Monetary Policy Report

For use at 10:00 a.m., EDT Wednesday July 19, 2006 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 19, 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 July 19, 2006 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 19, 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 2006 4 Monetary Policy Report to the Congress Report submitted to the Congress on July 19, 2006, ment in the transition is the lagged effect of the changes pursuant to section 2B of the Federal Reserve Act in monetary policy since mid-2004, changes that have been intended to keep inflation low and to promote sus­ tainable economic expansion by aligning real economic MONETARY POLICY AND THE ECONOMIC OUTLOOK activity more closely with the economy’s productive potential. Moreover, longer-term interest rates have risen, The U.S. economy continued to expand at a brisk rate, contributing to increased borrowing costs for both house­ on balance, over the first half of 2006. Spending in the holds and businesses. Over time, pressures on inflation first quarter, which was especially robust, was tempo­ should abate as the pace of real activity moderates and, rarily buoyed by several factors, including federal spend­ as futures markets suggest, the prices of energy and ing for hurricane relief and the effects of favorable weather other commodities roughly stabilize. The resulting eas­ on homebuilding. The pace of the expansion moderated ing in inflation should help contain long-run inflation in the spring, to some degree because the influence of expectations. these special factors dissipated. More fundamentally, Even as the rate of increase in real economic activity consumer spending slowed as further increases in energy moderates, the prospects for sustained expansion of prices restrained the real incomes of households. In household and business spending appear favorable. addition, home sales and new homebuilding dropped back Higher energy prices have put strains on household bud­ noticeably from the elevated levels of last summer, partly gets, but once that effect fades, households should expe­ in response to higher mortgage interest rates. Outside of rience gains in real income consistent with the ongoing the household sector, increases in demand and produc­ expansion of jobs. Household balance sheets remain gen­ tion appear to have been well maintained in the second erally sound; although some pockets of distress have sur­ quarter. Demand for U.S. exports was supported by strong faced, average delinquency rates on mortgages and other economic activity abroad, and business fixed investment consumer debt are still low. Similarly, in the business sec­ remained on a solid upward trend. Early in the year, as tor, balance sheets are strong, credit quality is high, and aggregate output increased rapidly, businesses added most firms have ready access to funds. Sustained expan­ jobs at a relatively robust pace, and the unemployment sion of the global economy, along with the effects of rate moved down further. Since April, monthly gains in the earlier depreciation of the foreign exchange value of payroll employment have been smaller but still sufficient the dollar, should support demand for U.S. exports. The to keep the jobless rate steady. potential for efficiency gains, as well as further declines Thus far in 2006, inflation pressures have been in the relative cost of capital, are likely to continue to elevated. Higher prices for crude oil contributed to a fur­ spur capital spending. Indeed, the ongoing advances in ther run-up in domestic energy costs; this year’s increases, efficiency should sustain solid growth of labor produc­ combined with the steep increases in 2004 and 2005, not tivity, providing support for gains in real wages and only boosted the prices of gasoline and heating fuel but income. also put upward pressure on the costs of production for As always, considerable uncertainties attend the out­ a broad range of goods and services. Partly as a result look. Regarding inflation, the margin between produc­ of these cost pressures, the rate of core consumer price tion and consumption of crude oil worldwide is quite inflation picked up. Nevertheless, measures of inflation narrow, and oil markets are especially sensitive to news expectations remained contained, and the rate of increase about the balance of supply and demand and to geo­ in labor costs was subdued, having been held down by political events with the potential to affect that balance; strong gains in productivity and moderate increases in adverse developments could result in yet another surge labor compensation. in energy costs. Indeed, futures markets provide only Taking a longer perspective, the U.S. economy appears imperfect readings on the prospects for energy markets, to be in the midst of a transition in which the rate of as witnessed by the fact that the surprises in crude oil increase in real gross domestic product (GDP) is moving prices during the past few years have been predominantly from a pace above that of its longer-run capacity to a to the upside. In addition, a further rise in prices of other, more moderate and sustainable rate. An important ele­ non-energy materials and commodities, if it materializes, 2 Monetary Policy Report to the Congress July 2006 could also intensify cost pressures. Another risk is that gate demand noticeably. Consumer spending might be the effect on imported-goods prices of earlier declines in depressed by the loss of income and wealth, and that the foreign exchange value of the dollar, which has been effect could be amplified if the downturn is abrupt enough limited to date, could become larger. More broadly, if the to shake households’ confidence about their ability to higher rate of core inflation seen this year persists, it could finance spending or manage their current financial induce a deterioration in longer-run inflation expecta­ obligations. tions that, in turn, might give greater momentum to infla­ tion. However, the risks to the inflation outlook are not entirely to the upside. In the current environment of The Conduct of Monetary Policy elevated profit margins, competitive forces, both in over the First Half of 2006 domestic markets and from abroad, could impose sig­ nificant restraint on the pricing decisions of businesses. The Federal Open Market Committee (FOMC) contin­ Regarding risks to the outlook for real activity, rates ued to firm the stance of monetary policy over the first of increase in real GDP have been uneven during the past half of 2006. At the time of the January meeting, avail­ year, complicating the assessment of whether the pace able information suggested that underlying growth in of the economic expansion is moving into line with its aggregate demand was solid at the turn of the year. The underlying potential rate. One possible risk to the expansion of real GDP in the fourth quarter of 2005 was upside is that the softer tone of the recent data on real estimated to have slowed temporarily, in part because of activity will prove transitory rather than mark a shift to the disruptions associated with last autumn’s hurricanes. a more sustainable underlying rate of expansion. For Core inflation had stayed relatively low, and inflation example, slower spending and hiring in recent months expectations had remained contained. With rising energy may represent a shorter-lived adjustment to a higher level prices and increases in resource utilization having the of energy prices or to the unusually robust increases in potential to add to inflationary pressures, the FOMC economic activity earlier in the year. In coming months, decided to extend the firming of policy that it had imple­ a sharp rebound in consumer spending accompanied mented over the previous eighteen months by tightening by an acceleration of capital spending could return real the policy rate 25 basis points, to 4½ percent. The Com­ activity to a pace that would be unsustainable over the mittee indicated that some further policy firming might longer run. But downside risks also exist. In particular, be needed to keep the risks to price stability and to sus­ the slowing in real estate markets since last summer has tainable economic growth roughly in balance. been moderate, and the easing of house-price inflation By March, economic activity appeared to be expand­ has been gradual. If the softening in the demand for ing rapidly, propelled by robust consumer spending and housing and in real estate values becomes more pro­ accelerating business investment. Although readings on nounced, the resulting drop in construction activity and core inflation for January and February were generally the erosion of household wealth could weaken aggre- favorable, higher prices for energy and other commodi- Selected interest rates, 2003–06 Percent 5 Ten-year Treasury 4 3 Target federal funds rate 2 1 1/29 3/18 5/6 6/25 8/12 9/16 10/28 12/9 1/28 3/16 5/4 6/30 8/10 9/21 11/1012/14 2/2 3/22 5/3 6/30 8/9 9/20 11/1 12/13 1/31 3/28 5/10 6/29 2003 2004 2005 2006 NOTE: The data are daily and extend through July 12, 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 ties, together with relatively tight labor and product mar­ tinues to seek further improvements. Between the March kets, threatened to add to existing inflation strains. Against and May meetings, the Chairman appointed a subcom­ this backdrop, the Committee raised the target federal mittee to help the FOMC frame and organize the discus­ funds rate another 25 basis points, to 4¾ percent. The sion of a broad range of communication issues. At the statement released at the end of the meeting continued to June meeting, the Committee discussed the subcom­ point to the possible need for further policy firming. mittee’s plans for work in coming months and decided to Data received by the time of the May meeting con­ begin its consideration of communication issues at its firmed that the economy had expanded robustly in the August meeting and to lengthen meetings later this year first quarter, though both consumer spending and hous­ to allow a fuller discussion of these issues. ing activity appeared to have moderated in late winter. In addition, inflationary pressures had intensified as core consumer prices rose more rapidly in March than in ear­ Economic Projections for 2006 and 2007 lier months. Inflation expectations, as measured by some surveys and by comparisons of yields on nominal and In conjunction with the FOMC meeting at the end of June, inflation-indexed Treasury securities, also rose in April. the members of the Board of Governors and the Federal The Committee still judged those expectations to be con­ Reserve Bank presidents, all of whom participate in the tained, but it was mindful that a further increase could deliberations of the FOMC, provided economic projec­ impart additional momentum to inflation, as could the tions for 2006 and 2007. In broad terms, the participants surge in energy and other commodity prices and the drop expect a sustained, moderate expansion of real economic in the foreign exchange value of the dollar that took activity during the next year and a half. The central ten­ place in April and early May. To gain greater assurance dency of the FOMC participants’ forecasts for the increase that inflationary forces would not intensify, the FOMC in real GDP is 3¼ percent to 3½ percent over the four decided to raise the target federal funds rate another quarters of 2006 and 3 percent to 3¼ percent in 2007. 25 basis points, bringing it to 5 percent. The FOMC also The central tendency of their forecasts for the civilian indicated in the policy statement that some further policy unemployment rate is 4¾ percent to 5 percent in the fourth firming could be required. However, the Committee was quarter of this year, and the jobless rate is expected to aware that the cumulative effects of past monetary policy still be in that range at the end of 2007. For inflation, the actions on economic activity could turn out to be larger central tendency of the forecasts is an increase in the price than expected. Accordingly, the FOMC stressed that the index for personal consumption expenditures excluding extent and timing of any further firming would depend food and energy (core PCE) of 2¼ percent to 2½ percent importantly on the evolution of the economic outlook as over the four quarters of 2006; in 2007, the forecast shows implied by incoming data. By the time of the June meeting, available data appeared to confirm that economic growth had moder­ Economic projections for 2006 and 2007 ated from the strong pace evident earlier in the year. Con­ Percent sumer spending had softened, and activity in housing Federal Reserve Governors markets had continued to cool gradually. Evidence of and Reserve Bank presidents inflationary pressures was accumulating, however, and Indicator core price inflation had increased. In addition, the high Central Range tendency levels of resource utilization and of the prices for energy and other commodities had the potential to spur further 2006 inflation. Consequently, the FOMC decided to increase Change, fourth quarter to fourth quarter1 the target federal funds rate an additional 25 basis points, Nominal GDP ........................................................ 5½–6½ 6–6¼ Real GDP .............................................................. 3–3¾ 3¼–3½ to 5¼ percent. The Committee recognized that the mod­ PCE price index excluding food and energy ........ 