Monetary Policy Report

For use at 10:00 a.m., EST Wednesday February 16, 2005 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress February 16, 2005 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 16, 2005 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 16, 2005 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 and Early 2005 4 Monetary Policy Report to the Congress Report submitted to the Congress on February 16, 2005, ing and gains in industrial production dropped back nota­ pursuant to section 2B of the Federal Reserve Act bly during the summer. Equity prices and longer-term interest rates moved lower over this period as well. In the event, the slowdown in household spending growth proved MONETARY POLICY AND THE ECONOMIC OUTLOOK short lived. Both hiring and increases in factory output The year 2004 was marked by continued expansion in stepped up again in the autumn, and these gains were economic activity and appreciable gains in employment. extended early this year. With profits healthy and finan­ With fiscal policy stimulative, monetary policy accom­ cial conditions still supportive, capital spending modative, and financial conditions favorable, household increased at a brisk pace throughout the year. Over the spending remained buoyant and businesses increased final quarter of 2004, short-term interest rates rose fur­ investment in capital equipment and inventories, despite ther as monetary policy was firmed at each FOMC meet­ the restraint imposed by sizable increases in oil prices. ing, but long-term interest rates were largely unchanged. Labor market conditions improved significantly, albeit Equity prices rose appreciably in the fourth quarter, and at an uneven pace, and productivity rose notably further. the dollar depreciated against most other major curren­ Consumer price inflation moved higher with the surge in cies. The FOMC increased the target federal funds rate energy prices, but core consumer price inflation (that is, 25 basis points again at its meeting this month, bringing excluding food and energy) remained well contained, and the cumulative tightening over the past year to 11/ 2 per­ measures of expected inflation over longer horizons held centage points. steady or edged lower. The fundamental factors underlying the continued Although economic activity had increased substantially strength of the economy last year should carry forward in 2003, the expansion nevertheless appeared somewhat into 2005 and 2006, promoting both healthy expansion tentative as 2004 opened, in large measure because busi­ of activity and low inflation. Monetary policy is still nesses still seemed to be reluctant to boost hiring. Over accommodative, and financial conditions more generally the course of the spring, however, it became clearer that continue to be advantageous for households and firms. the expansion was solidifying. Businesses added appre­ Profits have been rising briskly, and corporate borrowing ciably to their payrolls, boosted investment in equipment costs are low. Household net worth has increased with and software, and started restocking inventories. While the continued sharp rise in the value of real estate assets household spending growth softened somewhat, residen­ as well as gains in equity prices, and this will likely help tial construction expanded rapidly. Rising energy prices support consumer demand in the future. Absent a signifi­ boosted overall consumer price inflation, and core infla­ cant increase in oil prices from current levels, the drag tion moved up as well. In response to positive economic from last year’s run-up should wane this year. The lagged news and higher inflation during this period, market par­ effects of the decline in the exchange value of the dollar ticipants came to anticipate that monetary policy tighten­ since the autumn and sustained foreign economic growth ing would begin sooner than they had expected, and are likely to boost the demand for U.S. exports. The pros­ interest rates increased considerably. With the economic pects for the expansion of aggregate supply also appear expansion more firmly established and slack in labor and to be quite favorable. Gains in structural labor productiv­ product markets somewhat diminished, the Federal Open ity should continue, although not necessarily at the pace Market Committee (FOMC) at its June meeting began to of recent years. Economic growth will likely be sufficient reduce the substantial degree of monetary accommoda­ to generate notable increases in employment, although tion that was in place. any reversal of the decline in labor force participation The gradual removal of monetary policy stimulus con­ observed since 2001 would tend to hold up the unem­ tinued in the second half of the year as the economy ployment rate. Core consumer price inflation has remained expanded at a healthy clip on balance. Around midyear, low since the larger increases posted in the early months some measures of growth in activity softened, partly of 2004, and long-term inflation expectations have been because of the drain on income and the rise in business similarly well contained. With some slack likely remain­ costs created by higher oil prices. The expansion of con­ ing in labor and product markets at present and with the sumer spending slowed in the spring, and the pace of hir­ indirect effects of higher oil and import prices diminish- 2 Monetary Policy Report to the Congress February 2005 ing, the prospects for inflation staying low are good. A By the time of the May and June FOMC meetings, favorable economic outcome is, of course, not assured, incoming economic data pointed to a broader and more but at the most recent FOMC meeting the Committee firmly established expansion, with continued strength in again assessed the risks to both output and inflation as housing markets and business fixed investment. Also, the balanced. The Committee also reaffirmed that it is pre- employment reports for March, April, and May had indi­ pared to respond to events as necessary in its pursuit of cated strong and widespread gains in private nonfarm price stability. payrolls, and previous reports for January and February were revised upward significantly. Overall consumer price inflation in the first quarter was faster than it had been a year earlier, and core inflation also increased, in part Monetary Policy, Financial Markets, and the because of the indirect effects of higher energy prices. Economy in 2004 and Early 2005 The Committee maintained its target for the federal funds In early 2004, against the backdrop of stimulative fiscal rate at 1 percent in May, but on the basis of the evolving and monetary policy, continued rapid growth in produc­ outlook for economic activity and prices, it revised its tivity, and supportive financial market conditions, busi­ assessment of risks to indicate that the upside and down- ness outlays appeared to be firming significantly and side risks for inflation had moved into balance. The Com­ household spending remained strong. The FOMC became mittee also stated that monetary policy accommodation more confident that the economic expansion was likely could “be removed at a pace that is likely to be mea­ gaining traction and that the risk of significant further sured” to communicate its belief, given its economic out- disinflation had been greatly reduced. In these circum­ look, that policy would probably soon need to move stances, it recognized that a highly accommodative stance toward a more neutral stance, though probably not at a for monetary policy could not be maintained indefinitely. rapid pace. The Committee retained this language at the Nonetheless, the Committee was concerned about the June meeting while raising its target for the federal funds persistently slow pace of hiring and viewed underlying rate from 1 percent to 11/ 4 percent and noting that it would inflation pressures as likely to remain subdued. Accord­ “respond to changes in economic prospects as needed to ingly, the Committee left its target for the federal funds fulfill its obligation to maintain price stability.” rate unchanged at 1 percent at its January and March The information that the Committee had received by meetings. However, beginning in January, it modified the the time of its August meeting indicated that economic language of its policy statement to gain greater flexibil­ growth had softened somewhat earlier in the summer. ity to tighten policy should circumstances warrant by Although the housing market had remained strong and indicating that monetary policy accommodation would business outlays had continued to be healthy, consumer eventually have to be removed. At the same time, the spending growth had slowed significantly, and industrial Committee suggested that it could be patient in under- production had begun to level off. Also, the June and July taking such actions. labor market reports revealed that employment growth 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 8/10 9/21 11/10 12/14 2/2 2002 2003 2004 2005 NOTE. The data are daily and extend through February 9, 2005. Treasury rates are constant-maturity yields based on the most actively traded securities. The dates on the horizontal axis are those of FOMC meetings. SOURCE. Department of the Treasury and the Federal Reserve. Board of Governors of the Federal Reserve System 3 had slowed considerably. At the same time, core consumer and the news on job growth was uneven—lackluster price inflation had moderated in May and June even increases in nonfarm payrolls in September were followed though sizable increases in food and energy prices con­ by robust expansion in October. Inflation measures were tinued. However, the Committee believed that the soft­ moderate, although up somewhat from one year earlier. ness in economic activity was caused importantly by On balance, the Committee saw the economy as growing higher prices of imported oil and would prove short lived. at a pace that would reduce margins of slack in the utili­ With financial conditions remaining stimulative, the zation of resources. The Committee also judged that economy appeared poised to grow at a pace sufficient to inflationary pressures would likely be well contained if trim slack in resource utilization. In that regard, given monetary policy accommodation were gradually with- the unusually low level of the federal funds rate, espe­ drawn. The Committee’s decision to raise its target for cially relative to the level of inflation, policymakers noted the federal funds rate from 13/ 4 percent to 2 percent with that significant cumulative policy tightening would likely minimal change in the language in the accompanying be needed to meet the Federal Reserve’s long-run objec­ statement was largely anticipated by financial markets tives of price stability and sustainable economic growth. and elicited little reaction. The Committee’s decision at the meeting to raise its At its December meeting, the Committee viewed avail- target for the federal funds rate 25 basis points, to able information as continuing to indicate that the pace 11/ 2 percent, and to maintain its assessment of balanced of the economic expansion was sufficient to further risks with respect to sustainable growth and price stabil­ reduce the underutilization of resources, despite elevated ity was largely anticipated by financial markets. How- oil prices. Consumer spending remained solid, investment ever, market participants revised up their expectations spending was strong, and manufacturing production for the path of the federal funds rate, reportedly because showed modest growth. Also, employment gains in the announcement conveyed a somewhat more optimis­ October and November were consistent with gradual tic outlook for the economy than many had anticipated. improvement in the labor market. Meanwhile, core infla­ By the time of the September FOMC meeting, avail- tion, while above the unusually low rates of late 2003, able information suggested that the economy had regained remained subdued. Accordingly, the Committee voted to momentum. Real consumer spending bounced back raise its target for the federal funds rate 25 basis points, sharply in July after a weak second quarter, and incom­ to 21/ 4 percent, and to retain the previous statement that ing data on industrial production indicated a modest the removal of policy accommodation would likely be strengthening. Housing activity had increased further, and “measured.” Investors had largely anticipated the policy business outlays had picked up significantly in the sec­ rate decision, but a few market participants had report­ ond quarter. In addition, the labor market showed signs edly speculated that the Committee would signal increased of improvement in August, as the unemployment rate concern about inflationary pressures. In the absence of edged down and nonfarm payrolls grew moderately. Core any such signal, implied rates on near-dated futures con- consumer price inflation slowed in June and July, and a tracts and longer-term Treasury yields declined a few basis decline in energy prices from record levels pushed down points after the release of the December statement. readings on headline inflation. Although the Committee Also at its December meeting, the Committee consid­ acknowledged that higher oil prices had damped the pace ered an accelerated release of the minutes of FOMC meet­ of economic activity around midyear, it nonetheless saw ings. The Committee’s practice had been to publish the the expansion as still on solid footing. Consequently, the minutes for each meeting on the Thursday after the next Committee agreed to increase its target for the federal scheduled meeting. The Committee believed that, because funds rate another 25 basis points, to 13/ 4 percent; to reit­ the minutes contain a more nuanced explanation of policy erate its view that the risks to price stability and to sus­ decisions than the statement released immediately after tainable growth were balanced; and to repeat its indica­ each meeting, publishing them on a timelier basis would tion that the removal of policy accommodation would help market participants interpret economic developments likely proceed at a “measured” pace. The reaction in and thereby better anticipate the course of interest rates. financial markets to the policy rate decision and the Earlier release would also provide a context for the pub­ accompanying statement was muted. lic remarks of individual FOMC members. It was also The information in hand at the time of the November recognized, however, that financial markets might misin­ FOMC meeting generally suggested that the economy had terpret the minutes at times and that earlier release might continued to expand at a moderate rate despite the adversely affect the Committee’s discussions and, per- restraint that higher oil prices imparted to real incomes haps, the minutes themselves. After weighing these con­ and consumer confidence. Consumer and business spend­ siderations, the Committee voted unanimously to pub­ ing stayed firm, and the housing market remained buoy- lish the FOMC minutes three weeks after the day of the ant. However, industrial production was about unchanged, policy decision. 4 Monetary Policy Report to the Congress February 2005 The information that the Committee reviewed at its the chain-type price index for personal consumption February 2005 meeting indicated that the economy had expenditures excluding food and energy (core PCE) will continued to expand at a steady pace. The labor market increase between 11/ 2 percent and 13/ 4 percent both this showed signs of further improvement, and consumer year and next—about the same as the 1.6 percent increase spending and the housing market remained robust. posted over 2004. Industrial production accelerated, particularly at the end of 2004, and growth of business fixed investment was solid in the fourth quarter. Core inflation stayed moder­ ECONOMIC AND FINANCIAL DEVELOPMENTS ate, and measures of inflation expectations remained well IN 2004 AND EARLY 2005 anchored. Given the solid economic expansion and lim­ The economy proved to be sufficiently resilient to main­ ited price pressures, the Committee voted to continue its tain solid growth and moderate core inflation in 2004 removal of policy accommodation by raising its target even as higher oil prices drained consumers’ purchasing f a o n r d t h to e f e e s d se e n ra ti l a f l u ly n d r s e p ra e t a e t f t r h o e m l a 2 n 1 g / 4 u p a e g r e c e o n f t t t h o e 2 D 1/ 2 e c p e e m rc b en er t power and boosted firms’ costs. Real GDP rose 33/ 4 per- statement. Futures market quotes indicated that investors cent last year after having increased 41/ 2 percent in 2003. Activity was supported by continued robust advances in had already priced in a 25 basis point increase in the tar- household spending. In addition, capital spending by get federal funds rate at the meeting, and market partici­ businesses increased notably. Labor market conditions pants reportedly expected no substantive changes to the improved significantly, though at an uneven pace over accompanying statement. Accordingly, the reaction in fi­ the course of the year. Private payrolls, which turned up nancial markets to the announcement was minimal. in late 2003, rose 170,000 per month last year, on aver- age, and the unemployment rate declined below 51/ 2 per- Economic Projections for 2005 and 2006 cent by year-end and to 51/ 4 percent in January 2005— the lowest rates since 2001. Federal Reserve policymakers expect the economy to Consumer price inflation was driven higher last year expand moderately and inflation to remain low in 2005 by the sharp rise in energy prices. Although core con­ and 2006.1 The central tendency of the forecasts of real sumer price inflation moved up somewhat from unusu­ GDP growth made by the members of the Board of Gov­ ally low levels recorded in 2003, it remained well con­ ernors and the Federal Reserve Bank presidents is tained. Price increases were restrained by continuing, 33/ 4 percent to 4 percent over the four quarters of 2005. though diminishing, slack in labor and product markets, The civilian unemployment rate is expected to average which tended to offset the effects of higher energy and about 51/ 4 percent in the fourth quarter of 2005. For 2006, commodity prices, as well as the weaker dollar, on firms’ the policymakers project real GDP to increase about overall costs. In addition, solid productivity gains 31/ 2 percent, and they expect the unemployment rate to implied that unit labor costs rose only modestly, even if edge down to between 5 percent and 51/ 4 percent. With up from the declines in the preceding two years. The regard to inflation, FOMC participants project that decline in crude oil prices, on balance, since October points to some easing of cost pressures on firms from 1. As a further step to enhance monetary policy communications, that source in the period ahead. Federal Reserve policymakers will now provide economic projections Several forces likely contributed to last year’s impres­ for two years, rather than one, in the February Monetary Policy Report. sive economic performance in the face of the sizable Economic projections for 2005 and 2006 Percent Federal Reserve Governors and Reserve Bank presidents Indicator 200 M 4 E a M c O tu al 2005 2006 Range Central Range Central tendency tendency Change, fourth quarter to fourth quarter1 Nominal GDP ........................................................................ 6.2 5–6 5½–5¾ 5–5¾ 5 –5½ Real GDP .............................................................................. 3.7 3½–4 3¾–4 3¼–3¾ 3½ PCE price index excluding food and energy ........................ 1.6 1½–2 1½–1¾ 1½–2 1½–1¾ Average level, fourth quarter Civilian unemployment rate .................................................. 5.4 5–5½ 5¼ 5–5¼ 5 –5¼ 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated. Board of Governors of the Federal Reserve System 5 Change in real GDP spreads on corporate bonds narrowed, and commercial banks eased terms and standards on business loans. In Percent, annual rate this environment, household debt again increased briskly. The borrowing needs of nonfinancial businesses were damped by their strong cash flows. Equity values rose, 6 especially toward the end of the year. At the same time, the exchange value of the dollar declined, on net, over the year as market participants apparently focused on the 4 financing implications of the large and growing U.S. cur- rent account deficit. 2 The Household Sector Consumer Spending 1998 2000 2002 2004 NOTE. Here and in subsequent charts, except as noted, change for a given Consumer spending grew substantially last year. Personal period is measured to its final quarter from the final quarter of the preceding consumption expenditures (PCE) advanced nearly 4 per- period. SOURCE. Department of Commerce, Bureau of Economic Analysis. cent in real terms, about the same as the increase in 2003. Sales of new motor vehicles remained brisk, on average, adverse oil shock. The growth of real output continued at 163/ 4 million units. Excluding motor vehicles, consumer to be undergirded by gains in structural labor productiv­ spending on most categories of durable and nondurable ity. Moreover, fiscal policy remained stimulative last year goods rose rapidly, as gains in real expenditures for food through the combination of the lagged effect of earlier and clothing both exceeded 5 percent; however, spend­ cuts in personal tax rates, the rise in defense spending, ing on computing equipment increased less in 2004 than and perhaps also the partial-expensing tax incentives for in preceding years, and consumers responded to the high business investment. Monetary policy was highly accom­ cost of gasoline and heating fuel by cutting back on real modative in the early part of the year and remained spending for these items. Real outlays for services also accommodative, though progressively less so through- increased rapidly last year, and medical services posted out the year, and credit remained readily available at especially large gains. favorable terms. Consumer demand was also boosted by Real disposable personal income (DPI) rose nearly the strong increases in asset values during the past two 4 percent last year, but this figure is exaggerated by years. Microsoft’s $32 billion special dividend payment in Financial conditions remained stimulative last year December (the bulk of which is estimated to have even as market participants revised up their expectations accrued to U.S. households). If this one-time event for the near-term path of monetary policy. Interest rates is excluded from the calculation, real DPI rose only on longer-term Treasury securities remained low, risk 23/ 4 percent in 2004, well below the increase posted in 2003. Faster job growth helped to support increases in Change in PCE chain-type price index Change in real income and consumption Percent Percent, annual rate Total Excluding food and energy Disposable personal income Personal consumption expenditures 3 6 2 4 1 2 1998 2000 2002 2004 1998 2000 2002 2004 NOTE. The data are for personal consumption expenditures (PCE). SOURCE. Department of Commerce, Bureau of Economic Analysis. SOURCE. Department of Commerce, Bureau of Economic Analysis. 