Monetary Policy Report

For use at 11:00 a.m., EST Wednesday February 11, 2004 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress February 11, 2004 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 11, 2004 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 11, 2004 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 and Early 2004 4 Monetary Policy Report to the Congress Report submitted to the Congress on February 11, 2004, nomic activity abroad gave few signs of bouncing back, pursuant to section 2B of the Federal Reserve Act even though long-term interest rates in major foreign economies had declined sharply. At its June meeting, the FOMC provided additional policy accommodation, given that, as yet, it had seen no clear evidence of an accelera­ MONETARY POLICY AND THE ECONOMIC OUTLOOK tion of U.S. economic activity and faced the possibility that inflation might fall further from an already low level. The economic expansion in the United States gathered During the next several months, evidence was accu­ strength during 2003 while price inflation remained quite mulating that the economy was strengthening. The low. At the beginning of the year, uncertainties about the improvement was initially most apparent in financial mar­ economic outlook and about the prospects of war in Iraq kets, where prospects for stronger economic activity and apparently weighed on spending decisions and extended corporate earnings gave a further lift to equity prices. the period of subpar economic performance that had Interest rates rose as well, but financial conditions begun more than two years earlier. However, with the appeared to remain, on net, stimulative to spending, and support of stimulative monetary and fiscal policies, the additional impetus from the midyear changes in federal nation’s economy weathered that period of heightened taxes was in train. Over the remainder of the year, in the uncertainty to post a marked acceleration in economic absence of new shocks to economic activity and with activity over the second half of 2003. Still, slack in gathering confidence in the durability of the economic resource utilization remained substantial, unit labor costs expansion, the stimulus from monetary and fiscal poli­ continued to decline as productivity surged, and core cies showed through more readily in an improvement in inflation moved lower. The performance of the economy domestic demand. Consumer spending and residential last year further bolstered the case that the faster rate of construction, which had provided solid support for the increase in productivity, which began to emerge in the expansion over the preceding two years, rose more rap- late 1990s, would persist. The combination of that favor- idly, and business investment revived. Spurred by the glo­ able productivity trend and stimulative macroeconomic bal recovery in the high-tech sector and by a pickup in policies is likely to sustain robust economic expansion economic activity abroad, U.S. exports also posted solid and low inflation in 2004. increases in the second half of the year. Businesses At the time of our last Monetary Policy Report to the began to add to their payrolls, but only at a modest pace Congress, in July, near-term prospects for U.S. economic that implied additional sizable gains in productivity. activity remained unclear. Although the Federal Open The fundamental factors underlying the strengthening Market Committee (FOMC) believed that policy stimu­ of economic activity during the second half of 2003 should lus and rapid gains in productivity would eventually lead continue to promote brisk expansion in 2004. Monetary to a pickup in the pace of the expansion, the timing and policy remains accommodative. Financial conditions for extent of the improvement were uncertain. During the businesses are quite favorable: Profits have been rising spring, the rally that occurred in equity markets when the rapidly, and corporate borrowing costs are at low levels. war-related uncertainties lifted suggested that market In the household sector, last year’s rise in the value of participants viewed the economic outlook as generally equities and real estate exceeded the further accumula­ positive. By then, the restraints imparted by the earlier tion of debt by enough to raise the ratio of household net sharp decline in equity prices, the retrenchment in capi­ worth to disposable income after three consecutive years tal spending, and lapses in corporate governance were of decline. In addition, federal spending and tax policies receding. As the price of crude oil dropped back and con­ are slated to remain stimulative during the current fiscal sumer confidence rebounded last spring, household year, while the restraint from the state and local sector spending seemed to be rising once again at a moderate should diminish. Lastly, the lower foreign exchange value rate. Businesses, however, remained cautious; although of the dollar and a sustained economic expansion among the deterioration in the labor market showed signs of abat­ our trading partners are likely to boost the demand for ing, private payroll employment was still declining, and U.S. production. Considerable uncertainty, of course, still capital spending continued to be weak. In addition, eco­ attends the economic outlook despite these generally 2 Monetary Policy Report to the Congress February 2004 favorable fundamentals. In particular, questions remain At its meeting on March 18, the FOMC maintained its as to how willing businesses will be to spend and hire 11/ 4 percent target for the federal funds rate to provide and how durable will be the pickup in economic growth support for a stronger economic expansion that appeared among our trading partners. At its meeting on January likely to materialize. The Committee noted that the pre­ 27–28, 2004, the Committee perceived that upside and vailing high degree of geopolitical uncertainty compli­ downside risks to the attainment of sustainable growth cated any assessment of prospects for the economy, and for the next few quarters are roughly equal. members refrained from making a determination about Prospects for sustained high rates of increase in pro­ the balance of risks with regard to its goals of maximum ductivity are quite favorable. Businesses are likely to employment and stable prices. At the same time, the Com­ retain their focus on controlling costs and boosting effi­ mittee agreed to step up its surveillance of the economy, ciency by making organizational improvements and which took the form of a series of conference calls in late exploiting investments in new equipment. With the March and early April to consult about developments. ongoing gains in productivity, the existing margins of When military action in Iraq became a certainty, finan­ slack in resource utilization should recede gradually, and cial markets began to rally, with risk spreads on corpo­ any upward pressure on prices should remain well con­ rate debt securities narrowing and broad equity indexes tained. The FOMC indicated at its January meeting that, registering notable gains. Economic news, however, with inflation low and resource use still slack, it can be remained mixed. patient in removing its policy accommodation. Indicators of the economy at the time of the May 6 FOMC meeting continued to suggest only tepid growth. Uncertainty in financial markets had declined, and rising consumer confidence and a wave of mortgage refi­ Monetary Policy, Financial Markets, and the nancing appeared to be supporting consumer spending. Economy over 2003 and Early 2004 However, persistent excess capacity evident in labor and product markets pointed to possible further disinflation. During the opening months of 2003, the softness in eco­ The lifting of some of the uncertainty clouding the eco­ nomic conditions was exacerbated by the substantial nomic outlook allowed the Committee to make the deter­ uncertainty surrounding the onset of war in Iraq. Private mination that the risks to economic growth were balanced nonfarm businesses began again to cut payrolls substan­ but that the probability of an unwelcome substantial tially, consumer spending slowed, and business invest­ fall in inflation exceeded that of a pickup in inflation. ment was muted. Although the jump in energy prices The FOMC judged that, taken together, the balance of pushed up overall inflation, slack in resource utilization risks was weighted toward weakness. The Committee left and the rapid rise in labor productivity pushed core infla­ the federal funds rate target at 11/ 4 percent, but the tion down. In financial markets, the heightened sense of Committee’s announcement prompted a rally in the Trea­ caution among investors generated safe-haven demands sury market, and coupon yields fell substantially as mar­ for Treasury and other fixed-income securities, and ket participants marked down their expectations for the equity prices declined. path of the federal funds rate. Selected interest rates Percent Ten-year Treasury 6 5 Two-year Treasury 4 3 Intended federal funds rate 2 1 1/30 3/19 5/7 6/26 8/13 9/24 11/6 12/10 1/29 3/18 5/6 6/25 8/12 9/16 10/28 12/9 1/28 2002 2003 2004 NOTE. The data are daily and extend through February 4, 2004. The dates on the horizontal axis are those of scheduled FOMC meetings. Board of Governors of the Federal Reserve System 3 By the time of the June 24–25 FOMC meeting, risk upward pressure on equity prices and longer-term inter­ spreads had narrowed further and equity prices had est rates. The Committee’s retention of the phrase “con­ extended their rise, but the prospects for sustained eco­ siderable period” in the announcements following each nomic expansion still seemed tentative. Although Com­ of these meetings apparently provided an anchor for near- mittee members referred to signs of improvement in some term interest rates. The Committee’s discussion at these sectors of the economy, they saw no concrete evidence two meetings focused on the increased evidence of a of an appreciable overall strengthening in the economic broadly based acceleration in economic activity and on expansion and viewed the excess capacity in the economy the continued weakness in labor markets. Rising indus­ as likely to keep inflation in check. The Committee low­ trial production, increased personal consumption and ered the target for the federal funds rate 1/ 4 percentage business investment spending, higher profits, receptive point, to 1 percent, to add further support to the economic financial markets, and a lower foreign exchange value of expansion and as a form of insurance against a further the dollar all suggested that sustained and robust eco­ substantial drop in inflation, however unlikely. The mem­ nomic growth was in train. The Committee’s decision to bers saw no serious obstacles to further conventional leave the stance of monetary policy unchanged over this policy ease down to the zero lower bound on nominal period reflected, in part, a continuing confidence that interest rates should that prove to be necessary. The Com­ gains in productivity would support economic growth and mittee also discussed alternative means of providing suppress inflationary pressures. In fact, the Committee monetary stimulus should the target federal funds rate be generally viewed its goal of price stability as essentially reduced to a point at which they would have little or having been achieved. no latitude for additional easing through this traditional By the time of the December 9 FOMC meeting, the channel. economic expansion appeared likely to continue at a rate Longer-term interest rates backed up following the sufficient to begin to reduce slack in labor and product meeting, as investors had apparently placed substantial markets. Equity markets continued to rally, and risk odds on a policy move larger than 25 basis points and spreads, particularly on the debt of speculative-grade may have been disappointed that the announcement failed firms, narrowed further. The labor market was finally to mention any potential “unconventional” monetary showing some signs of improvement, and spending by policy options. Ten-year Treasury yields rose sharply households remained strong even as the impetus from during the following weeks in reaction to interpretations earlier mortgage refinancings and tax cuts began to wane. of the Chairman’s congressional testimony, the release The acceleration in capital spending and evidence that of Committee members’ economic projections, and posi­ some firms were beginning to accumulate inventories tive incoming news about the economy and corporate seemed to signal that business confidence was on the profits. A substantial unwinding of hedging positions mend. However, twelve-month core consumer price related to mortgage investments may well have ampli­ inflation was noticeably lower than in the previous year. fied the upswing in market yields. Over the intermeeting Even though the unemployment rate was expected to period, labor markets continued to be soft, but industrial move down gradually, continued slack in labor and prod­ production, personal consumption expenditures, and busi­ uct markets over the near term was viewed as