2¼–3 2¼–2½ eration in the growth of aggregate demand that appeared Average level, fourth quarter to be under way would help to limit inflationary pres­ Civilian unemployment rate .................................. 4½–5 4¾–5 sures over time, but it judged that, even after its policy action, some upside inflation risks remained. Yet the 2007 Change, fourth quarter to fourth quarter1 FOMC made clear that the extent and timing of any addi­ Nominal GDP ........................................................ 4¾–6 5–5½ tional firming needed to address those risks will depend Real GDP .............................................................. 2½–3¼ 3–3¼ PCE price index excluding food and energy ........ 2–2¼ 2–2¼ on the evolution of the outlook for both inflation and eco­ Average level, fourth quarter nomic growth as implied by incoming information. Civilian unemployment rate .................................. 4¼–5¼ 4¾–5 In recent years, the FOMC has worked to improve the 1. Change from average for fourth quarter of previous year to average for transparency of its decisionmaking process, and it con­ fourth quarter of year indicated. 4 Monetary Policy Report to the Congress July 2006 a slower rate of 2 percent to 2¼ percent, which is similar Change in real GDP, 2000–06 to the rate of core PCE price inflation in 2004 and 2005. A slowing in activity now appears to be under way in Percent, annual rate the housing sector, where home sales and residential con­ struction have receded from the elevated levels of last Q1 6 summer. The associated easing in house-price apprecia­ 5 tion will likely temper gains in household wealth, which, over time, may be a factor in damping consumer spend­ 4 ing. However, households’ financial positions should receive a boost from an acceleration of real income if 3 energy prices stabilize as suggested by futures markets. 2 In the business sector, participants view the outlook for fixed investment over the forecast period as positive. 1 Although outlays for new equipment and software may increase a little more slowly with the deceleration in real 2000 2001 2002 2003 2004 2005 2006 output, investment opportunities appear to remain attrac­ NOTE: Here and in subsequent figures, except as noted, change for a given tive: The relative user cost of capital for equipment, par­ period is measured to its final quarter from the final quarter of the preceding period. ticularly high-technology items, is expected to remain SOURCE: Department of Commerce, Bureau of Economic Analysis. favorable, and competitive pressures should maintain strong incentives to exploit opportunities for efficiency ing the preceding year and a half. Over this period, pay­ gains and cost reduction. At the same time, nonresiden­ roll employment posted additional solid gains, and the tial construction seems likely to continue to move up. unemployment rate declined further. In recent months, Finally, the strong performance of the economies of the the incoming information on real activity has suggested United States’ major trading partners should continue to that the pace of the expansion is moderating, with the stimulate U.S. exports of goods and services. deceleration in spending most apparent in the household The more moderate pace of expansion and the stabil­ sector. Still, as of midyear, resource utilization in labor ity in resource utilization, when coupled with less pres­ and in product markets remained high. sure from the prices of energy and other commodities, Inflation picked up over the first five months of the should contribute to an environment in which inflation year, boosted importantly by the effects of rising energy expectations are contained and inflation edges lower. prices. Long-term inflation expectations fluctuated over Moreover, ongoing solid gains in productivity should the period but remained contained, and increases in unit work to limit increases in unit labor costs. labor costs were subdued. Although short-term market Over the next year and a half, FOMC participants interest rates rose in line with the FOMC’s firming of expect the economy to achieve a sustainable rate of eco­ monetary policy, financial market conditions were still nomic expansion. That rate will be determined in large generally supportive of economic expansion in the first part by the rate of increase in productivity. Productivity has been rising at a solid rate over the past two years, albeit more slowly than the especially rapid pace that Change in PCE chain-type price index, 2000–06 prevailed during the first three years of the expansion. A Percent, annual rate strong trend in productivity is likely to be maintained as Total businesses take advantage of new investment in facilities Excluding food and energy and equipment, as diffusion of technology continues, and 4 as organizational advancements and business process improvements yield further increases in efficiency. 3 2 ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2006 1 Although last year’s hurricanes caused the pace of aggregate economic activity around the turn of the year 2000 2001 2002 2003 2004 2005 2006 to be uneven, real GDP increased at an average annual NOTE: The data are for personal consumption expenditures (PCE). rate of 3.6 percent in the final quarter of 2005 and first Through 2005, change is from December to December; for 2006, change is from December to May. quarter of 2006—about the same pace that prevailed dur- SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 5 half of 2006. Long-term interest rates rose but were still Personal saving rate, 1986–2006 moderate by historical standards, and credit spreads and risk premiums stayed narrow. Percent 12 The Household Sector 9 Consumer Spending 6 After increasing at a robust rate around the turn of the year, consumer spending has been rising at a more mod­ 3 erate pace in recent months. Over the first half of 2006, + rising employment and the lagged effect of increases in 0_ wealth continued to provide support for spending by households. However, consumers’ purchasing power was 1986 1990 1994 1998 2002 2006 restrained by a further run-up in energy costs in the spring. NOTE: The data are quarterly and extend through 2006:Q2; the reading for Sales of new cars and light trucks bounced back sharply 2006:Q2 is the average for April and May. at the turn of the year; those sales had slackened in late SOURCE: Department of Commerce, Bureau of Economic Analysis. 2005 after manufacturers ended the special “employee discount” programs that had boosted sales last summer. such a surge in spending. Estimates of retail sales, which New light vehicles sold at an annual rate of 16.8 million are available through June, suggest that real expenditures units between January and April, about the same as the for these goods rose more slowly in the second quarter. average rate in 2004 and 2005. However, elevated gaso­ In contrast to the uneven pattern of spending for goods, line prices affected the composition of demand, and con­ real outlays for consumer services remained on a moder­ sumers shifted their purchases away from light trucks and ate upward trend over the first half of 2006; they rose at sport-utility vehicles (SUVs) and toward autos. That shift an annual rate of 2½ percent from the fourth quarter of led to an increase in the market share captured by foreign 2005 through May 2006. producers. As households’ concerns about the higher price Boosted by gains in nominal wage and salary income, of gasoline weighed on their attitudes toward buying after-tax aggregate personal income rose at an annual rate vehicles, sales dipped to an annual rate of 16.2 million of 4 percent over the first five months of 2006. However, units in May and June. the acceleration in consumer prices held real income about Spending for other household goods, such as furni­ constant. As a result, the steep decline in the personal ture, electronic equipment, food, and clothing, was quite saving rate, which began in 2004, extended into 2006. strong in the first quarter of 2006; real outlays for goods Since 2003, rising household wealth has provided other than motor vehicles increased at an annual rate of 8¾ percent. Some moderation was to be expected after Wealth-to-income ratio, 1983–2006 Ratio Change in real income and consumption, 2000–06 Percent, annual rate 6 Disposable personal income Personal consumption expenditures 6 Q1 5 4 4 2 + 0_ 1986 1990 1994 1998 2002 2006 NOTE: The data are quarterly and extend through 2006:Q1. The wealth- to-income ratio is the ratio of household net worth to disposable personal 2000 2001 2002 2003 2004 2005 2006 income. SOURCE: For net worth, Federal Reserve Board, flow of funds data; for SOURCE: Department of Commerce, Bureau of Economic Analysis. income, Department of Commerce, Bureau of Economic Analysis. 6 Monetary Policy Report to the Congress July 2006 Consumer sentiment, 1993–2006 Mortgage rates, 2002–06 1985 = 100 1966 = 100 Percent Fixed rate 140 Conference Board 140 7 120 120 6 100 100 5 Michigan SRC 80 80 4 60 60 Adjustable rate 3 1994 1997 2000 2003 2006 2002 2003 2004 2005 2006 NOTE: The Conference Board data are monthly and extend through June NOTE: The data, which are weekly and extend through July 12, 2006, are 2006. The Michigan SRC data are monthly and extend through a preliminary contract rates on thirty-year mortgages. estimate for July 2006. SOURCE: Federal Home Loan Mortgage Corporation. SOURCE: The Conference Board and University of Michigan Survey Research Center. on the market was 6½ months’ supply; in 2005, the stocks of both unsold new and existing homes averaged roughly important support for spending, even as gains in real 4½ months of supply. income have been damped by increases in energy prices. An increase in mortgage rates contributed to the slack­ In 2005 and the first part of 2006, much of the increase ening in the demand for housing. Since the middle of in wealth was the result of the rapid appreciation in the 2005, the average rate for a thirty-year fixed-rate mort­ value of homes. gage has increased about 1 percentage point, to 6¾ per­ According to the survey by the University of Michi­ cent, and the average for a one-year adjustable-rate mort­ gan Survey Research Center (SRC), the run-up in energy gage has risen a bit more, to 5¾ percent. According to prices contributed importantly to the deterioration in con­ respondents to the Michigan SRC survey, the rise in bor­ sumer confidence this spring. Consumers’ pessimism rowing costs has been an important consideration damp­ peaked in May and then lessened somewhat, on average, ing their assessment of buying conditions for homes since in June and early July. Nonetheless, at midyear, house­ mid-2005; the rise in home prices has apparently also holds indicated that they were still concerned about the weighed on consumers’ attitudes. effect of the high cost of energy on their financial situa­ tion. In addition, households’ assessments of current and expected business conditions remained considerably less Change in prices of single-family houses, 1983–2006 optimistic than they were at the beginning of the year. Percent 14 Residential Investment 12 Repeat-transactions index 10 The demand for homes had begun to soften in the sum­ 8 mer of 2005, and, by the spring of 2006, starts of new 6 single-family homes were well below the very rapid pace 4 that had prevailed in the preceding two years. The Existing home reduced level of activity in real estate markets also led to price index 2 + some easing in house-price appreciation early this year. 0_ Sales of new and existing single-family homes, which 2 had been climbing steadily since 2003, stopped rising 1986 1990 1994 1998 2002 2006 during the third quarter of 2005. By May, sales of new and existing homes together were 7¼ percent below their NOTE: The data are quarterly, and change is from one year earlier. The repeat-transactions index extends through 2006:Q1. For the years preceding peak in June 2005. The cooling in sales caused invento­ 1991, that index includes appraisals associated with mortgage refinancings; beginning in 1991, it includes purchase transactions only. The existing home ries of unsold homes to rise. In May, the backlog of price index extends through 2006:Q2, and the reading for Q2 is the average unsold new homes equaled 5½ months’ supply at that for April and May compared with the same period a year earlier. SOURCE: For repeat transactions, Office of Federal Housing Enterprise month’s selling rate, and the backlog of existing homes Oversight; for existing home prices, National Association of Realtors. Board of Governors of the Federal Reserve System 7 Although recent increases in house prices have been been advanced into the first quarter, single-family starts smaller than those that accompanied the robust real dropped to an average rate of 1.57 million units in April estate markets of 2004 and 2005, the deceleration thus and May. In contrast to the recent trend in the single- far appears to have been modest. The repeat-transactions family sector, construction of new multifamily homes index of house prices, which is published by the Office averaged an annual rate of 360,000 units from January to of Federal Housing Enterprise Oversight, increased at an May, about where it has been for more than four years. annual rate of 7¼ percent in the first quarter of 2006, Housing activity, as measured by real expenditures on the smallest quarterly increase since the fourth quarter