Monetary Policy Report

For use at 10:00 a.m., EST Wednesday February 15, 2006 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress February 15, 2006 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 15, 2006 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 15, 2006 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, Ben Bernanke, Chairman Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2005 and Early 2006 4 Monetary Policy Report to the Congress Report submitted to the Congress on February 15, 2006, conditions remained supportive for businesses last year, pursuant to section 2B of the Federal Reserve Act facilitating a brisk expansion of capital spending. In addition, labor productivity has been on a strong uptrend in recent years, which has fostered substantial growth in MONETARY POLICY AND THE ECONOMIC OUTLOOK the economy’s productive capacity and no doubt lifted households’ and businesses’ assessments of their long- The U.S. economy delivered a solid performance in 2005 term income prospects. despite a further sharp increase in energy prices and dev- In light of elevated inflation pressures and shrinking astating hurricanes that claimed many lives, destroyed margins of unutilized resources, and with short-term homes and businesses, and displaced more than 1 mil- interest rates relatively low, the Federal Open Market lion persons. Real gross domestic product is estimated to Committee (FOMC) continued to remove monetary policy have risen a little more than 3 percent over the four quar- accommodation gradually in 2005, raising the target fed- ters of 2005 even though growth slowed significantly in eral funds rate 25 basis points at each of its eight meet- the fourth quarter as a result of storm-related disruptions ings. This cumulative policy firming of 2 percentage and other factors that are likely to prove transitory. The points was substantially greater than market participants increase in real GDP in 2005 was sufficient to add 2 mil- had expected at the start of the year. But each action was lion new jobs, on net, to employers’ payrolls and to fur- anticipated by the time of the meeting at which it was ther reduce slack in labor and product markets. As in 2004, taken, as the Committee’s communications, policy strat- overall consumer price inflation was boosted by the surge egy, and responses to incoming economic data appear to in energy prices. Core consumer price inflation (as mea- have been well understood. At its meeting in January sured by the price index for personal consumption 2006, the FOMC increased the target federal funds rate expenditures excluding the direct effects of movements another 25 basis points, bringing it to 4½ percent. The in food and energy prices) picked up early in the year, Committee indicated that possible increases in resource but it subsequently eased and totaled less than utilization as well as elevated energy prices had the 2 percent over the year as a whole. The dollar appreci- potential to add to inflation pressures and that, as a ated against most major currencies in 2005, and, with result, some further policy tightening may be needed. domestic demand expanding strongly, the U.S. current The U.S. economy should continue to perform well in account deficit widened further. 2006 and 2007. To be sure, higher energy prices will prob- In 2005, energy prices were up substantially for a sec- ably exert some restraint on activity for a while longer. ond year in a row. Crude oil costs climbed further, on But so long as energy price increases slow, as is suggested net, and prices of refined petroleum products and natural by futures prices, this restraint should diminish as 2006 gas came under additional upward pressure for a time progresses. In addition, economic activity should receive after supplies were curtailed by hurricane damage to pro- some impetus from post-hurricane recovery efforts. duction facilities in the Gulf Coast region. As a result, Although progress to date has been uneven in the affected households in the United States faced steep increases in regions, the reopening of facilities shut down by the hur- gasoline and home heating expenses, and many firms were ricanes is already being reflected in a rebound in indus- likewise burdened with rising energy costs. trial production. Federal assistance will buttress rebuild- The resilience of the U.S. economy in the face of these ing activity in coming quarters. major shocks likely reflects, in part, improvements in More broadly, the major factors that contributed to energy efficiency over the past several decades. A num- the favorable performance of the U.S. economy in 2005 ber of other factors also helped to keep economic activ- remain in place. Long-term interest rates are low, and con- ity moving forward in 2005. For one, the rapid gain in ditions in corporate credit markets are generally positive. real estate values in the past few years, in combination The household sector is also in good financial shape over- with the rise in stock prices since 2002, has encouraged all and should stay so even if—as expected—the housing households to sustain their spending through a period of sector cools. In addition, the improved outlook for eco- relatively weak growth in real income. For another, credit nomic growth abroad bodes well for U.S. exports. How- 2 Monetary Policy Report to the Congress February 2006 ever, the effects of the cumulative tightening in monetary Monetary Policy, Financial Markets, and the policy should keep the growth in aggregate output close Economy in 2005 and Early 2006 to that of its longer-run potential. Core inflation is likely to remain under some upward The year 2005 opened with the target federal funds rate pressure in the near term from rising costs as the pass- at 2¼ percent, a level that Federal Reserve policymakers through of higher energy prices runs its course. But those judged to be quite accommodative. During the first cost pressures should wane as the year progresses. More- few months of the year, output appeared to be growing at over, strength in labor productivity should continue to a solid pace despite rising energy prices. Improving damp business costs more generally. With little evidence labor market conditions and favorable financing terms to date that resource utilization has put appreciable were providing considerable support to consumer out- upward pressure on prices, and with longer-run inflation lays and homebuilding activity, while reasonably bright expectations continuing to be well anchored, core infla- sales prospects and strong profitability were buoying tion should remain contained in 2006 and 2007. business investment. Pressures on inflation appeared Nonetheless, significant risks attend this economic out- to be mounting, however, partly owing to increasing look. Some of the uncertainty is centered on the pros- energy prices. Measures of inflation compensation pects for the housing sector. On the one hand, some derived from securities markets were on the rise as well. observers believe that home values have moved above In these circumstances, the Committee firmed policy levels that can be supported by fundamentals and that 25 basis points at both its February and March meetings some realignment is warranted. Such a realignment—if and signaled that, if economic conditions progressed as abrupt—could materially sap household wealth and con- anticipated, it would need to continue to remove policy fidence and, in turn, depress consumer spending. On the accommodation gradually to keep inflation pressures other hand, if home values continue to register outsized contained. increases, the accompanying increment to household In the spring, policymakers perceived some signs of wealth would stimulate aggregate demand and raise softness in spending, which they attributed in part to the resource utilization further. With the economy already earlier step-up in energy prices. Nonetheless, the federal operating in the neighborhood of its productive poten- funds rate was still relatively low, and robust underlying tial, this higher resource utilization would risk adding to growth in productivity was providing ongoing support to inflation pressures. Another major source of uncertainty economic activity. Accordingly, the Committee antici- is the price of energy, which continues to be buffeted by pated some strengthening of activity, and it reduced policy concerns about future supply disruptions. Additional steep accommodation further in May by lifting the target increases in the price of energy would intensify cost pres- federal funds rate another quarter percentage point, to sures and weigh on economic activity. 3 percent. Selected interest rates, 2003–06 Percent 6 5 Ten-year Treasury 4 3 2 Target federal funds rate 1 1/29 3/18 5/6 6/25 8/129/16 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 8/9 9/20 11/1 12/13 1/31 2003 2004 2005 2006 NOTE: The data are daily and extend through February 8, 2006. 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 In the event, the signs of softness proved transitory. 4¼ percent. In the accompanying statement, monetary Incoming data suggested that output, employment, and policy was no longer characterized as “accommodative” spending were growing moderately through midyear. because the federal funds rate had been boosted substan- Inflation expectations seemed to be well contained, but tially and was now within the broad range of values that, pressures on inflation remained elevated. With the stance in the judgment of the Committee, might turn out to be of policy still accommodative, the Committee added consistent with output remaining close to its potential. another 25 basis points to the target federal funds rate at Indeed, because policy actions over the previous both its June and August meetings. eighteen months had significantly reduced the degree of Subsequently, the devastation caused by Hurricane monetary accommodation, Committee members thought Katrina increased uncertainty about the vitality of the that the outlook for their near-term policy actions was economic expansion in the near term. The destruction in becoming considerably less certain. In such an environ- the Gulf Coast region, the associated dislocation of eco- ment, policy decisions would increasingly depend on nomic activity—including considerable disruption of incoming data and their implications for future economic energy production—and the accompanying further boost growth and inflation. Nonetheless, the Committee indi- to energy prices were expected to impose some restraint cated that some further measured policy firming was likely on spending, production, and employment in the near to be needed to keep the risks to the attainment of its term. Although the region had been dealt a severe blow, goals of sustainable economic growth and price stability the Committee did not see these developments as posing roughly in balance. a more persistent threat to the overall economic expan- Over the period leading up to the January 2006 meet- sion. Consequently, it decided to firm policy another ing, incoming data on economic activity were uneven. 25 basis points at its September meeting. The advance estimate of real GDP pointed to a slowing Over the following weeks, the Gulf Coast region in the growth of output in the fourth quarter, but the absorbed further setbacks from Hurricanes Rita and underlying strength in consumer and business spending Wilma. The growth of economic activity dipped for a suggested that the economic expansion remained on solid time—hiring slowed, consumer spending softened, and footing. With the potential for added pressures on infla- confidence declined. At the same time, however, soaring tion still evident, the FOMC raised the target federal funds energy prices fed through to top-line consumer price rate another 25 basis points, bringing its level to 4½ per- inflation and pushed some survey measures of inflation cent. In its statement after the meeting, the Committee expectations upward. With employment and growth indicated that some further policy firming may be neces- expected to be supported by accommodative financial sary and again noted that it would respond to changes in conditions, the FOMC continued the process of policy economic prospects as needed. tightening at its November meeting. By December, incoming data indicated that the over- all expansion remained on track, although recovery from Economic Projections for 2006 and 2007 the damage in the hurricane-affected areas would appar- ently require considerable time. The Committee judged In conjunction with the FOMC meeting in January, the that possible increases in resource utilization as well as members of the Board of Governors and the Federal elevated energy prices had the potential to add to infla- Reserve Bank presidents, all of whom participate in the tion pressures. Accordingly, policy was firmed another deliberations of the FOMC, provided economic projec- 25 basis points, bringing the target federal funds rate to tions for 2006 and 2007. The central tendency of the Economic projections of Federal Reserve Governors and Reserve Bank presidents for 2006 and 2007 Percent 2006 2007 MEMO Indicator 2005 actual Range te C n e d n e t n ra c l y Range te C n e d n e t n ra c l y Change, fourth quarter to fourth quarter1 Nominal GDP........................................................................ 6.2 5¼–6½ 5½–6 5–6 5–5¾ Real GDP.............................................................................. 3.1 3¼–4 About 3½ 3–4 3–3½ PCE price index excluding food and energy........................ 