sufficient ness outlays all strengthened, and the housing market to keep any nascent inflation subdued. Uncertainty about remained robust. By the time of the August 12 FOMC the pace at which slack would be worked down, how- meeting, members generally perceived a firming in the ever, made longer-run prospects for inflationary pressures economy, most encouragingly in business investment difficult to gauge. Given the better outlook for sustained spending, and believed that, even after the rise in longer- economic growth, the possibility of pernicious deflation term rates, financial conditions were still supportive of associated with a pronounced softening in real activity vigorous economic growth. Given the continued slack in was seen as even more remote than it had been earlier in resource use across the economy, however, members saw the year. The Committee indicated that keeping policy little risk of inducing higher inflation by leaving the fed­ accommodative for a considerable period was contingent eral funds rate at its accommodative level. On the basis on its expectation that inflation would remain low and of the economic outlook, and to reassure market partici­ that resource use would remain slack. pants that policy would not reverse course soon, Com­ At its meeting on January 27–28, 2004, the Commit- mittee members decided to include in the announcement tee viewed a self-sustaining economic expansion as even a reference to their judgment that under the anticipated more likely. Members drew particular reassurance from circumstances, policy accommodation could be main­ reports of plans for stronger capital spending and the tained for a “considerable period.” widespread distribution of increased activity across Through the September 16 and October 28 FOMC regions. Accommodative financial market conditions, meetings, the brightening prospects for future growth put including higher equity prices, narrower risk spreads on 4 Monetary Policy Report to the Congress February 2004 bonds, and eased standards on business loans, also seemed sonal consumption expenditures (PCE) is 1 percent to supportive of economic expansion. However, some risks 11/ 4 percent; this measure of inflation was 1.4 percent over remained in light of continued lackluster hiring evidenced the four quarters of 2003. by the surprisingly weak December payroll employment report. With the likelihood for rapid productivity growth seemingly more assured, Committee members generally ECONOMIC AND FINANCIAL DEVELOPMENTS IN agreed that inflation pressures showed no sign of increas­ 2003 AND EARLY 2004 ing and that a bit more disinflation was possible. Under these circumstances, the Committee concluded that cur- The pace of economic expansion strengthened consider- rent conditions allowed monetary policy to remain ably in the second half of 2003 after almost two years of patient. As to the degree of policy accommodation, the uneven and, on balance, sluggish growth. In early 2003, Committee left its target for the federal funds rate accommodative monetary policy and stimulative fiscal unchanged. The Committee’s characterization that policy policies were in place, but economic activity still seemed could be patient instead of its use of the phrase “consid­ to be weighed down by a number of factors that had erable period” in its announcement prompted a rise in restrained the recovery earlier: Geopolitical tensions were Treasury yields across the yield curve and a fall in equity again heightened, this time by the impending war in Iraq, prices. businesses remained unusually cautious about the strength of the expansion, and economic activity abroad was still Economic Projections for 2004 weak. In June the continued lackluster economic growth and a further downshift in inflation from an already low level prompted a further reduction in the federal funds Federal Reserve policymakers expect that the economic rate. In addition, the tax cuts that became effective at expansion will continue at a brisk pace in 2004. The cen­ midyear provided a significant boost to disposable tral tendency of the forecasts of the change in real gross income. In the succeeding months, the macroeconomic domestic product made by the members of the Board of stimulus began to show through clearly in sales and pro­ Governors and the Federal Reserve Bank presidents is duction, and some of the business caution seemed to 41/ 2 percent to 5 percent, measured from the final quarter recede. Real GDP increased at an annual rate of 6 per- of 2003 to the final quarter of 2004. The full range of cent, on average, in the third and fourth quarters of last these forecasts is somewhat wider—from 4 percent to year. In contrast, between late 2001 and mid-2003, real 51/ 2 percent. The FOMC participants anticipate that the projected increase in real economic activity will be asso­ GDP had risen at an annual rate of only 21/ 2 percent. During the period of recession and subpar economic ciated with a further gradual decline in the unemploy­ expansion, considerable slack developed in labor and ment rate. They expect that the unemployment rate, which product markets. The firming of economic activity in the has averaged 53/ 4 percent in recent months, will be second half of last year produced modest increases in between 51/ 4 percent and 51/ 2 percent in the fourth quar­ rates of resource utilization. Sustained efforts by busi- ter of the year. With rapid increases in productivity likely to be sustained and inflation expectations stable, Federal Reserve policymakers anticipate that inflation will remain Change in real GDP quite low this year. The central tendency of their fore- casts for the change in the chain-type price index for per- Percent, annual rate Economic projections for 2004 8 Percent 6 Federal Reserve Governors and Indicator 200 M 3 E a M c O tu al Reserve Bank presidents 4 Range Central tendency 2 Change, fourth quarter to fourth quarter1 + Nominal GDP ............................ 5.9 5½–6½ 5½–6¼ 0_ Real GDP .................................. 4.3 4–5½ 4½–5 PCE chain-type price index ...... 1.4 1–1½ 1–1¼ Average level, fourth quarter 1997 1999 2001 2003 Civilian unemployment rate ...... 5.9 5¼–5½ 5¼–5½ NOTE. Here and in subsequent charts, except as noted, change for a given 1. Change from average for fourth quarter of previous year to average for period is measured to its final quarter from the final quarter of the preceding fourth quarter of year indicated. period. Board of Governors of the Federal Reserve System 5 Change in PCE chain-type price index Change in real income and consumption Percent Percent, annual rate Total Disposable personal income Excluding food and energy Personal consumption expenditures 3 6 2 4 1 2 1997 1999 2001 2003 1997 1999 2001 2003 NOTE. The data are for personal consumption expenditures (PCE). nesses to control costs led to further rapid gains in spring and in the summer, however, households stepped productivity. As a result, unit labor costs declined, and up their spending sharply. As a result, in the second half core rates of inflation continued to slow in 2003; exclud­ of last year, real personal consumption expenditures rose ing food and energy, the PCE chain-type price index at an annual rate of 43/ 4 percent after having increased at increased just 0.9 percent last year. Measures of overall a rate of just under 3 percent in the first half. Although inflation, which were boosted by movements in food and wage and salary earnings rose slowly during most of the energy prices, were higher than those for core inflation. year, the midyear reductions in tax rates and the advance Domestic financial market conditions appeared to of rebates to households eligible for child tax credits pro­ become increasingly supportive of economic growth last vided a substantial boost to after-tax income. In 2003, year. The economic expansion lowered investors’ percep­ real disposable personal income increased 31/ 4 percent, tion of, and perhaps aversion to, risk, and continued after having risen 31/ 2 percent in 2002. Low interest rates disinflation was interpreted as a sign that monetary policy provided additional impetus to household spending by would remain on hold, even as the economy picked up reducing borrowing costs for new purchases of houses steam. Although yields on Treasury coupon securities rose and durable goods; they also indirectly stimulated spend­ modestly on balance over the year, risk spreads on cor­ ing by facilitating an enormous amount of mortgage porate debt narrowed to the point that yields on corpo­ refinancing. rate issues declined. The low-interest-rate environment The personal saving rate has fluctuated within a fairly spurred considerable corporate bond issuance and gen­ narrow range around 2 percent over the past three years. erated a massive wave of mortgage refinancing activity Although households continued to see the value of their by households. Equity markets began to rally when the uncertainty over the timing of military intervention in Iraq was resolved. The climb in stock prices continued for the Personal saving rate rest of the year, driven by improving corporate earnings Percent reports and growing optimism about the prospects for the economy. At the same time, with economic conditions abroad improving and with concerns about the financing 12 burden of the U.S. current account deficit gaining increased attention in financial markets, the dollar fell 9 appreciably on a trade-weighted basis. 6 The Household Sector 3 Consumer Spending Early in 2003, consumer spending was still rising at about 1983 1987 1991 1995 1999 2003 the same moderate pace as in 2001 and 2002. In the late NOTE. The data are quarterly and extend through 2003:Q4. 6 Monetary Policy Report to the Congress February 2004 Wealth-to-income ratio Consumer sentiment Ratio 1985 = 100 1966 = 100 140 140 6 Conference Board 120 120 5 100 100 Michigan SRC 80 80 4 60 60 1983 1987 1991 1995 1999 2003 1992 1995 1998 2001 2004 NOTE. The data are quarterly and extend through 2003:Q3. The wealth- NOTE. The data are monthly and extend through January 2004. to-income ratio is the ratio of household net worth to disposable personal SOURCE. University of Michigan Survey Research Center and The Con­ income. ference Board. homes appreciate over this period, they also were adjust­ the year ahead. Those positive views became more widely ing to the substantial drop in equity wealth that occurred held in January, and the index of consumer sentiment pre- after the peak in the stock market in 2000. By itself, a fall pared by the Michigan Survey Research Center (SRC) in the ratio of household wealth to income of the magni­ reached its highest level in three years. tude that households experienced between 2000 and 2002 might have triggered a noticeable increase in the personal saving rate. However, in this case, the tendency for house- Residential Investment holds to save more as their wealth declines appears to have been tempered in part by their willingness to take Housing activity was robust for a second consecutive year advantage of the attractive pricing and financing envi­ in 2003. After having risen 7 percent in 2002, real ronment for consumer goods. expenditures on residential construction jumped more Real consumer expenditures for durable goods surged than 10 percent in 2003. These gains were fueled impor­ more than 11 percent in 2003. Sales of new motor tantly by the lowest levels of mortgage interest rates in vehicles remained brisk as many consumers responded more than forty years, which, according to the Michigan to the low financing rates and various incentive deals that SRC’s survey of consumer sentiment, buoyed consumer manufacturers offered throughout the year. Falling prices attitudes toward homebuying throughout the year. The also made electronic equipment attractive to consumers, average rate on thirty-year fixed-rate mortgages dropped and spending on home furnishings likely received a boost from the strength of home sales. Altogether, real outlays for furniture and household equipment jumped 131/ 2 per- Private housing starts cent in 2003. In contrast, real consumer expenditures on nondurable Millions of units, annual rate goods and on services continued to rise at a moderate pace, on balance, last year. Outlays for food and apparel 1.6 increased a bit faster than in 2002, and the steady uptrend in spending for medical services was well maintained. Single-family However, consumers responded to the higher cost of 1.2 energy by cutting back their real spending on gasoline, fuel oil, and natural gas and electricity services. .8 Consumer confidence was shaken temporarily early in 2003 by concerns about the consequences of a war in Multifamily .4 Iraq, but it snapped back in the spring. Toward year-end, sentiment appeared to brighten more as households saw their current financial conditions improve and gained con­ 1991 1993 1995 1997 1999 2001 2003 fidence that business conditions would be better during NOTE. The data are quarterly and extend through 2003:Q4. Board of Governors of the Federal Reserve System 7 sharply during the first half of 2003 and reached a low of Mortgage rates 51/ 4 percent in June. Although the thirty-year