Monetary Policy Report

For use at 10:00 a.m., EDT Wednesday July 20, 2005 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 20, 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 July 20, 2005 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 20, 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 2005 3 Monetary Policy Report to the Congress Report submitted to the Congress on July 20, 2005, that policy remained accommodative. With appropriate pursuant to section 2B of the Federal Reserve Act monetary policy, however, the upside and downside risks to output and inflation were viewed as balanced, and the Committee underscored its commitment to respond to MONETARY POLICY AND THE ECONOMIC OUTLOOK changes in economic prospects as needed to fulfill its obligation to maintain price stability. The U.S. economy continued to expand at a solid pace The fundamental factors that supported the U.S. over the first half of 2005 despite the restraint imposed economy in the first half of 2005 should continue to do on aggregate demand by a further rise in crude oil prices. so over the remainder of 2005 and in 2006. In the house- Household spending trended up, propelled by rising hold sector, the combination of further gains in employ­ wealth and income and by low interest rates, and busi­ ment, favorable borrowing terms, and generally healthy ness outlays received ongoing support from favorable balance sheets should keep consumer spending and resi­ financial conditions, rising sales, and increased profit- dential investment on an upward path. In the business ability. Moreover, the earlier declines in the foreign sector, expanding sales, the low cost of capital, and the exchange value of the dollar shifted some domestic and replacement or upgrade of aging equipment and software foreign demand toward U.S. producers. Overall, the eco­ should help to maintain increases in capital spending. And, nomic expansion was sufficient to create jobs at roughly although economic performance has been uneven across the same pace as in late 2004 and to lower the unemploy­ countries, continued growth overall in the economies of ment rate further over the first half of this year. U.S. trading partners should sustain the demand for U.S. Higher oil prices boosted retail prices of a broad range exports. In contrast, ongoing increases in imports will of consumer energy products and, as a result, continued likely continue to subtract from the growth of U.S. gross to hold up the rate of overall consumer price inflation in domestic product. In addition, high energy prices remain the first half of 2005. In addition, the rise in energy prices a drag on aggregate demand both here and abroad, though this year, coupled with increases in the prices of some this drag should lessen over time if prices for crude oil other commodities, imported goods, and industrial mate- level out in line with quotes in futures markets. rials, put upward pressure on the costs of many businesses. Despite the upward pressure on costs and prices over A portion of these costs was passed on to consumers, the past year or so, core consumer price inflation is likely which contributed to a higher rate of inflation in core to remain contained in 2005 and 2006. Longer-run infla­ consumer prices (that is, total prices excluding the food tion expectations are still well anchored, and because and energy components, which are volatile). As measured businesses are adding to their stocks of capital and are by the price index for personal consumption expenditures continuing to find ways to use their capital and work excluding food and energy, core inflation increased from forces more effectively, structural productivity will likely an annual rate of 1½ percent in 2004 to about 2 percent rise at a solid pace over the foreseeable future. In addi­ between the fourth quarter of 2004 and May 2005. While tion, barring a further increase in oil prices, the boost survey measures of near-term inflation expectations have that higher energy costs have given to core inflation should edged up this year, surveys, as well as readings from wane in coming quarters, while the recent appreciation financial markets, suggest that expected inflation at longer of the dollar, as well as the deceleration in global materi­ horizons has remained contained. als prices, will likely reduce the impetus to inflation from With financial conditions advantageous for households rising import prices. and firms, a solid economic expansion in train, and some Of course, substantial uncertainties surround this eco­ upward pressure on inflation, the Federal Open Market nomic outlook. A further sharp rise in crude oil prices Committee (FOMC) continued to remove policy accom­ would have undesirable consequences for both economic modation at a measured pace over the first half of the activity and inflation, and the possibility that housing year, raising the intended federal funds rate an additional prices, at least in some locales, have moved above levels 1 percentage point, to 3¼ percent, by the end of June. At that can be supported by fundamentals remains a con­ the most recent FOMC meeting, the Committee judged cern. As another example, if the recent surge in measured 2 Monetary Policy Report to the Congress July 2005 unit labor costs were to prove more persistent than cur­ mittee voted at its March meeting to raise the federal funds rently appears likely, the outlook for inflation would be rate another 25 basis points, to 2¾ percent. In view of adversely affected. Economic growth and inflation will the rise in prices of energy and other commodities and also be shaped importantly by the evolution of the imbal­ recent elevated readings on inflation in core consumer ance in the U.S. current account. prices, the Committee altered the text of the policy state­ ment to note the pickup in inflationary pressures. The Committee also decided to modify the assessment of the The Conduct of Monetary Policy balance of risks to make it explicitly conditional on an over the First Half of 2005 assumption of “appropriate” monetary policy, so as to underscore that maintaining balanced risks would likely Despite increases in the federal funds rate totaling require continued removal of policy accommodation. 1¼ percentage points in 2004, monetary policy was still The evidence that had accumulated by the spring judged to be accommodative at the start of 2005. At the pointed to some moderation in the pace of activity. time of the February FOMC meeting, the available infor­ Retail spending flattened out for a time, likely in response mation indicated that the economy had expanded at a to higher energy prices, and the growth of capital spend­ robust pace through the end of 2004 and retained consid­ ing dropped back from its elevated pace of late last year. erable momentum. Accordingly, the Committee voted to Nonetheless, with long-term interest rates still quite low raise its target for the federal funds rate from 2¼ percent and with employment and profits continuing to rise, eco­ to 2½ percent and to make minimal changes to the text of nomic activity appeared to retain considerable momen­ the accompanying statement. The statement reiterated that tum, suggesting that the softness would be short lived. “the Committee believes that policy accommodation can Against this backdrop, the FOMC decided to raise the be removed at a pace that is likely to be measured.” federal funds rate another 25 basis points at its May meet­ Members noted, however, that this forward-looking lan­ ing and to make few changes to the text of the accompa­ guage was clearly conditioned on economic developments nying statement. and therefore would not stand in the way of either a pause In the weeks after the May meeting, incoming indica­ or a step-up in policy firming depending on events. tors supported the view that the underlying pace of activ­ By March, the data were pointing to a further solid ity was not faltering. The information that the Committee gain in activity during the first quarter, fueled especially reviewed at the time of the June FOMC meeting showed by continued increases in consumption expenditures and that consumer spending and business investment had residential investment. In addition, private nonfarm pay- turned up, on balance, and that demand for housing rolls were posting widespread advances, and slack in continued to be strong. With economic activity remain­ resource utilization appeared to be diminishing. The Com- ing firm and crude oil prices ratcheting higher, the FOMC Selected interest rates Percent Ten-year Treasury 6 5 4 3 2 Intended federal funds rate 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 11/1012/14 2/2 3/22 5/3 6/30 2002 2003 2004 2005 NOTE: The data are daily and extend through July 13, 2005. The ten-year Treasury rate is the constant-maturity yield 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 voted to raise the funds rate an additional 25 basis points, ECONOMIC AND FINANCIAL DEVELOPMENTS to 3¼ percent, and to make only minimal changes to the IN 2005 text of the accompanying statement. This action brought the cumulative increase in the target federal funds rate The economic expansion entered 2005 on a solid footing since June 2004 to 2¼ percentage points. and was led by ongoing increases in consumption, resi­ dential investment, and business spending on equipment and software. Although the pace of expansion slowed Economic Projections for 2005 and 2006 somewhat in the early spring, activity has picked up again more recently. On average, real GDP appears to have In conjunction with the FOMC meeting at the end of June, increased a little less rapidly over the first half of 2005 the members of the Board of Governors and the Federal than in the second half of 2004, a reflection in part of Reserve Bank presidents, all of whom participate in the reduced fiscal stimulus and the drag on economic activ­ deliberations of the FOMC, were asked to provide eco­ ity from higher energy prices. Industrial production has nomic projections for 2005 and 2006. In general, Fed­ also risen more slowly so far this year than in 2004: The eral Reserve policymakers expect the economy to con­ increase totaled 3 percent at an annual rate between tinue to expand at a moderate pace and core inflation to December 2004 and June 2005, down from 5 percent dur­ remain roughly stable over this period. The central ten­ ing the previous six months. Nevertheless, the economic dency of the FOMC participants’ forecasts for the increase expansion has been sufficient to gradually absorb slack in real (that is, inflation adjusted) GDP is 3½ percent over in labor and product markets. Nonfarm payroll employ­ the four quarters of 2005 and 3¼ percent to 3½ percent ment has continued to increase, and the unemployment in 2006. The civilian unemployment rate is expected to rate has moved down further since the beginning of the average 5 percent in both the fourth quarter of 2005 and year, to 5 percent in June. Similarly, the rate of capacity the fourth quarter of 2006. FOMC participants project utilization in the manufacturing sector stood at 78.4 per- that the chain-type price index for personal consumption cent in June, up from 77.9 percent at the end of 2004 and expenditures excluding food and energy will increase just a little below its long-term historical average. between 1¾ percent and 2 percent both this year and next. Rising energy prices continued to boost consumer price inflation in the first half of 2005. With consumer energy prices having climbed more than 13 percent at an annual rate so far this year, the price index for personal con­ sumption expenditures (PCE) increased at an annual rate of about 2½ percent between the fourth quarter of 2004 and May 2005, the same pace as in 2004. Meanwhile, the Economic projections for 2005 and 2006 core PCE price index rose at an annual rate of about Percent Federal Reserve Governors and Change in real GDP Reserve Bank presidents Indicator Central Percent, annual rate Range tendency 2005 Change, fourth quarter to fourth quarter1 6 Nominal GDP ........................................................ 