The following is an economic forecast put together by the Macroeconomic Forecasting class (Economics 478) taught at Southern Oregon University. This class, lead by Dr. Daniel Rubenson, focused on predicting the short term economy using both research and an advanced mathematical model. As our forecast is meant to be short term, the reader should bear in mind that predictions are meant to begin this quarter (quarter two of 2008) and end in late 2010 (quarter four of that year). Our forecast is broken down into different sections of the economy, representing various research teams within our class. In some cases a number of alternate scenarios are detailed, explaining possible outcomes to possible courses of events. However, our closing conclusions are drawn from a most likely scenario and should be taken as a kind of aggregate of all our individual research results. Join us in exploring the past, current, and future course of the changing US economy.
In order to engineer a macroeconomic forecast for the US economy over the next two years, we utilized the Fairmodel, a publicly available (http://fairmodel.econ.yale.edu) econometric model created and maintained by Professor Ray C. Fair of Yale University. The Fairmodel is a collection of empirical economic data, collected from 1952 to the present (ie, the first quarter of 2008). The model is a compilation of multiple regression equations that produce accurate predictions based on 56 years of historical data and established relationships among these variables. In order to develop a robust forecast using this model, one must take into account relevant information that is determined outside the model and information that is more current than previous data. The data inherently built into the model from the outset comes from the U.S. Flow of Funds Accounts, the U.S. National Income and Product Accounts, the Federal Reserve, the Bureau of Labor Statistics, the IMF, and the OECD.
Within the model, variables are segmented into two main categories. There are variables determined outside the model (exogenous), and variables that are determined within the model (endogenous). Those determined within the model include things like levels of corporate profits reported to the government or corporate profit tax rates, essentially things that are determined by policy decisions and do not have other causal factors. Internal variables include things like total net wealth, overall output, consumption levels, and amount of business investment. All such variables contain multiple determinant factors that are ordered within a logarithmic equation.
One can change some variables to meet a predicted scenario fairly easily. For instance the effect of tax rebate checks can be measured by finding the amount of money being sent out by the government and adding that to the variable for transfer payments to households. This change can then be modeled on its own or alongside other changes to see their cumulative effect on the entire economy.
To change other variables, more calculations become necessary. There are two main ways to go about modifying a more complicated variable. One could change the magnitudes of the coefficients that make up the equation, or calculate the change in the variable based on a predicted value (known as an add factor). Changing a coefficient changes the structure of the equation in question and therefore has resulting effects on many other variables within the model. Employing an add factor can be done on a quarterly basis and, once the magnitude is calculated, can be used very precisely to model an exact set of circumstances. Using these tools, one can enact changes that are much more representative of the actual economy than the model can produce on its own.
In order to intelligently change the model, the members of the class separated into groups that focused on a particular aspect of the economy. Attention to detail was necessary as each group followed current events and economic releases. It became a priority to sift through news devoid of real substance in order to find what was truly influential. Information was researched and extracted and compiled from diverse sources. Much of the data used to construct the forecast was gathered from government entities such as the Congressional Budget Office, the official arbiters on US economic matters. Numbers regarding future fiscal policies of different presidential candidates were gathered from their respective websites.
The economy as a whole is measured in terms of the income that it generates. This income is the value of all the products that are produced domestically (also called output). A way to evaluate the current state of the economy is to assess whether output (ie, income) is higher or lower than it was in the previous period. In the last quarter of 2007 and the first quarter of 2008, the US economy has grown by 0.6 percent compared to the last quarter of 2006 and the first quarter of 2007, respectively. This reflects the ongoing discussion about whether the US economy is still growing or whether income declines. Regardless of the exact level of growth, the figures suggest that the economy is not in a desirable state. In order to explain how the economy got to this point, we look at some of the factors that affect overall output. These factors are the spending of people or households, government spending, company spending on items that are supposed to help produce products and earn money (ie, investment spending), as well as exports and imports.
Among these factors, personal or household spending (ie, consumption) is the largest element, making up around 60 percent of total output. First, as house prices fall and as consumers find it more difficult to take out loans for buying houses, residential construction is apt to decline. This causes lower output, thereby putting pressure on construction companies. Consequently, unemployment in this sector rises, which leaves the economy with less people consuming. From February to March 2008, the total US unemployment rate rose from 4.8 percent to 5.1 percent. However, April figures showed a slight decrease to 5.0 percent. Second, economists expect that the prices for consumer goods will continue to rise. This estimate is in line with consumers' perception of rising prices. Meanwhile, consumers fear that slow economic growth and falling house prices negatively impact their income and wealth. Thus, they limit their spending, which is reflected by recent drops in retail sales (Dec.: -0.6 percent; Jan.: +0.4 percent; Feb.: -0.4 percent; March: +0.2 percent). Accordingly, consumer sentiment, which is a survey focusing on consumers' economic expectations (ie, consumer confidence), fell nearly to a 28-year low in May. Similar indicators covering the situation in the service and the manufacturing industries show that these industries expect shrinking contract volumes; a consequence of their expectations for declining consumption and waning investment.
Investment, in turn, is affected by the question whether potential investors expect to earn a reasonable return on a certain investment and whether funds for investment are readily available. The former is doubtful as the economy appears to stagnate or to shrink. The latter, availability of credit, is currently strained as financial institutions are somewhat reluctant to make new loans, because they face losses from loans made during the last years, most notably from residential mortgages made to borrowers who did not have the financial ability to pay back the money. Goldman Sachs estimates that the supply of credit for businesses and consumers may be in the process of a 7 percent decline (approximately $2 trillion), a change that is often referred to as a "squeeze", "crunch" or a "drying up" of credit markets.
Finally, US import volumes still highly exceed export levels. Buying products from abroad rather than buying them from a domestic source indirectly decreases domestic output. Thus, the US economy forewent generating income on items that were imported instead of being produced domestically. However, as the dollar has continuously been losing value against other major currencies (eg. 14 percent against the euro since September /2007), the price of US exports in foreign markets has lowered while imports have become more expensive in the US. Thus, people and businesses adjust their buying behavior so that export volume moves closer to import volumes. In one respect, US production (or income) benefits from this development. In another, there is also a negative effect: the US imports so much that the increase in the price of imports causes an overall price increase. This is particularly true with regard to oil prices, which continue to drive increases in import prices. Wages do not respond quickly to higher prices; thus, consumers are able to buy less.
Over the last few years, we have seen retail mortgage institutions go deeper and deeper into trouble. Mortgage retailers and banks sold nonconforming mortgage products to buyers based on several previous years of home value appreciation. Thus, the buyer was willing to take very low monthly payments at the time, literally betting that the appreciating value would ensure a refinance or second mortgage before the 'real' interest rate kicked in. US housing prices rose 124 percent from 1997 to 2006. Under these assumptions borrowers were convinced that with no down payments and no proof of income, they could have the $250,000 dollar house they always dreamed of, yet couldn't currently afford. These mortgage products included adjustable rate mortgages and negative amortization mortgages, which allowed home buyers to purchase homes more costly than if the buyer had been offered only the traditional federally backed mortgage products (ie, FreedieMac, FannieMae, VA or FHA). These private mortgage products were substantially more expensive over the life of the loan but initially, in the first three to five years, cheaper than the federally backed products. This shift away from traditional products toward risky products put both the buyer and the lenders at much higher risk. Recognizing these rising risks, the private lenders began a system of 'securitization'. A euphemism for passing the risk on to a private insurer to take the place of the federal insurance provided to lenders by the traditional mortgage products.
A sub-prime mortgage is a loan that doesn't meet the standards of government sponsored regulatory agencies like Fannie Mae and Freddie Mac. The reason the loan had a low interest rate initially is because it was adjustable, which allowed banks to raise the interest rate to a higher rate at a later date to make up the difference. For many borrowers, the adjusted interest rate produced a monthly payment that is excessive, and as a result people could no longer afford their homes. Our forecast investigates the effects of sub-prime mortgages on credit markets and determines whether the US economy is in the midst of a credit crunch.
