John Silvia – Chief Economist

March 8, 2005

Translating Trends into Actions

Presentation to: The 2005 Global Economic Outlook

Conference

Economic Transition

• Traditional Business Cycle• Not the Sky is Falling

200420032002200120001999

8%

6%

4%

2%

0%

-2%

8%

6%

4%

2%

0%

-2%Quarter/Quarter Percent Change, Seasonally Adusted Annual Rate

SUSTAINED GROWTH: ABOVE TREND BIASReal GDP

4th Quarter 2004@ 3.8%

Mid-Cycle Economics: Real GDP

2.90%

2.95%

3.00%

3.05%

3.10%

3.15%

3.20%

3.25%

3.30%

3.35%

Phase 1 Phase 2

0403020100999897

15%

10%

5%

0%

-5%

-10%

15%

10%

5%

0%

-5%

-10%

INVESTMENT RECOVERY MODERATESFINAL DOMESTIC DEMAND COMPONENTS

Blue Line = Consumer SpendingRed Line = Government Spending

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

Mid-Cycle Economics: Housing Starts

0%

5%

10%

15%

20%

25%

Phase 1 Phase 2

Where are we going?• Outlook – Growth: But Slower• Not Your Father’s Economic Recovery.

2005200420032002

500

450

400

350

300

250

500

450

400

350

300

250

FEWER CLAIMS SIGNAL RECOVERYInitial Jobless Claims, In Thousands

Blue Line = 4-Week Moving Average @ 307.00

February 26

Green Line = Weekly Figure @ 310.00

050403020100999897

65

60

55

50

45

40

35

65

60

55

50

45

40

35

MANUFACTURING RECOVERYISM COMPOSITE INDEX

February @ 55.3Diffusion Index

050403020100999897

140

130

120

110

100

90

140

130

120

110

100

90

DURABLES VS NONDURABLE GOODS MANUFACTURINGIndustrial Production, Index

January

Blue Line = Durable Goods @ 137.0

Green Line = Nondurable Goods @ 101.7

050403020100999897

70

65

60

55

50

45

40

35

70

65

60

55

50

45

40

35

SERVICE SECTOR GAINS CONTINUEISM NON-MANUFACTURING INDEXBUSINESS ACTIVITY INDEX

February@ 59.8

Seasonally Adjusted

A Hybrid WorldClues for Change

04030201

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

CONSUMER PRICE INDEXYear-over-Year Percent Change

Blue Line = CPIGreen Line = Core CPI

CanadaRussiaU.K. EurozoneJapanU.S.

8%

7%

6%

5%

4%

3%

2%

1%

8%

7%

6%

5%

4%

3%

2%

1%

G8 Real GDP Growth RatesYear-on-Year % Change

2Q 20043Q 2004

200520042003

105

100

95

90

85

80

75

105

100

95

90

85

80

75

WHAT DOLLAR IS IN YOUR WALLET?

Blue Line = Major Currency Index

Green Line = OITP Index

04020098969492

12%

10%

8%

6%

4%

2%

0%

-2%

12%

10%

8%

6%

4%

2%

0%

-2%

ACCOMODATIVE FED POLICY CONTINUESREAL FEDERAL FUNDS RATE VS. M2 MONEY GROWTH

Green Line = Real Fed Funds Rate*,

Blue Line = M2 Growth, Yr/Yr % Change, January @ 5.6%

* Fed Funds Rate minus "Core" Consumer Price Index

January @ 0.0%

05030199979593918987

23%

22%

21%

20%

19%

18%

17%

16%

15%

23%

22%

21%

20%

19%

18%

17%

16%

15%

FEDERAL BUDGET IMBALANCESpending & Revenue As Percent of GDP

January '05

16.1%

SPENDING

REVENUE

19.3%

Latest 12 months:

Spending $2,333 TrillionRevenue $1,943 Trillion

(Blue Line)

(Green Line)

20052004200320022001200019991998

$30

$20

$10

$0

$-10

$-20

$-30

$-40

$-50

$30

$20

$10

$0

$-10

$-20

$-30

$-40

$-50

FEDERAL BUDGET SURPLUS OR DEFICIT12 month moving average

January 2005 @ -$32.6 Billion

Social Security, Medicare, and Medicaid Spending

as a Percent of GDP

0

5

10

15

20

25

30

2000 2010 2020 2030 2040 2050 2060 2070 2080

Percent of GDP

Social Security

Medicaid

Medicare

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.

