Monetary Policy Report

For use at 2:30 p.m., EDT Tuesday July 20, 2004 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 20, 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 July 20, 2004 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 20, 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 2004 3 Monetary Policy Report to the Congress Report submitted to the Congress on July 20, 2004, ment in the labor market and to ensure that the previous pursuant to section 2B of the Federal Reserve Act year’s threat of an unwelcome disinflation would con­ tinue to recede. Although real GDP had accelerated sharply in the second half of 2003, the incoming data MONETARY POLICY AND THE ECONOMIC OUTLOOK through the time of the March meeting suggested that employment was growing only slowly, as employers were The economic expansion in the United States became relying on increased production efficiencies to satisfy increasingly well established in the first half of 2004, but considerable gains in aggregate demand. Surging oil the pace of inflation picked up from its very low rate in prices were boosting overall inflation, while core infla­ 2003. At the time of the February Monetary Policy tion—though no longer declining—was still low. With Report to the Congress, considerable evidence was subsequent labor market reports suggesting that hiring already in hand indicating that the U.S. economy had was on a stronger track, growth in output continuing at a made the transition from a period of subpar growth to solid pace, and core consumer price inflation possibly one of more-vigorous expansion. Nevertheless, job cre­ running higher, the FOMC announced in May that it saw ation remained limited, and gains in investment, although the risks to the goal of price stability as having moved sizable, still seemed restrained by a lingering caution on into balance. Even so, the Committee stated that it the part of some businesses. In the event, businesses believed that the monetary policy accommodation then stepped up their hiring in the spring, and capital spend­ in place could be “removed at a pace that is likely to be ing seems to have continued apace. measured.” Indeed, at its June meeting, the FOMC Over the first half of this year, energy prices soared; decided that sufficient evidence was in hand to begin mov­ moreover, inflation in core consumer prices—as measured ing the federal funds rate back toward a more neutral set­ by the price index for personal consumption expenditures ting and raised the federal funds rate ¼ percentage point excluding the direct effects of movements in food and to 1¼ percent, a decision that was widely anticipated by energy prices—increased from an exceptionally low rate market participants. of 1 percent over the four quarters of 2003 to an annual Although some of the recent data have been on the rate of a little more than 2 percent. To some extent, the soft side, the available information on the outlook for the upturn in core inflation reflected the indirect effects of U.S. economy is, on balance, positive. Households are higher energy prices, but other forces also played a role. enjoying a generally improving job market, rising real Strengthening aggregate demand both at home and abroad incomes, and greater wealth, all of which are providing induced a surge in the prices of many primary commodi­ them with the confidence and wherewithal to spend. In ties and industrial materials. In addition, the decline in the business sector, capital spending apparently is con­ the foreign exchange value of the dollar in 2003 put tinuing to increase briskly, bolstered by expectations of upward pressure on the prices of imported goods and ser­ strong sales as well as by booming profits and supportive vices. With strong demand in the United States and financial conditions; investment should also continue to increased utilization of the productive capacity of the be buoyed by firms’ adoption of productivity-enhancing economy, firms were better able to pass on the higher technologies. Moreover, inventories appear to be lean costs of imports, raise the prices of domestically pro­ relative to sales even after taking account of the substan­ duced items that compete with imports, and in many cases tial improvements firms have made in managing their boost their profit margins. Likely in response to the faster stocks, suggesting that stockbuilding may provide some rate of price increases experienced this year, surveys sug­ impetus to production in the near term. The brightening gest that near-term inflation expectations have moved up outlook for economic activity abroad suggests that somewhat; still, expectations for price inflation over the demand for U.S. exports should grow and provide a fur­ longer term have remained in their recent range. ther lift to domestic production. Monetary policy was very accommodative at the start The prospects also seem favorable for inflation to of 2004 as the Federal Open Market Committee (FOMC) remain contained in the period ahead. For one reason, sought to provide continuing support to an economic some of the forces that contributed to the upturn in core expansion that had yet to produce a sustained improve­ inflation in the first half of 2004 are likely to prove tran- 2 Monetary Policy Report to the Congress July 2004 sitory. In particular, the upward impetus from the rise in disinflation. However, the Committee remained con­ energy and commodity prices is likely to lessen in com­ cerned about the persistent weakness in the labor market. ing quarters. For another reason, the evidence suggests At its January meeting, the FOMC left the target for the that the productive capacity of the economy is still not federal funds rate at 1 percent. The Committee generally being fully used and that the attendant slack is probably felt that the apparent slack in labor and product markets exerting some downward pressure on inflation. If—as and continued strong productivity growth were likely to seems likely—the economy approaches full utilization keep the underlying trend in inflation subdued, but it nev­ of its productive capacity only gradually, that downward ertheless was cognizant that a highly accommodative pressure should persist for a time. Moreover, productiv­ stance for monetary policy could not be maintained ity remains on a solid uptrend and should continue to indefinitely. Given these considerations, the Committee restrain costs. To date, the gains in productivity have modified the language of its policy statement to gain helped to boost profit margins. As firms compete to take greater flexibility to firm policy should circumstances war- advantage of profit opportunities, they may eventually rant. The Committee achieved this added flexibility by be forced to absorb a portion of any increases in labor removing its assessment that monetary policy would be and other costs that occur. But history suggests that the accommodative for “a considerable period” and instead absorption of costs has limits. Indeed, unit labor costs saying that the Committee could be “patient” in remov­ have turned up of late, as productivity growth has slowed ing its policy accommodation. below the rate of increase in hourly compensation. If At the time of the March FOMC meeting, the Com­ increases in those costs were to develop any upward mittee believed that conditions were mostly in place for momentum, the well-behaved nature of inflation in further solid economic growth. Industrial production had recent years could be jeopardized. picked up broadly, and consumer and business spending continued to expand briskly. However, the employment reports for January and February still painted a picture of subdued hiring. With financial markets quite accommo­ Monetary Policy, Financial Markets, and the dative, the Committee recognized that maintaining the Economy over the First Half of 2004 current stance of policy could fuel inflation pressures and perhaps encourage excessive risk-taking by financial At the beginning of 2004, the FOMC was growing more market participants. The Committee concluded that the confident that the economic expansion was likely to be low level of core consumer price inflation and continued self-sustaining, particularly in light of the significant firm­ evidence of weak hiring argued for the retention of both ing of business outlays and the continued strength in its 1 percent target for the federal funds rate and the word­ household spending. Moreover, stimulative fiscal and ing in its statement that the Committee could be “patient” monetary policies, in conjunction with receptive finan­ with respect to changes in monetary policy. cial markets, appeared likely to provide substantial sup- At the May FOMC meeting, members noted a distinct port to economic activity and to ward off any further improvement in the economic outlook. The labor market 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 3/16 5/4 6/30 2002 2003 2004 NOTE. The data are daily and extend through July 14, 2004. The dates on the horizontal axis are those of FOMC meetings. Board of Governors of the Federal Reserve System 3 figures reported for March had proved to be strong, and Economic projections for 2004 and 2005 the reports for the two previous months had been revised Percent upward significantly. Consumer price inflation in the first Federal Reserve Governors quarter of the year was faster than it had been in the pre­ and Reserve Bank presidents vious quarter. Although much of this rise was due to Indicator escalating energy costs, core inflation also stepped up, Range te C n e d n e t n ra c l y and survey-based measures of near-term inflation expec­ tations had edged higher. In response to the indications 2004 of rising aggregate demand and a strengthening job mar­ Change, fourth quarter ket, yields on Treasury securities had risen appreciably. to fourth quarter1 Nominal GDP ........................................................ 6–7 6¼–6¾ Accordingly, the Committee was of the view that the Real GDP .............................................................. 4–4¾ 4½–4¾ PCE price index excluding food and energy ........ 1½–2 1¾–2 expansion would be vigorous and believed that the odds of any further disinflation had been substantially reduced. Average level, fourth quarter Civilian unemployment rate .................................. 5¼–5½ 5¼–5½ On the basis of the evolving outlook for economic activ­ 2005 ity and prices, the Committee revised its assessment of risks to indicate that the upside and downside risks for Change, fourth quarter inflation had moved into balance. To underscore its to fourth quarter1 Nominal GDP ........................................................ 4¾–6½ 5¼–6 belief that policy would probably soon need to move Real GDP .............................................................. 