C H A P T E R 1

The Year in Review and the Years Ahead

T he expansion of the U.S economy continued for the fifth consecutive

year in 2006. Economic growth was strong, with real gross domestic
product (GDP) growing at 3.4 percent during the four quarters of 2006. This
strong economic growth comes in the face of numerous headwinds and
resulted from the inherent strengths of the U.S. economy and pro-growth
policies such as tax relief, regulatory restraint, and opening foreign markets to
U.S. goods and services. Growth in the first quarter rebounded from the
effects of the 2005 hurricanes, including a recovery in consumer confidence
and consumer spending, and the rebuilding of oil and natural gas infrastruc-
ture in the Gulf of Mexico. Although growth slowed in the middle two
quarters of the year, the overall pace of real activity was strong in the face of
near-record inflation-adjusted prices of crude oil and a sharp decline in home
construction. On the inflation front, energy prices fell substantially towards
the end of the year, allowing overall consumer price inflation to moderate in
2006; however, price inflation increased for goods and services other than
food and energy. In response to these output and inflation developments, the
Federal Reserve continued raising the federal funds rate through June, and
then held it constant for the rest of the year. The Administration forecast calls
for the economic expansion to continue in 2007, but we must continue to
pursue pro-growth policies such as those designed to keep tax relief in place,
restrain government spending, slow the rate of health care inflation, enhance
national energy security, and expand free and fair trade.
This chapter reviews the economic developments of 2006 and discusses the
Administration’s forecast for the years ahead. The key points of this chapter are:
• Real GDP posted strong 3.4 percent growth in 2006, up from the
3.1 percent 2005 pace. The composition of aggregate demand changed
from preceding years. More growth came from exports and business
structures investment, while residential investment flipped from
contributing to GDP growth in 2005 to subtracting from it in 2006.
• Labor markets continued to strengthen, with the unemployment rate
descending to 41⁄2 percent in the fourth quarter , and payroll job growth
averaging 187,000 per month.
• Energy prices, which rose through August and then declined, dominated
the movement of overall inflation in the consumer price index. Core
inflation (which excludes food and energy inflation) moved up from
2.2 percent during the 12 months of 2005 to 2.6 percent in 2006, with
much of this upward trend due to an acceleration in the amount that

23
 renters pay for apartments and other rental properties and the estimated
rent on owner-occupied housing. Energy prices fell sharply from September
through October, and core inflation fell toward the end of the year.
• Real average hourly earnings accelerated to a 1.7 percent increase during
the 12 months of 2006, reflecting solid labor markets combined with
tamer energy prices.
• The Administration’s forecast calls for the economic expansion to
continue in 2007 and beyond, although the pace of expansion is
projected to slow somewhat from the stronger growth of recent years.
The unemployment rate is projected to edge up slightly in 2007, while
remaining below 5 percent. Real GDP growth is projected to continue
at around 3 percent in 2008 and thereafter, while the unemployment
rate is projected to remain stable and below 5 percent.

Developments in 2006
and the Near-Term Outlook
The economy went through a period of rebalancing during 2006, with
faster growth in business structures investment and exports partially offsetting
pronounced declines in homebuilding. At the same time, consumer spending
continued to grow.

Consumer Spending and Saving

Consumer spending sustained its strong growth during the four quarters
of 2006 (rising 3.7 percent in real terms), continuing its 15-year pattern of
rising faster than disposable income. Several factors helped to keep spending
elevated, and as a result, kept saving down (according to the official definition
in the national income and product accounts (NIPA)). These factors included
rising energy costs (through the third quarter), rising wealth, and falling
unemployment rates. As a result, the personal saving rate fell to a negative
1.0 percent for the year as a whole—its lowest annual level during the post-
World War II era. Despite the negative saving rate, Americans continue to
build wealth in the form of capital gains (the rise in asset prices), which are
not included in the definition of saving in the NIPAs. The declining saving
rate continues a long-term trend which began in the 1980s.

Energy Expenditures
World demand for crude oil increased from 79.74 million barrels per day in
2003 to 84.18 million barrels per day during the first three quarters of 2006.
The United States accounted for about one-eighth (0.5 million barrels per day)
of this higher (4.4 million barrel per day) pace of crude oil consumption. Most

24 | Economic Report of the President

of this increase in world demand was accounted for by non-OECD countries
(up 4.1 million barrels per day). Consumption of the non-U.S. OECD coun-
tries fell 0.2 million barrels per day. In the face of this increase in world oil
demand, the supply available to U.S. consumers was restrained, and consumers
paid higher prices to maintain their consumption.
With the rise in energy prices, nominal energy purchases rose sharply. That
consumers altered their spending patterns only slightly contributed to the fall
in the saving rate. Consumer energy prices increased 29 percent relative to
nonenergy prices (according to the NIPA price indexes) from the fourth
quarter of 2003 to the fourth quarter of 2006, while real consumption of
energy per household fell only slightly, by 2.1 percent. Between 2004 and
2006, consumers appear to have maintained both energy and nonenergy
consumption by reducing their saving. Consumers’ response to persistently
high energy prices is likely to emerge gradually, as consumers economize on
energy consumption and possibly on nonenergy consumption.

Wealth Effects on Consumption and Saving

The rise in household wealth has also played a role in the decline of the
saving rate. During the late 1990s and again during the past 3 years, a strong
rise in household net worth coincided with a sizeable increase in consumer
spending relative to disposable personal income (see Chart 1-1).

