Monetary Policy Report

For use at 10:00 a.m., EST Tuesday July 15, 2003 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 15, 2003 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act July 15, 2003 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 15, 2003 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to section 2B of the Federal Reserve Act. Sincerely, Alan Greenspan, Chairman Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2003 4 Monetary Policy Report to the Congress Report submitted to the Congress on July 15, 2003, for economic growth were balanced, the risk of an pursuant to section 2B of the Federal Reserve Act unwelcome substantial fall in inflation from its already low level, though minor, exceeded that of a pickup in inflation. In the weeks that followed, market participants MONETARY POLICY AND THE ECONOMIC OUTLOOK pushed down the expected future path of the federal funds rate, which contributed to the fall in longer-term interest The subpar performance of the U.S. economy extended rates and a further rise in equity prices. into the first half of 2003. Although accommodative At the time of the June FOMC meeting, the available macroeconomic policies and continued robust produc­ evidence did not yet compellingly demonstrate that a tivity growth helped to sustain aggregate demand, busi­ material step-up in economic growth was under way, nesses remained cautious about spending and hiring. All though some indicators did point to a firming in spend­ told, real gross domestic product continued to rise in the ing and a stabilization in the labor and product markets. first half of the year but less quickly than the economy’s The Committee concluded that a slightly more expansive productive capacity was increasing, and margins of slack monetary policy would be warranted to add further sup- in labor and product markets thereby widened further. As port to the economic expansion. The Committee’s assess­ a result, underlying inflation remained low—and, indeed, ment and ranking of the risks to the outlook for economic seems to have moved down another notch. In financial growth and inflation were the same as in May. markets, longer-term interest rates fell, on net, over the The Federal Reserve expects economic activity to first half of the year as the decline in inflation and the strengthen later this year and in 2004, in part because subdued performance of the economy led market partici­ of the accommodative stance of monetary policy and pants to conclude that short-term interest rates would be the broad-based improvement in financial conditions. In lower than previously anticipated. These lower interest addition, fiscal policy is likely to be stimulative as the rates helped to sustain a rally in equity prices that had provisions of the Jobs and Growth Tax Relief Reconcili­ begun in mid-March. ation Act of 2003 go into effect and as defense spending During the first quarter of the year, the economy’s pros­ continues to ramp up. Severe budgetary pressures are pects were clouded by the uncertainties surrounding the causing state and local governments to cut spending and onset, duration, and potential consequences of war in Iraq. to increase taxes and fees, but these actions should offset War-related concerns provided a sizable boost to crude only a portion of the impetus from the federal sector. oil prices; as a result, households faced higher bills for Moreover, the continued favorable performance of pro­ gasoline and heating oil, and many firms were burdened ductivity growth should lift household and business with rising energy costs. These concerns also caused con­ incomes and thereby encourage capital spending. Given sumer confidence to sag and added to a general disincli­ the ongoing gains in productivity and the existing margin nation of firms to spend, hire, and accumulate invento­ of resource slack, aggregate demand could grow at a solid ries. Caution was apparent in financial markets as well, pace for some time before generating upward pressure and investors bid down the prices of equities in favor of on inflation. less-risky securities. The swift prosecution of the war in Iraq resolved some of these exceptional uncertainties but by no means all of Monetary Policy, Financial Markets, and the them. Nonetheless, oil prices receded, and the improve­ Economy over the First Half of 2003 ment in the economic climate was sufficient to cause stock prices to rally, risk spreads on corporate securities to nar­ During the weeks before the January meeting of the row, and consumer confidence to rebound. At the same FOMC, geopolitical developments and the uneven tone time, the incoming economic data—much of which of economic data releases created substantial uncertainty. reflected decisions made before the war—remained Businesses had continued to reduce their payrolls and mixed, and inflation trended lower. At the conclusion of postpone capital expenditures. However, the absence of its May meeting, the Federal Open Market Committee fresh revelations of lapses in corporate governance or (FOMC) indicated that, whereas the risks to the outlook accounting problems and some increased appetite for risk 2 Monetary Policy Report to the Congress July 2003 Selected interest rates Percent Ten-year Treasury 6 5 Two-year Treasury 4 Discount rate (primary credit) 3 Intended federal funds rate 2 Discount rate 1 (adjustment credit) 1/3 1/31 3/20 4/18 5/15 6/27 8/219/1710/2 11/6 12/11 1/30 3/19 5/7 6/26 8/13 9/24 11/6 12/10 1/29 3/18 5/6 6/25 2001 2002 2003 NOTE. The data are daily and extend through July 9, 2003. The dates on the the main credit program offered at the discount window by terminating the horizontal axis are those of scheduled FOMC meetings and of any adjustment credit program and beginning the primary credit program. intermeeting policy actions. On January 9, 2003, the Federal Reserve changed on the part of investors helped push down yields on cor­ When the Committee met on March 18, full-scale mili­ porate debt, which encouraged firms to issue bonds to tary conflict in Iraq seemed imminent. In an environment reduce their financing costs and restructure their balance of considerable uncertainty, the FOMC had to weigh sheets. Meanwhile, moderate gains in household income whether economic sluggishness was largely related to and historically low mortgage rates underpinned still- worries about the war, and hence would lift once the out- considerable demand for housing. Retail sales, particu­ come was decided, or was indicative of deep-seated larly those of motor vehicles, also were strong at the end restraints on economic activity. The Committee, which of 2002 despite some drop-off in consumer confidence. reasoned that it could not make such a distinction in the Core inflation seemed to be on a declining trend, although presence of so much uncertainty, left the funds rate the foreign exchange value of the dollar had depreciated, unchanged and declined to characterize the balance of and top-line inflation was being boosted by a sizable run- risks with respect to its dual goals. However, the Com­ up in energy prices. The substantial slack in resource uti­ mittee noted that, given the circumstances, heightened lization, as well as the solid gains in labor productivity, surveillance would be particularly informative, and it held led members to the view that consumer price inflation— a series of conference calls during late March and April by then already very low—was unlikely to increase mean­ to discuss the latest economic developments. ingfully. Against that backdrop, the Committee members Some of the uncertainty was resolved by the quick end continued to believe that economic fundamentals were to major military action in Iraq. Equity prices and con­ in place to support a pickup in the growth of economic sumer confidence rose while oil prices and risk spreads activity during the year ahead. Accordingly, the FOMC on corporate debt fell. Fiscal policy seemed set to decided at the January meeting to leave interest rates become even more stimulative given the prospect of unchanged and assessed the risks as balanced with increased spending on defense and homeland security as respect to its dual goals of sustainable economic growth well as the likely enactment of additional tax cuts. Part and price stability. of the federal stimulus, however, was thought likely to be In subsequent weeks, economic performance proved offset by the efforts of state and local governments to disappointing. The increasing likelihood of war in Iraq close their budget gaps. was accompanied by a steep rise in crude oil prices and Economic reports were generally disappointing. considerable volatility in financial markets. For much of Industrial production declined in March, and capacity that period, investors sought the relative safety of fixed- utilization fell to a twenty-year low. The employment income instruments; that preference induced declines in reports for March and April indicated that private non- yields on Treasury securities and high-quality corporate farm payrolls had continued to fall. Although order back- bonds and a drop in stock prices. Consumer outlays also logs for nondefense capital goods had risen recently, busi­ softened after January, although low mortgage rates and nesses generally remained reluctant to invest in new rising incomes were still providing support for house- capacity. hold spending. Businesses continued to trim workforces In light of the financial and policy stimulus already in and cut capital spending. place, the FOMC left the federal funds rate unchanged at Board of Governors of the Federal Reserve System 3 its May meeting. To provide more specific guidance about Economic Projections for 2003 and 2004 its views, the FOMC included in its announcement sepa­ The members of the Board of Governors and the Federal rate assessments of the risks to the outlook for economic Reserve Bank presidents, all of whom participate in the growth and inflation as well as the overall balance deliberations of the FOMC, expect economic activity to between the two. The Committee viewed the upside and accelerate in the second half of this year and to gather downside risks to economic growth as balanced, but it additional momentum in 2004. The central tendency of perceived a higher probability of an unwelcome substan­ the FOMC participants’ forecasts for the increase in real tial fall in inflation than of a pickup in inflation from its GDP over the four quarters of 2003 spans a narrow range current low level. The Committee considered that the overall balance of risks to its dual objectives was weighted of 21/ 2 percent to 23/ 4 percent, which, given the modest increase in real GDP in the first quarter, implies a notice- toward weakness. That said, members concluded that able pickup in growth as the year progresses. The central there was only a remote possibility that resource utiliza­ tendency for projections of real GDP growth in 2004 tion would remain so low that the disinflation process would cumulate to produce a declining overall price level spans a range of 33/ 4 percent to 43/ 4 percent. The civilian unemployment rate is expected to be between 6 percent for an extended period. Financial market participants reacted strongly to this and 61/ 4 percent in the fourth quarter of 2003 and to characterization of risks, believing that the Committee’s decline to between 51/ 2 percent and 6 percent by the fourth quarter of 2004. focus on leaning against appreciable disinflation implied Inflation is anticipated to be quite low over the next that monetary policy would be more accommodative and year and a half. The chain-type price index for personal remain so for longer than previously thought. Investors pushed down the expected path of the federal funds rate consumption expenditures (PCE) rose 13/ 4 percent over the four quarters of 2002, and most FOMC participants in the weeks following the meeting. Intermediate- and expect inflation to run somewhat lower this year and then long-term interest rates fell significantly and spurred to hold fairly steady in 2004. The central tendency of another round of long-term bond issuance. The resulting decline in real interest rates helped sustain the projections for PCE inflation is 11/ 4 percent to 11/ 2 per- rally in equity prices. cent in 2003 and 1 percent to 11/ 2 percent in 2004. Between the May and June meetings, a few tentative signs suggested that the pace of economic activity might be firming. Industrial production and retail sales edged up in May, available data indicated that employment had stopped declining, residential investment remained strong, and survey measures of consumer sentiment and busi­ ness conditions were well above the levels of earlier in Economic projections for 2003 and 2004 the year. Financial conditions had improved markedly, Percent but businesses reportedly remained somewhat averse to Federal Reserve Governors new investment projects, in part because of significant and Reserve Bank presidents unused capacity. They also seemed reluctant to expand Indicator Central their workforces until they viewed a sustained pickup in Range tendency aggregate demand as more certain. 