3½–4 3½–4 PCE price index excluding food and energy ........ 1½–2½ 1½–2 toward a more neutral stance while emphasizing that this process was not expected to be rapid, the Committee Average level, fourth quarter Civilian unemployment rate .................................. 5–5½ 5–5¼ stated its judgment that monetary policy accommodation 1. Change from average for fourth quarter of previous year to average for “can be removed at a pace that is likely to be measured.” fourth quarter of year indicated. At the time of the June FOMC meeting, incoming information tended to confirm that the economy was expanding at a solid pace but also indicated that inflation The civilian unemployment rate is expected to lie between was higher than had been anticipated. Quotes on near- 5¼ percent and 5½ percent in the fourth quarter of 2004 term money market futures and options suggested that and to decline to between 5 percent and 5¼ percent by market participants were nearly certain of an increase of the fourth quarter of 2005. 25 basis points in the target for the federal funds rate at Starting with this report, the Federal Reserve will pro- that meeting and had priced in a cumulative increase of vide projections for the price index for personal consump­ about 2¼ percentage points in the federal funds rate over tion expenditures excluding food and energy (core PCE), the next year. The Committee agreed that the current sub­ which the Committee believes is better as an indicator of stantial degree of policy accommodation was no longer underlying inflation trends than is the overall PCE price warranted and decided to increase its target for the fed­ measure previously featured. Core PCE inflation appears eral funds rate 25 basis points. The Committee noted that to have run a little above an annual rate of 2 percent it considered the risks to both sustainable economic in the first half of 2004; for 2004 as a whole, most growth and stable prices to be roughly balanced and main­ FOMC participants expect it to lie between 1¾ percent tained its appraisal that policy accommodation “can be and 2 percent. For 2005, the central tendency of the removed at a pace that is likely to be measured” but also projections for core PCE inflation is 1½ percent to emphasized that it will “respond to changes in economic 2 percent. prospects as needed to fulfill its obligation to maintain price stability.” ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2004 Economic Projections for 2004 and 2005 After having surged in the second half of 2003, economic In conjunction with the FOMC meeting at the end of June, activity continued to expand at a solid pace in the first the members of the Board of Governors and the Federal half of 2004. In the labor market, payroll employment Reserve Bank presidents, all of whom participate in the started to increase last fall after a long string of declines deliberations of the FOMC, were asked to provide eco­ and picked up further during the first half of this year. nomic projections for 2004 and 2005. The central ten­ Headline inflation has been boosted significantly by the dency of the FOMC participants’ forecasts for the increase jump in energy prices this year, but core inflation has in real GDP is 4½ percent to 4¾ percent over the four also moved up from the exceptionally low levels of late quarters of 2004 and 3½ percent to 4 percent in 2005. 2003. 4 Monetary Policy Report to the Congress July 2004 Change in real GDP other than motor vehicles, which had risen 6½ percent in real terms in 2003, posted another huge increase in the Percent, annual rate first quarter; spending on services also perked up after having advanced only modestly in 2003. The available data point to a much smaller increase in consumer spend­ 6 ing in the second quarter; the deceleration mainly reflects a sharp slowing in the growth of outlays on goods other Q1 4 than motor vehicles. Real disposable personal income (DPI)—that is, 2 after-tax income adjusted for inflation—rose at an annual rate of nearly 4 percent between the fourth quar­ + ter of 2003 and May 2004, a gain about in line with its 0_ rate of growth last year. To be sure, the rise in energy prices cut into the growth of real income in the first half 1998 2000 2002 2004 of the year. However, aggregate wages and salaries, boosted by increases in both employment and earnings, NOTE. Here and in subsequent charts, except as noted, change for a given period is measured to its final quarter from the final quarter of the preceding rose appreciably in nominal terms. In addition, last year’s period. tax legislation, which had already reduced withholding rates in mid-2003, added further to households’ cash flow by increasing refunds and lowering final settlements this The Household Sector spring. Household wealth increased only about in line with Consumer Spending nominal DPI in the first quarter of 2004, and the wealth- to-income ratio was likely little changed in the second Consumer spending, which had gathered a good bit of quarter as well. Nonetheless, the increase in wealth over steam in the second half of 2003, continued to move the past year has been considerable—and probably large higher in the first half of 2004. The growth in spending enough to more or less offset any lingering restraint on was spurred by substantial gains in income. In addition, spending growth from the earlier declines in stock prices. household wealth has risen sharply over the past year, Thus, with wealth approximately a neutral influence on and consumer surveys indicate that individuals are gen­ the growth of spending of late, the personal saving rate erally upbeat in their assessments of the economy’s pros­ has held fairly steady. In fact, the average saving rate over pects and of their own situations. the first five months of the year—at 2¼ percent of DPI— Personal consumption expenditures rose at an annual was very close to the annual figures for 2002 and 2003. rate of 3¾ percent in real terms in the first quarter. Spend­ ing on light motor vehicles, which had been supported in late 2003 by aggressive price and financing incentives, slipped somewhat in early 2004. But outlays for goods Wealth-to-income ratio Ratio Change in real income and consumption Percent, annual rate Disposable personal income Personal consumption expenditures 6 6 Q1 5 4 2 1984 1988 1992 1996 2000 2004 NOTE. The data are quarterly and extend through 2004:Q1. The wealth-to-income ratio is the ratio of household net worth to disposable 1998 2000 2002 2004 personal income. Board of Governors of the Federal Reserve System 5 Personal saving rate Mortgage rates Percent Percent Fixed rate 7 10 5 Adjustable rate 5 3 1984 1988 1992 1996 2000 2004 2001 2002 2003 2004 NOTE. The data are quarterly; the reading for 2004:Q2 is the average for NOTE. The data, which are weekly and extend through July 14, 2004, are April and May. contract rates on thirty-year mortgages. SOURCE. Federal Home Loan Mortgage Corporation. Residential Investment Home prices have continued to rise rapidly. For example, the national repeat-sales price index from the Activity in the housing sector remained torrid in the first Office of Federal Housing Enterprise Oversight—which half of 2004. Although starts in the single-family sector partially adjusts for shifts in the quality of homes sold— faltered a bit early in the year, in part because of unusu­ rose 7¾ percent over the year ending in the first quarter ally adverse weather, they subsequently snapped back and (the latest available data), a rate similar to the average reached an annual rate of more than 1.6 million units in annual gain since late 2000. By this measure—and many April and May—8½ percent greater than the already rapid others—house price increases have outstripped gains in pace for 2003 as a whole. Sales of new and existing homes incomes as well as in rents in recent years. have also been exceptionally strong, and they hit record Starts in the multifamily sector averaged an annual rate highs in May. In general, housing activity has been sup- of 360,000 units over the first five months of the year, a ported by the favorable developments regarding jobs and pace slightly faster than that of the past several years. income and, especially early in the year, by low mort­ Low interest rates have apparently helped maintain the gage rates. Rates on thirty-year fixed-rate mortgages, profitability of apartment construction, given that other which had dipped to 5½ percent in March, rose markedly fundamental determinants of activity in the sector have in the spring; they have edged down in recent weeks and been weak: In particular, rents have remained soft, and in now stand at 6 percent, a level still quite low by histori­ the first quarter, vacancy rates for multifamily rental prop­ cal standards. erties reached a new high. Private housing starts Household Finance Millions of units, annual rate Household debt rose at an annual rate of about 10¾ per- cent in the first quarter of 2004. The especially rapid 1.6 growth of mortgage debt was driven by the strong pace of activity in the housing market and the renewed wave Single-family 1.2 of mortgage refinancing. However, the second-quarter rise in interest rates appears to have slowed the rate of refi­ nancing and, consequently, the amount of equity being .8 extracted from the value of homes through such transac­ Multifamily tions. Consumer credit—which constitutes the bulk of .4 household debt aside from mortgage borrowing— expanded at an annual rate of about 6 percent over the first quarter of the year and at roughly a 4 percent pace 1992 1994 1996 1998 2000 2002 2004 in April and May. The growth of consumer credit likely NOTE. The data are quarterly; the readings for 2004:Q2 are the averages for April and May. has continued to be restrained by the substitution 6 Monetary Policy Report to the Congress July 2004 Mortgage refinancing application index Delinquency rates on selected types of household loans March 16, 1990 = 100 Percent Credit card pools 6 8,000 5 6,000 4 Auto loans at domestic auto finance companies 4,000 3 2,000 2 Mortgages + 0_ 1 1994 1996 1998 2000 2002 2004 1992 1994 1996 1998 2000 2002 2004 NOTE. The data are monthly and extend through June 2004. NOTE. The data are quarterly and extend through 2004:Q1. SOURCE. Mortgage Bankers Association. SOURCE. For mortgages, the Mortgage Bankers Association; for auto loans, the Big Three automakers; for credit cards, Moody’s Investors Service. toward mortgage debt as a means to finance household Rapid increases in home prices have continued to buoy expenditures. household net worth this year. In contrast, stock prices Low interest rates, in concert with strong growth in are about unchanged. Although news on earnings and eco­ disposable personal income, have helped to keep finan­ nomic activity has generally been favorable, rising oil cial obligations manageable for most households. In prices and interest rates and, perhaps, heightened geopo­ the first quarter of the year, the debt service ratio and litical concerns have weighed on investor sentiment. Nev­ the financial obligations ratio for the household sector in ertheless, inflows into equity mutual funds have been even the aggregate, both of which gauge pre-committed stronger thus far in 2004 than they were last year. expenditures relative to disposable income, continued to edge down from their peaks in 2001. Other indicators also suggest that the financial well-being of households The Business Sector has stabilized and may be improving. Delinquencies on Fixed Investment credit card and auto loans generally declined in the first three months of the year, and bankruptcy rates, while still For the most part, businesses appear to be shaking off the high, stepped down in the first quarter from their recent extraordinary reluctance to undertake new investment peak. projects that was evident in 2002 and 2003. Indeed, although outlays on nonresidential construction have not Household financial obligations ratio yet turned up decisively, real spending on equipment and Percent software (E&S) has been advancing briskly. The broadly based growth in E&S spending has been driven by in­ creasingly favorable fundamentals: positive expectations 20 for sales, high levels of corporate profits and cash flow, a 19 desire to replace or upgrade aging equipment after a period of weak investment spending, and the continued 18 low cost of capital. 