1.9 1¾–2½ About 2 1¾–2 1¾–2 Average level, fourth quarter Civilian unemployment rate.................................................. 5.0 4½–5 4¾–5 4½–5 4¾–5 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated. 4 Monetary Policy Report to the Congress February 2006 FOMC participants’ forecasts for the increase in real GDP Change in PCE chain-type price index, 1999–2005 is about 3½ percent over the four quarters of 2006 and 3 percent to 3½ percent in 2007. The civilian unemploy- Percent ment rate is expected to lie between 4¾ percent and Total Excluding food and energy 5 percent in the fourth quarter of 2006 and to remain in that area in 2007. As for inflation, the FOMC partici- 3 pants expect that the price index for personal consump- tion expenditures excluding food and energy (core PCE) will rise about 2 percent in 2006 and between 1¾ percent 2 and 2 percent in 2007. 1 ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2005 AND EARLY 2006 1999 2001 2003 2005 The economic expansion remained firmly entrenched in NOTE: The data are for personal consumption expenditures (PCE). SOURCE: Department of Commerce, Bureau of Economic Analysis. 2005, although the growth of real GDP late in the year was apparently restrained by the effects of the hurricanes and by sharp drops in some volatile categories of spend- energy prices last year continued to siphon off household ing. In the labor market, payroll employment rose mod- purchasing power, and short-term interest rates moved erately for a second year in a row, and the unemployment up; nevertheless, spending was again bolstered by an im- rate declined further. As in 2004, headline inflation was proving labor market and rising household wealth. boosted appreciably by soaring energy prices; however, Real personal consumption expenditures (PCE) had core inflation remained subdued. In 2005, financial mar- posted back-to-back increases of 3¾ percent in 2003 and ket conditions were once again supportive of growth, with 2004 and continued to rise at about that pace over the long-term market interest rates low and credit spreads first three quarters of 2005; in the fourth quarter, PCE and risk premiums narrow. growth slowed to an annual rate of just 1 percent as con- sumer outlays for motor vehicles slackened after a surge prompted by last summer’s “employee discount” pro- The Household Sector grams. For 2005 as a whole, sales of light vehicles (cars, vans, sport-utility vehicles, and pickup trucks) totaled Consumer Spending nearly 17 million units, about the same as the annual fig- ure for 2004. Real spending on consumer goods other Consumer spending had gathered considerable steam in than motor vehicles was robust in 2005, with substantial 2003 and 2004 and remained vigorous in 2005. Higher gains almost across the board; a notable exception was real spending on gasoline, which was up only modestly Change in real GDP, 1999–2005 Percent, annual rate Change in real income and consumption, 1999–2005 Percent, annual rate 6 Disposable personal income Personal consumption expenditures 6 4 4 2 2 + _0 1999 2001 2003 2005 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 1999 2001 2003 2005 period. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 5 for a second year in a row as prices at the pump soared. Consumer sentiment, 1992–2006 Real expenditures on services rose moderately in 2005, as a sizable further increase in outlays for medical care 1985 = 100 1966 = 100 was partly offset by a relatively small gain in outlays for energy services. 140 140 Excluding the estimated effects of the one-time spe- Conference Board cial dividend payment that Microsoft made in December 120 120 2004, disposable personal income (DPI)—that is, per- sonal income less personal current taxes—rose about 100 100 1½ percent in real terms in 2005, considerably less than Michigan SRC 80 80 in 2003 and 2004. Although aggregate wages and sala- ries advanced moderately last year and some other major 60 60 types of nominal income posted notable gains, the increases in real terms were eroded by the rise in energy prices. In addition, personal tax payments rose faster last 1994 1997 2000 2003 2006 year than did personal income as measured in the national NOTE: The data are monthly and extend through January 2006. income and product accounts (NIPA). In the second half SOURCE: The Conference Board and University of Michigan Survey Research Center. of the year, the growth of real DPI was volatile, mainly because of the hurricanes. Rental income and proprietors’ income were pulled down in the third quarter as a result and it rose further in 2005 as house values continued to of uninsured losses on residential and business property. climb and as stock prices moved modestly higher. At the Real DPI snapped back in the fourth quarter as end of the third quarter (the most recent period for which income in these hurricane-affected categories rebounded complete data on wealth are available), the ratio of house- from the exceptionally low levels in the third quarter. hold net worth to disposable income stood at 5.65, well Although the run-up in energy prices restrained the above its long-run average level of 4.75. Meanwhile, sur- growth of real DPI in 2005, its effect on overall spending veys by the Michigan Survey Research Center (SRC) and appears to have been largely offset by other factors. In the Conference Board suggest that, apart from the first particular, sharp increases in household wealth since 2002 few months after the hurricanes, consumer confidence have provided many households with the resources and was about at the favorable levels that had prevailed in inclination to sustain their spending through a period of 2004. All in all, personal outlays exceeded disposable relatively weak growth of real income. Household net income in 2005. As a result, the personal saving rate, worth, which typically feeds through to spending over which had dropped below 2 percent in 2004, fell further several quarters, posted sizable gains in 2003 and 2004, in 2005, ending the year at negative ½ percent. Wealth-to-income ratio, 1982–2005 Ratio Personal saving rate, 1982–2005 Percent 6 12 5 9 6 4 3 + 1985 1989 1993 1997 2001 2005 _0 NOTE: The data are quarterly and extend through 2005:Q3. The wealth- to-income ratio is the ratio of household net worth to disposable personal 1985 1990 1995 2000 2005 income. SOURCE: For net worth, Federal Reserve Board, flow of funds data; for NOTE: The data are quarterly and extend through 2005:Q4. income, Department of Commerce, Bureau of Economic Analysis. SOURCE: Department of Commerce, Bureau of Economic Analysis. 6 Monetary Policy Report to the Congress February 2006 Residential Investment Mortgage rates, 2001–06 Activity in the housing sector remained torrid through Percent much of 2005. By the end of the year, however, a few tentative signs of cooling had begun to appear. In the Fixed rate single-family sector, starts of new units dipped in 7 December after a string of exceptionally strong months; still, they totaled 1.7 million for the year as a whole— 6½ percent above the already rapid pace in 2004. Starts 5 in the multifamily sector totaled 350,000 in 2005, a pace similar to that of the preceding three years. Real expen- Adjustable rate 3 ditures on residential structures—which include outlays not only for new construction but also for additions and alterations as well as commissions paid to real estate agents— rose nearly 8 percent in 2005, the fourth large 2001 2002 2003 2004 2005 2006 yearly increase in a row. NOTE: The data, which are weekly and extend through February 8, 2006, are contract rates on thirty-year mortgages. Sales of both new and existing homes set records in SOURCE: Federal Home Loan Mortgage Corporation. 2005, although they, like housing starts, seem to have lost some steam late in the year. Rates on thirty-year fixed-rate mortgages were in the neighborhood of that prices continued to rise rapidly through the third quar- 5¾ percent for much of the year, but they rose in the ter of 2005, though partial data for the fourth quarter point autumn. Since October, they have averaged close to to some slowing. Notably, the purchase-only version of 6¼ percent, at the upper end of the narrow range that has the repeat-transactions price index for existing homes, prevailed since 2003 but still fairly low by historical stan- which is published by the Office of Federal Housing En- dards. Rates on adjustable-rate mortgages have been terprise Oversight and tracks sales of the same houses trending up since early 2004. The softening of home sales over time, rose 11 percent over the year ending in the in recent months has contributed to an updrift in the stock third quarter (the latest available data), once again out- of unsold new and existing homes. As of December, the stripping the increases in household incomes and rents. stock of unsold new homes was equal to nearly five The Census Bureau’s constant-quality price index for new months of supply when measured at that month’s sales homes, which controls for changes in the composition of pace. Between 1998 and 2004, the stock of unsold new sales by geography, home size, and other readily observ- homes had averaged about four months of supply. able characteristics, had also shown sizable increases Measures of house prices that attempt to control for through the third quarter, but it decelerated sharply in the shifts in the quality and composition of homes sold show Change in house prices, 1982–2005 Percent Private housing starts, 1992–2005 12 Millions of units, annual rate Repeat-transactions index 9 1.6 6 Single-family 1.2 3 New home price index + .8 _0 Multifamily .4 1985 1989 1993 1997 2001 2005 NOTE: The repeat-transactions index includes purchase transactions only and extends through 2005:Q3. The new home price index extends through 1993 1995 1997 1999 2001 2003 2005 2005:Q4. Change is over four quarters. SOURCE: For repeat transactions, Office of Federal Housing Enterprise NOTE: The data are quarterly and extend through 2005:Q4. Oversight; for new home prices, Department of Commerce, Bureau of the SOURCE: Department of Commerce, Bureau of the Census. Census. Board of Governors of the Federal Reserve System 7 fourth quarter and was up just 4¾ percent over 2005 as a Delinquency rates on selected types of household loans, whole; in 2004, this measure had risen 8½ percent. 