The U.S. economic picture

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Confirming the continuation of the solid, steady expansion that finally became firmly entrenched during the second quarter of 2003, the U.S. economy grew at an impressive 3.4 percent annual rate last quarter. It was the ninth consecutive quarter during which the economy has expanded by an annual rate of at least 3.3 percent. During the two previous years beginning in July 2003, the U.S. economy has grown by an average of 4.1 percent per year.

Last quarter's broad-based expansion was once again led by business investment, which grew at a 9 percent annual rate. Over the past two years, business investment has increased by nearly 20 percent. Business spending on equipment and software alone has increased more than 25 percent compared to two years ago. Residential fixed investment, which represents construction of single- and multifamily housing, continued to expand at its first-quarter growth rate of about 10 percent after temporarily slowing down during the second half of last year. Personal consumption expenditures, which now account for more than 70 percent of gross domestic product, rose at a respectable 3.3 percent annual rate last quarter. Exports, which are now 20 percent higher than they were two years ago, registered a healthy annualized gain of 13 percent last quarter, reflecting the second-fastest growth rate since the fourth quarter of 1998.

The U.S. economy appears poised to continue to experience solid growth in the short term. In fact, were it not for a significant drawdown of inventories during the April-June period, the economy's growth rate last quarter would have been much higher. Final sales of domestic product, which represents GDP less inventory changes, grew at nearly 6 percent last quarter. Firms will need to replenish their inventories, and that process will contribute to a growing economy. According to the Federal Reserve's latest forecast, the U.S. economy should continue to grow by 3.5 percent through 2006.

What Fed Chairman Alan Greenspan recently characterized as "a remarkable acceleration of productivity" helps to explain why the economy has been able to perform so well recently. For the 2002-2004 period, for example, productivity (output per hour) in the business sector increased at an average rate of 4.2 percent per year. Not only is that the fastest three-year period of productivity growth in more than 50 years; it is also 60 percent higher than the average annual productivity increase during the best three-year period of the go-go 1990s.

Over the past two years, the U.S. economy has experienced sizable gains in employment on top of the productivity explosion. Specifically, the U.S. economy has generated a net gain of 3.7 million jobs in nonfarm payrolls since June 2003. That month the unemployment rate reached its cyclical peak of 6.3 percent. Today, it is 5 percent, a level that most economists consider to be full employment. For two years now, average employment growth has exceeded 150,000 per month. Nearly 1.1 million jobs, or more than 180,000 per month, have been created during the first half of 2005. Given the recent off-the-chart increases in productivity, U.S. employment growth since the summer of 2003 has been solid.

In addition to the ongoing "remarkable" performance in productivity, the steady, "measured pace" at which the Fed has been increasing short-term interest rates over the past year has dampened inflationary pressures. The Fed's hard-earned credibility in monetary policy has also surely been responsible for containing inflation expectations, which reflect themselves in long-term interest rates. Confirming Mr. Greenspan's view that the Fed should continue to remove monetary accommodation in order to keep inflationary pressures contained, Friday's report on second-quarter economic growth revealed upticks in several price indexes. The price index for personal consumption expenditures, for example, increased at a 3.3 percent annual rate, up from 2.3 percent for the first quarter. The price index for gross domestic purchases, which measures prices paid by U.S. residents, also accelerated, hitting an annual rate of 3.2 percent.

To be sure, not everything about the U.S. economy is good. As we have noted in the past, the U.S. economy continues to face several structural imbalances, including a budget deficit far too large for this stage of the business cycle; a personal savings rate that is much too low; and a record trade deficit, which is growing rather than declining, notwithstanding last quarter's welcome increase in exports.

Despite the structural imbalances that afflict the U.S. economy, its performance remains the envy of the developed world. Compared to the 4.1 percent average annual growth rate achieved in the United States over the past two years, the euro-zone economies have grown at less than 2 percent per year. Over the latest 12 months for which data is available, the euro region has expanded by 1.4 percent, and the growth rates of the largest euro-zone economies have been: Germany (1.1 percent); France (1.8 percent); and Italy (-0.2 percent). Even Britain, which is not in the euro area, has grown by only 1.7 percent during the past year. The Japanese economy, which has been mired in one recession after another during the past 15 years, has grown by only 1.3 percent over the last 12 months.

Compared to the U.S. unemployment rate of 5 percent, which reflects a decline of 1.3 percentage points over the past year, the German unemployment rate has increased by 1 percentage point over 12 months to 11.6 percent. France's 10.2 percent unemployment rate is also higher than it was a year ago. Compared to 12 months earlier, the unemployment rate for the euro area remains essentially unchanged at 8.8 percent. That rate is more than 75 percent higher than the U.S. rate of 5 percent. Thus, while experiencing an economic growth rate that is roughly one-third the rate in the United States, the euro region suffers from an unemployment rate that is more than three-quarters higher than America's.