17 Real E&S spending rose at an annual rate of more than 15 percent in the second half of last year, and it posted 16 another sizable increase in the first quarter of 2004 despite flat business purchases of motor vehicles and a 15 dip in deliveries of aircraft. Excluding transportation equipment, real spending on E&S rose at an annual rate 1992 1994 1996 1998 2000 2002 2004 of 13½ percent in the first quarter. In the high-tech cat­ NOTE. The data are quarterly and extend through 2004:Q1. The financial obligations ratio equals the sum of required payments on mortgage and con­ egory, real purchases of computers and software remained sumer debt, automobile leases, rent on tenant-occupied property, home- on the solid uptrend that has been evident for the past owners’ insurance, and property taxes, all divided by disposable personal income. couple of years, and real outlays on communications Board of Governors of the Federal Reserve System 7 Change in real business fixed investment roughly half the pace of 2000, although vacancy rates have stabilized—albeit at very high levels—and the de- Percent, annual rate cline in rents has slowed. Factory construction also Structures remains sluggish. Construction of retail and wholesale Equipment and software 20 facilities, in contrast, has held up fairly well, a perfor­ mance consistent with the strength in consumer spend­ Q1 10 ing. Outlays on buildings for health care and education also have been reasonably well sustained. + 0_ 10 Inventory Investment 20 Inventory investment has generally remained subdued even as final sales have strengthened. Although real non- farm inventory investment picked up to an annual rate of High-tech equipment and software $30 billion in the first quarter, the accumulation occurred Other equipment excluding transportation 40 almost entirely in the motor vehicle sector, in which sag­ ging sales and a high level of production early in the year 30 created a noticeable bulge in dealer stocks, especially of 20 light trucks. In the second quarter, the automakers reduced Q1 assemblies; but with sales running only a little above their 10 first-quarter pace on average, inventories of motor + vehicles remained elevated. Outside the motor vehicle 0_ industry, nonfarm inventories increased at a meager 10 $6 billion annual rate in real terms in the first quarter, and the available data point to only a moderate step-up in 1998 1999 2000 2001 2002 2003 2004 real stockbuilding, on balance, in April and May. In gen­ NOTE. High-tech equipment consists of computers and peripheral equip­ eral, non-auto inventories appear lean relative to sales, ment and communications equipment. even after factoring in the downward trend in inventory– sales ratios that has accompanied the ongoing improve­ equipment increased further, reaching a level about ments in supply-chain and logistics management. 20 percent above the low in the fourth quarter of 2002. Spending for equipment other than high-tech and trans­ portation, which accounts for about 40 percent of E&S Corporate Profits and Business Finance (measured in nominal terms), also rose markedly in the first quarter. Such spending tends to be particularly sen­ Continuing the gains of last year, profits of the business sitive to the prospects for aggregate demand. In addition, sector to date have remained strong. In the first quarter it may be receiving a lift from the partial-expensing tax of 2004, earnings per share for S&P 500 firms were about provision, which is especially valuable for equipment with 26 percent higher than their level four quarters earlier, relatively long service lives for tax purposes; that provi­ and before-tax profits of nonfinancial corporations as a sion is slated to expire at the end of 2004. share of GDP from that sector edged up following a steep Equipment spending appears to have posted another increase in 2003. A jump in profits in the petroleum and solid increase in the second quarter. Outlays on transpor­ gas industries owing to higher oil prices was responsible tation equipment seem to have rebounded, and the for much of the rise in earnings. However, firms across incoming data on high-tech equipment point to robust many industries, with the notable exception of telecom­ real expenditures. Some indicators for spending on other munication services, registered solid gains in earnings. nontransportation equipment have been a bit soft recently. In response to this pattern of higher profits, analysts have But the May level of shipments for this broad category been steadily marking up their forecasts for earnings in was still above that of the first quarter, and backlogs of subsequent quarters. unfilled orders, which have risen impressively over the Net equity issuance has remained negative this year. past year, continued to build. Seasoned offerings have been scarce, the pace of initial Real nonresidential construction has remained about public offerings has only inched up, and share retirements unchanged, on net, since the steep decline in 2001 and have continued to be strong. Corporations have contin­ 2002. Construction of office buildings is still running at ued to repurchase shares at a rapid rate to manage their 8 Monetary Policy Report to the Congress July 2004 Before-tax profits of nonfinancial corporations Corporate bond yields as a percent of sector GDP Percent Percent 14 15 High-yield 12 10 10 AA 8 5 6 2000 2002 2004 1979 1984 1989 1994 1999 2004 NOTE. The data are monthly averages of daily data. The final observation NOTE. The data are quarterly and extend through 2004:Q1. Profits are from is the average of trading days through July 14, 2004. The AA rate is the domestic operations of nonfinancial corporations, with inventory valuation Merrill Lynch AA index with a remaining maturity of seven to ten years. The and capital consumption adjustments. high-yield rate is the yield on the Merrill Lynch 175 high-yield index. cash positions, even as they have increased dividend at banks have fallen on balance so far this year but at a payments. much slower pace than in 2003. The Federal Reserve’s Firms relied heavily on their elevated profits and sub­ Senior Loan Officer Opinion Survey conducted in April stantial cash holdings to finance their investment in 2004 indicated that demand for business loans had be- inventories and fixed capital in the first half of 2004. As gun to expand and that commercial banks had again eased a result, the growth of nonfinancial business debt remained both standards and terms on these loans over the previ­ modest. Much of the proceeds from bond issuance was ous three months. used to pay down higher-cost debt, and the timing of the Strong profits, low interest rates, and continued issuance of investment-grade bonds in particular was deleveraging helped improve the credit quality of nonfi­ influenced by movements in interest rates; issuance spiked nancial firms over the first half of the year. In the second in March in the wake of the drop in yields but subsided in quarter, the delinquency rate on business loans dropped April as rates rebounded. Short-term debt financing showed signs of turning around after contracting over the previous three years. Commercial paper outstanding Net percentage of domestic banks tightening expanded in the first two quarters of 2004. Business loans standards on commercial and industrial loans to large and medium-sized firms Major components of net business financing Percent Billions of dollars 60 Commercial paper Bonds 40 Bank loans Sum of major 400 components 20 200 + 0_ + 0_ 20 200 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. The data are based on a survey generally conducted four times per 2002 2003 2004 year; the last reading is from the April 2004 survey. Large and medium-sized firms are those with annual sales of $50 million or more. Net percentage is NOTE. Seasonally adjusted annual rate for nonfinancial corporate business. the percentage reporting a tightening less the percentage reporting an easing. The data for the sum of major components are quarterly. The data for SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank 2004:Q2 are estimated. Lending Practices. Board of Governors of the Federal Reserve System 9 Delinquency rates on selected types of loans at banks Ratings changes of nonfinancial corporate bonds Percent Percent Upgrades Commercial and industrial 6 20 10 5 0 Consumer 4 10 3 Residential real estate Downgrades 20 2 30 1 40 1992 1994 1996 1998 2000 2002 2004 1997 1998 1999 2000 2001 2002 2003 2004 NOTE. The data, from bank Call Reports, are quarterly, are seasonally NOTE. Data are at an annual rate; for 2004, they are the annualized values adjusted, and extend through 2004:Q1. of monthly data through May. Debt upgrades and downgrades are expressed as a percentage of the par value of all bonds outstanding. SOURCE. Moody’s Investors Service. for the sixth consecutive quarter; the continued decline has reversed a large part of the preceding run-up. Early Delinquency rates on commercial mortgages held by in the year the twelve-month trailing default rate on out- banks and insurance companies remained very low in the standing bonds fell into the relatively low range observed first quarter. A drop in delinquencies on commercial- over much of the 1990s, and