Joel Prakken April 14,2004

Macroeconomic Advisers, LLC Challenging Transitions: The US Economic Outlook Dr. Joel L. Prakken, Chairman Macroeconomic Advisers, LLC Presentation for The Global Interdependence Center: Global Issues and the US Outlook April 14, 2004 For more information about Macroeconomic Advisers write or call us at: 231 South Bemiston Ave, #900, Saint Louis, MO 63105 (314-721-4747) or visit us on the web at www.macroadvisers.com

April 2004

Š Macroeconomic

1

Themes in the Outlook • Above-trend (> 3.5%) GDP growth in ’04 and ’05 – Healthy (monthly) profile heading into ’04 – Still positive (but waning) fiscal/financial stimulus – Synchronized global recovery, weakened dollar – Capital excesses of the 1990s turned to shortfalls – Lean inventories (outside of vehicle sector) • Still, only gradual improvement in labor markets • Further, but temporary, disinflation thru mid-’04 • First monetary tightening in early ’05 • Key transitions: withdrawal of policy stimulus; rotation to cap ex, net exports; inventory rebound • Biggest imponderables: productivity, terrorism April 2004

© Macroeconomic

2

Monthly Real GDP through January 2004 10800 Did you know that MA’s monthly GDP is now used by the NBER to date business cycles?!

Billions of Chained (2000) Dollars

10600

Jan

Jan/Q4 = 3.0% a.r.

Q4

10400

10200

10000

9800

9600 2000

April 2004

2001

2002

© Macroeconomic

2003

3

2004

First-Half Growth: MA vs. Our Own Consensus Panel

Survey results reported regularly in MA’s Weekly Economic Commentary.

April 2004

Š Macroeconomic

4

The Forecast in Summary GDP

GDP Price

Unem Rate

Fed Funds Rate

T-Note Yield

9 Growth of: '04:H1 '04:H2 '04 '05 Real GDP 4.4 4.2 4.3 4.0 GDP Price 1.4 1.1 1.2 1.2

Annual Percent / Percent Change

8 7 6 5 4 3 2 1 0 -1

H

F

-2 2000

2001

April 2004

2002

2003

Š Macroeconomic

2004

2005

5

Growth of Real GDP in 2004: MA vs Blue Chip 5.0

Percent Change, Year / Year

MA 4.5 Blue Chip

4.0

3.5

3.0 Aug 03

Sep 03

April 2004

Oct 03

Nov 03

Dec 03

Š Macroeconomic

Jan 04

Feb 04

6

Mar 04

Apr 04

The Forecast in Summary 2003 Q4

Q1

Real GDP, PCAR CIPI (Contribution) Final Sales, PCAR Consumption Nonres Fixed Inv Residential Inv Exports Imports ( - ) Govt C&GI Dom Demand, PCAR

4.1 0.9 3.4 3.2 10.9 7.9 20.5 16.4 -0.1 3.6

4.4 1.1 3.3 3.6 7.4 -0.6 0.7 3.2 2.2 3.5

Unem Rate (%) Core CPI, PCAR Fed Funds Rate (%) 10-Yr T-Note Yld (%)

5.9 1.0 1.0 4.3

Foreign GDP, PCAR Exchange Rate Equity Wealth, % Chg Corp Profits, PCAR

April 2004

2004 Q2

4/4 or Yr Avg 03 04

Q3

Q4

4.3 0.5 3.8 4.0 11.9 -4.2 11.8 12.3 3.5 4.2

4.2 0.0 4.2 3.6 13.4 -4.8 12.0 6.4 1.9 3.8

4.1 0.1 4.0 3.3 13.1 -9.5 12.1 4.9 1.8 3.3

4.3 -0.1 4.4 4.0 7.4 9.5 6.4 4.5 2.1 4.2

4.3 0.5 3.8 3.6 11.4 -4.8 9.0 6.6 2.3 3.7

4.0 0.0 4.0 3.7 9.2 -8.9 11.8 4.0 1.1 3.2

5.6 1.4 1.0 4.0

5.6 1.3 1.0 4.0

5.5 1.3 1.0 4.3

5.4 1.4 1.0 4.5

6.0 1.1 1.0 4.0

5.5 1.3 1.1 4.2

5.2 1.7 2.0 5.3

4.9 115.6

3.0 113.3

3.3 113.8

3.4 113.7

3.1 113.5

2.6 119.3

3.2 113.6

3.3 112.3

12.2 32.3

0.4 10.2

2.4 10.2

1.7 9.5

2.0 8.2

30.1 29.1

6.7 9.5

10.3 6.0

Š Macroeconomic

7

05

Qualitative Features of the Forecast • Steady growth in final sales (~ 4% ) punctuated by a sharp increase ($49 bil) in inventory inv during ’04 • Gradual deceleration of domestic final demand offset by robust recovery of net exports, especially in ’05 • Household expenditures, government C&GI undermined by the withdrawal of policy stimulus – PCE, govt C&GI grow slower than GDP – Residential construction declines in ’04 and ’05

• Partial offset from a sharp acceleration of capital expenditures, especially E&S • Trade benefits from recovery of global growth, deceleration of domestic demand, weaker dollar April 2004

© Macroeconomic

8

Qualitative Features of the Forecast • Gradual improvement in labor markets – Trailing edge of recent productivity surge – Modest cyclical rebound in labor force participation rate, average workweek – Lethargic employment not a threat to recovery…

– …or even very mysterious!