2003 With inflation already low and inflation expectations subdued, the Committee judged that it would be prudent Change, fourth quarter to fourth quarter1 to add further support for economic expansion, and it Nominal GDP .................................................... 3½–4¾ 3¾–4½ lowered the target for the federal funds rate 25 basis Real GDP .......................................................... 2¼–3 2½–2¾ PCE chain-type price index .............................. 1–1¾ 1¼–1½ points, to 1 percent. The FOMC continued to view the Average level, fourth quarter risks to economic growth as balanced and again noted Civilian unemployment rate .............................. 6–6¼ 6–6¼ that the minor probability of substantial further 2004 disinflation exceeded the probability of a pickup in infla­ tion from its current low level. But because of the con­ Change, fourth quarter to fourth quarter1 siderable amount of economic slack prevailing and the Nominal GDP .................................................... 4¾–6½ 5¼–6¼ Real GDP .......................................................... 3½–5¼ 3¾–4¾ economy’s ability to expand without putting upward pres­ PCE chain-type price index .............................. ¾–2 1–1½ sure on prices, the Committee indicated that the small Average level, fourth quarter chance of an unwelcome substantial decline in the infla­ Civilian unemployment rate .............................. 5½–6¼ 5½–6 tion rate was likely to remain its predominant concern 1. Change from average for fourth quarter of previous year to average for for the foreseeable future. fourth quarter of year indicated. 4 Monetary Policy Report to the Congress July 2003 ECONOMIC AND FINANCIAL DEVELOPMENTS Change in PCE chain-type price index IN 2003 Percent, annual rate Economic activity in the United States remained slug­ Total gish in the first half of 2003. Businesses continued to be Excluding food and energy reluctant to undertake new projects given the unusual degree of uncertainty in the economic environment, and Q1 3 the softness in activity abroad crimped the demand for U.S. exports. However, consumer spending grew moder­ 2 ately, housing activity retained considerable vigor, and defense spending picked up. Real GDP rose at an annual rate of just 11/ 2 percent in the first quarter and appears to 1 have posted another modest gain in the second quarter. With output growth remaining tepid and labor produc­ tivity rising at a fairly robust pace, firms continued to 1997 1999 2001 2003 trim payrolls in the first half of 2003, though job losses in the private sector were a little smaller than they had NOTE. The data are for personal consumption expenditures (PCE). been, on average, in 2002. on corporate bonds and triggered inflows to equity and For much of the first half of the year, headline infla­ high-yield bond mutual funds. Since the beginning of the tion news was shaped by movements in energy prices, year, the foreign exchange value of the dollar has depre­ which soared during the winter, retreated during the ciated nearly 5 percent against the broad group of cur­ spring, and more recently firmed. Core inflation—which rencies of our major trading partners. excludes the direct effects of food and energy prices— Households and businesses have taken advantage of was held to a low level by slack in resource utilization the decline in intermediate-term and long-term interest and continued sizable advances in labor productivity. rates from their already low levels, mostly by refinanc­ As a result of slow economic growth and the prospect ing debt at ever more favorable rates. Partly as a result, that inflation would remain very subdued, the federal household credit quality was little changed over the first funds rate was maintained at the accommodative level half of the year, and household debt continued to expand of 11/ 4 percent for much of the first half of the year. at a rapid pace as mortgage interest rates fell to their low­ Intermediate- and longer-term yields declined, in some est levels in more than three decades. Business balance cases to their lowest levels on record. Equity prices, which sheets strengthened noticeably, and many measures of cor­ through mid-March had fallen in response to weaker-than- porate credit performance showed some improvement. expected economic news and rising geopolitical tensions, Still, net borrowing by businesses continued to be damped began a broad rally as it became clear that the war in Iraq by the softness in investment spending. would begin imminently. The apparent increase in inves­ tors’ appetite for risk also helped push down risk spreads The Household Sector Change in real GDP Consumer Spending Percent, annual rate Consumer spending continued to increase in the first half of 2003, though not as quickly as in the past few years. In 6 total, real personal consumption expenditures (PCE) rose at an annual rate of 2 percent in the first quarter and likely posted another moderate advance in the second quarter. 4 Purchases of new light motor vehicles were sustained by the automakers’ use of increasingly aggressive price and Q1 2 financing incentives. Spending on goods other than motor vehicles rose briskly in the first quarter, though + 0_ that was largely because of the high level of spending around the turn of the year; the data through May suggest a further increase for this category in the second quarter. 1997 1999 2001 2003 In contrast, outlays on services rose only slowly over the NOTE. Here and in subsequent charts, except as noted, change for a given first five months of the year as weakness lingered in a period is measured to its final quarter from the final quarter of the preceding period. number of categories, including air travel and recreation. Board of Governors of the Federal Reserve System 5 Change in real income and consumption Personal saving rate Percent, annual rate Percent Disposable personal income Personal consumption expenditures 6 10 4 5 Q1 2 1997 1999 2001 2003 1983 1987 1991 1995 1999 2003 NOTE. The data are quarterly; the reading for 2003:Q2 is the average for April and May. The rise in real consumption expenditures so far in drop in wealth. Meanwhile, the high level of mortgage 2003 has about matched the growth in real disposable refinancing in recent quarters has bolstered consumer personal income (DPI), which has been restrained by the spending by allowing homeowners to reduce their monthly poor job market and by the surge in consumer energy payments, pay down more costly consumer debt, and in prices early in the year. Real DPI rose about 21/ 4 percent many cases cash out some of the equity that has accumu­ at an annual rate between the fourth quarter of 2002 and lated during the upswing in house prices over the past May after having increased at a considerably faster pace few years. Reflecting these influences, the personal sav­ in 2002; the larger increase in real DPI in 2002 in part ing rate averaged 31/ 2 percent over the first five months reflected the effects of the tax cuts enacted in 2001. of the year—about the same as the annual average for Among other key influences on consumption, house- 2002 but more than 1 percentage point above that for hold wealth grew about in line with nominal DPI in the 2001. fourth quarter of 2002 and the first quarter of 2003 after Consumer confidence, which has exhibited some sharp having fallen sharply over the preceding two years. While swings in recent years, remained volatile in the first half the rebound in the stock market in the second quarter of 2003. After having declined markedly over the second should help the wealth-to-income ratio recoup some of half of 2002, survey readings from both the Michigan the ground it lost earlier, households likely have not yet Survey Research Center and the Conference Board took completed the adjustment of their spending to the earlier another tumble early this year on concerns about the Wealth-to-income ratio Consumer sentiment Ratio 1985 = 100 1966 = 100 128 128 Conference Board 6 106 106 Michigan SRC 84 84 5 62 62 1983 1987 1991 1995 1999 2003 1991 1994 1997 2000 2003 NOTE. The data are quarterly and extend through 2003:Q1. The NOTE. The data are monthly and extend through June 2003. wealth-to-income ratio is the ratio of household net worth to disposable SOURCE. University of Michigan Survey Research Center and The Con­ personal income. ference Board. 6 Monetary Policy Report to the Congress July 2003 potential consequences of a war in Iraq. With the combat totaled 325,000 units at an annual rate over the first five in Iraq largely over and the stock market recovering, con­ months of the year, a pace 6 percent below that for 2002 fidence rose appreciably, on net, in the spring. as a whole. In addition, vacancy rates for multifamily rental properties rose further in the first quarter, and apart­ ment rents continued to fall. Residential Investment Housing activity remained robust in the first half of this Household Finance year, as very low mortgage interest rates apparently off- set much of the downward pressure from the soft labor Household real estate debt grew rapidly in the first half market. In the single-family sector, starts averaged an of the year with the support of the brisk pace of home annual rate of 1.39 million units over the first five months sales, rising home prices, and falling mortgage interest of the year—2 percent greater than the rapid pace for rates. Indeed, according to Freddie Mac, the average rate 2002 as a whole. In addition, sales of new and existing on thirty-year conventional home mortgages fell sharply homes moved to exceptionally high levels. According to until June, though it has edged back up in recent weeks the Michigan survey, consumers’ assessments of and now stands at about 51/ 2 percent. Applications for homebuying conditions currently are very favorable, mortgages to purchase homes rose well above the already mainly because of the low mortgage rates. elevated level of last year. Sales of existing homes, in The available indicators provide differing signals on particular, add significantly to the level of mortgage debt the magnitude of recent increases in home prices, but, in because the purchaser’s mortgage is typically much larger general, they point to smaller gains than those recorded a than the seller’s had been. The pace of mortgage refi­ year or two ago. Notably, over the year ending in the first nancing—which adds to borrowing because households quarter, the constant-quality price index for new homes often increase the size of their mortgages when they refi­ rose just 21/ 2 percent, one of the lowest readings of the nance—set consecutive quarterly records in the first and past few years. Meanwhile, the four-quarter increase in second quarters of 2003 in response to the declines in the repeat-sales price index for existing homes, which mortgage rates. According to Freddie Mac, more than 40 topped out at 81/ 2 percent in 2001, was 61/ 2 percent in the percent of the refinancings in the first quarter were “cash- first quarter. Still, the share of income required to finance out” refinancings, and the amount of equity extracted the purchase of a new home, adjusted for variations over likely set a record in the first half of this year. The combi­ time in structural characteristics, has continued to move nation of rising home prices and low interest rates also down as mortgage rates have dropped, and it is now very energized home equity lending during the first half of low by historical standards. 