5–6¼ 5½–5¾ Real GDP .............................................................. 3–3¾ 3½ PCE price index excluding food and energy ........ 1½–2¼ 1¾–2 Average level, fourth quarter Q1 4 Civilian unemployment rate .................................. 5–5¼ 5 2006 2 Change, fourth quarter to fourth quarter1 Nominal GDP ........................................................ 5–6 5¼–5½ Real GDP .............................................................. 3¼–3¾ 3¼–3½ PCE price index excluding food and energy ........ 1½–2½ 1¾–2 1999 2001 2003 2005 Average level, fourth quarter Civilian unemployment rate .................................. 5 5 NOTE: Here and in subsequent charts, except as noted, change for a given period is measured to its final quarter from the final quarter of the preceding 1. Change from average for fourth quarter of previous year to average for period. fourth quarter of year indicated. SOURCE: Department of Commerce, Bureau of Economic Analysis. 4 Monetary Policy Report to the Congress July 2005 Change in PCE chain-type price index level of interest rates. However, higher costs for consumer energy products have eroded households’ purchasing Percent, annual rate power. Total Sales of light motor vehicles, which had been buoyed Excluding food and energy in the second half of last year by a variety of sales 3 inducements, dropped back in the first quarter after many of the inducements expired. However, sales firmed again in the second quarter to an average annual pace of more 2 than 17 million units, a level similar to that in the fourth quarter of last year. Underlying demand for light motor vehicles has remained relatively strong, though sales likely 1 have also been boosted recently by sizable price discounts. Excluding motor vehicles, consumer spending posted strong gains in early 2005, flattened out in March, and 1999 2001 2003 2005 picked up again in the spring. On a quarterly average basis, NOTE: The data are for personal consumption expenditures (PCE). The the rate of increase in non-auto spending appears to have changes for 2005 are from 2004:Q4 to May 2005. stepped down in the second quarter, largely because of a SOURCE: Department of Commerce, Bureau of Economic Analysis. deceleration in outlays for consumer goods. Meanwhile, real outlays for services rose at an annual rate of about 3 percent in the first quarter, and the available data point 2 percent in the first half of 2005, up from 1½ percent in to an increase of about the same magnitude in the second 2004. quarter. If the effect of Microsoft’s $32 billion special divi­ dend payment in December 2004 is excluded from the The Household Sector calculation, real disposable personal income (that is, Consumer Spending after-tax income adjusted for inflation) rose at an annual rate of about 2 percent between the fourth quarter of 2004 Consumer spending continued to move higher in the first and May 2005, a slower pace than in 2004. Although half of this year, though not as rapidly as in the second increases in employment and earnings pushed up wage half of 2004. After increasing at an average annual rate and salary income over the first half of 2005, the rise in of 4½ percent in the third and fourth quarters of last year, real income was damped to some degree by the energy- real personal consumption expenditures rose at a 3½ per- driven increase in consumer prices. Higher energy prices cent rate in the first quarter and appear to have advanced also appear to have weighed on consumer confidence for at a roughly similar pace in the second quarter. House- much of this year. Surveys by both the Michigan Survey hold spending this year has been supported by rising employment and household wealth as well as by the low Consumer sentiment 1985 = 100 1966 = 100 Change in real income and consumption 140 140 Percent, annual rate Disposable personal income Conference Board 120 120 Personal consumption expenditures 6 100 100 Q1 4 Michigan SRC 80 80 2 60 60 + _0 1993 1996 1999 2002 2005 NOTE: The Conference Board data are monthly and extend through June 2005. The Michigan SRC data are monthly and extend through a preliminary 1999 2001 2003 2005 estimate for July 2005. 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 5 Wealth-to-income ratio to just ½ percent of disposable income in April and May. Over the previous two decades, the personal saving rate Ratio averaged close to 5 percent. 6 Residential Investment Activity in the housing market continued at a strong pace 5 in the first half of 2005. Real expenditures on residential structures increased at an annual rate of 11½ percent in the first quarter and appear to have posted another gain 4 in the second quarter. In the single-family sector, starts of new units averaged 1.69 million at an annual rate between January and June—nearly 4 percent above the 1985 1989 1993 1997 2001 2005 pace posted over the second half of 2004. Similarly, starts of multifamily units averaged 360,000 over the first six NOTE: The data are quarterly and extend through 2005:Q1. The wealth- to-income ratio is the ratio of household net worth to disposable personal months of 2005, about 3¼ percent higher than in the pre­ income. SOURCE: For net worth, Federal Reserve Board, flow of funds data; for vious six months. income, Department of Commerce, Bureau of Economic Analysis. As in 2004, the demand for housing during the first half of 2005 was supported by rising employment and Research Center (SRC) and the Conference Board indi­ income and by low mortgage rates. Rates on thirty-year cate that household sentiment edged down through the fixed-rate mortgages have fluctuated between 5½ percent early spring, though readings from these surveys turned and 6 percent in recent months and are currently near the up again more recently. low end of that range. In addition, demand reportedly Household wealth appears to have increased a bit faster has been boosted by a rise in purchases of second homes— than nominal disposable income over the first half of this either as vacation units or as investments—and by the year; the small increase in the wealth-to-income ratio greater availability of less-conventional financing instru­ comes on the heels of substantial increases in 2003 and ments. These financing instruments, including interest- 2004. Although stock prices have changed little, on net, only mortgages and adjustable-rate mortgages that allow thus far this year, home prices have continued to rise borrowers a degree of flexibility in the size of their sharply. Because changes in wealth influence consumer monthly payments, have enabled some households to buy spending with a lag, both the earlier and the more-recent homes that would otherwise have been unaffordable. As increases in household net worth have supported con­ a result, both new and existing home sales have remained sumption this year. As wealth increased and interest rates remarkably robust this year, and both were at or near remained quite low, the personal saving rate edged down record levels in May. Personal saving rate Private housing starts Percent Millions of units, annual rate 12 1.6 9 Single-family 1.2 6 .8 3 + Multifamily _0 .4 1985 1990 1995 2000 2005 1993 1995 1997 1999 2001 2003 2005 NOTE: The data are quarterly; the reading for 2005:Q2 is the average of April and May. NOTE: The data are quarterly and extend through 2005:Q2. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Department of Commerce, Bureau of the Census. 6 Monetary Policy Report to the Congress July 2005 Mortgage rates Household Finance Percent Supported by rising house prices and continued economic expansion, household debt increased at an annual Fixed rate rate of about 9¼ percent in the first quarter of 2005. 7 This advance was paced by a rise in mortgage debt of 10½ percent at an annual rate. However, even that rapid rise in mortgage debt represented a slight deceleration 5 from the torrid pace in 2004, a development in line with Adjustable rate the small slowdown in the pace of house price apprecia­ tion. Despite the increase in mortgage debt, net housing 3 wealth rose. Refinancing activity has remained subdued, as rates on fixed-rate mortgages are a little above levels at which many households would currently find refinanc­ 2001 2002 2003 2004 2005 ing to be attractive. NOTE: The data, which are weekly and extend through July 13, 2005, are Consumer credit expanded at an annual rate of about contract rates on thirty-year mortgages. 4½ percent over the first quarter of the year and was about SOURCE: Federal Home Loan Mortgage Corporation. unchanged in April and May. The growth of consumer credit has continued to be restrained by substitution The strong demand for housing has continued to push toward home equity debt as a means to finance house- up home prices this year. Although rates of house hold expenditures. price appreciation were a little slower in the first Measures of household credit quality have remained quarter of this year than in 2004, the repeat-transactions favorable. Delinquency rates on credit card debt and auto price index for existing homes (limited to purchase- loans have continued to decline from already low levels. transactions only), which is published by the Office of The pace of bankruptcy filings has run a little higher than Federal Housing Enterprise Oversight and partially at the same time last year; however, that pace has prob­ adjusts for changes in the quality of homes sold, was none­ ably been boosted by a rush to file before the new rules theless up 10 percent relative to its year-earlier level. Price in the Bankruptcy Abuse Prevention and Consumer Pro­ appreciation has been especially sharp over the past year tection Act of 2005 take effect in October. Reflecting the in some large metropolitan areas, including Las Vegas, rapid pace of household debt growth, the ratio of house- Miami, San Francisco, and New York, but rapid increases hold financial obligations to disposable personal income in home prices have been observed in other areas as well. has edged up from a year earlier, though this ratio In many of these locales, recent price increases have far remains a bit below the peak level reached in late 2002. exceeded the increases in rents and household incomes. Change in house prices Delinquency rates on selected types of household loans Percent Percent 12 Credit card pools 6 9 5 Repeat-transactions index 6 4 Auto loans at domestic auto finance companies 3 3 + 2 0_ Mortgages 1 1985 1989 1993 1997 2001 2005 1993 1995 1997 1999 2001 2003 2005 NOTE: The data are quarterly and extend through 2005:Q1. Change is over four quarters. For the years preceding 1991, changes are based on an index NOTE: The data are quarterly and extend through 2005:Q1. that includes appraisals associated with mortgage refinancings. Beginning in SOURCE: For credit cards, Moody’s Investors Service; for auto loans, the 1991, changes are based on an index that includes purchase transactions only. financing subsidiaries of the three major U.S. automobile manufacturers; for SOURCE: Office of Federal Housing Enterprise Oversight. mortgages, Mortgage Bankers Association. Board of Governors of the Federal Reserve System 7 Household financial obligations ratio Change in real business fixed investment Percent Percent, annual rate Structures Equipment and software 20 19 Q1 10 18 + 0_ 17 10 16 20 1993 1996 1999 2002 2005 High-tech equipment and software NOTE: The data are quarterly and extend through 2005:Q1. The financial obligations ratio equals the sum of required payments on mortgage and con­ Other equipment excluding transportation Q1 30 sumer debt, automobile leases, rent on tenant-occupied property, home- owners’ insurance, and property taxes, all divided by disposable personal income. 