in June it registered another mortgage-backed securities (CMBS) in recent months has decline. Moreover, in the first part of the year, the pace partially reversed last year’s rise, and the narrow risk of upgrades of bond ratings by Moody’s Investors Ser­ spreads on CMBS suggest that investors have limited vice rose while the pace of downgrades fell. concerns about loan quality. Borrowing against commercial real estate assets con­ tinued at a rapid pace during the first half of this year. Anecdotal reports suggest that some firms were using The Government Sector mortgages on commercial property to lock in low-cost, long-term funding. Despite the persistently high vacancy Federal Government rates for most types of commercial property, the loans backed by these assets have continued to perform well. The deficit in the federal unified budget has continued to widen. Over the twelve months ending in June, the uni­ fied budget recorded a deficit of $431 billion, $120 bil­ Default rate on outstanding bonds lion more than during the comparable period last year and equal to nearly 4 percent of nominal GDP. In large Percent part, the rise in the deficit is attributable to further rapid increases in spending on defense and other programs and 4 the loss of revenues resulting from the tax legislation enacted in recent years. In addition, interest costs, which 3 fell sharply between fiscal 1997 and fiscal 2003 as a result of budget surpluses and declining interest rates, 2 have leveled off and thus are no longer a significant fac­ tor helping to restrain the deficit. The primary deficit, 1 which excludes net interest, totaled $276 billion over the + twelve months ending in June, also approximately $120 0_ billion more than over the year ending in June 2003. Over the twelve months ending in June, nominal fed­ 1992 1994 1996 1998 2000 2002 2004 eral spending was nearly 7 percent higher than during the NOTE. The default rate is monthly and extends through June 2004. The rate same period a year earlier and stood at about 20 percent for a given month is the face value of bonds that defaulted in the twelve of nominal GDP—virtually the same as in fiscal 2003 months ending in that month divided by the face value of all bonds outstanding at the end of the calendar quarter immediately preceding the but 1½ percentage points above the recent low in fiscal twelve-month period. SOURCE. Moody’s Investors Service. 2000. Spurred by the war in Iraq, defense spending 10 Monetary Policy Report to the Congress July 2004 Federal receipts and expenditures Federal receipts in the twelve months ending in June were 1½ percent higher than during the comparable Percent of nominal GDP period of the previous year after having fallen markedly between fiscal 2000 and fiscal 2003. Receipts received a 24 substantial boost over the past year from a strong gain in Expenditures corporate taxes, which were lifted by robust profits. 22 Social insurance taxes, which tend to move in line with Receipts wages and salaries, also increased. But individual income Expenditures 20 taxes were below last year’s level: Although taxable excluding net interest incomes rose moderately, collections were reduced by 18 the lower withholding rates in place since mid-2003 and by the effects of JGTRRA on refunds and final settle­ 16 ments this spring. The deterioration in the unified budget since 2000 has 1986 1989 1992 1995 1998 2001 2004 been mirrored in a sharp downswing in federal saving— essentially, the unified surplus or deficit adjusted to con- NOTE. The budget data are from the unified budget; through 2003 they are for fiscal years (October through September), and GDP is for Q4 to Q3. For form to the accounting practices followed in the national 2004, the budget data are for the twelve months ending in June, and GDP is income and product accounts (NIPA). Gross federal sav­ for 2003:Q4 to 2004:Q1. ing fell from a high of nearly 3 percent of nominal GDP in 2000 to negative 3 percent of GDP in the first quarter ramped up another 14 percent; outlays for nondefense of 2004; measured net of estimated depreciation, federal discretionary programs, which include homeland secu­ saving fell from 2 percent of GDP to negative 4 percent rity, moved up further as well. Spending on the major of GDP over this period. In the past couple of years, the health programs rose at a rapid clip, in part because the rise in business saving from the rebound in profits and Jobs and Growth Tax Relief Reconciliation Act of 2003 reductions in corporate taxes has cushioned to some (JGTRRA) temporarily increased grants to the states extent the effect of growing budget deficits on national under the Medicaid program and boosted payments to saving. In fact, because of the dramatic increase in busi­ some Medicare providers. In addition, as noted, net ness saving in recent quarters, national saving has recov­ interest payments, which had plummeted between 1997 ered some from the extreme lows of early 2003. Even so, and 2003, flattened out. Real federal expenditures for con­ as of the first quarter of 2004, national saving (measured sumption and gross investment—the part of government net of estimated depreciation) was still equal to just about spending that is a component of real GDP—rose at an 2½ percent of GDP, compared with a recent high of 6½ annual rate of 8½ percent in the first calendar quarter of percent in 1998. If not reversed over the longer haul, such 2004; that increase reflected a surge in real defense spend­ low levels of national saving could eventually impinge ing, which now stands more than 30 percent above the levels that prevailed, on average, from 1997 to 2000. Net saving Change in real government expenditures Percent of nominal GDP on consumption and investment Percent, annual rate 12 Federal Nonfederal saving 9 State and local Q1 9 6 6 3 Total + 3 0_ Federal saving + 0_ 3 3 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. The data are quarterly and extend through 2004:Q1. Nonfederal saving is the sum of personal and net business saving and the net saving of 1998 2000 2002 2004 state and local governments. Board of Governors of the Federal Reserve System 11 Federal government debt held by the public State and local government net saving Percent of nominal GDP Percent of nominal GDP 55 .5 45 + 0_ 35 .5 25 1964 1974 1984 1994 2004 1984 1988 1992 1996 2000 2004 NOTE. Through 2003, 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 2004:Q1. Net saving excludes social is for 2004:Q1. Excludes securities held as investments of federal gov­ insurance funds. ernment accounts. on private capital formation and thus slow the rise of liv­ budget.) Although a few states are still struggling with ing standards. strained fiscal situations, most have entered fiscal 2005 Reflecting the need to finance the sizable federal bud- (which started on July 1 in all but four states) with expec­ get deficit, federal debt held by the public expanded at tations of respectable growth in revenues and with bud- an annual rate of 11¾ percent in the first half of the year. gets in place that allow for some increases in spending The ratio of this debt to nominal GDP now exceeds 36 on high-priority services and some rebuilding of reserve percent. The Treasury tilted its issuance toward longer- funds. term and inflation-indexed securities somewhat, and an­ Real consumption and investment spending by state nounced semiannual issuance of a twenty-year inflation- and local governments was essentially flat in the first protected bond beginning in July and a five-year quarter of 2004; available indicators point to a moderate inflation-protected note beginning in October. increase in the second quarter. Outlays for consumption items, which were little changed in 2003, appear to have remained subdued throughout the first half of the year. State and Local Governments Investment expenditures also were about unchanged in the first quarter, but they turned up sharply in the spring, States and localities have started to see some improve­ mainly because of a jump in spending on highways. ment in their budget positions after having gone through Significant demand for infrastructure spending and several difficult years. Strong growth in household favorable interest rates led to robust issuance of state and income and consumer spending has boosted revenues in local government debt to finance capital expenditures and recent quarters, as have the additional federal grants to advance refund higher-cost debt. Nevertheless, over authorized under JGTRRA. And although rising medical the first half of the year, net issuance edged down from costs and security needs have continued to put upward its rapid pace in 2003 to about a 6 percent annual rate. pressure on spending, state and local governments have The deceleration reflected a decline in short-term bor­ generally held the line on hiring and have kept other out- rowing as improvements in the fiscal positions of state lays in check. The restraint on spending, in combination and local governments lessened the need for temporary with a drawdown of reserve funds and some increases in funding of budget shortfalls. taxes, has helped states and localities satisfy their bal­ The credit quality of municipal borrowers has stabi­ anced-budget requirements. In fact, between the third lized after two years of deterioration; for the year to date, quarter of 2003 and the first quarter of 2004, NIPA net upgrades and downgrades of credit ratings have been saving (excluding social insurance funds) for this sector roughly equal. In a marked change from last year’s senti­ averaged $21 billion at an annual rate (¼ percent of nomi­ ment, rating agencies have begun to express guarded nal GDP), compared with negative $7 billion in 2002 and optimism about the credit quality of states because of negative $31 billion in the first half of 2003. (Net saving improvements in state revenue flows and restraint on is roughly similar to the surplus or deficit in an operating spending. 