Chapter 1 | 25
 Despite the negative saving rate during 2006, Americans continued to build
wealth because of capital gains. During the four quarters ending in the third
quarter of 2006, the household wealth-to-income ratio increased 0.04 years,
to 5.63 years of income. (The units of the wealth-to-income ratio are years
because wealth is measured in dollars while income is measured in dollars per
year. That is, total household wealth in the third quarter of 2006 represents the
equivalent of 5.63 years of accumulated income.) More than half of the
increase during these four quarters was accounted for by an increase in stock
market wealth. Housing wealth (net of mortgage debt) also edged up relative
to income over these four quarters, but by much less than its increases during
the preceding 2 years. By the third quarter of 2006, the overall wealth-to-
income ratio was well above the ratio over most of the past 50 years.

Personal and National Saving

Consumer responses to the rise in energy prices and increases in the wealth-
to-income ratio lowered the personal saving rate to negative 1.0 percent in
2006. The personal saving rate, the rate at which households save, has been
declining since the mid-1980s.
Corporate net saving takes the form of retained earnings which are not paid
out to shareholders. (Net saving excludes funds used to replace worn out
capital goods.) Retained earnings add to the wealth of corporate shareholders
and supply funds for new investment. Corporate net saving rose to
3.8 percent of gross domestic income (GDI) during the first three quarters of
2006, its highest level since the 1960s. (GDI is the economy-wide sum of all
sources of income and differs from GDP only by measurement error.) But
even with these high levels of net corporate saving, net private saving (the sum
of personal and corporate saving) was only 3.1 percent of GDI during the first
three quarters of 2006, near its lowest level in the post-war period.
A still broader measure of net saving—net national saving—is the sum of
government and private (personal plus corporate) net saving. When the
Federal government runs a deficit (spends more than it collects in tax
revenue), Federal saving is negative, as it was in 2006. Because the Federal
deficit declined substantially in 2006, and because corporate saving rose, net
national saving (which was negligible in 2005) rose to 2.0 percent of GDI
during the first three quarters of 2006, its highest level since early 2002. Gross
national saving, which includes funds for replacing worn out capital goods, is
higher than net saving (13.8 percent versus 2.0 percent during the first three
quarters of 2006), but shows similar historical fluctuations.

Projected Consumer Spending

Looking ahead, real consumer spending during the four quarters of 2007 is
expected to grow less than 3 percent, down from an average of 3.5 percent
during the past 3 years. This projected rate is slightly less than the projected

26 | Economic Report of the President

2007 growth of real disposable personal income (household income less taxes,
adjusted for inflation), and so the saving rate is forecasted to edge up. During
the longer term, real consumption is projected to increase at about the same
pace as real GDP and real income.

Housing Prices
Nationally, housing prices increased less in 2006 than in 2005. An inflation-
adjusted version of the housing price index (the nominal version of which is
compiled by the Office of Federal Housing Enterprise Oversight from new
home sales and appraisals during refinancing) increased at an average annual
rate of 6.4 percent from 2000 to 2005, and then slowed to a 2.6 percent
annual rate of increase in the first three quarters of 2006. (These inflation-
adjusted prices are deflated by the consumer price index.) Looking back, the
cumulative increase in inflation-adjusted housing prices during the 6 years
from 1999 to 2005 is one of the largest on record, exceeded only by the
period immediately following the Second World War. Since 1929, periods of
rising real prices have been linked to increases in the share of the gross
national product allocated to home construction (see Chart 1-2). The
6.4 percent annual rate of increase in the relative price of housing from 2000
to 2005 was associated with an increase in the residential construction share
of GDP from 4.6 percent to 6.2 percent.

Chapter 1 | 27
 Although relative housing prices (that is relative to the consumer price
index (CPI)) increased in almost all metropolitan areas during the 5 years
from 2000 to 2005, the increases were concentrated in a few high-profile
markets; increases in most areas were only modest. For example, real prices in
Los Angeles increased at a 14.3 percent annual rate, but real price increases in
71 percent of metropolitan areas were less than the 6.4 percent national
average. Most house price changes reflect local conditions (such as local
economic and population growth, tastes, and geographic and zoning limita-
tions on construction). In areas with restricted supply, small changes in
demand may translate into large price changes.
Although house-price increases during these 5 years were concentrated in a
few markets, the decline in mortgage rates from 2000 to 2005 was one
common factor that may have helped raise home prices across the nation.
Because of the drop in mortgage rates, prices could increase 4.4 percent per
year during this period without raising the monthly mortgage payment.

Residential Investment
Every major measure of housing activity dropped sharply during 2006, and
the drop in real residential construction was steeper than anticipated in last
year’s Report. New home sales fell 27 percent from a peak in October 2005
through July 2006, a period when rates on conventional mortgages moved up
about 70 basis points. (A basis point is one one-hundredth of a percentage
point.) Sales then edged up during the 5 months from August through
December, when mortgage rates dipped lower. Builders reacted sharply to the
early-2006 drop in sales so that housing starts, which peaked at an annual rate
of 2.27 million units in the beginning of the year, fell to slightly more than
1.6 million units by the end of the year. The drop in home construction
activity subtracted roughly 0.7 percentage point from the annual rate of real
GDP growth in the second quarter, and 1.2 percentage points in the second
half of the year. Furthermore, even if housing starts level off at their current
pace, normal lags between the beginning and completion of a construction
project imply that residential investment will subtract from GDP growth
during the first half of 2007.
During 2006, employment in residential construction fell, as did production
of construction materials and products associated with new home sales (such
as furniture, large appliances, and carpeting). Yet despite these housing sector
declines, the overall economy continued to expand (see Box 1-1).