20 SOURCE: Federal Reserve Board. 10 The Business Sector + 0_ Fixed Investment 10 After posting a robust gain in the second half of 2004, real business fixed investment rose at a more moderate 1999 2001 2003 2005 pace over the first half of 2005, as the rate of increase in NOTE: High-tech equipment consists of computers and peripheral equip­ expenditures on equipment and software (E&S) dropped ment and communications equipment. SOURCE: Department of Commerce, Bureau of Economic Analysis. back and outlays for nonresidential structures remained lackluster. Nonetheless, economic and financial condi­ tions appear to be supportive of capital spending: Sales encouraged capital spending to be pulled forward in and corporate profits have continued to increase, busi­ advance of the incentive’s expiration at the end of 2004. nesses have ample liquid assets at their disposal, and More-recent indicators of E&S spending point to financial market participants appear willing to finance another moderate rise in investment in the second quar­ new investment projects at favorable terms. ter. In particular, outlays for transportation equipment Real E&S spending rose at an annual rate of 6 percent appear to have turned up, on net, as a step-up in pur­ in the first quarter after having advanced at an 18 percent chases of aircraft more than offset a further decline in pace in the second half of 2004. Led by large increases in business spending on motor vehicles. At the same time, purchases of computers and communications equipment, the evidence on high-tech spending has been mixed: Real spending on high-tech equipment posted a sizable gain spending on computers appears to have registered in the first quarter. In contrast, outlays for transportation another large gain in the second quarter, while the rate of equipment dropped back early in the year because of a increase in outlays for communications equipment small decline in business expenditures on motor vehicles apparently fell back. Indicators of spending on equipment and a sharp drop in aircraft purchases after a surge in the other than transportation and high tech have looked more fourth quarter of 2004. Investment in equipment other favorable recently, as shipments and imports for this broad than high-tech and transportation goods, a category that category increased noticeably, on balance, in April and accounts for about 40 percent of E&S in nominal terms, May. In addition, unfilled orders for such equipment also edged down in the first quarter after registering a remain at high levels. sizable gain in the second half of last year. The types of Real nonresidential construction continued at a low equipment in this category of investment tend to be sen­ level in the first half of this year, but fundamentals are sitive to trends in business sales, but the timing of busi­ starting to show signs of improvement. The construction ness spending may have been influenced by the provi­ of office buildings and industrial facilities has been sions of the partial-expensing tax incentive, which restrained for some time by elevated vacancy rates, weak 8 Monetary Policy Report to the Congress July 2005 demand, and higher costs for construction materials. One important exception to this characterization is the However, vacancy rates in these sectors have recently motor vehicle industry, for which dealer stocks—espe­ turned down, and construction outlays for these types of cially of light trucks—were high by historical standards buildings appear to have edged higher, on net, so far this in recent months. In response, several major motor year. Commercial building—which includes retail out- vehicle manufacturers reduced production in the second lets and warehouses—also appears to have increased this quarter, and, more recently, some have introduced price year, in part because of strong growth in the construction discounts on many 2005 models. These efforts appear to of large retail stores. Meanwhile, investment in the drill­ have helped, in that inventories of light vehicles at the ing and mining sector has trended up, on balance, over end of June fell to sixty-five days of supply, a level more the past year, as higher prices for natural gas boosted the in line with historical norms. demand for new drilling rigs. Corporate Profits and Business Finance Inventory Investment Corporate profits have continued to rise so far this year, As in 2004, businesses accumulated inventories at an though at a slower pace than in 2003 and 2004. Earnings appreciable pace early this year. Outside the motor per share for S&P 500 firms in the first quarter of 2005 vehicle industry, nonfarm inventories increased at an were up about 13 percent since the same time last year, annual rate of $66 billion in real terms in the first quarter a pace in line with the profit figures reported in the of 2005. The rapid rate of inventory accumulation late national income and product accounts (NIPA). The ratio last year and early in 2005 appears primarily to have been of before-tax profits of nonfinancial corporations to that the result of efforts by firms to replenish stocks that had sector’s gross value added was about flat in the first quar­ been depleted by the strong pace of sales in 2003 and ter after having moved up in 2003 and 2004. In the first 2004; apart from firms in a limited number of sectors, half of this year, the petroleum and gas industries ben­ such as steel and paper, most businesses do not appear to efited from higher oil prices, but corporate earnings in be holding excess stocks, even taking into account the the automobile sector declined sharply. downward trend in inventory–sales ratios that has resulted Given continued strong corporate profits and the from the improvement in supply-chain management accompanying strength in cash flow, nonfinancial firms’ capabilities. The rebuilding of inventories in most indus­ demand for external financing to fund capital expendi­ tries appears to have been largely completed, and the tures has remained somewhat subdued. Net equity issu­ available data for April and May point to a noticeable ance has stayed negative so far this year, and share retire­ step-down in the pace of stockbuilding. Indeed, in recent ments have been boosted by considerable stock buybacks surveys, businesses have been reporting that they and their and cash-financed merger and acquisition activity. Gross customers are increasingly comfortable with current lev­ corporate bond issuance has been limited, and the pro- els of stocks, whereas in 2004 and early 2005, many were still characterizing inventory positions as too lean. Before-tax profits of nonfinancial corporations as a percent of sector GDP Percent Change in real business inventories Billions of chained (2000) dollars, annual rate 14 Q1 75 12 50 10 25 8 + 0_ 6 25 1981 1985 1989 1993 1997 2001 2005 NOTE: The data are quarterly and extend through 2005:Q1. Profits are from 1999 2001 2003 2005 domestic operations of nonfinancial corporations, with inventory valuation and capital consumption adjustments. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 9 Financing gap and net equity retirement Net percentage of domestic banks tightening at nonfinancial corporations standards on commercial and industrial loans to large and medium-sized borrowers Billions of dollars Percent Financing gap 300 250 60 Net equity retirement 200 40 150 100 20 50 + + 0_ 0_ 50 20 1991 1993 1995 1997 1999 2001 2003 2005 NOTE: The data are annual through 2004; for 2005, they are estimates 1991 1993 1995 1997 1999 2001 2003 2005 based on data from 2005:Q1. The financing gap is the difference between capital expenditures and internally generated funds. Net equity retirement is NOTE: The data are drawn from a survey generally conducted four times per year; the last observation is for the April (Q2) 2005 survey. Net the difference between equity retired through share repurchases, domestic percentage is the percentage of banks reporting a tightening of standards less cash-financed mergers, or foreign takeovers of U.S. firms and equity issued the percentage reporting an easing. The definition for firm size suggested for, in public or private markets, including funds invested by venture capital and generally used by, survey respondents is that large and medium-sized partnerships. firms have sales of $50 million or more. SOURCE: Federal Reserve Board, flow of funds data. SOURCE: Federal Reserve, Senior Loan Officer Opinion Survey on Bank Lending Practices. ceeds have been used mainly to pay down existing debt. stantial fractions of banks had eased standards and terms Short-term debt financing, however, continued to pick on these loans. In response to special questions regard­ up in the first half of 2005. Both commercial and indus­ ing longer-term changes in lending practices, most banks trial loans and commercial paper expanded at a brisk reported that standards on business loans were somewhat pace that was likely in part the result of firms’ need to tighter, but that terms were somewhat easier, than they fund the rapid rate of inventory accumulation earlier in had been in 1996 and 1997. the year. The Federal Reserve’s Senior Loan Officer Opin­ Indicators of credit quality in the nonfinancial busi­ ion Survey on Bank Lending Practices conducted in April ness sector have stayed generally very strong amid con­ 2005 indicated that demand for business loans had tinued growth of profits and corporate balance sheets that strengthened over the previous three months and that sub- remain flush with liquid assets. Both the default rate on outstanding corporate bonds and the delinquency rate Selected components of net business financing Billions of dollars Net interest payments of nonfinancial corporations as a percent of cash flow Commercial paper Bonds Bank loans Sum of selected 400 Percent components 200 20 + 0_ 15 200 10 2002 2003 2004 2005 NOTE: Seasonally adjusted annual rate for nonfinancial corporate business. The data for the sum of selected components are quarterly. The data for 2005:Q2 are estimated. 1981 1985 1989 1993 1997 2001 2005 SOURCE: Federal Reserve Board; Securities Data Company; and Federal Financial Institutions Examination Council, Consolidated Reports of Con­ NOTE: The data are quarterly and extend through 2005:Q1. dition and Income (Call Report). SOURCE: Department of Commerce, Bureau of Economic Analysis. 