Factors affecting Credit Markets
A 'credit crunch' is a reduction in the availability of loans and other types of credit making them more difficult to attain. It becomes troublesome and expensive to borrow because lenders want to avoid bankruptcy or default. To qualify for a loan, the borrower must have proof of income, and good credit to get a quality loan. Those who don't have good credit are offered loans with a higher interest rate because of the risk involved. Ultimately, a borrower in this situation would have a hard time paying off a loan due to the high interest rate. Mortgage loans along with other debt instruments were turned into securities that could be bought and sold as financial assets and were sold to investors and investment banks. A collateralized debt obligation (CDO) is a security that is meant to hold assets (in this case, mortgage loans) as collateral. The CDO became a popular investment because it had a high profitability to risk ratio. This gave investors the false impression of a safe investment that guaranteed returns. The CDOs were an attempt to hide the bad mortgages, and the securities were sold to investors with the promise that they would be paid back as the mortgages were paid off. When borrowers couldn't pay back their loans (of which there are still many) the domestic and foreign investors who bought the securities never saw significantly decreased returna on their investments. Underwriters (insurers) could lose money to such an extent as to not be able to cover their losses and therefore not be worthy of vital AAA credit ratings.
Credit Market Effect on Borrowers
Tight credit markets have varying effects on individual borrowers. Those who own their homes and can afford the mortgage they're currently paying will be worrying about taking out a second mortgage, declining home values, property taxes increasing, or coming into a time where they need the equity but can't access it because of new regulatory practices. A home is an asset that can depreciate in value under the aforementioned circumstances, which is not good for someone who wants to access the equity in his home. As was mentioned before, lending standards have tightened with new regulatory policies. Proof of income is mandatory, and 'wrapped' down-payments will no longer be an option. Obtaining a loan is going to become harder and more expensive for first-time home buyers. We're returning to the days when the standards for lending practices were tighter and much more scrutinized.
Credit liquidity is essential in the functioning of any sound economy. It is going to be difficult for borrowers to get a loan with poor credit or any outstanding debts. Before the credit crisis, the sub-prime loans were not written with standard guidelines making them easier to obtain. Borrowers are now walking away from their mortgages because the down payment and transaction fees were wrapped into the loan agreement. Walking away has become less of a liability than making the adjusted mortgage payments.
Credit Market Effect on Banks and Other Financial Institutions
By issuing a CDO, the investment bank earns a commission and management fees during the life of the security, and is therefore an investment in the cash flow of the assets. The assets are divided into three portions: senior (AAA credit rating), junior (AA to BB credit rating), and equity which is unrated. The triple AAA rating, as described above, is the safest investment, and as the mortgages are paid off, the investor holding the AAA investment gets reimbursed first. The unrated portion is the most risky of the three, but is attached to a high interest rate. The defaulted mortgages were pooled together in a special purpose vehicle (or SPVs) with other debt instruments. This was a way to hide the bad mortgages without investors knowing. Unfortunately, those SPVs eventually showed up on the balance sheets.
Bear Sterns, one of the largest investment banks and securities trading firms in the world, is a prime example of the negative effect of the sub-prime mortgage crisis. In June of 2007 they used a collateralized loan to pay for a sinking high-grade structured credit fund. Simultaneously, they convinced other financial institutions to loan money against a second hedge fund, a high-grade structured credit enhanced leverage fund. When the mortgages started to go bad because of defaults, these positions were found to be worth substantially less than market value.
Over the next few years we will likely witness major lawsuits because of adjustable rate and sub-prime mortgages. Borrowers will argue that they were misled by mortgage retailers, and that they didn't know what they were agreeing to when they signed for the loan. These repercussions, although smaller than those felt today, will be around for the foreseeable future.
Housing markets entail crucial significance to the overall economy for a number of reasons. Home construction supplies many jobs to the US economy in many different industries. Timber, steel, cement, home furnishings are just several of the industries of that are supported by the housing market.
During the recent housing boom many people were loaned money towards overpriced homes without sufficient finances to back the payment. This is what lead to the US housing market crisis. When interest rates started to creep up above a payable amount, mortgages were abandoned and foreclosures reached precipitous levels. With record amounts of people losing their homes due to foreclosure, lenders tightened the availability of credit. The US housing market crisis has resulted in substantial reductions in wealth for the majority of homeowners.
The lending scandal reached epic proportions as lenders all over the country started to write off bad debts which led to company takeovers and lower market capitalizations for many financial institutions. Since so many different players had a hand in the financial sector many companies started to see revenues and stock prices shrink dramatically.
This excessive speculation in the market has had a major effect on the US economy and has resulted in what some deem recessionary conditions. The demand of the market at one point was so high that houses were being purchased and sold twice in the same month. When builders started to see that they could build a spec home and then sell it in 20 days instead of the normal rate of 90 days they started to mass produce spec homes. The mass production of nicer spec homes was tolerable until the market became oversaturated with them. The result was an oversupply that worsened a downturn, triggered bankruptcies, and caused layoffs among construction workers. Currently, builders typically wait for a down payment before breaking ground as the supply of housing is quite large compared to sales.
A common question amidst this turmoil is: How long is the housing market crisis going to last? This question is rather complicated in the sense that macroeconomic forecasting cannot answer it directly. However, it is possible to research and compile an adequate amount of information to provide a viable answer. Other common questions are: How does the housing market affect the US economy? How does the housing market crisis affect GDP, unemployment, interest rates, the US Treasury bill rate, the money supply and total net wealth? Fortunately, macroeconomic forecasting can answer these questions directly.
Answering these questions consists of massaging residential investment variables in the household sector to reflect actual conditions. Using other forecasts and economic data gathered from a variety of sources, it was determined that the numbers assumed for these variables in the model were inaccurate. This conclusion was based on the current downtrend of the housing market and the base assumptions of other forecasts. Most of the current forecasts have the same conclusions predict that the US housing market will not continue a normal growth trend until late 2009. Our results indicate that housing markets across the country will experience another difficult year in 2008 before starting to recover in second or third quarter of 2009. Recovery will be uneven with some of the most troubled markets continuing to decline through 2009. The quarterly Anderson Forecast by the University of California at Los Angeles predicts growth in the gross domestic product of just over 1 percent for the fourth quarter of 2007 and first quarter of 2008. David Shulman, senior economist for the UCLA forecast, also expects housing prices to plunge 10 to 15 percent before they begin to recover sometime in 2009.
Our research and forecast results indicate that GDP will be insignificantly affected by the changes in residential investment in the housing market and will rise by small margins by 2010. Our forecast results also indicate that the unemployment rate is going to increase. However, like GDP, it will not increase substantially and by the end of 2009 unemployment should start to decrease again. Total net wealth is likely to decrease until early 2010 and should start to increase by the end of 2010. Residential investment should continue to decrease dramatically through 2010.
If our predictions about the housing market are correct the effects of the housing market crisis on the economy will mimic the current slow growth of the economy until the second quarter of 2009 then return to a normal growth trend. It is important to factor in lag times; when specific sectors in the economy pick up speed, the rest of the economy takes time to feel these increased effects. It may take a couple quarters to regain economic strength and the housing market is not likely to improve rapidly.
If our prediction of steady recovery is wrong and the housing market continues to decrease for two or even three more years, GDP, unemployment, total net wealth, investment in household sector and residential investment will continue to be negatively impacted until the housing market improves. However, through analyzing past housing recoveries, we retain full confidence in our predictions indicated by the model.
For two years, starting in June of 2004, the Federal Reserve nurtured what seemed to become a healthy and thriving economy. Equity markets were strong, housing and industrial sectors were booming and inflation was on the rise. In an attempt to fight inflation, the Federal Reserve raised interest rates 17 consecutive times until the middle of 2006 when they held fast for over a year. Typically the Federal Reserve will raise interest rates when an economy is booming in an effort to mitigate inflationary pressures that would tend to raise price levels.
The basket of monetary policy tools at the disposal of the Federal Reserve is rather limited due to the magnitude inherent in manipulating the lending practices of private sector banking. The private sector banking world is one in which consumers are involved, and we indirectly notice when the Federal Reserve decides whether to raise or lower its Federal Funds rate. For nearly 30 years, raising and lowering rates has been the primary monetary policy instrument of the Federal Reserve and has proven to be a viable and complimentary tool when correctly implemented alongside sound fiscal policy.