1992–2005 Percent Household Finance Credit card pools 6 Household debt expanded about 10½ percent at an 5 annual rate over the first three quarters of last year, roughly the same brisk pace as had been registered in 2004. Home- 4 mortgage debt continued to grow rapidly, as homeowners Auto loans at domestic auto finance companies 3 took advantage of the further sizable increases in house prices last year. The use of alternative mortgage prod- 2 Mortgages ucts spread further in 2005, in part because rising home 1 values generally made house purchases less affordable. Last May federal regulators issued guidance promoting 1993 1995 1997 1999 2001 2003 2005 sound risk-management practices to financial institutions with home equity lending programs. Mortgage-related NOTE: The data are quarterly. The data for credit card pools and mortgages extend through 2005:Q3; the rate for auto loans extends through 2005:Q4. borrowing likely took the place of some funding with SOURCE: For credit cards, Moody’s Investors Service; for auto loans, the consumer credit, which expanded only modestly again financing subsidiaries of the three major U.S. automobile manufacturers; for mortgages, Mortgage Bankers Association. last year. Overall, the expansion in household debt out- paced the growth in disposable personal income, and the financial obligations ratio moved up to a level close to cantly below the average of recent years, and they have the peak that it had reached earlier this decade. However, since remained low. This suggests that, to avoid the new the relatively low readings on most measures of loan rules, some households accelerated filings they would delinquencies last year indicate that most households were have undertaken eventually even under the old law. The not struggling to meet their obligations. spike in bankruptcies appears to have induced a jump in A large number of households filed for bankruptcy in charge-offs of consumer loans in the fourth quarter. the weeks leading up to October 17, the date when a new bankruptcy law took effect. The law was designed in part to diminish the ability of households to discharge their The Business Sector debts through chapter 7 filings. After the new law became effective, filings fell sharply to a level signifi- Fixed Investment Real business fixed investment rose 6½ percent in 2005. Real spending on equipment and software (E&S) posted Household financial obligations ratio, 1991–2005 an increase of more than 8 percent after rising nearly 14 percent in 2004. The broadly based growth in E&S Percent spending last year was supported by favorable fundamen- tals: appreciable growth in final sales, ample financial resources in the corporate sector, and supportive condi- 19 tions in financial markets. Real investment in high-technology equipment rose 18 17 percent in 2005, as further declines in prices provided a substantial incentive for firms to step up their outlays 17 on such items; the increase was 5 percentage points faster than in 2003 and 2004 and about in line with the average 16 annual gain over the past twenty-five years. Spending on communications equipment was exceptionally strong last year, as telecom service providers rolled out major new 1993 1996 1999 2002 2005 fiber-optic systems and third-generation wireless gear. NOTE: The data are quarterly and extend through 2005:Q3. The financial Business spending for computing equipment rose roughly obligations ratio equals the sum of required payments on mortgage and 30 percent in real terms, a pace close to its historical consumer debt, automobile leases, rent on tenant-occupied property, homeowner’s insurance, and property taxes, all divided by disposable average, while spending on software posted its largest personal income. SOURCE: Federal Reserve Board. increase in several years. 8 Monetary Policy Report to the Congress February 2006 Change in real business fixed investment, 1999–2005 Change in real business inventories, 1999–2005 Percent, annual rate Billions of chained (2000) dollars, annual rate Structures Equipment and software 20 75 10 50 + _0 25 + 10 _0 20 25 1999 2001 2003 2005 High-tech equipment and software SOURCE: Department of Commerce, Bureau of Economic Analysis. Other equipment excluding transportation 30 20 and 2003, and some industry reports suggest that an upturn in building activity is in train. 10 + _0 Inventory Investment 10 After having been exceptionally restrained earlier in the economic expansion, inventory investment picked up 1999 2001 2003 2005 sharply in 2004, and the higher pace of accumulation NOTE: High-tech equipment consists of computers and peripheral equip- extended into early 2005. The step-up in accumulation, ment and communications equipment. which provided considerable impetus to industrial pro- SOURCE: Department of Commerce, Bureau of Economic Analysis. duction for a time, brought stocks into better alignment with sales and set the stage for a subsequent downswing in inventory investment. Inventories in the motor vehicle Although aircraft investment remained depressed as sector were drawn down in both the second and third domestic airlines continued to grapple with overcapacity quarters, though accumulation resumed in the fourth quar- and soaring fuel prices, the other major categories of E&S ter after last summer’s surge in sales cleared out dealers’ spending outside the high-tech area did well in 2005. lots. Apart from motor vehicles, real stockbuilding slowed Business outlays on motor vehicles rose markedly, with sharply over the course of the year and, according to the the demand for heavy trucks especially strong. Invest- advance NIPA estimate, came to a halt in the fourth quar- ment in equipment other than high-tech and transporta- ter. At year-end, inventories seemed to be in reasonable tion goods—a broad category that accounts for nearly alignment with sales, even taking into account the down- half of E&S spending when measured in nominal terms— ward trend in inventory–sales ratios that has resulted from barely rose in real terms over the first half of 2005. the ongoing improvement in supply-chain management. Investment in this category sped up after midyear, to increase moderately over the year as a whole. Apart from the drilling and mining sector, where Corporate Profits and Business Finance investment has strengthened in response to higher energy prices, outlays for nonresidential construction have yet With profits posting further solid gains in 2005 and ample to gain much traction. Spending on office and commer- liquid assets on corporate balance sheets, nonfinancial cial structures has been essentially flat since 2003; con- businesses were able to finance much of their capital struction of manufacturing facilities leveled out in 2005 expenditures out of internal funds, pay record sums to after having firmed in late 2004; and investment in the shareholders in the form of share buybacks, and still power and communications sector moved down further maintain strong balance sheets. Nonetheless, elevated last year. However, vacancy rates have continued to merger and acquisition activity and the considerable rise reverse some of the run-up that occurred between 2000 in share buybacks boosted the pace of business borrow- Board of Governors of the Federal Reserve System 9 ing. Short-term borrowing rose significantly, driven Financing gap and net equity retirement by financing from banks. The issuance of long-term at nonfinancial corporations, 1990–2005 debt remained moderate overall, but debt related to Billions of dollars commercial mortgages continued to expand rapidly. Indicators of corporate credit quality generally remained 350 favorable. Financing gap 300 Corporate profits continued to grow strongly in 2005. 250 The ratio of before-tax profits of domestic nonfinancial Net equity retirement 200 corporations to that sector’s gross value added rose to 150 more than 12 percent, near its 1997 peak. Gains in earn- 100 ings were fairly widespread, with profits in the petroleum 50 + and gas industries especially strong. In the fourth quarter _0 of 2005, operating earnings per share for S&P 500 firms 50 appear to have been nearly 14 percent above their level 100 four quarters earlier. Gross equity issuance remained modest in 2005, while 1991 1993 1995 1997 1999 2001 2003 2005 net equity issuance sank into deeply negative territory as NOTE: The data are annual; the observations for 2005 are based on partially estimated data. The financing gap is the difference between capital corporations retired shares at a rapid pace. Both a jump expenditures and internally generated funds. Net equity retirement is the in cash-financed mergers and a record-setting level of difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued share repurchases were spurred by the strong growth of in public or private markets, including funds invested by venture capital profits as well as by the substantial liquidity that firms partnerships. SOURCE: Federal Reserve Board, flow of funds data. had built up in recent years. Net corporate bond issuance was subdued in 2005, as modest growth in nominal capital expenditures, strong their institutions had further eased standards and terms cash positions, and robust profits apparently limited for lending to businesses and that the demand for such the demand for such financing. However, commercial- loans had continued to strengthen. Most respondents mortgage debt grew rapidly last year. Gross issuance of attributed the stronger demand to borrowers’ increased commercial-mortgage-backed securities likely reached a need to finance inventories, accounts receivable, and record pace in the fourth quarter. investment in plant and equipment; a substantial fraction Short-term borrowing by businesses rose smartly in of respondents to some surveys also pointed to a pickup 2005, as business lending by both large and small com- in merger and acquisition activity. By contrast, outstand- mercial banks surged. Throughout the year, respondents ing commercial paper declined last year. to the Senior Loan Officer Opinion Surveys indicated that Selected components of net financing for nonfinancial corporate businesses, 2003–05 Before-tax profits of nonfinancial corporations as a percent of sector GDP, 1978–2005 Billions of dollars, annual rate Percent Commercial paper Bonds Bank loans Sum of selected 400 14 components 200 12 + 10 _0 8 200 6 2003 2004 2005 1981 1985 1989 1993 1997 2001 2005 NOTE: The data for the components except for bonds are seasonally adjusted. The data for the sum of selected components are quarterly; 2005:Q4 NOTE: The data are quarterly and extend through 2005:Q3. Profits are from is estimated. domestic operations of nonfinancial corporations, with inventory valuation SOURCE: Federal Reserve Board; Securities Data Company; and Federal and capital consumption adjustments. Financial Institutions Examination Council, Consolidated Reports of Con- SOURCE: Department of Commerce, Bureau of Economic Analysis. dition and Income (Call Report). 10 Monetary Policy Report to the Congress February 2006 Net percentage of domestic banks tightening Default rate on outstanding corporate bonds, 1991–2006 standards on commercial and industrial loans to large and medium-sized borrowers, 1990–2006 Percent Percent 4 60 3 40 2 20 1 + + _0 _0 20 1992 1994 1996 1998 2000 2002 2004 2006 NOTE: The data are monthly and extend through January 2006. The rate for 1991 1994 1997 2000 2003 2006 a given month is the face value of bonds that defaulted in the twelve months ending in that month divided by the face value of all bonds outstanding at the NOTE: The data are drawn from a survey generally conducted four times end of the calendar quarter immediately preceding the twelve-month period. per year; the last observation is from the January 2006 survey, which covers 2005:Q4. Net percentage is the percentage of banks reporting a tightening of SOURCE: Moody’s Investors Service. standards less the percentage reporting an easing. The definition for firm size suggested for, and generally used by, survey respondents is that large and medium-sized firms have sales of $50 million or more. were widely anticipated and had little effect on other SOURCE: Federal Reserve, Senior Loan Officer Opinion Survey on Bank Lending Practices. measures of aggregate credit quality. The credit quality of commercial mortgage debt also appeared to remain Readings on credit quality for nonfinancial compa- robust during 2005; delinquency rates on commercial nies generally remained favorable in 2005 despite some mortgages held by banks and on those pooled into secu- pockets of distress. The amount of corporate debt that rities trended down on balance over last year, while was downgraded by Moody’s Investors Service last year delinquencies on mortgages held by insurance compa- exceeded the amount that was upgraded, mainly as a nies remained low. result of the high-profile downgrades of the debt of Gen- eral Motors and Ford. After trending down over the first three quarters of last year, the six-month trailing bond The Government Sector default rate moved up in the fall, most notably because of the bankruptcies of Delta Air Lines, Northwest Air- Federal Government lines, Delphi, and Calpine. However, these bankruptcies The deficit in the federal unified budget narrowed appre- ciably in fiscal year 2005. Although outlays continued to rise rapidly, receipts rose even faster; as a consequence, Net interest payments of nonfinancial corporations the deficit fell to $318 billion, roughly $100 billion less as a percent of cash flow, 1978–2005 than the deficit in fiscal 2004. The latest projections from the Administration and the Congressional Budget Office, Percent however, point to a deterioration in the unified budget position in fiscal 2006, in part because of the start of the Medicare drug benefit and the need to pay for post- 20 hurricane reconstruction and relief. Nominal federal spending rose nearly 8 percent in fis- cal 2005 and stood at about 20 percent of GDP—virtu- 15 ally the same as in 2003 and 2004 but 1½ percentage points above the recent low in fiscal 2000. Defense spend- 10 ing rose 8½ percent after three years of double-digit increases; outlays for nondefense discretionary programs moved up further as well, in part because of higher spend- ing for education and for disaster relief. (Spending on 1981 1985 1989 1993 1997 2001 2005 disaster relief in fiscal 2005, which ended on September NOTE: The data are quarterly and extend through 2005:Q3. SOURCE: Department of Commerce, Bureau of Economic Analysis. 