| US Forecast: July 27, 2001 |
| Forecast Period 2001:3--2005:4 (18 quarters) Data The forecast is based on the national income and product accounts (NIPA) data that were released on July 27, 2001. The Latest Version of the US Model For purposes of this forecast the US model has been reestimated through 2001:2. These estimates are presented in the "Chapter 5 tables" at the end of The US Model Workbook. The rest of the specification of the model is in Appendix A at the end of this workbook. A complete discussion of the previous version of the US model (April 27, 2001) is in Macroeconometric Modeling, which is the main reference for this site. The only change made for the current version (July 27, 2001) is that equation 9, which explains the demand for money of the household sector, is now estimated under the assumption of a fourth order autoregressive error. For discussion of the various versions of the models on this site, see Current Versions and References and Previous Versions and References. Assumptions Behind the Forecast The following table gives the growth rates that were assumed for the current forecast for the key exogenous variables in the model along with the actual growth rates between 1993:3 and 2001:2.
Growth Rates (annual rates)
Current
Forecast Actual
Assumptions 2001:2-1993.3
TRGH 8.0 4.4
COG 3.0 0.7
JG 1.0 -1.4
TRGS 8.0 7.1
TRSH 7.0 6.5
COS 3.0 (beg. 2001:4) 6.2
JS 1.0 1.7
EX 5.0 (beg. 2001:4) 7.0
PIM 2.0 -0.5
The first seven variables are the main government policy variables in the model aside from tax rates. The tax cut package that was passed by Congress and signed by President Bush in May of this year has been incorporated into the current forecast. The Joint Committee on Taxation has estimates of the tax reductions by fiscal year, and these estimates were used as a guide in choosing values for D1G, the personal income tax parameter in the model. D1G was adjusted in the manner discussed in Section 5.2 of The US Model Workbook, experiment 5.5. You can examine the values for D1G to see what was done. Of the $38 billion rebate, half was put in 2001:3 and half in 2001:4. The tax reduction in each of the fiscal years 2003, 2004, and 2005 is roughly $100 billion. No assumption about monetary policy is needed for the forecast because monetary policy is endogenous. Monetary policy is determined by equation 30, an estimated interest rate reaction function or rule. The Results Selected forecast results are present in the tables that follow this memo. If you want more detail, click in the left menu "US Model," create a data set, and then go immediately to "Examine the results without solving the model." You can then examine any variable in the model. Although the model is used to forecast through 2005:4, you should not put much confidence on the results beyond about 2003. Forecast error bands are fairly large for predictions out a number of years. Real Growth and the Unemployment Rate: The main feature of the forecast is that the economy is not predicted to grow at a rate greater than 2 percent for the forseeable future. This leads the unemployment rate to rise to 5.5 percent by the middle of 2004. Inflation: Inflation as measured by the growth of the GDP deflator (GDPD) is predicted to be less than 3 percent throughout the forecast period. It falls slightly over time, which is due to the rising unemployment rate. Monetary Policy: The Fed lowered the short term interest rate more in 2001:1 and 2001:2 than the model predicted. (You can see this by estimating the model in Eviews or the FP program and examining the estimated residuals for equation 30.) The estimated interest rate rule (equation 30) is predicting that the three month bill rate (RS) will be around 4 percent for the next three years. If the Fed cuts the rate in August, this will be another example of the Fed being more aggressive than the interest rate rule predicts. Other Variables: The household saving rate (variable SRZ in the model) remains low throughout the forecast period. The federal government budget surplus (SGP) is forecast to be between $178.5 and $205.3 billion throughout the forecast period. These values are down sharply from the values for the April 27, 2000, forecast (before the tax cut), which were $263.9 and $339.5 billion, respectively. Most of these changes are due to the tax cut. The U.S. current account deficit (variable -SR in the model) is forecast to be extremely large throughout the period (between $434.7 and $521.5 billion). Stimulus Needed in 2002 and 2003? If the aim for 2002 and 2003 is to get growth above 2 percent and to prevent the unemployment rate from rising, then the forecast says that more stimulus is needed. One possibility is for the Fed to keep interest rates lower than the model is predicting it will do. You can do this in the model by dropping equation 30 and exogenously lowering RS. The other possibility is for there to be a further tax cut or a government spending increase. According to the model, the current tax cut is not large enough (through 2005) to do the job. Two reasons the model is predicting sluggish growth are 1) the recent drop in household wealth from the fall in the stock market and 2) the currently large stocks of durable goods and housing due to large past values of durable goods spending and housing investment. Other things equal, large stocks of durable goods and housing have negative effects on future durable goods spending and housing investment. In other words, these "initial