6 Monetary Policy Report to the Congress February 2005 households’ incomes last year in nominal terms, and the Wealth-to-income ratio Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which brought lower personal tax rates for- Ratio ward into 2003, led to larger refunds and smaller final payments in the spring of 2004. However, real income gains were held down, as higher oil prices siphoned off 6 household purchasing power. With the growth of real consumption spending out- pacing that of real income through most of last year, the 5 personal saving rate moved lower, from 11/ 2 percent, on average, in 2003 to only 1/ 2 percent in the third quarter of last year. (The fourth-quarter surge in income associated 4 with the Microsoft dividend payments pushed the saving rate back up to 11/ 4 percent, but this increase will likely be reversed early this year as dividend income falls back. 1984 1988 1992 1996 2000 2004 Because the company’s share price declined in step with NOTE. The data are quarterly and extend through 2004:Q3. The wealth- the dividend payouts, the dividends had no effect on share- to-income ratio is the ratio of household net worth to disposable personal income. holders’ overall financial resources and so probably had SOURCE. For net worth, Federal Reserve Board, flow of funds data; for little effect on consumption.) income, Department of Commerce, Bureau of Economic Analysis. Low interest rates were one factor that helped to sup- port consumption growth—especially for durable wealth feeds through into household spending over a goods—despite comparatively slow gains in real income. period of several quarters, the wealth increases in both Higher household wealth was also an important force that 2003 and 2004 were important in supporting consumer propelled consumer spending last year. According to the spending last year. The rise in house prices, together with Federal Reserve’s flow of funds accounts, the ratio of continued low interest rates, also led consumers to household net worth to disposable income rose sharply extract additional equity from their homes, in particular in 2003, as corporate equity values rebounded and home through home equity loans. Such actions provided many prices continued to rise. Moreover, although equity val­ households with a readily available and relatively low- ues were little changed, on net, through much of 2004 cost source of funds for financing consumption. before rising notably in the final quarter, home prices Consumer confidence, which had improved in 2003, continued to rise throughout the year, and the wealth-to- remained at generally favorable levels last year, accord­ income ratio moved up further; by the third quarter (the ing to surveys by both the Michigan Survey Research most recent period for which the complete wealth data Center (SRC) and the Conference Board. Confidence are available), the ratio had reversed nearly half its tended to dip at times during the year when energy prices decline since the stock market peak in 2000. Because were moving up most rapidly, but it recovered soon after those episodes. Consumer sentiment Personal saving rate 1985 = 100 1966 = 100 Percent 140 140 12 Conference Board 120 120 9 100 100 Michigan SRC 6 80 80 3 60 60 1993 1996 1999 2002 2005 1984 1988 1992 1996 2000 2004 NOTE. The data are monthly and extend through January 2005. NOTE. The data are quarterly and extend through 2004:Q4. SOURCE. The Conference Board and University of Michigan Survey SOURCE. Department of Commerce, Bureau of Economic Analysis. Research Center. Board of Governors of the Federal Reserve System 7 Mortgage rates Change in house prices Percent Percent Fixed rate 12 7 Repeat-transactions index 9 5 6 Adjustable rate 3 3 New home price index + 0_ 2001 2002 2003 2004 2005 1984 1988 1992 1996 2000 2004 NOTE. The data, which are weekly and extend through February 9, 2005, NOTE. The repeat-transactions index includes purchase transactions only are contract rates on thirty-year mortgages. and extends through 2004:Q3. The new home price index extends through SOURCE. Federal Home Loan Mortgage Corporation. 2004:Q4. Change is over four quarters. SOURCE. For repeat transactions, Office of Federal Housing Enterprise Oversight; for new home prices, Department of Commerce, Bureau of the Census. Residential Investment Residential investment remained robust last year. Real rapid pace of 1.5 million units started in 2003. In the expenditures increased 53/ 4 percent in 2004—the third multifamily sector, starts totaled a solid 350,000 units straight year of strong gains. Demand for housing was last year, a figure in line with that of the preceding sev­ influenced by the same factors that affected household eral years. Sales of both new and existing single-family spending more generally, but it was especially supported homes hit new highs last year, and home prices moved by nominal mortgage interest rates that have remained up sharply. The repeat-transactions price index for exist­ near their lowest levels since the late 1960s. Rates on ing homes (limited to purchase transactions only), which thirty-year fixed-rate mortgages fluctuated between about is published by the Office of Federal Housing Enterprise 51/ 2 percent and 61/ 4 percent over the past two years; they Oversight, climbed more than 10 percent over the four edged up to the high end of that range during the spring quarters ending in the third quarter of last year (the latest but dropped back to under 6 percent by the end of sum­ quarter for which data are available) and is up a cumula­ mer and now stand below 53/ 4 percent. tive 65 percent since 1997, when it started to rise notably In the single-family sector, housing starts amounted more rapidly than overall inflation. These price increases to 1.6 million units last year, a rate faster than the already have also outstripped by a wide margin the increases in household incomes and rents. Another nationwide price index, the Census Bureau’s constant-quality price index Private housing starts for new homes, rose only 63/ 4 percent last year. Because this index does not adjust for the location of new homes Millions of units, annual rate within metropolitan areas, and because new homes con­ stitute only a small fraction of the overall housing stock, this index is probably a less reliable indicator of overall 1.6 home values than is the repeat-transactions index. Single-family 1.2 Household Finance .8 Household debt is estimated to have increased about Multifamily 93/ 4 percent in 2004, a touch less than in the previous .4 year. Mortgage debt again paced this advance. The brisk expansion of mortgages reflected continued strong activity in housing markets and rising house prices. How- 1992 1994 1996 1998 2000 2002 2004 ever, the growth rate of mortgage debt did not quite match NOTE. The data are quarterly and extend through 2004:Q4. SOURCE. Department of Commerce, Bureau of the Census. that registered in 2003. Refinancing activity fell off 8 Monetary Policy Report to the Congress February 2005 Household financial obligations ratio hold financial obligations and debt service, which cap­ ture pre-committed expenditures relative to disposable Percent income, were little changed last year, on balance, though they remained high by historical standards. Nevertheless, 20 measures of household credit quality either held steady or improved during the course of the year. The latest avail- 19 able data indicate that delinquency rates on credit card 18 loans, consumer loans, and residential mortgages at commercial banks declined, while those on auto loans at 17 captive finance companies were about unchanged at a low level. Household bankruptcy filings ran below the 16 elevated levels of 2003, although they stayed generally 15 above the rates posted in earlier years. 1992 1995 1998 2001 2004 The Business Sector NOTE. The data are quarterly and extend through 2004:Q4. The final observation, 2004:Q4, is a projection. The financial obligations ratio equals the sum of required payments on mortgage and consumer debt, automobile Fixed Investment leases, rent on tenant-occupied property, homeowners’ insurance, and property taxes, all divided by disposable personal income. Business fixed investment rose robustly for a second con­ secutive year in 2004. Real spending on equipment and sharply last year, as the pool of outstanding mortgages software (E&S) increased 131/ 2 percent, about as much with interest rates above current market rates shrank con­ as in 2003, as firms’ final sales continued to increase, siderably. Mortgages with adjustable interest rates, profits and cash flow rose further, and many businesses including hybrids that feature both fixed and adjustable interest rate components, were increasingly popular in 2004. Consumer credit continued to expand at a moder­ Change in real business fixed investment ate pace by historical standards, restrained in part by the Percent, annual rate substitution of other forms of debt, such as home equity Structures loans. Higher interest rates on some consumer loans and Equipment and software credit cards in the second half of 2004 may have also 20 damped the growth of consumer credit. Relatively low interest rates and further gains in dis­ 10 posable personal income limited pressures on household + balance sheets in 2004. Measures of aggregate house- 0_ 10 Delinquency rates on selected types of household loans 20 Percent High-tech equipment and software Credit card pools 6 Other equipment excluding transportation 30 5 20 4 Auto loans at domestic auto finance companies 3 10 + Mortgages 2 0_ 1 10 1992 1994 1996 1998 2000 2002 2004 1998 2000 2002 2004 NOTE. The data are quarterly. The rates for credit card pools and mortgages extend through 2004:Q3; the rate for auto loans extends through 2004:Q4. NOTE. High-tech equipment consists of computers and peripheral equip­ SOURCE. For credit cards, Moody’s Investors Service; for auto loans, Big ment, software, and communications equipment. Three automakers; for mortgages, Mortgage Bankers Association. SOURCE. Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 9 reported a need to replace or upgrade existing equipment Change in real business inventories and software. Although many firms had little need to seek outside financing given their flush cash situation, Billions of chained (2000) dollars, annual rate those that did generally found financial markets to be receptive—interest rates remained low and other terms 75 and conditions stayed relatively favorable. The partial- expensing tax incentives, which covered new equipment 50 and software installed by the end of 2004, boosted prof- its and cash flow and may have also stimulated some 25 investment spending. + Increases in E&S spending were fairly widespread 0_ across categories of capital goods. Spending on high- 25 technology equipment increased 15½ percent last year after having risen 19 percent in 2003; these gains fol­ lowed two years of declines. Although the pattern of 1998 2000 2002 2004 spending was uneven over the four quarters of 2004, for SOURCE. Department of Commerce, Bureau of Economic Analysis. the year as a whole, business outlays for computing equip­ ment rose 25 percent in real terms, while spending on software and communications equipment posted increases of 13 percent and 10 percent respectively. Outside of the tories that were increasingly lean relative to sales. In 2004, high-tech sector, business spending on aircraft moved when stocks had become quite spare—even after taking lower for the third consecutive year, as airlines contin­ into account the ongoing improvements in inventory ued to struggle with a highly competitive market envi­ management that have allowed firms to economize on ronment and high fuel prices. In contrast, business out- stockholding—and businesses had apparently grown more lays on motor vehicles rose substantially last year, with confident in the durability of the recovery, businesses the demand for trucks exceptionally strong. Investment accumulated $45 billion of inventories (in real terms), in equipment other than high-tech and transportation according to preliminary data. The step-up in the pace of goods—a category that includes industrial machinery stockbuilding contributed about 1/ 4 percentage point to and a wide range of other types of equipment—moved GDP growth last year. up 11 percent last year, the most in more than ten years. In contrast to the rebound in equipment spending, real outlays in the nonresidential construction sector were Corporate Profits and Business Finance about unchanged for a second year in 2004 and have yet to recover from their sharp downturn during 2001 and Strong growth of corporate profits again allowed many 2002. In the office sector, where construction increased firms to finance capital spending with internal funds last rapidly in the late 1990s, spending has remained espe­ year. As a result, nonfinancial business debt rose at only cially weak; vacancy rates for these properties, although a moderate pace. Net equity issuance dropped further into down a touch over the past year, are still quite elevated. negative territory in 2004, and on balance nonfinancial Construction of industrial buildings has also remained corporations are estimated to have raised no net funds in low as a result of high vacancy rates. In contrast, demand credit and equity markets. However, short-term business for new retail and wholesale properties has been firmer, debt, including commercial paper and commercial and reportedly a reflection of the steady increases in consumer industrial (C&I) loans, expanded last year after three years spending, and outlays for these types of buildings moved of contraction, and commercial mortgage debt continued higher last year. In addition, investment in the drilling to increase rapidly. The credit quality of businesses and mining sector rose last year in response to high prices remained strong. for natural gas. Corporate profits held up well in 2004 after surging in the previous year. The ratio of before-tax profits of non- financial corporations to that sector’s gross value added increased for a second consecutive year. In the fourth Inventory Investment quarter of 2004, operating earnings per share for S&P Businesses added appreciably to inventories last year for 500 firms were nearly 20 percent above their level four the first time since running down their holdings sharply quarters earlier. Analysts’ earnings forecasts began to in 2001. As economic activity strengthened during 2002 moderate somewhat in the second half of 2004 after sev­ and 2003, many businesses chose to operate with inven- eral months of strong upward revisions. 