2003. Activity in the multifamily sector appears to have A major use of the proceeds from both cash-out refi­ slipped somewhat this year, perhaps in part because the nancing and home equity loans reportedly has been to strong demand for single-family homes may be cutting pay down credit card and other higher-cost consumer debt. into the demand for apartments. Multifamily starts Indeed, in line with those reports, consumer debt advanced Mortgage rates Private housing starts Percent Millions of units, annual rate Fixed rate 9.0 Single-family 1.2 8.0 7.0 .8 Adjustable rate 6.0 5.0 Multifamily .4 4.0 2000 2001 2002 2003 1991 1993 1995 1997 1999 2001 2003 NOTE. The data, which are weekly and extend through July 3, 2003, are NOTE. The data are quarterly; the readings for 2003:Q2 are the averages for contract rates on thirty-year mortgages. April and May. SOURCE. Federal Home Loan Mortgage Corporation. Board of Governors of the Federal Reserve System 7 Mortgage applications for purchases and refinancings Mutual fund investment flows Index Index Billions of dollars Equity 30 14,000 Bond and hybrid 25 400 12,000 20 10,000 Purchases 15 300 8,000 10 5 6,000 + 0_ 200 Refinancings 4,000 5 2,000 10 1998 1999 2000 2001 2002 2003 2000 2001 2002 2003 NOTE. The data are weekly and extend through July 4, 2003. The index for NOTE. Data are expressed at a monthly rate. Estimates for 2003:Q2 are purchases is seasonally adjusted by Federal Reserve Board staff. based on monthly data for April and May. SOURCE. Mortgage Bankers Association. SOURCE. Investment Company Institute. at a relatively subdued 41/ 2 percent annual rate in the first and the first quarter of this year—periods during which quarter. The growth of revolving debt was about borrowing rates fell and the average maturity of house- 5 percent at an annual rate, and nonrevolving debt hold debt rose. Although households continued to bor­ expanded at a 31/ 2 percent annual rate. The growth of con­ row at a rapid pace in the second quarter, the declines in sumer debt picked up in the spring; the acceleration in mortgage interest rates and an elevated level of refinanc­ part reflected somewhat higher motor vehicle sales that ing imply that the debt-service burden was likely little boosted the nonrevolving component, which in turn off- changed. set a deceleration in revolving credit. Meanwhile, the The credit quality of household debt remained fairly average interest rates charged on credit cards and on new stable in the first quarter. The delinquency rates both on car loans at auto finance companies this year have residential mortgages and on credit card loans edged down remained near the low end of their recent ranges. in the first quarter, though persistently high delinquen­ In total, household debt grew at a 10 percent annual cies among subprime borrowers remain a problem area. rate in the first quarter, a pace about unchanged from last Delinquency rates on auto loans at captive finance com­ year’s. Despite the marked rise of this debt over the past panies have edged up in recent months from their very several quarters, the aggregate debt-service burden of low levels of the past few years. However, lenders prob­ households ticked down in both the fourth quarter of 2002 ably anticipated some increase as the plethora of new Delinquency rates on selected types of household loans Bond mutual fund investment flows Percent Billions of dollars High-yield Credit card pools 6 Government 8 Other 5 6 4 4 Auto loans at domestic auto finance companies 3 2 + Mortgages 2 0_ 1 2 1991 1993 1995 1997 1999 2001 2003 2000 2001 2002 2003 NOTE. The data are quarterly and extend through 2003:Q1. NOTE. Data are expressed at a monthly rate. Estimates for 2003:Q2 are SOURCE. For mortgages, the Mortgage Bankers Association; for auto loans, based on monthly data for April and May. the Big Three automakers; for credit cards, Moody’s Investors Service. SOURCE. Investment Company Institute. 8 Monetary Policy Report to the Congress July 2003 vehicle loans issued in late 2001 and early 2002 seasoned. Change in real business fixed investment The fact that a large number of households declared bank­ ruptcy in the first half of the year suggests that some house- Percent, annual rate holds continue to experience considerable distress. Structures In a continuation of the trend during the second half Equipment and software 20 of 2002, households invested heavily in bond mutual funds—and relatively safe bond funds at that—during the 10 first quarter of 2003 and disinvested from equity funds. Q1 + However, starting in March, households showed a grow­ 0_ ing willingness to purchase shares of riskier funds. As corporate credit quality improved and risk-free interest 10 rates fell to record lows, a significantly larger portion of 20 the investment in bond mutual funds flowed into corpo­ rate bond funds—including high-yield funds—at the expense of government bond funds. Inflows to equity mutual funds reportedly resumed in mid-March and con­ High-tech equipment and software tinued through June. Other equipment excluding transportation 40 30 The Business Sector 20 Q1 Fixed Investment 10 + Investment in equipment and software (E&S) continues 0_ to languish. Firms reportedly remain reluctant to under- take new projects because of the uncertainty about the 10 economic outlook and heightened risk aversion in the wake of last year’s corporate governance and accounting 1997 1998 1999 2000 2001 2002 2003 problems. Excess capacity—in addition to being a factor NOTE. High-tech equipment consists of computers and peripheral equip­ weighing on nonresidential construction—also is limit­ ment and communications equipment. ing demand for some types of equipment, most notably in the telecommunications area. But other key determi­ an extended period of weakness. Meanwhile, investment nants of equipment spending are reasonably favorable. outside the transportation and high-tech areas dropped The aggressive actions taken by firms over the past few back a bit. years to boost productivity and trim costs have provided Real E&S spending appears to have turned up in the a lift to corporate profits and cash flow. In addition, low second quarter, in part because of a step-up in the pace of interest rates and a rising stock market are helping hold real computer investment. However, incoming data sug­ down firms’ cost of capital, as is the partial-expensing gest that outlays on communications equipment did not investment tax incentive. In addition, technological repeat their first-quarter spurt. The data on shipments of advances continue to depress the relative price of com­ capital goods point to moderate increases in spending out- puters at a time when stretched-out replacement cycles side of high-tech and transportation in the second quar­ have apparently widened the gap between the latest tech­ ter; moreover, backlogs of unfilled orders for equipment nology and that embodied in many of the machines cur­ in this broad category have risen some this year after hav­ rently in use. ing declined over the preceding two years. Real spending on E&S fell at an annual rate of nearly Nonresidential construction remained weak in the first 5 percent in the first quarter. The outlays were restrained half of 2003. Although real construction outlays were off by a sharp decline in spending on transportation equip­ only a little in the first quarter, they had fallen nearly 16 ment, especially motor vehicles; excluding that category, percent in 2002, and partial data for the second quarter spending posted a small gain. Real outlays on high-tech point to continued softness. The downturn in spending equipment and software rose at an annual rate of about has been especially pronounced in the office sector, where 11 percent in the first quarter, a bit faster than they had in vacancy rates have surged and rents have plunged. Spend­ 2002. Real purchases of computers and peripheral equip­ ing on industrial facilities also has fallen dramatically over ment remained on the moderate uptrend that has been the past couple of years; it has continued to contract in evident since such spending bottomed out in 2001, and recent quarters and is unlikely to improve much in the outlays on communications equipment picked up after absence of a significant rise in factory operating rates. Board of Governors of the Federal Reserve System 9 Change in real business inventories Before-tax profits of nonfinancial corporations as a percent of sector GDP Billions of chained 1996 dollars, annual rate Percent 75 50 12 25 Q1 + 0_ 10 25 50 8 75 1997 1999 2001 2003 1978 1983 1988 1993 1998 2003 NOTE. The data are quarterly and extend through 2003:Q1. Profits are from Construction expenditures on other commercial buildings domestic operations of nonfinancial corporations, with inventory valuation and capital consumption adjustments. (such as those for retail, wholesale, and warehouse space), which had declined less than did outlays for other major about 7 percent at a quarterly rate from the fourth quarter categories of nonresidential construction over the past of 2002 and were 11 percent higher than four quarters couple of years, moved up in the first quarter of 2003, earlier. Although oil companies accounted for the major­ but they too have shown some renewed softness lately. ity of the four-quarter increase, earnings from the finan­ One bright spot is the drilling and mining sector, in which cial, utility, and consumer durable sectors were also strong outlays have risen sharply this year in response to higher and exceeded the market’s conservative expectations by natural gas prices. larger-than-usual margins. The recent depreciation of the dollar substantially boosted revenues of U.S. multina­ tional corporations, but the hedging of currency risk likely Inventory Investment limited the extent to which sales gains showed through to profits. Most businesses have continued to keep a tight rein on Net equity retirements in the first quarter of 2003 were inventories after the massive liquidation in 2001. Real probably a shade larger than in the fourth quarter of 2002, inventory investment in the first quarter was a meager $5 billion at an annual rate and occurred entirely in the motor vehicle industry, where sagging sales and ambi­ Financing gap and net equity retirement at nonfarm nonfinancial corporations tious production early in the year created a noticeable bulge in dealer stocks, especially of light trucks. In the Billions of dollars second quarter, the automakers reduced assemblies and expanded incentives to bolster sales, but these steps were 300 sufficient only to reduce stocks a little, and inventories 250 remained high relative to sales through June. Apart from Net equity retirement the motor vehicle industry, firms reduced stocks, on net, 200 over the first five months of 2003, and, with only a few 150 exceptions, inventories appear reasonably well aligned with sales. Financing gap 100 50 + Corporate Profits and Business Finance 0_ Before-tax profits of nonfarm, nonfinancial corporations 1991 1993 1995 1997 1999 2001 2003 grew at a 61/ 2 percent annual rate in the first quarter of NOTE. The data are annual through 2002; for 2003, they are estimates 2003, and they constituted 81/ 2 percent of the sector’s first- based on data from 2003:Q1. The financing gap is the difference between capital expenditures and internally generated funds. Net equity retirement is quarter GDP, the highest proportion since the third quar­ the difference between equity retired through share repurchases, domestic ter of 2000. Focusing on the companies that make up the cash-financed mergers, or foreign takeovers of U.S. firms and equity issued in public or private markets, including funds invested by venture capital S&P 500, earnings per share for the first quarter were up partnerships. 10 Monetary Policy Report to the Congress July 2003 Major components of net business financing Corporate bond yields Billions of dollars Percent Commercial paper Bonds 600 Bank loans Sum of major High yield 15 components 400 200 10 + 0_ AA 5 200 2001 2002 2003 2001 2003 NOTE. Seasonally adjusted annual rate for nonfarm nonfinancial corporate business. The sum of major components is quarterly. Estimates for 2003:Q2 NOTE. The data are weekly averages and extend through July 9 except for are based on monthly data for April and May. the high-yield series, which extends through July 7. The AA rate is calculated from bonds in the Merrill Lynch AA index with seven to ten years of maturity remaining. The high-yield rate is the yield on the Merrill Lynch 175 as the decline in gross new issuance more than offset lower high-yield index. gross retirements. Equity retirements from cash-financed mergers were a bit below their pace in the past two years, tions, and bank credit appears to remain available for and share repurchases appear to be running somewhat qualified business borrowers. The net fraction of banks slower as well. Volatile and declining equity prices in the in the Senior Loan Officer Opinion Survey that reported first quarter brought initial public offerings (IPOs) to a having tightened lending standards and terms on C&I standstill during the first four months of this year. One loans during the first part of the year decreased mark­ small IPO was undertaken in May, and another one came edly, and the Survey of Small Business by the National to market in June. With regard to seasoned equity offer­ Federation of Independent Business showed that the net ings, a war-related lull in March and April held the aver- percentage of small businesses believing credit had age monthly pace of issuance this year well below become more difficult to obtain hovered near the middle last year’s level. Most of these offerings have been from of its recent range. Moreover, in the April Senior Loan energy firms and utilities that have used the proceeds pri­ Officer Opinion Survey, a number of banks reported that marily to reduce leverage and increase liquidity. they had eased lending terms in response to increased The net debt growth of nonfinancial corporate busi­ ness was just 3 percent at an annual rate in the first quar­ ter, as rising profits and lower outlays for fixed and work­ Standards and demand for C&I loans to large ing capital held down corporations’ need for external and medium-sized firms at domestic banks funds. Nonetheless, low interest rates continued to attract Percent firms to the bond market during the first half of 2003, and issuance ran well ahead of its rate of the second half Net percent tightening standards 60 of 2002. Moreover, a large fraction of the issues were from below-investment-grade firms, which likely were 40 responding to the even