rate subse­ quently firmed somewhat, it remained below 6 percent, Percent on average, in the second half of last year. Construction of new single-family homes accelerated Fixed rate 9 during 2003, and for the year as a whole, starts averaged 1.5 million units, an increase of 10 percent compared with the level in 2002. Sales of both new and existing single- 7 family homes also picked up sharply further last year. Adjustable rate The brisk demand for homes was accompanied by rapid 5 increases in the average price paid for them. The average price paid for new homes rose 10 percent over the four 3 quarters of 2003, and the average price of existing homes was up 73/ 4 percent over the same period. However, house price inflation was lower after adjusting for shifts in the 2000 2001 2002 2003 2004 composition of transactions toward more expensive NOTE. The data, which are monthly and extend through January 2004, are homes. The constant-quality price index for new homes, contract rates on thirty-year mortgages. SOURCE. Federal Home Loan Mortgage Corporation. which eliminates the influence of changes in their ameni­ ties and their geographic distribution, increased 43/ 4 per- cent over the four quarters of 2003—down from an household bankruptcies held roughly steady near their increase of 6 percent during 2002. The year-over-year elevated level in 2002. increase in Freddie Mac’s index of the prices paid in Even with the rapid expansion in debt, net worth of repeat sales of existing homes stood at 51/ 2 percent as the household sector increased as the value of household of the third quarter of 2003, compared with a rise of assets rose noticeably. Stock prices were boosted by the 71/ 4 percent as of the third quarter of 2002. rise in corporate earnings and the ebbing of uncertainty Starts in the multifamily sector totaled 350,000 units about future economic growth. Households directed sub­ in 2003, a pace little changed from that of the past sev­ stantial flows into stock mutual funds in the third and eral years. Vacancy rates for these units rose and rents fourth quarters despite highly publicized scandals in the fell during the year, but falling mortgage rates apparently mutual fund industry. Although the companies directly helped to maintain building activity. implicated in wrongdoing experienced heavy outflows from their funds, most of these withdrawals apparently were transferred to other mutual funds with little effect Household Finance on the industry as a whole. A considerable rise in real estate wealth further augmented household assets. Household debt increased 10 3/ 4 percent last year, in large Although prices of existing homes climbed more slowly part because of the surge in mortgage borrowing induced by record-low mortgage interest rates. Refinancing activity was torrid in the first half of the year, as mort­ Delinquency rates on selected types of household loans gage rates declined. Some of the equity that households Percent extracted from their homes during refinancings was apparently used to fund home improvements and to pay Credit card pools 6 down higher-interest consumer debt. When mortgage rates rebounded in the second half of the year, mortgage bor­ 5 rowing slowed from the extremely rapid clip of the first 4 half, but it remained brisk through year-end. Consumer Auto loans at domestic auto finance companies credit increased at a pace of 51/ 4 percent in 2003, a little 3 faster than a year earlier, as revolving credit picked up 2 somewhat from the slow rise recorded in 2002. Despite Mortgages the pickup in household borrowing, low interest rates kept 1 the household debt-service and financial-obligation ratios—which gauge pre-committed expenditures relative 1991 1993 1995 1997 1999 2001 2003 to disposable income—at roughly the levels posted in NOTE. The data are quarterly. The rates for credit card pools and mortgages 2002. Most measures of delinquencies on consumer loans extend through 2003:Q3; the rate for auto loans extends through 2003:Q4. and home mortgages changed little on net last year, and SOURCE. For mortgages, the Mortgage Bankers Association; for auto loans, the Big Three automakers; for credit cards, Moody’s Investors Service. 8 Monetary Policy Report to the Congress February 2004 than they had in the previous year, the rate of increase at an annual rate of 113/ 4 percent over the remaining three remained sizable. Overall, the advance in the value of quarters of the year. household assets outstripped the accumulation of house- Outlays for high-technology items—computers and hold debt by enough to boost the ratio of net worth to peripherals, software, and communications equipment— disposable income over the year. which had risen a moderate 41/ 2 percent in 2002, posted a significantly more robust increase of more than 20 per- cent in 2003. That gain contributed importantly to the pickup in overall business outlays for equipment and soft- The Business Sector ware and pushed the level of real high-tech outlays above Fixed Investment the previous peak at the end of 2000. The increase in spending last year on computing equipment marked the Business spending on equipment and software was still sharpest gain since 1998, and investment in communica­ sluggish at the beginning of 2003. However, it acceler­ tions equipment, which had continued to contract in ated noticeably over the course of the year as profits and 2002 after having plummeted a year earlier, turned up cash flow rebounded and as businesses gained confidence markedly. in the strength of the economic expansion and in the pro­ In contrast, the recovery in spending on non-high-tech spective payoffs from new investment. At the same time, equipment was, on balance, more muted, in part business financing conditions were very favorable: because outlays for transportation equipment continued Interest rates remained low, equity values rallied, and the to fall. The prolonged slump in business purchases of new enhanced partial-expensing tax provision gave a special aircraft continued in 2003 as domestic air carriers incentive for the purchase of new equipment and soft- grappled with overcapacity and high fixed costs. By the ware. After having changed little in the first quarter of fourth quarter, real outlays for aircraft had dropped to the year, real outlays for equipment and software increased their lowest level in ten years. In the market for heavy (class 8) trucks, sales were quite slow in early 2003 when businesses were concerned about the performance of models with engines that met new emission standards. Change in real business fixed investment But as potential buyers overcame those concerns, sales Percent, annual rate recovered. By the fourth quarter of 2003, sales of medium and heavy trucks had moved noticeably above Structures Equipment and software the slow pace of 2001 and 2002. Apart from outlays for 20 transportation equipment, investment in other types of non-high-tech equipment was, on balance, little changed 10 during the first half of the year. Demand was strong for + medical equipment, instruments, and mining and oilfield 0_ machinery, but sales of industrial equipment and farm 10 and construction machinery were sluggish. In the second half of the year, however, the firming in business spend­ 20 ing for non-high-tech items became more broadly based. The steep downturn in nonresidential construction that began in 2001 moderated noticeably in 2003, although market conditions generally remained weak. After hav­ High-tech equipment and software Other equipment excluding transportation 40 ing contracted at an average annual rate of 131/ 2 percent during 2001 and 2002, real expenditures for nonresiden­ 30 tial construction slipped just 11/ 4 percent, on balance, during 2003. Spending on office buildings and manufac­ 20 turing structures, which had dropped sharply over the 10 preceding two years, fell again in 2003. The high office + vacancy rates in many areas and low rates of factory uti­ 0_ lization implied little need for new construction in these sectors even as economic activity firmed. Investment in 10 communications infrastructure, where a glut of long-haul fiber-optic cable had developed earlier, also continued 1997 1998 1999 2000 2001 2002 2003 to shrink. In contrast, outlays for retail facilities, such as NOTE. High-tech equipment consists of computers and peripheral equip­ ment, software, and communications equipment. department stores and shopping malls, turned up last year, 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 (2000) dollars, annual rate Percent 75 50 14 25 12 + 0_ 10 25 50 8 75 6 1997 1999 2001 2003 1978 1983 1988 1993 1998 2003 NOTE. The data are quarterly and extend through 2003:Q3. Profits are from domestic operations of nonfinancial corporations, with inventory valuation and the retrenchment in construction of new hotels and and capital consumption adjustments. motels ended. In addition, investment in drilling and min­ ing structures, which is strongly influenced by the price levels for crude oil and natural gas, increased noticeably ity further limited the need to issue debt. Gross equity in 2003. issuance was extremely weak in the first half of the year but perked up in the latter half in response to the rally in equity prices. Nevertheless, for the year as a whole, firms extinguished more equity than they issued. Inventory Investment The pace of gross corporate bond issuance was mod­ erate at the start of the year but shot up in late spring as During 2002, businesses appeared to have addressed most firms took advantage of low bond yields to pay down of the inventory imbalances that had developed a year short-term debt, to refund existing long-term debt, and to earlier. But the moderate pace of final demand during the raise cash in anticipation of future spending. Bond issu­ first half of 2003 apparently restrained firms from ance by investment-grade firms slowed after midyear as embarking on a new round of inventory accumulation. firms accumulated a substantial cushion of liquid assets Even though final sales picked up in the second half of and as interest rates on higher-quality debt backed up. the year, the restraint seemed to recede only gradually. However, issuance by speculative-grade firms continued Over the first three quarters of 2003, nonfarm businesses trimmed their inventories at an average annual rate of $23/ 4 billion in constant-dollar terms, and the preliminary Corporate bond yields estimate for the final quarter of the year indicated only modest restocking. As a result, most firms appear to have Percent ended the year with their inventories quite lean relative to sales, even after taking into account the downward trend in inventory-sales ratios that has accompanied the ongo­ 20 ing shift to improved inventory management. Motor vehicle dealers were an exception; their days’ supply of 15 new vehicles moved higher on average for a second year High-yield in a row. 10 AA 5 Corporate Profits and Business Finance Higher profits allowed many firms to finance capital 1990 1992 1994 1996 1998 2000 2002 2004 spending with internal funds, and business debt rose only NOTE. The data are monthly averages and extend through January 2004. slightly faster than the depressed rate in 2002. Moreover, The AA rate is calculated from bonds in the Merrill Lynch AA index with a remaining maturity of seven to ten years. The high-yield rate is the yield on a paucity of cash-financed merger and acquisition activ- the Merrill Lynch 175 high-yield index. 10 Monetary Policy Report to the Congress February 2004 Financing gap and net equity retirement Spread of low-tier CP rates over high-tier CP rates at nonfinancal corporations Basis points Billions of dollars 150 300 125 250 Net equity retirement 100 200 150 75 100 50 Financing gap 50 25 + + 0_ 0_ 50 1997 1998 1999 2000 2001 2002 2003 2004 1991 1993 1995 1997 1999 2001 2003 NOTE. The data are daily and extend through February 4, 2004. The series NOTE. The data are annual; 2003 is based on partially estimated data. The shown is the difference between the rate on A2/P2 nonfinancial commercial financing gap is the difference between capital expenditures and internally paper and the AA rate. generated funds. Net equity retirement is the difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued in public or private markets, including funds invested by venture capital partnerships. dards on business loans were tightened during the first half of the year but that both had been eased consider- ably by year-end. They also reported that demand for apace, with the yields on their debt continuing to decline business loans was quite weak for much of the year. How- dramatically presumably because of investors’ increased ever, despite the fact that outstanding levels of business optimism about the economic outlook and greater will­ loans continued to decline, survey responses in the last ingness to take on risk. The sum of bank loans and com­ quarter of the year indicated that demand for loans had mercial paper outstanding, which represent the major begun to stabilize. Many banks cited customers’ increased components of short-term business debt, contracted investment and inventory spending as factors helping to throughout the year. In large part, this decline reflected generate the increase in loan demand toward the end of ongoing substitution toward bond financing, but it also the year. The apparent divergence between survey was driven by the softness of fixed investment early in responses and data on actual loan volumes may suggest the year and the liquidation of inventories over much of that demand for lines of credit has increased but that these the year. lines have not yet been drawn. In other short-term Respondents to the Senior Loan Officer Opinion Sur­ vey on Bank Lending Practices noted that terms and stan- Default rate on outstanding bonds Major components of net business financing Percent Billions of dollars 4 Commercial paper Bonds Bank loans 600 3 Sum of major components 400 2 200 1 + + 0_ 0_ 200 1991 1993 1995 1997 1999 2001 2003 NOTE. The default rate is monthly and extends through December 2003. 