10 Monetary Policy Report to the Congress February 2005 Before-tax profits of nonfinancial corporations Selected components of net business financing as a percent of sector GDP Billions of dollars Percent Commercial paper Bonds 14 Bank loans Sum of selected 400 components 12 200 + 10 0_ 8 200 6 2002 2003 2004 1980 1984 1988 1992 1996 2000 2004 NOTE. Seasonally adjusted annual rate for nonfinancial corporate business. NOTE. The data are quarterly and extend through 2004:Q3. Profits are from The data for the sum of selected components are quarterly. The data for domestic operations of nonfinancial corporations, with inventory valuation 2004:Q4 are estimated. and capital consumption adjustments. SOURCE. Federal Financial Institutions Examination Council, Consolidated SOURCE. Department of Commerce, Bureau of Economic Analysis. Reports of Condition and Income (Call Report). In equity markets, net issuance of shares by nonfinan­ issue bonds. Firms reportedly used a large portion of the cial firms turned more negative in 2004. Although initial proceeds to pay down existing debt, although some com­ public offerings rebounded from the sluggish pace of panies used the funds raised in the bond market to repur­ the past two years, ample profits and sizable cash hold­ chase equity shares or to finance mergers. ings helped boost share retirements from mergers and Short-term business borrowing revived in 2004 after repurchases. a prolonged contraction. Commercial paper outstanding Net corporate bond issuance was sluggish in 2004, as turned up in the first half of the year, although it flattened firms evidently relied heavily on their considerable prof- out over the second half. Business loans at banks its to fund investment in fixed capital and inventories. rebounded over the course of last year. According to The timing of gross bond issuance was influenced by results from the Federal Reserve’s Senior Loan Officer interest rate movements during the year, as firms took advantage of occasional dips in longer-term yields to Net percentage of domestic banks tightening standards on commercial and industrial loans Financing gap and net equity retirement to large and medium-sized firms at nonfinancial corporations Percent Billions of dollars 300 60 250 Net equity retirement 40 200 150 20 100 + Financing gap 0_ 50 + 0_ 20 50 1991 1993 1995 1997 1999 2001 2003 2005 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. The data are based on a survey generally conducted four times per NOTE. The data are annual; 2004 is based on partially estimated data. The year; the last reading is from the January 2005 survey. Large and financing gap is the difference between capital expenditures and internally medium-sized firms are those with annual sales of $50 million or more. Net generated funds. Net equity retirement is the difference between equity percentage is the percentage reporting a tightening less the percentage retired through share repurchases, domestic cash-financed mergers, or foreign reporting an easing. takeovers of U.S. firms and equity issued in public or private markets, SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank including funds invested by venture capital partnerships. Lending Practices. Board of Governors of the Federal Reserve System 11 Opinion Survey on Bank Lending Practices, commercial Default rate on outstanding corporate bonds banks eased terms and standards on business loans dur­ ing the course of 2004 in response to the improved eco­ Percent nomic outlook and to increased competition from other banks and nonbank lenders. Survey responses also indi­ 4 cated an increase in demand for C&I loans that reflected firms’ need to fund rising accounts receivable, invento­ 3 ries, capital expenditures, and merger activity. Concerns over loan quality seemed to diminish further in 2004, as 2 spreads on leveraged deals in the syndicated loan market edged down from already low levels. 1 Corporate credit quality remained solid in 2004 amid + strong earnings, low interest rates, and a further buildup 0_ of already substantial cash positions on firms’ balance sheets. The delinquency rate on C&I loans declined fur­ 1992 1994 1996 1998 2000 2002 2004 ther, and the twelve-month trailing default rate on corpo­ NOTE. The data are monthly and extend through December 2004. The rate rate bonds fell to historically low levels before edging up 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 late in the year. Net upgrades of bonds by Moody’s outstanding at the end of the calendar quarter immediately preceding the Investor Service for both investment- and speculative- twelve-month period. SOURCE. Moody’s Investors Service. grade nonfinancial firms increased last year. The stock of commercial mortgage debt outstanding The Government Sector grew at a rapid pace in 2004. Some firms reportedly con­ tinued to find mortgages an attractive source of long-term Federal Government funding. The expansion of commercial mortgage credit helped propel issuance of commercial-mortgage-backed The federal budget position deteriorated slightly further securities (CMBS) to near-record levels. Delinquency in 2004, as spending increases and further tax reductions offset the effects of stronger economic growth on rev­ rates on commercial mortgages on the books of banks enues. The unified budget deficit widened from $378 bil­ and insurance companies remained low throughout the lion in fiscal 2003 to $412 billion in fiscal 2004. As a year, and those on loans backing mortgage securities fell. share of GDP, the federal unified deficit stood close to Considerable gains in commercial real estate prices increased owners’ equity and largely kept pace with the 31/ 2 percent in both years. Receipts increased 51/ 2 percent in fiscal 2004 after two years of declines. Corporate sizable increase in mortgage debt obligations. Yield receipts surged more than 40 percent, or $58 billion, spreads of CMBS over comparable Treasury securities reflecting the improvement in corporate profits; individual remained moderate. tax receipts—restrained by JGTRRA, which pulled for- Net interest payments of nonfinancial corporations Federal receipts and expenditures as a percent of cash flow Percent of nominal GDP Percent 24 Expenditures 20 22 Receipts Expenditures 20 15 excluding net interest 18 10 16 1986 1989 1992 1995 1998 2001 2004 1980 1984 1988 1992 1996 2000 2004 NOTE. The budget data are from the unified budget and are for fiscal years NOTE. The data are quarterly and extend through 2004:Q3. (October through September); GDP is for the year ending in Q3. SOURCE. Department of Commerce, Bureau of Economic Analysis. SOURCE. Office of Management and Budget. 12 Monetary Policy Report to the Congress February 2005 ward reductions of personal tax rates that had been sched­ in the autumn provided disaster aid for victims of hurri­ uled for the second half of the decade—rose only about canes and for ranchers and farmers affected by drought 2 percent. Overall federal receipts increased less rapidly conditions. than nominal GDP, and the ratio of receipts to GDP edged The recent sizable deficits in the unified budget mean down to 161/ 4 percent, the lowest level in more than forty that the federal government, which had been contribut­ years. ing to the pool of national saving from 1997 through 2000, Meanwhile, nominal federal outlays increased about has been drawing on that pool since 2001. Net federal 6 percent in fiscal 2004. Spending for national defense saving—essentially the unified budget balance adjusted increased especially sharply, but spending also increased to the accounting practices of the national income and notably for Medicare and Medicaid. Debt service costs, product accounts (NIPA)—dropped from positive 2 per- which fell sharply from 1997 through 2003 as a result of cent of GDP in 2000 to a level below negative 3 percent reduced debt and declining interest rates, edged higher of GDP in 2003 and 2004. Personal saving moved lower last year. Federal government purchases of goods and ser­ over this period as well, while business net saving rose vices—the part of spending that is counted in GDP— with the rebound in corporate profits. In all, net national rose about 4 percent in real terms in 2004 after larger saving edged up in 2004 but remained near its postwar increases in the preceding two years. (Government spend­ lows. Because net national saving has fallen increasingly ing on items such as interest payments and transfers is short of net domestic investment over the past several excluded from GDP because these items do not consti­ years, the inflow of foreign funds needed to finance that tute a direct purchase of final production.) investment has risen. The growing inflow of foreign capi­ Regarding legislative initiatives, two new tax bills were tal is mirrored in the widening of the nation’s current enacted in the fall of 2004. First, the Working Families account deficit. Over time, the low national saving rate Tax Relief Act extended through 2010 a variety of per­ could eventually slow the rise in living standards either sonal tax reductions that had previously been set to by increasing the burden of servicing U.S. foreign debt expire earlier. Second, the American Jobs Creation Act or by impinging on domestic capital formation. replaced the exclusion of extraterritorial income (which The growth rate of Treasury debt moderated slightly the World Trade Organization had declared an illegal last year after increasing substantially in 2003. Nonethe­ export subsidy) with numerous other tax reductions for less, federal debt held by the public as a percentage of domestic manufacturers and U.S. multinationals. The first GDP continued to edge higher over the course of 2004 bill is expected to have a ten-year budget cost of around and currently stands at about 361/ 2 percent. To help $150 billion, while the second bill was scored as being finance substantial budget deficits, the Treasury issued revenue neutral. As for federal spending in fiscal 2005, a considerable volume of bills as well as two-, three-, the regular appropriations bills provided for sizable five-, and ten-year nominal notes. In addition, the Trea­ increases in spending on defense and homeland security sury expanded its borrowing program in 2004 by adding and for modest increases in nondefense discretionary semiannual auctions of twenty-year inflation-protected expenditures. In addition, emergency legislation passed bonds and five-year inflation-protected notes. Net saving Change in real government expenditures on consumption and investment Percent of nominal GDP Percent 12 Federal Nonfederal saving State and local 9 9 6 6 3 Total + 0_ 3 Federal saving 3 + 0_ 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 NOTE. The data are quarterly and extend through 2004:Q3. Nonfederal 1998 2000 2002 2004 saving is the sum of personal and net business saving and the net saving of state and local governments. SOURCE. Department of Commerce, Bureau of Economic Analysis. SOURCE. Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 13 Federal government debt held by the public resorted to accounting devices, suspended issuance of state and local government series securities, and post­ Percent of nominal GDP poned a four-week bill auction. In mid-November, Con­ gress raised the debt ceiling from $7.4 trillion to $8.1 trillion, and the Treasury subsequently resumed nor­ 55 mal financing operations. 