sharper fall in their borrowing 20 rates than investment-grade firms enjoyed. A substantial + portion of the proceeds of recent bond issues have been 0_ slated to pay down commercial paper and commercial 20 and industrial (C&I) loans, and each of those components 40 contracted markedly during the first half of the year. Net percent reporting stronger demand Another factor contributing to the weakening in demand 60 for C&I loans this year was the absence of merger and acquisition activity, according to the Federal Reserve’s 1991 1993 1995 1997 1999 2001 2003 Senior Loan Officer Opinion Survey on Bank Lending NOTE. The data are based on a survey generally conducted four times per year; the last reading is from the April 2003 survey. Large and medium-sized Practices. firms are those with annual sales of $50 million or more. Net percentage is The runoff in C&I loans appears related more to a the percentage reporting a tightening less the percentage reporting an easing. SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank decrease in demand than to a tightening of supply condi- Lending Practices. Board of Governors of the Federal Reserve System 11 Net interest payments of nonfinancial corporations Default rate on outstanding bonds and relative to cash flow C&I delinquency rate Percent Percent 6.0 20 5.0 4.0 15 3.0 C&I delinquency rate 2.0 10 Default rate on outstanding bonds 1.0 1979 1982 1985 1988 1991 1994 1997 2000 2003 1991 1993 1995 1997 1999 2001 2003 NOTE. The data are quarterly and extend through 2003:Q1. NOTE. The default rate is monthly and extends through June 2003. The C&I delinquency rate is quarterly and extends through 2003:Q1. The default rate for a given month is the face value of bonds that defaulted in the six competition for C&I loans from nonbank lenders. Indeed, months ending in that month divided by the face value of all bonds outstanding at the end of the calendar quarter immediately preceding the data from Loan Pricing Corporation indicate that non- six-month period. bank financial institutions purchased a record amount of new syndicated loans during the first quarter of this year; the buyers were reportedly attracted in part by improv­ ber of ratings downgrades continued to exceed upgrades ing liquidity in the secondary loan market. but by a notably smaller margin than last year. The six- The decline in both short- and long-term interest rates, month trailing bond default rate declined considerably in combined with slow increases in total business debt, con­ the first half of the year. The four-quarter moving aver- tributed to a further reduction in the net interest burden age of recovery rates on defaulted bonds improved a bit of nonfinancial corporations during the first quarter. in the first quarter, although it remained at the low end of Moreover, by issuing bonds and paying down short-term its range of the past several years. The delinquency rate debt, businesses have substantially lengthened the over- on C&I loans at commercial banks also moved down some all maturity of their debt, thus reducing their near-term in the first quarter, albeit to a level well above that of the repayment obligations. These developments, together with late 1990s. higher profitability, have helped most measures of cor­ porate credit performance to improve this year. The num- Commercial Real Estate Ratings changes of nonfinancial corporations The growth of debt backed by commercial real estate remained robust this year despite some deterioration in Percent that sector’s underlying fundamentals. In the first quarter Upgrades of 2003, the expansion of debt was driven by lending at 20 commercial banks and was spread about equally across 10 broadly defined types of commercial real estate loans. Although the issuance of commercial-mortgage-backed 0 securities (CMBS) slowed somewhat in the first quarter 10 from the rapid pace of the second half of last year, issu­ ance appears to have rebounded strongly in the second 20 quarter. 30 Despite continued increases in vacancy rates and Downgrades 40 declines in the rents charged for various types of com­ mercial properties, the credit quality of commercial mort­ 1995 1996 1997 1998 1999 2000 2001 2002 2003 gages has yet to show appreciable signs of deterioration. At commercial banks, delinquency rates on commercial NOTE. Data are at an annual rate; for 2003, they are the annualized values of monthly data through May. Debt upgrades and downgrades are expressed mortgages edged up only slightly in the first quarter of as a percentage of the par value of all bonds outstanding. SOURCE. Moody’s Investors Service. 2003 from their historically low levels of recent years. 12 Monetary Policy Report to the Congress July 2003 Delinquency rates on CMBS, which were stable in 2002 Federal receipts and expenditures at about the midpoint of their recent range, have also risen just a bit this year. Respondents to the April 2003 Senior Percent of nominal GDP Loan Officer Opinion Survey attributed the resiliency of the credit quality of commercial real estate loans in part 24 to borrowers’ ability to refinance at lower interest rates; Expenditures they also mentioned that the many borrowers with sub­ 22 stantial equity positions in the mortgaged properties have Receipts an extra incentive to remain current. Banks also pointed Expenditures 20 excluding net interest to their having tightened lending standards and terms, including maximum loan-to-value ratios, well in advance 18 of the current downturn. 16 In line with the assessment that, to date, credit quality in the sector remains good, spreads on CMBS over Trea­ suries have remained in the lower half of the ranges 1985 1988 1991 1994 1997 2000 2003 observed over the past few years. Market reports indi­ NOTE. The budget data are from the unified budget; through 2002 they are cate that CMBS issuers generally have had access to ter­ for fiscal years (October through September), and GDP is for Q4 to Q3. For 2003, the budget data are for the twelve months ending in May, and GDP is rorism insurance for the underlying properties, and the for 2002:Q2 to 2003:Q1. cost of that insurance has come down significantly. In addition, newly formed pools that include high-profile tal, fell from a high of a positive 2 percent of GDP in properties reportedly have been diversified to further pro­ 2000 to a negative 21/ 2 percent of GDP in the first quarter tect investors from losses due to acts of terrorism. of 2003. With little change, on balance, in nonfederal domestic saving over this period, the downswing in fed­ eral saving showed through into net national saving, which The Government Sector was equal to less than 1 percent of GDP in the first quar­ ter, compared with the recent high of 61/ 2 percent of GDP Federal Government in 1998. If not reversed over the longer haul, such low The federal budget deficit has widened significantly as a levels of national saving could eventually impinge on the consequence of the persistent softness in receipts and leg­ formation of private capital that contributed to the islative actions affecting both spending and taxes. Over improved productivity performance of the past half- the first eight months of the current fiscal year—October decade. to May—the deficit in the unified budget was $292 bil­ Federal receipts in the first eight months of the cur- lion, nearly $150 billion larger than that recorded during rent fiscal year were nearly 3 percent lower than during the comparable period last year. Moreover, recent policy the comparable period of fiscal 2002 after adjusting for actions are projected to boost the deficit significantly over some shifts in the timing of payments during the fall of the remainder of the fiscal year. In particular, receipts 2001. Individual receipts were especially weak: Although will be reduced appreciably by several provisions of the Net national saving Jobs and Growth Tax Relief Reconciliation Act of 2003, including advance refund checks for the 2003 increment Percent of nominal GDP to the child tax credit, downward adjustments to with- holding schedules for individual taxpayers, and the sweet­ 12 ening of the partial-expensing investment incentive for Nonfederal saving businesses. In addition, outlays will be boosted by the 9 supplemental appropriations for defense and foreign aid 6 and by additional grants to the states. If the latest projec­ tion from the Congressional Budget Office is realized, 3 the unified deficit will increase from $158 billion in fis­ Total + cal 2002 to more than $400 billion in fiscal 2003. 0_ Federal saving The deterioration in the unified budget has been mir­ 3 rored in a sharp downswing in federal saving—essentially, the unified surplus or deficit adjusted to conform to the 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 accounting practices followed in the national income and product accounts (NIPA). Indeed, net federal saving, NOTE. The data are quarterly and extend through 2003:Q1. Nonfederal saving is the sum of personal and net business saving and the current surplus which accounts for the depreciation of government capi- or deficit of state and local governments. Board of Governors of the Federal Reserve System 13 withheld taxes, which tend to move in line with wages Change in real government expenditures and salaries, held up fairly well (after adjusting for on consumption and investment changes in tax law) during this period, nonwithheld pay­ Percent, annual rate ments, which are more sensitive to capital income, dropped sharply. This spring’s net final payments, which Federal State and local are largely payments on the previous year’s liabilities, 9 were exceptionally soft for a second year in a row; in combination with the information on withheld and esti­ 6 mated payments, they imply that individual liabilities con­ tinued to shrink as a percentage of the NIPA tax base in 3 Q1 2002. The substantial drop in the ratio of liabilities to + NIPA income over the past couple of years reflects in 0_ part a reversal of the capital gains bonanza of the late 3 1990s and the tax reductions enacted in 2001. (Capital gains are not included in the NIPA income measure, which, by design, includes only income from current produc­ 1997 1999 2001 2003 tion.) In addition, the change in the distribution of income in the late 1990s, which concentrated more just slightly in real terms in the first quarter as a sizable income in the upper tax brackets, may have been reversed increase in nondefense purchases was nearly offset by a some during the past couple of years. surprising decline in defense spending. The dip in Federal spending during the first eight months of fis­ defense spending followed several quarters of large cal year 2003 was 61/ 2 percent higher than during the same increases; with the supplemental appropriation in place, period last year; excluding the drop in net interest out- defense spending in the second quarter appears to have lays, spending was more than 71/ 2 percent higher. Spurred resumed its rapid growth. by the war in Iraq, defense spending has moved up another 15 percent thus far this year; outlays for home- Federal debt held by the public advanced at a 21/ 4 percent annual rate in the first quarter and remained at land security have risen briskly as well. Expenditures for just below 35 percent of nominal GDP. During the first income security programs, which include the temporary half of the year, the Treasury announced several changes extended unemployment compensation program, also in its debt management, including the reintroduction of have risen at a fairly rapid rate. Though growth in spend­ three-year notes and regular reopenings of certain five- ing on Medicare and Medicaid, taken together, has slowed year and ten-year notes, to position itself better to a bit this year, the rising cost and utilization of medical address the widening federal deficit. These steps have care continue to put upward pressure on these programs. the consequences of lengthening the average maturity Expenditures for consumption and gross investment, of its outstanding debt and trimming the size of some the part of federal spending that is included in GDP, rose of its auctions. The Treasury also noted that it would be increasing the frequency and size of its auctions of Federal government debt held by the public inflation-indexed securities. Percent of nominal GDP Beginning in February 2003, the Treasury needed to take steps to avoid exceeding the level of the statutory debt ceiling and employed several accounting devices to which market participants have become accustomed. 45 It also temporarily suspended the issuance of the type of Treasury debt instrument in which the proceeds of advance refundings by state and local governments 35 are allowed to be invested. No adverse reaction in finan­ cial markets was apparent during this period, however, 25 and a bill increasing the debt ceiling $984 billion, to $7.384 trillion, was enacted on May 23. 