2001 2002 2003 The rate for a given month is the face value of bonds that defaulted in the twelve months ending in that month divided by the face value of all bonds NOTE. Seasonally adjusted annual rate for nonfinancial corporate business. outstanding at the end of the calendar quarter immediately preceding the The data for the sum of major components are quarterly. The data for twelve-month period. 2003:Q4 are estimated. SOURCE. Moody’s Investors Service. Board of Governors of the Federal Reserve System 11 Ratings changes of nonfinancial corporate bonds although only at a subdued pace. In addition, firms con­ tinued to retire a considerable volume of equity through Percent share repurchases. For the year as a whole, net equity Upgrades issuance was negative. 20 Corporate credit quality improved, on balance, over 10 the year. Notably, the default rate on corporate bonds declined sharply, delinquency rates on commercial and 0 industrial (C&I) loans at commercial banks turned down, 10 and the pace of bond-rating downgrades slowed consid­ erably. Low interest rates and the resulting restructuring Downgrades 20 of debt obligations toward longer terms also importantly 30 contributed to improved business credit quality. Bank loan 40 officers noted that the aggressive tightening of lending standards in earlier years was an important factor account­ 1995 1996 1997 1998 1999 2000 2001 2002 2003 ing for the lower delinquency and charge-off rates in recent quarters. NOTE. For a given year, the percentage is calculated as the par value of bonds that were upgraded or downgraded in that year and outstanding in the Commercial mortgage debt increased noticeably dur­ fourth quarter of the previous year divided by the par value of the outstanding bonds of all nonfinancial corporations in that quarter. ing most of 2003 despite persistently high vacancy rates, SOURCE. Moody’s Investors Service. falling rents, and sluggish growth in construction expen­ ditures. Low interest rates on this type of collateralized financing developments, nonfinancial firms that debt may have induced some corporate borrowers to tap issued commercial paper in 2003 found a very receptive the market to pay down more-costly unsecured debt. market, in large part because of the scarcity of outstand­ Delinquency rates on commercial mortgages generally ing issues. Many of the riskiest borrowers had exited the remained low throughout 2003, and risk spreads were market in 2002, and remaining issuers improved their relatively narrow. Loan performance has held up well attractiveness to investors by continuing to restructure because of low carrying costs for property owners and their balance sheets. because the outstanding loans generally had been struc­ Gross equity issuance rose over the course of 2003 as tured to include a sizable equity contribution, which the economic outlook strengthened and stock prices makes default less attractive to borrowers. moved higher. The market for initial public offerings con ­ tinued to languish in the first half of the year but showed The Government Sector signs of life by the end of the summer. The volume of seasoned offerings also picked up in the second half of Federal Government the year. On the other side of the ledger, merger and acquisition activity again extinguished shares in 2003, The federal budget deficit continued to widen in fiscal year 2003 as a result of the slow increase in nominal Net interest payments of nonfinancial corporations as a percent of cash flow Federal receipts and expenditures Percent Percent of nominal GDP 24 25 Expenditures 22 20 Receipts Expenditures 20 excluding net interest 15 18 10 16 1979 1982 1985 1988 1991 1994 1997 2000 2003 1985 1988 1991 1994 1997 2000 2003 NOTE. The data are quarterly and extend through 2003:Q3. NOTE. The budget data are from the unified budget and are for fiscal years SOURCE. Bureau of Economic Analysis. (October through September); GDP is for the year ending in Q3. 12 Monetary Policy Report to the Congress February 2004 incomes, outlays associated with the war in Iraq, and leg­ Net national saving islative actions that reduced taxes and boosted spending. The deficit in the unified budget totaled $375 billion, up Percent of nominal GDP substantially from the deficit of $158 billion recorded in fiscal 2002. The Congressional Budget Office is project­ 12 ing that the unified federal deficit will increase further in Nonfederal saving 9 fiscal 2004, to more than $475 billion. Federal receipts have fallen in each of the past three 6 years; the drop of nearly 4 percent in fiscal 2003 brought the ratio of receipts to GDP to 161/ 2 percent, 2 percent- 3 Total age points below the average for the past thirty years. + 0_ About half of the decrease in receipts last year was a con- Federal saving sequence of legislation that shifted due dates for corpo­ 3 rate payments between fiscal years. In addition, personal income tax collections dropped sharply because of the 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 slow rise in nominal wages and salaries, diminished capi­ NOTE. The data are quarterly and extend through 2003:Q3. Nonfederal tal gains realizations in 2002, and the tax cuts enacted saving is the sum of personal and net business saving and the net saving of state and local governments. under the Jobs and Growth Tax Relief Reconciliation Act of 2003. The act advanced refund checks to households eligible for the 2003 increment to the child tax credit and continued to push up spending for Medicare and Medi­ resulted in lower withholding schedules for individual caid. Overall, real federal consumption and investment taxpayers. The act also expanded the partial-expensing (the measure of federal spending that is included in real incentive for businesses, but because corporate profits GDP) increased 6 percent over the four quarters of 2003, accelerated sharply last year, corporate tax receipts rose after having risen 10 percent a year earlier. appreciably after adjusting for the shifts in the timing of The federal government had contributed increasingly payments. to national saving in the late 1990s and 2000 as budget At the same time, federal outlays other than for inter­ deficits gave way to accumulating surpluses. However, est expense rose rapidly for the second consecutive year with the swing back to large deficits in recent years, the in fiscal 2003; these outlays increased about 9 percent federal government has again become a drain on national after having risen 11 percent in fiscal 2002. Spurred by saving. Using the accounting practices followed in the operations in Iraq, defense spending soared again, and national income and product accounts (NIPA), gross fed­ outlays for homeland security rose further. Spending for eral saving as a percent of GDP dropped sharply in late income support, such as unemployment insurance, food 2001 and has trended down since then; the drop contrib­ stamps, and child credits under the earned income tax uted to a decline in overall gross national saving as a credit program, also posted a sizable increase. The ongo­ percent of GDP from 18 percent in calendar year 2000 to ing rise in the cost and utilization of medical services 13 percent, on average, in the first three quarters of 2003. Federal saving net of estimated depreciation fell from its recent peak of 21/ 2 percent of GDP in 2000 to negative Change in real government expenditures 4 percent of GDP, on average, in the first three quarters on consumption and investment of 2003. As a result, despite a noticeable pickup in sav­ ing from domestic nonfederal sources, overall net national Percent saving, which is an important determinant of private capi­ Federal tal formation, fell to less than 11/ 2 percent of GDP, on State and local average, in the first three quarters of 2003, compared with 9 a recent high of 61/ 2 percent of GDP in 1998. 6 Federal Borrowing 3 The Treasury ramped up borrowing in 2003 in response + 0_ to the sharply widening federal budget deficit, and fed­ eral debt held by the public as a percent of nominal GDP increased for a second year in a row after having trended 1997 1999 2001 2003 down over the previous decade. As had been the case in Board of Governors of the Federal Reserve System 13 Federal government debt held by the public State and local government net saving Percent of nominal GDP Percent of GDP 55 .5 45 + 0_ 35 .5 25 1963 1973 1983 1993 2003 1983 1987 1991 1995 1999 2003 NOTE. Through 2002, the data for debt are year-end figures, and the NOTE. The data, which are quarterly, are on a national income and product corresponding value for GDP is for Q4 at an annual rate; the final observation account basis and extend through 2003:Q3. is for 2003:Q3. Excludes securities held as investments of federal gov­ ernment accounts. Recent indications are that the fiscal stress in this sec­ tor is beginning to ease. The improvement reflects a 2002, the Treasury was forced to resort temporarily to noticeable upturn in tax collections in recent quarters accounting devices in the spring of 2003 when the statu­ while restraint on operating expenditures largely remains tory debt ceiling became a constraint, but debt markets in place. On a NIPA basis, real spending on compensa­ were not disrupted noticeably. In May, the Congress raised tion and on goods and services purchased by state and the debt ceiling from $6.4 trillion to $7.4 trillion. With local governments was little changed in the second half large deficits expected to persist, the Treasury made a of 2003, as it was over the preceding year. However, number of adjustments to its regular borrowing program, investment in infrastructure, most of which is funded in including reintroducing the three-year note, increasing the capital markets, accelerated in the second half of 2003. to monthly the frequency of five-year note auctions, As of the third quarter of 2003, state and local net saving reopening the ten-year note in the month following each had moved back into positive territory. new quarterly offering, and adding another auction of ten- year inflation-indexed debt. As a result of these changes, the average maturity of outstanding Treasury debt, which State and Local Government Borrowing had reached its lowest level in decades, began to rise in the latter half of 2003. Gross issuance of debt by state and local governments was quite robust last year. Weak tax receipts from a slug­ State and Local Governments gish economy, significant demands for infrastructure spending, and low interest rates all contributed to the State and local governments faced another difficult year heavy pace of borrowing. Borrowing was strongest in the in 2003. Tax receipts on income and sales continued to second quarter of the year, as governments took advan­ be restrained by the subdued performance of the economy. tage of the extraordinarily low longer-term rates to fund Despite further efforts to rein in spending, the sector’s capital expenditures and to advance refund existing aggregate net saving, as measured in the NIPA, reached a higher-cost debt. Because of the financial stresses facing low of negative $40 billion (at an annual rate), or nega­ these governments, the credit ratings of several states, tive 0.4 percent of GDP, in the first quarter of the year. most notably California, were lowered last year. Although Most of these jurisdictions are subject to balanced- bond downgrades outnumbered upgrades for the sector budget requirements and other rules that require them to as a whole, the imbalance between the two was smaller respond to fiscal imbalances. Thus, in addition to reduc­ than it was in 2002. ing operating expenses, governments drew on reserves, issued bonds, sold assets, and made various one-time adjustments in the timing of payments to balance their The External Sector books. In recent years, many have also increased taxes and fees, thereby reversing the trend toward lower taxes Over the first three quarters of 2003, the U.S. current that prevailed during the late 1990s. account deficit widened relative to the comparable 14 Monetary Policy Report to the Congress February 2004 U.S. trade and current account balances Change in real imports and exports of goods and services Billions of dollars, annual rate Percent, annual rate Imports + 