residential structures, contributed almost ½ percentage of 2001; that index attempts to control for the quality point per year to the annual rate of increase in real GDP of existing single-family homes sold by using prices in 2004 and 2005. In the first quarter of 2006, that con­ of homes involved in repeat transactions (excluding tribution dropped to 0.2 percentage point; with the refinancings). The first-quarter reading brought the reduced pace of sales and construction since the winter, a year-over-year change in this measure to 10 percent; in decline in residential investment is likely to have held the second and third quarters of 2005, purchase prices down the rise in real GDP in the second quarter. according to this index were up 11½ percent from the level of a year earlier. An alternative measure of house prices is the average price of existing single-family homes Household Finance sold, which is published by the National Association of Realtors. This measure, which does not control for the Household debt expanded at an annual rate of about type of homes sold, showed that the year-over-year change 11½ percent in the first quarter of 2006, about the same in prices peaked at 11½ percent in August 2005 and then pace as in 2005. Despite the rise in mortgage rates and fell to 4 percent in April and May of this year.The greater the slowing in housing activity, home mortgage debt deceleration in the latter measure suggests that, in addi­ expanded rapidly again early in the year as homeowners tion to some softening in prices, the mix of existing units apparently continued to extract some of the substantial sold may have shifted toward lower-priced homes. gains in equity that they have accumulated on their homes The effect of the slowdown in demand on new con­ in the past several years. Indeed, according to industry struction became apparent during the second half of 2005, estimates, although the number of homeowners refinanc­ when the number of permits issued for new single-family ing their mortgages has remained well below that seen homes began to fall. This year, the decline in permit issu­ during the refinancing boom of several years ago, a large ance was relatively steady from January to May. None­ fraction of homeowners who have refinanced so far this theless, new single-family homes were started at an year have chosen to withdraw equity from their homes. exceptionally high annual rate of 1.75 million units dur­ As has been the case in recent years, this mortgage- ing the first quarter, when builders were able to begin related borrowing likely replaced, in part, some consumer work on scheduled projects earlier than normal because of favorable weather conditions. With some starts having Household financial obligations ratio, 1992–2006 Private housing starts, 1993–2006 Percent Millions of units, annual rate 19 1.6 18 Single-family 1.2 17 .8 16 Multifamily .4 1992 1994 1996 1998 2000 2002 2004 2006 NOTE: The data are quarterly and extend through 2006:Q1. The financial 1994 1996 1998 2000 2002 2004 2006 obligations ratio equals the sum of required payments on mortgage and consumer debt, automobile leases, rent on tenant-occupied property, NOTE: The data are quarterly and extend through 2006:Q2; the readings for homeowner’s insurance, and property taxes, all divided by disposable 2006:Q2 are the averages for April and May. personal income. SOURCE: Department of Commerce, Bureau of the Census. SOURCE: Federal Reserve Board. 8 Monetary Policy Report to the Congress July 2006 Delinquency rates on selected types of household loans, noticeably in early 2006. The underlying determinants of 1998–2006 capital spending have stayed quite positive: Businesses have seen steady increases in sales, robust profits, and Percent declining user costs for equipment; they have ample liq­ uid assets; and, despite the rise in interest rates, credit Credit card pools 6 quality is strong. Real outlays for equipment and software rose at an 5 annual rate of 14¾ percent in the first quarter after hav­ 4 ing risen at a 5 percent rate in the fourth quarter of 2005. Auto loans at domestic As can often be the case, the timing of spending for a auto finance companies 3 number of types of equipment was uneven between these 2 two quarters. Business purchases of cars and trucks slowed in late 2005, after manufacturers reduced their Mortgages 1 special discounts on light vehicles, and then recovered in the first quarter. The first-quarter rebound was strength­ 1998 2000 2002 2004 2006 ened by a further acceleration of outlays for medium and NOTE: The data are quarterly and extend through 2006:Q1. heavy trucks. According to industry analysts, businesses SOURCE: For credit cards, Moody’s Investors Service; for auto loans, the have been pulling forward these purchases because the financing subsidiaries of the three major U.S. automobile manufacturers; for mortgages, Mortgage Bankers Association. engines in the 2007 models will be required to meet new emission regulations by the Environmental Protection credit borrowing, which, at an annual rate of a bit less Agency that will make the new vehicles more costly to than 3 percent, continued to expand modestly in the first operate. Deliveries of commercial aircraft to domestic five months of 2006. The ratio of household financial obligations to dis­ posable income rose 0.1 percentage point in the first quar­ Change in real business fixed investment, 2000–06 ter to about 18¾ percent, narrowly exceeding the top of its historical range. Nonetheless, the evidence points to Percent, annual rate only limited pockets of financial distress in the house­ Structures hold sector. Delinquency rates on residential mortgages Equipment and software were low by historical standards in the first quarter, though 20 they have edged higher since the middle of last year, par­ Q1 ticularly in the subprime sector. Delinquency rates on con­ 10 sumer debt also continued to be low. Meanwhile, house­ hold bankruptcy filings remained subdued in the first + half of 2006, running at a pace well below the average of 0_ recent years. Bankruptcies have likely been damped this year in part by the decision of some households in the 10 fall of 2005 to accelerate their filings to avoid the imple­ mentation of a stricter bankruptcy law in October. More recently, they may also have been restrained by the greater High-tech equipment and software costs of bankruptcy under the new law. Other equipment excluding transportation 30 Q1 20 The Business Sector 10 Fixed Investment + 0_ Real business fixed investment increased at a solid rate, on average, during the final quarter of 2005 and the first 10 quarter of 2006. Over that period, real business spending for new equipment and software rose at an annual rate of 2000 2001 2002 2003 2004 2005 2006 9¾ percent, a pace similar to that over the first three quar­ ters of 2005. In addition, investment in nonresidential NOTE: High-tech equipment consists of computers and peripheral equip­ ment and communications equipment. structures, which had remained weak in 2005, turned up SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 9 customers also rebounded in the first quarter from a very Change in real business inventories, 2000–06 low level in the fourth quarter. Billions of chained (2000) dollars, annual rate Demand for high-technology equipment stepped up noticeably in the first quarter because of a sharp jump in outlays for communications equipment. Providers of tele­ 60 communications services appear to be investing heavily in fiber-optic networks, which will allow them to offer a 40 Q1 wider range of Internet services; the recent spurt likely also includes some replacement demand for equipment 20 damaged by last year’s hurricanes. In contrast, business + demand for computing equipment, while still increasing 0_ at a double-digit pace in real terms, has been relatively 20 modest by historical standards so far this year. Industry analysts suggest that firms may be delaying investment in anticipation of introductions, later this year and in early 2000 2001 2002 2003 2004 2005 2006 2007, of several products that will allow faster and more SOURCE: Department of Commerce, Bureau of Economic Analysis. energy-efficient processing. Spending on equipment other than transportation and high-tech goods continued to trend Inventory Investment up at a solid pace, on average, during the fourth and first quarters. Demand was particularly strong for metalwork­ Business inventories appear generally to be well aligned ing and general industrial machinery as well as for equip­ with sales. In surveys taken during the first six months of ment used in construction, energy extraction, and services 2006, about two-thirds of purchasing managers at manu­ industries. facturing firms who responded characterized the level of Demand for equipment and software appears to have their customers’ inventories as about right. A similar risen again in the second quarter. The information from proportion of respondents at nonmanufacturing firms U.S. manufacturers on their orders and shipments of non­ reported that they were comfortable with their own lev­ defense capital goods and the data on imports of capital els of inventories. However, dealer stocks of new light goods suggest that business spending for equipment other motor vehicles, particularly trucks (including SUVs), have than transportation and high-tech items remained on a risen noticeably as sales have slowed; inventories of light strong upward trajectory in April and May. The elevated trucks reached an uncomfortable 89 days’ supply in May. backlog of unfilled orders at domestic firms likely pro­ In late June, a number of manufacturers introduced a new vided support for factory production of capital equipment round of incentives aimed at reducing dealer stocks in in the second quarter. The indicators of demand for high- advance of the introduction of their new models this fall. tech equipment suggest that spending for communications equipment remained at a high level, and real outlays for computing equipment were still rising slowly. Sales of Corporate Profits and Business Finance medium and heavy trucks continued to be robust in the second quarter, although they eased slightly from the Corporate profits were again strong in the first quarter of exceptional rate at the beginning of the year. 2006, and earnings per share for S&P 500 firms rose about Real expenditures for nonresidential construction 15 percent from the same time last year. Gains were wide­ increased at an annual rate of 12½ percent in the first spread but were especially large for firms in the energy quarter after having edged up slightly during 2005. Last sector. Before-tax profits of nonfinancial corporations year, the small net increase in this sector reflected a sharp measured as a share of sector GDP rose to about 14 per­ upturn in spending on structures used in domestic energy cent in the first quarter, above the previous peak reached exploration; construction of new office and industrial in 1997. buildings was restrained by elevated vacancy rates. How­ The expansion of business debt picked up to an ever, vacancy rates for office and industrial properties annual rate of nearly 10 percent in the first quarter of this gradually declined over the course of 2005, and, by the year, and data in hand suggest a robust pace in the sec­ turn of the year, nonresidential construction began to firm. ond quarter. A substantial fraction of borrowing proceeds As a result, the increase in nonresidential investment in reportedly went to finance mergers and acquisitions in the first quarter of 2006 was broadly based; it included the first half of the year. Net bond issuance has been strong pickups in outlays in the office, retail, and industrial sec­ so far in 2006. Short-term borrowing by nonfinancial tors in addition to another steep rise in spending on struc­ corporations stepped up in the first quarter of 2006 after tures associated with energy exploration. slowing somewhat in the fourth quarter of last year; it 10 Monetary Policy Report to the Congress July 2006 Before-tax profits of nonfinancial corporations Net percentage of domestic banks tightening as a percent of sector GDP, 1979–2006 standards on commercial and industrial loans to large and medium-sized borrowers, 1991–2006 Percent Percent 14 60 12 40 10 20 8 + 0_ 6 20 1982 1986 1990 1994 1998 2002 2006 1991 1994 1997 2000 2003 2006 NOTE: The data are quarterly and extend through 2006:Q1. Profits are from domestic operations of nonfinancial corporations, with inventory valuation NOTE: The data are drawn from a survey generally conducted four times and capital consumption adjustments. per year; the last observation is from the April 2006 survey. Net percentage is SOURCE: Department of Commerce, Bureau of Economic Analysis. the percentage of banks reporting a tightening of 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 appears to have remained strong in the second quarter as have sales of $50 million or more. well. Commercial paper outstanding started rising again, SOURCE: Federal Reserve, Senior Loan Officer Opinion Survey on Bank Lending Practices. on balance, after edging lower in 2005. Bank business loans outstanding expanded at an annual rate of 15½ per­ cent in the first quarter. Businesses benefited from a more ing policies were more-aggressive competition from other accommodative lending environment: For example, a sig­ banks and nonbank