir 5000 ( rod stock mrkt indx) incrsd 3.9 prcnt

during 2007, whi th Stndrd nd Poor 500 (n indx of th 500 rgstcorportions) incrsd 3.5 prcnt. This ws th fifth conscutiv yr ofstock mrkt gins, nd it foowd 3 yrs of dcins.

Yids on 10-yr Trsury nots ndd 2006 t 4.6 prcntnr th ownd of th historic rngnd f nothr 46 sis points during 2007. Thsyid droppd furthr in Jnury. Th ow v of ths ong-trm intrst rtsws du in prt to ow nd st ong-run inftion xpcttions.


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Th Administrtions forcst of short-trm intrst rts is roughy sdon finnci mrkt dt s w s survy of conomic forcstrs t th dttht th forcst ws dvopd in mid-Novmr. Th nr-trm forcst hsn ovrtkn y vnts s intrst rts hv fn noty sinc th forcstws finizd. Whtvr th strting point, th Administrtion projcts thrt on 91-dy Trsury is to dg up grduy to 4.1 prcnt y 2011nd thn rmin t tht v. At tht v, th r rt (tht is, th nominrt ss th rt of inftion) on 91-dy Trsury is woud cos to itshistoric vrg.

Th yid on 10-yr Trsury nots on Novmr 15 (whn th forcstws finizd) ws 4.17 prcnt. Th Jnury dcin in this yid mns thtthis nr-trm forcst hs so n ovrtkn y vnts. Th Administrtionxpcts th 10-yr rt to incrs, vntuy rching norm sprd

of out 1.2 prcntg points ovr th 91-dy Trsury-i rt y 2012.An incrs in yid so pprs to xpctd y mrkt prticipnts (svidncd y highr rts on 20-yr Trsury nots thn on nots with10-yr mturitis). As rsut, yids on 10-yr nots r xpctd to incrssomwht furthr, rching ptu t 5.3 prcnt from 2012 onwrd.

Th Long-Trm Outook Through 2013

During th sixth yr of xpnsion in 2007, th composition of dmndws rshuffd, procss tht is iky to continu in 2008. Th priod ofsomwht sowr-thn-norm growth tht gn in 2007 is iky to continuinto 2008. Thrftr, th conomy is projctd to xpnd t roughy stdyrt t or just ow 3.0 prcnt. Hving rchd v of rsourc utiiz-tion consistnt with st inftion y th nd of 2007, inftion wi rminin th ow-to-modrt rng currnty suggstd y cor inftion rts.

Pyro jo growth is xpctd to rmin soid whi th unmpoymnt rtis xpctd to itt chngd ovr th projction intrv (T 1-1). Thforcst is sd on consrvtiv conomic ssumptions tht r cos to thconsnsus of profssion forcstrs. Ths ssumptions provid soundsis for th Administrtions udgt projctions.

Growth in GDP ovr th Long TrmTh Administrtion projcts tht, foowing sight pickup of growth from

2008 to 2009, r GDP wi incrs t sowy diminishing rt from 2009through 2013, du to th xpctd rtirmnt of th y-oom gnrtion.Indd, r GDP is projctd to dcrt from 3.0 prcnt growth rtduring th four qurtrs of 2009 to 2.8 prcnt y 2013. Th vrg growthrt during this intrv is roughy in in with th consnsus of privt


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forcstrs for thos yrs. Aftr 2008, th yr-y-yr pc is cos to thstimtd growth rt ofpotential realGDP, msur of th rt of growthof productiv cpcity. (An conomy is sid to growing t its potntirt whn of its rsourcs r utiizd nd inftion is st. Th suppy-sid componnts of potnti GDP growth r prsntd in T 1-2 ndr discussd ow.) Th unmpoymnt rt is projctd to roughy ftin 2008 nd 2009 t round its Dcmr 2007 v for dging ck

down to 4.8 prcnt thrftr. As discussd ow, potnti GDP growth isxpctd to sow in th mdium trm s productivity growth rvrts towrdits ong-run trnd (out 2.5 prcnt pr yr), nd to sow furthr duringth priod from 2008 to 2011 s or forc growth dcins du to th rtir-mnt of th y-oom gnrtion.

Th growth rt of th conomy ovr th ong run is dtrmind y itssuppy-sid componnts, which incud popution, or forc prticiption,th rtio of nonfrm usinss mpoymnt to houshod mpoymnt, th

ngth of th workwk, nd or productivity. Th Administrtions for-cst for th contriution of th growth rts of diffrnt suppy-sid fctorsto r GDP growth is shown in T 1-2.