28 | Economic Report of the President

Box 1-1: Indirect Effects of the Housing Sector

Thus far, the sharp drop in homebuilding has had few consequences
for the rest of the economy. Employment fell in sectors related to new
home construction and housing sales. Despite these repercussions,
overall payroll employment continued to increase, the unemployment
rate continued to fall, and real consumer spending continued to move
upward through the end of 2006.
Although residential investment fell sharply, real GDP growth during
2006 was sustained by increases in other forms of investment. As can
be seen in the chart below, private nominal nonresidential construction
(that is, business construction of office buildings, shopping centers,
factories, and other business structures) grew rapidly in the first three
quarters of the year and moved up a bit further in the fourth quarter.
Nonresidential construction draws from some of the same resources
(such as construction labor and materials) as the residential construc-
tion sector. The high level of residential investment during the past
couple of years may have limited the growth of investment in nonresi-
dential structures. While the case for housing crowding out other
sectors is strongest for nonresidential investment, residential invest-
ment competes with all other sectors of production in credit and labor
markets. A drop in the share of the economy engaged in housing could
provide some room for other sectors to grow.

continued on the next page

Chapter 1 | 29
 Box 1-1 — continued
The housing market could also affect the rest of the economy
through the wealth channel. That is, declines in housing prices could
reduce household net worth and thereby reduce consumption. The
increase in housing prices during 2000–2005 contributed noticeably to
the gain in the ratio of household wealth to income (shown earlier in
chart 1-1) and supported growth in consumer spending. Some of this
support may have been facilitated by homeowners taking out larger
mortgages after their homes appreciated in value. In contrast, housing
wealth decelerated in the second and third quarters of 2006, while the
stock market accounted for most of the gain in the wealth-to-income
ratio. Thus far, national measures of housing prices have not declined,
and negative effects through the wealth channel have not occurred.

In addition to incomes and mortgage rates, the number of homes built is

underpinned by demographics. Homebuilding during 2004 and 2005 aver-
aged about 2.0 million units per year, in excess of the roughly
1.8-to-1.9-million unit annual pace of starts that is consistent with the pace
of household formation implied by demographic models. As a result, the pace
of homebuilding will tend to be drawn below this level for long enough so
that the above-trend production of 2004 and 2005 will be offset by below-
trend production. The construction of new homes has fallen rapidly, however,
and this offset may well be complete sometime during 2007. Looking further
ahead, the residential sector is not expected to make noticeable positive
contributions to real GDP growth until 2008 and beyond.

Business Fixed Investment

During 2006, real business investment in equipment and software grew
5 percent, slower than the 7 percent average pace during the 3 previous years.
Its fastest-growing components included computers, as well as machinery
in the agricultural and service sectors. Investment in mining and oil field
machinery was also strong, likely in response to elevated crude oil prices, and
to the need to replace Gulf of Mexico facilities damaged by the 2005 hurri-
canes. Investment in heavy trucks has been solid throughout 2006 as trucking
firms have been buying in advance of new environmental regulations (on
particulate matter emissions issued in 2000 that became effective in 2007),
which will raise heavy truck prices in 2007. Aircraft investment, however,
declined sharply for the second consecutive year. Software investment posted
a strong 7.9 percent gain in 2006, but since 2000, it has grown at only a 3.7
percent annual rate, a noticeable deceleration from the roughly 16 percent
annual rate of growth during the 1990s.

30 | Economic Report of the President

 The turnaround in investment in business structures (that is, nonresidential
construction) during 2006 has been dramatic, with growth at 12 percent, up
from an anemic 2 percent gain during 2005. Growth in 2006 was strongest
for office buildings, multi-merchandise centers, lodging facilities, and recre-
ational structures. Investment in petroleum and natural gas structures also
grew rapidly, reflecting high petroleum and natural gas prices and the recon-
struction of the Gulf of Mexico capacity. Investment continued to fall,
however, in air transportation structures and medical buildings.
Business investment growth is projected to remain strong in 2007, somewhere
in the neighborhood of the 9 percent annual rate of growth during the first
three quarters of 2006. Continued growth in output combined with a tight
labor market are expected to maintain strong demand for new capital equip-
ment at the same time as corporations are flush with funds for these
investments. The financial environment for these investments is favorable.
Cash flow (the internally generated funds that are available for corporate
investment) was at a record 10.3 percent average share of GDP in the first
three quarters of 2006, while nonresidential investment (at 10.5 percent of
GDP) was close to its historical average. In the longer run, business invest-
ment is projected to grow only slightly above the growth rate of real GDP.

Business Inventories
Inventory investment was fairly steady during 2006, and had only a minor
influence on quarter-to-quarter fluctuations. Real nonfarm inventories grew
at an average $44 billion annual pace during 2006, a 3.0 percent rate of
growth that is roughly in line with the pace of real GDP growth over the same
period. Coming off a long-term decline, the inventory-to-sales ratio for
manufacturing and trade (in current dollars) remained relatively flat during
the first half of the year, but began to pick up in August.
Inventory investment is projected to be approximately stable during the
next several years, as is generally the case for periods of stable growth. The
overall inventory-to-sales ratio is expected to continue trending lower.