1963 1973 1983 1993 2003 State and Local Governments NOTE. Through 2002, the data for debt are year-end figures, and the corresponding value for GDP is for Q4 at an annual rate; the final observation On the whole, the budget situation at state and local gov­ is for 2003:Q1. Excludes securities held as investments of federal gov­ ernment accounts. ernments remains grim. Like the federal government, 14 Monetary Policy Report to the Congress July 2003 states and localities were running sizable budgetary sur­ year ending in the first quarter, compared with increases pluses in the late 1990s and now face large deficits. After averaging more than 31/ 2 percent per year over the pre- having enacted a series of tax reductions in the second ceding five years. Available data point to continued soft­ half of the 1990s, they subsequently saw their receipts ness in such spending in the second quarter. eroded by weak incomes and the falling stock market. At The pace of gross issuance of municipal bonds the same time, these entities boosted their outlays con­ remained robust in the first half of the year; it was fueled siderably, in large part because of rising health care costs in part by the needs of state and local governments to and increased demands for security-related spending. The finance capital spending, which is not subject to balanced fiscal difficulties have been especially acute at the state budget requirements. Long-term debt issuance was level. And although local governments generally have heavily used for new education and transportation fared somewhat better, many are now facing reductions projects. Declining yields on municipal debt and high in assistance from cash-strapped states. According to the short-term borrowing demands also provided important NIPA, the state and local sector’s aggregate current impetus to debt issuance. Despite continued fiscal pres­ deficit rose to about $50 billion in 2002—or 1/ 2 percent sures on many state and local governments, the credit of GDP, the largest annual deficit relative to GDP on quality of municipal bonds has shown some signs of sta­ record—and that gap exceeded $65 billion at an bilizing. Although the spread of BBB-rated over AAA- annual rate in the first quarter of 2003. rated municipal bond yields has widened somewhat, the Almost all states and most localities are subject to number of municipal bond upgrades by S&P has slightly balanced budget and other statutory rules that force them exceeded the number of downgrades so far this year. The to address fiscal imbalances. These rules typically apply yields on municipal bonds declined more slowly than the to operating budgets, and governments have taken a yields on Treasury securities of comparable maturity over variety of actions to meet their budgetary requirements much of the first half of the year; these moves lowered for fiscal 2003 and to pass acceptable budgets for fiscal the yield differential from the tax-advantaged status of 2004, which started on July 1 in most states and many municipal securities. localities. Strategies have included drawing upon accu­ mulated reserves, issuing bonds, and, in some cases, using one-time measures such as moving payments into The External Sector the next fiscal year and selling assets. Increases in taxes Trade and the Current Account and fees also have become more widespread. Still, spend­ ing restraint has remained an important component of the In the first quarter of 2003, the U.S. current account defi­ adjustment. Governments—especially at the state level— cit amounted to $544 billion at an annual rate, or about have held the line on hiring and have limited their out- 5 percent of GDP, a somewhat higher percentage than in lays for a variety of other goods and services. In the NIPA, any quarter of last year. The deficit on trade in goods and real expenditures for consumption and gross investment services widened $22 billion in the first quarter, to in the state and local sector rose only 1/ 2 percent over the $486 billion, as the value of imports rose more than that of exports. U.S. net investment income registered a State and local government current surplus or deficit U.S. trade and current account balances Percent of GDP Billions of dollars, annual rate + .5 0_ 100 + 0_ Trade 200 Current account 300 .5 400 500 1983 1987 1991 1995 1999 2003 NOTE. The data, which are quarterly, are on a national income and product 1996 1997 1998 1999 2000 2001 2002 2003 account basis and extend through 2003:Q1. The current surplus or deficit excludes social insurance funds. NOTE. The data are quarterly and extend through 2003:Q1. Board of Governors of the Federal Reserve System 15 $16 billion surplus in the first quarter, little changed from Prices of oil and of nonfuel commodities the previous quarter but significantly larger than the out- come for last year as a whole. The increase over last year January 2001 = 100 Dollars per barrel is attributable primarily to lower net interest and divi­ dend payments. Net unilateral transfers and other income were a negative $74 billion, down from a negative Oil 110 30 $67 billion in the fourth quarter. Real exports of goods and services fell 11/ 4 percent at an annual rate in the first quarter; this decline, like that in 100 20 the previous quarter, reflected in part slow economic growth of our major trading partners. Within this total, exports of goods increased nearly 2 percent after declin­ Nonfuel 90 10 ing sharply in the fourth quarter of last year. Moderate increases in most trade categories were partly offset by a decrease in exports of capital goods (particularly aircraft and computers). Meanwhile, real exports of services 2001 2002 2003 declined about 8 percent in the first quarter, mainly NOTE. The data are monthly and extend through June 2003. The oil price is because of a drop in receipts from foreign travelers. Prices the spot price of West Texas intermediate crude oil. The price of nonfuel of exported goods and services, which rose nearly 4 per- commodities is a weighted average of thirty-nine primary-commodity prices from the International Monetary Fund. cent at an annual rate in the first quarter, were boosted by rising prices of services and industrial supplies (mainly goods with a high energy component). Prices of exported Slight declines in prices of imported capital goods, auto- capital goods, automotive products, and consumer goods motive products, and consumer goods were offset by small showed little change in the first quarter. increases in other categories. U.S. real imports of goods and services declined 61/ 4 The spot price of West Texas intermediate crude oil percent at an annual rate in the first quarter following rose to a twelve-year high of nearly $38 per barrel in four quarters of increases. Imports of oil, other industrial mid-March as the United States moved closer to war in supplies, aircraft, and services (primarily U.S. travel Iraq and as a nationwide strike slowed Venezuelan oil abroad) all dropped sharply. Imports of automotive prod­ production to a trickle. With the commencement of mili­ ucts decreased for the second consecutive quarter, but tary action in Iraq and the relatively rapid conclusion of imports of machinery and consumer goods rose. The price the war, prices fell to less than $26 per barrel by late of imported goods jumped 12 percent at an annual rate in April. Downward pressure on prices was also exerted by the first quarter, mainly resulting from spikes in the prices increased production from some OPEC countries, par­ of natural gas and oil. The price of imported goods ticularly Saudi Arabia, Kuwait, and Venezuela, where oil excluding fuels rose about 2 percent in the first quarter, production recovered substantially relative to the first the fourth consecutive quarter of small increases, in part quarter. In early June, oil prices moved back above $30 because of the depreciation of the dollar since early 2002. per barrel after it became apparent that Iraqi exports of oil would return more slowly than market participants had previously expected. Change in real imports and exports of goods and services Percent, annual rate The Financial Account Imports Exports 20 The U.S. current account deficit continued to be financed 15 in large part by private flows into U.S. bonds and by for­ 10 eign official inflows. Private foreign purchases of U.S. 5 securities, which slowed in the latter part of 2002, stepped + down a bit more in the first quarter of 2003, owing in 0_ part to weaker demand for U.S. equities. In contrast, 5 inflows into the United States from official sources, which Q1 10 surged in 2002, picked up further in the first half of 2003 15 partly in response to downward pressures on the foreign exchange value of the dollar. U.S. residents, who had sold 1997 1999 2001 2003 foreign securities on net last year, recorded sizable net 16 Monetary Policy Report to the Congress July 2003 U.S. international securities transactions Net change in payroll employment Billions of dollars Thousands of jobs, monthly average Private foreign purchases of U.S. securities Private nonfarm 180 300 Bonds, net 160 Equities, net 140 200 120 100 100 80 Q2 + 0_ 60 40 100 20 + 200 0_ 1993 1995 1997 1999 2001 2003 Private U.S. purchases of foreign securities Bonds, net 75 month over the first half of 2003—essentially as fast as Equities, net over 2002 as a whole. Employment declines were wide- 50 spread, but the metals, machinery, and computers and electronics industries continued to be especially hard hit. 25 The weakness in manufacturing also cut into employment at help-supply firms and at wholesale trade establish­ + ments, although help-supply jobs increased noticeably in 0_ May and June. Apart from manufacturing and related industries, pri­ 2000 2001 2002 2003 vate employment increased slightly, on net, in the first SOURCE. Department of Commerce and the Federal Reserve Board. half after having been about unchanged in 2002. Employ­ ment in the financial activities sector rose briskly, in part purchases in the first quarter of this year: Relatively large because of the boom in mortgage refinancings. Construc­ purchases of foreign equities outweighed further sales of tion employment, which had been essentially unchanged, bonds. on net, since 1999, remained soft in the first quarter but Direct investment into the United States, after being posted a sizable gain in the second quarter. Employment restrained in 2002 by a slowdown of global mergers and in the information sector, which includes telecommuni­ acquisitions, picked up in the first quarter of 2003, as cations, publishing, and Internet-related services, contin­ merger activity resumed. U.S. direct investment abroad ued to decrease, though a shade less rapidly than over was steady in 2002 and the first quarter of 2003. the preceding two years. Demand for workers in retail Civilian unemployment rate The Labor Market Percent Employment and Unemployment The demand for labor has weakened further this year, though the pace of job losses appears to have slowed 9 somewhat. After having fallen an average of 55,000 per month in 2002, private payroll employment declined 35,000 per month, on average, in the first quarter of 2003 6 and 21,000 per month in the second quarter. The civilian unemployment rate, which had been fluctuating around 53/ 4 percent since late 2001, was little changed in the first 3 quarter but moved up in the spring. In June, it stood at 6.4 percent. The manufacturing sector has continued to shed jobs 1973 1983 1993 2003 this year. On average, factory payrolls fell 55,000 per NOTE. The data extend through June 2003. Board of Governors of the Federal Reserve System 17 trade, leisure and hospitality, and transportation and utili­ Measures of change in hourly compensation ties remained lackluster. The unemployment rate was little changed in the first Percent quarter, but it subsequently turned up. In June, it stood at 6.4 percent, 1/ 2 percentage point higher than the average 8 in the fourth quarter of 2002 and about 21/ 2 percentage points above the lows reached in 2000. The rise in the Nonfarm compensation per hour unemployment rate over the spring was chiefly driven by 6 the ongoing softness in labor demand. Most recently, it also coincided with an uptick in labor force participa­ 4 tion. That uptick notwithstanding, the participation rate Employment has trended down over the past couple of years, a slide cost index 2 mainly reflecting declines for adult men and younger persons. 