conditions" are negative regarding future demand. Uncertainties There are two main uncertainties regarding the current forecast. The first concerns inflation. The unemployment rate enters linearly in the price equation (equation 10), but at some point one would expect to see large (i.e., nonlinear) price increases in response to a low unemployment rate. Unfortunately, there are not enough observations at low unemployment rates for the data to estimate this nonlinearity, and so there are no nonlinear effects in the model. It could thus be that inflation will be even worse in the future than the model is predicting if the economy has been in this nonlinear zone and is about to feel the effects. The second main uncertainty concerns the stock market. Even though the stock market has fallen substantially in the past few months, price/earnings ratios are still very high by historical standards, and it may be that a further correction will take place. There is a stock price equation in the model (equation 25, explaining CG), but it cannot pick up booms and crashes. The equation is predicting that stock prices will grow modestly in the future. If, on the other hand, the stock market crashes, the effect on the economy through the wealth effect could be substantial. If you want to see this, you can run an experiment in which you crash the stock market (see Chapter 7 of The US Model Workbook for how to do this). You will see that a large sustained crash leads to a recession even if you assume that the Fed substantially lowers the interest rate in response to the crash. In other words, the model has the property that the Fed does not have the power to prevent a recession if there is a large crash. Possible Experiments to Run The present forecast is a good base from which to make alternative fiscal-policy assumptions, depending on what you think Congress might do if the economy remains sluggish. As a historical footnote, the model has consistently been more optimistic about the size of future federal government deficits or surpluses than have most others, especially regarding future tax revenues, and the recent data suggest that the model has been right. The CBO and others have now moved in the optimistic direction. You may want to compare the current CBO forecasts with those from the model. My sense is that the model has conveyed useful information in the past about the deficit or surplus that was not in the CBO forecasts at the time. You may also want to drop the interest rate reaction function (equation 30) and put in your own assumptions about Fed behavior. For example, do you think the Fed will keep RS low, contrary to what equation 30 is predicting? Given the above discussion about nonlinearities and inflation, you may want to experiment with the price equation (equation 10). Will inflation be higher than predicted because of the low unemployment rates? Related to the inflation question, the current forecast is based on the assumption that the price of imports (PIM) grows at a rate of 2 percent per year throughout the forecast period. A strong dollar helps keep PIM down, but oil price increases push it up. It may be that the assumption of 2 percent is too optimistic, and you may want to experiment with higher values. This will, of course, make inflation even worse in the future. The real value of exports (EX) has been assumed to remain unchanged in 2001:3 and than to grow at an annual rate of 5 percent after that. Given that the world economy is not doing real well, a 5 percent value may be too high. You may want to try lower values. This will, of course, make the U.S. economy even more sluggish than is predicted. Finally, as discussed above, you may want to crash the stock market. |
| US Forecast Tables: July 27, 2001 |
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Table F1: Forecasts of Selected Variables--Real GDP
and Components
Table F1 (continued)--Prices and Wages Table F1 (continued)--Money and Interest Rates Table F1 (continued)--Employment and Labor Force Table F1 (continued)--Other Endogenous Table F1 (continued)--Selected Exogenous Table F2: Forecasts of the Federal Government Budget Table F3: Forecasts of the State and Local Government Budget Table F4: Forecasts of Savings Flows NIPA Table 1.1 NIPA Table 1.2 NIPA Table 3.2 NIPA Table 3.3 NIPA Table 7.1 |
| Table F1: Forecasts of Selected Variables |
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| Table F1 (continued) |
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| Table F1 (continued) |
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| Table F1 (continued) |
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| Table F1 (continued) |
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| Table F1 (continued) |
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| Table F2: Forecasts of the Federal Government Budget |
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| Table F3: Forecasts of the State and Local Government Budget |
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| Table F4 Forecasts of Savings Flows |
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| NIPA Table 1.1 |
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| NIPA Table 1.2 |
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| NIPA Table 3.2 |
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| NIPA Table 3.3 |
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| NIPA Table 7.1 |
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