What road will U.S. economy take in 2003?

The past two years have been tough for the U.S. economy, with recession eroding the job base and stock market fluctuations wiping out a lot of financial equity for many Americans. As we turn to 2003, a lot of us are wondering, “What's in store for the U.S. economy this year?”

First, it's worth noting that while the boom years of the 1990s are certainly over, the year just ended was far from disastrous for the economy as a whole. Overall economic growth in 2002 was fairly healthy at about 3 percent. And while unemployment certainly is higher, the unemployment rate at roughly 6 percent nationally is still consistent with what many economists consider “full employment.”

The best way to describe recent economic conditions is as “A tale of two economies.” Most of the pain in the economy has been concentrated in that part of the economy that produces business equipment or investment goods.

Business spending on plant and equipment has declined for a number of reasons. A decline in corporate profits in 2000 and 2001; the declines in stock market valuations, as investors have become less willing to finance new business spending; and the natural pause in investment spending after the excesses of the 1990s all have played a part in the decline in investments last year.

At the same time, consumer spending has remained fairly healthy over the past couple of years, serving to stabilize the overall economy. Consumers have been willing to spend because consumer incomes have remained strong, boosted by tax cuts last year. In addition, the decline in interest rates, especially on home mortgages, has allowed consumers to lower the carrying cost on consumer debt.

By freeing up money that otherwise would be spent on mortgage payments, lower interest rates have helped boost demand for a host of other consumer goods, especially automobiles.

Of course, the more pressing issues surround the outlook for the economy as we move forward. Will the economy's return to strong growth be a slow crawl or a bounce?

A lot of what will happen in the year ahead depends on the business sector. If the business sector returns to growth this year, the economy is well poised to bounce back to healthy rates of growth.

In particular, the ability of the consumer sector to further boost the U.S. economy this year likely will be more limited. Interest rates are unlikely to fall further, so there will be no additional boost from lower interest costs. The employment picture is not likely to improve until business spending picks up.

Even if personal income rises moderately this year, consumers are likely to become more cautious about the outlook, and thus more inclined to trim spending.

What does this mean for individual businesses and households? First, there is little reason to think that the Federal Reserve will raise interest rates any time in the first half of 2003. Rather, the Fed is likely to adopt a “wait and see” attitude, putting off interest rate hikes until hard evidence of job growth is available.

This means that households and businesses can benefit from low financing costs a while longer. At the same time, there is little reason to expect the rapid increase in wages we saw in the late 1990s.

Of course, one critical factor in the outlook is federal fiscal policy - the combination of taxes and spending that makes up the federal deficit. Recently, I participated in an economic briefing held at the U.S. Treasury as part of the annual meetings of the American Economic Association. President Bush's economic program, with its focus on tax cuts to boost economic growth, was a centerpiece of the discussion. Tax relief can be an important factor in boosting the U.S. economy as we go forward.

Tax cuts, especially when they are large and widespread, directly affect household income and thus spending. We saw this clearly in 2002, when the change in tax-withholding schedules resulted in a jump in household spending power in January. The average tax cut under the President's plan is $1,083, and that benefits a wide range of households.

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