45 State and Local Governments 35 Pressures on the budgets of state and local governments have eased as economic activity has strengthened. Tax 25 receipts have been spurred by the increases in household income, consumer spending, and property values. As a result, many states seem to be on track to meet balanced 1964 1974 1984 1994 2004 budget requirements in the current fiscal year (which ends NOTE. Through 2003, the data for debt are year-end figures, and the June 30 for all but a few states) without using as much corresponding value for GDP is for Q4 at an annual rate; the final observation is for 2004:Q3. Excludes securities held as investments of federal gov­ borrowing or other extraordinary measures as in recent ernment accounts. years. Nevertheless, a number of states still must deal with lingering fiscal problems, particularly depleted Various indicators suggested a continued strong reserve funds, the expiration of temporary tax hikes, and appetite for Treasury securities among foreign investors rising Medicaid costs. In addition, several states still face last year. Indirect bidding at Treasury auctions, which serious structural imbalances in their budgets. includes bidding by the Federal Reserve Bank of New Real expenditures by state and local governments as York on behalf of foreign official institutions, remained measured in the NIPAs remained about flat for a second robust, and Treasury securities held in custody at the Fed­ year in 2004. Real spending on current operations rose eral Reserve Bank of New York on behalf of such institu­ less than 1 percent last year, while real investment spend­ tions increased just over $200 billion in 2004. Also, data ing declined. However, even as they were holding the from the Treasury International Capital System showed a line on spending increases, states and localities were able substantial increase in holdings of Treasury securities by to resume net hiring in 2004 after having left employ­ foreign official and private investors, particularly those ment about unchanged in 2003. in Japan. The proportion of Treasury securities held by Net issuance of debt by state and local governments foreign investors is estimated to have risen to a record edged down from the rapid pace set in 2003, as improved 431/ 2 percent by the third quarter of 2004. budget positions permitted some contraction in short-term Treasury debt reached its statutory ceiling late last year. debt. Advance refunding offerings were again strong dur- To cope with the constraint, the Treasury temporarily State and local government net saving Treasury securities held by foreign investors as a share of total outstanding Percent of GDP Percent .5 45 + 0_ 40 35 .5 30 1983 1986 1989 1992 1995 1998 2001 2004 NOTE. The data, which are quarterly, are on a national income and product 1997 1998 1999 2000 2001 2002 2003 2004 account basis and extend through 2004:Q3. Net saving excludes social insurance funds. NOTE. The data are quarterly and extend through 2004:Q3. SOURCE. Department of Commerce, Bureau of Economic Analysis. 14 Monetary Policy Report to the Congress February 2005 ing the year, as states and municipalities took advantage After increasing at an annual rate of almost 6 percent of low long-term interest rates and moderate credit in the first half of 2004, prices of exported goods moved spreads. Credit quality of tax-exempt borrowers improved up at just a 21/ 2 percent rate in the second half. This in 2004. Rating upgrades of tax-exempt bonds outpaced deceleration was due in large part to a reversal of the downgrades, especially later in the year. run-up in the prices of agricultural products that had occurred in late 2003 and early 2004. Better harvests last year returned prices of agricultural products to levels near The External Sector those that had prevailed before the spike. Solid growth in income in the United States spurred After narrowing in 2003, the U.S. current account deficit widened again last year and was $660 billion (annual rate), growth of real imports of 91/ 2 percent in 2004. The increase primarily reflected higher imports of goods that or 5.6 percent of GDP, in both the second and third quar­ occurred despite a notable rise in their prices. Real oil ters. Much of this widening reflected a considerable imports expanded almost 10 percent in 2004. Imports of increase in the deficit on goods and services trade, as a capital equipment increased throughout the year, but marked rise in imports more than offset solid increases imports of consumer goods suffered a period of weak­ in exports. The trade deficit expanded from $500 billion ness through the middle of the year before rebounding during the fourth quarter of 2003 to more than $650 bil­ in the fourth quarter. Imports of services moved up only lion, on average, during the second half of 2004. 13/ 4 percent in 2004. Prices of imported non-oil goods increased at an annual rate of just over 4 percent in the first half of 2004, International Trade but the pace slowed to 2 percent in the second half. This Real exports of goods and services rose an estimated step-down largely reflected a deceleration in the prices 51/ 2 percent in 2004 despite a deceleration in the fourth of industrial supplies, driven by a leveling off of nonfuel quarter. In the first half, exports were supported by the commodity prices at the elevated levels reached in March. lagged effect of the fall in the dollar’s value in 2003. Declines in the prices of foods offset continued price Strong expansion of foreign economic activity also helped increases for metals. boost exports in the first half, but that stimulus dimin­ The spot price of West Texas intermediate (WTI) crude ished in the second half of the year when foreign growth oil moved up during most of 2004 and surged tempo­ slowed. For the year as a whole, exports of industrial sup- rarily to a record high of $55 per barrel in October. Since plies and capital goods posted solid growth. Exports to then, it has fluctuated somewhat below that peak but still Canada, Mexico, and western Europe rose smartly in at levels well above $33 per barrel, the price at which it 2004, whereas exports to Japan were relatively weak. Real started 2004. Oil prices were driven up by intensified exports of services increased about 31/ 2 percent through concerns that oil supply would not keep pace with sur­ 2004 as a whole. prisingly strong global demand. Oil consumption in China grew nearly 15 percent in 2004, pushing that economy past Japan as the world’s second-largest consumer. As oil prices rose, OPEC increased its oil production, U.S. trade and current account balances Percent of nominal GDP Change in real imports and exports of goods and services + Percent 0_ Imports 1 Exports 15 2 Trade 10 3 Current account 5 4 + 5 0_ 6 5 10 1997 1998 1999 2000 2001 2002 2003 2004 NOTE. The data are quarterly. The trade data extend through 2004:Q4 and 1998 2000 2002 2004 the current account data extend through 2004:Q3. SOURCE. Department of Commerce. SOURCE. Department of Commerce and Federal Reserve staff estimates. Board of Governors of the Federal Reserve System 15 Prices of oil and of nonfuel commodities down some production. Russian oil output, however, con­ tinued despite the breakup of Yukos, formerly Russia’s January 2001 = 100 Dollars per barrel largest oil company. Late in the year, oil prices declined from their October highs, as production recovered in the Gulf of Mexico and OPEC added new capacity. The price 160 50 of the far-dated NYMEX oil futures contract (currently for delivery in December 2011) rose about $10 per bar­ 140 40 rel during 2004, possibly reflecting expectations of greater 120 Oil 30 oil demand in Asian emerging-market economies. The far-dated futures contract averaged about $38 per barrel 100 20 in January 2005, while the spot price of WTI averaged about $48 per barrel. Nonfuel 80 10 The Financial Account 2001 2002 2003 2004 2005 In 2004, the U.S. current account deficit was financed NOTE. The data are monthly and extend through January 2005. The oil once again largely by foreign purchases of U.S. bonds. price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices. Foreign official inflows picked up further last year and SOURCE. For oil, Wall Street Journal; for nonfuel commodities, Inter- were especially strong in the first quarter, reflecting siz­ national Monetary Fund. able bond purchases by Asian central banks. Private for­ eign purchases of U.S. bonds rebounded in 2004 from a diminishing the cartel’s estimated spare capacity to his­ slight decline in 2003, with especially large purchases torically low levels. Increased OPEC production damped coming late in the fourth quarter. In contrast, foreign particularly the rise in prices of heavier, more sulfurous demand for U.S. equities weakened further in 2004, grades of crude oil but had less effect on prices of lighter although this also picked up late in the year. Net pur­ grades like WTI. Supply disruptions also played a role in chases of foreign securities by U.S. investors remained the run-up of oil prices. In October, Hurricane Ivan strong in 2004, with most of the strength coming in the extensively damaged oil and gas production facilities in second half of the year. the Gulf of Mexico, boosting the price of WTI relative to U.S. direct investment abroad continued at a strong other grades of crude oil. Sabotage of production and pace, as reinvested earnings remained sizable. Direct distribution facilities in Iraq hindered oil exports from investment into the United States rebounded in the first that country, which remain below pre-war levels. In three quarters of 2004 from its anemic pace in 2003; glo­ Nigeria, ethnic violence and community protests shut bal mergers and acquisitions revived, and reinvested earn­ ings picked up. Overall, net direct investment outflows continued over the first three quarters of 2004 but at a Prices of major nonfuel commodities lower pace than in 2003. January 2001 = 100 U.S. net financial inflows 145 Metals Billions of dollars Beverages 130 Official 200 Private 175 115 Food 150 Agricultural 100 125 raw materials 100 85 75 50 25 2001 2002 2003 2004 2005 + NOTE. The data are monthly and extend through January 2005. The metals 0_ category includes aluminum, copper, and iron ore; food includes cereals, 25 vegetable oils and protein meals, seafood, and meat; agricultural raw materials consists of timber, cotton, wool, rubber, and hides; beverages 2001 2002 2003 2004 consists of coffee, cocoa beans, and tea. SOURCE. International Monetary Fund. SOURCE. Department of Commerce. 16 Monetary Policy Report to the Congress February 2005 U.S. net international securities transactions May; net hiring then dropped back to subpar rates of about 100,000 per month in June through September. In the four Billions of dollars months since then, increases in private payrolls have Net private foreign purchases of U.S. securities averaged 165,000 per month. 175 The improved pace of hiring was widespread, as all Bonds 150 major industry groups contributed to faster employment Equities 125 growth relative to that of the latter part of 2003. The larg­ est gains were in professional and business services and 100 health services. The construction sector also posted sub­ 75 stantial gains. In the manufacturing sector—where 50 employment had declined almost continuously since early 25 2000—payrolls increased in the spring when overall + employment was rising sharply but were about unchanged, 0_ on net, over the second half of the year. Employment gains 2001 2002 2003 2004 in retail trade and in food services were also brisk over the first half of the year but tapered off in the second SOURCE. Department of Commerce and the Federal Reserve Bank of New York. half. Meanwhile, state and local governments added sub­ stantially to their payrolls last year, especially for educa­ Net inflows of portfolio capital exceeded net outflows tion, but civilian employment in the federal government of direct investment and represented the financial coun­ edged lower. terpart to the U.S. current account deficit. These net The unemployment rate fell from near 6 percent in financial inflows imply a further decline in the U.S. net late 2003 to less than 51/ 2 percent by late last year; job­ international investment position, which began 2004 at lessness fell further in January 2005, to 51/ 4 percent. The a reported level of negative $2.4 trillion (22 percent of decline in the unemployment rate over the past year GDP). reflected both the pickup in hiring and a labor force par­ ticipation rate that remained surprisingly low. From 2001 through 2003, the participation rate declined by more than The Labor Market would have been predicted on the basis of past relation- ships with indicators of labor demand, and in 2004, when Employment and Unemployment the pace of hiring increased, the participation rate lev­ The labor market improved notably in 2004. Private pay- eled off but failed to rise. These considerations suggest rolls, which began to post sustained increases in late 2003, that there may be a persistent component to the recent rose an average of 170,000 per month last year. Progress softness in participation. However, participation had been was not steady over the course of the year, however. quite strong through 2000, when the labor market was Employment growth stepped up sharply in the spring to a extremely tight, and the fact that participation turned down pace of almost 300,000 per month in March, April, and Civilian unemployment rate Net change in payroll employment Percent Thousands of jobs, monthly average Private nonfarm Jan. 300 9 200 100 6 + 0_ 3 100 200 1975 1985 1995 2005 1999 2001 2003 2005 NOTE. The data are monthly and extend through January 2005. SOURCE. Department of Labor, Bureau of Labor Statistics. SOURCE. Department of Labor, Bureau of Labor Statistics. Board of Governors of the Federal Reserve System 17 Labor force participation rate gains seem to have been related to more effective use of capital equipment that had been acquired earlier and to Percent one-time organizational innovations induced by firms’ earlier reluctance to commit to increased hiring. Still, last year’s 21/ 2 percent increase in productivity was impres­ 67 sive by long-run standards: It was in line with the pace of the late 1990s and well above rates that had prevailed during the preceding two decades. 