30, was primarily for needs that emerged before Hurri- Board of Governors of the Federal Reserve System 11 Federal receipts and expenditures, 1985–2005 Federal receipts rose 14½ percent in fiscal 2005; as a ratio to GDP, they stood at 17½ percent—more than Percent of nominal GDP 1 percentage point higher than in 2004. Corporate pay- ments rose nearly 50 percent, lifted by the robust profits 24 of 2004 and 2005 and the termination of the partial- Expenditures expensing tax incentive at the end of calendar 2004. 22 Individual income taxes increased nearly 15 percent; Receipts nonwithheld taxes rose especially rapidly because of both Expenditures 20 substantial strength in nonwage taxable incomes (includ- excluding net interest ing capital gains) and certain features of JGTRRA that 18 altered the timing of tax payments in a way that tempo- rarily reduced the level of collections in 2004. Social 16 insurance taxes rose in line with wages and salaries. Mirroring the narrowing of the unified deficit, federal 1985 1990 1995 2000 2005 saving (essentially, the unified surplus or deficit adjusted NOTE: The receipts and expenditures data are on a unified-budget basis and to conform to the accounting practices followed in the are for fiscal years (October through September); GDP is for the four quarters NIPA) improved from negative 3½ percent of GDP in ending in Q3. SOURCE: Office of Management and Budget. calendar 2004 to negative 2½ percent in the first half of 2005. However, the beneficial effect of the smaller defi- cane Katrina.) As for the major health programs, Medi- cit in terms of national saving was essentially offset by a care outlays continued to climb. Medicaid spending rose sharp decline in personal saving. Measured net of esti- relatively slowly, mainly because it had been boosted mated depreciation, national saving in the first half of during much of fiscal 2004 by the temporary increase in 2005 was equal to just 1½ percent of GDP, about the the federal share of the program’s costs included in the same as in 2004 and well below the recent highs of more Jobs and Growth Tax Relief Reconciliation Act of 2003 than 6 percent of GDP in the late 1990s. In the third quar- (JGTRRA). Net interest payments, which had declined ter, net saving was dragged down by sizable hurricane- steadily from 1998 to 2003 and had increased only mod- related reductions in both federal and nonfederal net sav- erately in 2004, were up significantly in fiscal 2005 as ing; excluding these one-time factors, net saving in the short-term interest rates rose. Thus far in fiscal 2006, out- third quarter would have been roughly the same as it was lays have continued to rise rapidly, in part because of in the first half of the year. If not reversed over the longer heavy spending for flood insurance payouts and other haul, persistent low levels of saving will necessitate ei- hurricane-related disaster relief. According to the NIPA, ther slower capital formation or continued heavy borrow- real federal expenditures on consumption and gross ing from abroad, either of which would hamper the abil- investment, the part of government spending that is a com- ity of the nation to cope with the retirement needs of the ponent of real GDP, increased 1¼ percent over the four quarters of calendar year 2005. Net saving, 1985–2005 Change in real government expenditures on consumption and investment, 1999–2005 Percent of nominal GDP Percent 12 Federal Nonfederal saving State and local 9 9 6 6 3 Total + _0 3 Federal saving 3 + _0 1985 1989 1993 1997 2001 2005 NOTE: The data are quarterly and extend through 2005:Q3. Nonfederal 1999 2001 2003 2005 saving is the sum of personal and net business saving and the net saving of state and local governments. SOURCE: Department of Commerce, Bureau of Economic Analysis. SOURCE: Department of Commerce, Bureau of Economic Analysis. 12 Monetary Policy Report to the Congress February 2006 baby-boom generation and would retard the growth of Treasury securities held by foreign investors the standard of living. as a share of total outstanding, 1997–2005 Percent Federal Borrowing 45 Borrowing by the Treasury moderated somewhat in cal- endar year 2005—federal debt rose 7 percent last year 40 after increasing 9 percent in 2004. Much of the improve- ment reflected the surge in tax receipts noted earlier. As a 35 result, the amount of Treasury bills outstanding contracted on net in 2005, and Treasury sales of coupon securities 30 declined. As was widely anticipated, the Treasury announced in August that it would resume regular semi- annual issuance of a thirty-year nominal bond. The first 1997 1998 1999 2000 2001 2002 2003 2004 2005 such auction, held on February 9, 2006, was well received, NOTE: The data are quarterly and extend through 2005:Q3. with a high level of participation from indirect bidders. SOURCE: Federal Reserve Board, flow of funds data. The Treasury expects issuance of the thirty-year bond to help stabilize the average maturity of outstanding mar- more than 45 percent in the third quarter of 2005, a record. ketable Treasury debt, which declined from a high of Data from the Treasury International Capital reporting about seventy months at the end of 2000 to fifty-three system suggest that net purchases of Treasury securities months at the end of 2005. by foreign private investors jumped last year, whereas Federal debt held by the public as a percentage of such purchases by foreign official institutions slowed sig- nominal GDP was steady during 2005 and stood at about nificantly amid upward pressure on the foreign exchange 36 percent at the end of the third quarter. The federal value of the dollar. debt ceiling did not need to be raised last year, but the Treasury has announced that it expects that the debt will reach its statutory ceiling in February 2006. State and Local Governments The appetite for Treasury securities among foreign investors remained strong in the aggregate in 2005. The The fiscal positions of state and local governments con- proportion of outstanding Treasury securities held by for- tinued to improve in 2005. Strong growth in income and eign investors is estimated to have climbed to slightly retail sales boosted revenues, as did rising property val- ues. And although the sector continued to grapple with Federal government debt held by the public, 1960–2005 State and local government net saving, 1982–2005 Percent of nominal GDP Percent of nominal GDP 55 .6 .4 45 .2 + 35 _0 .2 25 .4 .6 1965 1975 1985 1995 2005 1984 1987 1990 1993 1996 1999 2002 2005 NOTE: The final observation is for 2005:Q3. For previous years, the data for debt are as of year-end, and the corresponding values for GDP are for Q4 NOTE: The data, which are quarterly, are on a national income and product at an annual rate. Excludes securities held as investments of federal gov- account basis and extend through 2005:Q3. Net saving excludes social ernment accounts. insurance funds. SOURCE: Federal Reserve Board, flow of funds data. SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 13 higher medical costs and pressures to restore funding to U.S. trade and current account balances, 1998-2005 programs that had been cut back earlier in the decade, states and localities generally kept a tight rein on current Percent of nominal GDP outlays. On a NIPA basis, net saving by state and local + governments—which is broadly similar to the surplus in _0 an operating budget—turned positive in the first half of 1 2005 after having been negative between 2002 and 2004, 2 Trade and it would have remained positive in the third quarter 3 in the absence of the hurricanes. The sizable revenue gains 4 reported by many states in fiscal 2005, which ended on Current 5 June 30 in all but four states, appear to have extended account into fiscal 2006. Even so, some governments are still 6 struggling with strained fiscal situations, and some face 7 significant structural imbalances in their budgets that likely will be exacerbated in coming years by the need to 1998 1999 2000 2001 2002 2003 2004 2005 provide pensions and health care to a growing number of NOTE: The data are quarterly. The current account data extend through retired employees. In addition, the jurisdictions in the 2005:Q3, and the trade data extend through 2005:Q4. SOURCE: Department of Commerce. Gulf Coast region confront the dual challenge of sub- stantial post-hurricane demands and diminished flows of tax revenues. tial portion of the widening of the current account deficit According to the NIPA, real expenditures on consump- came from a larger deficit on trade of goods and ser- tion and gross investment by state and local governments vices, but a decrease in net investment income also wors- rose 1¼ percent in 2005. Real outlays for current con- ened the external account. Net investment income edged sumption were up only about 1 percent for a second year, into negative territory in the second quarter of 2005 for in part because of the relatively slow pace of hiring. Real the first time in the post–World War II period. Unilateral investment expenditures also registered a small gain. transfer payments to foreigners dropped sharply on net in the third quarter because of a surge in receipts from foreign insurance companies for damage caused by the State and Local Government Borrowing hurricanes, leading to a slight narrowing of the deficit from the previous quarter. The trade data through Borrowing by state and local governments picked up in December showed that the U.S. trade deficit widened fur- 2005. Gross issuance of municipal securities was brisk, ther in the fourth quarter of 2005, to about $790 billion as the relatively low level of longer-term market interest at an annual rate. This increase suggests that the fourth- rates spurred advance refundings of outstanding securi- quarter current account deficit, yet to be reported, will ties. The bulk of new capital issues last year reportedly also widen substantially. was earmarked for education-related projects. Credit quality in the state and local sector generally remained favorable in 2005. Notable exceptions were the obliga- International Trade tions of numerous municipal issuers in Michigan, which were downgraded last year largely as a consequence of Real exports of goods and services continued the solid the difficulties of GM and Ford. In addition, the obliga- pace of expansion registered in both 2003 and 2004; they tions of a number of issuers in the regions that were hit rose an estimated 5¾ percent in 2005, supported by by last year’s hurricanes were downgraded in the fourth robust foreign economic activity. Export growth was rapid quarter, and some bonds from these areas remain on in the first half of the year, spurred by the depreciation of watch. Despite these isolated troubles, rating upgrades the dollar in previous years; it then slowed in the second of municipal bonds slightly outpaced downgrades in 2005. half of the year, in part owing to the dollar’s appreciation since the beginning of 2005. For the year as a whole, exports of capital goods posted solid growth. Exports of The External Sector aircraft performed especially well despite an interrup- tion of their production in September because of a strike The U.S. current account deficit widened further in 2005. at Boeing. Exports of industrial supplies were hampered At an annual rate, it came in at just under $800 billion, or late in the year by the effects of the hurricanes on pro- about 6¼ percent of nominal GDP, in the first three quar- duction and shipping in the Gulf Coast region. By desti- ters (the latest available data). As in the past, a substan- nation, exports to Canada and Mexico grew rapidly in 14 Monetary Policy Report to the Congress February 2006 Change in real imports and exports of goods and services, Prices of oil and of nonfuel commodities, 2002-06 1998-2005 January 2002 = 100 Dollars per barrel Percent change, Q4 to Q4 Imports 70 160 Exports 15 Nonfuel 60 140 10 50 5 120 40 + Oil _0 100 30 20 5 80 10 10 2002 2003 2004 2005 2006 1998 1999 2000 2001 2002 2003 2004 2005 NOTE: The data are monthly and extend through January 2006. The oil SOURCE: Department of Commerce. price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices. SOURCE: For oil, the Commodity Research Bureau; for nonfuel commodities, International Monetary Fund. 2005, those to Western Europe also increased, but exports to Japan were relatively weak. Exports of ser- A key event in 2005 was the substantial increase in vices rose about 3 percent in 2005 in real terms. the price of crude oil. The spot price of West Texas inter- Prices of exported goods increased at an annual rate mediate (WTI) crude oil climbed from about $43 per of 2¾ percent in 2005, a bit below the rate of increase in barrel at the start of 2005 to a peak of about $70 per 2004. Prices decelerated in the second and third quarters barrel in late August, at the time of Hurricane Katrina. as the dollar strengthened and as pressures on prices of The spot price then edged down as production revived in agricultural exports and other nonfuel commodities the Gulf of Mexico and as above-average temperatures ebbed. Prices accelerated again in the fourth quarter, when in the United States reduced oil demand. After falling to a sharp rise in the prices of oil and metals drove up prices below $60 per barrel by late November, oil prices moved for many nonagricultural industrial supplies. up to an average of about $65 per barrel for January, in After expanding at a double-digit pace in 2004, real part on concerns about possible disruptions of foreign imports of goods and services decelerated to about supply. However, oil prices have declined so far in Feb- 4½ percent in 2005, even as U.S. GDP growth remained ruary. Growing conviction among traders that oil- robust. Although overall growth of non-oil imports was market conditions would remain tight in future years slower last year than in 2004, capital goods imports con- pushed the price of the far-dated NYMEX oil futures tinued strong. The hurricanes affected several categories contract (currently for delivery in 2012) from an average of imports. Despite a contraction of domestic oil con- of $38 per barrel for January 2005 to about $61 per bar- sumption, real imports of oil expanded to offset reduced rel for January 2006. production in the Gulf Coast region. Chemicals imports Although the rate of growth in world oil consumption also registered strong gains toward year-end amid hurri- slowed in 2005 from its torrid pace of 2004, spare pro- cane-related losses in domestic production. Real imports duction capacity among OPEC members remained lim- of services moved up only 2¼ percent in 2005, a sub- ited, at an estimated level of only about 1 million barrels stantial cooling from their 2004 pace. per day. With the perception that additional capacity Prices of imported goods excluding oil and natural gas would be slow to come on line, oil markets were highly increased at an annual rate of 1½ percent in 2005, down sensitive to news about fluctuations in supply and from a rate of 2¾ percent in 2004. Prices decelerated in demand. Market participants’ concerns about crude oil midyear as the dollar appreciated and nonfuel commod- supply were heightened by production difficulties in Iraq ity prices steadied. However, import prices accelerated and by the resumption of nuclear activities in Iran, both in the fourth quarter of 2005, led by higher prices for posing risks to the stability of Middle East supply. Else- chemicals, metals, and building materials. In global com- where, production problems in Nigeria stemming from modity markets, prices of metals increased an average of social unrest and a marked slowdown in the growth of 30 percent in 2005, a surge that reflected both robust glo- Russian production also kept upward pressure on oil bal demand and limited increases in supply. prices throughout the year. Board of Governors of the Federal Reserve System 15 Domestic crude oil supply was severely hampered by Net private foreign purchases of long-term U.S. securities, last year’s hurricanes, which were the most damaging in 2002-05 the history of the U.S. energy industry. At the peak of the Billions of dollars disruption, all U.S. crude oil production in the Gulf of Mexico (about 28 percent of total U.S. production) and Bonds Equities 250 88 percent of U.S. natural gas production there (about 17 percent of total U.S. production) were shut in. At the 200 end of January 2006, 25 percent of Gulf oil production remained shut in, and cumulative lost production in the 150 Gulf stood at about 22 percent of the average annual out- 100 put from that region. Refinery outages, which peaked after Hurricane Rita at more than one-fourth of total U.S. 50 refining capacity, caused sharp increases in the prices of + refined products. Retail gasoline prices in the United _0 States jumped to more than $3 per gallon in early Sep- tember, briefly crimping gasoline demand and, in turn, 2002 2003 2004 2005 demand for crude oil. Petroleum product prices returned NOTE: The data are quarterly and extend through 2005:Q4. SOURCE: Department of Commerce and the Treasury International Capital to pre-hurricane levels within a few weeks as imports reporting system. soared and refineries resumed operations, but they began to rise again in December and January. tinued to be strong in 2005, with the average pace during the first three quarters a bit higher than in 2004. U.S. residents’ net purchases of foreign securities The Financial Account remained brisk last year, near the levels recorded in 2003 and 2004, with smaller purchases of foreign bonds offset In 2005, foreign official financial inflows slowed from by larger purchases of foreign equities. By contrast, U.S. their extraordinary pace of 2004 but remained sizable. direct investment flows abroad slowed markedly during Most of these official inflows took the form of purchases the first half of 2005 and turned negative in the third quar- of U.S. long-term government and private securities for ter. This unusual pattern reflected responses to the par- reserve accumulation, primarily by Asian central banks. tial tax holiday provided in the 2004 Homeland Invest- The slowdown in foreign official inflows last year was ment Act, which allowed firms to repatriate at a more than offset, however, by an increase in foreign pri- preferential tax rate previous years’ earnings that had been vate purchases of U.S. securities. Most of this pickup was reinvested in their foreign affiliates. concentrated in bonds, as in 2004, but foreign private purchases of U.S. equities also increased somewhat. For- eign direct investment flows into the United States con- The Labor Market Employment and Unemployment U.S. net financial inflows, 2002-05 Conditions in the labor market continued to improve, on balance, in 2005, although many individuals lost jobs in Billions of dollars the aftermath of the hurricanes. Nonfarm payroll employ- Official Private 300 ment rose 175,000 per month, on average, through August, the same as the average monthly increase in 2004. 250 Net hiring then slowed sharply in September and Octo- 200 ber, as job losses in the Gulf Coast region largely offset moderate increases in payrolls elsewhere in the nation. 150 In November and December, monthly job growth was 100 uneven, but it averaged 250,000, and hiring remained 50 brisk in January. The reemployment of many of those who + lost jobs because of the hurricanes appears to have pro- _0 vided a modest lift to overall hiring in recent months. However, others affected by the storms apparently have 2002 2003 2004 2005 not found new jobs yet, and the unemployment rate among NOTE: The data are quarterly and extend through 2005:Q3. evacuees seems to have remained quite high. SOURCE: Department of Commerce. 16 Monetary Policy Report to the Congress February 2006 Net change in nonfarm payroll employment, 2000–06 January 2006, it decreased to 4.7 percent. The labor force participation rate, which had dropped noticeably between Thousands of jobs, monthly average 2000 and 2004, edged up, on net, in 2005. The participa- tion rate in January 2006 was 66 percent, well below the January 300 high of 67¼ percent reached in early 2000 but not far from its trend, which has been declining in recent years 200 as a consequence of demographic forces. 100 Other indicators also pointed to a gradual improve- + ment in labor market conditions over the course of 2005. _0 Initial claims for unemployment insurance drifted lower, and the job openings rate moved up. At year-end, the Con- 100 ference Board reported that a larger proportion of respon- 200 dents to its monthly survey thought that jobs were plenti- ful than thought that jobs were hard to get. 2000 2002 2004 2006 SOURCE: Department of Labor, Bureau of Labor Statistics. Productivity and Labor Costs Employment gains were widespread by industry in 2005. As in 2004, hiring was especially strong at firms Labor productivity in the nonfarm business sector con- supplying professional and business services and in health tinued to advance in 2005. Last year’s increase in output care. The construction industry also continued to exhibit per hour of 2¼ percent was noticeably below the average a good deal of vigor, spurred by the booming housing annual gain over the preceding four years. But taking the sector. Employment in retail trade and in food services longer view, growth in labor productivity over the past rose fairly briskly in the first half of the year, but it was five years has averaged 3¼ percent per year, nearly held down in the second half by job losses in the Gulf ¾ percentage point faster than the already impressive Coast region. In the manufacturing sector, employment gains posted between 1995 and 2000. Productivity was essentially flat for a second year after three years appears to have received considerable impetus in recent of steep declines. In the government sector, state and lo- years from a number of factors, including the rapid pace cal payrolls continued to rise modestly, while civilian of technological change and the growing ability of firms employment in the federal government was about to use information and other technology to improve the unchanged. efficiency of their operations. Increases in the amount of After hovering around 5½ percent during the second capital per worker, especially high-tech capital, have also half of 2004, the unemployment rate fell, on net, over the helped to spur productivity growth over the past few years, first three months of 2005. During the remainder of the although apparently by less than was the case during the year, it fluctuated in a narrow range around 5 percent. In capital spending boom in the late 1990s. Civilian unemployment rate, 1973–2006 Change in output per hour, 1948–2005 Percent Percent, annual rate 10 5 8 4 6 3 4 2 2 1 1976 1986 1996 2006 1948–73 1973–95 1995–2000 2003 2005 NOTE: The data are monthly and extend through January 2006. NOTE: Nonfarm business sector. 