1995 1997 1999 2001 2003 NOTE. The data extend through 2003:Q1. For nonfarm compensation, Productivity and Labor Costs change is over four quarters; for the employment cost index (ECI), change is over the twelve months ending in the last month of each quarter. Nonfarm compensation is for the nonfarm business sector; the ECI is for private in­ Labor productivity has continued to post solid gains in dustry excluding farm and household workers. recent quarters as businesses have remained reluctant to expand their payrolls and instead have focused on cut­ the preceding year but more than 1/ 2 percentage point ting costs in an environment of sluggish—and uncertain— below the increases of a few years earlier. The decelera­ demand. According to the currently published data, out- tion in hourly compensation over the past few years has put per hour worked in the nonfarm business sector rose been concentrated in wages, for which gains slowed from at an annual rate of 2 percent in the first quarter and 21/ 2 about 4 percent per year in 2000 and 2001 to 3 percent percent over the four quarters ending in the first quarter. over the year ending this March. The slowing in wage Though the recent gains are down from the very rapid growth primarily reflects the effects of the soft labor increases in late 2001 and 2002, they are similar to those market and lower rates of price inflation; in addition, achieved in the second half of the 1990s. However, employers may be exerting more restraint on wages to whereas the earlier productivity gains were driven offset some of the upward pressure on total compensa­ importantly by an expansion of the capital stock, the tion from rising benefit costs. The increase in benefits recent gains appear to have come mainly from efficiency- was especially sharp in the first quarter of 2003; in that enhancing changes in organizational structures and bet­ period, employers stepped up their contributions to ter use of the capital already in place. defined-benefit retirement plans in response to declines The employment cost index (ECI) for private nonfarm in the market value of plan assets, and health insurance businesses increased about 33/ 4 percent over the twelve costs continued to increase rapidly. In total, benefit costs months ending in March—only a shade less than over rose 6 percent over the year ending in March. The growth in compensation per hour in the nonfarm business sector—an alternative measure of hourly com­ Change in output per hour pensation based on the NIPA—has swung widely in Percent, annual rate recent years. Fluctuations in the value of stock option exercises, which are excluded from the ECI, likely have contributed importantly to these swings. In any event, the increase in this measure over the year ending in the first 4 quarter was 31/ 4 percent and roughly in line with the rise indicated by the ECI. Q1 2 Prices + 0_ Headline inflation numbers have been heavily influenced by movements in energy prices, but underlying inflation has remained subdued and according to some measures 1993 1995 1997 1999 2001 2003 has even moved somewhat lower. Reflecting the surge in energy prices, the chain-type price index for personal NOTE. Nonfarm business sector. 18 Monetary Policy Report to the Congress July 2003 consumption expenditures (PCE) increased at an annual Change in consumer prices excluding food and energy rate of 23/ 4 percent in the first quarter, about 1 percentage point faster than the increase over 2002 as a whole; this Twelve-month percent change index moved down in April and May as energy prices retreated. PCE prices excluding food and energy—the so-called core PCE price index—were nearly unchanged 3 Consumer price index during the spring, and the twelve-month change in this series stood at 11/ 4 percent in May, compared with a read­ ing of 13/ 4 percent over the preceding twelve months. 2 In the main, the quiescence of underlying inflation reflects continued slack in labor and product markets and the robust productivity gains of recent years. In addition, Chain-type price index for PCE 1 inflation expectations have remained in check—and, indeed, may have subsided a bit further. For example, according to the Michigan Survey Research Center, the 1993 1995 1997 1999 2001 2003 median expectation for inflation over the coming year NOTE. The data extend through May 2003. was running about 2 percent in May and June, compared with 21/ 2 percent to 3 percent over much of the preceding few years. Readings on this measure had been consider- crude oil costs rose and wholesale margins remained large; ably higher earlier in the year, when energy prices by June 1, gasoline prices had reversed that increase, and were rising, and it is difficult to know whether the they have changed little, on net, since that time. Natural decline of late was driven chiefly by the retreat in energy gas prices also soared in early 2003 as tight inventories prices during the spring. Non-oil import prices posted a were depleted further by unusually cold weather; since sizable increase in the first quarter after having been little the unwinding of February’s dramatic spike, prices have changed in 2002, but the first-quarter rise was due largely held in a narrow range. Inventories of natural gas have to a spike in the price of imported natural gas, which increased significantly of late, but they are still low enough should not have much effect on core consumer price to raise concerns about the possibility of future price inflation. Given the decline in the dollar from its peak in spikes in the event of a heat wave later this summer or an early 2002, non-oil import prices will probably trend up unusually cold winter. Reflecting the higher natural gas modestly in coming quarters. input costs, PCE electricity prices rose substantially over PCE energy prices rose sharply in the first quarter but the first five months of 2003 after having fallen some in turned down in the spring, a pattern largely mirroring the 2002. swings in crude oil prices. Gasoline prices, which had Increases in core consumer prices of both goods and already been elevated in late 2002 by weather-related services have slowed over the past year, with the decel­ supply disruptions, increased further early this year as eration most pronounced for goods. Prices for core PCE goods fell 21/ 4 percent over the year ending in May after having decreased 1 percent over the preceding twelve months. Meanwhile, the rise in prices for non-energy ser­ Change in consumer prices vices totaled 23/ 4 percent over the year ending in May, a Percent little less than over the preceding period. Among the major types of services, the price of owner-occupied housing Consumer price index Chain-type price index for PCE was up only 21/ 2 percent after having risen 41/ 4 percent 4 over the preceding period. But prices for some other types of services accelerated. Most notably, the prices of 3 financial services provided by banks without explicit charge turned up after having decreased over the preced­ ing two years; because these prices cannot be derived 2 from market transactions and thus must be imputed, they are difficult to measure and tend to be volatile from year 1 to year. Increases in the core consumer price index (CPI) also have been very small recently, and the twelve-month 1993 1995 1997 1999 2001 2003 NOTE. Change for 2003 is from December 2002 to May 2003 at an annual change in this measure slowed from 21/ 2 percent in May rate; changes for earlier periods are from December to December. 2002 to 11/ 2 percent in May 2003—a somewhat greater Board of Governors of the Federal Reserve System 19 Alternative measures of price change Before the War in Iraq Percent The year began on an optimistic note in financial mar­ Price measure 2001 to 2002 2002 to 2003 kets, in part owing to the release of a surprisingly strong Chain-type report from the Institute for Supply Management and the Gross domestic product .............................. 1.4 1.6 announcement of a larger-than-expected package of pro- Gross domestic purchases ........................... .8 2.2 Personal consumption expenditures ........... .9 2.2 posed tax cuts, which included elimination of the per­ Excluding food and energy ..................... 1.5 1.5 Chained CPI ................................................ .9 2.5 sonal federal income tax on many corporate dividend Excluding food and energy ..................... 1.9 1.4 payments. In addition, yields and risk spreads on corpo­ Fixed-weight rate bonds had dropped significantly in the fourth quar­ Consumer price index ................................. 1.3 2.9 Excluding food and energy ..................... 2.5 1.8 ter of 2002, partly in reaction to the absence of new rev- elations of accounting irregularities and to the improved Note. Changes are based on quarterly averages and are measured from Q1 to Q1. outlook for corporate credit quality. Money market futures rates apparently embedded an expectation that the FOMC would begin increasing the federal funds rate as deceleration than in core PCE prices. The greater decel­ early as mid-summer 2003. eration in the CPI is primarily accounted for by its nar­ That short burst of optimism was quickly damped by rower scope and different weighting structure than the subsequent economic reports that were decidedly less PCE measure. In particular, it excludes the imputed prices rosy, a jump in oil prices in response to the looming pros­ of financial services rendered without explicit charge as pect of war in Iraq, and increased tensions with North well as several other categories for which market prices Korea. Measures of uncertainty, such as implied volatil­ are not available; these non-market-based prices have ity, moved up in several markets. Major equity indexes accelerated notably recently. In fact, when the nonmarket slid and by mid-March were off about 4 percent to 9 per- categories are stripped from the core PCE index, the cent from the beginning of the year. Investors also came remaining components show a deceleration close to that to believe that the onset of FOMC tightening would in the core CPI. Another consideration is that housing occur later than they had earlier believed, a shift in per­ costs have a much larger weight in the CPI than in the ception that was reflected in lower yields on Treasury PCE index, partly because of the CPI’s narrower cover- bonds. Yields on investment-grade corporate bonds fell age. Thus, the smaller price increases for housing ser­ about in line with those on Treasuries, and investors vices of late have a bigger damping effect on core CPI appeared to be substituting high-quality bonds for equi­ inflation, just as the hefty increases in this category in ties as part of a broader flight to fixed-income securities 2001 and 2002 tended to lift the CPI relative to the PCE over this period. By contrast, yields on below-investment- index. grade bonds rose a bit, on balance, between mid-January Broader price measures likewise point to low infla­ and mid-March, a move that left their risk spreads higher tion over the year ending in the first quarter. In particu­ as well. lar, the chain-type price index for GDP rose only 11/ 2 percent over that period, about the same as during the comparable period four quarters earlier. Meanwhile, the price index for gross domestic purchases—which is defined as the prices paid for consumption, investment, Major stock price indexes and government purchases—increased 21/ 4 percent, up from 3/ 4 percent during the preceding period. The upswing Week of January 5, 2000 = 100 mainly reflects the effect of higher energy prices and roughly matches the acceleration in total PCE prices; the 125 price indexes for construction and government purchases also recorded somewhat larger increases than they had over the preceding period. 100 Wilshire 5000 75 U.S. Financial Markets Nasdaq 50 On balance, major stock indexes have climbed notice- ably this year, government and corporate interest rates have declined, and risk spreads, which had dropped sig­ 2000 2001 2002 2003 nificantly late last year, have fallen further. NOTE. The data are weekly averages and extend through July 9. 