0_ Exports 20 15 100 10 Trade 200 5 Current account + 300 0_ 5 400 10 500 15 1996 1997 1998 1999 2000 2001 2002 2003 1997 1999 2001 2003 NOTE. The data are quarterly and extend through 2003:Q3. large increases. In response to poor crops and strong period in 2002, a move largely reflecting developments demand, prices for cotton and soybeans increased sharply. in the deficit on trade in goods and services. Net invest­ For beef, disruptions in supply led to notably higher prices ment income rose over the same period, as receipts from through much of 2003. Beef prices, however, fell back in abroad increased and payments to foreign investors in late December after a case of mad cow disease was dis­ the United States declined. covered in the state of Washington and most countries imposed bans on beef imports from the United States. Real imports of goods and services rose about International Trade 31/ 2 percent in 2003. Imports of services fell in the first half of the year but bounced back in the second half, as The trade deficit widened considerably in the first half of concerns about the SARS epidemic and the war in Iraq 2003 but narrowed slightly in the third quarter, as the came and went; for the year as a whole, real imports of value of exports rebounded in response to strengthening services were about unchanged from the previous year. foreign economic activity and the depreciation of the Real imports of goods expanded about 4 percent in dollar. Available trade data through November suggest response to the strengthening of U.S. demand, but the that the trade deficit narrowed further in the fourth quar­ pattern was choppy, with large gains in the second and ter, as an additional strong increase in exports outweighed fourth quarters partially offset by declines in the first and an increase in imports. third. Despite a surge in the second quarter, the volume Real exports of goods and services increased about of oil imports increased modestly, on balance, over the 6 percent in 2003. Exports of services rose about 5 per- course of the year. Real non-oil imports were up about cent. They were held down early in the year by a drop in 41/ 2 percent, with the largest increases in capital goods receipts from foreign travelers, owing to the effects of and consumer goods. Imports of computers posted solid the SARS (severe acute respiratory syndrome) epidemic gains, whereas imports of semiconductors were flat. and the war in Iraq; services exports rebounded strongly Despite a substantial decline in the value of the dollar, later in the year as those concerns receded. Exports of the prices of imported non-oil goods rose only moder­ goods rose about 63/ 4 percent over the course of the year— ately in 2003. By category, the prices of consumer goods considerably faster than in 2002. Exports increased in all were unchanged last year, and prices of capital goods major end-use categories of trade, with particularly strong excluding aircraft, computers, and semiconductors gains in capital goods and consumer goods. Reflecting increased only a little more than 1 percent. Price increases the global recovery in the high-tech sector, exports of were larger for industrial supplies. The price of imported computers and semiconductors picked up markedly in natural gas spiked in March and rose again late in the 2003, particularly in the second half. By geographic area, year; these fluctuations were large enough to show through exports of goods increased to Western Europe, Canada, to the overall price index for imported goods. At year- and, particularly, to developing countries in East Asia— end, prices of industrial metals rose sharply, with the spot a region where economic activity expanded at a rapid price of copper reaching the highest level in six and one- pace last year. Prices of exported goods rose in 2003, half years. The strength in metals and other commodity with prices of agricultural exports recording particularly prices has been attributed, at least in part, to depreciation Board of Governors of the Federal Reserve System 15 Prices of oil and of nonfuel commodities security conditions, the recovery of oil exports from Iraq was slower than expected. Prices also were boosted in January 2001 = 100 Dollars per barrel September by the surprise reduction in OPEC’s produc­ tion target. In the fourth quarter of 2003 and early 2004, strengthening economic activity, falling oil inventories, 120 40 and the continued depreciation of the dollar contributed to a further run-up in oil prices. 110 Oil 30 100 20 The Financial Account Nonfuel The financing counterpart to the current account deficit 90 10 experienced a sizable shift in 2003, as net private inflows fell while foreign official inflows increased. Private for­ 2001 2002 2003 2004 eign purchases of U.S. securities were at an annual rate NOTE. The data are monthly and extend through January 2004. The oil of about $350 billion through November, about $50 bil­ price is the spot price of West Texas intermediate crude oil. The price of lion lower than in the previous year. Private foreign pur­ nonfuel commodities is a weighted average of thirty-nine primary-commodity prices from the International Monetary Fund. chases of U.S. equities continued to recede, and, although the level of bond purchases was little changed in the of the dollar and strong global demand, particularly from aggregate, foreign purchases shifted somewhat away from China. agency bonds and toward corporate bonds. Over the same In 2003, the spot price of West Texas intermediate period, purchases by private U.S. investors of foreign (WTI) crude oil averaged more than $31 per barrel—the securities increased nearly $80 billion. Accordingly, net highest annual average since the early 1980s. The spot inflows through private securities transactions decreased price of oil began to rise at the end of 2002 when ethnic unrest in Nigeria and a nationwide strike in Venezuela sharply limited oil supplies from those two countries. In U.S. net international securities transactions the first quarter of 2003, geopolitical uncertainty in the period leading up to the war in Iraq also added upward Billions of dollars pressure on oil prices. On March 12, the spot price of Net private foreign purchases of U.S. securities 180 WTI closed at $37.83 per barrel, the highest level since Bonds 160 the Gulf War in 1990. When the main Iraqi oil fields had Equities 140 been secured and it became apparent that the risks to oil 120 supplies had subsided, the spot price of WTI fell sharply 100 to a low of $25.23 per barrel on April 29. However, oil 80 prices began rising again when, because of difficult 60 40 20 U.S. net financial inflows + 0_ Billions of dollars Official Net private U.S. purchases of foreign securities 175 Private 75 150 Bonds Equities 125 50 100 75 25 50 + 25 0_ + 0_ 25 25 2000 2001 2002 2003 2000 2001 2002 2003 SOURCE. Department of Commerce. SOURCE. Department of Commerce and the Federal Reserve Board. 16 Monetary Policy Report to the Congress February 2004 markedly. In contrast, foreign official purchases of U.S. Civilian unemployment rate assets surged to record levels in 2003, with the accumu­ lation of dollar reserves particularly high in China and Percent Japan. Compared with the pace in 2002, foreign direct investment in the United States increased, as merger 9 activity picked up and corporate profits improved. U.S. direct investment abroad held relatively steady at a high level that was largely the result of continued retained earn­ 6 ings. On net, foreign direct investment outflows fell about $50 billion through the first three quarters of 2003. 3 The Labor Market 1974 1984 1994 2004 Employment and Unemployment NOTE. The data are monthly and extend through January 2004. With economic activity still sluggish during the first half of 2003, the labor market continued to weaken. Over the job. However, for many unemployed workers, jobs con­ first eight months of the year, private nonfarm payroll tinued to be difficult to find, and the number of unem­ employment fell, on average, more than 35,000 per month, ployed who had been out of work for twenty-seven weeks extending the prolonged period of cutbacks that began in or more remained persistently high. The labor force par­ early 2001. The civilian unemployment rate, which had ticipation rate, which tends to be sensitive to workers’ hovered around 53/ 4 percent for much of 2002, moved up perceptions of the strength of labor demand, drifted lower. to 61/ 4 percent by June. However, by late in the summer, Although the CPS indicated a somewhat greater improve­ the labor market began to recover slowly. Declines in ment in employment than the payroll report—even after private payrolls gave way to moderate increases in adjusting for conceptual differences between the two mea­ employment; over the five months ending in January, pri­ sures—the increase in household employment lagged the vate nonfarm establishments added, on average, about rise in the working-age population, and the ratio of 85,000 jobs per month. By January, the unemployment employment to population fell further during 2003. rate moved back down to 5.6 percent. The modest upturn in private payroll employment that During the late summer and early fall, prospects for began in September was marked by a step-up in hiring at business sales and production brightened, and firms businesses supplying professional, business, and educa­ began to lay off fewer workers. Initial claims for unem­ tion services, and medical services continued to add jobs. ployment insurance dropped back, and the monthly Cur- Employment in both the construction industry and the rent Population Survey (CPS) of households reported a real estate industry rose further, although the number of decline in the number of workers who had lost their last jobs in related financial services dropped back a bit as mortgage refinancing activity slackened. At the same time, although manufacturers were still laying off workers, the Net change in payroll employment monthly declines in factory employment became smaller and less widespread than earlier. Employment stabilized Thousands of jobs, monthly average in many industries that produce durable goods, such as Private nonfarm metals, furniture, and wood products, as well as in a num­ 300 ber of related industries that store and transport goods. In several other areas, employment remained weak. Manu­ 200 Jan. facturers of nondurables, such as chemicals, paper, 100 apparel, and textiles, continued to cut jobs. Employment + in retail trade remained, on net, little changed. 0_ 100 Productivity and Labor Costs 200 Business efforts to increase efficiency and control costs 1992 1994 1996 1998 2000 2002 2004 led to another impressive gain in labor productivity last Board of Governors of the Federal Reserve System 17 Change in output per hour 21/ 2 percent that prevailed between 1996 and 2000. In the earlier period, an expansion of the capital stock was Percent an important element in boosting the efficiency of work­ ers and their firms; that impetus to productivity has weak­ ened in the recent period as a result of the steep cutbacks 4 in business investment in 2001 and 2002. Instead, the recent gains appear to be grounded in organizational 2 changes and innovations in the use of existing resources— which are referred to as multifactor productivity. The per­ + 0_ sistence of a rapid rise in multifactor productivity in recent years, along with signs of a pickup in capital spend­ ing, suggests that part of the step-up in the rate of 2 increase of labor productivity may be sustained for some time. 1993 1995 1997 1999 2001 2003 In 2003, the employment cost index (ECI) for private nonfarm businesses, which is based on a survey conducted NOTE. Nonfarm business sector. quarterly by the Bureau of Labor Statistics, rose 4 per­ year. Output per hour in the nonfarm business sector cent—about 3/ 4 percentage point more than the increase surged 51/ 4 percent in 2003 after having risen a robust in 2002. Compensation per hour in the nonfarm business 4 percent in 2002 and 23/ 4 percent in 2001. What is par­ sector, which is based on data constructed for the NIPA, ticularly remarkable about this period is that productiv­ is estimated to have increased 31/ 4 percent in 2003, up ity did not decelerate significantly when output declined from 11/ 2 percent in 2002. In recent years, the NIPA- in 2001, and it posted persistently strong gains while the derived series has shown much wider fluctuations in recovery in aggregate demand was sluggish. Typically, hourly compensation than the ECI, in part because it the outsized increases in productivity that have occurred includes the value of stock option exercises, which are during cyclical recoveries have followed a period of excluded from the ECI. The value of options exercised declines or very weak increases in productivity during shot up in 2000 and then dropped over the next two years. the recession and have been associated with rebounds in Most of the acceleration in hourly compensation in economic activity that were stronger than has been the 2003 was the result of larger increases in the costs of case, until recently, in this expansion. employee benefits. The ECI for wages and salaries rose On balance, since the business cycle peak in early 3 percent—up slightly from the pace in 2002 but still 2001, output per hour has risen at an average annual rate well below the rates of increase in the preceding six years. of 4 percent—noticeably above the average increase of Wage gains last year likely were restrained by persistent slack in the demand for labor as well as by the pressure on employers to control overall labor costs in the face of the rapidly rising cost of benefits. Employer costs for Measures of change in hourly compensation benefits, which had risen 43/ 4 percent in 2002, climbed Percent another 61/ 2 percent in 2003. The cost of health insurance as measured by the ECI has been moving up at close to a double-digit rate for three consecutive years. In addition, 8 in late 2002 and early 2003, employers needed to sub­ stantially boost their contributions to defined-benefit Nonfarm compensation per hour 6 retirement plans to cover the declines in the market value of plan assets. 