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 Measures of change in hourly compensation, 1995–2005 Change in unit labor costs, 1999–2005 Percent Percent 5 Nonfarm business 8 compensation per hour 4 6 3 2 4 1 Employment cost index 2 + _0 1995 1997 1999 2001 2003 2005 1999 2001 2003 2005 NOTE: The data are quarterly and extend through 2005:Q4. For nonfarm NOTE: Nonfarm business sector. The change in unit labor costs is defined business compensation, change is over four quarters; for the employment cost as the change in nonfarm compensation per hour less the change in labor index (ECI), change is over the twelve months ending in the last month of productivity. each quarter. The ECI is for private industry excluding farm and household SOURCE: Department of Labor, Bureau of Labor Statistics. workers. SOURCE: Department of Labor, Bureau of Labor Statistics. after having been close to flat over the preceding three years. Increases in hourly labor compensation were moder- ate in 2005 even though overall consumer prices rose rela- tively rapidly for a second year and the downward pres- Prices sure on wages from labor market slack diminished. As measured by the employment cost index (ECI) for pri- Headline inflation continued to be boosted by soaring vate nonfarm businesses, hourly compensation increased energy prices in 2005, while core inflation—which 3 percent last year, ¾ percentage point less than in 2004. excludes the direct effects of movements in food and The wages and salaries component of the ECI rose just energy prices—remained subdued. The PCE chain-type 2½ percent, the same as in 2004, while the cost of pro- price index rose 3 percent for the second year in a row. viding benefits rose 4 percent after two years of increases The increase in core PCE prices, which in 2004 had ticked in the area of 6½ percent to 7 percent. Much of the decel- up to 2¼ percent, remained high in early 2005 by recent eration in benefits costs was in employers’ contributions standards. Core PCE inflation subsequently subsided and to retirement plans, which had increased markedly in 2003 came in a shade below 2 percent for the year as a whole. and 2004 as firms ratcheted up their contributions to The market-based component of the core PCE price defined-benefit plans to cover earlier declines in the mar- ket value of the plans’ assets. Health insurance costs rose Change in core consumer prices, 1999–2005 6½ percent in 2005, the smallest increase since the late 1990s. Percent According to preliminary data, compensation per hour Core consumer price index in the nonfarm business (NFB) sector—an alternative Chain-type price index for core PCE measure of compensation developments derived from the data in the NIPA—rose 3¼ percent in 2005, about the 3 same rise as in the ECI. In 2004, NFB compensation had risen nearly 6 percent; a fourth-quarter surge in the value 2 of stock option exercises, which are excluded from the ECI, likely contributed to that increase. The preliminary estimate for NFB compensation in 2005 reflects the 1 apparent reversal of some of the late-2004 upswing in compensation, though it is subject to revision when more- detailed information becomes available later this year. In 1999 2001 2003 2005 any event, the deceleration in hourly compensation last year held the increase in unit labor costs to 1 percent. SOURCE: For core consumer price index, Department of Labor, Bureau of Labor Statistics; for core PCE price index, Department of Commerce, Bureau Unit labor costs had risen more than 3 percent in 2004 of Economic Analysis. 18 Monetary Policy Report to the Congress February 2006 Alternative measures of price change, 2003–05 Consumer food prices rose about 2 percent in 2005 Percent after slightly larger increases in 2003 and 2004. Food prices received some upward pressure late in the year. Price measure 2003 2004 2005 Crop damage from Hurricane Wilma temporarily pushed Chain-type up the prices of some fruits and vegetables, and beef prices Gross domestic product (GDP)....................... 2.0 2.9 3.0 Gross domestic purchases................................ 2.0 3.4 3.4 were boosted by the resumption of some exports to Personal consumption expenditures (PCE)..... 1.7 3.1 3.0 Excluding food and energy.......................... 1.3 2.2 1.9 Pacific Rim countries after the lifting in early December Market-based PCE excluding food and energy........................................................... 1.0 1.7 1.7 of an extended ban (which was subsequently reinstated in January 2006). But, in general, the higher production Fixed-weight Consumer price index...................................... 1.9 3.4 3.7 of several livestock products and a bumper harvest of Excluding food and energy.......................... 1.2 2.1 2.1 grains helped to limit increases in retail food prices to NOTE: Changes are based on quarterly averages of seasonally adjusted data. about the rate of core inflation. SOURCE: For chain-type measures, Department of Commerce, Bureau of Eco- nomic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor The broad contours of core inflation in 2005 were Statistics. about the same as those in 2004. Prices of core goods, which had declined in 2002 and 2003, were about flat for a second year. Prices of core services decelerated a bit— index—which excludes prices that must be imputed from about 3 percent in 2004 to 2¾ percent in 2005. The because they cannot be observed in market transactions deceleration was concentrated in some nonmarket cat- and that often move erratically—rose 1¾ percent in 2005, egories—in particular, prices of financial services pro- unchanged from its pace in 2004. A similar pattern is vided by banks without explicit charge, foreign travel by evident in the core consumer price index, which rose about U.S. residents, and life and motor vehicle insurance— 2 percent in both 2004 and 2005, and in broad NIPA price that had posted large increases in 2004. With the notable measures such as the price index for GDP, which was up exception of airfares, which picked up in 2005 after hav- about 3 percent in both years. ing fallen in 2004, prices in other market-based catego- The PCE price index for energy rose roughly 20 per- ries of services rose about as fast as they had in 2004. cent in 2005 for the second year in a row. The nearly The run-up in energy prices in 2005 boosted the cost 25 percent increase in gasoline prices in 2005 largely of producing other goods and services—especially for reflected the effects of the continuing surge in crude oil energy-intensive items, including chemicals, plastics, and prices on retail energy prices. Gasoline prices recorded nitrogenous fertilizers. In addition, prices of other com- some dramatic spikes—notably in the spring and after modities such as lumber and a variety of metals, which the hurricanes—when disruptions at refineries depleted had soared in 2004 in response to the strengthening of inventories and pushed up the margin of the retail price economic activity worldwide, moved up further in early over the already-elevated cost of the associated crude oil. 2005. Many of those prices slackened in the spring and After peaking at more than $3 per gallon in early Sep- summer as industrial production softened, but they turned tember, gasoline prices fell sharply over the balance of up again in the fall. All told, however, the higher input 2005 as demand moderated, refinery capacity in the Gulf costs left only a small mark on the prices of core goods Coast region came back on line, and imports surged. In and services. A major reason is that the robust upward January 2006, gasoline prices turned up in response to trend in labor productivity helped to hold labor costs in higher crude oil costs, and they are now running about check and gave firms scope to absorb cost increases. 50 cents per gallon higher than they were in January 2005. Near-term inflation expectations have come under Consumer prices for natural gas rose more than some upward pressure over the past year, but recent read- 35 percent in 2005, with most of the increase coming in ings have been close to those at the beginning of 2005. the second half of the year. Prices started to move up Apart from an energy-related spurt to 4½ percent in early around midyear and then skyrocketed in September and autumn, the Michigan SRC measure of households’ me- October after Hurricanes Katrina and Rita curtailed pro- dian expectation for inflation over the next twelve months duction in the Gulf of Mexico. Most of the shut-in pro- has been in the neighborhood of 3 percent to 3¼ percent duction was restored by late 2005, and inventories since March 2005 after hovering in the area of 2¾ per- remained ample for a normal heating season, but spot cent to 3 percent in late 2004 and early 2005. In January natural gas prices held at elevated levels through mid- 2006, it stood at 3 percent. The Michigan SRC measure December. They have since plummeted in response to of the median expectation for inflation over the next five unseasonably warm weather in much of the nation but to ten years was also running a bit above 3 percent in late are still far above their levels of a year ago. Reflecting 2005, but it dipped to 2.9 percent in January of this year, higher input costs, PCE electricity prices rose 10 percent a reading similar to those in 2004 and in the first eight in 2005 after a much smaller rise in 2004. months of 2005. Other indicators likewise suggest that Board of Governors of the Federal Reserve System 19 mediate-term interest rates rose in line with the gradual TIPS-based inflation compensation, 2003–06 firming in the stance of monetary policy, but longer-term Percentage points interest rates moved lower on balance. For a time early in the year, rising oil prices and incoming data showing Five-year, five-year ahead 3.5 higher-than-expected inflation appeared to lift policy expectations as well as interest rates at intermediate- and 3.0 longer-term horizons. The minutes of the December 2004 FOMC meeting, released on January 4, 2005, and the 2.5 FOMC’s conditioning of its risk assessment on “appro- 2.0 priate monetary policy action” after its March 2005 meet- Five-year ing were read as indicating more concern among Com- 1.5 mittee members about inflation pressures than investors 1.0 had anticipated. The ten-year Treasury yield moved up after Chairman Greenspan’s semiannual congressional 2003 2004 2005 2006 testimony in February 2005, as investors reportedly focused on his remark that the low level of long-term NOTE: The data are daily and extend through February 8, 2006. Based on a comparison of the yield curve for Treasury inflation-protected securities interest rates at that time was a “conundrum.” However, (TIPS) with the nominal off-the-run Treasury yield curve. the subsequent release of weaker-than-expected data on SOURCE: Federal Reserve Board calculations based on data provided by the Federal Reserve Bank of New York and Barclays. consumer spending, consumer sentiment, and output led investors to mark down again their anticipated path for longer-run inflation expectations have remained well con- monetary policy and caused intermediate-term Treasury tained. According to the Survey of Professional Forecast- yields to retreat somewhat on balance during the second ers, conducted by the Federal Reserve Bank of Philadel- quarter, while the ten-year Treasury yield declined sharply. phia, expectations of inflation over the next ten years On balance over the second half of the year, investors remained at 2½ percent in 2005, as they have since 1998. became more confident that the economic expansion had In addition, inflation compensation, as measured by the substantial momentum, and the expected path of policy spread of yields on nominal Treasury securities over their and nominal Treasury yields moved considerably higher. inflation-protected counterparts, fell a bit, on balance, in Economic data that came in over the summer months sug- 2005. gested more strength in spending and output than inves- tors had been anticipating. However, in response to the devastation caused by Hurricane Katrina in August and U.S. Financial Markets the subsequent landfall of two additional major storms, investors marked down sharply their expectations for the U.S. financial markets withstood some strains in 2005, path of monetary policy, predominantly at longer hori- most notably a large cumulative upward revision to the zons, and nominal Treasury yields dipped. Those declines expected path of monetary policy, sharp increases in energy prices, troubles in the auto and airline sectors, and three major hurricanes. Longer-term market interest rates Interest rates on selected Treasury securities, 2003–06 remained low, corporate risk spreads stayed relatively narrow by historical standards, and equity prices advanced Percent modestly. Banks continued to ease standards and terms on loans to businesses, and bank lending to businesses Ten-year 5 surged. Overall, debt growth in the business sector picked up, and the expansion of household debt remained quite 4 brisk, but federal borrowing dropped back. The M2 mon- etary aggregate grew moderately. 3 Two-year 2 Interest Rates Three-month 1 The FOMC lifted the target federal funds rate a total of 2 percentage points in 2005, nearly 1 percentage point 2003 2004 2005 2006 more than market participants had anticipated at the start NOTE: The data are daily and extend through February 8, 2006. of the year. Over the first half of 2005, short- and inter- SOURCE: Department of the Treasury. 