12 Monetary Policy Report to the Congress July 2004 U.S. trade and current account balances average, data for April and May suggest that the trade deficit continued to widen in the second quarter. Percent of nominal GDP Real exports of goods and services increased at an annual rate of 7½ percent in the first quarter of 2004, + 0_ well off the blistering 20 percent pace of the fourth quar­ ter but still above the average for 2003. Solid gains in 1 exports since mid-2003 arose in part from the strong eco­ 2 nomic performance of many of our major trading part­ Trade ners. In addition, the net decline in the exchange value of Current account 3 the dollar since 2002 continued to make U.S. goods and services more competitive abroad. Increases in exports 4 of U.S. goods were widespread across our major trading 5 partners, with the exception of Japan, and were concen­ trated in real exports of capital goods, industrial supplies, 1997 1998 1999 2000 2001 2002 2003 2004 and consumer goods. Real exports of agricultural prod­ ucts fell sharply, hurt by foreign bans on U.S. beef prod­ NOTE. The data are quarterly and extend through 2004:Q1. SOURCE. Department of Commerce. ucts following reports of mad cow disease in a U.S. herd. Exports of services rose moderately. The External Sector Prices of total exports rose at an annual rate of 5¾ percent in the first quarter, boosted by another jump In the first quarter of 2004, the U.S. current account defi­ in agricultural prices along with substantial increases in cit expanded to an annual rate of $580 billion, or about the prices of other primary commodities and industrial 5 percent of GDP. As in the past, the widening was driven supplies. Prices of U.S. agricultural exports have been primarily by a larger deficit in trade of goods and ser­ pushed up by very strong global demand, particularly from vices. The surplus on net investment income declined in China. For specific products, such as cotton and soybeans, the first quarter but remained well above its average value lower production in some countries also contributed to in the previous year. The deficit on net unilateral trans­ price run-ups. More recently, prices of soybeans and other fers rose because of a concentration of disbursements of agricultural products have eased in the face of a slowing government grants in the first quarter. in the growth of demand from China and the anticipation of larger harvests. Even so, available data point to con­ tinued strong increases in export prices in the second International Trade quarter. Supported by solid U.S. economic growth, real The U.S. trade deficit in goods and services registered imports of goods and services rose at an annual rate of $548 billion at an annual rate in the first quarter, about $46 billion larger than in the fourth quarter of 2003. On Prices of oil and of nonfuel commodities Change in real imports and exports of goods and services January 2001 = 100 Dollars per barrel Percent, annual rate Imports Exports 20 120 40 15 Q1 110 Oil 30 10 5 + 100 20 0_ Nonfuel 5 90 10 10 15 2001 2002 2003 2004 NOTE. The data are monthly and extend through June 2004. The oil price is 1998 2000 2002 2004 the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices from the SOURCE. Department of Commerce. International Monetary Fund. Board of Governors of the Federal Reserve System 13 Prices of major nonfuel commodities ties at a major Russian oil company. The recent increase in OPEC production (mainly by Saudi Arabia) has eased January 2003 = 100 the upward pressure on prices a bit, but they have remained elevated. Metals Prices of imported non-oil goods rose at an annual 140 rate of 5½ percent in the first quarter after minimal increases in the second half of 2003. Prices for imported 120 consumer goods rose at an annual rate of 2¾ percent Food after being flat in 2003. Skyrocketing global commodity 100 prices last year and early this year boosted prices of imported industrial supplies (especially metals) and of Beverages foods, feed, and beverages. The jump in commodity prices Agricultural 80 raw materials reflected strong demand, the net depreciation of the dol­ lar over the past two years, and the limited expansion in 2003 2004 supply of many commodities since the 2001 trough in NOTE. The data are monthly and extend through June 2004. The metals commodity prices. Available data suggest a modest step- category includes aluminum, copper, and iron ore; food includes cereals, down in the rate of increase of import prices in the sec­ vegetable oils and protein meals, seafood, and meat; agricultural raw mate- rials consists of timber, cotton, wool, rubber, and hides; beverages consists of ond quarter; the move in part reflects a flattening of con­ coffee, cocoa beans, and tea. sumer goods prices. SOURCE. International Monetary Fund. 10½ percent in the first quarter. This increase was below The Financial Account the fourth-quarter pace but still roughly double the rate of increase for 2003 as a whole. Real imports of goods The U.S. current account deficit has continued to be were boosted by a sharp increase in oil imports. Gains in financed largely by foreign flows into U.S. bonds. For- imports of non-oil goods were also sizable and widespread across categories. Imports of services grew slightly in the U.S. net international securities transactions first quarter. The spot price of West Texas intermediate (WTI) crude Billions of dollars oil surged above $40 per barrel in May and has since Net private foreign purchases of U.S. securities fluctuated close to that level. The run-up in the price since 175 the beginning of the year has been driven by surprisingly Bonds 150 Equities strong global demand for oil. Supply issues have been 125 important as well. These were mainly continued violence in Iraq, including the sabotage of oil facilities, attacks on 100 foreigners in Saudi Arabia, ongoing unrest in Nigeria, 75 political turmoil in Venezuela, and tax payment difficul- 50 25 + U.S. net financial inflows 0_ Billions of dollars Official Net private U.S. purchases of foreign securities 200 Private 100 175 Bonds 150 Equities 75 125 50 100 75 25 50 + 25 0_ + 0_ 25 25 2001 2002 2003 2004 2001 2002 2003 2004 SOURCE. Department of Commerce. SOURCE. Department of Commerce and the Federal Reserve Board. 14 Monetary Policy Report to the Congress July 2004 eign official inflows, already sizable in 2003, rose sharply Civilian unemployment rate in the first quarter of 2004 and then moderated some- what. Similarly, private foreign purchases of U.S. bonds, Percent which were significant in 2003, increased sharply in the first quarter and also appear to have moderated in the second quarter. In contrast, foreign demand for U.S. 9 equities was weak in 2003 and has remained so in 2004. Purchases of foreign equities by private U.S. investors appear to be strengthening, but U.S. investors still show 6 no appetite for foreign bonds. Direct investment into the United States in the first quarter continued to be restrained by the slowdown of 3 global mergers and acquisitions since 2002. In contrast, U.S. direct investment abroad was strong in 2003 and in the first quarter of 2004, as the effect of fewer mergers 1974 1984 1994 2004 and acquisitions was offset by sizable reinvested NOTE. The data are monthly and extend through June 2004. earnings. tomed out in January and then rose a cumulative 65,000 jobs through June. The rise in manufacturing jobs was The Labor Market concentrated in the durable goods industries—in particu­ lar, those making fabricated metals and other construc­ Employment and Unemployment tion-related products, computers and electronic equip­ ment, and machinery. After a long string of declines, The demand for labor turned up in late 2003 after an employment at producers of nondurable goods was little extended period of weakness, and it has gathered addi­ changed, on net, over the first half. Job gains in virtually tional steam this year. After averaging about 60,000 per all other major sectors have been greater this year than month in the fourth quarter of 2003, gains in private non- last. In particular, hiring in retail trade, which had been farm payroll employment rose to an average of about lackluster in 2003, turned up appreciably, and construc­ 200,000 per month in the first half of 2004. The job gains tion employment increased further. The professional and were especially large in March, April, and May but ebbed business services sector also posted a sizable rise, in part somewhat in June. The civilian unemployment rate, which because the rebound in manufacturing activity lifted hir­ had fallen from a recent peak of 6.3 percent in June 2003 ing at temporary-help firms. A clear indication of the to 5.7 percent in December 2003, was little changed over breadth of the employment increases is provided by the the first half of the year. In June, it stood at 5.6 percent. six-month diffusion index compiled by the Bureau of The increases in payrolls over the first half of 2004 Labor Statistics (BLS). The index is equal to the percent- were widespread. Especially notable was the turnaround age of industries that increased employment over the most in the manufacturing sector, in which employment bot- recent six months plus one-half the percentage with unchanged employment; in June, the index moved up to Net change in payroll employment its highest level since April 2000. Thousands of jobs, monthly average Productivity and Labor Costs 300 Q2 Gains in labor productivity have slowed somewhat in 200 recent quarters after the spectacular increases of mid- 100 2003. Still, according to the currently published data, + output per hour in the nonfarm business sector rose a re­ 0_ markable 5½ percent over the year ending in the first quarter. Over the past three years, increases in productiv­ 100 ity have averaged more than 4 percent per year, com­ 200 pared with average increases of about 2½ percent per year in the second half of the 1990s. During that earlier 1994 1996 1998 2000 2002 2004 period, an expansion of the capital stock was an impor­ tant source of productivity growth. However, in the more NOTE. Private nonfarm. Board of Governors of the Federal Reserve System 15 Change in output per hour face of the soft labor market and the low consumer price inflation in 2003. As a result, increases in the employ­ Percent, annual rate ment cost index (ECI) measure of hourly compensation, which is based on a survey of private nonfarm businesses conducted quarterly by the BLS, have held fairly steady Q1 4 of late. In fact, the rise in the ECI over the twelve months ending in March—at a shade less than 4 percent—was virtually the same as the increases over the preceding two 2 years. Benefit costs, which rose 7 percent over the year ending in March, have continued to be the fastest rising + portion of hourly compensation; health insurance costs 0_ have remained on a steep uptrend, and employers have boosted their contributions to defined-benefit retirement plans to make up for earlier stock market losses. The ris­ 1994 1996 1998 2000 2002 2004 ing benefit costs have likely exerted some downward pres­ sure on wages, which rose just 2½ percent over the twelve NOTE. Nonfarm business sector. months ending in March; the twelve-month change in the wage component of the ECI, which was close to 4 per- recent period, when the business environment—at least cent in 2000 and 2001, has been in the range of 2½ per- until the past few quarters—was characterized by slug­ cent to 3 percent since late 2002. gish demand, lean capital budgets, and an extraordinary The change in compensation per hour in the nonfarm reluctance of firms to add to payrolls, businesses