Government Purchases
Real Federal consumption and gross investment grew 2.4 percent during
2006. This was the third consecutive year of growth at roughly 2 percent.
Defense spending accounted for all of the increase during the four-quarter
period, while nondefense purchases fell. The quarterly pattern of these Federal
purchases has been volatile with sizeable increases in the first and fourth quar-
ters of the year. Most of the first-quarter surge was in defense components.
Federal outlays (which include purchases, investment, and transfers such as
Social Security) were boosted by a $111 billion appropriation in fiscal year

Chapter 1 | 31
(FY) 2006 for reconstruction and relief efforts arising from the 2005
hurricanes. In addition, the supplemental defense spending package for on-
going operations in Afghanistan and Iraq was $70 billion for FY 2006 and
was passed in mid-June. An additional $70 billion emergency funding was
provided in the regular defense appropriation act passed at the end of
September 2006. Another supplemental appropriation for defense is likely for
FY 2007.
Nominal Federal revenues grew 15 percent in FY 2005 and 12 percent in
FY 2006. These rapid growth rates exceeded growth in outlays and GDP as a
whole, and the U.S. fiscal deficit as a share of GDP shrank from 3.6 percent
in FY 2004 to 2.6 percent in FY 2005 to 1.9 percent in FY 2006.
State and local government purchases rose 3 percent during 2006, up
noticeably from rates below 1 percent during each of the 3 previous years. In
the wake of the 2001 recession, this sector fell sharply into deficit in 2002.
Revenues began to recover in 2003, and by the first half of 2006 the sector
was out of deficit, allowing for an increase in state and local consumption and
investment. This pattern of delayed response to downturns resembles the past
several business-cycle recoveries.

Exports and Imports

Real exports of goods and services grew 9.2 percent during 2006, up from
the 6.7 percent export growth over the four quarters of 2005. This accelera-
tion reflects rapid growth among our trading partners. Real GDP among our
OECD trading partners grew 2.9 percent during the four quarters of 2005,
and is estimated to have grown at the same pace in 2006. In addition, the
economies of some of our major non-OECD trading partners such as China,
Singapore, and India are growing at rates of 7 to 10 percent per year, although
these countries comprise only about 7 percent of our exports.
The fastest growth in U.S. goods and services exports was to India, but
exports to China, Africa, and Latin America also grew rapidly. Despite the
rapid export growth to these emerging economies, the European Union (EU)
remains the major export destination, consuming nearly 25 percent of our
exports. Within the EU, Great Britain’s imports of American goods and serv-
ices grew at a notable 18 percent annual rate during the first three quarters
of 2006.
Real imports grew 3.1 percent in 2006, a slower pace than the 5.2 percent
increase over the four quarters of 2005. Petroleum imports, which grew
strongly in the fourth quarter of 2005 to replace production losses after
the hurricanes, declined 10 percent during the four quarters of 2006. Real
imports of nonpetroleum goods grew 5.3 percent over the same period, down
slightly from the year-earlier pace.

32 | Economic Report of the President

 The current account deficit (the excess of imports and income flows to
foreigners over exports and foreign income of Americans) jumped to 7.0 percent
of GDP in the fourth quarter of 2005, partly due to petroleum imports that
replaced lost Gulf of Mexico production. The current account deficit then
retraced some of its earlier increase in the first three quarters of 2006, when
oil imports declined. It appears to have fallen further in the fourth quarter,
reflecting the drop in prices of imported crude oil. Current account deficits
mean that domestic investment continues to exceed domestic saving, with
foreigners financing the gap between the two.

Employment
Nonfarm payroll employment increased 2.2 million during the 12 months
of 2006, an average pace of about 187,000 jobs per month. The unemploy-
ment rate declined by 0.4 percentage point during the 12 months of the year
to 4.5 percent. The average unemployment rate in 2006 (4.6 percent) was
below the averages of the 1970s, the 1980s, and the 1990s.
Job gains were spread broadly across major sectors in 2006, with the natural
resource and mining sector (which includes oil and natural gas extraction)
experiencing the fastest growth rate (8.1 percent), likely due to increased
demand for energy products. The service-providing sector accounted for
95 percent of job growth during the 12 months of 2006, a slightly larger
contribution than would be suggested by its 83-percent share of overall
employment. Within the service-providing sector, 24 percent of job growth
was in professional and business service jobs. As noted, the service-providing
sector accounted for almost all of the 2006 job gains. The goods-producing
sector accounted for the remaining 5 percent of the gains (notably weaker than
its 17-percent share of overall employment), a continuation of the long-term
trend under which the goods-producing share of total employment has fallen
in each of the past five decades. Within the goods-producing sector, employ-
ment growth during 2006 was concentrated in mining and construction, while
manufacturing employment decreased for the ninth consecutive year.
Jobless rates fell among most major demographic segments of the population
during the 12 months of 2006. The unemployment rate dropped for each of the
four educational-attainment groups (less than high school, high school, some
college, and college graduates). For the second consecutive year, the drop in the
unemployment rate was most pronounced among those without a high school
degree. After falling 0.8 percentage point during 2005 (when the overall rate fell
0.5 percentage point), the jobless rate in this group fell another 0.7 percentage
point during the 12 months of 2006 (when the overall unemployment rate fell
0.4 percentage point). By race and ethnicity, the unemployment rate fell the

Chapter 1 | 33
most during 2006 among Asians, Hispanics and blacks (1.4, 1.1 and 0.9
percentage points), in contrast to 0.2 percentage point for whites. By age, the
jobless rate fell most among workers 25 to 34 years old. By sex, the jobless rate
fell more among adult women than adult men.
Furthermore, the median duration of unemployment, an indicator that
typically follows the business cycle with a substantial lag, declined from its
December 2005 level of 8.5 weeks to a December 2006 level of 7.3 weeks,
close to its historical average. The number of long-term unemployed (those
out of work for more than 26 weeks) fell by 263,000 during the year.
The Administration projects that employment will increase at a pace of
129,000 jobs per month on average during the four quarters of 2007. In the
long run the pace of employment growth will slow, reflecting the aging of the
population and the diminishing rates of labor force growth. The Administration
also projects the unemployment rate will average 4.6 percent over 2007, before
edging up to 4.8 percent in 2008 and beyond.