64 Increases in hourly labor compensation remained mod­ erate last year. As measured by the employment cost in­ dex (ECI), which is based on a quarterly survey from the 61 Bureau of Labor Statistics, hourly compensation in pri­ vate nonfarm businesses increased 33/ 4 percent in 2004, a bit less than in 2003. An alternative measure is com­ 1975 1985 1995 2005 pensation per hour in the nonfarm business sector as derived from compensation data in the NIPAs. This mea­ NOTE. The data are monthly and extend through January 2005. SOURCE. Department of Labor, Bureau of Labor Statistics. sure of hourly compensation rose 31/ 2 percent last year, an increase similar to that in the ECI but substantially at the same time that labor demand weakened suggests less than the 51/ 2 percent rise in 2003. that at least some of the recent low participation is cycli­ As has been the case for several years, the cost of cal. To the extent that some of this low participation proves employee benefits rose considerably more than did wages to be transitory, the resumption of more-rapid labor force and salaries last year. The benefits component of the ECI growth will limit the speed at which employment gains increased nearly 7 percent, while the wages and salaries further push down the unemployment rate. component posted a much more moderate 3 percent increase. The rise in hourly wages and salaries was about the same as increases in the preceding two years; although Productivity and Labor Costs probably boosted by last year’s higher rate of price infla­ tion, wages were likely held down by the continued, Labor productivity rose solidly again last year. Output though diminishing, labor market slack and also by per hour in the nonfarm business sector increased an employers’ attempts to offset continued large increases estimated 21/ 2 percent over the year. This increase was in benefits costs. Health insurance costs continued to rise somewhat below the outsized 4 percent average pace of rapidly. As measured by the ECI, employers’ costs of increase from 2001 through 2003. Those earlier huge pro­ health insurance, which account for about 6 percent of ductivity gains were not associated with especially large accumulations of new capital equipment, as had been the case during the late 1990s; instead, to a large degree, the Measures of change in hourly compensation Percent Change in output per hour Percent, annual rate 8 Nonfarm compensation per hour 5 6 4 4 3 Employment cost index 2 2 1996 1998 2000 2002 2004 1 NOTE. The data are quarterly and extend through 2004:Q4. For nonfarm compensation, change is over four quarters; for the employment cost index 1948–73 1973–95 1995–2000 2002 2004 (ECI), change is over the twelve months ending in the last month of each quarter. Nonfarm compensation is for the nonfarm business sector; the ECI is NOTE. Nonfarm business sector. for private industry excluding farm and household workers. SOURCE. Department of Labor, Bureau of Labor Statistics. SOURCE. Department of Labor, Bureau of Labor Statistics. 18 Monetary Policy Report to the Congress February 2005 overall compensation costs, rose 7 percent last year after Change in PCE prices excluding food and energy having increased more than 10 percent per year in 2002 and 2003. Percent, annual rate Prices 2 Overall consumer prices rose notably more in 2004 than they did in 2003, and the sharp increase in energy prices accounted for much of the step-up. The chain-type price index for personal consumption expenditures (PCE) rose 1 21/ 2 percent last year, compared with an increase of 13/ 4 percent in 2003. The increase in PCE prices exclud­ ing food and energy was considerably smaller—only 11/ 2 percent, up a little more than ¼ percentage point from 1998 2000 2002 2004 the increase in 2003. Inflation as measured by the market-based component of core PCE prices—which SOURCE. Department of Labor, Bureau of Labor Statistics. excludes a collection of erratic prices that are unobserv­ able from market transactions and which the Bureau of the energy price increase was attributable to the higher Economic Analysis began to publish early last year—was prices of imported oil, which are excluded from GDP in line with overall core PCE inflation last year. The core because they are not part of domestic production. GDP consumer price index (CPI) rose about 2 percent last year prices increased 21/ 2 percent last year, 3/ 4 percentage point after having increased 11/ 4 percent in 2003. (The CPI dif­ faster than in 2003. In addition to the rise in PCE prices fers from PCE prices in a number of respects, but one (excluding the influence of imported oil), GDP prices factor that boosted CPI inflation relative to PCE infla­ were affected by a sizable increase in construction prices tion last year was a difference in the way the two indexes for residential and nonresidential structures. measure the prices of medical services, especially physi­ The jump in consumer energy prices in 2004 was cians’ services, which rose much more rapidly in the CPI driven by the run-up in crude oil prices. The prices of than in the PCE index.) The rise in core consumer prices both gasoline and fuel oil increased approximately was largest in the early months of 2004: Core PCE prices 30 percent over the year, and higher oil costs accounted increased at an annual rate of nearly 2 percent over the for the bulk of the increase. Prices of natural gas, which first half of the year and then decelerated to a 11/ 4 percent can often substitute for fuel oil in the industrial sector, rate of increase in the second half. rose notably as well last year despite the restraining in­ The price index for GDP was less affected by last year’s fluence of ample inventories. Electricity prices, which rise in energy prices than was the PCE measure; much of tend to reflect fuel costs with a lag, also moved higher through most of the year but dropped back some near year-end. Change in consumer prices Consumer food prices rose around 3 percent for a sec­ ond consecutive year in 2004. Exports of beef dropped Percent Consumer price index Chain-type price index for PCE Alternative measures of price change Percent 4 Price measure 2002 2003 2004 Chain-type Gross domestic product ............................ 1.6 1.7 2.4 Gross domestic purchases ......................... 1.8 1.8 2.9 Personal consumption expenditures ......... 1.8 1.7 2.5 2 Excluding food and energy ................... 1.5 1.2 1.6 Market-based PCE excluding food and energy ................................. 1.4 1.0 1.6 Fixed-weight Consumer price index ............................... 2.2 1.9 3.4 Excluding food and energy ................... 2.0 1.2 2.1 1998 2000 2002 2004 NOTE. Changes are based on quarterly averages of seasonally adjusted data. SOURCE. For consumer price index, Department of Labor, Bureau of Labor SOURCE. For chain-type measures, Department of Commerce, Bureau of Eco­ Statistics; for chain-type measure, Department of Commerce, Bureau of nomic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor Economic Analysis. Statistics. Board of Governors of the Federal Reserve System 19 sharply last year when most of the largest importing coun­ TIPS-based inflation compensation tries placed restrictions on U.S. beef after a case of mad cow disease was discovered. Nevertheless, domestic Percentage points demand was sufficiently strong to support consumer meat prices last year. Fruit and vegetable prices trended side- 3.5 ways through most of the year but then rose sharply in Five-year, five-year ahead 3 the fall because of crop damage associated with the series of hurricanes that hit the Southeast in August and 2.5 September. In addition, prices for food away from home, which are driven more by labor costs than by raw food 2 prices, increased more rapidly last year than in 2003. 1.5 Core consumer prices were influenced by a variety of forces last year. Price increases were likely restrained by Five-year 1 continuing slack in labor markets and in some product markets, but businesses faced considerable pressure from 2002 2003 2004 2005 several sources of increased costs. First, the indirect NOTE. The data are daily and extend through February 9, 2005. Based on a effects of the large jump in energy prices fed through to comparison of the yield curve for Treasury Inflation-Protected Securities (TIPS) to the nominal off-the-run Treasury yield curve. businesses throughout the economy and were especially important for firms in energy-intensive industries, such declines in 2003. In particular, the prices of new motor as those that produce plastics and fertilizers. Second, vehicles leveled off after falling notably in 2003, and the prices were up sharply for a number of other industrial prices of used vehicles reversed some of their sharp 2003 commodities, including lumber and a variety of metals. declines. Prices of non-energy PCE services rose about These price increases reflected strengthening economic 2 percent in 2004—a smaller increase than in 2003. activity abroad as well as in the United States. Although Last year’s rise in inflation showed through to short- these non-oil commodities represent a small part of busi­ term measures of expected inflation, but longer-term mea­ nesses’ overall costs, some businesses likely felt the pinch sures remained stable. According to the Michigan SRC, of sustained price increases in these areas. Third, the households’ median expectations for inflation over the declining exchange value of the dollar boosted import next year moved up considerably in the spring as infla­ prices, including those of many inputs to production. tion was rising, but then they eased back and ended the Finally, the deceleration in labor productivity boosted unit year near 3 percent—up from around 21/ 2 percent in late labor costs after two years of declines; nevertheless, last 2003. In contrast, the median expectation for inflation year’s 1 percent rise in unit labor costs was quite modest. over the next five to ten years held about steady near Taken together, these influences left their clearest mark 2¾ percent throughout this period. Inflation compensa­ on the prices of goods rather than services. Core goods tion as measured by spreads between yields on nominal prices were about unchanged, on average, last year, but Treasury securities and inflation-indexed securities— this period of stability followed a period of unusually large another indicator of expected inflation, albeit one that is also influenced by perceptions of inflation risk and per- Change in unit labor costs haps also by the development of the market for inflation- indexed debt—showed a similar pattern. Inflation com­ Percent pensation over the next five years moved up about 1/ 2 percentage point during 2004, to 21/ 2 percent, while compensation at the five- to ten-year horizon edged lower, 4 on net, over the year. 2 U.S. Financial Markets Domestic financial conditions were supportive of eco­ + 0_ nomic growth in 2004. Interest rates on longer-term Trea­ sury securities remained low, corporate risk spreads fell, and stock prices, on balance, registered gains. These developments occurred even as market participants 1998 2000 2002 2004 revised up their expectations for the path of the federal NOTE. Nonfarm business sector. SOURCE. Department of Labor, Bureau of Labor Statistics. funds rate. At the beginning of 2004, futures market quotes 20 Monetary Policy Report to the Congress February 2005 Interest rates on selected Treasury securities In the statement released after its May meeting, the Com­ mittee indicated that policy accommodation was likely Percent to be removed at a “measured” pace. At its June meeting, the Committee raised the target for the federal funds rate Ten-year 6 from 1 percent to 11/ 4 percent, but it continued to assess the risks to sustainable growth and to price stability as 5 balanced and reiterated the “measured pace” language. 