• Despite high oil prices, lower dollar, little inflation risk – Labor market slack: modest growth in wages – Productivity surge: falling unit labor costs • Fed is patient, but long rates eventually edge up in anticipation of first tightening.

April 2004

© Macroeconomic

9

Fiscal Policy Assumptions • Provisions assumed to expire on schedule – Emergency unem benefits (“soft” expiration Dec 03) – 50% expensing “bonus” (Dec 04): impact on BFI?

• JGTRRA provisions assumed not to expire in Dec 04 – – – –

Expanded 10% bracket (JCT: $4.3 bil in FY05) Child credit at $1000 ($2.6 bil) Relief from “marriage penalty” ($5.4 bil) Increased AMT exemption amount ($6.9 bil)

• $48 bil decline in net nonwithheld taxes in 2004 – $30 bil as refunds (BEA: $26 bil; OTA: $36 bil) – $18 bil as reduced final settlements (OTA)

• Late-year Iraq supplemental, smaller than last two April 2004

© Macroeconomic

10

Other Key Forecast Assumptions • Monetary policy (more from Larry, next) – First tightening in Jan ’05 – Fed funds rate hits 3% by Dec ’05

• Oil prices remain high in ’04, decline modestly in ’05 • Uncertainty that has restrained both businesses and investors gradually lifts – Further rise in stock prices – Businesses willing to rebuild inventories, re-hire labor – And resume accumulating fixed capital

• Recent, rapid productivity growth is unsustainable • US leads, but global recovery in phase • No significant terrorist acts in the US April 2004

© Macroeconomic

11

Notes on the Implementation of Fiscal Stimulus • There is a lot a tax money hitting the economy in the first half of 2004, but overall stimulus is modest • Refunds of over-withholdings from first half of 2003 are a one-time event with a “temporary” MPC • The decline in final settlements is mostly against estimated taxes on dividends and capital gains – We do assume this is permanent (not sunset in ’08) – But expectation of tax cut already working via wealth effect – With little extra kick when lower settlements realized

• Tax stimulus partly offset by impact of the expiration of emergency unemployment benefits in Dec • Discretionary outlays will slow (relative to trend) April 2004

© Macroeconomic

12

MA's Fiscal Conditions Index 4

Percentage Points of GDP Growth

3

Transition from fiscal stimulus to restraint

2 1 0 -1 -2 H F -3 1999

2000

April 2004

2001

2002

Š Macroeconomic

2003

2004

13

2005

MA's Monetary & Financial Conditions Index 4 Transition from monetary / financial acceleration to deceleration

Percentage Points of GDP Growth

3 2

From Rates/Yields 1 0 -1 -2 Total

H F

-3 1999

2000

April 2004

2001

2002

Š Macroeconomic

2003

2004

14

2005

MA's Combined Fiscal/Financial Conditions Index 4 The gradual withdrawal of combined stimulus.

Percentage Points of GDP Growth

3 2 1 0 -1

For more see “A Combined Monetary, Financial, and Fiscal Conditions Index”, Economic Outlook (Sept 2003) -2 H F -3 1999

2000

April 2004

2001

2002

© Macroeconomic

2003

2004

15

2005

Surprise! Refiners' Cost of Oil Imports 35 2003 $28

30

2004 $31

2005 $27

Dollars per Barrel

25 20 July 2003 Forecast

15 10 For more, see “Are High Oil Prices a Threat”, US Economic Outlook (March 20, 2004)

5 0 1989

1991

April 2004

1993

1995

1997

© Macroeconomic

1999

H F 2001

16

2003

2005

Growth of Labor Productivity 6

4-Quarter Percent Change

5 Actual 4 3 Potential 2 1 0 H F -1 1989

1991

April 2004

1993

1995

1997

Š Macroeconomic

1999

2001

17

2003

2005

Phased Global Slowdown…& Recovery 6 H F

4-Quarter Percent Change

5 4 3 Asian Crisis

2 1

Gulf War

36-country GDP excl US (OEF)

0 U.S. Real GDP -1 -2 1989

1991

April 2004

1993

1995

1997

© Macroeconomic

1999

2001

18

2003

2005

FRB Broad, Real, Trade-Weighted Dollar 130 H F

125

Index (March 1973 = 100)