Unlike other market bubbles that have burst, housing is inextricable rooted in our banking system. When the housing bubble burst, US financial institutions were at risk, and in the middle of 2007, the largest and most powerful US financial institutions suffered a series of devastating blows. The Federal Reserve recognized the importance of liquidity in credit markets to financial institutions and that absence of this liquidity would adversely affect the economy. Late in 2007 the Federal Reserve Act was employed and the Federal Reserve developed a way for financial institutions to borrow from what would become the lender of first resort. This was in stark contrast to the historical role of the Federal Reserve as a lender of last resort
The Federal Reserve created an avenue for short-term borrowing that would be available to banks and other financial institutions and for periods longer than overnight. The Term Auction Facility is a way for financial institutions to borrow from the Fed for 28 days at a rate determined by the auction. This rate is very close to the Federal funds rate and is much more competitive than offers from private lending institutions. This Fed 'bail-out' program seems to have been sufficient to supply many financial institutions crucial infusions of money on a timely basist. Besides banks, other institutions such as (the curiously healthy) Goldman Sachs and Lehman Brothers have been receptors of these gracious Fed loans.
Contrary to popular belief, banks do not acquire a significant portion of their revenues from lending to other banks. Their main business comes from lending to consumers and businesses. Thus, the idea that banks will collapse due to the Fed's involvement in lending is not likely. Another issue of concern is that seemingly unstable institutions borrowing from the Fed pose a potential default risk. To eliminate this worry, the Fed has made it mandatory for each requested loan to be secured with an equal amount of collateral. From these precautions we can assume that the Federal Reserve in its experience and wisdom has taken sufficient precautionary measures to ensure that this new policy tool will not have harmful long-term effects on the economy.
We can expect that with a stabilizing economy, the Fed will likely keep the Federal funds rate near 2 percent for the remainder of the year. Inflation appears to be easing for the month of April, but is still on the rise. Starting in 2009, we predict that the primary policy concern of the Federal Reserve will be to combat inflation with the use of open market operations and the discount rate. The target for the Federal funds rate at this point will likely be a gradual increase to approximately 3 percent by the fourth quarter of 2010. The Federal Reserve has a significant influence on the economy through the manipulation of interest rates. This influence combined with the recent changes in its inherent structure have made overall financial markets more stable and have bolstered their liquidity. It is not likely that the Federal Reserve will react sharply to the potential future growth of the economy since inflation has recently become an economic factor of secondary importance.
Stimulus Spending
Our fiscal spending analysis focuses on short term policy changes, which will be relevant in our forecast period of about two years. The policy changes most likely to be implemented by our federal and state governments in the short term are economic stimulus packages and modifications to war spending. Here we'll be analyzing the effects of various stimulus solutions, some proposed, some enacted, and some little talked about.
To start lets take the already passed stimulus bill the federal government recently began implementing.In essence this program sends $100 billion to tax payers in the form of 'kicker checks' of around $300 to $600 dollars per person. However the likely effects of these 'kicker checks' are rather mild. The economy will enjoy a slight boost for a few quarters, but overall it will not be changed. Unemployment could be reduced slightly by the overall effects of this policy, but unfortunately the over $100 billion price tag further increases our federal budget deficit, and the effect will be pressure on the credit markets, which generally are tied to the budget deficit. In a time like this, when lenders are already becoming choosy about who to lend to, such drawbacks may outweigh the positives. For more information on the effects of this policy see the Consumption Spending chapter of this report.
Another frequently talked about stimulus solution is the 'gas tax holiday', in which the 18 cent per gallon federal gasoline tax would be suspended for the summer of '08. This is discussed in more depth in the taxation section of this chapter, but in short economics tells us that prices will not be moved unless either the supply or the demand of a product are affected in some way, and the removal of a tax does neither. Thus the effect of this policy will likely be nothing, or if anything so slight it will not be relevant.
In earlier versions of the recently passed stimulus package bill, there were provisions calling for longer time for unemployment benefits and a ten percent increase in food stamps benefits. In states with the highest unemployment rates the time allowed unemployment benefits would have been doubled. Compared to the rest of the stimulus package these provisions would have been somewhat inexpensive to implement, somewhere in the range of $20 to $40 billion. The effects of increasing food stamps benefits would be minor on the economy as a whole. The unemployment benefit increase would be the higher cost item of the two and would have the most effect. Both program changes serve to aid those most in need of money and thus most likely to spend it immediately. This makes these aid increases a more cost effective means of boosting the economy and ironically reducing unemployment, and they have the benefit of being expedient solutions compared to the 'kicker checks', which have taken some time to put together and mail out.
In general, if one is attempting to stimulate the economy in the short run using government policy it is best to create new programs or better fund existing ones, rather than just putting money directly in the hands of consumers. The reason for this is tied up in the fact that consumers sometimes save their money and that saved money will not have an immediate effect on the economy. In this way direct spending is also preferable to reduced taxes when making such attempts to quickly pump stimulus into an economy. Increased public works, such as fixed roads, bridges and other infrastructure is a good example. Longer term projects, such as universal health care, would not fall under this category, as the increased spending would basically last indefinitely.
The state of our national infrastructure has been in the news of late and it's possible that politicians will pick up on this, creating bills that aid our states in keeping roads and electricity working. Most states are suffering from budget problems, due to reduced tax revenues, caused by our slowing economy.A program spending federal money on the order of the cost of the recent stimulus package would have a far more positive effect on our economy than the current package will.
One important thing to remember when analyzing the effects of fiscal policy aimed at causing short term benefits to the economy is that policies that either increase spending or reduce taxes will exacerbate our already growing national debt. The long run negative effects of the existence and the growth of our national debt include higher interest rates, causing slowed economic growth; inflation caused by the expanded money supply resulting from the borrowing; and unemployment caused by the combination of the previous problems.It would seem prudent to keep the long run in mind when considering the short run.
Taxation Forecast Analysis
Our fiscal taxation analysis focuses on policy changes, which will be relevant in our economic forecast period of about two years. The policy changes most likely to be implemented by our federal government will specifically be enacted by the President and Congress. As President Bush has less than one year left in office he has purposed the President's Budget for the upcoming year fiscal year 2009. The President purposes to make various provisions that were originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, better known as the Bush Tax Cuts. As Bush's Tax Cuts are currently set to expire at the end of December 2010, the President is pushing to make them permanent.
The President purposes to offer further relief from the Alternative Minimum Tax (AMT). The AMT was created in the late 1960s to ensure that the wealthy that benefited from various tax shelters paid at least some tax. It was never intended to be a mass tax, but the AMT is not adjusted for inflation and the ordinary income tax generally is, causing the AMT subject to bracket creep. Over time moderate rates of inflation rose AMT relative to ordinary tax liabilities. The minimum tax rate under the AMT is 26 percent, considerably higher than the regular income tax rates of many families that will be thrown in the AMT. Congress extended relief from the AMT for 2008, which will reduce revenues by about $70 Billion. After 2008, based on past legislation, the President and Congress will offer future AMT relief for middle-income tax payers who will be subjected to pay the tax due to inflation.
As President Bush's budget will be in place for 2009, a new President will be entering office on January 20, 2009 with the proposals for fiscal policy taxation. The issue is what the Presidential Candidates' proposed tax changes are, whether rates will increase or decrease and who is affected. The Republican Presidential nominee, Senator John McCain's taxation proposals will be forecasted with their effects on the US economy. As well as the Democratic Presidential nominee, Senator Barack Obama as of June 3, taxation proposals will be forecasted with their effects on the US economy.
McCain's fiscal policy taxation proposals are to maintain low taxes to make the Bush Tax cuts permanent and further attempt to lower taxes for economic growth. McCain proposes to permanently repeal the AMT and to maintain the current rates on dividends which are 5 percent and capital gains 15 percent. For the corporate tax, McCain proposes to lower it from 35 percent to 25 percent to encourage business investment. The analysis for the forecast on the lowering of the corporate tax rate will begin in the third quarter of 2009, since the new President enters office in the first quarter of 2009, tax bills will not pass through the legislator over night. A period of six months will be allowed for the creation and voting of the bills. McCain's move to lower the corporate tax by 10 percentage points will cause a slight increase in the Gross Domestic Product (GDP) growth rate which is the growth rate of all output produced in the US economy. The unemployment rate will drop slightly, while the federal budget deficit will increase by $77 Billion more per year than projected without the drop in the corporate tax. The $77 Billion decrease in tax revenues from businesses will have an impact not only on the federal government budget but if government spending is not reduced the budget deficit will increase. Business investment which is targeted to increase by the lowering of the corporate tax actually decreases slightly instead of increasing. This change in the US economy will take place in the beginning of the third quarter of 2009.