4 Interest rates across the term structure declined some- what immediately after the announcement, reportedly 3 because some market participants had expected the Two-year FOMC to mention upside risks to growth or inflation in 2 its statement. Three-month 1 Chairman Greenspan’s congressional testimony in July on monetary policy, which suggested that recent softness 2002 2003 2004 2005 in consumer spending would likely prove short lived, sparked a jump in yields on Treasury securities. How- NOTE. The data are daily and extend through February 9, 2005. SOURCE. Department of the Treasury. ever, interest rates subsequently moved lower, on bal­ ance, as incoming data pointed to weaker spending and employment than investors had expected as well as to implied that investors expected a 13/ 4 percent target for more-subdued core inflation. Apart from the August the federal funds rate at year-end, 50 basis points below employment report, which seemed to hint that the the target actually established at the FOMC meeting in economy was emerging from its “soft patch,” incoming December 2004. Consistent with the revision in policy economic news remained somewhat lackluster through expectations, yields on two-year Treasury notes increased the end of the third quarter. However, investors report­ about 11/ 4 percentage points in 2004. Yields on longer- edly viewed FOMC statements and comments by FOMC dated Treasury securities, however, ended the year officials as more sanguine on near-term prospects for the essentially unchanged. Despite the run-up in oil prices, economy than they had expected. In particular, the equity prices registered solid gains in 2004 after rising release of the minutes from the August FOMC meeting, sharply the year before. Risk spreads on investment-grade which referenced the probable need for “significant corporate debt declined a touch, and those on specula­ cumulative tightening,” prompted investors to mark up tive-grade debt fell more noticeably. Moreover, banks their expectations for the near-term path of monetary appreciably eased terms and standards for lending to policy. businesses. Short-term Treasury yields rose a bit further over the fall in association with actual and expected policy tight­ ening, but long-term Treasury yields were little changed Interest Rates on net. Investors’ expectations for the path of monetary Most market interest rates rose, on balance, over the first policy firmed a bit more in the fourth quarter in response half of 2004, particularly at shorter maturities. The to higher-than-anticipated inflation and remarks from FOMC’s decision at its January meeting to shift from a Federal Reserve officials that were reportedly interpreted statement that monetary policy could remain accommo­ as suggesting that an imminent pause in the tightening dative for “a considerable period” to an indication that it cycle was unlikely. could be “patient” in removing policy accommodation As the economic expansion gathered momentum and prompted a rise in market interest rates. In early Febru­ measures of corporate credit quality improved, investors’ ary and March, yields fell substantially in response to perception of risk seemed to diminish, and their willing­ employment reports that indicated tepid job growth. Prices ness to bear risk apparently increased. Risk spreads on of federal funds and Eurodollar futures contracts implied investment-grade corporate debt over comparable Trea­ that investors placed only small odds on an increase in suries ended the year slightly below their levels at the the target funds rate before late 2004 and that they envi­ end of 2003. Spreads of speculative-grade yields declined sioned only moderate monetary policy tightening there- further after narrowing sharply during 2003. after. Longer-term interest rates and the expected path In early 2005, market participants boosted their for the federal funds rate were considerably marked up expectations for the path of the federal funds rate, partly later in the spring in response to data suggesting a pickup in response to the publication of the minutes of the in aggregate demand and hiring, readings on core infla­ December FOMC meeting, which investors reportedly tion that came in above expectations, and rising oil prices. interpreted as pointing to greater concerns about infla- Board of Governors of the Federal Reserve System 21 Spreads of corporate bond yields over Implied S&P 500 volatility comparable off-the-run Treasury yields Percent Percentage points 10 40 8 30 High-yield 6 20 BBB 4 2 10 AA + 0_ 1998 1999 2000 2001 2002 2003 2004 2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 NOTE. The data are daily and extend through February 9, 2005. The series NOTE. The data are daily and extend through February 9, 2005. The shown is the implied thirty-day volatility of the S&P 500 stock price index as high-yield index is compared with the five-year Treasury yield, and the BBB calculated from a weighted average of options prices. and AA indexes are compared with the ten-year Treasury yield. SOURCE. Chicago Board Options Exchange. SOURCE. Merrill Lynch AA and BBB indexes and Merrill Lynch Master II high-yield index. tion than had been expected. Short- and intermediate-term in the second quarter, worries about geopolitical devel­ Treasury yields rose along with expectations for the path opments, and sharply higher oil prices. Stock prices of monetary policy, but longer-term yields edged lower. dipped early in the second half in response to softer eco­ Yields on investment- and speculative-grade corporate nomic data, further concerns about energy prices, and bonds largely moved with those on comparable Treasury guidance from corporations that pointed to a less opti­ securities, and hence risk spreads remained at low levels. mistic trajectory for earnings than investors had report­ edly been expecting. However, as oil prices pulled back toward the end of 2004 and news on the economy Equity Markets improved, stock prices rebounded to post solid gains for the year. The increases were led by stocks with compara­ After surging as much as 30 percent in 2003, broad stock tively small market capitalizations; the Russell 2000 market indexes climbed modestly over the first half of index climbed 17 percent in 2004 to a record high. The 2004. The boost to equity prices from robust earnings S&P 500 and the technology-laden Nasdaq advanced reports and analysts’ upward revisions for future profits about 9 percent and 81/ 2 percent respectively. To date in during this period was offset in part by rising interest rates 2005, equity prices have edged lower, on balance, as investors have responded to a rebound in oil prices, lackluster earnings reports, cautious guidance for future Stock price indexes profits, and indications of continued monetary policy tightening. January 2, 2003 = 100 Expected volatility implied by options prices for both 170 the Nasdaq 100 and the S&P 500 declined further in Russell 2000 160 2004 from already low levels. The difference between the earnings–price ratio and the real ten-year Treasury 150 yield—a crude measure of the premium investors require 140 for holding equity shares—changed little, on balance, 130 remaining close to its average value over the past two 120 decades but above its level during the late 1990s. Wilshire 5000 110 100 90 Debt, Bank Credit, and M2 2003 2004 2005 The aggregate debt of domestic nonfinancial sectors is NOTE. The data are daily and extend through February 9, 2005. estimated to have increased about 73/ 4 percent in 2004, 22 Monetary Policy Report to the Congress February 2005 Growth of domestic nonfinancial debt mergers. After adjusting for certain reclassifications of securities as loans, the growth of consumer loans on banks’ Percent books remained sluggish. Despite reports of increased competition among banks and nonbank intermediaries, bank profits were again strong in 2004. Banks experi­ 8 enced further improvements in asset quality and, as a result, reduced their provisions for loan losses. Total M2 grew at a pace roughly in line with that of nominal 6 GDP during the first half of 2004. A resurgence of mort­ gage refinancing spurred by the first-quarter decline in mortgage rates likely boosted liquid deposit growth, as 4 proceeds from refinancing were temporarily held in deposit accounts pending disbursement to the holders of mortgage-backed securities. M2 growth slowed in the second half of the year in response to a drop in mortgage Percent refinancing activity and the increased opportunity cost of holding M2 assets, as returns available on market 15 instruments rose more than those on M2 components. For Nonfederal 10 example, yields on retail money market mutual funds moved up more slowly than did short-term market inter­ 5 est rates, and assets of money funds accordingly contin­ + ued to shrink. Small time deposits, which had contracted 0_ over the previous three years, resumed expansion in the Federal, 5 second half of the year, as their yields began to rise in held by public association with the increase in other market rates. Cur­ 10 rency grew at its slowest rate since 2000, apparently reflecting sluggish demand by both domestic and foreign 1990 1992 1994 1996 1998 2000 2002 2004 holders. On balance, M2 growth from the fourth quarter ear N li O e T r E y . e F ar o s r , 2 t 0 h 0 e 4 d , a c t h a a a n r g e e a is n n fr u o a m l a 2 n 0 d 0 3 a : r Q e 4 c o to m 2 p 0 u 0 t 4 ed :Q b 3 y a t d i a v n i d a i n n n g u a th l e ra a te n . n F u o a r l of 2003 to the fourth quarter of 2004 was about 51/ 4 per- flow for a given year by the level at the end of the preceding year. The total cent. The velocity of M2 rose 1 percent, on net, roughly consists of nonfederal debt and federal debt held by the public. Nonfederal in line with the historical relationships among money, debt consists of the outstanding credit market debt of state and local gov­ ernments, households, nonprofit organizations, and nonfinancial businesses. income, and opportunity cost. Federal debt held by the public excludes securities held as investments of federal government accounts. somewhat faster than nominal income but a bit slower M2 growth rate than the pace set the year before. Household and federal debt expanded rapidly. Borrowing by nonfinancial busi­ Percent nesses was moderate, although it picked up in the fourth quarter. 