20 Monetary Policy Report to the Congress July 2003 Interest rates on selected Treasury securities those rates down, on balance, during the period covering the war in Iraq and its immediate aftermath. Yields on Percent corporate bonds also declined, in part because of strength­ ened corporate balance sheets, the reduction in uncer­ 7 tainty, and perhaps because investors began to search for 6 higher returns. Moreover, according to one widely used Ten-year measure, spreads on speculative-grade bonds tumbled 5 about 150 basis points, to about 520 basis points, from 4 mid-March until mid-May, and then fluctuated somewhat before ending June near that level. The rally in below- 3 Two-year investment-grade bonds was particularly evident in sec­ 2 tors that had previously experienced some of the greatest Three-month 1 widening of spreads—telecom, energy trading, and utili­ ties; the interest in these sectors further indicated inves­ 2000 2001 2002 2003 tors’ increased appetite for risk. A stubbornly sluggish economy and rapid growth of NOTE. The data are weekly averages and extend through July 9. productivity muted both inflation and inflation expecta­ tions, inducing the FOMC to begin pointing to a further After the War in Iraq substantial decline in inflation as a concern at its May Once it became clear that military action in Iraq was meeting. Market participants took this to imply that short- imminent, a robust rally erupted in both the equity and term rates would be held along a lower path for longer bond markets, as some of the uncertainties apparently than they had previously expected. This shift in expecta­ dissipated and investors began to show a greater appetite tions triggered a further decline in intermediate- and long- for riskier assets. Equity indexes jumped about 8 percent term yields. With long-term inflation expectations appar­ in the two weeks bracketing the President’s ultimatum to ently only little changed, the decline in yields translated Saddam Hussein, and prices climbed an additional 3 per- into a sizable decline in real interest rates. cent through the end of April, partly on the release of That drop in real interest rates was among several fac­ generally better-than-expected earnings reports for the tors providing a boost to equity prices in May and June. first quarter. Gains in share prices were fairly widespread Implied volatility of the S&P 100 index, which had been and included technology, defense, petroleum, and espe­ elevated earlier in the year, fell substantially with the cially financial companies. conclusion of major hostilities in Iraq; it is now near the The easing of tensions also put upward pressure on bottom of its range of the past several years. Moreover, Treasury yields, but additional disappointing economic downward revisions to analysts’ earnings expectations for data offset the diminished safe-haven demands and left the year ahead have been the smallest since early 2000. The tax package passed in late May, which included a Spreads of corporate bond yields over the ten-year Treasury yield Implied S&P 100 volatility Percentage points Percentage points Percent 3.5 10 50 High yield 3.0 9 BBB 40 2.5 8 2.0 30 7 1.5 20 6 1.0 AA 10 .5 5 2000 2001 2002 2003 2000 2001 2002 2003 NOTE. The data are weekly averages and extend through July 9 except for NOTE. The data are weekly averages and extend through July 9. The series the high-yield series, which extends through July 7. The spreads compare the shown is the implied volatility of the S&P 100 stock price index as calculated yields on Merrill Lynch AA, BBB, and 175 indexes with the yield on the from the prices of options that expire over the next several months. ten-year off-the-run Treasury note. SOURCE. Chicago Board Options Exchange. Board of Governors of the Federal Reserve System 21 cut in taxes on capital gains and dividends, may have Average C&I loan rate, domestic banks provided some additional impetus to equity prices. The FOMC decided on June 25 to reduce the target Percent federal funds rate 25 basis points, to 1 percent, but some 10 observers had been anticipating a cut of 50 basis points. In addition, markets appeared to read the Committee’s 9 assessment of economic prospects as more upbeat than 8 expected. Partly as a result, yields on longer-dated Trea­ sury securities reversed a portion of their previous 7 decline in the weeks following the meeting. Yields on 6 high-quality corporate bonds rose about in line with Treasuries over the same period, but yields on 5 speculative-grade bonds edged up only slightly, and risk 4 spreads narrowed further. Forward-looking economic indicators were generally positive, and stock price 1991 1993 1995 1997 1999 2001 2003 indexes—the Nasdaq, in particular—continued to trend NOTE. The data are quarterly and extend through 2003:Q2. higher. SOURCE. Federal Reserve, Survey of Terms of Business Lending. On net, the constant-maturity yield on the two-year Treasury note has fallen 24 basis points this year, to 1.37 adjustable interest rates—has fallen to its lowest level percent as of July 9, while the yield on the ten-year Trea­ since the start of the Federal Reserve’s Survey of Terms sury bond has fallen 10 basis points, to 3.73 percent. Over of Business Lending in 1977. The survey also indicates the same period, the Wilshire 5000 is up 151/ 2 percent, that risk spreads on these loans receded a bit over the and the Nasdaq has surged more than 30 percent. As a first half of 2003 after having trended up for most of the result of the decline in real interest rates, the spread past several years. Prices in the secondary loan market between the twelve-month forward earnings–price ratio have risen this year, reportedly in part because some of for the S&P 500 and the real ten-year yield remains wide the large inflows to high-yield mutual funds were used to despite the run-up in stock prices. purchase distressed loans and because of the expectation that many outstanding loans would continue to be pre- paid with the proceeds of bond refinancing. Shorter-term Debt Markets Interest rates on commercial paper also dropped to very low levels in the first half of 2003. Risk spreads in The average interest rate on commercial and industrial this market were relatively stable and near the bottom of loan originations—a substantial majority of which have the range observed over the past several years, in part because of businesses’ efforts to strengthen their balance sheets and improve their liquidity. S&P 500 forward earnings–price ratio and the real interest rate C&I loan rate spreads, by internal risk rating Percent Basis points S&P 500 earnings–price ratio Acceptable 8 300 250 6 200 4 Moderate 150 100 2 Real interest rate Low 50 1991 1993 1995 1997 1999 2001 2003 1997 1998 1999 2000 2001 2002 2003 NOTE. The data are monthly and extend through June 2003. The earnings–price ratio is based on I/B/E/S consensus estimates of earnings over NOTE. The data are quarterly and extend through 2003:Q2. Spreads are the coming year. The real rate is estimated as the difference between the over a market interest rate of comparable maturity. Low-risk loans are those ten-year Treasury rate and the five-year to ten-year expected inflation rate in risk categories “minimal” and “low.” from the FRB Philadelphia survey. SOURCE. Federal Reserve, Survey of Terms of Business Lending. 22 Monetary Policy Report to the Congress July 2003 Debt and Financial Intermediation Measures of bank profitability The debt of all domestic nonfinancial sectors—govern­ Percent Percent ment, businesses, and households—grew at a 61/ 2 per- cent annual rate in the first quarter, down from 8 percent 14 Return on equity in the fourth quarter of 2002 but still well in excess of the 1.2 12 growth of nominal GDP. The proportion of the new credit Return on assets 1.0 supplied by depository institutions rose significantly in 10 the second half of last year and remained at about 25 .8 8 percent in the first half of this year. In large part, the jump .6 reflects the sector’s support of the booming mortgage mar­ 6 ket—through both direct lending and the acquisition of 4 .4 mortgage-backed securities—which has more than off- 2 .2 set weak business lending. At commercial banks, revenues from mortgage-related activities reportedly helped sus­ 1985 1988 1991 1994 1997 2000 2003 tain profits in the first quarter at the elevated levels of the past several years despite some erosion in net NOTE. Through 2002 the data are annual; for 2003 they are seasonally adjusted data for Q1 at an annual rate. interest margins. SOURCE. Call Report. The delinquency rate on all loans and leases at banks edged down further during the first quarter, to its lowest commercial real estate loans and non-credit-card con­ level in two years. Increases in the delinquency rates on sumer loans were offset by declines in those on residen­ tial real estate loans, credit card loans, and business loans. For business and credit card loans, however, the delin- Change in domestic nonfinancial debt Percent Delinquency rates on selected types of loans at banks Percent 8 11 10 9 6 8 7 Total Commercial real estate 6 4 Commercial 5 and industrial 4 3 2 Percent 1 Percent Nonfederal 10 6 5 Credit card 5 + 0_ 4 Federal, Other consumer held by public 5 3 Residential real estate 2 1989 1991 1993 1995 1997 1999 2001 2003 NOTE. The data are annual; the observations for 2003 are annualized values for Q1. The total consists of nonfederal debt and federal debt held by the 1991 1993 1995 1997 1999 2001 2003 public. Nonfederal debt consists of the outstanding credit market debt of state and local governments, households, nonprofit organizations, nonfinancial NOTE. The data are quarterly, seasonally adjusted, and extend through businesses, and farms. Federal debt held by the public excludes securities 2003:Q1. held as investments of federal government accounts. SOURCE. Call Report. Board of Governors of the Federal Reserve System 23 Net percentage of domestic banks tightening standards on Regulatory capital ratios of commercial banks loans to households Percent Percent 50 Total (tier 1 + tier 2) ratio 14 Credit card loans 40 12 30 Tier 1 ratio Consumer loans 20 10 10 + 8 0_ Residential mortgages 10 1991 1993 1995 1997 1999 2001 2003 1991 1993 1995 1997 1999 2001 2003 NOTE. The data, which are quarterly and extend through 2003:Q1, are ratios of capital to risk-weighted assets. Tier 1 capital consists primarily of NOTE. The data are based on a survey generally conducted four times per common equity and certain perpetual preferred stock. Tier 2 capital consists year; the last reading is from the April 2003 survey. Net percentage is the primarily of subordinated debt, preferred stock not included in tier 1 capital, percentage reporting a tightening less the percentage reporting an easing. and a limited amount of loan-loss reserves. Le S n O d U in R g C E P . r a F c e ti d c e e r s a . l Reserve, Senior Loan Officer Opinion Survey on Bank SOURCE. Call Report. quency rates at banks remain elevated, and the recent but to a lesser extent. On net, there appears to be little, if improvement likely reflects, in part, the effect of the tight­ any, spillover into broader financial markets. ening of lending standards and terms that has been reported for some time now in the Senior Loan Officer Opinion Survey. On a seasonally adjusted basis, the ratio Monetary Aggregates of loan-loss provisions to assets declined in the final quar­ Through the first half of 2003, the growth rate of M2 was ter of last year, and it was about unchanged from that buoyed by several factors and remained elevated. The still-elevated level in the first quarter of 2003. In addi­ rising level of mortgage refinancing causes money growth tion to the buffer against future losses provided by their to accelerate because the associated prepayments on high profitability and substantial provisions, virtually all mortgage-backed securities that are temporarily held in banks—98 percent by assets—remain well capitalized. escrow accounts increase liquid deposits. Demand for M2 Among nondepository financial institutions, issuers of was also supported by the decline in short-term market asset-backed securities provided about 13 percent of the interest rates, which further reduced the opportunity cost total credit extended to domestic nonfinancial sectors in the first quarter. The share of net lending supplied by mutual funds increased notably to almost 10 percent in M2 growth rate the first quarter, and with the continuation of strong flows to bond mutual funds, they likely were large suppliers in Percent, annual rate the second quarter as well. Meanwhile, available data suggest that insurance companies likely accounted for 10 about 7 percent of total credit extended during the first H1 half of the year, a proportion near the top of the range 8 seen since the mid-1990s. Government-sponsored enterprises (GSEs) provided 6 11 percent of the net lending (net acquisition of credit market instruments) in the first quarter, an amount roughly 4 in line with their level in the second half of 2002. The 2 duration gaps in the portfolios of the housing GSEs were maintained near their targets. In early June, Freddie Mac replaced its top three executives amid questions about its 1991 1993 1995 1997 1999 2001 2003 accounting practices. The spreads on longer-term Freddie NOTE. M2 consists of currency, travelers checks, demand deposits, other Mac debt widened a bit, and its stock price declined checkable deposits, savings deposits (including money market deposit accounts), small-denomination time deposits, and balances in retail money sharply; the prices of Fannie Mae securities also declined market funds. 24 Monetary Policy Report to the Congress July 2003 M2 velocity and opportunity cost were, in turn, partially the result of an unwinding of the strength late last year and the fact that interest rates paid Ratio, ratio scale Percentage points, ratio scale by those funds declined faster than the interest rates paid 2.3 by the underlying assets this year. The drop in institu­ 8 tional money funds has been offset by growth in eurodollar M2 velocity deposits and repurchase agreements. 