lenders, increased liquidity in the nificant net fraction of respondents to the Federal secondary market for business loans, and increased tol­ Reserve’s Senior Loan Officer Opinion Survey on Bank erance for risk. Lending Practices in April 2006 noted that their institu­ Gross equity issuance has remained moderate so far tions had eased both standards and terms on commercial this year, while an elevated level of cash-financed merg- and industrial loans in the first three months of the year. The most commonly cited reasons for the easing of lend- Financing gap and net equity retirement at nonfinancial corporations, 1991–2006 Selected components of net financing for nonfinancial corporate businesses, 2003–06 Billions of dollars Billions of dollars, annual rate 600 Commercial paper 500 Bonds Net equity retirement Bank loans Sum of selected 400 400 components 300 200 200 + 100 0_ + 0_ Financing gap 100 200 1991 1994 1997 2000 2003 2006 2003 2004 2005 2006 NOTE: The data are annual through 2005; for 2006, they are as of Q1. The financing gap is the difference between capital expenditures and internally NOTE: The data for the components except bonds are seasonally adjusted. generated funds, adjusted for inventory valuation. Net equity retirement is the The data for the sum of selected components are quarterly. The data for difference between equity retired through share repurchases, domestic 2006:Q2 are estimated. cash-financed mergers, or foreign takeovers of U.S. firms and equity issued SOURCE: Federal Reserve Board; Securities Data Company; and Federal by domestic companies in public or private markets. Equity issuance includes Financial Institutions Examination Council, Consolidated Reports of Condi­ funds invested by venture capital partnerships and stock option proceeds. tion and Income (Call Report). SOURCE: Federal Reserve Board, flow of funds data. Board of Governors of the Federal Reserve System 11 Net interest payments of nonfinancial corporations Commercial real estate debt expanded briskly in the as a percent of cash flow, 1979–2006 first half of 2006, albeit not as quickly as during 2005. Spreads on BBB-rated commercial-mortgage-backed Percent securities have fallen this year. The decline reversed an increase that took place at the end of last year, when issu­ ance surged; these spreads are now back in line with those 20 of comparable-quality corporate bonds. With rents climb­ ing and vacancy rates falling, delinquency rates on com­ mercial real estate loans have been low, and credit qual­ 15 ity has remained generally good. 10 The Government Sector Federal Government 1982 1986 1990 1994 1998 2002 2006 NOTE: The data are quarterly and extend through 2006:Q1. The deficit in the federal unified budget narrowed fur­ SOURCE: Department of Commerce, Bureau of Economic Analysis. ther during the past year. Over the twelve months ending in June, the unified budget recorded a deficit of $276 ers along with record share repurchases has produced fur­ billion, about $60 billion less than during the comparable ther sizable net equity retirements. Taken together, net period last year. The federal deficit over the twelve months funds raised by nonfinancial corporations in the credit ending in June was approximately 2 percent of nominal and equity markets have been slightly negative in 2006, GDP and was significantly lower than its recent fiscal an indication that nonfinancial corporations have financed year peak of 3.6 percent of GDP in 2004. Although out­ their increased investment spending with internal funds. lays increased faster than nominal GDP over the past year, With profitability strong and balance sheets flush with the rise in receipts was even larger. Thus, in its recent liquid assets, credit quality in the nonfinancial business Mid-Session Review of the budget, the Administration sector generally has remained quite high. The six-month estimated that the federal government will finish fiscal trailing default rate on corporate bonds dropped after 2006 with a deficit of $296 billion; that figure marks a some large firms in the troubled airline and automobile decline from the fiscal 2005 deficit of $318 billion and is sectors defaulted during the past fall and winter. much lower than most analysts had projected at the Delinquency rates on business loans have stayed near the beginning of this year. bottom of their historical range. Default rate on outstanding corporate bonds, 1992–2006 Federal receipts and expenditures, 1986–2006 Percent Percent of nominal GDP 4 24 Expenditures 3 22 Receipts 2 Expenditures 20 excluding net interest 1 18 + 0_ 16 1992 1994 1996 1998 2000 2002 2004 2006 1986 1991 1996 2001 2006 NOTE: The data are monthly and extend through June 2006. The rate for a NOTE: Through 2005, the receipts and expenditures data are on a given month is the face value of bonds that defaulted in the six months unified-budget basis and are for fiscal years (October through September); ending in that month, multiplied by two to annualize the defaults and then GDP is for the four quarters ending in Q3. For 2006, the receipts and divided by the face value of all bonds outstanding at the end of the calendar expenditures data are for the twelve months ending in June, and GDP is the quarter immediately preceding the six-month period. average of 2005:Q4 and 2006:Q1. SOURCE: Moody’s Investors Service. SOURCE: Office of Management and Budget. 12 Monetary Policy Report to the Congress July 2006 Change in real government expenditures the inception of the new Part D prescription drug pro­ on consumption and investment, 2000–06 gram in January, outlays for benefits have added more than $20 billion to spending in this category. Legislative Percent, annual rate actions related to the hurricanes in the Gulf Coast region Federal last autumn have added significantly to spending for State and local 12 disaster relief over the past ten months. Although defense Q1 spending has slowed from the annual double-digit rates 9 of increase from 2002 to 2004, it still has increased about 8 percent per year in the past two years. 6 As measured in the national income and product accounts (NIPA), real federal expenditures on consump­ 3 tion and gross investment—the part of federal spending + that is a direct component of real GDP—increased at an 0_ annual rate of 3¾ percent, on average, during the final calendar quarter of 2005 and the first calendar quarter of 2000 2001 2002 2003 2004 2005 2006 2006 and contributed roughly 0.3 percentage point to the SOURCE: Department of Commerce, Bureau of Economic Analysis. annualized change in real GDP over the period. Over these two quarters, real defense purchases were about constant, on average, while spending related to disaster relief from During the twelve months ending in June, federal the hurricanes contributed importantly to a rise in real receipts were 13¼ percent higher than over the same nondefense purchases. period a year earlier and equivalent to almost 18¼ per­ The narrowing of the federal deficit recently has cent of nominal GDP. Income tax receipts from individu­ reduced its drain on national saving. However, net als have outpaced the rise in nominal income; final tax national saving excluding the federal government has payments on income from 2005 were especially strong remained low relative to historical norms. Although the in April and May. Corporate tax payments continued to saving rate for private business has moved up during the rise at a robust rate, even faster than corporate profits. past two years, the improvement has been offset by the Nominal federal outlays rose 9 percent between June further decline in personal saving. Overall, national sav­ 2005 and June 2006 and were about 20½ percent of nomi­ ing, net of depreciation, stood at 2½ percent of nominal nal GDP. The rise in outlays was bolstered by increases GDP in the first quarter of 2006. Although the recent rate in several components of federal spending. Net interest is a noticeable improvement from the lows of the preced­ payments increased 20 percent over the year ending in ing few years, it has been insufficient to avoid an increas­ June as federal debt continued to rise and interest rates ing reliance on borrowing from abroad to finance the increased. Medicare outlays were up 14½ percent; since nation’s capital spending. Net saving, 1986–2006 Federal Borrowing Percent of nominal GDP Federal debt rose at an annual rate of 13 percent in the first quarter, a bit less than in the corresponding quarter Nonfederal saving 9 of 2005. In February, federal debt subject to the statutory limit reached the ceiling of $8.184 trillion, and the Trea­ 6 sury resorted to accounting devices to avoid breaching the limit. The Congress subsequently increased the debt 3 ceiling to $8.965 trillion in March. In the second quarter, Total + federal debt likely declined temporarily because of a surge 0_ in tax receipts. On net, the Treasury has raised substan­ Federal saving tially less cash in the market so far this year than in the 3 comparable period of 2005. In February, the Treasury conducted an auction of 1986 1990 1994 1998 2002 2006 thirty-year bonds for the first time since 2001. The issue generated strong interest, especially from investment NOTE: The data are quarterly and extend through 2006:Q1. Nonfederal saving is the sum of personal and net business saving and the net saving of funds; foreign investors were awarded only a small frac­ state and local governments. tion of the total. In general, foreign demand for Treasury SOURCE: Department of Commerce, Bureau of Economic Analysis. Board of Governors of the Federal Reserve System 13 Federal government debt held by the public, 1960–2006 State and Local Governments Percent of nominal GDP The fiscal positions of states and localities continued to improve through early 2006. In particular, revenues are on track to post a relatively strong gain for a third con­ 55 secutive year. Tax receipts from sales, property, and per­ sonal and corporate income were up 8¼ percent during 45 the year ending in the first quarter of 2006, a rate similar to the increase in the preceding year. The sustained 35 strength in revenues has enabled these jurisdictions to increase their nominal spending somewhat while rebuild­ ing their reserve funds. On a NIPA basis, net saving by 25 state and local governments—a measure that is broadly similar to the surplus in an operating budget—rose to an 1966 1976 1986 1996 2006 annual rate of $21½ billion in the first quarter of 2006 after having been close to zero in 2005. Although most NOTE: The final observation is for 2006:Q1. For previous years, the data for debt are as of year-end, and the corresponding values for GDP are for Q4 states have seen improvement, a number of states are still at an annual rate. Excludes securities held as investments of federal government accounts. struggling with structural imbalances in their budgets, and SOURCE: Federal Reserve Board, flow of funds data. those in the Gulf Coast region are coping with demands related to damage from last year’s hurricanes. In addi­ tion, local governments may face pressure to hold the securities appears to have eased somewhat in 2006. The line on property taxes after the sharp increases in the past proportion of nominal coupon securities bought at auc­ several years, and governments at all levels will have to tion by foreign investors has continued to fall from its contend with the need to provide pensions and health ben­ peak of 24 percent in 2004; it averaged about 14 percent efits to a rising number of retirees in coming years. in the first six months of 2006. Data from the Treasury Real expenditures by state and local governments on International Capital system generally suggested subdued consumption and gross investment, as estimated in the demand from both foreign private investors and foreign NIPA, rose at an annual rate of 1½ percent in the first official institutions over this period. The amount of Trea­ quarter of 2006 after having increased roughly 1 percent sury securities held in custody at the Federal Reserve Bank per year in 2004 and 2005. Real expenditures for invest­ of New York on behalf of foreign official and interna­ ment turned up in the first quarter after having fallen dur­ tional accounts has changed little since the end of ing the second half of 2005. Real outlays for current con­ 2005. sumption posted a moderate increase in the first quarter, and that trend appears to have continued into midyear. State and local government net saving, 1986–2006 Treasury securities held by foreign investors as a share of total outstanding, 1998–2006 Percent of nominal GDP Percent .6 .4 45 .2 + 40 0_ .2 35 .4 .6 30 1986 1990 1994 1998 2002 2006 1998 1999 2000 2001 2002 2003 2004 2005 2006 NOTE: The data, which are quarterly, are on a national income and product account basis and extend through 2006:Q1. Net saving excludes social NOTE: The data are quarterly and extend through 2006:Q1. insurance funds. SOURCE: Federal Reserve Board, flow of funds data. SOURCE: Department of Commerce, Bureau of Economic Analysis. 