10 Commercial bank credit rose about 9 percent in 2004, a larger advance than in the previous year. Expansion of 8 mortgage and home equity loans on banks’ books remained strong, as activity in the housing market stayed 6 robust while mortgage originations shifted somewhat toward adjustable-rate products. After several years of 4 runoffs, business loans began to grow in the second quar­ ter of the year. According to survey evidence, commer­ 2 cial banks eased terms and standards on business loans as the economic outlook improved and competition from 1990 1992 1994 1996 1998 2000 2002 2004 other banks and nonbank lenders intensified. Also, banks reported a pickup in demand for business loans that was NOTE. The data are annual and extend through 2004. M2 consists of currency, traveler’s checks, demand deposits, other checkable deposits, said to be driven by customers’ needs to fund rising savings deposits (including money market deposit accounts), small-denomination time deposits, and balances in retail money market accounts receivable, inventories, capital expenditures, and funds. Board of Governors of the Federal Reserve System 23 International Developments Equity indexes in selected foreign industrial countries Foreign economic activity expanded in 2004 at a faster Week ending January 4, 2002 = 100 pace than in the preceding three years. The pickup in growth was widespread—global manufacturing and trade Canada 115 rebounded across industrial and emerging economies, in Japan part because of strong demand from the United States 100 and China. In the second half of the year, trade and for­ eign GDP growth slowed, partly as a result of higher oil United Kingdom 85 prices and the appreciation of some foreign currencies against the dollar. The run-up in oil prices and other com­ 70 modity prices contributed to higher, though still moder­ ate, inflation across industrial and emerging economies. Euro area 55 Monetary policy in many foreign economies tightened over the course of 2004. Citing high rates of capacity 2002 2003 2004 2005 utilization and mounting inflationary pressures, the Bank of England raised its target interest rate 100 basis points NOTE. The data are weekly. The last observation for each series is the average of trading days through February 9, 2005. but has been on hold since August amid signs that hous­ SOURCE. Bloomberg L.P. ing prices and consumer spending are cooling. After cut­ ting official interest rates earlier in the year, the Bank of 2004. Rates rose in the second quarter as new data Canada raised rates in the fall in response to diminishing (including reports from the United States) that showed slack in the economy. The Bank of Mexico tightened faster growth and higher inflation led market participants policy throughout the year to resist rising inflation, and to expect more-aggressive monetary tightening. However, Chinese authorities made monetary policy more restric­ foreign long-term interest rates slipped after midyear, tive to rein in soaring investment demand. In the euro when foreign growth slowed and foreign currencies area and Japan, central banks kept policy interest rates appreciated against the dollar. Over the first half of the unchanged in 2004. year, spreads on internationally issued sovereign debt of Foreign equity price indexes recorded moderate net emerging-market economies over U.S. Treasuries moved gains last year after larger increases in 2003. Equity mar­ up somewhat from low levels, but spreads more than kets started the year strong, but prices declined in the reversed those increases in the second half. spring as interest rates rose. The run-up in oil prices The path of the exchange rate was uneven over the between July and October appeared to weigh on foreign course of 2004. The dollar rose slightly in the first half of equity prices, but the subsequent decline in oil prices helped support a rise in equity prices late in the year. Foreign long-term interest rates declined, on net, during Spread on internationally issued sovereign debt of emerging-market economies Official interest rates in selected foreign industrial countries Percentage points Percent 10 6 5 8 United Kingdom 4 Canada 3 6 2 Euro area 4 1 Japan + 0_ 2002 2003 2004 2005 2001 2002 2003 2004 2005 NOTE. The data are weekly averages. The last observation is the average of trading days through February 9, 2005. The series shown is the spread of the NOTE. The data are as of month-end; the last observation for each series is yield of certain dollar-denominated sovereign debt instruments of emerg­ the average of trading days through February 9, 2005. The data shown are the ing-market economies over U.S. Treasury securities; over the period shown, call money rate for Japan, the overnight rate for Canada, the refinancing rate the index encompassed nineteen countries. for the euro area, and the repurchase rate for the United Kingdom. SOURCE. J.P. Morgan Emerging Market Bond Index Plus (EMBI+). 24 Monetary Policy Report to the Congress February 2005 U.S. dollar nominal exchange rate, broad index mentary focusing on the positive differential between U.S. economic growth and that in Europe and Japan. January 2001 = 100 105 Industrial Economies After increasing strongly in the first quarter, Japanese 100 GDP growth stagnated in the remainder of 2004. Growth in exports and business investment slowed over the year, 95 and government investment contracted. However, corpo­ rate profits and balance sheets improved, and labor mar­ ket conditions also brightened, with the job-offers-to-ap­ 90 plicants ratio rising to a twelve-year high. Consumer prices continued to decline in 2004, though only slightly. 2001 2002 2003 2004 2005 In contrast, higher commodity prices helped push twelve- month wholesale price inflation up to 2 percent late 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 9, 2005. the year, its highest rate since 1990. The yield on the ten- The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading year bellwether government bond rose from its June 2003 partners. The index weights, which change over time, are derived from U.S. record low of about 1/ 2 percent to nearly 2 percent in mid- export shares and from U.S. and foreign import shares. year before retreating to about 11/ 2 percent recently. After making substantial sales of yen for dollars in the the year on perceptions that monetary policy would tighten first quarter, Japanese authorities ceased intervention in more quickly in the United States than abroad. Begin­ mid-March and remained on the sidelines even as the yen ning in September, however, the dollar resumed the appreciated significantly against the dollar in the fall. depreciation that had started in 2002, as market partici­ Economic conditions in the euro area firmed during pants focused on the financing implications of the large the first half of 2004 but weakened in the second half. and growing U.S. current account deficit. In 2004, the Private consumption and investment spending continued dollar depreciated about 7 percent, on net, against the to rise, but export growth slowed after midyear. German euro, the U.K. pound, and the Canadian dollar. The dol­ GDP growth slowed to a crawl in the second half, as lar declined 4 percent, on net, against the Japanese yen German consumer spending remained anemic, held down and 13 percent against the Korean won, but some other by a weak labor market and low consumer confidence. In Asian central banks, most notably the People’s Bank of contrast, French GDP growth was strong in the fourth China, kept their currencies stable against the dollar. So quarter. The euro-area unemployment rate has been near far in 2005, the dollar has rebounded, with market com- 9 percent since rising to that level in early 2003. Infla­ tion for the euro area remained just above the European U.S. dollar exchange rate against Central Bank’s medium-term goal of less than, but close selected major currencies to, 2 percent. With the exception of a slowdown in the third quarter, Week ending January 4, 2002 = 100 economic expansion in the United Kingdom stayed strong during 2004, largely because of the brisk growth of con­ Canadian sumption and government spending. Labor markets dollar 100 remained tight in 2004; the unemployment rate ticked down to its lowest level in almost three decades, and 90 labor earnings posted solid gains. Consumer price infla­ Japanese yen tion over the twelve months ending in December was Euro 80 11/ 2 percent, below the central bank’s official target rate of 2 percent. Housing price rises slowed sharply from rapid rates and were muted during the second half of 2004. 70 U.K. Household net mortgage borrowing declined to a level pound 20 percent below its 2003 peak. 2002 2003 2004 2005 The Canadian economy expanded at a healthy pace NOTE. The data are weekly and are in foreign currency units per dollar. throughout 2004. Sizable gains in consumption and The last observation for each series is the average of trading days through investment boosted output throughout the year. Export February 9, 2005. SOURCE. Bloomberg L.P. growth, supported by demand from the United States, was Board of Governors of the Federal Reserve System 25 strong in the first half of the year but stagnated in the can government spending to provide stimulus while still second half as U.S. manufacturing growth slowed and meeting fiscal targets. the Canadian dollar’s appreciation hurt Canadian trade. In Brazil, economic activity continued to expand The unemployment rate declined moderately over the robustly in 2004. Domestic demand was supported by year, and employment posted strong gains. Consumer the monetary loosening that occurred in the second half price inflation has settled at about 2 percent, the mid- of 2003 and early 2004. Export growth was boosted by point of the Bank of Canada’s inflation target range, demand for commodities and the recovery in Argentina. whereas inflation excluding food, energy, and indirect Brazilian asset prices declined through May on expecta­ taxes declined to around 11/ 2 percent by year-end. tions that higher global interest rates would make it more difficult for the Brazilian government to finance its debt, but stock prices have moved up sharply since May, and Emerging-Market Economies the currency has appreciated. Concerns over inflation pressures have prompted the central bank to tighten mon­ Growth of real GDP in China remained very robust in etary policy since September. 2004, supported by strong domestic demand and exports. In Argentina, the economic recovery picked up steam The Chinese government took steps early in the year to last year, as exports were supported by strong demand slow investment spending, curbing investment approvals for commodities. The country continues, however, to and lending. Investment growth slowed significantly grapple with difficult structural problems. After more than but remained rapid. At the same time, indicators of per­ three years in default, the government launched a debt sonal consumption spending strengthened, and Chinese swap in January with the goal of restructuring more than exports and imports continued to soar in 2004. Consumer $80 billion in defaulted bonds. price inflation peaked at a twelve-month change of more than 5 percent in July but has fallen since then to less than 3 percent, as food prices have moderated. Inflation Equity indexes in selected emerging-market economies excluding food is only about 1 percent. Week ending January 3, 2003 = 100 Supported by exports to China, economic growth in other Asian emerging-market economies was generally strong in 2004. Economic expansion in Korea remained 255 Argentina heavily dependent on external demand because high lev­ els of consumer debt continued to weigh on consumption 210 spending. Inflation across emerging Asia, though still Mexico 165 moderate, was pushed up by higher energy prices and Asian emerging- strong aggregate demand. market economies 120 The Mexican economy grew rapidly in the first half Brazil of the year in response to strong demand from the United 75 States. In the third quarter, Mexican GDP growth slowed somewhat, as manufacturing exports stagnated, but domestic demand remained buoyant. Increases in energy 2002 2003 2004 2005 and food prices pushed up twelve-month consumer price NOTE. The data are weekly. The last observation for each series is the av­ erage of trading days through February 9, 2005. The Asian emerging-market inflation to more than 5 percent, above the Bank of economies are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the Mexico’s target range of 2 percent to 4 percent. Mon­ Philippines, Singapore, South Korea, Taiwan, and Thailand; the index weight for each of these economies is its market capitalization as a share of the etary policy tightened throughout the year, and inflation group’s total. began to fall near year-end. Oil revenues boosted the SOURCE. For Argentina, Brazil, Mexico, Bloomberg L.P.; for Asian emerging-market economies, Morgan Stanley Capital International (MSCI) Mexican public-sector fiscal surplus and allowed Mexi­ index.

Federal Reserve (2005, February 15). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20050216

@misc{wtfs_monetary_policy_report_20050216,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2005},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20050216},
  note = {Retrieved via When the Fed Speaks corpus}
}