Monetary Policy and Economic Developments 3

Monetary Policy and the Economic Outlook

The economic expansion in the United eventually lead to a pickup in the pace States gathered strength during 2003 of the expansion, the timing and extent while price inflation remained quite low. of the improvement were uncertain. At the beginning of the year, uncertain- During the spring, the rally that occurred ties about the economic outlook and in equity markets when the war-related about the prospects of war in Iraq appar- uncertainties lifted suggested that mar- ently weighed on spending decisions ket participants viewed the economic and extended the period of subpar eco- outlook as generally positive. By then, nomic performance that had begun more the restraints imparted by the earlier than two years earlier. However, with sharp decline in equity prices, the the support of stimulative monetary and retrenchment in capital spending, and fiscal policies, the nation’s economy lapses in corporate governance were weathered that period of heightened receding. As the price of crude oil uncertainty to post a marked accelera- dropped back and consumer confidence tion in economic activity over the sec- rebounded last spring, household spend- ond half of 2003. Still, slack in resource ing seemed to be rising once again at utilization remained substantial, unit a moderate rate. Businesses, however, labor costs continued to decline as remained cautious; although the deterio- productivity surged, and core inflation ration in the labor market showed signs moved lower. The performance of the of abating, private payroll employment economy last year further bolstered the was still declining, and capital spending case that the faster rate of increase in continued to be weak. In addition, eco- productivity, which began to emerge in nomic activity abroad gave few signs of the late 1990s, would persist. The com- bouncing back, even though long-term bination of that favorable productivity interest rates in major foreign econo- trend and stimulative macroeconomic mies had declined sharply. At its June policies is likely to sustain robust eco- meeting, the FOMC provided additional nomic expansion and low inflation in policy accommodation, given that, as 2004. yet, it had seen no clear evidence of an At the time of our last Monetary Pol- acceleration of U.S. economic activity icy Report to the Congress, in July, near- and faced the possibility that inflation term prospects for U.S. economic activ- might fall further from an already low ity remained unclear. Although the level. Federal Open Market Committee During the next several months, evi- (FOMC) believed that policy stimulus dence was accumulating that the econ- and rapid gains in productivity would omy was strengthening. The improve- ment was initially most apparent in Note. The discussion here and in the next financial markets, where prospects for section (‘‘Economic and Financial Developments stronger economic activity and corpo- in 2003 and Early 2004’’) consists of the text, rate earnings gave a further lift to equity tables, and selected charts from the Monetary Pol- icy Report submitted to the Congress on Febru- prices. Interest rates rose as well, but ary 11, 2004, pursuant to section 2B of the Federal financial conditions appeared to remain, Reserve Act. on net, stimulative to spending, and 4 90th Annual Report, 2003 additional impetus from the midyear look despite these generally favorable changes in federal taxes was in train. fundamentals. In particular, questions Over the remainder of the year, in the remain as to how willing businesses will absence of new shocks to economic be to spend and hire and how durable activity and with gathering confidence will be the pickup in economic growth in the durability of the economic expan- among our trading partners. At its sion, the stimulus from monetary and meeting on January 27–28, 2004, the fiscal policies showed through more Committee perceived that upside and readily in an improvement in domestic downside risks to the attainment of sus- demand. Consumer spending and resi- tainable growth for the next few quar- dential construction, which had provided ters are roughly equal. solid support for the expansion over Prospects for sustained high rates of the preceding two years, rose more rap- increase in productivity are quite favor- idly, and business investment revived. able. Businesses are likely to retain their Spurred by the global recovery in the focus on controlling costs and boost- high-tech sector and by a pickup in eco- ing efficiency by making organizational nomic activity abroad, U.S. exports also improvements and exploiting invest- posted solid increases in the second half ments in new equipment. With the ongo- of the year. Businesses began to add to ing gains in productivity, the existing their payrolls, but only at a modest pace margins of slack in resource utiliza- that implied additional sizable gains in tion should recede gradually, and any productivity. upward pressure on prices should The fundamental factors underlying remain well contained. The FOMC indi- the strengthening of economic activity cated at its January meeting that, with during the second half of 2003 should inflation low and resource use still slack, continue to promote brisk expansion in it can be patient in removing its policy 2004. Monetary policy remains accom- accommodation. modative. Financial conditions for busi- nesses are quite favorable: Profits have been rising rapidly, and corporate bor- Monetary Policy, Financial rowing costs are at low levels. In the Markets, and the Economy household sector, last year’s rise in over 2003 and Early 2004 the value of equities and real estate exceeded the further accumulation of During the opening months of 2003, the debt by enough to raise the ratio of softness in economic conditions was household net worth to disposable exacerbated by the substantial uncer- income after three consecutive years of tainty surrounding the onset of war in decline. In addition, federal spending Iraq. Private nonfarm businesses began and tax policies are slated to remain again to cut payrolls substantially, con- stimulative during the current fiscal sumer spending slowed, and business year, while the restraint from the state investment was muted. Although the and local sector should diminish. Lastly, jump in energy prices pushed up overall the lower foreign exchange value of the inflation, slack in resource utilization dollar and a sustained economic expan- and the rapid rise in labor productivity sion among our trading partners are pushed core inflation down. In financial likely to boost the demand for U.S. pro- markets, the heightened sense of caution duction. Considerable uncertainty, of among investors generated safe-haven course, still attends the economic out- demands for Treasury and other fixed- Monetary Policy and the Economic Outlook 5