14 Monetary Policy Report to the Congress July 2006 Hiring by state and local governments was slow early in International Trade the year but appears to have firmed in the spring. Of the cumulative increase in employment of 100,000 Real exports of goods and services increased 14¾ per­ between December and June, 40 percent of the jobs were cent at an annual rate in the first quarter of 2006, far faster in education. than the 6½ percent rate recorded in 2005. The surge in export growth in the first quarter resulted in part from a recovery in exports of many types of industrial supplies State and Local Government Borrowing following a period of hurricane-related disruptions late last year. Exports of capital goods also increased rapidly Borrowing by state and local governments has slowed in the first quarter, with deliveries of aircraft to foreign thus far in 2006. The deceleration likely reflects the gen­ carriers exhibiting particular strength. The first-quarter eral improvement in budget conditions and a decline in increase in exports was widespread across destinations, advance refundings, which have dropped below their 2005 a sign of robust economic activity in many parts of the pace amid rising interest rates and a dwindling pool of world, and exports to Mexico and Canada showed espe­ eligible securities. Credit quality in the state and local cially large increases. Real exports of services rose at an sector has continued to improve, and upgrades of credit annual rate of about 6½ percent in the first quarter after ratings have far outnumbered downgrades. Consistent increasing just 2¾ percent in 2005. Available data for with the improvement in credit quality, yields on long- nominal exports in April and May suggest that the dated municipal bonds have increased substantially less increase in real exports was smaller in the second quar­ than those on comparable-maturity Treasury securities, ter, held down in part by a drop in aircraft exports after a and the yield ratio has accordingly fallen sharply. strong first quarter. Prices of exported goods increased at an annual rate of 2¾ percent in the first quarter of 2006, a pace some­ The External Sector what faster than in the second half of 2005. Prices of non­ agricultural industrial supplies continued to increase The U.S current account deficit narrowed in the first quar­ steadily in the first quarter, driven importantly by higher ter of 2006 to $835 billion at an annual rate, or about prices for oil and metals. An acceleration in prices for 6½ percent of nominal GDP, from $892 billion in the finished goods, especially for capital and consumer goods, fourth quarter of 2005. The narrowing resulted from three contributed to the faster pace of export price inflation in factors. Unilateral transfer payments to foreigners the first quarter. The available data for the second quar­ dropped, largely because of a decrease in government ter point to further increases in export prices on the grants. The trade deficit narrowed, primarily because the strength of additional run-ups in the prices of non­ value of imported oil and natural gas declined. In addi­ agricultural industrial supplies, especially metals. tion, higher direct investment receipts and lower direct Real imports of goods and services rose at an annual investment payments produced an increase in the invest­ rate of 10¾ percent in the first quarter, slightly slower ment income balance. U.S. trade and current account balances, 1998–2006 Change in real imports and exports of goods and services, 1998–2006 Percent of nominal GDP Percent, annual rate + 0_ Imports 1 Exports Q1 15 2 10 Trade 3 5 4 + Current 5 0_ account 6 5 7 10 1998 1999 2000 2001 2002 2003 2004 2005 2006 1998 1999 2000 2001 2002 2003 2004 2005 2006 NOTE: The data are quarterly and extend through 2006:Q1. SOURCE: Department of Commerce. SOURCE: Department of Commerce. Board of Governors of the Federal Reserve System 15 than in the fourth quarter but still considerably faster than The spot price of West Texas intermediate crude oil the 5¼ percent rate observed for 2005 as a whole. increased from around $60 per barrel at the end of last Robust growth of real GDP in the United States supported year to more than $75 per barrel in July, higher than the the first-quarter increase in imports. Among categories peak that followed last year’s hurricanes. Oil prices have of goods, large increases in imports of consumer goods, been highly sensitive to news about both supply and automotive products, and capital goods, particularly com­ demand, particularly in light of the narrow margin of puters, more than offset declines in imports of oil and worldwide spare production capacity. Global oil demand some other industrial supplies. The rise in imports in the has continued to grow as the foreign economic expan­ first quarter was widely distributed across countries, and sion has spread, and developing countries have posted the increases for China and Mexico were especially large. the largest increases in oil consumption. Recent events in Real imports of services jumped at an annual rate of the Middle East—including concerns over Iran’s nuclear 8½ percent in the first quarter. Nominal imports in April program, violence in Iraq, and the recent conflict in Leba­ and May point to an abrupt slowing of real imports in the non—have put additional upward pressure on oil prices. second quarter from the first quarter’s rapid pace. In Nigeria, attacks against oil infrastructure have reduced Prices of imported goods excluding oil and natural gas oil production for most of this year. Government inter­ rose at an annual rate of about 1 percent in the first quar­ vention in energy markets also raised concerns about sup­ ter of 2006, ¾ percentage point faster than the pace in ply from some countries: In recent months, Bolivia the second half of 2005. Prices of material-intensive nationalized its natural gas reserves, and Venezuela and goods, such as nonfuel industrial supplies and foods, Russia continued to tighten governmental control of their increased steadily in the last quarter of 2005 and in the energy industries. first quarter of 2006. Also in the first quarter, prices of The rise in the price of the far-dated NYMEX oil finished goods, such as consumer goods and many kinds futures contract (currently for delivery in 2012) to more of capital goods, turned up slightly. Available data for than $70 per barrel likely reflects a belief by oil market the second quarter indicate that prices of finished goods participants that the balance of supply and demand will kept rising at a subdued pace. However, prices of mate­ remain tight over the next several years. rial-intensive goods continued to increase sharply, a development reflecting higher prices for metals. The International Monetary Fund’s index of global metals The Financial Account prices rose 46 percent between December 2005 and May 2006, largely because of robust global demand. In June, The U.S. current account deficit continues to be financed metals prices retreated about 8 percent, although they primarily by foreign purchases of U.S. debt securities. remained well above the levels of earlier this year. Foreign official inflows in the first quarter maintained the strength exhibited in 2005 but remained below the record levels of 2004. As in recent years, the majority of these official inflows were attributable to Asian central Prices of oil and of nonfuel commodities, 2002–06 banks and have taken the form of purchases of U.S. gov­ ernment securities. January 2002 = 100 Dollars per barrel U.S. net financial inflows, 2002–06 220 80 200 70 Billions of dollars 180 Oil 60 Official 160 50 Private 250 140 40 200 120 30 Nonfuel 150 100 commodities 20 80 10 100 2002 2003 2004 2005 2006 50 NOTE: The data are monthly. The last observation for the oil price is the + average for July 3 through July 12, 2006. The prices of nonfuel commodities 0_ extend through June 2006. The oil 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. 2002 2003 2004 2005 2006 SOURCE: For oil, the Commodity Research Bureau; for nonfuel com­ modities, International Monetary Fund. SOURCE: Department of Commerce. 16 Monetary Policy Report to the Congress July 2006 Net private foreign purchases of long-term U.S. securities, Net change in payroll employment, 2000–06 2002–06 Thousands of jobs, monthly average Billions of dollars 200 Bonds Equities 150 200 Q2 100 150 50 + 0_ 100 50 100 50 150 + 0_ 200 2000 2001 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 NOTE: Nonfarm business sector. SOURCE: Department of Commerce and the Treasury International Capital SOURCE: Department of Labor, Bureau of Labor Statistics. reporting system. vailed during 2004 and 2005. During the second quarter, Foreign private purchases of U.S. securities contin­ hiring slowed, and monthly gains in payrolls averaged ued in the first quarter at the extraordinary pace set in the 108,000 jobs per month. Over the two quarters, the civil­ second half of 2005. Although private flows into U.S. ian unemployment rate edged down further, to the lowest Treasury bonds were significantly smaller than in recent quarterly level of joblessness in five years. quarters, this slowing was more than offset by larger flows In the first quarter, with homebuilding quite strong, into agency bonds and equities. Preliminary data for April hiring continued to be particularly robust at construction and May suggest a slowdown in foreign purchases of U.S. sites; part of this strength was the result of favorable securities relative to the first quarter. Foreign direct weather, which allowed more construction activity than investment flows into the United States continued in the is typical during the winter months. Although nonresi­ first quarter near last year’s average levels. dential construction activity was firming by the spring, Net purchases of foreign securities by U.S. residents, the pullback in housing starts slowed the demand for resi­ which represent a financial outflow, strengthened slightly dential contractors and workers in the building trades. in the first quarter and continued at a solid pace in April As a result, monthly additions to construction industry and May. In addition, significant outflows were associ­ payrolls declined from more than 25,000 per month in ated with U.S. direct investment abroad, a reversal of the first quarter to just 3,000 per month in the second some unusual inflows in the second half of 2005. These quarter. Cutbacks at retailers also were an important fac­ second-half inflows were prompted by the partial tax tor holding down the overall gain in employment in the holiday offered under the 2004 Homeland Investment Act (HIA), which induced the foreign affiliates of U.S. firms to repatriate a portion of earlier earnings that had been Civilian unemployment rate, 1974–2006 retained abroad. In the first quarter, the foreign affiliates Percent partially unwound the HIA-induced flows by retaining an unusually large portion of their first-quarter earnings. Increased merger activity abroad also boosted direct 10 investment outflows in the first quarter. 8 The Labor Market 6 Employment and Unemployment 4 Conditions in the labor market continued to improve in 2 the first half of 2006, although the pace of hiring has slowed in recent months. Nonfarm payroll employment 1976 1986 1996 2006 increased 176,000 per month during the first quarter, a NOTE: The data are monthly and extend through June 2006. rate roughly in line with the relatively brisk pace that pre- SOURCE: Department of Labor, Bureau of Labor Statistics. Board of Governors of the Federal Reserve System 17 second quarter. After having been stable early in 2006, ket conditions. Rates for most broad age groups were little employment at retail outlets fell almost 30,000 per month changed from last year’s levels. From a longer perspec­ between March and June; most of the cutbacks occurred tive, developments during the past decade highlight the at general merchandisers. importance of structural as well as cyclical influences on In other sectors, employment remained on a solid participation. The rise in the attachment of adult women upward trend during the first half of the year. As has been to the workforce, which was a significant factor in the the case since mid-2004, establishments providing edu­ secular rise in participation over much of the post–World cation and health services, those offering professional and War II period, appears to have leveled off. And the aging technical business services, and those involved in finan­ of the population is increasing the proportion of the cial activities, taken together, added more than 60,000 workforce that is 55 years and older; it rose from less jobs per month. Employment in manufacturing, which had than 12 percent in 1996 to 16¾ percent in recent months. turned up at the end of 2005, rose further over the first Although older workers have tended in recent years to half of 2006. Expanding industrial production was also stay in the labor force longer, their participation rate, at associated with further job gains in related industries, such 38 percent in the second quarter, was less than half the as wholesale trade and transportation. In addition, the rate for workers who are age 25 to 54. Thus, the demo­ increase in energy production led to a sustained rise in graphic shift to an older population has already employment in the natural resources and mining industry begun to reduce the overall rate of labor force participa­ over the first half of the year. tion and has offset part of the rise in participation that The increase in job opportunities so far in 2006 led to has been associated with the cyclical upturn in job cre­ a further reduction in the civilian unemployment rate, from ation. The secular forces that are slowing the expansion an average of 5.0 percent in the second half of 2005 to of the labor force imply that the increase in employment 4.7 percent in the second quarter of 2006. Although hir­ that is consistent with a stable unemployment rate will, ing moderated in the spring, layoffs remained low. New over time, be smaller than it was during the period when claims for unemployment insurance (UI) dipped below labor force participation was rising steadily. 