Productivity
Labor productivity growth usually increases during the early stage of a
business-cycle recovery but then falls somewhat as the cycle matures. Early in
this most recent expansion, productivity grew at a remarkable 3.9 percent
annual rate for the years 2002 and 2003 and then slowed to a 2.6 percent
annual rate for the years 2004 and 2005. Overall productivity has grown at a
vigorous 3.1 percent annual rate from the business-cycle peak in the first
quarter of 2001 until the third quarter of 2006.
Although 1995 has been regarded as a watershed year for productivity
because of the acceleration of productivity from a 1.5 percent to a 2.4 percent
annual rate of growth, the further acceleration to a 3.1 percent annual rate of
growth during 2001 to 2006 is striking, especially given a flat or diminished
contribution from capital deepening (the increase in capital services per hour
worked). (The time periods referred to are those shown in Table 1-2 later in this
chapter.) The 1995–2001 acceleration may be plausibly accounted for by a
pickup in capital deepening and by increases in organizational capital, the
investments businesses make to reorganize and restructure themselves, in this
instance in response to newly installed information technology. In contrast,
capital deepening does not explain any of the post-2001 increase in productivity
growth. The post-2001 acceleration in productivity therefore appears to be
accounted for by factors that are more difficult to measure than the quantity of
capital, such as continuing improvements in technology and business practices.
(See Chapter 2, Productivity Growth for an extended discussion of this.)

34 | Economic Report of the President

 Rather than assuming that the recent remarkable pace of productivity
growth will continue, the Administration believes it is prudent to build a
budget based on a forecast somewhat lower that the 3.1-percent pace of
productivity growth since 2001. Productivity growth is projected to average
2.6 percent per year during the 6-year span of the budget projection—
roughly equal to the average annual pace during the past decade.

Prices and Wages

As measured by the consumer price index (CPI), overall inflation fell from
3.4 percent during the 12 months of 2005 to 2.5 percent during 2006
(Chart 1-3). The drop in overall CPI inflation was almost entirely due to the
deceleration of energy prices from a 17.1-percent increase in 2005 to a 2.9-
percent increase in 2006. Food prices increased 2.1 percent during 2006,
similar to the pace of the previous year. Core CPI prices (that is, excluding
food and energy) increased 2.6 percent during 2006, up from a 2.2-percent
increase a year earlier.

Chapter 1 | 35
 After rising sharply during 2004 and 2005, prices of petroleum products
slowed to a 6.1 percent increase during the 12 months of 2006, as the sharp
rise through August was reversed later in the year. Prices of natural gas, which
had risen sharply during 2005, fell 14 percent during 2006. As of mid-
January 2007, prices in futures markets suggested that crude oil prices will rise
modestly during 2007, while natural gas prices will increase substantially.
The 0.4 percentage point acceleration of core CPI prices was accounted for
primarily by rent of shelter (which consists primarily of rent paid by renters
and by the rent on owner-occupied dwellings), which accelerated to a
4.3 percent rate of increase during the 12 months of 2006 from 2.7 percent
in 2005. Some of the acceleration in core CPI prices may also have been a
delayed reaction to the rapid increase in energy prices from mid-2003 to mid-
2006, as the higher energy prices were absorbed into the prices of every service
and commodity that requires inputs of energy or transportation. Econometric
estimates (although imprecise) suggest that perhaps a quarter of a percentage
point of the increases in the core CPI during the past year may be attribut-
able to the past increases of these energy inputs. The Administration projects
that the CPI will increase at a 2.6 percent annual rate during 2007 and 2008,
about the same as the 2006 pace of the core CPI.
Hourly compensation (which is about 61 percent of nonfarm business
output) has increased a bit faster in 2006 than in 2005. Nominal hourly
compensation for workers in private industry increased 3.2 percent in 2006,
up from 2.9 percent during the 12 months of 2005 according to the
Employment Cost Index (ECI). All of this increase was from growth in wages
and salaries (3.2 percent in 2006 versus 2.5 percent during 2005) while
hourly benefits grew more slowly (3.1 percent versus 4.0 percent).
Another measure of hourly compensation published by the Department of
Labor and derived from the National Income and Product Accounts has
increased somewhat faster (at 4.3 percent) than the 3 percent increase in the
ECI during the four quarters through the third quarter of 2006.
Unit labor costs have put little—if any—upward pressure on inflation thus far,
and it appears unlikely that they will over the next year. Unit labor costs have
increased at the same pace as the GDP price index, a 2.9 percent rate during the
four quarters through the third quarter of 2006. The Administration expects the
growth rate of hourly compensation to increase during 2007, as this nation’s
rapid productivity gains are shared by workers. But even with this acceleration in
compensation, the expected strong pace of productivity growth will likely keep
unit labor costs from putting upward pressure on inflation during 2007.
Moderate growth of hourly compensation and solid growth of productivity
together with strong aggregate demand has driven the profit share of gross
domestic income to its highest level since 1966.
Non-supervisory production-worker wages (which cover 82 percent of the
private workforce) increased 4.2 percent (in nominal terms) during the