20 Monetary Policy Report to the Congress February 2006 in yields proved temporary, though, as incoming data in 30 basis points at the ten-year horizon over 2005. Finally, the weeks after the hurricanes indicated that output had it is possible that an excess of global saving over planned been expanding briskly before the storms hit and that the investment has lowered real longer-term interest rates. resulting disruptions to economic activity would prob- In the corporate bond market, risk spreads widened ably be less severe than investors had initially feared. In modestly in 2005, but the generally healthy state of cor- addition, a drop in some energy prices might have con- porate balance sheets and the robust growth of profits tributed to an upgrading of the economic outlook. Over kept spreads low by historical standards. Spreads in the the remaining three months of the year, data on spending auto sector were an exception, however, as the troubles and production generally appeared robust, and investors that emerged in the spring at GM and Ford and the bank- raised their expectations for the path of monetary policy ruptcy of Delphi last fall boosted spreads sharply in this a bit more. sector. The bankruptcies of two major airlines and the On net in 2005, the yield on the two-year nominal Trea- revelation of apparent accounting fraud at Refco, a large sury note rose about 135 basis points, whereas the yield derivatives broker, did not appear to have a material on the ten-year Treasury note increased only about effect on broad corporate risk spreads. 15 basis points. As a result, longer-horizon forward rates To date in 2006, amid uneven incoming economic data, extended their decline that had begun around the middle investors’ expectations for the path of the target federal of 2004, the onset of the current tightening cycle. funds rate have edged up, as have intermediate- and Although the reasons for this large cumulative drop are longer-term nominal Treasury rates. However, spreads on not entirely clear, this general pattern was also evident investment-grade corporate securities have changed little, last year in other major industrialized economies, where whereas those on speculative-grade issues have declined longer-term interest rates mainly declined. One possibil- somewhat. ity is that higher energy prices might have led investors to trim their assessment of the cumulative amount of mon- etary policy restraint required over the longer run that Equity Markets would be consistent with sustainable economic growth. Investors also appeared to become less uncertain about Share values, as measured by the Wilshire 5000 index, the outlook and so might have become more willing to rose about 4½ percent in 2005. Higher energy prices and accept smaller risk premiums on long-term securities. expectations for tighter monetary policy damped equity Another possible explanation is that long-term inflation prices at times during the year, but these downward pres- expectations have fallen and have become more firmly sures were offset by continued strong corporate earnings anchored. As measured by the spread between yields on growth and largely upbeat news on the economy. The nominal Treasury securities and their inflation-protected response of stock prices to the hurricanes was generally counterparts, inflation compensation fell a bit more than muted—low longer-term interest rates and the prospect of additional fiscal stimulus apparently offset concerns that yet-higher energy prices might trim economic growth. Spreads of corporate bond yields over On net last year, energy-related stocks registered substan- comparable off-the-run Treasury yields, 1997–2006 Percentage points Stock price indexes, 2004–06 10 January 2, 2004 = 100 High-yield 8 130 6 Russell 2000 BBB 4 120 2 110 AA + _0 Wilshire 5000 100 1998 2000 2002 2004 2006 NOTE: The data are daily and extend through February 8, 2006. The high-yield index is compared with the five-year Treasury yield, and the BBB 2004 2005 2006 and AA indexes are compared with the ten-year Treasury yield. SOURCE: Merrill Lynch AA and BBB indexes and Merrill Lynch Master II NOTE: The data are daily and extend through February 8, 2006. high-yield index. SOURCE: Frank Russell Company; Dow Jones Indexes. Board of Governors of the Federal Reserve System 21 Implied S&P 500 volatility, 1999–2006 Change in domestic nonfinancial debt, 1990–2005 Percent Percent Total 10 40 8 30 6 4 20 Components 10 15 Nonfederal 10 5 + 1999 2000 2001 2002 2003 2004 2005 2006 _0 NOTE: The data are daily and extend through February 8, 2006. The series Federal, 5 shown is the implied thirty-day volatility of the S&P 500 stock price index as held by public 10 calculated from a weighted average of options prices. SOURCE: Chicago Board Options Exchange. 1991 1993 1995 1997 1999 2001 2003 2005 tial gains in response to the rise in the price of oil. To NOTE: For 2005, change is from 2004:Q3 to 2005:Q3 at an annual rate. For earlier years, the data are annual and are computed by dividing the annual date in 2006, major equity indexes have risen modestly flow for a given year by the level at the end of the preceding year. The total amid largely positive news about fourth-quarter earnings. consists of components shown. Nonfederal debt consists of the outstanding credit market debt of state and local governments, households, nonprofit Volatilities of equity prices implied by prices on organizations, and nonfinancial businesses. Federal debt held by the public options contracts on both the S&P 500 and Nasdaq 100 excludes securities held as investments of federal government accounts. indexes remained low over most of 2005, apparently SOURCE: Federal Reserve Board, flow of funds data. owing to perceptions of only modest near-term macro- economic risk. However, the spread between the twelve- last year. They attributed the easing to an improved eco- month forward earnings–price ratio for S&P 500 firms nomic outlook and more-aggressive competition from and an estimate of the real long-term Treasury yield—a other banks and nonbank lenders. They also reported that measure of the long-term equity risk premium—widened loan demand had strengthened. Real estate lending by a bit last year and is now in the upper part of its range of banks was brisk again last year, though it cooled some- the past two decades. Arithmetically, the widening in this what in the fourth quarter in the wake of the backup in spread can be attributed to a decline in the measure of longer-term interest rates. Consumer loans on banks’ the real long-term Treasury yield; the measure of the earn- books expanded rapidly during the first quarter of 2005 ings yield on the S&P 500 changed little on balance last but then less so over the balance of the year, in part year. because some households substituted lower-cost mort- gage credit for consumer loans. Measures of bank profitability in 2005 fell back a bit Debt and Financial Intermediation from the very high levels posted in 2003 and 2004 but remained robust by historical standards. Profitability was The total debt of the domestic nonfinancial sectors restrained by vigorous competition and downward pres- expanded an estimated 9 percent in 2005, about the same sure on net interest margins from increases in market pace as in 2004. However, the composition of debt growth interest rates, but it was supported by excellent asset qual- differed somewhat from the previous year: Borrowing by ity and reductions in noninterest expenses relative to nonfinancial businesses picked up in 2005 while federal assets. Banks’ provisioning for loan losses over the first borrowing dropped back. The growth of debt of the house- three quarters of last year was lower, on average, than in hold sector remained brisk, driven by the rapid expan- 2004, even with the increase in provisioning in the third sion of mortgages. quarter owing to the prospective surge in personal bank- Commercial bank credit expanded 10½ percent in ruptcies and to the hurricanes. 2005, a bit faster than the brisk pace registered in 2004. Mortgage market assets held by government-sponsored Growth of commercial and industrial loans jumped to 13½ enterprises declined in 2005, as Fannie Mae reduced its percent, the fastest pace in more than two decades. As mortgage portfolio about 20 percent and the rate of port- noted, senior loan officers reported in quarterly surveys folio increase by Freddie Mac was somewhat below the that they had eased terms and standards on such loans rate of growth of residential mortgage debt in general. 22 Monetary Policy Report to the Congress February 2006 The reduction at Fannie Mae occurred partly in response efforts likely added a little to the growth of M2 last year: to regulatory concerns about the adequacy of its capitali- Funds provided by the federal government to displaced zation. These concerns increased substantially after the households and funds advanced by insurance companies company revealed in late 2004 that it had improperly probably buoyed M2 over the last four months of 2005, accounted for certain derivative transactions. Fannie as did a rise in the use of currency in the affected areas. Mae’s share price dropped about 30 percent last year, and Freddie Mac’s declined about 10 percent. Yield spreads on both firms’ debt over comparable-maturity International Developments Treasury securities were little changed on net. Foreign economic activity remained strong in 2005, as the global economy displayed resilience in the face of The M2 Monetary Aggregate sizable increases in energy prices. Manufacturing and trade expanded in most industrial and emerging econo- M2 rose 4 percent in 2005, a pace significantly slower mies. As in 2004, global economic growth in 2005 was than the growth in nominal income and the lowest annual driven importantly by strong demand from the United rate of expansion in about a decade.1 As is typical in a States and China, but domestic demand picked up in a period of rising rates, the opportunity cost of holding M2 number of other countries as well. The run-up in prices assets increased significantly over the course of the year, of crude oil and other commodities over 2005 appeared as changes in rates on liquid deposits lagged those in to have had only a modest effect on measures of inflation market yields. Consequently, growth in liquid deposits in most countries. almost came to a halt following double-digit expansion Cumulative changes in monetary policy in foreign during the previous several years. Some offset was pro- industrial economies during 2005 varied in direction and, vided by a rapid increase in small time deposits, rates on in contrast to the United States, were mostly small. The which remained better aligned with short-term market European Central Bank, which had maintained its main rates. After having contracted sharply in the past couple policy interest rate at 2 percent since the middle of 2003, of years, shares of retail money market mutual funds were tightened 25 basis points late in 2005, citing a need to about flat, on net, as the return on such balances improved keep inflation expectations in check. The Bank of in line with short-term interest rates. Hurricane relief England, after tightening 100 basis points in 2004, low- ered its policy rate 25 basis points in August 2005, as the 1. The Board announced in November that in March 2006 it U.K. housing market had cooled and as the growth of would cease compilation and publication of data on the M3 monetary household spending and business investment had slowed. aggregate; publication of M3 was judged to be no longer generating The Bank of Canada raised its target for the overnight sufficient benefit in the analysis of the economy or of the financial sector to justify the costs of publication. rate a total of 100 basis points in the latter part of 2005 M2 growth rate, 1990–2005 Official interest rates in selected foreign industrial countries, 2003-06 Percent Percent 10 6 8 United Kingdom 5 6 4 4 Canada 3 2 2 Euro area + 1 _0 Japan + _0 1991 1993 1995 1997 1999 2001 2003 2005 2003 2004 2005 2006 NOTE: The data are annual and extend through 2005. M2 consists of currency, traveler’s checks, demand deposits, other checkable deposits, NOTE: The data are monthly. The last observation for each series is for savings deposits (including money market deposit accounts), small- February 8, 2006. The data shown