Selected Interest Rates

Percent

Ten-year Treasury 6

5

Two-year Treasury 4

3

Intended federal funds rate 2

1

1/30 3/19 5/7 6/26 8/13 9/24 11/6 12/10 1/29 3/18 5/6 6/25 8/12 9/16 10/28 12/9 1/28 2002 2003 2004

NOTE. The data are daily and extend through February 4, 2004. The dates on the horizontal axis are those of scheduled FOMC meetings. income securities, and equity prices to suggest only tepid growth. Uncer- declined. tainty in financial markets had declined, At its meeting on March 18, the and rising consumer confidence and a FOMC maintained its 11⁄4 percent target wave of mortgage refinancing appeared for the federal funds rate to provide to be supporting consumer spending. support for a stronger economic expan- However, persistent excess capacity sion that appeared likely to materialize. evident in labor and product markets The Committee noted that the prevailing pointed to possible further disinflation. high degree of geopolitical uncertainty The lifting of some of the uncertainty complicated any assessment of pros- clouding the economic outlook allowed pects for the economy, and members the Committee to make the determina- refrained from making a determination tion that the risks to economic growth about the balance of risks with regard were balanced but that the probability of to its goals of maximum employment an unwelcome substantial fall in infla- and stable prices. At the same time, the tion exceeded that of a pickup in infla- Committee agreed to step up its surveil- tion. The FOMC judged that, taken lance of the economy, which took the together, the balance of risks was form of a series of conference calls in weighted toward weakness. The Com- late March and early April to consult mittee left the federal funds rate target about developments. When military at 11⁄4 percent, but the Committee’s action in Iraq became a certainty, finan- announcement prompted a rally in the cial markets began to rally, with risk Treasury market, and coupon yields fell spreads on corporate debt securities nar- substantially as market participants rowing and broad equity indexes reg- marked down their expectations for the istering notable gains. Economic news, path of the federal funds rate. however, remained mixed. By the time of the June 24Ð25 FOMC Indicators of the economy at the time meeting, risk spreads had narrowed fur- of the May 6 FOMC meeting continued ther and equity prices had extended their 6 90th Annual Report, 2003 rise, but the prospects for sustained eco- strengthened, and the housing market nomic expansion still seemed tentative. remained robust. By the time of the Although Committee members referred August 12 FOMC meeting, members to signs of improvement in some sec- generally perceived a firming in the tors of the economy, they saw no con- economy, most encouragingly in busi- crete evidence of an appreciable overall ness investment spending, and believed strengthening in the economic expan- that, even after the rise in longer-term sion and viewed the excess capacity in rates, financial conditions were still sup- the economy as likely to keep inflation portive of vigorous economic growth. in check. The Committee lowered the Given the continued slack in resource target for the federal funds rate 1⁄4 per- use across the economy, however, mem- centage point, to 1 percent, to add fur- bers saw little risk of inducing higher ther support to the economic expansion inflation by leaving the federal funds and as a form of insurance against a rate at its accommodative level. On the further substantial drop in inflation, basis of the economic outlook, and to however unlikely. The members saw reassure market participants that policy no serious obstacles to further conven- would not reverse course soon, Commit- tional policy ease down to the zero tee members decided to include in the lower bound on nominal interest rates announcement a reference to their judg- should that prove to be necessary. The ment that under the anticipated circum- Committee also discussed alternative stances, policy accommodation could be means of providing monetary stimulus maintained for a ‘‘considerable period.’’ should the target federal funds rate be Through the September 16 and Octo- reduced to a point at which they would ber 28 FOMC meetings, the brightening have little or no latitude for additional prospects for future growth put upward easing through this traditional channel. pressure on equity prices and longer- Longer-term interest rates backed up term interest rates. The Committee’s following the meeting, as investors had retention of the phrase ‘‘considerable apparently placed substantial odds on a period’’ in the announcements follow- policy move larger than 25 basis points ing each of these meetings apparently and may have been disappointed that provided an anchor for near-term inter- the announcement failed to mention any est rates. The Committee’s discussion potential ‘‘unconventional’’ monetary at these two meetings focused on the policy options. Ten-year Treasury yields increased evidence of a broadly based rose sharply during the following weeks acceleration in economic activity and in reaction to interpretations of the on the continued weakness in labor Chairman’s congressional testimony, markets. Rising industrial production, the release of Committee members’ eco- increased personal consumption and nomic projections, and positive incom- business investment spending, higher ing news about the economy and corpo- profits, receptive financial markets, and rate profits. A substantial unwinding of a lower foreign exchange value of the hedging positions related to mortgage dollar all suggested that sustained and investments may well have amplified robust economic growth was in train. the upswing in market yields. Over the The Committee’s decision to leave the intermeeting period, labor markets con- stance of monetary policy unchanged tinued to be soft, but industrial pro- over this period reflected, in part, a con- duction, personal consumption expen- tinuing confidence that gains in produc- ditures, and business outlays all tivity would support economic growth Monetary Policy and the Economic Outlook 7 and suppress inflationary pressures. In reassurance from reports of plans for fact, the Committee generally viewed its stronger capital spending and the wide- goal of price stability as essentially hav- spread distribution of increased activity ing been achieved. across regions. Accommodative finan- By the time of the December 9 cial market conditions, including higher FOMC meeting, the economic expan- equity prices, narrower risk spreads on sion appeared likely to continue at a rate bonds, and eased standards on business sufficient to begin to reduce slack in loans, also seemed supportive of eco- labor and product markets. Equity mar- nomic expansion. However, some risks kets continued to rally, and risk spreads, remained in light of continued lackluster particularly on the debt of speculative- hiring evidenced by the surprisingly grade firms, narrowed further. The labor weak December payroll employment market was finally showing some signs report. With the likelihood for rapid of improvement, and spending by productivity growth seemingly more households remained strong even as the assured, Committee members generally impetus from earlier mortgage refinanc- agreed that inflation pressures showed ings and tax cuts began to wane. The no sign of increasing and that a bit more acceleration in capital spending and evi- disinflation was possible. Under these dence that some firms were beginning circumstances, the Committee con- to accumulate inventories seemed to cluded that current conditions allowed signal that business confidence was on monetary policy to remain patient. As to the mend. However, twelve-month core the degree of policy accommodation, the consumer price inflation was noticeably Committee left its target for the federal lower than in the previous year. Even funds rate unchanged. The Committee’s though the unemployment rate was characterization that policy could be expected to move down gradually, con- patient instead of its use of the phrase tinued slack in labor and product mar- ‘‘considerable period’’ in its announce- kets over the near term was viewed as ment prompted a rise in Treasury yields sufficient to keep any nascent inflation across the yield curve and a fall in subdued. Uncertainty about the pace at equity prices. which slack would be worked down, however, made longer-run prospects for inflationary pressures difficult to gauge. