John Silvia Presentation March 0805

Presentation to: The 2005 Global Economic Outlook Conference

Translating Trendsinto Actions

John Silvia – Chief Economist March 8, 2005

Economic Transition •

Traditional Business Cycle •

Not the Sky is Falling

SUSTAINED GROWTH: ABOVE TREND BIAS Real GDP

8%

8%

4th Quarter 2004 @ 3.8%

6%

6%

4%

4%

2%

2%

0%

0%

-2% 1999

2000

2001

2002

2003

-2% 2004

Quarter/Quarter Percent Change, Seasonally Adusted Annual Rate

Mid-Cycle Economics: Real GDP 3.35% 3.30% 3.25% 3.20% 3.15% 3.10% 3.05% 3.00% 2.95% 2.90% Phase 1

Phase 2

INVESTMENT RECOVERY MODERATES 15%

FINAL DOMESTIC DEMAND COMPONENTS

15%

Green Line = Business Fixed Investment (Year-on-Year Growth)

10%

10%

5%

5%

0%

0%

-5%

-5%

-10%

Red Line = Government Spending Blue Line = Consumer Spending

97

98

99

00

01

02

03

04

-10%

d-Cycle Economics: Housing Sta

Phase 1

Phase

Where are we going?

•

Outlook – Growth: But Slower • Not Your Father’ s Economic Recovery.

FEWER CLAIMS SIGNAL RECOVERY 500

Initial Jobless Claims, In Thousands

Blue Line = 4-Week Moving Average @ 307.00 Green Line = Weekly Figure @ 310.00

450

February 26

500 450

400

400

350

350

300

300

250

250

2002

2003

2004

2005

MANUFACTURING RECOVERY 65 60

ISM COMPOSITE INDEX

Diffusion Index

February @ 55.3

65 60

55

55

50

50

45

45

40

40

35 97 98 99 00 01 02 03 04 05 35

DURABLES VS NONDURABLE GOODS MANUFACTURING 140

Industrial Production, Index

140

Blue Line = Durable Goods @ 137.0

130

130

120

120

January

110

110

100

100 Green Line = Nondurable Goods @ 101.7

90 97 98 99 00 01 02 03 04 05 90

SERVICE SECTOR GAINS CONTINUE 70 65

ISM NON-MANUFACTURING INDEX BUSINESS ACTIVITY INDEX

February @ 59.8

70 65

60

60

55

55

50

50

45

45

40

40

Seasonally Adjusted

35 97 98 99 00 01 02 03 04 05 35

A Hybrid World Clues for Change

CONSUMER PRICE INDEX Year-over-Year Percent Change

4.0%

4.0%

Blue Line = CPI Green Line = Core CPI

3.5%

3.5%

3.0%

3.0%

2.5%

2.5%

2.0%

2.0%

1.5%

1.5%

1.0%

1.0%

0.5%

0.5%

01

02

03

04

G8 Real GDP Growth Rates Year-on-Year %Change

8% 7%

8%

2Q 2004 3Q 2004

7%

6%

6%

5%

5%

4%

4%

3%

3%

2%

2%

1% U.S. Japan Eurozone U.K. Russia Canada 1%

WHAT DOLLAR IS IN YOUR WALLET? 105

Green Line = OITP Index

105

100

100

95

95

90

90

85

85

80

80

Blue Line = Major Currency Index 75 75 2003 2004 2005

ACCOMODATIVE FED POLICY CONTINUES 12% 10%

REAL FEDERAL FUNDS RATE VS. M2 MONEY GROWTH

Blue Line = M2 Growth, Yr/Yr % Change, January @ 5.6% Green Line = Real Fed Funds Rate*, January @ 0.0%

12% 10%

8%

8%

6%

6%

4%

4%

2%

2%

0%

0% * Fed Funds Rate minus "Core" Consumer Price Index

-2% 92

94

96

98

00

02

04

-2%

FEDERAL BUDGET IMBALANCE 23% 22% 21%

Spending & Revenue As Percent of GDP

January '05 SPENDING (Blue Line) 19.3%

20%

Latest 12 months: Revenue $1,943 Trillion 19% Spending $2,333 Trillion

18% 17% 16%

23% 22% 21% 20% 19% 18%

REVENUE (Green Line) 16.1%

17% 16%

15% 87 89 91 93 95 97 99 01 03 05 15%

FEDERAL BUDGET SURPLUS OR DEFICIT $30

12 month moving average

$30

$20

$20

$10

$10

$0

$0

$-10

$-10

$-20

$-20

$-30

$-30

$-40

January 2005 @ -$32.6 Billion

$-40

$-50 1998 1999 2000 2001 2002 2003 2004 2005 $-50

0

Social Security, Medicare, and Medicaid Spending as a Percent of GDP Percent of GDP

Medicare

Medicaid Social Security

2020

2030

2040

2050

2060

Note: Social Security and Medicare projections based on the intermediate assumptions of the 2004 Trustees’ Reports. Medicaid projections based on CBO’s January 2004 short-term Medicaid estimates and CBO’s December 2003 long-term Medicaid projections under mid-range assumptions.

Source: GAO analysis based on data from the Office of the Chief Actuary, Social Security Administration, Office of the Actuary, Centers for Medicare and Medicaid Services, and the Congressional Budget Office.

FEDERAL GOVERNMENT SPENDING, Ex. INTEREST PAYMENTS Year to Year Percent Change, 12 Month Moving Average

20%

Blue Line = Gov't Spending ex. Interest Payments @ 5.8%

20%

Red Line = Nominal GDP, Yr/Yr @ 5.6%

15%

15%

10%

10%

5%

5%

0%

0%

-5%

-5%

78

83

88

93

98

03

9%

10-YEAR TREASURY VS. BAA CORPORATE BOND YIELD

9%

February 8%

8%

7%

7%

6%

6%

5%

5%

4%

4%

3%

Green Line = BAA Yield Blue Line = 10-Yr Treasury

97 98 99 00 01 02 03 04 05

3%

Traditional Model • Fed Raises Rates • Inflation Up • Sustained Economic Growth • Persistent Fiscal Deficits • Declining Dollar • Yet Treasury Rates

NOMINAL GDP VS. 10-YR TREASURY 8% 7%

Blue Line = Nominal GDP, Yr/Yr % Change Green Line = 10-Yr Treasury Yield

8% 7%

6%

6%

5%

5%

4%

4%

3%

3%

2%

2%

96 97 98 99 00 01 02 03 04

AA and BAA Corporate Bond Yield Spreads (Over 10-Year Treasury)

2.00%

2.00% Enron - Oct 2001 World Com - March 2002 Sarbannes-Oxley - July 2002

1.80%

Red Line = Baa Spread

1.60%

1.40%

1.80%

1.60%

1.40% Blue Line = Aa Spread

1.20%

2002

2003

2004

2005

1.20%

35% 30%

CORPORATE INTEREST EXPENSE AS A PERCENT OF CASH FLOW Nonfinancial Corporate Business

3Q 2004 @ 13.5%

35% 30%

25%

25%

20%

20%

15%

15%

10% 80 82 84 86 88 90 92 94 96 98 00 02 04 10%

Traditional Model Managed Exchanged Rates China, Japan Profit Motive Central Bank Directed Capital Flows Preferred Habitat

Managed Exchange Rates • Domestic, Foreign Bonds not Perfect Substitutes. • Buy UST to Manage Exchange Rate Even if Adjusted for Exchange Rate Risk and if Below Other Sovereign Debt Expected Rates of Return.

FED CUSTODY HOLDINGS OF U.S. TREASURY SECURITIES FOR FOREIGN CENTRAL BANKS

$1100

In Billions of Dollars

$1100

$1000

$1000

$900

$900

$800

$800

$700

$700

$600

$600

$500 96 97 98 99 00 01 02 03 04 05 $500

Total Net Foreign Purchases of U.S. Treasurys by World Region 200,000

150,000

Net Foreign Purchases of U.S. Treasurys ($ Millions)

100,000

50,000

0

-50,000

200 4

Europe

200 3

Japan

200 2

200 1

0

199 9

8 199

200

Source: Dept. of U.S. Treasury

199 7

6 199

199 5

-100,000

Latin America & Caribbean

China

Total Net Foreign Purchases of U.S. Corporate and Agency Bonds by World Region 250,000

200,000

Net Foreign Purchases of U.S. Corporate and Agency Bonds ($ Millions)

150,000

100,000

50,000

0

200 4

3

Europe

200

200 1

Japan

200 2

200 0

199 9

199 8

6 199

Source: US Dept. of Treasury

199 7

5 199

-50,000

Latin America & Caribbean

China

Why Euro so Strong if U.S. Growth Stronger Than Euro Community? • Only Trade the Euro.

Eurozone vs U.S. Policy Rates 7%

ECB Rate Fed Funds Rate $ per Euro

5%

$1.40 $1.30 $1.20

4% $1.10 3% $1.00

2% 1%

$0.90

0%

$0.80

2000 2001 2002 2003 2004 2005

$ p e r Eu r o

C e n tr a l B a n k P o lic y R a te s

6%

versus Euro/Dollar Echange Rate

versus Euro/Dollar Echange Rate

10%

$1.30

Eurozone GDP U.S. GDP $ per Euro

8%

$1.20

6% $1.10 4% $1.00 2% $0.90

0% -2%

2000

2001

2002

2003

Real Growth at a Quarterly Annualized Change

2004

$0.80

$ p e r Eu r o

G D P G r o w th R a te s

Eurozone GDP vs U.S. GDP Growth

Profit Motive Central Banks of Japan, China not mark to market not quarterly report to shareholders Therefore Buy Treasuries Even if Expected Rate of Return Lower and Exchange Risk Higher.

Directed Capital Flows • Preferred Habitat • Global Demand is the Marginal Buyer • Imperfect Capital Mobility

Net Foreign Purchases of U.S. Debt Products 60%

50%

Foreigners Purchases as a Percentage of U.S. Debt Financial Assets

40%

30%

20%

10% 1998

1999

2000

2001

2002

2003

2004

Source: Flow of Funds and U.S. Dept. of Treasury Note: Total debt created represents the sum of government, household and non financial corporate sector net borrow ing.

Tax Reform Fundamentals

100%

Top 20% of Taxpayers Pay More in Taxes Than Their Share of Income 81%

80%

58%

60% 40% 20% 0%

3% 0%

7%

12% 2%

5%

20% 12%

Bottom 20% Second 20% Middle 20% Fourth 20%

Top 20%

Percentage of Total Income (AGI) Percentage of Income Taxes Paid

Source: Tax Foundation Individual Tax Model, does not include refundable portion of EITC or Child Tax Credit

Tale of Two Americas Payers -Rising Number of Dual-Income Working Professional Couples in Urban Areas - Growing Class of Entrepreneurs & Business Owners (Sole Proprietors, Partnerships, S-Corporations) Non-Payers - Growing Class of Tax Filers Who Have No Tax Liability

The Number of Non-Paying Filers Has Exploded Since 2000 50 45 40 35 30 25 20 15 10 5 0

44.2

26.7

1995

29.2

29.9

1998

2000

2004 Est.

Millions of Tax Returns Source: Tax Foundation Individual Tax Model based on IRS and Census Data

Who are the NonPayers?

Low-Income: 97% Earn Less Than $40,000 •

• Young: 36% below Age 25, 56% below 35 • Women and Unmarried: 54% are single Women or Female-Headed Households • Part-Time Workers: 42% Work Part-Time, 20% Work Full-Time but less than 50 weeks • Benefit from Credits: 34% Claim

Who are the Payers?

They are married, dual-income professionals; •

• They are entrepreneurs and business owners; • They tend to live in high-cost areas; • They are educated; • They are older; and • They pay the lion’ s share of income taxes

Married? Then You Are Most Likely "Rich" 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

86%

84% 71%

69% 57% 43% 31%

29% 16%

Poorest 20% 2nd 20% 0$ -- $14,415

14%

Middle 20% $25,500 -$41,640

4th 20%

Richest 20% $68,296+

Singles Married Source: Tax Foundation Calculations based on IRS Data

College Educated? You Are Most Likely "Rich" 100% 90%

90%

80% 70% 60%

63%

56%

55% 44%

50% 40%

25%

30% 20% 10%

37% 33%

14%

20%

0% Bottom 20% Second 20% Middle 20% Fourth 20%

Top 20%

High School or Less Bachelor or Above Source: Tax Foundation Individual Tax Model based on IRS and Census data

What Does This Mean For Tax Reform?

• Tax reform must recognize changing demographics of American taxpayers – Today’ s “ middle-class” is not our father’ s middle-class.

• Traditional distributional tables are of little value to good tax policy – no two tax returns are the same.

• Broadening the base could put people back on the tax rolls – difficult politically.

• Cutting rates will be perceived as “ tax cuts for the rich” – difficult politically.

• Adhering to a progressive rate structure will continue to put tax burden on urban professional families, educated Americans, older workers, and business owners.

Economic Forecast *(Qtr/Qtr% Change, Annual Rate)

2002 2003 2004

2005

Real GDP* 1.9% 3.0% 4.4% 3.7% Personal 3.1% 3.3% 3.8% 3.3% Consumptio n* Equipment & Software*

- 6.4% 5.5%

13.6 %

11.9 %

CPI (YoY)

1.5% 2.3% 2.7% 2.8%

Corporate Profits (YoY)

14.0 16.8 % %

14.5 %

10.4 %

10-Yr TNote

4.30 3.89 % %

4.21 %

4.54 %

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