Obama's fiscal policy taxation proposals are to maintain low taxes for the lower and middle class, while rolling back the top two income tax rates that were lowered by the Bush tax cuts. Obama supports eliminating the marriage penalty and extending the child tax credit. Proposed is the scaling back of the capital gains tax from 15 percent to 20 percent the amount it was during the Clinton Administration, it was reduced via the Bush tax cuts. Obama proposes further AMT relief for the middle-class of tax payers, while a reform of the AMT is proposed for the future. Obama proposes Social Security tax reform by raising the cap on the payroll tax for the top percent of earners over $102,000. As for corporate taxes, Obama proposes to increase taxes by $150 Billion per year by restoring fairness to the tax code, aggressively seeking out international tax shelters, fixing corporate loopholes, and requiring countries that harbor tax havens to be open about who is investing in them.
Obama's fiscal taxation policy for the following will be forecasted as will their effects on the US economy. The rolling back of the top two income tax rates and rate cuts for capital gains and qualified dividends, and extending other income tax cuts, as well as freezing the estate tax law, would increase tax revenues by $47.8 Billion in 2009 and $82.7 Billion in 2010. The effect of the $150 Billion increase in corporate tax revenues by fixing corporate tax loopholes will be forecasted. As well as the reforming of the Social Security System by the elimination of the earnings cap, for 2009, revenues will increase by $46.35 Billion and $127.7 Billion for 2010. The adjustment on the top two income tax rates and rate cuts for capital gains tax will be in effect for the first quarter 2009, while the reform on corporate tax revenues and Social Security will be in effect beginning the third quarter of 2009. The US economic forecast for Obama's taxation proposals will cause a drop in the GDP, a small decrease in the beginning when he enters office in the first quarter of 2009, and the decease follows until the third quarter 2010. The unemployment rate increases substantially beginning the third quarter of 2009 but remains constant at 5 percent while business investment and residential housing investment both decline. The federal budge begins to decrease in deficit which leads to a budget surplus in the third quarter of 2010. The taxation changes instituted by Obama will have a drastic affect on the federal budge leading to a surplus. The last two quarters of 2009 the revenues increase by $69 Billion for each quarter, while for 2010 revenues are $83 Billion for each quarter, the last quarter of 2010 the federal budget surplus is $10 Billion.
Overall, the Presidential candidates' taxation proposals lower the GDP growth rate having similar effects on the economy, but Obama's tax policy restores the federal budget surplus and maintains the sustainability of the Social Security System. While both candidates are offering the lowering of taxes for the individual, specifically the lower and middle class, McCain supports maintaining lower taxes for the top earners, while Obama supports increasing taxes for the top earners.
War Spending
Operation Iraqi Freedom officially started on March 19th, 2003 at that time estimated total cost for the war was $100 to $200 billion and it was only expected to last from 30 to 60 days. Five years later the total cost of the war to date is $564 billion and if Congress approves the $197 billion called for in the 2008 budget the total will increase to $761 billion. Currently there are about 155,000 American troops deployed in Iraq estimates are that when the surge ends in July 2008 there will be about 132,000 troops left in the country. There have been a total of 4,074 casualties in Iraq, with 30,004 wounded, in Afghanistan there are 30,000 troops with 492 killed and 1,944 wounded.
The war on terror has been officially funded entirely by emergency funding the cost of which has grown from $32 billion in 2001 to 2002 to $197 billion in 2008, with an official government estimate of $70 billion in 2009. The Bush administration has borrowed the funds for the wars in Iraq and Afghanistan because they didn’t want to raise taxes, which means the US is paying interest on the $564 billion already spent. The official money spent is not the entire amount of money spent on the war but other sources of funds are harder to trace. For instance, the Department of Defense estimates that 25 percent of its baseline budget, $515.4 billion for 2009, will go to fund the global war on terror, approximately $129 billion in addition to the emergency funding appropriated by the administration. Only numbers that are explicitly stated by the Congressional Budget Office and the President’s supplemental appropriations budget have been used in this forecast.
In this analysis we use two different scenarios for what may happen in the next two years. For each scenario we estimate that the military will grow from the current strength of 1,415,092 soldiers in 2008 to 1,487,628 in 2010. Also in each scenario we estimate that the emergency spending on the war will begin to drop in the next two years because of changes in the way it is managed by a different President. Because the scenario presented by President Bush is highly unrealistic we have not run an analysis of it here.
Our first scenario is an optimistic scenario where emergency spending drops sharply from $197 billion in 2008 to $50 billion in 2010, while the number of troops in the region drops from 185,000 to 30,000. We have also included estimates for veteran’s benefits spending in the next two years. In 2007 the government spent $1.3 billion according to this scenario spending in 2008 drops to $1.1 billion then rises to $1.4 billion in 2010.
In the second scenario which is more realistic emergency funding drops less dramatically in the next two years, from $197 billion to $147 billion, the troop drawdown drops less drastically as well from 185,000 in 2008 to 141,000 soldiers in the region in 2010. Veterans’ benefits in this scenario are more expensive from $2.8 billion in 2008 to $3.5 billion in 2010. While these numbers are more realistic than in the optimistic scenario described above, we believe these numbers are still very conservative and that the costs of veteran’s benefits will probably be higher in the next two years.
In the last part of this analysis numbers on the military strength of Iraq, Afghanistan, and Iran along with a short analysis of why it is unlikely that the US will be invading Iran looking for weapons of mass destruction are included.
In the President’s scenario, he provides no funding after 2009, the reasoning behind this is that there will be a new president in place ready to formulate their own policy in 2010. The Congressional Budget Office has put forward its own numbers for the continued cost of the war. Their reasoning is that with the historical costs of the war to date it is unlikely that there will be no funding for the war after 2009. Also the President’s 2009 budget estimates government surpluses by 2012 according to the CBO after you add in the cost of the war it is unlikely that there will be a surplus at any time close to 2012.
We can expect the prosecution of the wars in Afghanistan and Iraq to change in 2009 when a new president takes office. Senator John McCain wants to decrease our combat military presence in the region while Senator Clinton proposes a “three phase” draw down and redeployment of troops in Iraq beginning 60 days after she takes office. Senator Obama wants to have all the troops out and redeployed within 16 months of his taking office. No matter what actually happens with our troops in Iraq and Afghanistan we can expect the military forces to get larger. Right now because of the unpopularity of the war military recruiting is down, but troops that have been wounded or killed must be replaced and once a drawdown in troop levels begins troops that have been on extended deployments will be discharged and replacements will be needed. The Bush administration has added $20.5 billion to the department of defense budget to increase the size of the active Army and Marine Corps. Also the military is in need of a “reset” period where troops on extended deployments are finally discharged and replaced and overused equipment is pulled out of the combat area and repaired or replaced. So while the actual number of troops in the region may decrease, the total number of military personnel will increase.
The numbers in the table above assume that the military replaces the 209,800 soldiers being discharged over the next two years plus 37,000 new recruits per year (this is the number of new recruits provided for in the presidents budget for the DoD in 2009) and takes into account the yearly average of 732 killed and wounded in Iraq and Afghanistan.
Even if all of the troops are pulled out of both Iraq and Afghanistan before 2010, other costs associated with the war will continue to increase. Veterans’ benefits are the largest expense in this category. Already costs for medical care, education, housing and business loans for veterans have skyrocketed and with the debacle at Walter Reed where disabled veterans were living in squalid conditions more spending for veterans benefits is likely to occur. This affects not only the Department of Defense, and the Department of Veterans Affairs, but also Medicare and social security; benefits which many disabled veterans will qualify for after they return home. As of December 2007, there have been 751,000 veterans discharged from military service with another estimated 314,700 expected by 2010. If we use the average veteran’s benefits award from the first Gulf War, $6,506, and use the department of defense statistics that 20 percent to 50 percent will file claims we see an expense of approximately $1.4 billion to $3.5 billion in 2010.
These cost estimates are most likely very conservative because in the first Gulf War the average claim for benefits included at least three medical conditions while the average claim for today’s wars in Iraq and Afghanistan include an average of five medical disabilities; hence the benefits awards for today’s soldiers will be higher.
In the first scenario we used the numbers from the optimistic scenario proposed by the Congressional Budget Office, where government spending and borrowing on the war drops to $50 billion in 2010 and veterans’ benefits grow modestly by about $1 billion a year. In this forecast we see a modest drop in GDP, an increase in unemployment and a larger increase in the deficit for the national income accounts.