appear business (NFB) sector—an alternative measure of hourly to have raised their productivity mainly through changes compensation based on data constructed for the NIPA— in organizational structures and better use of the capital has swung widely in recent years. Fluctuations in the value already in place. With hiring having picked up of late, of stock option exercises, which are excluded from the measured productivity growth may slow in coming quar­ ECI but included in the NFB measure, likely account for ters; but if recent experience is any guide, businesses will some of the differential movements in the two series. The continue to focus on achieving structural improvements four-quarter change in the NFB measure bottomed out at in the efficiency of their operations. The upswing in in- a bit less than 2 percent in 2002, when the value of exer­ vestment spending now under way also bodes well for cised options was dropping; it has moved up steadily since sustained favorable productivity performance in the pe­ that time and, in the first quarter, stood at 4½ percent—a riod ahead. rate not much different from the increase in the ECI. With The rapid productivity growth in recent years has productivity growth slowing to a pace below that of NFB helped to bolster increases in hourly compensation in the hourly compensation, unit labor costs rose in both the fourth and first quarters after having trended down over the preceding two years. Measures of change in hourly compensation Percent Change in unit labor costs 8 Percent, annual rate Nonfarm compensation per hour 6 4 4 2 Q1 Employment + cost index 2 0_ 1996 1998 2000 2002 2004 2 NOTE. The data extend through 2004:Q1. For nonfarm 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 quarter. Nonfarm 1994 1996 1998 2000 2002 2004 compensation is for the nonfarm business sector; the ECI is for private in­ dustry excluding farm and household workers. NOTE. Nonfarm business sector. 16 Monetary Policy Report to the Congress July 2004 Prices Change in consumer prices excluding food and energy Inflation moved higher in the first half of 2004. After Twelve-month percent change rising just 1½ percent over the four quarters of 2003, the price index for personal consumption expenditures (PCE) increased at an annual rate of 3½ percent between the 3 Consumer price index fourth quarter of 2003 and May 2004. In that period, energy prices soared, and increases in core consumer prices picked up to an annual rate of 2¼ percent—more 2 than 1 percentage point faster than the increase in 2003. Data for the consumer price index (CPI) are available through June and show some moderation in the core com­ 1 PCE price index ponent of the series. Over the first half of the year, the core CPI rose at an annual rate of 2½ percent, compared with an increase of 1¼ percent over the four quarters of 1994 1996 1998 2000 2002 2004 2003. NOTE. The data for the CPI extend through June 2004; for PCE, they Reflecting the surge in crude oil prices, PCE energy extend through May 2004. prices rose at an annual rate of more than 25 percent in the first quarter; they apparently posted another outsized increase in the second quarter. Gasoline prices increased 2004 after having moved up in late 2003. Robust global rapidly through May as crude oil costs rose and as price demand is imparting upward impetus to food prices, but markups were boosted by strong demand and lean inven­ U.S. producers are in the process of boosting supply, tories; although gasoline prices have fallen on balance which should help restrain increases in retail food prices since late May, they are currently nearly 30 percent above in coming quarters. their level at the end of last year. As for natural gas, which The step-up in core PCE inflation this year has been can often substitute for fuel oil in the industrial sector, especially pronounced in a few categories. In particular, spot prices were elevated at the start of the year, fell some- prices of motor vehicles have firmed after a noticeable what in February and March, and trended up over the decrease in 2003. In addition, increases in shelter costs, spring. The higher spot prices for natural gas this spring which were surprisingly low in 2003, are now running pushed up prices paid by consumers through June. PCE more in line with earlier trends. Core inflation has also electricity prices appear to have risen at an annual rate of been lifted this year by substantial increases, on balance, 3 percent over the first half of the year, a pace similar to in a number of categories for which prices cannot be that in 2003. derived from market transactions and thus must be Although volatile from month to month, consumer food imputed by the Bureau of Economic Analysis—for prices rose moderately on balance over the first half of example, prices of financial services provided by banks without explicit charge. These non-market-based prices, which were about flat in 2003, are difficult to estimate, and the imputed figures tend to be volatile. Change in PCE price index A number of factors have contributed to the run-up in Percent, annual rate core inflation this year. Higher oil prices have doubtless raised the cost of producing other goods and services. So Total Excluding food and energy have the steep increases in prices of non-oil commodi­ 4 ties such as copper and lumber, which came about as eco­ H1 nomic activity strengthened worldwide and as industrial 3 capacity utilization both here and abroad tightened. Like- wise, the decline in the dollar has boosted non-oil import prices and thus the costs of inputs for many domestic pro­ 2 ducers. The weaker dollar has also likely lessened the pressure on firms facing foreign competition to hold the 1 line on prices—a consideration that is probably contrib­ uting to the widespread perception that firms’ pricing power has increased lately. Moreover, unit labor costs 1998 2000 2002 2004 have edged up recently after having declined noticeably NOTE. The data are for personal consumption expenditures (PCE). The changes for 2004 are from 2003:Q4 to May 2004. in 2002 and 2003. Board of Governors of the Federal Reserve System 17 From a cyclical perspective, the sharp upturn in com­ Alternative measures of price change modity prices is not surprising, given the pickup in the Percent growth of industrial production. In fact, such large Price measure 2002 to 2003 2003 to 2004 increases in commodity prices are typical as economic Chain-type (Q1 to Q1) activity accelerates and capacity utilization rises—espe­ Gross domestic product ................................... 1.7 1.8 cially for products for which the supply is relatively fixed Gross domestic purchases ................................ 2.3 1.7 Personal consumption expenditures ................ 2.4 1.6 in the short run. Some portion of these increases usually Excluding food and energy .......................... 1.6 1.3 proves transitory. More important, cyclical swings in com­ Fixed-weight (Q2 to Q2) modity prices tend to have only a minor effect on overall Consumer price index ...................................... 2.2 2.8 Excluding food and energy .......................... 1.5 1.8 inflation, both because they account for a small share of NOTE. Changes are based on quarterly averages of seasonally adjusted data. total costs and because changes in commodity prices tend to be partly absorbed in firms’ profit margins, at least for a time. The faster rate of inflation this year underscores the through the first quarter, and the four-quarter changes in difficulty of gauging price pressures. Nevertheless, on these series do not show the rise in inflation indicated by the whole, the evidence suggests that slack remains in the monthly data discussed above. In particular, the rate labor and product markets, which should be exerting some of increase in the price index for GDP over the year end­ downward pressure on inflation. The unemployment ing in the first quarter was just 1¾ percent, the same as rate—at 5½ percent currently—is not significantly lower over the preceding year. The four-quarter change in the than it was through much of 2002 and 2003, when core price index for gross domestic purchases—which is inflation was trending down. And despite the run-up this defined as the prices paid for purchases of domestic and year, capacity utilization in the manufacturing sector is imported consumption, investment, and government still below its longer-run average. In addition, the strong goods and services—dropped from 2¼ percent to 1¾ upward trend in productivity is continuing to help keep percent over the same period; the deceleration reflects the rise in labor costs muted, and profit margins are suf­ mainly the effects of energy prices, which rose even more ficiently wide to give firms scope to absorb cost increases rapidly over the year ending in the first quarter of 2003 for a while without putting undue upward pressure on than they did over the most recent year. prices. The upturn in actual inflation has been echoed in some measures of inflation expectations. For example, accord­ U.S. Financial Markets ing to the Michigan Survey Research Center, the median expectation for inflation over the coming year has aver- As 2004 opened, financial market conditions were quite aged slightly more than 3 percent since early spring after accommodative, with low corporate bond yields, narrow hovering in the area of 2¼ percent to 2¾ percent in 2003 risk spreads, and relatively easy terms and standards on and early 2004. The median expectation for inflation over bank lending. Although equity prices changed little, and the next five to ten years has been running a bit below interest rates rose on balance in response to positive eco­ 3 percent in recent months, a reading similar to the fig­ nomic news and expectations of a tightening of monetary ures for 2002 and 2003. According to the Survey of Pro­ policy, financial conditions in the first half of the year fessional Forecasters conducted by the Federal Reserve remained supportive of economic growth. Business bor­ Bank of Philadelphia, expectations of inflation over the rowing nevertheless remained tentative, while increases next ten years held steady in June at 2½ percent. Infla­ in the debt of the federal government and of households tion compensation over the next five years as measured were sizable. by the spread between the yield on nominal Treasury securities and their indexed counterparts rose noticeably during the first half of 2004. To be sure, inflation com­ Interest Rates pensation is also influenced by perceptions of inflation risk and the secular increase in demand for inflation- From the end of 2003 through the end of March, yields indexed debt, but the rise in near-term inflation compen­ on nominal Treasury coupon securities fell, on net, about sation likely