Th or forc prticiption rt gnry f from 2001 to 2007 ndis projctd to trnd owr through 2013. Th rcnt hvior stnds incontrst to th ong priod of incrs from 1960 through 1996. Looking

Table 1-1.Administration Economic Forecast1

YearNominal

GDP

Real GDP(chain-type)

GDP priceindex

(chain-type)

Consumerprice

index(CPI-U)

Unemploy-

ment

rate(percent)

Interestrate,

91-day

Treasurybills2

(percent)

Interestrate,

10-year

Treasurynotes

(percent)

Nonfarmpayrollemploy-

ment(average

monthlychange,

Q4-to-Q4,thou-

sands)3

Percent change, Q4-to-Q4 Level, calendar year

2006 (actual)........ 5.4 2.6 2.7 1.9 4.6 4.7 4.8 192

2007..................... 5.1 2.7 2.3 3.9 4.6 4.4 4.7 129

2008..................... 4.8 2.7 2.0 2.1 4.9 3.7 4.6 109

2009..................... 5.1 3.0 2.0 2.2 4.9 3.8 4.9 129

2010..................... 5.0 3.0 2.0 2.3 4.8 4.0 5.1 118

2011..................... 5.0 2.9 2.0 2.3 4.8 4.1 5.2 1122012..................... 4.9 2.8 2.0 2.3 4.8 4.1 5.3 102

2013..................... 4.9 2.8 2.0 2.3 4.8 4.1 5.3 92

1Based on data available as of November 15, 2007.

2Secondary market discount basis.

3The figures do not reflect the upcoming BLS benchmark which is expected to reduce 2006 and 2007 job growth by acumulative 300,000 jobs.

Sources: Council of Economic Advisers, Department of Commerce (Bureau of Economic Analysis and Economics andStatistics Administration), Department of Labor (Bureau of Labor Statistics), Department of the Treasury, and Office ofManagement and Budget.


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Chptr 1 | 45

Table 1-2.Supply-Side Components of Real GDP Growth, 19532013[Avrg nnu prcnt chng]

Item1953 Q2

to1973 Q4

1973 Q4to

1995 Q2

1995 Q2to

2001 Q1

2001 Q1to

2007 Q3

2007 Q3to

2013 Q4

1) Civilian noninstitutional population aged 16+1 ........................... 1.6 1.4 1.2 1.2 0.9

2) PLUS: Civilian labor force participation rate............................... 0.2 0.4 0.1 -0.3 -0.2

3) EQUALS: Civilian labor force2...................................................... 1.8 1.8 1.4 0.9 0.7

4) PLUS: Civilian employment rate ................................................. -0.1 0.0 0.3 -0.1 0.0

5) EQUALS: Civilian employment2 ................................................... 1.7 1.8 1.6 0.8 0.7

6) PLUS: Nonfarm business employment as

a share of civilian employment2,3..................................... -0.1 0.1 0.4 -0.5 0.0

7) EQUALS: Nonfarm business employment4.................................. 1.6 1.9 2.0 0.4 0.7

8) PLUS: average weekly hours (nonfarm business) ....................... -0.3 -0.3 -0.1 -0.2 0.0

9) EQUALS: Hours of all persons (nonfarm business)4 .................... 1.3 1.6 1.9 0.2 0.7

10) PLUS: Output per hour (productivity, nonfarm business)4 ........... 2.5 1.5 2.4 2.7 2.5

11) EQUALS: Nonfarm business output4 ........................................... 3.8 3.1 4.3 2.9 3.2

12) PLUS: Ratio of real GDP to nonfarm business output5................ -0.2 -0.2 -0.5 -0.3 -0.4

13) EQUALS: Real GDP ...................................................................... 3.6 2.8 3.8 2.6 2.8

1Adjusted by CEA to smooth discontinuities in the population series since 1990.

2BLS research series adjusted to smooth irregularities in the population series since 1990.

3Line 6 translates the civilian employment growth rate into the nonfarm business employment growth rate.

4Nonfarm employment, workweek, productivity, and output sourced from the BLS productivity and cost database.5Line 12 translates nonfarm business output back into output for all sectors (GDP), which includes the output of farms and

general government.