36 | Economic Report of the President

12 months through December 2006—an acceleration of 1.1 percentage points
from the pace a year earlier. Real hourly wages of production workers increased
1.7 percent, a 2.1-percentage point acceleration from the pace a year earlier.
The acceleration in real earnings reflects both the 1.1-percentage point increase
in nominal wages and a 1 percentage point deceleration in consumer prices.
Among the many available measures of inflation, the Administration fore-
cast focuses on two: the CPI and the price index for the GDP. The CPI
measures prices for a fixed basket of consumer goods and services. It is widely
reported in the press, and is used to index Social Security, the individual
income tax, Federal pensions, and many private-sector contracts. The GDP
price index covers prices of goods and services produced in the United States
including consumption, investment, and government purchases. In contrast
to the CPI, its weights are not fixed but move to reflect changes in spending
patterns. Of the two indexes, the CPI tends to increase more rapidly in part
because it measures a fixed basket of goods; the GDP price index increases less
rapidly because it allows for households and businesses to shift their purchases
away from items with increasing relative prices and toward items with
decreasing relative prices. Among the differences, the GDP price index
(which includes investment goods) places a larger weight on computers,
which tend to decline in price (on a quality-adjusted basis). In contrast, the
CPI places a much larger weight on rent and energy.
The “wedge,” or difference between the CPI and the GDP measures of
inflation, has implications for Federal budget projections. A larger wedge
(with the CPI rising faster than the GDP price index) raises the Federal
budget deficit because Social Security and Federal pensions rise with the CPI,
while Federal revenue tends to increase with the GDP price index. For a given
level of nominal income, increases in the CPI also cut Federal revenue because
they raise the brackets at which higher income tax rates apply and affect other
inflation-indexed features of the tax code.
During the 25 years from 1981 to 2005, the wedge between inflation in the
CPI-U-RS (a historical CPI series designed to be consistent with current CPI
methods) and the rate of change in the GDP price index averaged 0.32
percent per year. The wedge was particularly high during 2005 when the CPI
increased 0.6 percentage point faster than the GDP price index. The wedge
during 2005 reflected the 35 percent increase in crude oil prices, which have
a larger weight in consumer prices (via their effect on refined-petroleum prod-
ucts) than in GDP as a whole. Because domestic production accounts for only
about 35 percent of U.S. oil consumption, the weight of oil prices in GDP is
roughly one-third of its weight in consumption. This effect unwound during
the fourth quarter of 2006 when oil prices declined, causing the wedge to
fall to -0.6 percentage point during the four quarters of 2006. From 2008
forward, the wedge is projected to average 0.3 percentage point.

Chapter 1 | 37
Financial Markets
The Wilshire 5000 (a broad stock market index) increased 13.9 percent
during 2006, while the Standard and Poor 500 (an index of the 500 largest
corporations) increased 13.6 percent. This was the fourth consecutive year of
stock market gains following 3 years of declines. The market has now recov-
ered most of its losses since the March 2000 peak, at least in nominal terms.
Despite increases in short-term rates, yields on 10-year notes remained low,
increasing only 9 basis points during the 12 months of 2006. The low level of
long-term interest rates was due in part to low and stable long-run inflation
expectations.
The Administration forecast of short term interest rates is roughly based
on financial market data as well as a survey of economic forecasters. As of
November 13, 2006, the date that the economic forecast was finalized,
trading in financial futures suggested that market participants expected short-
term rates to fall over the next several years, and the Administration’s interest
rate projections reflect those views. The Administration projects the rate on
91-day Treasury bills (5.1 percent on November 13 ) to remain flat in 2007
before edging down in 2008 and 2009. The short-term rate is projected to fall
to 4.1 percent by 2012. At that level, the real rate on 91-day Treasury bills
would be close to its historical average.
The yield on 10-year Treasury notes on November 13 was 4.61 percent,
48 basis points below the discount rate on the 91-day Treasury bills—a
noticeable reversal of the usual pattern which shows higher rates for long-term
yields. The Administration expects the 10-year rate to increase above the
91-day rate during 2007, eventually reaching a more normal spread of about
1.2 percentage points by 2010. An increase of a similar magnitude appears to
be expected by market participants (as evidenced by higher rates on 20- and
30-year Treasury notes than on notes with 10-year maturities). As a result,
yields on 10-year notes are expected to increase somewhat further, reaching a
plateau at 5.3 percent from 2010 onward.

The Long-Term Outlook Through 2012

Coming off a fifth year of expansion, the U.S. economy is settling into a
period of steady growth. Having reached a high level of resource utilization
by year-end 2006, growth is likely to slow in 2007 and then will expand
through 2012 at around 3.0 percent. Inflation will remain low and is expected
to edge a bit lower, and the labor market will remain firm (Table 1-1). The
forecast is based on conservative economic assumptions that are close to
the consensus of professional forecasters. These assumptions provide a sound
basis for the Administration’s budget projections.

38 | Economic Report of the President

 TABLE 1-1.— Administration Forecast 1
Nonfarm
payroll
Interest Interest
Nonfarm employ-
GDP price Consumer Unemploy- rate, rate,
Real GDP payroll ment
Nominal index price ment 91-day 10-year
Year (chain- employ- (average
GDP (chain- index rate Treasury Treasury
type) ment monthly
type) (CPI-U) (percent) bills 2 notes
(millions) change,
(percent) (percent)
Q4-to-Q4
thousands)3
Percent change, Q4-to-Q4 Level, calendar year

2005 (actual) .... 6.4 3.1 3.1 3.7 5.1 3.1 4.3 133.5 160
2006.................. 5.9 3.1 2.7 2.3 4.6 4.7 4.8 135.3 151
2007.................. 5.5 2.9 2.5 2.6 4.6 4.7 5.0 137.0 129
2008.................. 5.5 3.1 2.3 2.6 4.8 4.6 5.1 138.6 139
2009.................. 5.3 3.1 2.2 2.5 4.8 4.4 5.2 140.2 126
2010.................. 5.2 3.0 2.1 2.4 4.8 4.2 5.3 141.5 113
2011.................. 5.0 3.0 2.0 2.3 4.8 4.1 5.3 143.0 118
2012.................. 5.0 2.9 2.0 2.3 4.8 4.1 5.3 144.3 107

1
Based on data available as of November 13, 2006.
2
Discount basis.
3
If the effect of the BLS benchmark adjustment were included, monthly job growth would average 202 and 191
thousand in 2005 and 2006 respectively. The level of payroll employment would be 133.7 and 136.2 million in these 2 years.
Sources: Council of Economic Advisers, Department of Commerce (Bureau of Economic Analysis and Economics and
Statistics Administration), Department of Labor (Bureau of Labor Statistics), Department of the Treasury, and Office of
Management and Budget.

Growth in GDP over the Long Term

The Administration projects that, following a slight pickup of growth from
2007 to 2008, real GDP will increase at a slowly diminishing rate from 2008
through 2012. Indeed, real GDP is projected to decelerate from a 3.1 percent
rate of growth during the four quarters of 2008 to 2.9 percent by 2012. The
average growth rate during this interval is roughly in line with the consensus
of private forecasters for those years. After 2007, the year-by-year pace is close
to the estimated growth rate of potential real GDP, a measure of the rate of
growth of productive capacity. (An economy is said to be growing at its poten-
tial rate when all of its resources are utilized and inflation is stable. The
supply-side components of potential GDP growth are presented in Table 1-2
and are discussed below). The unemployment rate is projected to edge up in
2007 (from its 4.5 percent level in the fourth quarter of 2006) and to plateau
at 4.8 percent in 2008. As discussed below, potential GDP growth is expected
to slow in the near term as productivity growth reverts toward its long-run
trend (about 2.6 percent per year), and to slow further during the 2007-to-
2011 period as labor force growth declines due to the retirement of the
baby-boom generation.
The growth rate of the economy over the long run is determined by its
supply-side components, which include population, labor force participation,

Chapter 1 | 39
the ratio of nonfarm business employment to household employment, the
length of the workweek, and labor productivity. The Administration’s forecast
for the contribution of the growth rates of different supply-side factors to real
GDP growth is shown in Table 1-2.

TABLE 1-2.— Supply-Side Components of Real GDP Growth, 1953–2012

[Average annual percent change]

1953 Q2 1973 Q4 1995 Q2 2001 Q1 2006 Q3

Item to to to to to
1973 Q4 1995 Q2 2001 Q1 2006 Q3 2012 Q4

1) Civilian noninstitutional population aged 16+ 1 ........................... 1.6 1.4 1.2 1.2 1.0
2) Plus: Civilian labor force participation rate ............................. 0.2 0.4 0.1 -0.3 -0.2

3) Equals: Civilian labor force 2 ......................................................... 1.8 1.8 1.4 1.0 0.8
4) Plus: Civilian employment rate ................................................. -0.1 0.0 0.3 -0.1 0.0

5) Equals: Civilian employment 2 ....................................................... 1.7 1.8 1.7 0.9 0.8

6) Plus: Nonfarm business employment as
a share of civilian employment 2 3 .................................... -0.1 0.1 0.4 -0.7 0.1

7) Equals: Nonfarm business employment........................................ 1.6 1.9 2.0 0.2 0.8

8) Plus: Average weekly hours (nonfarm business) ...................... -0.3 -0.3 -0.1 -0.2 0.0

9) Equals: Hours of all persons (nonfarm business)......................... 1.3 1.6 1.9 0.0 0.8
10) Plus: Output per hour (productivity, nonfarm business) .......... 2.5 1.5 2.4 3.1 2.6

11) Equals: Nonfarm business output................................................. 3.8 3.1 4.3 3.0 3.4
12) Plus: Ratio of real GDP to nonfarm business output 4 .............. -0.2 -0.2 -0.5 -0.3 -0.4

13) Equals: Real GDP........................................................................... 3.6 2.8 3.8 2.7 3.0

1
Adjusted by CEA to smooth discontinuities in the population series since 1990.
2
BLS research series adjusted to smooth irregularities in the population series since 1990.
3
Line 6 translates the civilian employment growth rate into the nonfarm business employment growth rate.
4
Line 12 translates nonfarm business output back into output for all sectors (GDP), which includes the output of farms
and general government.
Note: 1953 Q2, 1973 Q4, and 2001 Q1 are NBER business-cycle peaks. Detail may not add to total because of rounding.
Sources: Council of Economic Advisers, Department of Commerce (Bureau of Economic Analysis), and Department of
Labor (Bureau of Labor Statistics).