reflects, at least in part, higher inflation 30 to 45 basis points. Although interest rates rose imme­ expectations. Similar to the survey-based measures of diately after the FOMC’s January meeting in response to longer-run inflation expectations, inflation compensation the Committee’s decision to remove its statement that for the period five years to ten years ahead was little monetary policy could remain accommodative for “a con­ changed on net over the first half of the year. siderable period,” the increase proved to be short lived. Broader NIPA price measures are available only Weak employment reports released in early February and 18 Monetary Policy Report to the Congress July 2004 Interest rates on selected Treasury securities Spreads of corporate bond yields over the ten-year Treasury yield Percent Percentage points 6 Ten-year 10 5 High-yield 8 4 6 3 Two-year 4 2 BBB Three-month 2 1 AA + _0 2002 2003 2004 2002 2003 2004 NOTE. The data are daily and extend through July 14, 2004. NOTE. The data are daily and extend through July 14, 2004. The spreads compare the yields on the Merrill Lynch AA, BBB, and 175 high-yield indexes with the yield on the ten-year off-the-run Treasury note. early March prompted yields to fall amid doubts about the strength of the economic expansion. Federal funds employment reports published in April and May, higher- futures contracts at the end of March appeared to indi­ than-expected readings on core inflation, and surging oil cate that market participants placed small odds on a tight­ prices all spurred increases in Treasury yields. After the ening of monetary policy before late 2004, and contracts release of the employment report in May, federal funds also seemed to price in only a gradual increase in the futures contracts priced in a hike in the target federal funds federal funds rate during 2005. rate at the June FOMC meeting and a more rapid tighten­ Interest rates backed up in the second quarter as data ing of monetary policy than had been anticipated. With releases increasingly suggested that the economic expan­ the evolving outlook for monetary policy, the volatility sion would remain vigorous. Yields on the two-year and of short-term interest rates implied by option prices ten-year nominal Treasury notes ended the first half of jumped in the first half of the year after staying in a rela­ the year 90 and 36 basis points higher, respectively, than tively low range in 2003. Near-term interest rates declined at the end of 2003, as markets adjusted to the greater a bit after the Committee’s decision at its June meeting to likelihood of an earlier onset and more rapid pace of raise the intended federal funds rate 25 basis points; the monetary policy tightening. The surprisingly strong Committee’s reaffirmation that policy accommodation likely could be removed at a “measured” pace apparently reassured investors that a steep rise in the federal funds Implied volatility of short-term interest rates rate probably was not in train. Yields on investment-grade corporate debt moved Basis points roughly in line with those on comparable nominal Trea­ sury securities over the first half of the year, producing 350 little net change in risk spreads from their level at the end 300 of last year. Spreads on speculative-grade debt over Trea­ sury debt declined a bit further after having narrowed 250 sharply during 2003 as the economic expansion was seen as gathering steam. 200 150 Equity Markets 100 Over the first half of 2004, equity prices were subject to 1997 1998 1999 2000 2001 2002 2003 2004 the strong crosscurrents of robust earnings reports, rising NOTE. The data are daily and extend through July 14, 2004. The series interest rates, fluctuating fears about geopolitical devel­ shown is the implied volatility of the three-month eurodollar rate over the coming four months, as calculated from option prices. opments, and sharply higher oil prices. On balance, broad Board of Governors of the Federal Reserve System 19 Major stock price indexes Debt and Financial Intermediation January 2, 2002 = 100 Aggregate debt of the domestic nonfinancial sectors expanded at an annual rate of about 8½ percent in the 120 first quarter of 2004, a gain similar to last year’s increase. Russell 2000 Debt growth in the business sector has remained subdued 110 so far this year, as ample internal funding has limited the 100 need for external finance. In contrast, household debt has continued to expand rapidly, spurred by an elevated pace 90 of home purchases and cash-outs from mortgage refinanc­ Wilshire 5000 ing. The large federal budget deficit led to another sharp 80 increase in Treasury debt in the first half of this year. 70 Municipal borrowing moderated somewhat, on balance, in the first half of the year, as the improving fiscal condi­ 2002 2003 2004 tion of state and local governments reduced the need for NOTE. The data are daily and extend through July 14, 2004. short-term borrowing to cover budget gaps. The growth of credit on the books of depository insti­ tutions picked up to an annual rate of 14 percent in the first quarter of 2004. Financing secured by residential equity price indexes at the end of June had edged about 2½ percent to 3¼ percent above year-end levels after hav­ Change in domestic nonfinancial debt ing surged 25–30 percent over the course of 2003. Over the first half, analysts raised their estimates of profits for Percent coming quarters; the upward revision outstripped the more modest increase in equity prices and boosted the ratio of 10 expected year-ahead earnings to stock prices. With real interest rates higher, however, the difference between the earnings–price ratio and the real ten-year Treasury yield— 8 a crude measure of the equity risk premium—changed Total little to remain close to its average value over the past 6 two decades and above its level during the late 1990s. 4 S&P 500 forward earnings–price ratio and the real interest rate Percent Percent 15 Nonfederal 10 10 S&P 500 earnings–price ratio 5 8 + 6 0_ 4 Federal, 5 held by public 10 2 Real interest rate + 0_ 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. For 2004, change is from 2003:Q4 to 2004:Q1 at an annual rate. For 1990 1992 1994 1996 1998 2000 2002 2004 earlier years, the data are annual and are computed by dividing the annual flow for a given year by the level at the end of the preceding year. The total NOTE. The data are monthly and extend through June 2004. The forward consists of nonfederal debt and federal debt held by the public. Nonfederal earnings–price ratio is based on I/B/E/S consensus estimates of earnings over debt consists of the outstanding credit market debt of state and local gov­ the coming year. The real interest rate is estimated as the difference between ernments, households, nonprofit organizations, and nonfinancial businesses. the ten-year Treasury rate and the expected ten-year inflation rate reported in Federal debt held by the public excludes securities held as investments of the survey by the Federal Reserve Bank of Philadelphia. federal government accounts. 20 Monetary Policy Report to the Congress July 2004 real estate—including home mortgages, home equity Official interest rates in selected foreign industrial countries loans, and mortgage-backed securities—drove the expan­ sion. In contrast, business loans continued to run off, fall­ Percent ing at an annual rate of about 5 percent in the first half of 6 the year after a 10 percent drop in 2003. The decelera­ tion was consistent with some signs that demand for busi­ 5 ness loans was beginning to recover as well as with an United Kingdom 4 easing of standards and terms on these loans. Canada 3 2 The M2 Monetary Aggregate Euro area 1 Japan + In the first half of 2004, short-term interest rates were 0_ stable and M2 grew at an annual rate of 6½ percent—a pace that was roughly in line with estimates of nominal 2001 2002 2003 2004 GDP—after contracting at a record rate in the fourth quar­ NOTE. The data are as of month-end; the last observation for each series is ter of 2003. Liquid deposits—the largest component of the average of trading days through July 14, 2004. The data shown are the call money rate for Japan, the overnight rate for Canada, the refinancing rate M2—had been depressed late last year by the ebbing of for the euro area, and the repurchase rate for the United Kingdom. last summer’s mortgage refinancing boom. Mortgage refinancings tend to boost M2 as the proceeds are tem­ International Developments porarily placed in non-interest-bearing deposit accounts pending disbursement of funds to the holders of mort­ Foreign economic activity expanded in the first half of gage-backed securities. When refinancings slowed last this year at a pace only slightly below the rapid increase year, the decline in such escrow accounts held down the in the second half of 2003. Global trade has been boosted growth of liquid deposits. In the first half of this year, by strong demand, especially from the United States and M2 probably received a boost from the new round of mort­ China. The run-up in oil and commodity prices has con­ gage refinancings that followed the first-quarter tributed to rising, though still moderate, inflation across decline in mortgage interest rates. The strength in liquid the industrial and developing countries. deposits was partly offset, however, by continued weak­ By the end of the first half of this year, monetary policy ness in money market mutual funds and small time in most major foreign economies had either tightened or deposits. Given the recent very low yields on these two assumed a less accommodative tone. Citing high rates of components of M2, households likely viewed them as capacity utilization and mounting inflationary pressures, less attractive savings vehicles than other assets. the Bank of England has raised its target rate 100 basis points since early November. Mexico and China also have tightened policy. Elsewhere, including the euro area, M2 growth rate Equity indexes in selected foreign industrial countries Percent, annual rate Week ending January 3, 2003 = 100 10 Canada 140 8 H1 Japan 6 120 4 100 United Kingdom 2 Euro area 80 1994 1996 1998 2000 2002 2004 NOTE. M2 consists of currency, travelers checks, demand deposits, other 2003 2004 checkable deposits, savings deposits (including money market deposit accounts), small-denomination time deposits, and balances in retail money NOTE. The data are weekly. The last observation for each series is the market funds. average of trading days through July 14, 2004. Board of Governors of the Federal Reserve System 21 Equity indexes in selected emerging-market economies U.S. dollar nominal exchange rate, broad index Week ending January 3, 2003 = 100 January 2001 = 100 Argentina 105 200 Brazil Mexico 100 160 95 Asian 120 emerging-market economies 80 90 2003 