300,000 per week in January and February and then fluc­ tuated around a still-low level of about 315,000 per week for most of the period from March through early July. Productivity and Labor Costs Over the first half of 2006, longer-term unemployment (fifteen weeks or more) also moved down, and the pro­ After having advanced at an unusually rapid rate from portion of UI claimants who remained on the unemploy­ 2001 to mid-2004, labor productivity in the nonfarm busi­ ment rolls until the exhaustion of their benefits contin­ ness sector increased at a more moderate annual rate of ued to recede. 2½ percent from mid-2004 to early 2006. Nonetheless, After having edged up during 2005, the labor force by historical standards, productivity performance recently participation rate was relatively stable over the first half of 2006 despite the ongoing improvement in labor mar- Change in output per hour, 1948–2006 Labor force participation rate, 1974–2006 Percent, annual rate Percent 5 Q1 4 67 3 64 2 1 61 1948– 1974– 1996– 2002 2004 2006 73 95 2000 1976 1986 1996 2006 NOTE: Nonfarm business sector. Change for each multiyear period is measured from the fourth quarter of the year immediately preceding the NOTE: The data are monthly and extend through June 2006. period to the fourth quarter of the final year of the period. SOURCE: Department of Labor, Bureau of Labor Statistics. SOURCE: Department of Labor, Bureau of Labor Statistics. 18 Monetary Policy Report to the Congress July 2006 Measures of change in hourly compensation, 1996–2006 Change in unit labor costs, 1996–2006 Percent Percent, annual rate 5 Nonfarm business 8 compensation per hour 4 6 3 Q1 2 4 1 Employment + cost index 2 0_ 1996–2000 2001 2002 2003 2004 2005 2006 1996 1998 2000 2002 2004 2006 NOTE: Nonfarm business sector. The change for 1996 to 2000 is measured NOTE: The data are quarterly and extend through 2006:Q1. For nonfarm from 1995:Q4 to 2000:Q4. business compensation, change is over four quarters; for the employment cost SOURCE: Department of Labor, Bureau of Labor Statistics. index (ECI), change is over the twelve months ending in the last month of each quarter. The nonfarm business sector excludes farms, government, nonprofit institutions, and households. The sector covered by the ECI used here is the same as the nonfarm business sector plus nonprofit institutions. A 2006, compared with an increase of 5.5 percent between new ECI series was introduced for data as of 2001, but the new series is March 2004 and March 2005. The cost of health insur­ continuous with the old. SOURCE: Department of Labor, Bureau of Labor Statistics. ance, which typically accounts for about one-fourth of overall benefit costs, rose just 4¾ percent during the year has still been solid, with gains at a rate matching those ending in March 2006; between 2000 and 2005, these during the second half of the 1990s. In an environment costs increased, on average, 8¾ percent per year. Another of a sustained expansion of aggregate demand, businesses likely contributor to the slower rise in benefit costs over have gradually adjusted their use of labor, capital, and the past year was smaller employer contributions to their services to achieve ongoing gains in efficiency. Produc­ defined-benefit pension plans; those costs dropped back tivity has continued to benefit importantly from invest­ somewhat after employers made sizable payments to bol­ ment in new technologies, organizational changes, and ster those pension assets in 2004. improvements in business processes, although the con­ Indicators of the recent trend in the wage component tribution from capital deepening has been smaller in of worker compensation have been providing mixed sig­ recent years than it was during the capital investment nals. As measured in the ECI, wages rose 2.4 percent boom of the late 1990s. between March 2005 and March 2006, slightly less than Broad measures of hourly labor compensation, which in the preceding two years. In contrast, the year-over­ include both wages and the costs of benefits, posted mod­ year change in average hourly earnings of production or erate gains over the year ending in early 2006 despite the nonsupervisory workers—which refers to a narrower run-up in headline price inflation and the further tighten­ group of private nonfarm employees and has tended to ing of labor markets. Both the employment cost index show greater cyclical variation than the ECI—has (ECI) and the estimate of compensation per hour that uses increased steadily over the past three years. Average data from the national income and product accounts hourly earnings rose 3.9 percent over the twelve months increased 2¾ percent between the first quarter of 2005 ending in June 2006, compared with an increase of and the first quarter of 2006.1 Both series had reported 2.7 percent over the twelve months ending in June 2005. higher rates of change in hourly labor compensation a year earlier. The deceleration in labor compensation appears to Prices have been associated largely with smaller increases in employers’ benefit costs. The benefits component of the Inflation pressures were elevated during the first half of ECI was up just 3 percent between March 2005 and March 2006. The chain-type price index for personal consump­ tion expenditures (PCE) rose at an annual rate of 4¼ per­ cent between December 2005 and May 2006. Over the 1.. The Bureau of Labor Statistics (BLS) developed a new ECI same period, core PCE prices increased at an annual rate series and has provided data for the changes in that series beginning of 2.6 percent, nearly 0.6 percentage point faster than in 2001. The BLS considers the new ECI to be continuous with the old series. over the twelve months of 2005. Board of Governors of the Federal Reserve System 19 Change in core consumer prices, 2000–06 home, which typically are influenced heavily by labor and other business costs, have continued to increase rela­ Percent, annual rate tively rapidly, rising at an annual rate of 3¾ percent over Core consumer price index the first five months of the year. Chain-type price index for core PCE The pickup in core inflation in the first half of 2006 4 was evident in the indexes for both goods and services. Prices of consumer goods excluding food and energy, 3 which were unchanged in 2005, edged up at an annual rate of ¾ percent this year. Prices of consumer services 2 also accelerated this spring; as a result, the PCE price index for non-energy services increased at an annual rate 1 of 3½ percent between December 2005 and May 2006, compared with a rise of 2¾ percent in 2005. In the three months ending in May, increases in housing rents were 2000 2001 2002 2003 2004 2005 2006 especially steep; the rise may reflect, in part, a shift in NOTE: Through 2005, change is from December to December; for 2006, demand toward rental units because home purchases have change is from December to May. SOURCE: For core consumer price index, Department of Labor, Bureau of become less affordable. Another contributor to the higher Labor Statistics; for core PCE price index, Department of Commerce, Bureau inflation rate for consumer services has been the accel­ of Economic Analysis. eration in the index for nonmarket services to an annual Although energy prices eased temporarily in Febru­ rate of 4 percent over the first five months of the year ary, they turned up sharply again from March to May; as from 3 percent last year.2 More broadly, the pickup in a result, the PCE price index for energy increased 13 per­ core consumer price inflation over the first five months cent (not at an annual rate) over the first five months of of 2006 likely is the result of the pass-through of higher 2006, a rise that marked a continuation of the steep climb energy costs to a wide range of goods and services. in prices that began in 2004. This year, almost the entire The cost pressures from the increase in energy costs rise in energy prices has been associated with higher prices during the past three years have been apparent in rising for petroleum-based products. The PCE price index for prices of inputs used in the production and sale of final gasoline and motor fuel, which increased more than goods and services. The producer price index for inter­ 16½ percent last year, climbed another 24 percent (not at mediate goods, excluding food and energy, rose at an an annual rate) by May. Although recent data from the annual rate of 7¼ percent between December 2005 and Department of Energy indicate that gasoline prices fell May 2006; this index rose 4¾ percent in 2005 and 8¼ back in June, they moved up again in early July. Retail percent in 2004. In particular, prices of industrial chemi­ prices of gasoline this year have risen faster than the cost of crude oil in part because of the additional cost of pro­ ducing and distributing reformulated product with etha­ 2. These are services—such as foreign travel or the financial services provided by banks—for which no prices based on market nol. Also, the demand for fuel ethanol has been strong transactions are available; the Bureau of Economic Analysis must relative to the current capacity to produce it. In contrast, impute or estimate these price indexes. the consumer price of natural gas has turned down this year as inventories have remained relatively high; the Alternative measures of price change price decline between January and May almost completely Percent reversed the steep run-up that occurred last autumn. Food price inflation remained moderate during the first Price measure 2004 to 2005 2005 to 2006 five months of 2006; between December 2005 and May Chain-type (Q1 to Q1) 2006, the PCE price index for food and beverages Gross domestic product (GDP) ....................... 2.8 3.1 Gross domestic purchases ................................ 3.1 3.5 increased at an annual rate of 2¼ percent. Retail prices Personal consumption expenditures (PCE) ..... 2.7 3.0 Excluding food and energy .......................... 2.2 1.9 of meat and poultry have fallen so far this year. Domestic Market-based PCE excluding food and energy ........................................................... 1.8 1.5 supplies of meat have been ample. Production has been expanding at a time when export demand for beef has Fixed-weight (Q2 to Q2) Consumer price index ...................................... 3.0 4.0 been soft largely because of bans on imports of U.S. beef Excluding food and energy .......................... 2.1 2.4 by Japan and Korea. Prices of processed food have con­ NOTE: Changes are based on quarterly averages of seasonally adjusted data. tinued to rise at only a moderate rate despite higher prices For the consumer price index, the 2006:Q2 value is calculated as the average for April and May compared with the average for the second quarter of 2005 and is for grains; export demand for grains has been strong, and expressed at an annual rate. the price of corn has been boosted by demand from pro­ SOURCE: For chain-type measures, Department of Commerce, Bureau of Eco­ nomic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor ducers of ethanol. Prices for food consumed away from Statistics. 