10 Monetary Policy Report to the Congress July 2005 Default rate on outstanding corporate bonds especially strong. Even at its lower level, the deficit was still equal to about 2¾ percent of nominal GDP. Percent Nominal federal receipts during the twelve months end­ ing in June were 14 percent higher than during the same 4 period a year earlier and reached 17 percent of nominal GDP. Revenues were boosted by a large increase in cor­ 3 porate receipts that was driven by the strength of corpo­ rate profits. In addition, individual income and payroll 2 taxes rose nearly 12 percent, twice as fast as the growth of household income. However, some of this rise was due 1 to the features of the Jobs and Growth Tax Relief Recon­ + ciliation Act of 2003 that altered the timing of tax pay­ 0_ ments in a way that temporarily reduced the level of tax collections last year. 1991 1993 1995 1997 1999 2001 2003 2005 Nominal federal outlays during the twelve months end­ ing in June were 7 percent higher than during the same NOTE: The data are monthly and extend through June 2005. The rate for a given month is the face value of bonds that defaulted in the twelve months period a year ago and stood at 20 percent of nominal ending in that month divided by the face value of all bonds outstanding at the GDP. Spending for national defense continued to trend end of the calendar quarter immediately preceding the twelve-month period. SOURCE: Moody’s Investors Service. up at a rapid clip, and outlays for Medicare also posted a sizable increase. In addition, federal net interest payments, on business loans stand at the low end of their historical boosted both by higher interest rates and by the higher ranges. However, the automobile sector has been an level of federal debt, rose more than 13 percent over this exception to the pattern of solid corporate credit quality. period. Real federal expenditures for consumption and All three major credit rating agencies downgraded investment—the part of government spending that is a the debt of both Ford and General Motors this year component of real GDP—increased at an annual rate of in response to disappointing earnings news. General just ½ percent in the first calendar quarter of 2005 after Motors’ debt now has a below-investment-grade rating having risen 4 percent in 2004. Although defense spend­ from both Standard & Poor’s and Fitch, though it is still ing changed little in real terms in the first quarter, it has rated as investment-grade by Moody’s. Ford retains an risen considerably in recent years and is likely to increase investment-grade rating with all the rating agencies further in coming quarters. Nondefense spending in the except Standard & Poor’s. first quarter edged up in line with its recent trend, and Expansion of commercial-mortgage debt continued enacted legislation is consistent with its continuing to rise apace in the first half of the year and was accompanied at a subdued pace. by record issuance of commercial-mortgage-backed securities. Likely because of that heavy issuance, spreads of yields on commercial-mortgage-backed securities over Federal receipts and expenditures those on comparable-maturity Treasuries have turned up recently, but these spreads remain relatively low. The Percent of nominal GDP credit quality of commercial-mortgage debt remains quite strong, as delinquency rates on holdings of commercial 24 mortgages at banks and insurance companies and on loans Expenditures that back mortgage securities have been declining from 22 already low levels. Receipts Expenditures 20 excluding net interest The Government Sector 18 Federal Government 16 The deficit in the federal unified budget narrowed over the past year. Over the twelve months ending in June, 1985 1990 1995 2000 2005 the unified budget recorded a deficit of $336 billion, NOTE: The budget data are from the unified budget through 2004 and are $99 billion less than during the comparable period last for fiscal years (October through September), and GDP is for Q4 to Q3. For year. Both revenues and outlays rose faster than did nomi­ 2005, the budget data are for the twelve months ending in June, and GDP is for 2004:Q4 to 2005:Q1. nal GDP over this period, but the rise in receipts was SOURCE: Office of Management and Budget. Board of Governors of the Federal Reserve System 11 Change in real government expenditures Federal Borrowing on consumption and investment Because of the need to finance the sizable federal budget Percent, annual rate deficit, federal debt held by the public expanded at a sea­ Federal sonally adjusted annual rate of 13¾ percent in the first State and local quarter of the year. The ratio of this debt to nominal GDP 9 increased to more than 37 percent for the first time since 2000. The average maturity of outstanding marketable 6 Treasury debt has been declining for several years and reached fifty-three months at the end of the first quarter 3 of 2005, down from about seventy months in 2000. How- Q1 ever, in the May mid-quarter refunding statement, the + 0_ Treasury announced that it was considering reintroduc­ ing regular issuance of a thirty-year nominal bond in Feb­ ruary 2006, a move that would presumably slow or arrest 1999 2001 2003 2005 this downtrend. SOURCE: Department of Commerce, Bureau of Economic Analysis. Indicators of demand for Treasury securities by for­ eign investors have been mixed so far this year; demand The deficit in the federal budget has depressed by foreign official institutions seems to have moderated, national saving in the past few years. The narrowing of but demand by foreign private investors appears to have the deficit of late has lessened this reduction in national remained robust. Indirect bidders at Treasury auctions— saving from a little more than 3 percent of nominal GDP which include foreign official institutions that place bids in 2003 and 2004 to roughly 2 percent in the first quarter through the Federal Reserve Bank of New York—have of 2005. Even so, as business and personal saving rates been awarded an average of 33 percent of coupon securi­ changed little, on average, over the past year, net national ties issued at auctions held so far this year, down from saving rose to just 3¼ percent of nominal GDP in the 42 percent in 2004. Treasury securities held in custody at first quarter, well below the long-term historical average the Federal Reserve Bank of New York on behalf of for­ of about 7 percent and below recent levels of net domes- eign official institutions have grown only about $25 bil­ tic investment. If not reversed, such a low level of net lion so far this year after an increase of more than $200 national saving will necessitate either slower capital for­ billion in 2004. Data from the Treasury International Capi­ mation or continued heavy borrowing from abroad. The tal System also suggest an ebbing of demand for Trea­ pressures on national saving will intensify greatly with sury securities from foreign official investors during the the retirement of the baby-boom generation and the asso­ first five months of the year. These data, however, indi- ciated increases in Social Security and Medicare benefit payments. Federal government debt held by the public Net saving Percent of nominal GDP Percent of nominal GDP 12 55 Nonfederal saving 9 45 6 35 3 Total + 0_ 25 Federal saving 3 1965 1975 1985 1995 2005 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 NOTE: The final observation is for 2005:Q1. For previous years, the data NOTE: The data are quarterly and extend through 2005:Q1. Nonfederal for debt are as of year-end, and the corresponding values for GDP are for Q4 saving is the sum of personal and net business saving and the net saving of at an annual rate. Excludes securities held as investments of federal gov­ state and local governments. ernment accounts. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Federal Reserve Board, flow of funds data. 12 Monetary Policy Report to the Congress July 2005 cate that foreign private investors have continued to ac­ State and Local Government Borrowing cumulate Treasury securities at a rapid pace. State and local government debt held by the public expanded at a rapid pace in the first quarter of the year, State and Local Governments rising at a seasonally adjusted annual rate of 16¼ per- cent, up from 5½ percent in the fourth quarter of last year. The fiscal positions of states and localities have improved However, much of this borrowing was for the advance this year. Ongoing gains in income and consumer spend­ refunding of existing debt, as state and local governments ing, along with sharp increases in property values, have continued to take advantage of low long-term interest continued to boost tax receipts. Although many jurisdic­ rates. A significant portion of the proceeds of these tions have increased their spending moderately, some are advance refundings were invested in U.S. Treasury also using the additional revenues to rebuild reserve funds. instruments tailored to meet the cash management needs On a NIPA basis, net saving by state and local govern­ of municipal governments. In addition, financing of trans­ ments equaled $34 billion at an annual rate in the first portation- and education-related projects boosted issu­ quarter (roughly ¼ percent of nominal GDP), double the ance of long-term municipal bonds for new capital. 2004 average. In addition, virtually all states registered The credit quality of municipal borrowers improved surpluses in their general fund budgets in fiscal year 2005, last year, and this trend has generally continued so far in which ended on June 30 for all but four states. Neverthe­ 2005, as upgrades of municipal bonds by Standard & less, lingering fiscal concerns are still evident in some Poor’s continued to outpace downgrades. jurisdictions; these concerns are related primarily to rising Medicaid costs, the termination of temporary fed­ eral grants that were appropriated in fiscal year 2004, The External Sector and pressures to restore funding to programs—such as elementary and secondary education—that were cut back The U.S. current account deficit expanded in the first earlier in the decade. quarter of 2005 to $780 billion at an annual rate, or about Real consumption and investment spending by state 6.4 percent of nominal GDP. The deficit in trade in goods and local governments edged down in the first quarter of continued to widen, increasing $17 billion from the pre­ 2005 after having changed little in 2004. Real outlays for vious quarter. The deficit on net unilateral transfers also consumption items increased at an annual rate of less than widened in the first quarter, largely because of an increase ½ percent, a reflection of some slowing in the pace of in government grants. In contrast, the surplus on trade in hiring. Nominal spending on investment rose at a moder­ services rose $7 billion, and the surplus on net invest­ ate rate in the first quarter, but because construction costs ment income rose $2 billion. escalated, investment spending declined a little in real terms. International Trade State and local government net saving Real exports of goods and services accelerated in the first quarter of 2005 to an annual rate of about 9 percent, Percent of nominal GDP roughly twice as fast as the rate in the second half of last year. The dollar’s decline in recent years has raised the .6 competitiveness of U.S. relative prices and has contin­ ued to provide a mounting boost to exports. Support from .4 foreign economic activity, though still substantial, mod­ .2 erated after the first half of 2004 as growth abroad slowed. + Increases in exports of U.S. goods were widespread across 0_ major U.S. trading partners, with the exception of Japan, and were concentrated in capital goods and consumer .2 goods. Real exports of services rose at an annual rate of .4 about 13¼ percent. Real imports of goods and services rose at an annual 1981 1984 1987 1990 1993 1996 1999 2002 2005 rate of about 9½ percent in the first quarter, a pace simi­ lar to the average in 2004. The growth of real oil imports NOTE: The data, which are quarterly, are on a national income and product account basis and extend through 2005:Q1. Net saving excludes social ebbed after surging late last year. Increases in imports of insurance funds. non-oil goods were widespread across categories. The SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 13 U.S. trade and current account balances Prices of oil and of nonfuel commodities Percent of nominal GDP January 2001 = 100 Dollars per barrel + 0_ 60 160 1 50 140 2 Trade 40 3 120 Current Oil account 30 4 100 20 5 Nonfuel 80 6 10 1997 1998 1999 2000 2001 2002 2003 2004 2005 2001 2002 2003 2004 2005 NOTE: The data are quarterly and extend through 2005:Q1. NOTE: The data are monthly and extend through June 2005. The oil price is SOURCE: Department of Commerce. the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices. SOURCE: For oil, Wall Street Journal; for nonfuel commodities, Inter- national Monetary Fund. expiration of the Multifibre Arrangement and the result­ ing elimination of quotas shifted the source of some U.S. Prices of imported non-oil goods rose at an annual textile and apparel imports among U.S. trading partners, rate of 3¾ percent in the first quarter, almost 1½ percent- but these events appear to have had a limited effect on age points faster than in the second half of 2004. Prices the overall level of imports of these goods. Real imports of material-intensive items, such as industrial supplies of services reversed their fourth-quarter decline, posting and foods, steadily increased in the last quarter of 2004 a gain of 7 percent at an annual rate, as some travel- and in the first quarter of 2005. In part, this rise reflected related expenditures and also royalties and license fees higher prices for nonfuel primary commodities, as strength recovered from a very weak fourth quarter. in global demand for many commodities outstripped a Boosted by substantial increases in the prices of pri­ slow expansion of supply. Prices for finished goods, such mary commodities and industrial supplies, prices of total as consumer goods and many kinds of capital goods, exports rose at an annual rate of 4¼ percent in the first also turned noticeably higher. Available data for the sec­ quarter. Prices of U.S. agricultural exports rebounded in ond quarter show that the increases in prices of both the first quarter after good harvests in the second half of material-intensive and finished goods have slowed. 2004 had caused prices to fall sharply. The available data for the second quarter point to continued increases in export prices. Prices of major nonfuel commodities January 2001 = 100 Change in real imports and exports of goods and services Percent, annual rate 170 Imports Exports 15 145 Metals Q1 10 120 5 + Food 0_ r A aw gr m ic a u t l e tu ri r a a l l s 95 5 2001 2002 2003 2004 2005 10 NOTE: The data are monthly and extend through June 2005. The category of agricultural raw materials consists of timber, cotton, wool, rubber, and 1997 1999 2001 2003 2005 hides; food includes cereals, vegetable oils and protein meals, seafood, and meat; and metals includes aluminum, copper, and iron ore. SOURCE: Department of Commerce. SOURCE: International Monetary Fund. 14 Monetary Policy Report to the Congress July 2005 The spot price of West Texas intermediate (WTI) crude U.S. net international securities transactions oil began 2005 near $43 per barrel, but it climbed above $50 per barrel in late February and breached $60 per Billions of dollars barrel in late June. The increase in the spot price of WTI Net private foreign purchases of U.S. securities 200 largely reflects several global factors: continued strong Bonds 175 demand for oil, limited spare production capacity, and Equities concerns about the reliability of supply from some for­ 150 eign sources. In contrast to the market outlook during 125 last October’s peak in oil prices, futures contracts 100 indicate that market participants now expect oil prices to 75 remain near their current high levels, a view consistent 50 with the belief that demand will remain strong and pro­ 25 duction will have difficulty keeping pace. The price of + 0_ the far-dated NYMEX oil futures contract (currently for delivery in December 2011) rose from about $38 per bar­ 2001 2002 2003 2004 2005 rel as of last October to about $56 per barrel in late June. SOURCE: Department of Commerce and the Federal Reserve Bank of New OPEC spare production capacity appears to be near York. historical lows, with only Saudi Arabia able to increase production substantially. Many other OPEC producers are either pumping close to capacity or encountering pro­ 2004, slowed significantly in the first quarter but showed duction problems. Venezuela and Indonesia cannot meet signs of renewed strength in April and May. In contrast, their production quotas, and Iraqi production this year private inflows moderated in April and May after having has averaged less than in 2004. In addition, several gov­ increased substantially in the preceding six months. As ernments have moved to increase their control of the has been the case for several years, the U.S. current energy industry as oil prices have risen. Russian oil pro­ account has been financed primarily by foreign purchases duction, which had provided most of the growth in non- of U.S. debt securities. U.S. residents’ purchases of for­ OPEC supply over the previous five years, has stagnated eign securities increased after a temporary lull in the fourth since last September amid the partial nationalization of quarter and have been more heavily weighted toward Yukos, formerly Russia’s largest oil company. Venezuela purchases of equities. has also increased the taxes and royalty payments of for­ Net direct investment outflows in the first quarter were eign oil firms. well below their levels in the fourth quarter; direct investment into the United States was roughly unchanged, but U.S. direct investment abroad fell back after a surge The Financial Account in new equity late last year. There is little evidence to date that U.S. companies have repatriated earnings from Foreign official inflows, which accounted for more than their foreign subsidiaries using the temporarily reduced half of all net financial inflows to the United States in tax rate available under the American Jobs Creation Act of 2004. However, there are indications that these remit­ U.S. net financial inflows tances may pick up in the second half of this year. Billions of dollars Official 200 The Labor Market Private 175 Employment and Unemployment 150 125 Labor markets have continued to improve this year, 100 albeit at an uneven pace from month to month. On aver- 75 age, nonfarm payroll employment expanded roughly 50 180,000 per month over the first half of 2005, about the 25 + same pace as in the fourth quarter of 2004. At the same 0_ time, the civilian unemployment rate, which had declined 25 from 5¾ percent to just below 5½ percent over 2004, 2001 2002 2003 2004 2005 continued to move down. The jobless rate stood at 5 percent in June, the lowest level since September 2001. SOURCE: Department of Commerce. Board of Governors of the Federal Reserve System 15 Net change in payroll employment Labor force participation rate Thousands of jobs, monthly average Percent Nonfarm 300 Q2 200 67 100 + 64 0_ 100 61 200 1999 2001 2003 2005 1975 1985 1995 2005 SOURCE: Department of Labor, Bureau of Labor Statistics. NOTE: The data are monthly and extend through June 2005. SOURCE: Department of Labor, Bureau of Labor Statistics. The increases in payrolls over the first half of 2005 were relatively widespread across industries. Particularly ments slowed somewhat in the first half of this year from sizable gains were registered at providers of health-care the pace in the second half of last year, and federal civil­ services and leisure and hospitality services and at ian employment changed little. establishments that provide business services, such as pro­ The gradual rise in job opportunities appears to be fessional and technical assistance and administrative and attracting some potential workers back into the labor mar­ support services (a category that includes temporary help). ket. The labor force participation rate, which had declined In addition, construction employment continued to climb noticeably between 2000 and 2004, edged up over the at a steady pace, a reflection of the buoyant residential first half of 2005. Nevertheless, the participation rate in housing market and increased spending on infrastructure June, at 66 percent, remained well below the high of by state and local governments. In contrast, manufactur­ 67¼ percent reached in early 2000. To some extent, both ing employment continued to trend down, as cutbacks in the high level of the participation rate in 2000 and the industries that produce wood products, furniture, and a more recent decline are likely related to cyclical devel­ variety of nondurable goods more than offset hiring at opments in the economy: The tight labor markets of the producers of fabricated metals and machinery. Employ­ late 1990s, perhaps coupled with the introduction of work ment in retail trade has advanced at a moderate pace this requirements for many welfare recipients, undoubtedly year. Increases in employment at state and local govern- drew additional people into the labor force at that time, while the subsequent recession and slow recovery in the labor market have discouraged many job seekers in recent years. However, the downtrend in the aggregate Civilian unemployment rate participation rate also appears to be associated with structural developments that seem likely to limit future Percent increases. For example, the large baby-boom cohorts are now entering ages at which labor force participation rates 10 typically drop off sharply. And, in contrast to patterns observed in previous decades, participation rates for 8 women between 25 and 54 years of age no longer appear to be trending up. 6 4 Productivity and Labor Costs 2 Gains in labor productivity have slowed, on balance, in recent quarters. According to currently published data, 1975 1985 1995 2005 output per hour in the nonfarm business sector rose NOTE: The data are monthly and extend through June 2005. SOURCE: Department of Labor, Bureau of Labor Statistics. 