In the next scenario, and in the primary forecast, we used the realistic set of numbers from the CBO where spending on the war drops from $197 billion in 2008 to $147 billion in 2010 and we used higher estimates for veterans’ benefit spending, starting at $2.8 billion in 2008 and growing to $3.5 billion in 2010. The changes to military jobs remains the same in each of the scenarios. In this forecast we see almost negligible changes in unemployment rates and real GDP but government spending continues to be in deficit by about $125 billion in 2010. The President’s budget proposal for 2009 projects a government surplus by 2012. However, those estimates do not take into account the wars in Afghanistan and Iraq. Even in the best case scenario where only $50 billion is spent on the war in 2010, the government still runs a deficit of about $100 billion dollars. With these numbers its hard to see how the government can create a surplus by 2012.
Iran has been in the news because of its nuclear program and there has been some idle speculation of what would happen if we decided to go to war in that country while fighting in Afghanistan and Iraq. Without making up monetary amounts to guess how much it would cost to add another war to our list of conflicts I compared the different military strengths of Iran, Iraq, Afghanistan and the United States.
According to these numbers from the CIA world factbook we can estimate that an invasion of Iran would be prohibitively expensive both the cost of lives and of money would be much higher than the current wars that are being fought. Iran is a much bigger and more unified country than Iraq and they have a larger military to fight a war with. Our military, while still larger and very able to defeat the Iranian army, is already stretched by the ongoing conflicts in Iraq and Afghanistan.
We forecast that the amount of spending on the war in Iraq to drop in the next two years mostly because of a change in leadership. The democratic candidates have consistently promoted a drawdown of troops and recently Senator McCain also said that he would begin to bring combat troops home upon election. The difference between all three plans is the timeline. In our realistic scenario the drawdown is very slow (75,000 troops in the region by 2013) and the funding likewise drops slowly as well. While all candidates wants to pull American troops out of Iraq the pace of the drawdown will most likely depend on conditions in the country. We think that progress will continue to be slow; therefore we have estimated that only 40,000 troops will be home by 2010. In this scenario veterans’ benefits just for veterans of this war grow to $3.5 billion in 2010. This number is based on an estimated 1,065,700 veterans half of which apply for and receive benefits. This estimate is on top of benefits paid to veterans of other wars and is likely low. In a recent article posted on the Department of Defense website, Secretary of Defense Gates announced that the end game in Iraq is within reach but patience is necessary. Pulling all American troops out precipitously could put the country in a civil war. Beginning a slow pull out while gradually turning control over to the Iraqis will allow US troops to exit the country while Iraqis steadily regain control of their country.
Consumption Trends
There seems to be a palpable fear of an impending recession both on Wall Street and Main Street America. Consumption spending is the largest sector of Gross Domestic Product, and as economic turmoil begins, how consumers react, even if in very small ways can aggregate to billions of dollars in GDP growth, or shrinkage. These concerns stem from increasing energy and food costs, as well as waning consumer expectations, and confidence; possibly altering consumer propensities to spend or save.
A reduction in disposable income and consumption spending could tip an already precariously balanced US economy from bull to bear. The possibility of shifting consumer attitudes towards thriftiness, the responsiveness of those receiving the federal government's economic stimulus dollars, where in consumers budgets will see cuts, and to what extent borrowing in a tight credit market will pick up the slack of a softening job market are among the most significant looming questions in the economy
The US economy has seen job losses; non-farm employment was down 80,000 in April, as well as a reduction in the average work week (down 0.2 percent year over year). However, unemployment, a rather finessed, and less accurate, though more widely quoted figure nudged down from 5.1 percent in March to 5 percent in April. These employment numbers, though not good, are not doom and gloom either. We have not seen large employee cuts by major firms either because of, or causing the economic downturn, we are seeing continued productivity gains.
Consumer confidence and expectations have been slipping in recent quarters, and nearly six in ten consumers believe a recession is looming. This perception of impending peril could precipitate a tightening of consumers' belts and an adjustment in spending habits. This could be seen in reduced consumption spending at a variety of levels.
Related Trends
Net financial assets (wealth), disposable income, interest rates, and taxes all play a part in consumer spending, thus their past and future trend lines play a significant a role in future consumption habits and in this forecast.
Net financial assets and total net wealth, for the bulk of consumers lies in their home value, which have for the recent past been trending downwards nationally; as has the S&P 500 a relatively broad national index of U.S. equities. The S&P 500 is off 4 percent for the year, though it has rallied from a mid-March low of 12 percent below where is started the year.
Though total income has continued its trend pattern of increases, it has slowed to an annual growth rate from the first-quarter of 2007 to first-quarter 2008 of 4.5 percent, down from 7 percent growth during the previous period. It continues to decelerate as annualized growth dropped in the period from the fourth-quarter of 2007 to first-quarter 2008 to 4.37 percent.
The core Consumer Price Index (CPI), a broad indicator of consumer prices, less food and energy jumped 5.758 percent in March, after seeing growth rates of approximately 4 percent since the start of the year. Food prices have jumped significantly, 11.695 percent, 3.198 percent and 1.264 percent from January to March, 2008, respectively. Energy Prices have seen the most violent increases, with only one month seeing a decrease (January) in the past eight, November saw a jump of 122.592 percent, while March energy prices jumped 25.924 percent. Goldman Sachs analyst Arjun Murti forecast oil at $200 per barrel saying, 'The possibility of $150 to $200 per barrel seems increasingly likely over the next six-24 months,' he also indicates that emerging markets' demand and lack of refining capability will remain strong and that a cessation of gas price increases is not yet in sight. Increases in food and fuel costs are hard for the average consumer to avoid and reduce consumers' discretionary income and net purchasing power.
The Federal Reserve under Chairman Ben Bernanke has gone to unprecedented lengths to increase liquidity in the equity markets and at credit pinched financial institutions. Through open market operations, pioneering new lending practices and decreasing Federal funds rate targets they have done a fairly good job. The Fed funds rate (FFR) target has plummeted since the September 2007 meeting of the Board of Governors when it stood at 5.25 percent, falling in increments as high as ¾ of a percentage point per month to a targeted rate of 2.00 percent. The Federal Reserve has indicated that they will not be looking to cut the interest rate again for some time, signaling a perceived risk balance between inflationary pressures and slowing GDP growth. The effective FFR; the actual rates at which banks loan differ from the Federal Reserve's target only slightly. This rate has fallen accordingly from 5.26 percent in July 2007 to 2.28 in April. The prime loan rate, the rate at which financial institutions are willing to loan to high credit, low risk borrowers has analogously decreased from a high of 8.25 percent in August of last year, to 5.24 percent as of April. Interest rates have significantly decreased over the past eight months, as has total consumer credit outstanding; up almost three percent. This begs the question; is there really a credit crunch, or at least one that consumers are feeling? The answer is twofold: Though loan rates are significantly lower now than eight months ago banks have tightened lending practices, presumably in an attempt to correctly reevaluate the solvency of new barrowers, and mitigate underappreciated default risk in the past.
Related Past Experience: 2001 Rebate Checks
In response to a shrinking economy, in 2001 the US Government dispersed $38 billion dollars via rebate checks to the American taxpayer. As it was nearly impossible to send out 90 million checks at the same time, the rebate checks were dispersed randomly, ten percent per week over a ten week period. Because of the random distribution of rebate checks over a ten week period a very rare opportunity was had to conduct a randomized truly scientific study of the actual impact on consumer spending.
This study was done by David S. Johnson from the Bureau of Labor Statistics, Division of Consumer Prices and Price Indexes, Dr. Jonathan A. Parker of the Benheim Center for Finance at Princeton University and Dr. Nicholas S. Souleles of the Wharton School at the University of Pennsylvania. A special question was added to the Consumer Expenditure Survey conducted by the Bureau of Labor Statistics: 'to measure the change in consumption expenditures caused by receipt of the rebate.'
The study concluded that households spent twenty to forty percent of the rebate amount 'on non-durable goods during the three-month period in which they received their rebates and roughly two-thirds of their rebates cumulatively during the quarter of receipt and the subsequent three-month period.' The aggregate expenditure increase caused total personal consumption expenditures (PCE) to increase 0.8 percent in the quarter received and 0.6 in the subsequent quarter. Non-durable consumption saw a significantly larger increase of 2.9 and 2.1 percent in the quarter received and the subsequent quarter, respectively.