4 Employment Prices cost index 2 Headline consumer price inflation in 2003 was maintained by an acceleration in food prices and another sizable 1995 1997 1999 2001 2003 increase in energy prices, but core rates of inflation fell NOTE. The data are quarterly and extend through 2003:Q4. For nonfarm for a second year. Although the strong upturn in economic compensation, change is over four quarters; for the employment cost index (ECI), change is over the twelve months ending in the last month of each activity in the second half of last year began to reduce quarter. Nonfarm compensation is for the nonfarm business sector; the ECI is unemployment and to boost industrial utilization rates, for private industry excluding farm and household workers. 18 Monetary Policy Report to the Congress February 2004 Change in unit labor costs Change in consumer prices excluding food and energy Percent Percent 4 3 Consumer price index 2 2 + 0_ 1 2 Chain-type price index for PCE 1993 1995 1997 1999 2001 2003 1993 1995 1997 1999 2001 2003 NOTE. Nonfarm business sector. NOTE. Change is over four quarters, and the data extend through 2003:Q4. considerable slack in labor and product markets contin­ 71/ 4 percent over the period. In the first quarter of the ued to restrain inflation throughout the year. A further year, the combination of a further rise in the cost of crude moderation in the costs of production also helped to check oil, increased wholesale margins for gasoline, and inflation: As a result of another rapid rise in productivity, unusually tight supplies of natural gas pushed up con­ businesses saw their unit labor costs decline in 2003 for sumer energy prices sharply. Although the prices of a second consecutive year. In contrast, prices for imported petroleum-based products turned down when the price goods excluding petroleum, computers, and semiconduc­ of crude oil fell back in March, a number of supply dis­ tors increased at about the same rate as prices more gen­ ruptions in late summer resulted in another temporary erally; between 1996 and 2002, these import prices fell run-up in the retail price of gasoline. In the spring, the relative to overall prices for personal consumption price of natural gas began to ease as supplies improved, expenditures (PCE). The chain-type price index for PCE but it remained high relative to the level in recent years. excluding food and energy rose just under 1 percent in Electricity prices also moved up during 2003, in part 2003, about 3/ 4 percentage point less than in 2002. A because of the higher input costs of natural gas. In Janu­ broader measure of inflation, the chain-type price index ary 2004, a cold wave in the Northeast, together with the for GDP, increased 11/ 2 percent in 2003, the same slow rise in the price of crude oil since early December, once pace as in 2002. Both measures of inflation were roughly again led to spikes in the prices of gasoline and natural a percentage point lower than in 2001. gas. Consumer energy prices fluctuated widely over the four The PCE price index for food and beverages increased quarters of 2003, and the PCE index for energy was up 23/ 4 percent in 2003 after having risen just 11/ 4 percent a year earlier. Much of the acceleration can be traced to strong demand for farm products, but prices paid by con­ Change in consumer prices sumers for food away from home—which depend much more heavily on the cost of labor than on prices of food Percent products—were up 3 percent in 2003, also somewhat Consumer price index more than overall consumer price inflation. Poor harvests Chain-type price index for PCE abroad, especially in Europe, contributed importantly to 4 the heightened demand for U.S. farm products. Thus, despite a bumper crop of corn and some other grains in 3 the United States, world stocks were tight and prices remained high. In addition, the U.S. soybean crop was 2 crimped by late-season heat and dryness, which further tightened world supplies. Concerns about the cases of 1 mad cow disease that were identified in herds in Japan and Canada supported strong domestic and export demand for U.S. beef for most of last year while supplies 1993 1995 1997 1999 2001 2003 edged down. But, at year-end, when a case of mad cow Board of Governors of the Federal Reserve System 19 Alternative measures of price change varied over a wide range in 2003, settling at just under Percent 21/ 2 percent at year-end. Shorter-term inflation expecta­ tions also posted some wide swings during 2003; year- Price measure 2001 2002 2003 ahead expectations in the Michigan SRC survey spiked Chain-type early in the year with the sharp increase in energy prices Gross domestic product ........................ 2.4 1.4 1.5 Gross domestic purchases ..................... 1.6 1.7 1.6 and dipped briefly to an unusually low level at midyear Personal consumption expenditures ..... 1.6 1.8 1.4 Excluding food and energy ............... 2.1 1.6 .9 as actual inflation eased in response to lower energy Chained CPI .......................................... 1.5 1.8 1.4 Excluding food and energy ............... 2.1 1.6 .6 prices. However, year-ahead inflation expectations settled Fixed-weight back to just over 21/ 2 percent at the end of the year, about Consumer price index ........................... 1.8 2.2 1.9 the same as at the end of 2002. Excluding food and energy ............... 2.7 2.1 1.2 The PPI for crude materials excluding food and Note. Changes are based on quarterly averages and are measured to the fourth energy products, which had dropped 10 percent in 2001, quarter of the year indicated from the fourth quarter of the preceding year. rose 113/ 4 percent in 2002 and another 171/ 2 percent in 2003. The upswing was driven by the pickup in demand disease was discovered in a domestic herd, export associated with the acceleration in both domestic and demand for U.S. beef plunged and drove the price of live worldwide industrial activity and by the pass-through of cattle down sharply. A portion of the drop in cattle prices higher energy costs. Such wide cyclical swings in com­ likely will show through to consumer prices for beef early modity prices have only a small effect on movements in this year. the prices of intermediate and finished goods. At later The decline in core inflation in 2003 was broadly stages of production and distribution, commodity costs based. Prices of core consumer goods fell somewhat faster represent only a small share of overall costs, and some than a year earlier; the declines were led by larger cuts in portion of the change in commodity prices tends to be prices of apparel, motor vehicles, electronic equipment, absorbed in firms’ profit margins. Thus, the recent pickup and a variety of other durable goods. At the same time, in prices at the intermediate stage of processing has prices of non-energy services rose less rapidly. The been more muted; after having fallen almost 11/ 2 percent deceleration in core consumer prices measured by the in 2001, the PPI for core intermediate materials rose CPI is somewhat greater than that measured by the PCE 11/ 4 percent in 2002 and 2 percent in 2003. index. In each index, the costs of housing services to ten- ants and owners rose less in 2003 than in 2002, but because these costs receive a larger weight in the CPI, U.S. Financial Markets their slowing contributed a greater amount to the CPI’s deceleration. In addition, the different measurement of On balance, financial market conditions became increas­ the prices of medical services in the two series contrib­ ingly supportive of growth over 2003 as investors uted to the smaller deceleration in non-energy services in became more assured that the economy was on solid foot­ the PCE. The medical services component of the CPI, ing. Equity prices marched up after the first quarter of which measures out-of-pocket expenses paid by consum­ the year in response to the initiation and swift conclusion ers, increased 4 percent in 2003, down from 51/ 2 percent of major combat operations in Iraq, positive earnings a year earlier. Alternatively, the PCE for medical services reports, and—in the second half of the year—a stronger is a broader measure that uses producer price indexes pace of economic growth. Risk spreads on corporate (PPI) to capture the costs of services provided by hospi­ debt declined, with the spreads on the debt of both tals and doctors; it continued to increase more slowly than investment-grade firms and speculative-grade firms end­ the CPI for medical services last year, 31/ 4 percent, but it ing 2003 at their lowest levels since 1998. Thus, although was up slightly from its increase of 21/ 2 percent in 2002. Treasury coupon yields ended the year 30–40 basis points Survey measures of expected inflation were little higher, yields on many corporate bonds ended the year changed, on balance, in 2003. According to the Federal lower. Commercial banks appeared somewhat slower than Reserve Bank of Philadelphia’s survey of professional bond investors to lend at more favorable terms; never­ forecasters, expectations for CPI inflation ten years ahead theless, by late in the year, banks had eased both stan­ remained at 21/ 2 percent last year. As measured by the dards and terms on C&I loans. Michigan Survey Research Center survey of households, Demand for short-term debt, however, remained very median five- to ten-year inflation expectations, which weak, and business loans and outstanding commercial averaged 3 percent in 2001, were steady at 23/ 4 percent in paper continued to run off. In response to a widening 2003 for a second consecutive year. Inflation compensa­ budget deficit and a rapid expansion of federal debt, the tion as measured by the spread between the yield on nomi­ Treasury increased the frequency of its debt auctions. nal Treasury securities and their indexed counterparts Declines in mortgage interest rates over the first half of 20 Monetary Policy Report to the Congress February 2004 Interest rates on selected Treasury securities further easing of policy and did not imply any tightening before early 2004. Even as geopolitical tensions eased, Percent weaker-than-expected economic data continued to hold down Treasury yields. The FOMC’s statement following 6 its May meeting that an “unwelcome fall in inflation” Ten-year remained a risk reinforced the notion that monetary policy 5 would stay accommodative, and, indeed, judging from 4 market quotes on federal funds futures, market partici­ pants anticipated further easing. Mortgage rates followed 3 Treasury yields lower, precipitating a huge surge of mort­ Two-year gage refinancing. To offset the decline in the duration of 2 their portfolios stemming from the jump in prepayments, Three-month 1 mortgage investors reportedly bought large quantities of longer-dated Treasuries, amplifying the fall in yields. 