4 2.1 M2 2 International Developments opportunity cost 1 Economic activity abroad was sluggish in the first quar­ ter of 2003, with real output in the euro area and Japan 1.9 little changed from the previous quarter. Geopolitical uncertainties, higher oil prices, slow growth in the United 1994 1997 2000 2003 States, persistent weakness in global high-tech sectors, and continued negative wealth effects from past declines NOTE. The data are quarterly. They extend through 2003:Q1 for velocity and 2003:Q2 for opportunity cost. The velocity of M2 is the ratio of nominal in equity prices all weighed on foreign growth. Foreign gross domestic product to the stock of M2. The opportunity cost of holding M2 is a two-quarter moving average of the difference between the economic expansion appeared to remain weak in the sec­ three-month Treasury bill rate and the weighted average return on assets ond quarter despite the reduction in uncertainty associ­ included in M2. ated with Iraq. Indicators suggest that manufacturing activity abroad has not picked up; instead, industrial pro­ of holding money. Precautionary demand for safe and liq­ duction declined in April and May, on average, relative uid M2 assets also likely buttressed the growth of M2 in to the first quarter in Japan, Germany, and France. Con­ the run-up to the war in Iraq. cerns over the spread of the SARS virus appear to have In contrast, mutual fund flows related to the bond mar­ hurt growth in the second quarter in several Asian devel­ ket rally and the post-war pickup in the stock market may oping economies and in Canada. have siphoned funds from M2. Retail money market Central banks in several major foreign industrial coun­ mutual funds and small time deposits both experienced tries moved to ease monetary policy during the first half net outflows during the first half of the year. While some of this year. The European Central Bank and the central of that money continued to feed the extraordinary growth banks of the United Kingdom, Sweden, Switzerland, of liquid deposits, it is likely that a portion was redirected Norway, and New Zealand all cut official interest rates. to long-term mutual funds. The pace of monetary easing in Europe picked up toward After having weakened significantly in 2002, growth midyear, when inflation pressures dissipated amid grow­ of M3 slowed further in the first half of 2003. Much of ing slack, currency appreciation vis-à-vis the dollar, and this year’s slowdown can be attributed to rapid runoffs of the decline in oil prices after the conflict in Iraq. In con- institutional money market mutual funds. The runoffs Official interest rates in selected foreign industrial countries M3 growth rate Percent Percent, annual rate 6 12 5 10 United Kingdom 4 8 3 H1 6 Euro area 2 4 Canada 1 2 Japan 2001 2002 2003 1991 1993 1995 1997 1999 2001 2003 NOTE. The data are as of month-end and extend through June 2003. The NOTE. M3 consists of M2 plus large-denomination time deposits, balances interest rates shown are the call money rate for Japan, the overnight rate for in institutional money market funds, repurchase-agreement liabilities Canada, the refinancing rate for the euro area, and the repurchase rate for the (overnight and term), and eurodollars (overnight and term). United Kingdom. Board of Governors of the Federal Reserve System 25 trast, the Bank of Canada raised interest rates twice in Equity indexes in selected emerging markets the spring, in a continued effort to contain inflation. The Bank of Canada left rates unchanged in June, however, Week ending January 5, 2001 = 100 in response to a sharp appreciation of the Canadian dol­ lar and a drop in Canadian inflation in April, some slack­ Argentina 160 ening of demand in labor markets in May, and concerns 140 about the pace of activity in the United States. The Bank Developing Asia of Japan (BOJ) maintained short-term interest rates at Mexico 120 near-zero levels, further expanded its target for current account balances held by financial institutions at the BOJ, 100 and took some additional measures to add stimulus to the 80 economy. In the first quarter, foreign financial markets were 60 influenced by heightened anxieties ahead of the war in Brazil Iraq, but those concerns appeared to diminish as the war 2001 2002 2003 proceeded. Foreign equity prices declined in the first quar­ NOTE. The data are weekly. The last observations are the average of ter, but they have since recovered. Broad stock indexes trading days through July 9, 2003. Developing Asia consists of China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, Singapore, South for the major industrial countries are up on balance since Korea, Taiwan, and Thailand. the beginning of the year but, with the exception of Japan, they have gained less than in the United States. Long-term interest rates in most foreign industrial coun­ 5 percent against the currencies of a broad group of U.S. tries fell during the first half of the year because pros­ trading partners. The dollar has declined 13 percent pects for inflation diminished, growth sputtered, and mar­ against the Canadian dollar and more than 7 percent on ket participants began to expect that policy interest rates net against the euro but has fallen less than 1 percent ver­ would remain low for an extended period. Asset prices in sus the Japanese yen. During the first quarter, the dollar emerging markets, particularly in Latin America, picked appeared to react to concerns about the war in Iraq, fall­ up during the first half of this year; equity prices rose ing when news indicated a heightened risk of hostilities significantly, and risk spreads on emerging-market bonds and strengthening as concerns appeared to abate. After narrowed. Bonds issued by a number of emerging- the resolution in April of major hostilities, the dollar fell market economies included collective action clauses further, and market commentary focused more on the (CACs) that are designed to facilitate a debt restructur­ financing needs posed by the large and growing U.S. cur- ing in the event of default; this development had little rent account deficit. noticeable effect on spreads. The dollar’s foreign exchange value continued to decrease in the first half of 2003. Since the end of 2002, U.S. dollar nominal exchange rate, broad index the dollar has depreciated on a trade-weighted basis nearly January 2000 = 100 Equity indexes in selected foreign industrial countries Week ending January 5, 2001 = 100 115 110 Japan 100 105 Canada 80 100 60 2000 2001 2002 2003 Euro area United Kingdom NOTE. The data are monthly and are in foreign currency units per dollar. The last observation is the average of trading days through July 9, 2003. The 2001 2002 2003 broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. NOTE. The data are weekly. The last observations are the average of The index weights, which change over time, are derived from U.S. export trading days through July 9, 2003. shares and from U.S. and foreign import shares. 26 Monetary Policy Report to the Congress July 2003 U.S. dollar exchange rate against sharply, and exports declined because of the weak global selected major currencies economy. The severity of consumer price deflation less­ ened somewhat, partly because of the spike in energy Week ending January 5, 2001 = 100 prices. Japanese banks continued to be weighed down by bad loans. Japanese yen Canada’s economy maintained a moderate pace of 110 expansion in the first quarter, but recent indicators sug­ U.K. gest that growth of real GDP slowed in the second quar­ Canadian pound 100 ter. First-quarter growth was supported by continued dollar strength in domestic demand, as Canada’s strong labor 90 and housing markets kept propelling the economy. How- ever, exports declined in the first quarter, largely because Euro 80 of a drop in exports of industrial supplies and forestry products to the United States. More recently, employment declined slightly in April and May, and the unemploy­ 2001 2002 2003 ment rate moved up. The outbreak of the SARS virus in NOTE. The data are weekly. Last observations are the average of trading Toronto hurt Canadian travel and tourism, and weak U.S. days through July 9, 2003. Exchange rates are in foreign currency units per demand slowed the Canadian manufacturing sector. In dollar. June, employment rebounded, but the gain was almost all in part-time work, and manufacturing employment Industrial Economies continued to fall. The euro-area economy stagnated in the first quarter of 2003. Consumer spending continued to expand at a mod­ Emerging-Market Economies est rate and inventory investment grew, but business fixed investment fell sharply and exports declined. The Ger­ Economic growth in the Asian developing countries man economy contracted in the first quarter and contin­ slowed in the first quarter, brought down by weakness in ued to underperform the euro-area average, in part business investment and consumer spending. In South owing to a fiscal tightening undertaken to bring the bud- Korea, growth of real GDP turned negative in the first get deficit into line with limits set out in the euro area’s quarter after a rapid expansion in 2002. Tensions with Stability and Growth Pact. The rise in the exchange value North Korea contributed to a decline in consumer and of the euro over the past year has begun to hurt euro-area business sentiment, but these indicators have stabilized manufacturers; exports have leveled off while imports in the past couple of months. The Hong Kong economy have continued to rise. Recent indicators have shown little also contracted, following strong growth in the second rebound in the pace of euro-area activity following the half of last year. The SARS outbreak held down both conclusion of the Iraq war, and business and consumer personal consumption and tourism in the first quarter, and sentiment have remained sour. Core inflation has slowed even more negative effects are likely to be seen in the from its 2002 peak, and headline inflation, which was second-quarter data. Although the Chinese economy has temporarily boosted by oil prices, recently has fallen to also been adversely affected by SARS, it has been sus­ the 2 percent upper limit of the ECB’s definition of price tained by strong export growth and investment. Chinese stability. inflation has moved back into positive territory on a Economic growth in the United Kingdom slowed to twelve-month basis, largely owing to higher prices for a crawl in the first quarter, but recent indicators—such energy and food. as consumer confidence and industrial production—sug­ The Mexican economy contracted in the first quarter, gest that the pace has been somewhat stronger during the and exports and business confidence have declined in past few months. Growth of consumption has slowed but recent months. Consumer price inflation has come down continues to be held up by a strong labor market and by recently, a decline helped in part by the net appreciation past gains in housing prices, although lately these prices of the Mexican peso since early March. Measures of have decelerated. inflation expectations suggest that market participants The Japanese economy barely grew in the first quar­ expect the central bank to come close to achieving its ter after expanding almost 21/ 2 percent in 2002. Business inflation target this year. investment continued to grow in the first quarter, and pri­ Brazilian economic growth stagnated in the first quar­ vate consumption increased despite stagnating incomes; ter largely as a result of the tightening of macroeconomic however, residential and public investment both fell policies in response to the financial crisis that erupted in Board of Governors of the Federal Reserve System 27 U.S. dollar exchange rates and bond spreads mid-2002. The growth slowdown largely reflected a con­ for selected emerging markets tinued weakening in domestic demand, but exports also deteriorated. Monthly inflation has come down since early January 5, 2001 = 100 January 5, 2001 = 100 this year, and Brazil’s central bank recently lowered Exchange rates slightly its benchmark interest rate. The Lula admin­ istration’s efforts to implement social security and tax 360 220 reforms have bolstered investor confidence. Financial conditions in Brazil have improved markedly: Equity Argentine peso 280 180 prices have risen more than 20 percent so far this year, the real has gained more than 20 percent against the U.S. 200 Brazilian real 140 dollar, and credit spreads on Brazilian government debt Mexican peso have narrowed more than 600 basis points. The Argentine economy has started to turn around from 120 100 Korean won the sharp contraction that occurred in the wake of the devaluation and default in late 2001, but the level of eco­ nomic activity remains far below pre-crisis levels, and Percentage points Percentage points many of Argentina’s structural problems have not been Bond spreads addressed. The Argentine peso appreciated more than 20 80 Brazil 20 percent against the dollar during the first half of the year. In July, Argentina implemented controls on short-term capital inflows in an effort to stabilize the appreciating 60 Argentina 15 currency. 40 10 Mexico 20 5 2001 2002 2003 NOTE. The exchange rate data are weekly averages that are indexed to the week ending January 5, 2001. Last observations are the average of trading days through July 9, 2003. Exchange rates (top panel) are in foreign currency units per dollar. Bond spreads (bottom panel) are the J.P. Morgan Emerging Market Bond Index (EMBI+) spreads over U.S. Treasuries.

Federal Reserve (2003, July 14). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20030715

@misc{wtfs_monetary_policy_report_20030715,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2003},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20030715},
  note = {Retrieved via When the Fed Speaks corpus}
}