Note: 1953 Q2, 1973 Q4, and 2001 Q1 are NBER business-cycle peaks.Detail may not add to total because of rounding.

Sources: Council of Economic Advisers, Department of Commerce (Bureau of Economic Analysis) and Department of Labor(Bureau of Labor Statistics).

Box 1-3: Aging and the Pattern of Labor Force Participation

The overall labor force participation rate trended up to 67.1 percent

in 1997, and after holding steady between 1997 and 2000, has generally

edged lower during the past 7 years. Mens labor force participation ratesfell fairly steadily through 2004. Womens labor force participation rose

steadily through 1999, and has edged lower since then.



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Participation in the labor force (by working or by looking for a job)

declines as people age through their 50s and 60s as is shown for women

in the chart below. As a result, the overall rate of labor force participation

is projected to decline as the baby-boom cohorts (those born between

1946 and 1964) advance into age brackets with much lower participation

rates.

Female participation rises rapidly from age 20 to 24, drops off during

the child-rearing years, and then rises again to a maximum in the40 to 50 age bracket, as shown in the chart above. Looking at how the

shape of this age-participation profile has evolved shows some striking

changes: The participation rates of women in their 40s moved upward

rapidly from the cohorts born in 1928 to those born in 1948, but has not

risen any further in the years since. Also, the dip in participation during

the child-rearing years has become less pronounced. Neither of these

patterns of evolution suggests that the pre-1999 trend of rising female

participation will re-emerge. Although participation of women over age

55 rose dramatically from the cohort born in 1938 to the cohort born in1948, the age-participation profile of the cohort born in 1958 suggests

that this trend of rising participation of older women is unlikely to

Box 1-3 continued



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Chptr 1 | 47

continue. This follows because the 1958 cohort shows no advance in

participation at age 49 (their age in 2007) compared with somewhat

older cohorts (such as the 1948 or 1953 cohorts shown in the chart),

hinting that the rising participation rates for older women has plateaued.

Also, the drop in participation during the child-rearing years has almost

vanished, leaving only a little room for further increase among 25- to-35-

year-old women.

hd, th prticiption rt is projctd to dcin, rfcting th ging of thy-oom cohorts, ding to mor rtirmnts nd iky incrs in thshr of pop on disiity pnsions (Box 1-3).

Th Composition of Incom ovr th Long Trm

Th Administrtions conomic forcst is usd to stimt futur govrn-mnt rvnus, purpos tht rquirs projction of th componntsof tx incom. Th incom-sid projction is sd on th historicstiity of or compnstion s shr of gross domstic incom (GDI).During th first hf of 2007, th or compnstion shr of GDI ws 56.9prcnt (ccording to th priminry dt vi whn th projction ws

Box 1-3 continued


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finizd), ow its 19632006 vrg of 58.0 prcnt. From this jump-off point, th or shr is projctd to sowy rturn towrd its historicvrg, rching 57.7 prcnt y 2013. (Anothr dfinition of th orshrincuding th imputd wgs of th sf-mpoydis highr, out62 prcnt for th nonfrm usinss sctor.)

Th or compnstion shr of GDI consists of wgs nd sris (whichr tx), nonwg compnstion (mpoyr contriutions to mpoypnsion nd insurnc funds, which r not tx), nd mpoyr contri-utions for soci insurnc (which r not tx). Th Administrtionforcsts tht th wg nd sry shr of compnstion wi chng itttwn 2007 nd 2013.

As th or shr of GDI incrss towrd its historic vrg, th cpitshr of GDI is xpctd to dg down from its currnty high v for

vntuy rching its historic vrg in 2012. Profits during th first hfof 2007 wr out 11.6 prcnt of GDI, w ov thir post-1959 vrgof roughy 9 prcnt. Book profits (so known in th ntion incomccounts sprofits before tax) r xpctd to dcin s shr of GDI. ThGDI shr of othr tx incom (rnt, dividnds, propritors incom,nd prson intrst incom) is projctd to dg up sighty ovr th nxt2 yrs.