2½ percent over the year ending in the first quarter of 16 Monetary Policy Report to the Congress July 2005 2005, down from the 5½ percent pace registered in the performance of profits in 2004 may have been associ­ comparable period a year earlier. A deceleration in pro­ ated with sizable nonproduction bonus payments at the ductivity is not unusual as an economic expansion end of last year. matures and as businesses—which become increasingly A more modest rate of increase in hourly compensa­ confident about future prospects for sales—step up their tion is indicated by the employment cost index (ECI), pace of hiring. In addition, the recent slowdown in pro­ which is based on a quarterly survey of private nonfarm ductivity growth was from the unusually rapid average establishments conducted by the Bureau of Labor Statis­ rate that prevailed between 2002 and early 2004. That tics and which excludes income received from the exer­ elevated rate likely reflected both an atypical reluctance cise of stock options. In particular, the ECI measure of to hire—as employers reacted to a succession of economic hourly compensation rose 3½ percent over the twelve and geopolitical shocks—and newfound efficiencies months ending in March 2005, about ½ percentage point brought about by the better use of high-tech capital pur­ less than the increases over the preceding two years. The chased by businesses in earlier years and by organiza­ wages and salaries component of the ECI was up just tional changes implemented to maintain profitability when 2½ percent over the twelve months ending in March, a the economy was relatively weak. As the impetus from pace similar to that in the preceding year, while employer these influences has waned, productivity growth has fallen costs for benefits increased 5¾ percent, a bit below the back. pace of the previous year but a sizable gain nonetheless. Measures of labor compensation for recent quarters Part of the outsized rise in benefit costs stemmed from suggest that the remaining slack in labor markets contin­ the need by many companies to rebuild their defined- ued to restrain increases in base wage rates but that large benefit pension assets to make up for earlier losses in increases in some of the more flexible components of those plans. In addition, health insurance costs have con­ worker pay and for some types of employer-provided tinued to rise more rapidly than wages, although the benefits added to labor costs. In particular, compensa­ 7½ percent increase in these costs over the year ending tion per hour in the nonfarm business sector, which is in March of this year was down from the double-digit based on the data from the national income and product rates of growth in 2002 and 2003. accounts, rose 7 percent over the four quarters ending in The acceleration in the nonfarm business measure of the first quarter of this year, having registered a particu­ hourly compensation, coupled with the deceleration in larly large bulge in the final quarter of 2004. Much of productivity, has contributed to a noticeable pickup in this sharp rise may be the result of the exercise of a large unit labor costs in recent quarters. In particular, unit number of stock options late last year, a development labor costs rose 4¼ percent over the four quarters ending perhaps induced by an increase in equity prices that in the first quarter of 2005 after having declined 1 per- boosted the number of options that were “in the money” cent over the preceding four quarters. However, to the and by a proposed change in accounting regulations that extent that the acceleration in compensation was the led some companies to accelerate the vesting of options that had been previously granted. In addition, the strong Measures of change in hourly compensation Percent Change in output per hour Percent, annual rate Nonfarm compensation 8 per hour 5 6 4 4 Q1 3 Employment cost index 2 2 1995 1997 1999 2001 2003 2005 1 NOTE: The data are quarterly and extend through 2005:Q1. For nonfarm compensation, change is over four quarters; for the employment cost index 1948–73 1973–95 1995–2000 2003 2005 (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. Board of Governors of the Federal Reserve System 17 Change in unit labor costs Change in consumer prices Percent, annual rate Percent, annual rate Consumer price index 5 Chain-type price index for PCE 4 Q1 4 3 2 1 2 + 0_ 1 1999 2001 2003 2005 1999 2001 2003 2005 NOTE: Nonfarm business sector. The change in unit labor costs is defined NOTE: For 2005, the change for the PCE price index is from 2004:Q4 to as the increase in nonfarm compensation per hour less the growth in labor May 2005; for the consumer price index, it is from 2004:Q4 to 2005:Q2. productivity. SOURCE: For consumer price index, Department of Labor, Bureau of Labor SOURCE: Department of Labor, Bureau of Labor Statistics. Statistics; for chain-type measure, Department of Commerce, Bureau of Economic Analysis. result of a temporary bulge in stock option exercises in nearly 10 percent above their level at the end of last year, late 2004, unit labor costs should moderate significantly and they moved up further in early July. Electricity prices this year. Moreover, the implications of such a spike in also rose sharply over the first half of 2005 because of unit labor costs for price inflation are probably minimal, higher input costs for electricity generation. at least as judged by previous spikes of this nature. For Consumer food prices increased at an annual rate of example, the sharp rise in unit labor costs in 2000 had about 2½ percent over the first half of 2005, a bit less little or no subsequent effect on price inflation. than in 2004. Prices for fruits and vegetables dropped back early in the year, as supplies recovered from the damage associated with last year’s succession of hurri­ Prices canes. Although these prices turned up a little in the spring, they remain below their fourth-quarter levels. In contrast, Higher energy prices continued to show through to over- meat prices rose at an annual rate of 3 percent over the all consumer price inflation this year. The chain-type price first half of the year; relatively strong domestic demand index for personal consumption expenditures rose at an has lifted prices despite increases in the number of cattle annual rate of about 2½ percent between the fourth quar­ being fed for slaughter and ample supplies of other meats ter of 2004 and May 2005, a rate of increase similar to and poultry. Prices for beef were also influenced by a that over the four quarters of 2004. Within that total, core variety of trade restrictions associated with concerns about PCE prices accelerated over that period to an annual rate mad cow disease: Both the full resumption of imports of about 2 percent, from 1½ percent in 2004. However, data for the consumer price index (CPI), which are avail- able through June, suggest that core inflation Alternative measures of price change has moderated in recent months; the core CPI rose at an Percent annual rate of 1¼ percent in the three months ending in June after having increased at a 3¼ percent pace over the Price measure 2003 to 2004 2004 to 2005 first three months of this year. Chain-type (Q1 to Q1) Gross domestic product (GDP) ....................... 1.7 2.4 The PCE price index for energy, which moved up more Gross domestic purchases ................................ 1.7 2.8 than 18 percent in 2004, increased at an annual rate of Personal consumption expenditures (PCE) ..... 1.7 2.2 Excluding food and energy .......................... 1.4 1.6 nearly 14 percent between the fourth quarter of 2004 and Market-based PCE excluding food and energy ........................................................... 1.3 1.7 May 2005, having been pushed higher by a further run- up in crude oil prices. Gasoline prices climbed especially Fixed-weight (Q2 to Q2) Consumer price index ...................................... 2.9 2.9 rapidly between February and April, when higher crude Excluding food and energy .......................... 1.8 2.2 costs were accompanied by a significant widening in NOTE: Changes are based on quarterly averages of seasonally adjusted data. retail margins. Although these margins subsequently SOURCE: For chain-type measures, Department of Commerce, Bureau of Eco­ nomic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor dropped back, retail gasoline prices in June were still Statistics. 18 Monetary Policy Report to the Congress July 2005 from Canada (which would tend to push down prices) lative-grade debt had become very tight by the end of the and the resumption of exports to other important trading first quarter, but they subsequently rose, on balance, partners (which would tend to push up prices) were de­ after the downgrades of Ford and General Motors; cur- layed. Prices of food away from home, for which labor rent levels suggest more-typical compensation for costs are more important than raw food costs, rose at an default risk. Banks continued easing terms and standards annual rate of about 3½ percent over the first half of this on lending to businesses. The pace of business borrow­ year, a little higher than the recent trend. ing, which had been sluggish, picked up last year and The pickup in core PCE inflation this year is due both remained fairly robust in the first half of 2005. Neverthe­ to the sharp run-up in energy prices and to higher prices less, strong corporate profits and the large stockpile of for other intermediate materials; these developments have liquid assets already on firms’ balance sheets continued raised production and distribution costs for a wide range to limit their demand for external financing. Debt of the of domestically produced goods and services. In addi­ federal government, of state and local governments, and tion, the decline in the exchange value of the dollar into of households continued to expand briskly. Broad equity early 2005 continued to push up prices of core nonfuel price indexes were little changed on net; higher oil prices imports this year, both for items used in the domestic pro­ boosted share prices in the energy sector but weighed on duction of other goods and services and for items sold other stocks. directly to consumers. Partially offsetting these influences have been the gains in productivity, which have enabled firms to absorb a portion of the higher costs. Moreover, Interest Rates although the price of crude oil remains high, prices for some other industrial materials have decelerated or edged The FOMC boosted the intended federal funds rate down of late: The Journal of Commerce industrial price 25 basis points at each of its four meetings in the first index—which excludes energy items—has fallen 6 per- half of the year. Judging from federal funds futures quotes, cent since the beginning of April, while the producer price these policy actions had all been widely anticipated by index for core intermediate materials rose at an annual investors for some time before each meeting. Since the rate of just 1¼ percent in the second quarter of this year start of the year, rates on interest rate futures contracts after having increased at roughly a 7 percent pace, on that will expire at the end of 2005 have moved up about average, in the preceding few quarters. 