20 Monetary Policy Report to the Congress July 2006 cals, fertilizer, and stone and clay products, for which average over the first half of 2006, the median respon­ energy represents a relatively high share of the total costs dent to the Michigan SRC survey continued to expect the of production, accelerated over the past several years. rate of inflation during the next five to ten years to be just The costs of a number of important business services, under 3 percent. In June, the Survey of Professional Fore­ particularly transportation by air, rail, and truck, have also casters, conducted by the Federal Reserve Bank of Phila­ been boosted by higher energy costs. The pass-through delphia, reported expected inflation at a rate of 2½ per­ of the costs of energy to consumer prices is clear for a cent over the next ten years, an expectation that has been few items, such as airfares. For other components of core roughly unchanged for the past eight years. Inflation com­ consumer price indexes, however, the extent of the pass- pensation implied by the spread of yields on nominal through is harder to trace. Quantifying the extent of the Treasury securities over their inflation-protected coun­ pass-through is difficult, in part because it is diffused terparts rose slightly, on net, over the first half of the year; through a wide range of retail goods and services. In in early July it was just above 2½ percent. addition, the cost of energy is a small share of overall costs—and that share has been declining over time as businesses adopt more energy-efficient technologies and U.S. Financial Markets households reduce their consumption of energy. None­ theless, the cumulative rise in energy costs in recent years U.S. financial markets functioned smoothly in the first has been large enough to show through to pricing of final half of 2006 against the backdrop of increased volatility goods and services even as businesses have seen their in some asset prices. Yields on nominal Treasury coupon labor costs, which represent roughly two-thirds of their securities rose about 70 basis points, on net, through early costs, remain restrained. July as investors came to appreciate that economic con­ Near-term inflation expectations were also influenced ditions and inflation pressures required more monetary importantly over the first half of 2006 by movements in policy tightening than they had expected at the end of energy prices, but, as of midyear, they were only slightly 2005. Equity prices advanced until mid-May but then higher than they were at the turn of the year. The Michi­ reversed those gains. Apparently, evidence of increased gan SRC survey measure of the median expectation of inflationary pressures and some softer-than-expected data households for inflation over the next twelve months held on economic activity induced market participants to steady at 3 percent during the first three months of the revise down their longer-term outlook for business prof­ year but then rose sharply to 4 percent in May as gaso­ its and to perceive greater risks to that outlook. With cor­ line prices climbed. By early July, this measure of near- porate balance sheets remaining strong and liquid, risk term inflation expectations dropped back to 3.1 percent. spreads on corporate bonds stayed low, an indication that Longer-term inflation expectations remained within the the revision to the outlook had not sparked broad con­ ranges in which they have fluctuated in recent years. On cerns about credit quality. Firms had ample access to funds, and business-sector debt expanded rapidly in the first quarter. The need to finance brisk merger and acqui­ sition activity was one factor that reportedly induced non­ TIPS-based inflation compensation, 2003–06 financial businesses to tap the credit markets heavily. Bond issuance picked up noticeably, and commercial and Percentage points industrial loans increased robustly. Banks continued to ease terms and standards on such loans. Household debt Five-year, five-year ahead 3.5 expanded further in the first quarter amid rising house 3.0 prices and brisk cash-out refinancing activity. As was the case in 2005, the M2 monetary aggregate has advanced 2.5 moderately so far in 2006. 2.0 Five-year 1.5 Interest Rates 1.0 The FOMC increased the target federal funds rate 25 basis points at each of its four meetings this year. These 2003 2004 2005 2006 actions brought the rate to 5¼ percent, about 60 basis NOTE: The data are daily and extend through July 12, 2006. Based on a points above the rate expected at the end of last year for comparison of the yield curve for Treasury inflation-protected securities (TIPS) with the nominal off-the-run Treasury yield curve. early July. In contrast to the situation earlier in the tight­ SOURCE: Federal Reserve Board calculations based on data provided by the ening cycle, when it was evident to investors that consid­ Federal Reserve Bank of New York and Barclays. Board of Governors of the Federal Reserve System 21 Interest rates on selected Treasury securities, 2003–06 tors’ apparent awareness that monetary policy decisions increasingly depend on the implications of incoming in­ Percent formation for the economic outlook, the implied volatil­ ity on short-term Eurodollar rates calculated from option Ten-year 5 prices has remained near the low end of its historical range. 4 Yields on nominal Treasury coupon securities rose about 70 basis points across the maturity spectrum through 3 early July, in part because of the expectations for firmer Two-year policy. In addition, it appears that a modest rebound in 2 term premiums, including investor compensation for in­ Three-month flation risk, may have contributed to the rise in longer- 1 term rates; still, estimated premiums remain low by his­ torical standards. Yields on inflation-indexed Treasury 2003 2004 2005 2006 securities rose less than those on their nominal counter­ NOTE: The data are daily and extend through July 12, 2006. parts, leaving inflation compensation at medium- and SOURCE: Department of the Treasury. long-term horizons 20 to 30 basis points higher than at the turn of the year. erable monetary policy accommodation was in place and In the corporate bond market, yields on investment- had to be removed, market participants more recently grade securities moved about in line with those on com­ have had to focus to a greater degree on economic data parable-maturity Treasury securities through early July. releases and their implications for the outlook for eco­ In contrast, those on speculative-grade securities rose only nomic growth and inflation to form expectations about about 40 basis points; as a result, risk spreads were near-term policy. Although the information currently 30 basis points lower in that segment of the market. The available suggests that growth of real output slowed narrowness of high-yield spreads was likely a reflection appreciably in the second quarter, incoming price data of investors’ sanguine views about corporate credit qual­ have pointed to greater-than-expected inflationary pres­ ity over the medium term, given the strength of business sures throughout the first half of the year. Investors balance sheets and the outlook for continued economic anticipated that the FOMC would act to counter such pres­ expansion. sures, and the expected policy path moved upward, on balance, over the first half of 2006. Nevertheless, market participants currently appear to expect the target federal Equity Markets funds rate to ease after the end of the year. Despite inves- Broad equity indexes changed little, on net, through early July. Stock prices were boosted up to the first part of May Spreads of corporate bond yields over comparable off-the-run Treasury yields, 1998–2006 Percentage points Stock price indexes, 2004–06 10 January 2, 2004 = 100 High-yield 8 140 6 130 BBB 4 Russell 2000 120 2 AA + 0_ Wilshire 5000 110 100 1998 1999 2000 2001 2002 2003 2004 2005 2006 NOTE: The data are daily and extend through July 12, 2006. The high-yield index is compared with the five-year Treasury yield, and the BBB and AA 2004 2005 2006 indexes are compared with the ten-year Treasury yield. SOURCE: Derived from smoothed corporate yield curves using Merrill NOTE: The data are daily and extend through July 12, 2006. Lynch bond data. SOURCE: Frank Russell Company; Dow Jones Indexes. 22 Monetary Policy Report to the Congress July 2006 Implied S&P 500 volatility, 2000–06 Change in domestic nonfinancial debt, 1991–2006 Percent Percent Total 12 40 10 8 30 6 4 20 Components 10 15 Nonfederal 10 5 + 2000 2001 2002 2003 2004 2005 2006 0_ NOTE: The data are weekly and extend through July 12, 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. 1992 1994 1996 1998 2000 2002 2004 2006 by an upbeat economic outlook and by strong corporate NOTE: For 2006, change is from 2005:Q4 to 2006:Q1 at an annual rate. For earlier years, the data are annual and are computed by dividing the annual earnings in the first quarter. However, those gains were flow for a given year by the level at the end of the preceding year. The total subsequently reversed as incoming data clouded the pros­ consists of components shown. Nonfederal debt consists of the outstanding credit market debt of state and local governments, households, nonprofit pects for economic growth and continued to point to organizations, and nonfinancial businesses. Federal debt held by the public upward pressures on inflation; the drop in share prices excludes securities held as investments of federal government accounts. SOURCE: Federal Reserve Board, flow of funds data. was led by stocks that had logged the largest gains in the previous months, including those of firms with small capi­ talizations and of firms in cyclically sensitive sectors. A receipts held down borrowing. The available data also measure of the equity risk premium—computed as the point to somewhat reduced growth of nonfinancial busi­ difference between the twelve-month forward earnings– ness debt in the second quarter. price ratio for the S&P 500 and an estimate of the real Commercial bank credit increased at an annual rate of long-term Treasury yield—has increased slightly so far about 11 percent in the first quarter of 2006, a little faster this year and remains near the high end of its range of the than in 2005, and picked up further to an almost 13 per­ past two decades. The implied volatility of the S&P 500 cent pace in the second quarter. A continued rapid calculated from option prices spiked temporarily in late increase in business loans was likely supported by brisk May and early June and remained somewhat elevated merger and acquisition activity, rising outlays for invest­ compared with its levels earlier in the year. ment goods, ongoing inventory accumulation, and an Net inflows to equity mutual funds were very strong accommodative lending environment. Growth in commer­ through April, as investors were evidently attracted by cial mortgages was also strong, as fundamentals in that the solid performance of the equity market up to that point. sector continued to improve. Despite a slowing of hous­ In May and June, however, investors withdrew funds as ing activity in recent months, residential mortgage hold­ share prices began to sag. ings expanded robustly. However, higher short-term interest rates likely contributed to a runoff in loans drawn down under revolving home-equity lines of credit. Con­ Debt and Financial Intermediation sumer loans adjusted for securitizations decelerated in the second quarter after rising at a solid pace in the first In the first quarter of 2006, the total debt of domestic quarter. nonfinancial sectors expanded at an annual rate of 11 per­ Bank profitability remained solid, and asset quality cent. The household, business, and federal government continued to be excellent in the first quarter. Profits were components all increased at double-digit rates, while state supported by gains in non-interest income and reductions and local government debt advanced at about a 6 percent in loan-loss provisions that more than offset a rise in pace. Preliminary data suggest somewhat slower growth non-interest expenses. Delinquency and charge-off rates of the debt of nonfinancial sectors in the second quarter. remained low across all loan types. Delinquency rates on The slowdown is particularly noticeable in the federal residential mortgages on banks’ books edged lower in and state and local government sectors, where strong tax the first quarter after moving up during 2005. Charge-off Board of Governors of the Federal Reserve System 23 rates on consumer loans declined to the lowest level seen International Developments in recent years after a fourth-quarter surge in charge-offs on credit card loans that was associated with the imple­ Foreign economic growth was strong in the first quarter mentation of the bankruptcy legislation in October of last of 2006 as the expansion spread to all major regions of year. the world. Accelerating domestic demand boosted growth As the policy debate about the possibility of curbing in the foreign industrial countries, especially Canada and the balance sheet growth of both Fannie Mae and Freddie the euro area. Emerging-market economies continued to Mac continued, the combined size of the mortgage benefit from rapid export growth, and Chinese economic investment portfolios at the two government-sponsored activity was also spurred by a surge in investment spend­ enterprises increased about 1 percent over the first five ing. Data for the second quarter suggest continued strong months of 2006. growth abroad but with moderation in some countries. Rising energy prices have pushed up inflation in many countries this year, but upward pressure on core infla­ The M2 Monetary Aggregate tion has generally continued to be moderate. Foreign monetary policy tightened in the first half of In the first quarter of 2006, M2 increased at an annual this year in the context of solid growth and some height­ rate of about 6½ percent, but its expansion moderated in ened inflation concerns. The European Central Bank the second quarter to a 2¾ percent pace, likely because (ECB) raised its policy rate ¼ percentage point in March of some slowing in the growth of nominal GDP. Rising and again in June, citing rapid credit growth and the short-term interest rates continued to push up the oppor­ ECB’s expectation of above-target inflation. At its tunity cost of holding M2 assets. Growth in liquid depos­ July policy meeting, the Bank of Canada kept its target its, whose rates tend to adjust sluggishly to changes in for the overnight rate unchanged at 4¼ percent, but it market rates, was particularly slack. By contrast, the ex­ had increased its target for the overnight rate ¼ percent­ pansion in retail money market funds and, especially, age point at each of its previous seven policy meetings. small time deposits was brisk, as the yields on those On July 14, the Bank of Japan (BOJ) ended its zero- instruments kept better pace with rising market interest interest-rate policy by raising its target for the call money rates. Despite apparently modest demand from abroad, rate to ¼ percent for the first time since 2001. Earlier, on currency growth was strong in the first quarter but has March 9, the BOJ, announcing an end to its five-year-old slowed since. The velocity of M2 rose at an annual rate policy of quantitative easing, said that it would set policy of 2¼ percent in the first quarter and appears to have in the future to control inflation over the medium to long continued to rise in the second quarter. run, defined as one to two years ahead. Long-term bond yields abroad have risen along with U.S. bond yields on indications of robust global growth M2 growth rate, 1991–2006 Official or targeted interest rates in selected foreign industrial countries, 2003–06 Percent Percent 10 8 United Kingdom 5 6 4 4 Canada 3 2 2 Euro area + 0_ 1 Japan + 1992 1994 1996 1998 2000 2002 2004 2006 0_ NOTE: Through 2005, the data are annual on a fourth-quarter over fourth-quarter basis; for 2006, change is calculated from 2005:Q4 to 2006:Q2 2003 2004 2005 2006 and annualized. M2 consists of currency, traveler’s checks, demand deposits, other checkable deposits, savings deposits (including money market deposit NOTE: The data are weekly. The last observation for each series is July 14, accounts), small-denomination time deposits, and balances in retail money 2006. The data shown are the call money rate for Japan, the overnight rate for market funds. Canada, the refinancing rate for the euro area, and the repurchase rate for the SOURCE: Federal Reserve Board, Statistical Release H.6, “Money Stock United Kingdom. Measures” (July 13, 2006). SOURCE: The central bank of each area or country shown. 