There are several significant distinctions between the economic situation now, and seven years ago. Our discussion entails two topics: The differing economic conditions and the differences in the economic stimulus packages respectively.
The 2001 recession was led by a reduction in consumer spending, after the collapse of the relatively isolated technology sector. This reduction in consumer spending can be attributed, at least partially (if economic theory is to hold true), to a reduction in net assets. As wealth decreased (due to the wealth effect), consumers' real purchasing power dwindled. This caused a retooling of individual consumption habits. During the fourth quarter of 2007 and up to now, bank assets were often held in large conglomerations of mortgage debt known as Collateralized Debt Obligations (CDOs). CDOs have been hit hard with increasing default rates, thus decreasing, or eliminating profitability and causing a significant downward adjustment in the financial sector. The construction and real estate (both commercial and residential) sectors have seen similar declines as excess inventory, coupled with tighter lending standards left demand low, and supply high. Consumer spending however has not trended downward with the housing, construction, and financial sectors. Indeed, consumer spending has increased, though sluggishly. One explanation for this increase are (as discussed earlier), the nearly unavoidable and skyrocketing food and energy prices. One thing is clear: This economic downturn is not being fueled by decreased consumption spending, but by financial and housing sector losses.
The rebate section of the economic stimulus plan of 2008 is roughly double the size of the 2001 rebate when adjusted for inflation ($89.1 billion versus $38 billion) and will be sent to nearly 30 million more American Families (117 million in 2008 versus 90 million families in 2001). Though the timing and mechanisms of disbursement are similar in both stimulus efforts there is one large difference in methodology. Instead of tax payers being left to anxiously check their mailboxes, awaiting a check that may be nine weeks away, each eligible taxpayer who will be receiving a rebate check was sent a letter informing them of the approximate date of arrival. This new strategy was presumably done in hopes of spurring consumers to pre-spend their stimulus checks, hastening the resulting increase in consumer spending and helping to buoy the economy. The cumulative effectiveness of this action is unknowable until several quarters in the future.
Forecast Period Implications
Consumers may be feeling the pinch in increased food and fuel prices, but consumer debt may be increasing enough to keep the economy afloat as the financial and housing sectors right themselves. There has been no indication that consumer spending has decreased nor have consumers substantially shifted their propensities in regard to saving or spending.
Total income is still growing, though at a slower pace than core CPI (inflation), and is certainly not keeping pace with food and energy price increases. Consumers are pessimistic and worried about uncertainties in the economy and how those will play out on individual, community, state, and national levels. This uncertainty, specifically focused on job security and being pinched at the pump and the supermarket line has the potential to alter the rates at which consumers spend, save, and how they go about those activities. It is understandable that when in a precarious or uncertain financial situation that consumers tighten their belts, put off major purchases and reduce spending where possible.
Though there are many troublesome signs in the markets, both fiscal and monetary policy authorities have acted to bolster the economy in the short run and mitigate any disruptions to the overall economy by isolated failures in some sectors. The Federal Reserve has acted quite aggressively to stem any major financial system interruptions and keep to adequate liquidity in the market by increasing money supply and decreasing lending rate targets. The US Government passed a $168 billion dollar economic stimulus plan, the majority of which ($110 billion) is dedicated to the American consumer. Rebate checks have proved to be an effective tool of fiscal policy makers in quickly ratcheting up consumer spending.
Rebate checks will be in the hands of consumers very soon and should begin to effect consumption spending substantially in the third and fourth quarters of 2008 and into the first quarter of 2009. Consumption spending in services and non-durable goods should see the largest increases. Durable good purchases are positively correlated with the housing sector. When new houses are being built, new washing machines and refrigerators are needed to stock them. Large increases in food and energy prices are as likely to continue as to stagnate. It is logical that consumers will use the rebate money to mitigate their increased food and fuel expenditures, thus mending the gap between the pace of increasing inflation and personal income.
Net exports are a core component of a country's total output. The US has run a trade deficit since the mid 1970s, meaning that yearly import volumes have consistently been higher than exports. Meanwhile, US exports and imports have grown to a volume equal to about 8 percent and 14 percent of the US total production (gross domestic product, GDP) respectively. Thus, net exports are negative (-6 percent of GDP). This essentially means that the US is spending more than it earns and that it runs a large trade deficit. This excess spending is financed by investments in the US undertaken by the rest of the world.
Domestic factors influencing foreign trade are discussed in their respective sections of this forecast report. The main international factors influencing net exports are exchange rates and global economic activity.
Forecast Results
Over the course of the next two years, we forecast export and import growth to slow from recent years' pace. While 2008 exports (up 8 percent) will still benefit from the US dollar's trading at historic lows against several currencies in the first half of 2008, we see exports growing at only 4 percent in 2009 and (in the first half of) 2010 as the global economic outlook is worsening and as the US dollar is likely to appreciate beginning in the second half of 2008.
Meanwhile, based on both the weak start of the US economy into 2008 and the (still) weak US dollar we forecast import growth of only 3.5 to 4 percent in 2008.This will help narrow the US trade deficit and will provide some additional support for the US dollar and US gross domestic product. However, as we expect oil prices to rise further, import growth will be likely to exceed export growth again in 2009 and 2010. Consequently, the trade deficit should widen again beginning in 2009. This has the potential to eventually negatively affect the value of the US dollar later in 2009. Until then, a slight appreciation of the US dollar should contribute to a decrease in the price of imports. Apart from a rise in oil prices, this enables a positive short-term effect with regard to imports. As a strengthening US dollar decreases the price of non-oil imports, imports put downward pressure on the domestic price level, thereby increasing real disposable income and making a positive contribution to real GDP. Oil prices, however, overlay this effect by far and fuel inflationary pressures.
World Economic Outlook, International Trade and the US Position In Trade
International trade volumes vary with changes in international economic activity.
Since 2000, global merchandise trade has grown at roughly twice the annual growth rate of global output. Moreover, over the course of the last years, world production has grown at rates above the world economy's long-term growth trend, which resulted in merchandise export growth of 6 to 10 percent annually between 2004 and 2007. US exports show behavior consistent with this pattern and are closely related to global GDP growth.
Moreover, exchange rates play a considerable role in determining US trade volumes with certain countries. Volatility in foreign exchange markets has risen considerably since mid 2007 and remains to be above recent years' average despite its current calming down. However, the current volatility in foreign exchange markets does not directly find its way into import and export levels. Prices often respond to exchange rate changes with a lag, and trade contracts might prevent quick reactions on the demand side. Thus, our export forecast is based more heavily on global economic activity. Exchange rates are factored in with a lag and considered less influential than economic activity.
Both the positive international trade climate and the decrease in the value of the US dollar have made US exports rise by an annual average of 12 to 13 percent from 2004 to 2007. In 2007, this development contributed to the first shrinking of the US trade deficit since 2001.
Global Economic Outlook
We expect world economic growth to slow below its long-term trend in 2008 and 2009. In reaction to inflationary pressures, monetary policy has partly been tighter, and constraints from tightening credit markets affect several countries. The UK housing market remains a considerable concern. Plus, British banks have not made write-offs comparable to those that European banks and US banks previously have made amid the US housing and credit fallout. Thus, there is a potential for further worrisome news from financial markets.
The economic outlook for the Euro area, for the UK and for China is moderate for 2008 and 2009. Japan's interdependence with the US economy suggests slower growth in Asia's second biggest economy, too. Meanwhile, China still fuels growth particularly among Asian emerging economies, where growth rates are well above world GDP growth. However, Chinese inflation evokes severe doubts about China's ability to maintain real GDP growth at recent years' levels. Hence the reduced growth prospects for China.
Consequently, world GDP growth goes into the analysis at 2.6 percent and 2.7 percent in 2008 and 2009 respectively, down from 3.5 percent in 2007. In this environment, growth in international trade is likely to turn out weaker compared to recent years' levels.
US Foreign Trade
Based on prospective world output exclusively, US exports are most likely to grow at an average 6 percent over the next 2.5 years. Including exchange rate effects, 2008 exports have the potential to turn out higher than this average as the US dollar's downturn has gained even more pace during the last quarter of 2007 and the first quarter of 2008. In 2008, exports should gain another 8 percent. However, as we forecast that the US dollar gains value against major trading currencies beginning in the second half of 2008 through the first half of 2009, export growth is likely to slow to 4 percent in 2009 and 2010 (first half). We see a particularly promising outlook for exports to China as the Chinese Yuan will be allowed to appreciate at a steadily accelerating pace while Chinese demand for US products is already growing regardless of exchange rate effects.