2001 2002 2003 2004 Interest rates on corporate bonds also declined in the first half of the year, prompting many firms to issue long-term NOTE. The data are daily and extend through February 4, 2004. debt to pay down other, more expensive forms of debt the year led to an extraordinary increase in mortgage debt, and build up cash assets. Growing confidence that the as originations for home purchase and for refinancings frequency and severity of corporate accounting scandals both climbed to record levels. were waning likely contributed to the narrowing in risk spreads. By the end of spring, default rates on corporate bonds had begun to decline, and corporate credit quality Interest Rates appeared to stabilize. By the time of the June FOMC meeting, federal funds Interest rates fell for most of the first half of 2003, pri­ futures data implied that market participants had gener­ marily in response to continuing weak economic data and ally come to expect an aggressive reduction in the target an associated marking down of expectations for the fed­ federal funds rate, so the Committee’s decision to lower eral funds rate. Global uncertainty ran high, particularly the target rate by only 25 basis points came as a surprise surrounding the timing of military intervention in Iraq, to some. In addition, some investors were reportedly dis­ which elevated safe-haven demands and depressed yields appointed that the statement following this meeting on Treasury securities. Moreover, the weak March included no mention of “unconventional” monetary policy employment report and other disappointing news about actions that would be aimed at lowering longer-term yields economic activity seemed to cause a substantial shift in more directly than through changes in the federal funds views about monetary policy. Data from the federal funds rate target alone. As a result, market interest rates backed futures market suggested a significant probability of a Spreads of corporate bond yields over Implied volatility of short-term interest rates the ten-year Treasury yield Basis points Percentage points 350 10 300 High-yield 8 250 6 200 4 BBB 150 2 AA + 100 _0 1997 1998 1999 2000 2001 2002 2003 2004 2001 2002 2003 2004 NOTE. The data are daily and extend through February 4, 2004. The series NOTE. The data are daily and extend through February 4, 2004. The shown is the implied volatility of the three-month eurodollar rate over the spreads compare the yields on the Merrill Lynch AA, BBB, and 175 high- coming four months, as calculated from option prices. yield indexes with the yield on the ten-year off-the-run Treasury note. Board of Governors of the Federal Reserve System 21 up, with the move probably amplified by the unwinding Implied S&P 500 volatility of mortgage-related hedging activity. The Chairman’s monetary policy testimony in July, and the FOMC’s state­ Percent ments at subsequent meetings that noted that policy could remain accommodative for “a considerable period,” 40 apparently provided an anchor for the front end of the yield curve. At the same time, increasingly positive eco­ nomic reports bolstered confidence in the markets, and 30 longer-dated Treasury securities ended the year about 40 basis points above their year-earlier levels. But, with 20 the expansion evidently gaining traction and investors becoming more willing to take on risk, corporate risk 10 spreads, particularly those on speculative-grade issues, continued to fall over the second half of the year. Trea­ sury yields fell early in 2004, largely in response to the 1997 1998 1999 2000 2001 2002 2003 2004 weaker-than-expected December labor market report. NOTE. The data are daily and extend through February 4, 2004. The series After the release of the Committee’s statement following shown is the implied volatility of the S&P 500 stock price index as calculated from the prices of options that expire over the next several months. its January meeting, Treasury yields backed up a bit SOURCE. Chicago Board Options Exchange. as futures market prices implied an expectation of an earlier onset of tightening than had been previously anticipated. S&P 500 index to fall substantially. Over the rest of the year, increasingly positive earnings results contributed to a sustained rally in stock prices, and implied volatility Equity Markets in equity markets fell further. Corporate scandals—al­ beit on a smaller scale than in previous years—contin­ Broad equity price indexes ended the year 25 percent to ued to emerge in 2003, but these revelations appeared to 30 percent higher. Early in the year, stock prices were leave little lasting imprint on broad measures of stock buffeted by mixed news about the pace of economic ex­ prices. For the year as a whole, the Russell 2000 index of pansion and by heightened geopolitical tensions. Rising small-cap stocks and the technology-laden Nasdaq com­ oil prices boosted the shares of energy companies very posite index, which rose 45 percent and 50 percent, early in the year while, by and large, stocks in other sec­ respectively, noticeably outpaced broader indexes. To date tors were stumbling. By spring, however, positive news in 2004, equity markets have continued to rally. on corporate earnings—often exceeding expectations— and easing of geopolitical tensions associated with the initiation of military action in Iraq boosted equity prices S&P 500 forward earnings–price ratio significantly. Subsequently, the swift end to major com­ and the real interest rate bat operations in Iraq caused implied volatility on the Percent Major stock price indexes 10 S&P 500 earnings–price ratio January 2, 2002 = 100 8 120 6 Russell 2000 110 4 100 2 Real interest rate + 90 0_ Wilshire 5000 80 1991 1993 1995 1997 1999 2001 2003 70 NOTE. The data are monthly and extend through December 2003. The forward earnings–price ratio is based on I/B/E/S consensus estimates of earnings over the coming year. The real interest rate is estimated as the difference between the ten-year Treasury rate and the expected ten-year 2002 2003 2004 inflation rate reported in the survey by the Federal Reserve Bank of NOTE. The data are daily and extend through February 4, 2004. Philadelphia. 22 Monetary Policy Report to the Congress February 2004 With the sustained rise in stock prices, the ratio of In the business sector, investment spending, particu­ expected year-ahead earnings to stock prices for firms in larly in the beginning of the year, was mainly financed the S&P 500 edged down over 2003. The gap between with internal funds, limiting, though not eliminating, busi­ this ratio and the real ten-year Treasury yield—a crude nesses’ need to increase debt. With long-term rates fall­ measure of the equity risk premium—narrowed a bit over ing through midyear and credit spreads—especially for the course of the year, though it remains in the upper part riskier borrowers—narrowing, corporate treasurers of the range observed over the past two decades. shifted their debt issuance toward bond financing and away from shorter-term debt. Household borrowing also shifted in response to lower longer-term rates. Mortgage Debt and Financial Intermediation rates followed Treasury rates lower in the spring, and mortgage originations for both home purchases and Aggregate debt of the domestic nonfinancial sectors is refinancings surged. Refinancing activity appears to have estimated to have increased about 81/ 4 percent in 2003, held down growth of consumer credit as households just over a percentage point faster than in 2002. Federal extracted equity from their homes and used the proceeds, debt accelerated sharply, rising 11 percent, owing to the in part, to pay down higher-cost consumer debt. Never­ larger budget deficit. Household debt rose almost as rap- theless, consumer credit posted a moderate advance in idly, and the increase in state and local government debt 2003, buoyed by heavy spending on autos and other also was substantial. In contrast, business borrowing durables. A substantial widening of the federal deficit remained subdued last year. forced the Treasury to increase its borrowing significantly. To facilitate the pickup in borrowing, the Treasury altered its auction cycle to increase the frequency of cer­ Change in domestic nonfinancial debt tain issues and reintroduced the three-year note. Depository credit rose 6 percent in 2003 and was Percent driven by mortgage lending and the acquisition of mort­ gage-backed securities by both banks and thrift institu­ tions. Consumer lending also was substantial, as lower 10 interest rates and auto incentives spurred spending on durable goods. In contrast, business loans fell 71/ 4 per- 8 cent over 2003, a drop similar to the runoff in 2002. Sur­ vey evidence suggests that the decline in business lend­ 6 ing at banks was primarily the result of decreased demand Total 4 Net percentage of domestic banks tightening standards on commercial and industrial loans to large and medium-sized firms Percent Percent 15 60 Nonfederal 10 40 5 + 20 0_ + Federal, held by public 5 0_ 10 20 1989 1991 1993 1995 1997 1999 2001 2003 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. For 2003, change is from 2002:Q4 to 2003:Q3 at an annual rate. For earlier years, the data are annual and are computed by dividing the annual NOTE. The data are based on a survey generally conducted four times per flow for a given year by the level at the end of the preceding year. The total year; the last reading is from the January 2004 survey. Large and consists of nonfederal debt and federal debt held by the public. Nonfederal medium-sized firms are those with annual sales of $50 million or more. Net debt consists of the outstanding credit market debt of state and local percentage is the percentage reporting a tightening less the percentage governments, households, nonprofit organizations, and nonfinancial busi­ reporting an easing. nesses. Federal debt held by the public excludes securities held as SOURCE. Federal Reserve Senior Loan Officer Opinion Survey on Bank investments of federal government accounts. Lending Practices. Board of Governors of the Federal Reserve System 23 Delinquency rates on selected types of loans at banks M2 velocity and opportunity cost Percent Ratio, ratio scale Percentage points, ratio scale Commercial and industrial 6 2.2 M2 velocity 8 5 4 Consumer 4 2.0 2 M2 3 opportunity Residential real estate cost 1 2 1.8 1 1991 1993 1995 1997 1999 2001 2003 1994 1997 2000 2003 NOTE. The data, from bank Call Reports, are quarterly, seasonally ad­ NOTE. The data are quarterly and extend through 2003:Q4. The velocity of justed, and extend through 2003:Q4. M2 is the ratio of nominal 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 three-month Treasury bill rate and the weighted average return on assets included in M2. for these loans, with respondent banks often citing weak investment and inventory spending. Moreover, the con- traction was concentrated at large banks, whose custom­ The M2 Monetary Aggregate ers tend to be larger corporations that have access to bond markets, and the proceeds of bond issuance were appar­ M2 increased 51/ 4 percent in 2003, a pace somewhat ently used, in part, to pay down bank loans. The January slower than in 2002 and a bit below the rate of expansion 2004 Senior Loan Officer Opinion Survey reported a of nominal income. The deceleration in M2 largely pickup in business loan demand arising mainly from reflected a considerable contraction in the final quarter increased spending on plant and equipment and on in­ of the year after three quarters of rapid growth. The ventories. Supply conditions apparently played a second­ robust growth in money around midyear was concentrated ary role in the weakness in business loans in 2003. Banks in liquid deposits and likely resulted in large part from tightened standards and terms on business loans some- the wave of mortgage refinancings, which tend to boost what in the first half of the year, but by year-end they had M2 as the proceeds are temporarily placed in non- begun to ease terms and standards considerably, in part interest-bearing accounts pending disbursement to the because of reduced concern about the economic outlook. holders of mortgage-backed securities. Moreover, around the middle of the year, the equity that was extracted from home values during refinancings probably provided an M2 growth rate Mortgage refinancing application index Percent March 16, 1990 = 100 10 8,000 8 6,000 6 4,000 4 2,000 2 + 0_ 1991 1993 1995 1997 1999 2001 2003 NOTE. M2 consists of currency, travelers checks, demand deposits, other 1994 1996 1998 2000 2002 2004 checkable deposits, savings deposits (including money market deposit accounts), small-denomination time deposits, and balances in retail money NOTE. The data are monthly and extend through January 2004. market funds. SOURCE. Mortgage Bankers Association. 