24 Monetary Policy Report to the Congress July 2006 and expectations of additional tightening of monetary U.S. dollar nominal exchange rate, broad index, 2003–06 policy. Ten-year sovereign yields have risen roughly 70 basis points in the euro area since the end of last year, Week ending January 3, 2003 = 100 while the increases on similar securities in Canada and the United Kingdom have been about 50 basis points. Part 100 of the rise in yields abroad has been increased compen­ sation for possible future inflation as measured by the 95 difference in yield between ten-year nominal and infla­ tion-indexed bonds. Yield spreads of emerging-market bonds over U.S. Treasuries narrowed somewhat early in 90 the year, but that narrowing was more than reversed in the second quarter as investors apparently demanded 85 greater compensation for risk amid uncertainties about economic growth and inflation. The foreign exchange value of the dollar has declined 2003 2004 2005 2006 about 4½ percent, on net, this year against a basket of the NOTE: The data are weekly and are in foreign currency units per dollar. currencies of the major industrial countries but is down The last observation is the average for July 10 through July 12, 2006. The broad index is a weighted average of the foreign exchange values of the U.S. only about 1 percent, on net, against the currencies of the dollar against the currencies of a large group of major U.S. trading partners. other important trading partners of the United States. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. Much of the dollar’s downward move occurred at times SOURCE: Federal Reserve Board. when the market was focused on concerns about global current account imbalances. The dollar has recovered some ground since early May, as investors reportedly have cases involved sharp depreciations in the exchange value engaged in flight-to-safety transactions into dollar- of their currencies. denominated assets in conjunction with the volatility in Through the first four months of 2006, a favorable global commodity and asset markets. On net, the dollar economic outlook and low interest rates supported gains has depreciated since the turn of the year about 6½ per­ in equity prices in all major foreign countries. During cent against the euro and sterling, 3 percent against the May and early June, however, equity prices registered Canadian dollar, and 1½ percent against the Japanese yen. widespread declines, as market participants grew more In contrast, the dollar has risen roughly 4 percent, on bal­ concerned about inflation, monetary policy, and global ance, against the Mexican peso this year. During the first economic growth. More recently, developments in the half of this year, several smaller countries experienced Middle East have weighed further on stock prices. On episodes of substantial financial volatility that in some net, equity price indexes are up between 1 percent and U.S. dollar exchange rate against Yields on benchmark government bonds in selected selected major currencies, 2003–06 foreign industrial countries, 2003–06 Week ending January 3, 2003 = 100 Percent U.K. pound Canada United Kingdom 100 5 Japanese yen 4 90 Germany 3 Euro 80 Japan 2 Canadian dollar 70 1 2003 2004 2005 2006 2003 2004 2005 2006 NOTE: The data are weekly and are in foreign currency units per dollar. NOTE: The data are for ten-year bonds and are weekly. The last observation The last observation for each series is the average for July 10 through July 12, for each series is the average for July 10 through July 12, 2006. 2006. SOURCE: Bloomberg L.P. SOURCE: Bloomberg L.P. Board of Governors of the Federal Reserve System 25 Equity indexes in selected foreign industrial countries, Industrial Economies 2003–06 The Japanese economy has continued to strengthen this Week ending January 3, 2003 = 100 year, although economic growth has stepped down a bit from the comparatively strong rate recorded in 2005. 200 Household consumption maintained a solid rate of growth in the first quarter, and private investment spending rose 175 11 percent. However, net exports, which previously had been an additional source of strength, did not contribute Japan Canada 150 to growth in the first quarter; the growth of imports increased while export growth remained firm. The labor 125 market in Japan improved further in April and May: The unemployment rate fell to 4 percent, and the ratio United Kingdom 100 of job offers to applicants reached a thirteen-year high. Euro area Although the GDP deflator has continued to decline, other 2003 2004 2005 2006 signs indicate that deflation is ending. In the first quarter NOTE: The data are weekly. The last observation for each series is the of 2006, land prices in Japan’s six largest cities rose average for July 10 through July 12, 2006. 3.8 percent over their year-ago level, the first increase SOURCE: Bloomberg L.P. since 1991. Core consumer prices have shown small twelve-month increases over the past several months. Real GDP in the euro area accelerated in the first quar­ 4 percent so far in 2006 in Europe and Canada, but they ter, expanding 2½ percent, a rate of growth somewhat have fallen roughly 8 percent since year-end in Japan. above its average in recent years. The acceleration was Latin American and Asian emerging-market equity spurred by strength in domestic demand, especially pri­ indexes, which had generally gained more than indus­ vate consumption spending, which increased in the first trial-country indexes early in the year, have fallen more quarter at double its pace in 2005. Retail sales were also sharply since early May. Equity indexes in Mexico, Bra­ strong at the start of the second quarter. The revival in zil, and Argentina have dropped between 12 percent and household spending has been supported by a small rise 15 percent—leaving them still between 5 percent and in the growth rate of employment and by an improve­ 7 percent higher so far this year—while stock prices in ment in employer and consumer perceptions of employ­ Korea have fallen about 9 percent, on net, for the year. ment prospects. Private investment spending has remained strong in the euro area, and business sentiment has con­ tinued to brighten in recent months. Energy price increases Equity indexes in selected emerging-market economies, have pushed euro-area consumer price inflation to about 2003–06 2½ percent recently, a level above the ECB’s 2 percent ceiling, but core inflation has remained near 1½ percent. Week ending January 3, 2003 = 100 In the United Kingdom, real GDP expanded at an annual rate of 3 percent in the first quarter after rising 350 about 1¾ percent in 2005. Consumer spending grew about 1½ percent, the same moderate pace seen last year. House 300 prices, which remained relatively flat during late 2004 Argentina 250 and most of 2005, picked up in late 2005 and have con­ tinued to rise in the first half of this year. The twelve­ 200 Mexico month change in consumer prices was 2.2 percent in May. Consumer prices have been boosted importantly by Asian emerging- 150 market economies increases in energy prices over the past several months. Brazil 100 In Canada, real GDP grew at an annual rate of nearly 4 percent in the first quarter, an increase led by a jump in 2003 2004 2005 2006 spending on consumer durables and housing. Investment NOTE: The data are weekly. The last observation for each series is the in residential structures grew at its fastest rate in more average for July 10 through July 12, 2006. The Asian emerging-market than two years, and business investment continued to economies are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, Singapore, South Korea, Taiwan, and Thailand; each economy’s exhibit the strength observed in the previous two quar­ index weight is its market capitalization as a share of the group’s total. ters. Indicators for the second quarter point generally to SOURCE: For Asian emerging-market economies, Morgan Stanley Capital International (MSCI) index; for others, Bloomberg L.P. a deceleration of GDP. Housing starts in the second quar­ 26 Monetary Policy Report to the Congress July 2006 ter were significantly below their elevated first-quarter response, monetary policy has been tightened in some levels; the merchandise trade balance declined, on bal­ countries, including Korea, India, and Thailand. ance, during the first five months of this year; and in the In Mexico, strong performance in the industrial sec­ manufacturing sector, the volume of new orders and of tor, an expansion in services output, and a recovery in shipments both fell in April. In contrast, in the second agricultural production propelled real GDP growth to quarter, the labor market maintained its strength of the more than 6 percent at an annual rate in the first quarter. past year, and the unemployment rate has fallen to 6.2 per­ In addition, a surge in manufacturing exports boosted cent, the lowest level in more than thirty years. Consumer Mexico’s trade and current account balances noticeably. prices rose 2.8 percent in the twelve months ending in Industrial production continued to increase early in the May. second quarter. In June, Mexican inflation was 3.2 per­ cent, just above the center of the Bank of Mexico’s target range of 2 percent to 4 percent. After easing policy nine Emerging-Market Economies times between August and April, the Bank of Mexico sig­ naled in April that it would leave its policy rate unchanged In China, growth of real output was especially robust in for a time. the first half. Economic indicators suggest that fixed Real GDP growth in Brazil also increased in the first investment surged and that export growth continued to quarter, rising to 5¾ percent, and was supported by very be strong. The rapid growth of investment prompted the strong performances in manufacturing, mining, and con­ Chinese government to impose a series of new measures struction. The rate of inflation has been declining from a to slow capital spending, including controls on credit and high of 8 percent reached in April 2005; in June, the land use and stricter criteria for approving investment twelve-month change in prices edged down to 4 percent. projects. In addition, to restrain credit, which has soared In late May, the central bank reduced its target for the more than 15 percent over the past year, China’s central overnight interest rate 50 basis points, to 15¼ percent, bank raised the one-year bank lending rate in April and bringing the cumulative decline to 450 basis points since raised banks’ reserve requirements ½ percentage point in the current easing phase began last September. In the June. The Chinese trade surplus widened in the first half minutes of its late-May meeting, the policymaking com­ of this year as exports accelerated. Chinese consumer mittee said that the onset of market volatility over the price inflation is about 1½ percent, slightly above its pace past month had increased its uncertainty about the pros­ in the second half of last year but well below the more pects for inflation and had thus prompted it to ease less than 5 percent rate seen in 2004. than it would have otherwise. Economic growth in India, Malaysia, and Hong Kong In Argentina, output growth slowed slightly in the first also was quite strong in the first quarter, although the quarter.Amid emerging capacity constraints, inflation rose pace of activity of some of the other Asian emerging- to about 11 percent, up from 6 percent in 2004. The market economies has moderated a bit from last year’s Argentine government has tried to hold down inflation, rapid rate. Concerns about inflationary pressures have with limited success, through voluntary price agreements increased, largely because of rising energy prices. In in several sectors.

Federal Reserve (2006, July 18). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20060719

@misc{wtfs_monetary_policy_report_20060719,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2006},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20060719},
  note = {Retrieved via When the Fed Speaks corpus}
}