Concusion

Th conomy ntrd priod of rncing in 2006 nd 2007, s highrgrowth of nonrsidnti invstmnt nd xports offst th owr rts ofhousing invstmnt. This rncingnd th rducd rt of growth thtgos with itis projctd to continu in 2008. Th iprtisn conomicgrowth pckg cd for y th Prsidnt woud provid insurnc ginst

th nr-trm risks of ny rodr conomic sowdown rtd to finncind housing-rtd dvopmnts y providing oost to consumption,usinss invstmnt, nd jo crtion. Th conomy is projctd to sttinto stdy stt in which r GDP grows t out 2.9 prcnt pr yr,th unmpoymnt rt stys round th v consistnt with st inftion(out 4.8 prcnt) nd inftion rmins modrt nd st (out 2.3 onth CPI). Consumr spnding is projctd to grow in in with disposincom, nd usinss invstmnt nd xports r projctd to grow it fstr

thn GDP s who. Economic forcsts r sujct to rror, nd unforsnpositiv nd ngtiv dvopmnts wi ffct th cours of th conomyovr th nxt svr yrs. Givn th conomys strong sic structur, frmoiity of or, rtivy ow txs, w-ncd cpit mrkts, ndopnnss to trd, prospcts for continud growth in th yrs hd rmin


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Chptr 1 | 49

good. Ltr chptrs of this Reportxpor how pro-growth poicis such stx rform, fisc rstrint, opn commrc, nd mrkt-sd rforms cnnhnc our conomic prformnc.


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51

C H A P T E R 2

Crdit nd Housing Mrkts

In th summr of 2007, th contrction in th U.S. housing mrkt worsndnd crdit mrkts xprincd sustnti disruption. Dfut rts onsuprim mortggsprticury mor rcnt vintgs of djust-rtmortggsros rpidy. As rsut, invstors cm worrid out howmuch risk thy hd xposd thmsvs to y purchsing finnci scuri-tis ckd y ths mortggs. Finnci disruptions rippd through thU.S. nd word finnci mrkts s yids on mny privt dt scuritis

ros shrpy, whi invstor dmnd for thos scuritis drmticy f. As invstors sought th sfty of govrnmnt scuritis, dmnd for U.S.Trsury scuritis spikd upwrd, driving down thir yids.

Th Administrtion nd th Fdr Rsrv indpndnty rspondd toth suprim mortgg prom nd th finnci mrkt disruptions. ThAdministrtions poicy rspons ddrssd proms in th suprim ndingmrkt nd sought to improv th ong-run functioning of th housing ndcrdit mrkts through progrms such s FHASecure nd HOPE NOW.

FHASecurexpnds th Fdr Housing Administrtions (FHA) iity tooffr hom mortgg on rfinncing options y giving it th dditionfxiiity to hp not ony homownrs who r currnt on thir mortggpymnts, ut so orrowrs in dfut who hd md timy mortggpymnts for thir on intrst rts rst. HOPE NOW is n xmpof th govrnmnt ncourging mmrs of th privt sctorincudingndrs, on srvicrs, mortgg counsors, nd invstorsto idntify ndrch out to t-risk orrowrs nd hp mor fmiis sty in thir homs.

Th Fdr Rsrv ddrssd th risks to th conomy from finncimrkt disruptions y incrsing iquidity nd owring intrst rts, ndit ddrssd proms in th suprim mortgg mrkt y joining with itsfow suprvisory gncis to work on nw consumr protction rus nd toissu guidnc to nding institutions.

Dspit th mgnitud of th disruption in finnci mrkts, th impcton th rodr r conomy ws, t st through th fourth qurtr of 2007,rgy confind to rsidnti invstmnt, which hd n wk for out2 yrs. Nonthss, th tightning of crdit stndrds riss th possiiitytht spnding y usinsss nd consumrs coud rstrind in th futur.Dcins in housing wth my so imit consumr spnding.


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Th crdit mrkt disruptions ppr to rfct gnr rpricing of risk thtws triggrd, though not soy cusd, y suprim mortgg dinquncis,which wr in turn prti rsut of dcins in housing pprcition. Nwfinnci products, such s crtin mortgg-ckd scuritis, so ddd yr of compxity to th rcnt crdit mrkt disruptions. Ths scuritismrkdy xpndd iquidity in th mortgg mrkts nd providd mnyAmricns prviousy unvi opportunity to own thir own homs.

Th ky points from this chptr r: Rising dinquncis for suprim mortggs rvd n pprnt

undrpricing of risk nd risd concrns out which mrkt prtici-pnts wr xposd to tht risk, ut th suprim mrkt ws not thony cus for th contrction in crdit mrkts.

Th Fdr Rsrv providd iquidity nd took msurs to support

finnci stiity in th finnci mrkts in th wk of th disruptionsin th crdit mrkts.