As can be seen in the fourth column of the table, the mix of supply-side
factors determining real GDP growth has been unusual since the business-
cycle peak at the beginning of 2001. The high rate of productivity growth
(3.1 percent at an annual rate, shown in line 10) has been partially offset by
the decline in the participation rate (line 2) and the workweek (line 8). Also
notable is the large and puzzling decline in the ratio of nonfarm business
employment to household employment (line 6). This unusual decline reflects
the slow growth of employment as measured by the payroll survey (which asks
employers to report the number of jobs) relative to the more rapid growth of
employment as measured by the household survey (which estimates the
number of employed persons through a sample of households). This disparity

40 | Economic Report of the President

has been reduced somewhat by the just-issued benchmark revision to payroll
employment, but has yet to be satisfactorily explained.
The participation rate fell, on net, from 2001 to 2006 (although it ticked
up in 2006), and is projected to trend lower through 2012. The recent
behavior stands in contrast to the long period of increase from 1960 through
1996. Looking ahead, the participation rate is projected to decline, reflecting
the aging of the baby-boom cohorts, leading to more retirements and a likely
increase in the share of people on disability pensions (see Box 1-2).

Box 1-2: Long-Term Prospects for Labor Force Participation

The overall rate of labor force participation is projected to decline as

the baby-boom cohorts advance into age brackets with much lower
participation rates. Participation in the labor force (by working or by
looking for a job) declines as people age through their 50s and 60s, as
can be seen in the following chart.

This chart shows the estimated average lifetime age-participation

profile for the 13 cohorts born from 1928 to 1940. Men’s participation is
high (exceeding 90 percent) from age 24 through age 50, but then
declines thereafter, dropping to 83 percent by age 55 and 36 percent by
age 65. The rate of labor force exit is particularly rapid around 62, the
continued on the next page

Chapter 1 | 41
 Box 1-2 — continued
age at which one becomes eligible for early Social Security retirement
benefits. In fact, about 40 percent of those eligible elect to begin
collecting Social Security annuities at age 62, although this does not
necessarily mean that they exit the workforce.
The difference between the age-participation profile of this 1946
cohort (the dotted lines) and those of its elders illustrates how partici-
pation rates have evolved over time. Female participation rates have
moved sharply upward—in a roughly parallel shift. In contrast, male
participation rates have changed little over time, moving down only
slightly.
The current age distribution of the U.S. population is shown by the
bars in the following chart, and the black line shows an estimate of the
age distribution of the population in 2012. The large baby-boom cohorts
(who were born between 1946 and 1964) are now 42 to 60 years old,
and their aging will shift a sizeable fraction of the population into age
brackets with lower participation rates, thus decreasing the share of the
population in the high-participation ages.

42 | Economic Report of the President

 An extrapolation that moves the participation rate of each cohort
along a path that parallels the 1928–1940 reference cohort and projects
how the aging of the population translates into participation rates
suggests an average participation rate decline of roughly 0.3 percent
per year. A decline of this magnitude would alter a wide range of labor-
market behaviors. In response to the emerging shortage of experienced
workers, real wages are likely to increase and workweeks are likely to
lengthen. Labor productivity is likely to increase as employers invest in
labor-saving capital. And more immigrants may enter the U.S. labor
force. The largest effect of the baby–boom retirements, however, is
likely to be an endogenous effect on the labor force participation rate
itself as developments in pay and pension arrangements evolve to
induce higher participation rates among experienced workers than our
extrapolation would suggest.

The Composition of Income over the Long Term

The Administration’s economic forecast is used to estimate future govern-
ment revenues, a purpose that requires a projection of the components of
taxable income. The income-side projection is based on the historical stability
of labor compensation as a share of gross domestic income (GDI). During the
first half of 2006, the labor compensation share of GDI was 56.7 percent
(according to the preliminary data available when the projection was finalized),
slightly below its 1963–2005 average of 58.1 percent. From this jump-off
point, the labor share is projected to slowly rise to 57.8 percent by 2012.
The labor compensation share of GDI consists of wages and salaries (which
are taxable), non-wage compensation (employer contributions to employee
pension and insurance funds—which are not taxable), and employer contribu-
tions for social insurance (which are not taxable). The Administration forecasts
that the wage and salary share of compensation will be approximately flat
between 2007 and 2012. Employer contributions to defined-benefit pension
plans rose by almost 1 percentage point of total compensation between 2001
and 2002, boosting the growth of non-wage compensation. Contributions
leveled off and then edged lower in subsequent years.
The capital share of GDI is expected to edge down from its currently high
level before eventually reaching its historical average in 2012. Within the
capital share, private depreciation is expected to increase (as a result of the
strong growth of investment during the past 3 years). Profits during the first

Chapter 1 | 43
three quarters of 2006 were about 12.2 percent of GDI, well above their post-
1959 average of roughly 9 percent. Book profits (also known in the national
income accounts as profits before tax) are expected to decline as a share of GDI.
The GDI share of other taxable income (rent, dividends, proprietors’
income, and personal interest income) is projected to edge up slightly over the
next 2 years.

Conclusion
With the rapid-growth period of the expansion fading into the past, the
economy is currently going through a period of rebalancing, where higher
growth of nonresidential investment and exports are offsetting the lower rates
of housing investment. The economy is projected to settle into a steady state
in which real GDP grows at about 3 percent per year, the unemployment rate
creeps up towards a noninflationary level (of 4.8 percent) and inflation
remains moderate and stable (about 2.2 to 2.6 percent on the CPI).
Consumer spending is projected to grow in line with disposable income, and
business investment and exports are projected to grow a bit faster than GDP
as a whole. Economic forecasts are subject to error, and unforeseen positive
and negative developments will affect the course of the economy over the next
several years. Given the economy’s fundamental strengths, however, prospects
for continued growth in the years ahead remain good. Nonetheless, much
work remains in making our economy as productive as possible. Later chap-
ters of this Report explore how pro-growth policies such as tax reform, fiscal
restraint, open commerce, and enhancing our energy security can enhance
our economic performance.

44 | Economic Report of the President