Although imports can be expected to benefit from a stronger US dollar beginning in 2009, they are likely to grow only by 3.5 to 4 percent on both the still weak US dollar and the reduced growth prospects for the US economy. Still, as oil imports make up a major proportion of total US imports, the expected rise in oil prices will cause import volumes to rise faster in 2009 and 2010. Plus, our exchange rate forecasts suggest a decrease in the price of non-oil imports throughout the first half of 2009.
There are no relevant changes in trade agreements or any other foreseeable negative or positive factors that might affect US trade within the forecast period.
Foreign Exchange
In forecasting the volume of US exports and imports exchanged with the rest of the world over the course of the next two years, it is important to know how the US dollar is likely to develop vis-à-vis major trading currencies as this has a noteworthy effect on the price of imports and exports.
The US Dollar: Recent Development and Likely Future Trends
The US dollar has declined against the world's major currencies over the last years, marking an all-time low against the Euro. The widening US trade deficit has put downward pressure on the US dollar over this period. One of the primary factors that have accelerated the downturn of the dollar in the recent past is weakened confidence amid the wake of turbulence in credit markets. Confidence in US financial markets and financial assets suffered, thereby reducing the demand for the dollar. Also, the Federal Reserve has been conducting an expansionary policy with consecutive interest rate cuts in an attempt to save the economy from going into recession. The decline in US interest rates relative to other major countries decreased the attractiveness of US assets. Foreign investors seek higher returns on investment in other countries.
We expect that the US starts finding its way out of stagnation in late 2008 as the credit markets start to stabilize with the support from the Federal Reserve and as several economic relief packages including tax rebates are delivered to consumers, yielding positive impact on the US economy, followed by an at least temporary end of the dollar's decline.
We see that the dollar will start appreciating against major trading currencies (except for the Chinese Yuan) once investors anticipate that the Fed will decide to bring interest rates up again. We foresee a slight appreciation of the dollar against several currencies starting in 2008 and throughout our forecast period despite the minor shifts in direction along the way.
In our forecast, we pay considerable attention to the value of the US dollar against the Euro, the British Pound, the Chinese Yuan, the Mexican Peso, the Japanese Yen and the Canadian dollar as trading volumes with these areas make up about 70 percent of total US trading activity.
Besides forecasting exchange rates based on factors such as changes in interest rate differentials and changes in perception of the growth path of economies, we take the difference between nominal (market) and real exchange rates into consideration since it provides information on whether a currency is overvalued or undervalued in terms of a real purchasing power equilibrium- an equilibrium to which the currency should move according to the purchasing power parity theory.
The last time those nominal and real rates were in line with each other was in September 2001 and since then the US dollar's market value has declined faster than its purchasing power. As of January 2008, the dollar was undervalued by 11 percent. We see this gap between market value and real purchasing power narrowing over the next two years.
A cautionary note: The current undervaluation of the US dollar might partly be due to doubts about whether oil will be still be traded in the US dollar in the future. In the event and to the extent that these doubts aggravate, the US dollar might come under more severe pressure.
Import Prices
Import and export prices have a considerable influence on foreign trade. In order to forecast imports and exports, we calculated an import price index based on projected changes in exchange rates. This import price index does not incorporate price changes for specific goods except for oil.
In our forecast, the import price index drops from the second quarter of our forecast period (third quarter 2008) and will have dropped by 2.7 percent by the first quarter of 2010, if oil price changes are ignored. This reflects cheaper import prices as a result of a strengthening of the dollar. The forecasted appreciation of the dollar against major trading currencies is higher than the index suggests, because the appreciation of the Chinese Yuan, which accounts for 16 percent of the index, overlays the generally positive outlook for the US dollar.
Forecast Risks
Oil prices have a considerable influence on domestic prices, thereby affecting inflation. Moreover, oil is a major import item. However, as the US demand for oil is not very responsive to changes in the oil price, a higher oil price can be expected to increase imports. Thus, if oil prices rose to levels around $200 per barrel or higher, the US trade deficit would worsen, which would make the US dollar depreciate. This kind of scenario (although not the most likely outcome) could change the forecast remarkably.
The Importance of Oil
The world runs on oil. Oil is used for all forms of transportation, power generation, and for the production of plastics, pharmaceuticals, pesticides, solvents, automobiles and computers. The amount of energy, resilience, and ease of transportation give comparative advantage over any other substitute.
Increased Global Demand
The oil industry has been planning for a 2 percent usage increase per year, so when China and India came along with a 20 to 30 percent yearly increase, all excess production capacity was sucked up. Oil demand has been growing around the world by 2 to 3 percent per year. America is the world's largest oil consumer and accounts for one quarter percent of the total oil used. Domestic demand is expected to grow 25 percent, from 20.8m barrels per day (bpd) to 26.1m bpd; at a faster rate than domestic energy production.
At these current levels of consumption, it's predicted that all known oil reserves will tap out by 2039, which does not account for the increase in oil demand, new discoveries, or the use of alternative resources to run the world's energy.
Decreasing Supply
Most of the world's large oil deposits have already been discovered and are being refined at a rate of 98 percent of maximum capacity; this bottleneck in refining capacity keeps supply low and the cost up. To make matters worse, no refineries have been built in the US since 1976. In addition, it takes ten years to build a new refinery. Reserves are harder to find and costs are high for refining and exploring for oil. Many smaller discoveries are needed to sustain production levels of larger reservoirs which are no longer pumping at full capacity. Hubbert's Theory explains that oil production follows a bell shaped curve. As time goes on, with fewer large discoveries, total oil output eventually produces less than maximum capacity which reflects an exponential decrease in supply. Many believe we have reached or are slightly over the peak for worldwide oil production. We are already seeing decreased rates of discoveries - production levels are naturally decreasing 3 to 4 percent per year where increased rates of discovery look pessimistic.
Since 2000, there has been a strong and growing interest in renewable diesels worldwide. The cost to produce these resources is much higher and is limited in supply. Renewable diesel fuels are quickly evolving but have not yet been cost effective enough to create a substantial impact on the price of gas (with the slight exception of ethanol). Cheap oil has historically made alternative energy investment costly. But as the price of crude climbs, so does the motivation to find alternatives.
There are as much estimated heavy oil and natural bitumen reserves as that of light conventional oil. These hard to convert liquids found in Canada and the US may someday be worth extracting. Extremely large deposits have already been discovered, called oil shale and oil sand deposits. Currently, the technology isn't advanced enough for the efficient removal of these resources to be profitable.
ANWAR has 10.4 billion barrels in estimated reserves but the land is protected bythe EPA. The opening of these reserves would likely curb gas prices by 50 cents. There aren't many large oil reserves left to discover. Oil companies now look in hard to extract places and are mostly investing in deepwater, offshore exploration. The trend shows negative total oil company return on investment (ROI) for exploration-to-recovery.
Nuclear power is promising for the long term future. Europe generates 76 percent of its electricity from nuclear. The US may eventually follow Europe's lead in nuclear power generation but political and economic constraints prevent any short term action, not to mention nuclear plants take at least 10 years to build.
How Crude Oil Prices Affect US Economy
The higher energy prices rise, the more consumer disposable income is used to pay for energy costs. With less income, consumers spend less on consumer goods. Decreased sales reduce corporate profits. With production slowdown and higher labor costs, unemployment increases and real GDP decreases.
Inflation
Oil profits go to foreign suppliers, creating a balance of trade deficit. As more profits go overseas, there is less demand for US dollars and it takes more US exports to balance imports. The value of the dollar inflates, the exchange rate adjusts, and we lose buying power. Rising oil prices also create inflation. High prices make transporting and manufacture goods more expensive, which impact business expenses and drives costs up. This creates a positive, yet, delayed effect on inflation. It is possible that we are just now starting to see the effects of inflation on goods and services. This increases the price of gas further and drives the economy into recession. Conversely, weak oil prices have a negative effect on inflation. Consequently, as growth and demand slows, the price decreases and things become more affordable.