Th Administrtion focusd its rspons on housing mrkts nd hpinghomownrs void forcosurin prticur, suprim orrowrsfcing incrss in th intrst rt on thir djust-rt mortggs.

Prticipnts in th crdit nd housing mrkts r ctivy ddrssingchngs tht wr rvd during th summr of 2007. Mrktsr gnry ttr suitd thn govrnmnt to dpting to chngs

in th conomic nvironmnt; mrkts cn rspond quicky to nwinformtion, whi govrnmnt poicy oftn rcts with g or hs dyd impct.

Finnci innovtions in th mortgg nd crdit mrkts hv providd rng of conomic nfits, ut not without som costs. Ovr tim,mrkts tnd to rtin vu innovtions nd rpir or imintfwd innovtions.

Th mcroconomic ffcts of th downturn in housing nd th crdit

mrkt disruptions my occur through svr chnns, incuding thdirct ffct on rsidnti invstmnt, th rduction of wth on prsonconsumption, nd tightr nding stndrds on usinss invstmnt.

Wht Ar Crdit Mrkts?

Thr r two primry wys to finnc ny conomic ctivity: through

quity or through dt. With equity financing, invstors tk ownrship shrsin n conomic vntur, such s invsting in nw compny, nd rcivsom frction of th futur rturns. With debtor credit financing, crditor


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Chptr 2 | 53

nds dtor mony tody, which th dtor must rpy with intrst in thfutur. Crdit coms in mny diffrnt forms: crdit crds, utomoi ons,mortggs, corport onds, nd govrnmnt onds. Scuritis whos vuis drivd from undrying ssts r cd derivativesor derivative securities.Credit marketsr th mrkts in which ons nd thir drivtiv scuritisr trdd.

Considr mortggs. Suppos prson wnts to purchs hous, utdos not hv nough csh on hnd to uy it. Th prospctiv orrowr (thdtor) uss his vi csh s down pymnt nd pprochs ndr(th crditor), who nds th orrowr th rmining mony ndd to covrth cost of th hous. Ovr tim, th orrowr rns incom from his jond pys off th mortgg (dt). Bcus mony tody is worth mor thnmony tomorrow, th ndr chrgs intrst on th mount of th on

(th princip). Th intrst rt must st high nough to compnst thndr for ring th risks ssocitd with th on ut ow nough to mkth on ttrctiv to th orrowr.

Mortggs, ik most forms of crdit, r sujct to thr forms of risk:credit risk(th risk tht th dtor wi dfut on th on), interest rate risk(th risk tht mrkt intrst rts wi fuctut), nd prepayment risk(thrisk tht th orrowr wi py off th on ry). Lndrs mk mony ychrging orrowrs intrst pymnts on top of th priodic rpymnts of

princip. Thrfor, th ndr is wors off if ths intrst pymnts stop,such s whn th orrowr dfuts on on or pys off th on ry in nnvironmnt of ow intrst rts. Mortgg ndrs my so fc th risk of oss of princip if proprty is forcosd upon. Lons with grtr risk hvhighr intrst rts to compnst th ndr for ring mor risk.

Rcnt Dvopmnts in Mortgg Mrkts

From 2001 to 2007, thr ws sustnti incrs in th us of suprimmortggs. (Box 2-1 dfins suprim mortggs nd othr mortggmrkt trminoogy.) Th shr of mortgg origintions tht wr suprimincrsd from 5 prcnt in 2001 to mor thn 20 prcnt in 2006. Suprimmortggs crry grtr risk thn prim mortggs. Mny suprimorrowrs hv poorr crdit historis nd ss ri sourcs of incom thnprim orrowrs; thy my provid itt or no documnttion of incom or

ssts from which thy cn py th mortgg; nd thy tnd to hv highon-to-vu rtios. As rsut, comprd with prim orrowrs, suprimorrowrs r mor iky to dfut on thir ons.


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Box 2-1: Definitions of Select Mortgage Terms

Adjustable-rate mortgage (ARM): Adjustable-rate mortgages have

an initial period with a fixed interest rate, after which the interest rate

adjusts at set periods. For example, a 3/1 ARM would have a set interestrate for 3 years, but after that the interest rate would adjust every year.

The adjusted interest rate is a function of some index market interest

rate, such as the London Interbank Offer Rate.

