An Eight-Quarter Forecast of

Gross Private Domestic Investment

RODNEY W. DAVIS

College of Business

Western Carolina University

Abstract

The U.S. real Gross Private Domestic Investment is projected to decrease by approximately 16% by year-end 2002.This bleak outlook of investment expenditures could suggest a recession.Because inflation is relatively low and unemployment is also below the natural rate of 6%, it might be in the best interest of the Federal Reserve to loosen the current monetary policy.The basis of this forecast is the Keynesian aggregate investment function.This forecast uses the 3-month T-bill rate (secondary market) and the 20-year Treasury constant maturity rate as the explanatory variables.(JEL: E22).

Part 1. Introduction

This paper forecast U.S. real gross private domestic investment (GDPI) for the years 2001 and 2002.The explanatory variables used are the 20-year Treasury constant maturity rate and the 3-month Treasury bill interest rate.The approach for this forecast paper is based on the Keynesian investment function.
The target of this forecast, real gross private domestic investment, was selected because GPDI has a strong correlation to U.S. economic growth, described as GDP.As investment expenditures increase so does possible GDP.This paper forecast eight quarters through year-end 2002.This shorter time period enables a more precise forecast of gross private domestic investment.
The remainder of the paper is organized as follows:part 2. presents the data used to forecast GPDI; part 3. explains the theoretical basis for the approach adopted in forecasting GDPI; part 4. presents the regressions and the forecasting of GPDI for years 2001 and 2002; part 5. explains the significance of the forecasting as it relates to the economy; and part 6. discusses the conclusions for monetary policy.

Part 2. Data

All variables are taken from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED).Gross Private Domestic Investment is FRED variable GPDIC1 and is given in billions of chained 1996 dollars at seasonally adjusted annual rates (SAAR).The U.S. Department of Commerce Bureau of Economic Analysis is the primary source of data.
The interest rate data given are the 3-month Treasury bill rate (secondary market) and the 20-year Treasury constant maturity rate.These are given as FRED variables TB3MS and GS20.Both are given as a percent discount.The data is taken from a sample period beginning in 1994 and ending with year-end 2000.The interest rate data are both monthly variables.Gross private domestic investment, however, is a quarterly variable.The value taken for each quarter is the value given for the first month of each quarter (January, April, July, and October).The primary source for this data is the Board of Governors, U.S. Federal Reserve System.
The right hand side variables, the interest rates, were lagged eight quarters to the GPDI.This was done because the forecast target was two years into the future.A regression analysis of this data was run.

Part 3.  Forecasting with the Keynesian Investment Function

Investment spending is very volatile and is subject to change primarily based on interest rate change.Interest rate data is used to predict the investment expenditures for the next two years.The forecasting of real gross private domestic investment spending will be based on the Keynesian Investment Function which is:
I = f (i)

This is a simple linear model that will be used to predict investment spending.Dollars spent on investment is I.When the short and long term interest rate variable are added the Keynesian Investment Function becomes:

I = a + b*I(LR) + c*I(SR)

Part 4. An Eight Quarter Projection of Real Gross Private Domestic Investment

The investment function was estimated with 1994.1 2000.1 was estimated with quarterly data.The regression estimate is (t-statistics in parentheses):

It = 2277.43(5.57) 245.67(-4.71)i(LR)t-2 + 155.23(2.80)i(SR)t-2

In this estimate I is investment spending, the short term interest rate is the 90-day Treasury Bill rate, and the long term interest rate is the 20-year Treasury constant maturity rate.
The adjusted R-square of the estimate was .4789, which indicates that 47.89% of the forecast investment spending data can be explained by the interest rate variables in a linear equation.The F-statistic for this regression is 13.41, which indicates a strong rejection of the null hypothesis that the coefficients of the slope parameters equal zero.All t-statistics have a significance level less than 5%. This shows a strong correlation between interest rates and investment spending.
The forecasting of GPDI using a four-quarter mean for 2001 is 1490.61 and is 1619.32 for the year 2002.Investment expenditures were forecast quarterly and are reported in table 1.All numbers are reported in billions of chained 1996 dollars.

Table 1

Forecast Real Gross Private Domestic Investment 2001.1 2002.4

Quarter

Investment Forecast

2001.1

1612.24

2001.2

1513.58

2001.3

1440.93

2001.4

1395.69

2002.1

1417.97

2002.2

1637.80

2002.3

1679.46

2002.4

1742.05

Part 5. The Bears are Here!

This forecast shows a considerable decrease in investment expenditures for the next two years. Whether or not this will spawn a recession is undeterminable.The likelihood of recession is higher based on the data showing a choking of investment spending which translates into less capital available for real gross domestic product.GDP being the primary measure of growth, it would appear from this forecast to indicate a slowing of growth in the U.S. economy.

This forecast, bases on interest rates, appears to indicate a 19% decrease in investment spending from the year 2000 to the year-end 2001.However, 2002 will see an 8.5% increase in GPDI.Though a two-year average of expenditures for the years 2001 and 2002 will show an overall decrease, this may only indicate a one-year setback for 2001.It appears investment-spending will began to grow again beginning with the first quarter of 2002.

Part 6. Policy Conclusions

Because of the predicted large decrease in real GPDI in 2001, it would be wise for the Federal Reserve to loosen the monetary policy and lower interest rates in the short term.This could stimulate investment and because unemployment has remained below the natural rate (6%), this could also translate into growth.However this forecast only predicts a decrease in GPDI for the year 2001.As GPDI increases in 2002, the Federal Reserve should begin to raise interest rates to control growth and maintain low inflation.

Another alternative to interest rate reduction for economic stimulation is the proposed tax cut.This could provide a boost to the economy within a time period of 6 months, however the long term benefits and repercussions are undeterminable because this cut is based on ten-year government budget projections.

Reference

Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), (February 25, 2001), http://www.stls.frb.org/fred/ (February 25, 2001).