High Risk
Hurricanes and catastrophic events play a role in the amount of total production output. There is plenty of risk here. A small decrease in supply can have a magnified effect on gas prices. Great risk also comes from political tensions. Most oil reserves are in countries with geopolitical risks: Iraq, Iran, Saudi Arabia, Russia, Indonesia, Venezuela, Nigeria, etc. Political and US war tensions with Iran and Iraq have increased the uncertainty of supply disruptions. This creates speculation which can have as much as a 25 percent effect on the price of crude. It seems speculation is leading over actual spot prices. What economists speculate will be a big determinate of where prices are headed.
Economic Impacts
Scenario 1: The price of oil will decrease 30 percent to around $100 per barrel. Heating, food, transportation, and shipping costs decrease allowing consumers more disposable income to spend on consumption goods and services. More spending means real GDP growth, a reduction in unemployment, and lower inflation which translates to a stronger dollar.
Scenario 2: The price of oil will not change. GDP will continue to grow at around 2 percent per year.
Scenario 3: Oil has roughly averaged a 30 percent increase over the last 4 consecutive years. This rate will progressively slow as it reaches consumer thresholds. Consumers will begin to change their behavior and the price of crude will sustain.
Scenario 4: The price of oil will skyrocket to $300 a barrel. A small decrease in supply can have an astonishing increase in prices. The magnitude of the price increase will have different effects. Larger reactions in price can prevent people from making optimal solutions in the short term causing confusion and uncertainty when people look to make big purchases. Large structural changes also begin to take effect as alternatives become more desirable. Cheap oil has historically made alternative energy investment costly. But as the price of crude climbs, so does the motivation to find alternatives.
What is likely to happen?
We forecast for 2 years that oil price will follow scenario 3. Price of oil will peak around $145 per barrel by the end of second quarter 2008 and peak at $155 per barrel second quarter 2009 (summer months) with lows in the $130 range. Overall, the high prices are expected to increase greatly through the summer when demand is high, increase slightly in the spring and winter, and drop off slightly in the fall.
Why is this likely? Currently, prices are starting to adjust upwards with inflation, and consumers and businesses are uncomfortably feeling the effects. Costs are going up, there's less money in consumer's pockets, corporations are making less money, and may have to lay employees off if they are not able to ‘pass the buck' onto the consumer. This will have a slightly negative effect on the total output for the economy. If inflation goes up and growth slows, we could go into recession. If this happens, a recession will drive oil prices back down to the $85 to 100 per barrel.
Today the price is driven by demand. Demand is greatly increasing and output is limited by refineries' capacities. Combined with supply disruption concerns by importers and domestic suppliers alike, the outlook over the next two years points to increased prices that will continue to increase until the market adjusts.
External shocks are factors that directly affect the economy but originate outside of its framework. External shocks are sometimes referred to as black swans after the ancient Western notion that all swans are white. When black swans were discovered in 17th century Australia, it came as quite a shock, hence the use of the term to describe the improbable. A black swan is characterized by three principal characteristics: It is unpredictable and highly improbable; it entails a massive impact; and after the fact explanations make these events appear less random and more predictable. The terrorist attacks of 11 September 2001 and Hurricane Katrina are widely recognized examples of black swan events. Both were improbable and entailed an impact that was felt far beyond the economic realm. The purpose of this analysis is to forecast the implications of an event of similar scope on the future economic terrain. Herein, (unless stated otherwise) numbers and statistics refer to a forecast scenario that entails a natural disaster of comparable magnitude to Hurricane Katrina. This modeling was accomplished though rigorous analysis of reports, statistics and measures that have been reported subsequent to the occurrence of Hurricane Katrina. Analysis suggested that the future economic consequences of such a disaster would be remarkably similar to those previously experienced (ie, the overall economic impact would be minimal).
Natural disaster
Natural disasters severely affect human activities. Lack of planning or lack of appropriate emergency management, can lead to financial, environmental and human losses. The economic impact of a natural disaster would likely be far-reaching and felt across several components of the economy.
Food and commodity prices
Food prices have already undergone significant increases in the past several weeks. These increases have been due primarily to demand from growing economies such as China and India where economic development has coincided with increased appetites for grains and meat. These increases are due to what economists call demand-pull inflation which occurs when an excess of money is spent chasing too few goods. This type of inflation is predictable. According to the U.S. Department of Agriculture, food prices rose 4 percent in 2007, compared with an average annual rise of 2.5 percent over the last 15 years. A rise of 4.5 percent is expected in 2008. According to the Bureau of Labor Statistics the average American consumer's spending on food and beverages represents 15 percent of total expenditures. However, when a natural disaster causes a sharp increase in food and commodity prices another form of inflation is the result. Assuming that the demand-pull inflation is likely to continue, the combination of these two forms of inflation could result in food and commodity prices accelerating at unanticipated levels.
In the modeled natural disaster, the effect on food and commodity prices was determined to be minimal. When compared with a scenario in which the natural disaster had not occurred, fluctuations in inflation were comparable. Aside from a small initial spike in food and commodity prices, these fluctuations mirrored those of a healthy and resilient economy. These results agreed with historical data, suggesting that although these events incur a severe impact, much of that impact is absorbed or does not affect the economy as a whole.
Unemployment
In the natural disaster scenario, unemployment levels rose ever so slightly. This suggests that aside from the thousands of people that became unemployed in the region affected by the natural disaster, the overall unemployment level fluctuated within a normal, healthy range.
Gross domestic product
As a result of the natural disaster, GDP experienced a slight decline. This is a reflection of the fact that less paychecks were being cashed and less money was being spent. This caused a decrease in tax revenues and overall demand. However, this decline represented less than a tenth of a percent of overall GDP suggesting that the overall economic impact of the disaster was minimal and experienced mostly at the state and local levels.
External Shocks Summary
Predicting the impact of an improbable and unpredictable event on the economy is an intellectually demanding task. However, by integrating data from previous black swans, the probable impact on the economy can be determined. In this scenario, the impact of a natural disaster on the economy was minimal. This highlighted the resilience of the U.S. economy and the predictions compared favorably with the relevant data from previous natural disasters (and other black swan events).
The following is the forecast resulting from both our research based analysis as well as our mathematical simulations of future economic conditions. Bear in mind that this is a short-term forecast with a time horizon of about two years in the future.
We are projecting modest Real GDP Growth of 3.13 percent in 2008. We expect three month Treasury rates of 2.03 percent in 2008. Our projections imply an unemployment rate of 5.08 percent in 2008. Inflation is forecasted to increase in 2008, slowing in 2009-10 towards the two percent range. We project a Fed Funds Rate (FFR) of 2.00% through the remainder of the year, balancing inflationary pressure and GDP growth. We are expecting the Fed to gradually increase rates, trending with GDP growth to combat inflation in 2009, with a FFR of 3.00% by year end 2010.
We are forecasting a decrease in Residential housing investment for 2008 of negative 16.7 percent, and a modest increase in Nonresidential Fixed Investment of 0.88 percent over the same time period. We also expect to see a slowdown in the housing sector for the duration of 2008, with a recovery in that sector beginning, and returning to normal growth patterns in 2009.
The weak US Dollar has helped to bolster exports in 2008, we have seen an 8 percent rise so in the first few months, and we expect that trend to continue through the balance of the year. A stronger dollar should work to damper export increases, limiting growth to 3.5 to 4 percent in 2009. We are, however, expecting the US dollar to appreciate in value against the worlds major currencies (except the Chinese Yuan) after record lows on exchange markets in 2008. This is due to the Federal Reserve’s indication that it would most likely hold the Fed Funds Target at 2.00% for the foreseeable future, stabilization of financial markets within the United States, and modest US GDP growth coupled with a weakening global economy. We are expecting import prices excluding oil to decrease – trending with a strengthening US dollar.
We are forecasting aggregate private consumption, which accounts for over 70% of GDP to steadily increase during the forecast period. Consumption should gain traction and push GDP for the balance of the forecast period.
Personal consumption is made up of three sectors, durable, nondurable, and services, each with a slightly different forecast. We expect nondurable and service consumption to increase at healthy rates throughout the forecast period, due in part to the federal government’s economic stimulus plan, and increasing fuel and food prices. We expect sluggish growth in durable good orders for 2008, and trending upward to more respectable gains through 2009 and ’10, trending with the housing sector recovery. We are projecting a negative 5.27 percent change in household savings in 2008.
The following table offers a comparison of our forecast to a number of other major economic forecasts (Bank of America, Wachovia and the Federal Reserve):