Conforming loan limit: The charter-required limit, as determined by

Federal regulators, placed on the size of loans that can be purchased by

Fannie Mae and Freddie Mac.

Default: A borrower defaults on a mortgage when he or she fails to

make timely monthly mortgage payments or otherwise comply with

mortgage terms. A mortgage is generally considered in default whenpayment has not been made for more than 90 days. At this point, fore-

closure proceedings against the borrower become a strong possibility.

Delinquency: A borrower is delinquent on a mortgage when he or she

fails to make one or more scheduled monthly payments.

Fannie Mae: Fannie Mae is the registered service mark of the Federal

National Mortgage Association, a U.S. Government-sponsored enter-

prise. Fannie Mae buys mortgage loans that meet certain criteria from

primary mortgage lenders and sells mortgage-backed securities with

guaranteed principal and interest payments. In return for this guaranty,

investors pay a fee to Fannie Mae. Fannie Mae also holds some of the

mortgages it purchases, and mortgage-backed securities it originates, in

its portfolio.

Fixed-rate mortgage (FRM): A mortgage with an interest rate that

remains the same throughout the life of the loan.

Foreclosure: A legal process in which a lender seeks recovery of

collateral from a borrower (in the case of home mortgages, the home

itself is the collateral), with several possible outcomes, including that

the borrower sells the property or the lender repossesses the home.

Foreclosure laws are based on the statutes of each State.

Freddie Mac: Freddie Mac is the registered service mark of the Federal

Home Loan Mortgage Corporation, a U.S. Government-sponsored enter-

prise. Freddie Mac buys mortgage loans that meet certain criteria from

primary mortgage lenders and sells mortgage-backed securities with

guaranteed principal and interest payments. In return for this guaranty,

investors pay a fee to Freddie Mac. Freddie Mac also holds some of the

mortgages it purchases, and mortgage-backed securities it originates, inits portfolio.

Jumbo loan: A loan that exceeds the conforming loan limit.



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Chptr 2 | 55

Strong hous pric pprcition in much of th country ginning in 2003providd confidnc tht riskir orrowrs coud siy rfinnc mortggs,using thir uit-up quity, shoud thy un to kp up with thirmonthy mortgg pymnts. This xpcttion of hous pric pprcition,

coupd with n incrsingy comptitiv nding nvironmnt, d ndrsto rx thir undrwriting stndrds nd offr products with fturs thtowrd monthy pymnts. Lons with ow initi pymnts, incudingsuprim ons, hpd furthr fd hous pric pprcition, nd incrsdth risk of vntu dfut nd forcosur du to thir futur intrst rtrsts. Som suprim ons wr trdition fixd-rt mortggs (FRMs)tht spcifid fixd intrst rt throughout th if of th on, whi othrs wr djust-rt mortggs (ARMs), with intrst rts tht foowd mrkt intrst rt, such s th

London Interbank Offer Rate(LIBOR), th

intrst rt t which nks nd to on nothr using th London mrkt.Aout 70 prcnt of suprim ARMs wr 2/28 or 3/27 hyrid ARMs. A2/28 hyrid ARM, for xmp, hs 2 yrs of pymnts t fixd introduc-tory intrst rt, ftr which it resetsto highr foting rt, nd thn fotsfor th rmining 28 yrs.

Prime loan: Loans made to borrowers that meet stringent lending and

underwriting terms and conditions. Prime borrowers have good credit

records and meet standard guidelines for documentation of debt-to-income and loan-to-value ratios.

Reset: An interest rate on an adjustable-rate mortgage is said to have

reset whenever it is adjusted, or moved, in the direction of the market

interest rate that it tracks.

Subprime loan: Loans that meet less stringent lending and under-

writing terms and conditions. Subprime borrowers may have weaker

credit histories characterized by payment delinquencies; previous

charge-offs, judgments, or bankruptcies; low credit scores; high debt-

burden ratios; high loan-to-value ratios; or little to no documentation toprove income.

Workout: An adjustment to, or renegotiation of, a loan a lender

makes with a borrower, usually with the purpose of avoiding a default

or foreclosure on the loan. Types of workouts include modifications to

the original loan contract, forbearance agreements (agreements that

postpone payments), forgiveness of some debt, and short sales (the

lender accepts the proceeds from the homes sale as settlement for the

debt even if the proceeds do not cover the entire mortgage amount).