2004 2001 2002 2003 2004 NOTE. The data are weekly. The last observation for each series is the NOTE. The data are monthly and are in foreign currency units per dollar. average of trading days through July 14, 2004. The Asian emerging-market The last observation is the average of trading days through July 14, 2004. The economies are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the broad index is a weighted average of the foreign exchange values of the U.S. Philippines, Singapore, South Korea, Taiwan, and Thailand; the index weight dollar against the currencies of a large group of major U.S. trading partners. for each of these economies is its market capitalization as a share of the The index weights, which change over time, are derived from U.S. export group’s total. shares and from U.S. and foreign import shares. Canada, and Japan, central banks most recently have kept changed little, on balance. In contrast, rapidly improving policy unchanged after easing previously. In general, economic conditions in Japan have helped boost Japa­ official statements are expressing increasing concern over nese equity prices about 10 percent. Other Asian stock the inflationary risks associated with stronger economic price indexes have fallen, on average, in part because of activity and higher world energy and commodity prices. concerns about the possibility of an acute slowdown in In foreign financial markets, equity price performance China. Mexican stocks have been bolstered by strong has been more mixed so far in 2004 than during the sec­ earnings growth of leading Mexican communications ond half of 2003; sharply rising interest rates over the firms and, more generally, by the strengthening U.S. past few months have weighed on equity valuations, expansion. Foreign long-term interest rates rose rapidly damping the effects of an improved earnings outlook. in the second quarter as new data (including from the Since year-end, stock prices in Europe and Canada have United States) showing faster growth and higher infla­ tion led market participants to expect more-aggressive monetary tightening. Over the first half of the year, the Spread on internationally issued sovereign debt of emerging-market economies U.S. dollar exchange rate against Percentage points selected major currencies Week ending January 4, 2002 = 100 10 Canadian dollar Japanese yen 100 8 90 6 Euro 80 4 70 2002 2003 2004 U.K. pound NOTE. The data are weekly averages. The last observation is the average of trading days through July 14, 2004. The series shown is the J.P. Morgan 2002 2003 2004 Emerging Market Bond Index Plus (EMBI+), which is the spread of the yield of certain dollar-denominated sovereign debt instruments of emerging-market NOTE. The data are weekly and are in foreign currency units per dollar. economies over U.S. Treasury securities; over the period shown, the index The last observation for each series is the average of trading days through encompassed nineteen countries. July 14, 2004. 22 Monetary Policy Report to the Congress July 2004 spread on internationally issued sovereign debt of emerg­ Economic expansion in the United Kingdom contin­ ing-market economies over U.S. Treasuries moved up ued unabated over the first half of 2004. Labor markets somewhat from its very low level. tightened further; the unemployment rate edged down to After depreciating over the previous two years, the its lowest level in almost three decades, and labor earn­ value of the dollar rose slightly, on balance, in the first ings posted solid gains. Despite the strong economy, con­ half of 2004. The firming of the dollar has been sumer price inflation over the twelve months ending in attributed to perceptions by market participants that near- June was 1½ percent, remaining below the central bank’s term monetary tightening in the United States would be official target rate of 2 percent. Conditions in the U.K. faster than such tightening abroad. housing market, however, remained red hot, with double- digit price increases, high levels of household mortgage and consumer borrowing, and sizable withdrawals of Industrial Economies home equity. The Canadian economy picked up steam in the first A broadly based recovery appears to have been estab­ half of 2004 after a year plagued with difficulties includ­ lished in Japan over the first half of 2004. Real GDP rose ing SARS, mad cow disease, and a regional power out- at an annual rate of more than 6 percent in the first quar­ age. Sizable gains in consumption and investment boosted ter after an even greater increase in the fourth quarter. output in the first quarter, and indicators are pointing to Aided by demand from China, growth of Japanese real continued good performance in these sectors. Export exports remained robust. Personal consumption and busi­ growth was strong, as the robust economic performance ness investment also firmed. More-recent indicators show of the United States appears to have outweighed the nega­ that domestic strength continued in the spring with large tive effect of Canadian dollar appreciation on trade. The gains in household expenditures and improved labor unemployment rate was relatively stable over the first half, market conditions. Deflation continued to wane in Japan. and employment bounced back in the second quarter from Consumer price deflation over the first half of the year a first-quarter lull. Consumer price inflation decreased was slight, and wholesale prices increased. In financial early in the year, but energy costs helped drive up the markets, the stronger economy boosted equity markets rate to 2½ percent over the twelve months ending in June. and helped drive up the yield on the ten-year bellwether Prices excluding food, energy, and indirect taxes have government bond to more than 1¾ percent from its June remained more subdued, rising slightly less than 1½ per- 2003 record low of about ½ percent. After making sub­ cent over the same period. stantial sales of yen for dollars in the first quarter, Japa­ nese authorities ceased intervention in mid-March. Even so, the yen depreciated early in the second quarter before Emerging-Market Economies appreciating to around ¥109 per dollar. Economic conditions in the euro area firmed over the Estimates suggest that real GDP in China surged in the first half of 2004, but performance varied across coun­ first quarter with continued outsized gains in fixed-asset tries, and the region as a whole continues to lag the glo­ investment. Fears of overinvestment, particularly in the bal upturn. Real GDP in the euro area increased at an steel, cement, and aluminum industries, led Chinese offi­ annual rate of 2¼ percent in the first quarter; output in cials to intensify their tightening measures early in the France, Spain, and several smaller member countries rose second quarter. These measures included increases in relatively briskly, while growth in Germany and Italy was reserve requirements and in some interest rates as well as less robust. In the first quarter, domestic demand firmed stricter criteria for the approval of investment projects. A noticeably, except in Germany, where growth was due sharp slowdown in estimated real GDP for the second entirely to a spike in exports. German consumer spend­ quarter suggests that these steps are working. Despite the ing remains anemic, held down by a weak labor market recent slowing in growth, Chinese exports and imports and low consumer confidence. Euro-area indicators for soared in the first half of the year, and trade was close to the second quarter initially were upbeat, but more-recent balanced. data have been mixed. Labor markets have yet to benefit Growth in the other Asian emerging-market economies from the recovery, and the average unemployment rate in slowed only moderately in the first quarter from the fast the region edged up to 9 percent in the spring. Inflation pace at the end of last year. Exports, which continued to for the euro area over the twelve months ending in June be the driving force behind that growth, were fueled by was near 2½ percent, a rate above the European Central Chinese demand as well as by the recovery in the global Bank’s medium-term goal of less than, but close to, 2 per- high-tech market and stronger world demand overall. Con­ cent. Excluding energy, food, alcohol, and tobacco, prices sumer demand generally rose across the region with the rose slightly less than 2 percent over the same period. notable exception of Korea, where high levels of con- Board of Governors of the Federal Reserve System 23 sumer debt are weighing on spending. Although still only expand in the second quarter with support from strong moderate, inflation across the Asian emerging-market external demand. Job growth has been robust, although economies is beginning to rise as stronger aggregate de­ unemployment has remained high. Inflation, however, mand takes hold and higher energy and commodity prices continues to concern authorities. Asset prices weakened pass through to prices more generally. earlier this year, in part because of rising global interest The Mexican economy has been propelled this year rates but also because of market participants’ unease about by strong demand from the United States. Gains have been the direction of structural and fiscal reforms; since then, broadly based, with sharp increases in industrial produc­ asset prices have partially rebounded. tion, exports, construction, and retail sales. Employment The recovery in Argentina has continued at a rapid in the industries most closely linked to U.S. trade also pace in recent quarters, but limited investment in the has started to increase. Responding to a rise in twelve- energy sector, reflecting a lack of structural reforms, has month inflation to slightly above its 2 percent to 4 per- forced the government to import electricity, natural gas, cent target range, the Bank of Mexico has tightened policy and fuel oil from neighboring countries. Creditors have several times so far this year. Elevated oil prices boosted shown little enthusiasm for the country’s latest debt the Mexican public-sector fiscal surplus to a record high restructuring plan, and the federal government faces dif­ during the first five months of the year and facilitated an ficult challenges in normalizing its international finan­ increase in federal transfers to state governments. cial situation and reforming its fiscal relations with the In Brazil, GDP grew robustly in the first quarter, and provinces. indications are that economic activity continued to

Federal Reserve (2004, July 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20040720

@misc{wtfs_monetary_policy_report_20040720,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2004},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20040720},
  note = {Retrieved via When the Fed Speaks corpus}
}