60 basis points in response to evidence of robust eco­ Measures of shorter-term inflation expectations have nomic growth and concerns about the possible emergence edged higher this year, while those of longer-term expec­ of inflationary pressures. Two-year nominal Treasury tations have held steady or moved lower. Most notably, yields have risen about 80 basis points over that period, the Michigan SRC survey indicates that households’ reflecting both the firming of policy expectations and median expectations for inflation over the next twelve actual monetary policy tightening. months have ranged between 3 percent and 3¼ percent Nevertheless, ten-year nominal Treasury yields have in recent months, up from just under 3 percent at the edged down so far this year and are now about 60 basis beginning of the year. In contrast, households’ median points below their level just before the FOMC meeting expectations for inflation over the next five to ten years, in June 2004. Moreover, this fall in long-term yields is a at a little under 3 percent, are similar to readings in global phenomenon: Long-term yields have declined in recent years. The latest Survey of Professional Forecast­ most foreign industrialized economies, in several cases ers likewise shows that inflation is expected to average by more than in the United States. From the term struc­ 2½ percent over the next ten years, a figure unchanged ture of interest rates, the ten-year Treasury yield can be since 2001. Readings of longer-term inflation compen­ decomposed into a series of ten consecutive one-year for- sation from financial markets show a more pronounced ward rates. The last of these—the one-year forward rate decline: Inflation compensation as measured by the spread ending ten years hence—now stands about 160 basis of the yield on nominal Treasury securities over their points below its level just before the June 2004 FOMC indexed counterparts for the period five to ten years ahead meeting. has fallen about 50 basis points since the end of 2004. Several potential explanations have been offered for the decline in long-term yields and distant-horizon for- ward rates in the United States since mid-2004. Among U.S. Financial Markets these is the possibility that long-term inflation expecta­ tions have fallen and become more firmly anchored. Financial market conditions remained generally accom­ Indeed, longer-term inflation compensation, measured by modative during the first half of 2005, as Treasury and the spread between the yields on ten-year Treasury infla­ private interest rates stayed low. Risk spreads on specu­ tion-protected securities and their nominal counterparts, Board of Governors of the Federal Reserve System 19 Interest rates on selected Treasury securities Spreads of corporate bond yields over comparable off-the-run Treasury yields Percent Percentage points 6 Ten-year 10 5 8 4 High-yield 6 3 Two-year BBB 4 2 Three-month 2 1 AA + _0 2002 2003 2004 2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 NOTE: The data are daily and extend through July 13, 2005. SOURCE: Department of the Treasury. NOTE: The data are daily and extend through July 13, 2005. The high-yield index is compared with the five-year Treasury yield, and the BBB and AA indexes are compared with the ten-year Treasury yield. SOURCE: Merrill Lynch AA and BBB indexes and Merrill Lynch Master II high-yield index. has fallen about 30 basis points over this period. A sec­ ond possible explanation is investors’ willingness to Spreads of yields on investment-grade corporate debt accept smaller risk premiums on long-term securities amid over those on comparable-maturity Treasury securities declining macroeconomic and interest rate uncertainty. fell during the first quarter of 2005, and risk spreads on The volatility of short-term interest rates and Treasury high-yield corporate debt reached very low levels. How- yields implied by option prices has indeed declined to ever, in March, news about difficulties in the domestic historically low levels. A third possibility is that several motor vehicle industry apparently became a focal point factors have spurred an excess of global saving over for a revision of investors’ assessment of risks. Further planned investment, such as rising incomes in countries revelations of accounting irregularities in the insurance with high saving rates, the desire by the aging citizens of industry also seem to have made investors somewhat many industrialized countries to save for retirement, and charier of risk. As a result, risk spreads on corporate bonds apparently diminished investment prospects in many and credit default swaps have widened; speculative-grade industrialized and developing economies. bond spreads are now about 50 basis points higher than at the start of the year. TIPS-based inflation compensation Equity Markets Percentage points Broad equity price indexes fell modestly in the first quar­ 3.5 ter, but they rebounded and are now little changed, on Five-year, five-year ahead net, since the start of 2005. Thus far this year, stock prices 3.0 have been buoyed by continued strong profits and low long-term interest rates, but higher oil prices and a few 2.5 high-profile earnings disappointments have weighed 2.0 on share prices outside the energy sector. The forward earnings–price ratio held about steady despite the fall in 1.5 real interest rates. Equity price volatility implied by quotes on stock options declined, as the implied volatility on the Five-year 1.0 S&P 500 index dropped to a record low level of less than 11 percent. 2002 2003 2004 2005 Net inflows into equity mutual funds were moderate NOTE: The data are daily and extend through July 13, 2005. Based on a comparison of the yield curve for Treasury inflation-protected securities in the first half of 2005, down from the rapid pace during (TIPS) to the nominal off-the-run Treasury yield curve. the same period last year. These flows likely followed SOURCE: Federal Reserve Board calculations based on data provided by the Federal Reserve Bank of New York and Barclays. the pattern set by share prices, which surged about 20 Monetary Policy Report to the Congress July 2005 Stock price indexes picked up even though ample internal funding continued to limit firms’ need for external financing. January 2, 2002 = 100 Commercial bank credit expanded at an annual rate of 13 percent in the first quarter of 2005. Financing secured by residential real estate, including home mortgages, 140 home equity loans, and mortgage-backed securities, Russell 2000 extended its long, robust expansion. In May, the Federal 120 Reserve Board and other federal agencies that regulate depository institutions issued guidance on sound under- 100 writing and effective credit-risk-management practices for Wilshire 5000 home equity lending. Recently there has been increased use of potentially riskier types of mortgages, including 80 adjustable-rate and interest-only loans, which could pose challenges to both lenders and borrowers. Business loans, 2002 2003 2004 2005 which had begun to grow in 2004 after several years of runoffs, accelerated to a 15 percent annual rate of growth NOTE: The data are daily and extend through July 13, 2005. SOURCE: Frank Russell Company; Dow Jones Indexes. in the first quarter of 2005, supported in part by strong demand for short-term financing to fund rising accounts Implied S&P 500 volatility Change in domestic nonfinancial debt Percent Percent 40 10 30 8 20 Total 6 10 4 1997 1998 1999 2000 2001 2002 2003 2004 2005 NOTE: The data are daily and extend through July 13, 2005. The series shown is the implied thirty-day volatility of the S&P 500 stock price index as Percent calculated from a weighted average of options prices. SOURCE: Chicago Board Options Exchange. 15 Nonfederal 10 30 percent in 2003, rose about 10 percent in 2004, and have been flat so far this year. 5 + 0_ Debt and Financial Intermediation Federal, 5 held by public 10 The aggregate debt of the domestic nonfinancial sectors expanded at an annual rate of about 10 percent in the first quarter of 2005, up from an 8¼ percent pace in the 1991 1993 1995 1997 1999 2001 2003 2005 fourth quarter of 2004, mainly because of faster growth NOTE: For 2005, change is from 2004:Q4 to 2005:Q1 at an annual rate. For earlier years, the data are annual and are computed by dividing the annual of federal government debt and state and local govern­ flow for a given year by the level at the end of the preceding year. The total ment debt. The mix of household and business debt growth consists of nonfederal debt and federal debt held by the public. Nonfederal debt consists of the outstanding credit market debt of state and local gov­ has shifted modestly since the same time last year. House- ernments, households, nonprofit organizations, and nonfinancial businesses. hold debt decelerated, though it continued expanding at Federal debt held by the public excludes securities held as investments of federal government accounts. a rapid pace, and the growth of business-sector debt SOURCE: Federal Reserve Board, flow of funds data. Board of Governors of the Federal Reserve System 21 M2 growth rate sured by an export-weighted average of growth among U.S. trading partners. The pace of expansion in the Percent industrial economies has generally increased, but, with the important exception of China, this increase has been 10 offset by moderating growth in many developing econo­ mies. Inflation has remained well contained in most 8 countries. The stance of monetary policy has not changed this 6 year in most major foreign economies. The European Central Bank has held its policy rate constant since June 4 2003, and both the Bank of England and the Bank of Canada have kept policy rates unchanged after having 2 raised them in the latter half of 2004. The Bank of Japan has maintained its commitment to a policy of quantita­ 1991 1993 1995 1997 1999 2001 2003 2005 tive easing until deflation ends, but in late May it made NOTE: For 2005, growth is estimated using monthly data through May; for what it described as a technical change to allow tempo­ earlier years, the data are annual averages. M2 consists of currency, traveler’s rary deviations below the target range for reserve accounts checks, demand deposits, other checkable deposits, savings deposits (in­ cluding money market deposit accounts), small-denomination time deposits, if banks’ demand for funds is too weak to satisfy the tar- and balances in retail money market funds. get. Reserve account balances temporarily fell below SOURCE: Federal Reserve Statistical Release H.6, “Money Stock Measures.” ¥30 trillion, the lower end of the target, in early June. Monetary policy has also remained unchanged in most emerging Asian economies; however, several Latin Ameri­ receivable, inventories, and merger and acquisition can monetary authorities have continued tightening cycles activity. that began last year in efforts to restrain inflationary Credit market assets held by government-sponsored pressures. enterprises declined in the first quarter of this year, as After having edged up during the first three months of Freddie Mac and Fannie Mae reduced their outright hold­ this year, long-term interest rates in the major foreign ings of mortgage-backed securities. industrial economies have fallen and now stand below their levels at the start of the year. As in the United States, the decline in foreign long-term interest rates continues a The M2 Monetary Aggregate trend that began in mid-2004. However, long-term rates in the major foreign industrial economies have fallen more In the first half of 2005, M2 grew at a 2½ percent annual than rates in the United States this year. The decline in rate—probably slower than nominal GDP and down from a 5¼ percent pace last year. Slower growth in liquid deposits—likely a consequence of their rising opportu­ nity cost—accounted for most of this deceleration. Yields Official interest rates in selected foreign industrial countries on retail money market mutual funds rose noticeably in the first half but continued to lag interest rates on market Percent instruments, and assets in these funds continued their pro- longed runoff. Small time deposits, whose yields have 6 better kept pace with rising market interest rates, rose 5 briskly during the same period. Currency expanded at a United Kingdom slow rate, apparently a reflection in large measure of weak 4 demand from abroad. On net, the velocity of M2 is esti­ Canada 3 mated to have moved up in the first half at a somewhat slower pace than would be expected from the historical 2 Euro area relationship between money, income, and opportunity 1 cost. Japan + _0 International Developments 2002 2003 2004 2005 NOTE: The data are as of month-end; the last observation for each series is Foreign economic activity has expanded a bit less rap- for July 13, 2005. The data shown are the call money rate for Japan, the overnight rate for Canada, the refinancing rate for the euro area, and the idly this year than in the second half of 2004, as mea- repurchase rate for the United Kingdom. 