120 Dollar reversal to help spur trade

115 110 105 100 95 90 85

80 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

April 2004

Š Macroeconomic

19

Equity Wealth & S.E. Band Around "Fair" Value 20

0.50 Tech Bubble

Trillions of Dollars (End of Quarter)

18

0.45

16

0.40

14

0.35 Ruble Collapse

12 10

0.30 Ratio of NASDAQ to Wilshire (Right)

0.25

Irrational Exuberance

8

0.20

6

0.15 Geopolitical Uncertainties

4

0.10

Gulf War

2 0 1984

0.05 H

1987 Correction 1986

1988

April 2004

1990

1992

1994

1996

Š Macroeconomic

1998

2000

2002

20

F

2004

0.00

Contribution of Equity Wealth to GDP Growth 2.0 H F

Annualized Percentage Points

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 1980

1982

1984

April 2004

1986

1988

1990

1992

1994

Š Macroeconomic

1996

1998

2000

21

2002

2004

Consumer Durables & Residential Investment: Contr to 4-Qtr % Chg in Real GDP

Percentage Points of Annualized Growth

4 3 This time it was positive

2 1 0 Usually negative in recessions

-1 -2

H F -3 1979

1982

April 2004

1985

1988

1991

1994

Š Macroeconomic

1997

2000

22

2003

Nonfarm, Nonvehicle Inventories 21

120

Percent

20

80

19

40

18

0

17

-40

Inventory Investment (Right)

16

-80 Record Low I /S Ratio

15 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

April 2004

Š Macroeconomic

23

-120

Billions of Chained (2000) Dollars

H F

I / S Ratio (Left)

Investment in Equipment & Software 50 For more, see “What Happens when the Expensing Bonus Expires”, Economic Outlook (February 19, 2004)

H F

40 4-Quarter Percent Change

Computers & Software 30 20 10 0 Other Equipment -10 -20 1985

1987

April 2004

1989

1991

1993

1995

© Macroeconomic

1997

1999

2001

24

2003

2005

1000

20

900

16

800

Predicted (left)

Co-integrating Equation: log(K) = 2.95 + 1.00*log(Q) – 1.36*log(R)

12

700

8

600

4

500

0

400

-4 Error (right)

300

-8

200

-12 Actual (left)

100 0 1985

-16 -20 1987

April 2004

1989

1991

1993

1995

© Macroeconomic

1997

1999

2001

25

2003

Percent of Capital Stock

Billions of Chained (2000) Dollars

Capital Excess/Shortfall: Computers & Software

Capital Excess/Shortfall: Other Equipment 4000

5

3800

4

3600

3

3400

2

Predicted

3200

1

3000

0

2800

-1

Actual

2600

-2

2400

-3 Co-integrating Equation: log(K) = 4.60 + .80*log(Q) – 1.17*log(R)

2200 2000 1985

-4 -5

1987

April 2004

1989

1991

1993

1995

© Macroeconomic

1997

1999

2001

26

2003

Percent of Capital Stock

Billions of Chained (2000) Dollars

Error (right)

Contributions to PNF Price Inflation 5 From "Unit Labor Costs"

H F

4-Quarter Percent Change

4 3 2 1 Actual Inflation 0 -1

From unemployment and exchange rates

-2 1991

1993

April 2004

1995

1997

1999

Š Macroeconomic

2001

2003

27

2005

Interest Rates & the Term Spread 10 H F

9 8 10-Yr Note Yield

Percent per Annum

7 6 5

Fed Funds Rate

4 3 2

Term Spread

1 0 -1 -2 1989

1991

April 2004

1993

1995

1997

Š Macroeconomic

1999

2001

28

2003

2005

Unemployment Rate & the NAIRU 12 H F Initial conditions matter! Historically small unemployment gap is consistent with slow employment growth.

10

8 Percent

Unemployment Rate 6 NAIRU 4 90% Confidence Interval: Full Employment 2

0 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

April 2004

Š Macroeconomic

29

Elasticity of Pvt Nonfarm Estab Employment with Respect to MA's Index of Monthly GDP 1.20

0.10 0.09

1.00

0.08 Cumulative (Left)

0.80

0.07 0.06

0.60

0.05 0.04

0.40

0.03 Incremental (Right)

0.02

0.20

0.01 0.00

0.00 0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

Months

April 2004

Š Macroeconomic

30

15

16

17

Private Nonfarm Establishment Employment 0.3 For more see “Can Sluggish Employment Growth Scuttle the Expansion?”, Economic Outlook (March 10, 2004)

Monthly Percent Change

0.2 0.1 0.0 -0.1 -0.2 -0.3

+/- 1 Std. Err

H F

-0.4 2001

April 2004

2002

© Macroeconomic

2003

2004

31