039893888378

20%

15%

10%

5%

0%

-5%

20%

15%

10%

5%

0%

-5%

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

Blue Line = Gov't Spending ex. Interest Payments @ 5.8%Red Line = Nominal GDP, Yr/Yr @ 5.6%

050403020100999897

9%

8%

7%

6%

5%

4%

3%

9%

8%

7%

6%

5%

4%

3%

10-YEAR TREASURY VS. BAA CORPORATE BOND YIELD

Green Line = BAA Yield

February

Blue Line = 10-Yr Treasury

Traditional Model

• Fed Raises Rates

• Inflation Up

• Sustained Economic Growth

• Persistent Fiscal Deficits

• Declining Dollar

• Yet Treasury Rates Fall

040302010099989796

8%

7%

6%

5%

4%

3%

2%

8%

7%

6%

5%

4%

3%

2%

NOMINAL GDP VS. 10-YR TREASURYBlue Line = Nominal GDP, Yr/Yr % ChangeGreen Line = 10-Yr Treasury Yield

2005200420032002

2.00%

1.80%

1.60%

1.40%

1.20%

2.00%

1.80%

1.60%

1.40%

1.20%

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

World Com - March 2002Enron - Oct 2001

Sarbannes-Oxley - July 2002

Red Line = Baa Spread

Blue Line = Aa Spread

04020098969492908886848280

35%

30%

25%

20%

15%

10%

35%

30%

25%

20%

15%

10%

CORPORATE INTEREST EXPENSEAS A PERCENT OF CASH FLOW

3Q 2004@ 13.5%

Nonfinancial Corporate Business

Traditional Model

Managed Exchanged Rates

China, JapanProfit Motive

Central BankDirected 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.

05040302010099989796

$1100

$1000

$900

$800

$700

$600

$500

$1100

$1000

$900

$800

$700

$600

$500

FED CUSTODY HOLDINGS OF U.S. TREASURYSECURITIES FOR FOREIGN CENTRAL BANKS

In Billions of Dollars

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

-100,000

-50,000

0

50,000

100,000

150,000

200,000

Net For

eign

Pur

chas

es of U

.S. T

reas

urys

($ M

illions

)

Japan Europe Latin America & Caribbean ChinaSource: Dept. of U.S. Treasury

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

-50,000

0

50,000

100,000

150,000

200,000

250,000

Net Foreign

Purch

ases

of U

.S. C

orpo

rate and

Age

ncy Bon

ds ($

Millions

)

Japan Europe Latin America & Caribbean ChinaSource: US Dept. of Treasury

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

200520042003200220012000

7%

6%

5%

4%

3%

2%

1%

0%

$1.40

$1.30

$1.20

$1.10

$1.00

$0.90

$0.80

Centr

al B

ank P

olic

y R

ate

s$ p

er E

uro

Eurozone vs U.S. Policy Ratesversus Euro/Dollar Echange Rate

ECB RateFed Funds Rate$ per Euro

20042003200220012000

10%

8%

6%

4%

2%

0%

-2%

$1.30

$1.20

$1.10

$1.00

$0.90

$0.80

GD

P G

row

th R

ate

s$ p

er E

uro

Real Growth at a Quarterly Annualized Change

Eurozone GDP vs U.S. GDP Growthversus Euro/Dollar Echange Rate

Eurozone GDPU.S. GDP$ per Euro

Profit MotiveCentral Banks of Japan, China

not mark to marketnot quarterly report

to shareholdersTherefore 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

10%

20%

30%

40%

50%

60%

1998 1999 2000 2001 2002 2003 2004

Foreigne

rs P

urch

ases

as a Perce

ntag

e of U

.S. D

ebt F

inan

cial Ass

ets

Source: Flow of Funds and U.S. Dept. of Treasury

Note: Total debt created represents the sum of government, household and non f inancial corporate sector net borrow ing.

Tax Reform Fundamentals

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

3% 7% 12%20%

58%

0% 2% 5%12%

81%

0%

20%

40%

60%

80%

100%

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

26.729.2 29.9

44.2

05

101520253035404550

1995 1998 2000 2004 Est.

Millions of Tax Returns

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

Who are the Non-Payers?

• 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 EITC, 50% Claim Child Credit

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"

84%

71%

57%

31%

14%16%

29%

43%

69%

86%

0%10%20%30%40%50%60%70%80%90%

100%

Poorest 20% 0$ -- $14,415

2nd 20% 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"

63%56%

44%37%

20%

90%

14%

25%33%

55%

0%10%20%30%40%50%60%70%80%90%

100%

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 Consumption*

3.1% 3.3% 3.8% 3.3%

Equipment & Software*

-5.5%

6.4% 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 T-Note

4.30%

3.89%

4.21%

4.54%

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