22 Monetary Policy Report to the Congress July 2005 Yields on benchmark goverment bonds in selected U.S. dollar exchange rate against foreign industrial countries selected major currencies Percent Week ending January 4, 2002 = 100 Canada United Kingdom Canadian 5 dollar 100 4 90 Germany 3 Japanese yen Euro 80 2 Japan 70 1 U.K. pound 2002 2003 2004 2005 2002 2003 2004 2005 NOTE: The data are for ten-year bonds and are daily. The last observation is NOTE: The data are weekly and are in foreign currency units per dollar. The for July 13, 2005. last observation for each series is the average of July 11, 2005, through July SOURCE: Bloomberg L.P. 13, 2005. SOURCE: Bloomberg L.P. European long-term rates occurred amid weak economic As foreign interest rates have fallen in recent months, news and a shift away from market expectations of a the value of the dollar has risen. Most of this rise has policy rate increase. In contrast, long-term rates in Canada been against the currencies of the major industrial coun­ and the United Kingdom have trended down despite tries; the dollar is largely unchanged against the curren­ policy rate increases in the second half of last year by cies of the United States’ other important trading part­ both countries’ central banks, though market perceptions ners. The dollar has appreciated about 12 percent against that the Bank of England may cut rates have recently the euro and about 9 percent against the yen and sterling increased. Although the decline in Japanese rates last year since the start of the year. Some of the appreciation against was consistent with both the weak performance of the the euro occurred after voters in France and the Nether- economy and the persistence of deflation, long-term rates lands rejected the proposed constitution for the European fell further this year despite solid growth in the first Union by unexpectedly large margins in May. quarter. European, British, and Canadian stock indexes have risen more than 8 percent since the start of the year. The U.S. dollar nominal exchange rate, broad index January 2001 = 100 Equity indexes in selected foreign industrial countries 105 Week ending January 4, 2002 = 100 100 130 Canada 115 Japan 95 100 90 85 70 United Kingdom 2002 2003 2004 2005 Euro area 55 NOTE: The data are monthly and are in foreign currency units per dollar. The last observation is the average of trading days from July 1, 2005, through July 13, 2005. The broad index is a weighted average of the foreign exchange 2002 2003 2004 2005 values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived NOTE: The data are weekly. The last observation for each series is the from U.S. export shares and from U.S. and foreign import shares. average of July 11, 2005, through July 13, 2005. SOURCE: Federal Reserve Board. SOURCE: Bloomberg L.P. Board of Governors of the Federal Reserve System 23 Equity indexes in selected emerging-market economies cent after having temporarily registered a more modest decline in the fourth quarter of 2004. Week ending January 3, 2003 = 100 The pace of activity in the euro area appears to have slowed after a stronger start to the year. Real GDP grew 300 at a 2 percent annual rate in the first quarter, as private consumption rose moderately and both households and Argentina 255 firms switched expenditures away from imports and 210 toward domestically produced goods. Both Germany and Mexico Spain grew at rates above the area average in the first 165 quarter. In contrast, real GDP in both Italy and the Neth­ erlands declined, while French growth was slower than Asian emerging- 120 Brazil market economies in most of 2004. Measures of activity point toward slower 75 growth in the euro area in the second quarter. Retail sales, which had risen in the first quarter, were roughly flat, on 2002 2003 2004 2005 average, in April and May. The trade balance fell in April, NOTE: The data are weekly. The last observation for each series is the threatening a main engine of growth, though the recent average of July 11, 2005, through July 13, 2005. The Asian emerging-market rise in the dollar against the euro should help stimulate economies are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, Singapore, South Korea, Taiwan, and Thailand; the index weight export demand going forward. Twelve-month consumer for each of these economies is its market capitalization as a share of the price inflation edged up in June to just above the Euro­ group’s total. SOURCE: For Asian emerging-market economies, Morgan Stanley Capital pean Central Bank’s target ceiling of 2 percent for infla­ International (MSCI) index; for others, Bloomberg L.P. tion over the medium term. The European Central Bank’s measure of core inflation, which excludes energy and rise in European stock prices is notable because indica­ unprocessed foods, has eased since January to an annual tors of economic activity have been fairly weak. In con­ rate comfortably below 2 percent. trast, Japanese stock prices are now little changed after Consumer spending in the United Kingdom increased having reversed first-quarter gains. Equity prices in the only modestly in the first quarter, slowing real GDP majority of emerging markets began the year on a strong growth to 1½ percent. Nevertheless, the labor market note but reversed course late in the first quarter and cur­ remains tight, as unemployment is at its lowest levels since rently stand close to their January levels. Despite these the mid-1970s and real earnings continue to trend up. The swings, intraday volatility has remained subdued in most twelve-month rate of consumer price inflation ticked up equity markets. in June to the Bank of England’s target of 2 percent. In its May Inflation Report, the Bank of England forecast that inflation would temporarily rise but stay near the tar- Industrial Economies get over a two-year period. House prices have been fairly stable this year, and household net mortgage borrowing Real GDP in Japan increased at an annual rate of nearly has also been subdued. 5 percent in the first quarter of 2005, bouncing back from Growth in Canada remains moderate. Continuing a pat- last year’s recession. Personal consumption spending tern that has largely held for the past two years, private reversed its recent declines, pushing the household sav­ consumption and investment demand rose in the first ing rate down further. Private investment also rose sharply quarter while net exports fell. Activity in the second quar­ after having grown tepidly in the second half of 2004. In ter appears to have been solid. Data on housing starts contrast, the external sector made a small negative con­ indicate that construction spending grew further, and the tribution to GDP, as imports rose modestly but exports merchandise trade surplus improved in April, as exports fell. While Japanese manufacturers of high-tech goods rose and imports decreased slightly. Twelve-month con­ reduced their levels of inventories from last year’s peak, sumer price inflation fell in May to about 1½ percent inventory stocks of firms outside the high-tech sector after having averaged slightly above 2 percent in the first increased, perhaps because of the slowdown in exports. quarter. The Bank of Canada’s measure of core inflation The labor market has steadily improved: The unemploy­ has stayed below 2 percent throughout this year. ment rate has reached a seven-year low, and the ratio of job offers to job applicants is at a twelve-year high. Despite the pickup in economic activity and continuing Emerging-Market Economies inflation in wholesale prices, consumer price deflation has worsened slightly. The GDP price deflator returned Chinese real GDP continues to rise rapidly following to a year-over-year rate of deflation of more than 1 per- strong growth in 2004. Economic expansion has been led 24 Monetary Policy Report to the Congress July 2005 by investment, exports, and, more recently, a surge in over the preceding twelve months raised short-term domestic production of goods that had previously been interest rates 500 basis points. Twelve-month consumer imported. Investment expenditure has remained vigorous price inflation has fallen from its levels of late last year despite the government’s attempts early last year to slow but still stands above the Bank of Mexico’s target range its rate of increase. Import growth slowed in the first quar­ of 2 percent to 4 percent. After having risen in the sec­ ter, but the rise of exports was unabated, leading to a ond half of last year, core inflation has also trended down significant widening of the trade surplus. Although in recent months. recent attention has focused on China’s exports of tex­ Economic growth in most South American economies tiles, export growth has remained strong across most has also slowed compared with the pace of activity at the major categories of goods. The slowdown in imports has end of 2004. Brazil’s real GDP rose at only a 1¼ percent also been broadly based. Despite China’s strong rate of annual rate in the first quarter, as both private consump­ economic expansion, consumer price inflation fell to less tion and investment declined in the wake of the Brazilian than 3 percent in the first quarter and has remained low, central bank’s decision to begin raising its policy rate in as declining food prices have offset modest increases in the second half of 2004 to counter inflationary pressures. nonfood prices. Exports, which rose rapidly and outpaced imports, pro­ Economic developments in other Asian emerging- vided the only bright spot. Twelve-month inflation has market economies have varied. Hong Kong maintained remained above 7 percent, and the central bank has con­ its strong performance. As in China, growth in Hong Kong tinued to raise its policy rate this year. Argentina has has been driven by both investment and exports. Export gradually recovered from its 2001 crisis, but real GDP growth has also played an important role in supporting sharply decelerated in the first quarter. The unemploy­ growth in most of the other countries in this region, but ment rate, which had steadily fallen over the past few domestic demand, particularly inventory investment, has years, also edged up slightly. Twelve-month consumer declined in many economies so far this year. Inflation price inflation appears to have stabilized after having been has risen slightly, reflecting higher food and energy prices, pushed up by food price increases earlier in the year, but but remains well contained and under 3 percent in most it still lies above the central bank’s unofficial target range countries. of 5 percent to 8 percent. The Argentine government The Mexican economy has slowed so far this year, as recently completed the final settlement of its debt demand for its manufacturing exports has weakened and exchange but has not yet resolved the treatment of the monetary tightening has tempered investment and con­ remaining investors (holders of roughly one-fourth of all sumption demand. The Bank of Mexico has left mon­ defaulted government bonds) who rejected the agreement. etary policy unchanged since March, but its tightening

Federal Reserve (2005, July 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20050720

@misc{wtfs_monetary_policy_report_20050720,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2005},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20050720},
  note = {Retrieved via When the Fed Speaks corpus}
}