*EPF412 04/24/2003
Excerpt: U.S. Bank Official Projects Growth, Investment Gains Later in 2003
(Economic fundamentals broadly supportive of recovery, Bernanke says) (1380)

Business investment and economic growth in the United States are likely to pick up in the second half of 2003 and in 2004, a Federal Reserve official says.

Addressing an economic forecaster group in New York, Ben Bernanke said April 24 that the fundamental factors affecting investment such as the user cost of capital and interest rates are "broadly supportive of continuing recovery." Bernanke is a member of Board of Governors, a policy-setting body of the Federal Reserve System, the U.S. central bank.

He also cited expensing incentives for equipment purchases, the good financial condition of banks, improvements in corporate cash balances, and lower risk spreads in corporate bond markets as favorable factors.

Bernanke said that fast expansion of the residential sector is projected to continue to support economic growth in 2003 and "moderately" improved performance in high-tech investment "seems feasible and consistent with fundamentals."

However, he said the "state of expectations among corporate leaders is an important wild card."

Bernanke said that an "undercurrent of pessimism" has persisted among business leaders to a degree that cannot be "accounted for by what seem to be the generally good fundamentals of the U.S. economy." While a cause, or causes, of this mood are difficult to pin down, he said, corporate pessimism does matter because it has the potential to become self-fulfilling.

On the demand side, Bernanke said, conditions also are "potentially favorable, or at least improving" as high productivity, lower oil prices, reduced geopolitical uncertainty and other factors support spending. As a negative factor he cited weak growth abroad.

Following is an excerpt of Bernanke's remarks as prepared for delivery:

(begin excerpt)

Prospects for 2003 and 2004

So, to return finally to the question posed by the title of this talk: Will business investment bounce back this year and next?

My review of investment-forecasting methodology suggests several complementary ways to go about answering that question. First, one should consider the "fundamental" determinants of investment, the macroeconomic factors that determine the user cost of capital and the demand for business output. Second, one can take a more disaggregated approach and look at various sectors and types of capital to assess their potential for growth. Finally, a complete analysis requires some evidence on the views of managers and analysts about the expected profitability of new investment. Putting these pieces together, though no late-nineties type of boom seems likely, most factors point to a moderate pickup in business investment and economic growth in the second half of 2003 and in 2004. However, even putting aside the possibility of unexpected developments on the geopolitical front or elsewhere, the state of expectations among corporate leaders is an important wild card that must always be considered when forecasting investment.

The fundamental factors affecting investment are, as I have indicated, broadly supportive of continuing recovery. The user cost of capital is low and, dominated by continuing reductions in the quality-adjusted prices of high-tech equipment and historically low interest rates, will likely continue to decline. The partial expensing provision passed by the Congress in 2001 provides a significant incentive for firms to purchase equipment and certain types of software before the provision expires in the third quarter of 2004.(1) Under the general heading of financing conditions, favorable factors include the good financial condition of the banking system, improvements in corporate liquidity, and the substantial narrowing of risk spreads in corporate bond markets (though these remain somewhat elevated by historical standards).(2)

Potentially favorable, or at least improving, conditions prevail on the output or final demand side of the equation as well. Although many forecasters have marked down their estimates of GDP [gross domestic product] growth for the full year 2003, most still expect a pickup in the second half of the year and further acceleration in 2004. High productivity, lower oil prices, reduced geopolitical uncertainty, the waning effects of the stock market decline, and stimulative monetary and fiscal policies should all support spending, providing reasonable growth in final demand. However, a negative factor is weak growth abroad.

When we disaggregate investment to the sectoral level, what do we find? To begin, I mention the two parts of investment that so far have been omitted from this talk: residential investment and inventory investment. Residential investment was an important engine of growth in 2002, and most forecasters (as evidenced by the Blue Chip survey, for example) expect that it will continue strong in 2003. Inventory investment, by contrast, is generally expected to contribute little in 2003, in contrast to 2002, when this component made a significant net contribution to GDP growth. The risk here is clearly both downside and upside: On the downside, conceivably housing demand may weaken, but on the upside, firms may increase their inventories more than expected if they grow more optimistic about future sales.

With respect to the components of business fixed investment, the chance of a quick rebound in investment in nonresidential structures, particularly office buildings and industrial structures, seems slight. However, given the relatively small contribution of this sector to GDP, even continued (but slower) declines in structures investment would be consistent with an overall recovery in investment and GDP. The more critical sector -- because of its size -- is investment in equipment and software, particularly high-tech equipment. I have noted some grounds for modest optimism, as the high-tech sector already showed growth in 2002. Moderately improved performance for 2003 in high-tech investment, concentrated in a pickup in the second half of the year, seems feasible and consistent with fundamentals, particularly the continued decline in relative prices and growing replacement demand. Finally, some growth later in the year in non-high-tech equipment, excluding perhaps the relatively small aircraft component, is plausible and consistent with a scenario of strengthening overall investment. In short, a sectoral approach suggests that an investment bounceback of moderate proportions is a reasonable expectation.

Finally, what about investor and analyst expectations and attitudes? I noted earlier that adding analyst expectations to standard investment equations helps to explain the 2000-02 investment bust, as analysts (presumably reflecting what managers told them) became suddenly more pessimistic in 2000. It is interesting that the same exercise has little effect on projections of these augmented equations for 2003-04. In particular, long-term analysts' earning projections appear to be bottoming out, and short-term forecasts are brightening. These trends, if they continue, are consistent with an upturn in investment beginning in the second half of this year.

However, when we talk to managers themselves -- or talk to the people who talk to the managers -- we sometimes get a different story. Clearly, an undercurrent of pessimism has persisted among business leaders for some time now, more so than can be accounted for by what seem to be the generally good fundamentals of the U.S. economy. For policymakers, the most troubling aspect of this pessimism is our inability to ascertain its cause (or causes): Is it geopolitical uncertainty? The aftermath of the accounting scandals of last summer? Concerns about the ultimate profitability of new technologies and products? The depressive side of Keynesian animal spirits? This pessimism does matter, if for no other reason than because it has the potential to become self-fulfilling. For example, high-tech equipment and software will have to play an important part in any investment recovery this year; and as we have seen, this category may be particularly sensitive to management beliefs and expectations.

Time will tell how pervasive these downbeat attitudes are and what effects, if any, they will have on investment and the economy. In any case, the clear lesson of recent experience is that forecasting investment requires close attention to the expectations of those responsible for making capital expenditures. Understanding these expectations and their implications is yet another challenge that policymakers must face as we do our best to help the economy toward full recovery. Thank you.

Footnotes
(1). The President's proposed tax package contains additional expensing provisions for some types of equipment investment by small businesses.
(2). Bernanke (2003) discusses the relationship between balance sheet conditions and the economic recovery.

(end excerpt)

(Distributed by the Office of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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