are the call money rate for Japan, the denomination time deposits, and balances in retail money market funds. overnight rate for Canada, the refinancing rate for the euro area, and the SOURCE: Federal Reserve Statistical Release H.6, “Money Stock repurchase rate for the United Kingdom. Measures.” SOURCE: The central bank of each area or country shown. Board of Governors of the Federal Reserve System 23 Yields on benchmark goverment bonds in selected U.S. dollar exchange rate against foreign industrial countries, 2003-06 selected major currencies, 2003-06 Percent Week ending January 3, 2003 = 100 Canada United Kingdom U.K. pound 5 100 Japanese yen 4 90 Germany 3 Euro 80 2 Japan Canadian 1 dollar 70 2003 2004 2005 2006 2003 2004 2005 2006 NOTE: The data are for ten-year bonds and are weekly. The last observation NOTE: The data are weekly and are in foreign currency units per dollar. for each series is the average of February 6 through February 8, 2006. The last observation for each series is the average of February 6 through SOURCE: Bloomberg L.P. February 8, 2006. SOURCE: Bloomberg L.P. and the beginning of 2006, stating that the Canadian have dropped 35 basis points. Over the same period, economy was operating again at full capacity. The Bank Japanese ten-year sovereign yields have risen about of Japan did not depart in 2005 from its policy of quanti- 15 basis points, somewhat less than U.S. Treasury yields tative easing, as it continued to provide large amounts of of the same maturity. Despite higher energy prices, long- bank reserves to keep short-term interest rates near zero. term inflation expectations appear to have remained well However, in the second half of the year, amid growing contained abroad. In Europe, Canada, and Japan, the dif- evidence that an end to consumer price deflation might ferences between ten-year nominal and inflation-indexed be near, Bank of Japan officials began to discuss pub- bond yields currently are little changed from their levels licly the possibility of ending the policy in 2006. at the start of 2005. Ten-year sovereign yields in the euro area and Canada Our broadest measure of the nominal trade-weighted have declined 15 to 20 basis points on net since the exchange value of the dollar has risen 2½ percent on net beginning of 2005, and ten-year U.K. sovereign yields since the beginning of 2005. The dollar likely was sup- ported by the FOMC’s significant cumulative policy tight- ening, only part of which had been anticipated by market participants at the start of 2005. The dollar’s overall U.S. dollar nominal exchange rate, broad index, 2003-06 appreciation was driven by its sharp gains against the cur- Week ending January 3, 2003 = 100 rencies of several major industrial countries; the dollar depreciated on average against the currencies of the United States’ other important trading partners. Since the start of 2005, the dollar has appreciated about 15 percent 100 versus the euro and the Japanese yen, and 10 percent against the British pound. A notable exception to this 95 pattern is the Canadian dollar, against which the U.S. dol- lar has depreciated 4 percent since early 2005. With respect to currencies of other important trading partners, 90 the dollar has depreciated 6 percent against the Mexican peso, 17 percent versus the Brazilian real, and 7 percent against the Korean won. Equity prices have risen substantially in most foreign 2003 2004 2005 2006 industrial and emerging-market countries since early NOTE: The data are weekly and are in foreign currency units per dollar. The last observation is the average of February 6 through February 8, 2006. 2005; these prices have been supported by the continued The broad index is a weighted average of the foreign exchange values of the global economic expansion and by interest rates that, in U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. most countries, have remained well below historical export shares and from U.S. and foreign import shares. averages. Rising commodity prices have buoyed share SOURCE: Federal Reserve Board. 24 Monetary Policy Report to the Congress February 2006 Equity indexes in selected foreign industrial countries, remained just above the ECB’s medium-term goal of less 2003-06 than (but close to) 2 percent. The rate of growth of real GDP in the United King- Week ending January 3, 2003 = 100 dom slowed from 3¼ percent in 2004 to 1¾ percent in 2005. The slowdown was marked by a substantial decel- 200 eration of both private and government consumption. Labor markets remained tight, however; the unemploy- 175 ment rate of 2.9 percent in December was up only slightly from the twenty-year low of 2.6 percent recorded in Janu- Japan Canada 150 ary 2005. Consumer price inflation over the twelve months ending in December 2005 was 2 percent, in line 125 with the central bank’s official target. In contrast to the substantial run-up in real estate prices of 2004, housing United Kingdom 100 price increases in 2005 were small. Euro area Canadian economic growth was solid again in 2005. 2003 2004 2005 2006 Recovering from a slow first quarter that featured a sharp NOTE: The data are weekly. The last observation for each series is the but temporary pullback in exports, real GDP growth average of February 6 through February 8, 2006. rebounded to around 3½ percent in the second and third SOURCE: Bloomberg L.P. quarters. For a second straight year, strong domestic demand underpinned growth, but net exports also made prices of firms in the energy and mining sectors, and share a positive contribution to growth late in the year. prices in the technology sector have also increased Employment made gains, although not as large as in the sharply. Since the beginning of 2005, headline equity previous three years, and the unemployment rate touched indexes, measured in local currencies, have risen about a thirty-year low of 6.4 percent at year’s end. After spik- 20 percent on net in the United Kingdom, 30 percent in ing in the third quarter on rising gasoline prices, con- the euro area, and 45 percent in Japan. In the United sumer price inflation settled back toward 2 percent, the States, by contrast, equity prices have increased only midpoint of the Bank of Canada’s inflation target range. modestly over the same period. Emerging-Market Economies Industrial Economies Growth of real GDP in China remained vigorous in 2005, After expanding at an annual rate of 5¼ percent in the supported again by robust domestic demand and exports. first half of 2005, Japanese real GDP growth declined to Both personal consumption and investment expenditures 1 percent in the third quarter, largely because of slower continued to grow rapidly during the year. Export growth inventory accumulation. Throughout the year, the most also remained strong through most of the year, while important source of support to economic growth was import growth slowed. As a result, the Chinese trade sur- domestic demand, which was lifted by improvements plus more than tripled and exceeded $100 billion. Con- in corporate profitability and labor market conditions. sumer price inflation in 2005 was low in comparison with The unemployment rate declined sharply during the previous year, when higher food prices had caused 2005, ending the year at just under 4½ percent. The inflation to surge; the twelve-month change in consumer rate of deflation in core consumer prices subsided con- prices finished the year at just over 1½ percent. siderably in 2005; in fact, from December 2004 to On July 21, China revalued the renminbi 2.1 percent December 2005, core prices posted a 0.1 percent increase. versus the dollar and announced that henceforth it would However, the GDP deflator continued to fall at a slow manage the value of its currency with reference to a bas- rate. ket of foreign currencies. Since the July revaluation, the Economic growth in the euro area remained weak in exchange value of the renminbi versus the dollar has risen the first half of 2005, at around a 1½ percent annual rate. about ½ percent. Chinese authorities also have imple- Growth picked up to 2½ percent in the third quarter, mented some reforms of the financial system that are spurred by stronger exports, especially by Germany. How- intended to facilitate further exchange rate flexibility, ever, weakness in household spending persisted. The area- including the introduction of an over-the-counter trading wide unemployment rate fell slightly over the year, to system in the domestic foreign exchange market. China’s 8¼ percent near year-end, although employment only foreign exchange reserves increased more than $200 bil- edged up. For the sixth straight year, euro-area inflation lion in 2005; the pace of reserve accumulation did not Board of Governors of the Federal Reserve System 25 change appreciably after the revaluation of the renminbi ciated strongly, and stock prices rose sharply. Concerns in July. over inflation kept monetary policy very tight for most of In other emerging-market nations in Asia, economic the year, but the central bank began easing in September, activity also picked up substantially in 2005, driven by and the policy rate was reduced a total of 250 basis points, the growth of domestic demand and exports. Despite the to 17¼ percent, by January. In late December, Brazil paid global rise of energy costs, consumer price inflation gen- in full its debt to the International Monetary Fund (IMF), erally remained contained. Equity indexes registered large using a portion of its foreign exchange reserves. increases in a number of Asian countries, led in many In Argentina, the economic recovery continued last cases by gains in share prices of technology firms. year, driven in part by increases in consumption and In particular, Korean equity prices have risen about investment. After more than three years in default, the 45 percent since early 2005. Several countries in the government completed a debt swap, restructuring $80 bil- region added to their holdings of foreign exchange lion in bonds and obtaining a participation rate of 76 per- reserves over the period, but in all cases far less than cent. Early this year, Argentina also paid in full its IMF China did. obligations out of its foreign exchange reserves. After a solid performance in 2004, the Mexican economy slowed in the first quarter of 2005 and con- tracted in the second quarter because of weaker exports Equity indexes in selected emerging-market economies, to the United States and a sharp drop in agricultural pro- 2003-06 duction. However, the Mexican economy recovered in the second half of the year, as agricultural and manufac- Week ending January 3, 2003 = 100 turing production bounced back. Aggressive tightening of monetary policy from early 2004 to March 2005 300 seemed to be successful in restraining inflationary pres- sures: Consumer price inflation declined from more than Argentina 250 5 percent at the end of 2004 to a bit less than 4 percent in January 2006, within the central bank’s target range of 200 Mexico 2 percent to 4 percent. The soft economy and an improved outlook for inflation led the Bank of Mexico 150 to begin easing policy in August 2005, and the central Asian emerging- Brazil market economies 100 bank has continued to ease since then. High oil revenues boosted the public-sector surplus, and yield spreads of Mexican sovereign debt over U.S. Treasuries declined to 2003 2004 2005 2006 record lows. NOTE: The data are weekly. The last observation for each series is the In Brazil, growth in economic activity was moderate average of February 6 through February 8, 2006. The Asian emerging-market economies are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the in the first half of 2005, and some indicators point to a Philippines, Singapore, South Korea, Taiwan, and Thailand; each economy’s slowing over the second half. Nonetheless, risk spreads index weight is its market capitalization as a share of the group’s total. SOURCE: For Asian emerging-market economies, Morgan Stanley Capital of Brazilian sovereign debt declined over the course of International (MSCI) index; for others, Bloomberg L.P. the year to their lowest levels since 1997, the real appre-

Federal Reserve (2006, February 14). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20060215

@misc{wtfs_monetary_policy_report_20060215,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2006},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20060215},
  note = {Retrieved via When the Fed Speaks corpus}
}