Box 2-1 continued


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At th sm tim, th dor voum of privt mortgg-ckd scuritisissud y privt sctor ntitis grw rpidy ginning in 2001. Invstorswr ttrctd to ths scuritis cus of thir smingy high risk-djustdrturns; ARMs pprnty shiftd intrst rt risk from th ndr to thorrowr, whos mortgg pymnts woud vry ccording to mrkt intrstrts. This providd continud iquidity support for th furthr xpnsion ofmortgg nding, incuding poory undrwrittn suprim nding. Lndrssod ons on th scondry mrkt, pssing risks on to invstors who ridprimriy on rtings of th scuritis providd y third-prty rting gncis.

Thr r two importnt cvts to kp in mind whn thinking out crditrisk in th mortgg mrkts. First, dfuts nd forcosurs r xpctdvn in th st of tims. Som individu orrowrs wi xprinc diffi-cutissuch s jo osstht my d thm to dfut on thir mortggs.

Eiminting dfuts nd forcosurs cusd y such difficutis woud nry impossi, nd fforts to do so y rising crdit thrshods woud hvth unfortunt ffct of rstricting ccss to crditnd, thrfor, to homownrshipfor mny prospctiv orrowrs. Scond, in w-functioningmrkts, risks r pricd. Thr is nothing wrong or unntur out thpossiiity of highr dfut nd dinquncy rts, providd th orrowrnd ndr ntr th trnsction fuy informd. Lndrs nd invstors cncompnst for incrsd risk y stting n pproprity high intrst rt.

Of cours, if informtion on crdit risk is imprfct, th dmnd for ons inth scondry mrkt wi ffctd. For xmp, if crdit rting gncisor invstors undrstimt th dfut risk of suprim scuritis, th mrktmy undrpric suprim risk, ding to n xcss quntity of suprimcrdit. S Box 2-2 for ckground on th crdit rting gncis.

Box 2-2: Credit Rating Agencies

The securities credit rating industry began in 1909, but it was not until

the 1930s that regulators began mandating the use of credit ratings. For

example, banks cannot invest in bonds that are rated below investment

grade; insurance companies are required to link their capital require-

ments to the ratings of the bonds they invest in; and the Securities and

Exchange Commissions capital requirements require broker-dealers to

hold investment-grade bonds in their portfolios.

In order to regulate these ratings the Securities and Exchange

Commission created the National Recognized Statistical Rating

Organization designation (NRSRO) in 1975. Since then, the NRSRO

category has become a de facto license, and like all licenses, it aims

to enforce quality but in fact restricts quantity, by granting monopoly

power to the incumbent firms. Currently, seven firms are designated



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Chptr 2 | 57

In 2006, dfuts on mortggs gn to incrs, ut, s shown inChrt 2-1, th ris in dfut rts ws concntrtd in ARMs, prticurysuprim ARMs, whi dfut rts for FRMs wr rtivy unchngd.Th prformnc of suprim mortggs ws prticury poor for morrcnt vintgs. Suprim mortggs origintd in 2005 nd 2006 hvdfutd much mor quicky thn thos origintd in 2003 nd 2004, forxmp. By Juy of 2007, scting suprim ARM dfut rts d ndrsto shrpy curti nw origintions of suprim ons.

NRSROs. Critics have described the criteria for entry into the NRSRO

designation as opaque, effectively blocking new entry.

The industry came under scrutiny after a large energy company was

rated investment grade 5 days before its bankruptcy. In September2006, the Credit Rating Agency Reform Act was passed to increase

transparency and competition in the rating industry. Under the new act,

a credit rating firm whose ratings have been used by at least 10 investors

for 3 years can apply for registration as an NRSRO.

Although the new law is still being implemented, some contend that

barriers to entry are still high, and conflicts of interest between the rater

and the issuer persist. The Presidents Working Group on Financial

Markets is examining the need for reform of the credit rating agencies.

Box 2-2 continued


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Th currnt ris in dfuts rfcts comintion of fctors, incudingft or fing hom prics, wkr undrwriting stndrds (incuding highron-to-vu rtios), rgion conomic wknss, nd intrst rt rstson suprim ARMs. Aout 1.8 miion ownr-occupid ons in suprimmortgg poos r schdud to rst in 2008 nd 2009. For mortggsissud in th pst svr yrs, dfuts r occurring w for intrst rtsrst, which suggsts soft housing prics nd wk undrwriting stndrdsmy mor importnt fctors. As housing prics gn to ftr, ft orf

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