24 Monetary Policy Report to the Congress February 2004 additional boost to deposits for a time, as households tem­ Equity indexes in selected foreign industrial countries porarily parked these funds in M2 accounts before pay­ ing down other debt or spending them. In the fourth quar­ Week ending January 5, 2001 = 100 ter, M2 contracted at an annual rate of 2 percent, the largest quarterly decline since consistent data collection Japan 100 began in 1959. As mortgage rates backed up and the pace of refinancing slowed, the funds that had been swelling deposits flowed out, depressing M2. The sustained rally Canada 80 in equity markets after the first quarter of the year may also have slowed M2 growth, as expectations of contin­ 60 ued higher returns led households to shift funds from M2 Euro area assets to equities, a view reinforced by the strong flows 40 into equity mutual funds. United Kingdom 2001 2002 2003 2004 International Developments NOTE. The data are weekly. The last observations are the average of trading days through February 4, 2004. Economic growth abroad rebounded in the second half of last year as factors that weighed on the global economy in the first half—including the SARS epidemic and Monetary authorities abroad generally eased their poli­ uncertainty surrounding the war in Iraq—dissipated. For­ cies during the first half of 2003 as economic activity eign growth also was boosted by the strong rebound in stagnated. In the second half, market participants began the U.S. economy, the revival of the global high-tech sec­ to build in expectations of eventual monetary tightening tor, and, in many countries, ample policy stimulus. abroad, and official interest rates were raised by year- Strong second-half growth in China stimulated activ­ end in the United Kingdom and Australia. Canadian mon­ ity in other emerging Asian economies and Japan by rais­ etary policy followed a different pattern; the Bank of ing the demand for their exports. Growth in Japan also Canada raised official interest rates in the spring as infla­ was spurred by a recovery in private spending there on tion moved well above its 1 percent to 3 percent target capital goods. Economic activity in Europe picked up in range but cut rates later in the year and again early this the second half, as export growth resumed. Economic year as slack emerged and inflation moderated. Similarly, growth in Latin America has been less robust; the Mexi­ lower inflation in Mexico and Brazil allowed authorities can economic upturn has lagged that of the United States, to ease monetary policy during 2003. The Bank of Japan and Brazil’s economy has only recently begun to recover maintained official interest rates near zero and continued from the effects of its 2002 financial crisis. to increase the monetary base. Official interest rates in selected foreign industrial countries Equity indexes in selected emerging markets Percent Week ending January 5, 2001 = 100 6 250 5 United Kingdom 200 4 Argentina Asian emerging markets 3 150 Mexico 2 Canada Euro area 100 1 Japan + Brazil 50 0_ 2001 2002 2003 2004 2001 2002 2003 2004 NOTE. The data are as of month-end; the last observations are for February NOTE. The data are weekly. The last observations are the average of 5, 2004, when the Bank of England raised its official rate. The data shown are trading days through February 4, 2004. Asian emerging markets are China, the call money rate for Japan, the overnight rate for Canada, the refinancing Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, Singapore, rate for the euro area, and the repurchase rate for the United Kingdom. South Korea, Taiwan, and Thailand. Board of Governors of the Federal Reserve System 25 U.S. dollar nominal exchange rate, broad index J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. Treasury securities fell to their lowest levels since January 2000 = 100 before the Russian crisis of 1998. Gross capital flows to emerging markets, however, remained well below their 1997 peak. 115 The foreign exchange value of the dollar continued to 110 decline last year as concerns over the financing of the large and growing U.S. current account deficit took on 105 greater prominence. The dollar declined 18 percent against the Canadian dollar, 17 percent against the euro, 100 and 10 percent against the British pound and the Japa­ nese yen. In contrast, the value of the dollar was little 95 changed, on net, against the currencies of our other important trading partners, in part because officials of 2000 2001 2002 2003 2004 China and of some other emerging Asian economies man- aged their exchange rates so as to maintain stability in NOTE. The data are monthly and are in foreign currency units per dollar. The last observation is the average of trading days through February 4, 2004. terms of the dollar. Among Latin American currencies, The broad index is a weighted average of the foreign exchange values of the the dollar declined against the Brazilian and Argentine U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. currencies but appreciated against the Mexican peso. On export shares and from U.S. and foreign import shares. balance, the dollar depreciated 9 percent during 2003 on a trade-weighted basis against the currencies of a broad group of U.S. trading partners. In foreign financial markets, equity prices fell, on average, until mid-March but since then have risen in reaction to indications of stronger-than-expected global economic activity. Emerging-market equity indexes out- Industrial Economies paced those in the industrial countries in 2003, with mar­ kets in Latin America posting particularly strong gains. The euro-area economy contracted in the first half of Around midyear, long-term interest rates declined to 2003, weighed down in part by geopolitical uncertainty multiyear lows in many countries as economic growth and higher oil prices. In the second half, economic activ­ slowed and inflationary pressures diminished, but those ity in the euro area began to grow as the global pickup in rates moved higher in the second half as growth pros­ activity spurred a recovery of euro-area exports despite pects improved. Bond spreads came down substantially the continued appreciation of the euro. The monetary during the year, both for industrial-country corporate debt policy of the European Central Bank (ECB) was suppor­ and for emerging-market sovereign debt; spreads of the tive of growth, with the policy interest rate lowered to 2 percent by midyear. Consumer price inflation slowed to around 2 percent, the upper limit of the ECB’s defini­ U.S. dollar exchange rate against tion of price stability. Despite increased economic slack, selected major currencies inflation moved down only a little, partly because the sum­ mer drought boosted food prices. For the second straight Week ending January 5, 2001 = 100 year, the governments of Germany and France each Japanese yen recorded budget deficits in excess of the 3 percent 110 deficit-to-GDP limit specified by the Stability and Growth Pact. However, in light of economic conditions, Canadian U po .K un . d 100 European Union finance ministers chose not to impose dollar sanctions. After a sluggish first quarter, the U.K. economy 90 expanded at a solid pace for the remainder of 2003, sup- Euro ported by robust consumption spending and considerable 80 government expenditure. The Bank of England cut rates in the first half of the year but reversed some of that eas­ ing later in the year and early this year as the economy 2001 2002 2003 2004 picked up and housing prices continued to rise at a rapid, NOTE. The data are weekly and are in foreign currency units per dollar. albeit slower, pace. In June, the British government Last observations are the average of trading days through February 4, 2004. 26 Monetary Policy Report to the Congress February 2004 announced its assessment that conditions still were not U.S. dollar exchange rates and bond spreads right for the United Kingdom to adopt the euro. In for selected emerging markets December, the British government changed the inflation Week ending January 5, 2001 = 100 Week ending January 5, 2001 = 100 measure to be targeted by the Bank of England from the retail prices index excluding mortgage interest (RPIX) Exchange rates to the consumer prices index. U.K. inflation currently is 360 220 well below the objective of 2 percent on the new target index. Argentine peso 280 180 The Canadian economy contracted in the second quar­ ter owing to the impact of the SARS outbreak in Toronto Brazilian real on travel and tourism, but it rebounded in the latter half 200 140 of the year. Canadian economic growth continued to be Mexican peso led by strong domestic demand; consumption remained 120 100 robust and investment spending accelerated, offsetting Korean won the negative effect of Canadian dollar appreciation on both exports and import-competing industries. Canadian Percentage points Percentage points consumer price inflation swung widely last year, rising Bond spreads to 41/ 2 percent on a twelve-month basis in February before falling to 11/ 2 percent in November and ending the 80 Brazil 20 year at 2 percent. The swing partly reflected movements in energy prices, but changes in auto insurance premi­ 60 Argentina 15 ums and cigarette taxes also played an important role. Japanese real GDP recorded significant growth in 2003 40 10 for the second straight year. Private investment spending made the largest contribution to the expansion. Consumer Mexico 20 5 spending remained sluggish as labor market conditions continued to be soft. However, nominal wages stabilized following a sharp drop in 2002, and leading indicators of 2001 2002 2003 2004 employment moved higher. Despite an appreciation of NOTE. The data are weekly averages. Last observations are the average of the yen late in the year, Japanese exports posted a strong trading days through February 4, 2004. Exchange rates (top panel) are in increase in 2003 primarily because of gains in exports to foreign currency units per dollar. Bond spreads (bottom panel) are the spreads of the J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. China and other emerging Asian economies. With con­ Treasury securities. sumer prices continuing to decline, the Bank of Japan (BOJ) maintained its policy interest rate near zero and eased monetary policy several times during 2003 by recovery of retail sales and tourism after the epidemic increasing the target range for the outstanding balance of was contained was an important factor in the sharp reserve accounts held by private financial institutions at rebound. The pattern of Asian growth also reflected the the BOJ. The BOJ also took other initiatives last year to sharp recovery of the global high-tech sector in the sec­ support the Japanese economy, including launching a pro- ond half after a prolonged period of weakness. Exports gram to purchase securities backed by the assets of small- continued to be the main engine of growth for the region. and medium-sized enterprises. Japanese banks continued However, domestic demand contributed importantly to to be weighed down by large amounts of bad debt, but growth in China, where state-sector investment increased some progress was made in resolving problems of insuf­ at a rapid clip and a boom in construction activity contin­ ficient bank capital and in reducing bad-debt levels from ued. Supply problems caused food prices and overall their previous-year highs. consumer prices in China to rise on a twelve-month basis last year, following a period of price deflation dur­ ing the previous year. In addition, concerns emerged that Emerging-Market Economies some sectors of the Chinese economy, particularly the property markets in Beijing and Shanghai, may be Growth in the Asian developing economies rebounded overheating. sharply in the second half of 2003 after having contracted Korean economic growth turned negative in the first in the first half. The outbreak of SARS in China and its half, as the high level of household debt, labor unrest, spread to other Asian economies was the primary factor and concerns over North Korea’s nuclear development depressing growth in the first half, and the subsequent depressed private-sector spending. A sharp rise in exports Board of Governors of the Federal Reserve System 27 spurred a revival of growth in the second half even as 2003, in part because the Brazilian government began to domestic demand remained subdued. run a substantial primary budget surplus and to reform The Mexican economy remained sluggish through the public-sector pension system. The Brazilian stock mar­ much of the year but recently has shown some signs of ket soared nearly 100 percent last year, and Brazil’s improvement. After lagging the rise in U.S. production, EMBI+ bond spread narrowed by nearly two-thirds. As Mexican industrial production posted strong gains in the Brazilian currency stabilized and began to appreci­ October and November, although it remains well below ate, Brazil’s inflation outlook improved, allowing the the peak it reached in 2000. Exports rose late last year to central bank to reverse fully its earlier rate hikes and to almost the peak they had reached in 2000. Consumer price reduce the overnight interest rate to a multiyear low, inflation came down over the course of 2003 to 4 per- although real interest rates remained high. cent, the upper bound of the 2 percent to 4 percent target The Argentine economy rebounded in 2003 from the range. The Bank of Mexico has left policy unchanged sharp contraction that occurred in the wake of its finan­ since tightening five times between September 2002 and cial crisis in 2001–02. Still, economic activity remains March 2003, but market interest rates have fallen owing far below pre-crisis levels, and many of Argentina’s struc­ to weakness in economic activity. tural problems have not been addressed. With the gov­ The Brazilian economy contracted in the first ernment still in default to its bondholders, the country’s half of 2003 partly as a result of the 2002 financial crisis sovereign debt continued to carry a very low credit rat­ and the consequent monetary policy tightening. It then ing, and its EMBI+ spread remained extremely high. Even expanded moderately in the second half, boosted by strong so, the Argentine peso appreciated on balance in 2003, export growth and a recovery in investment spending. and the Merval stock index nearly doubled over the course Brazilian financial indicators improved significantly in of the year.

Federal Reserve (2004, February 10). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20040211

@misc{wtfs_monetary_policy_report_20040211,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2004},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20040211},
  note = {Retrieved via When the Fed Speaks corpus}
}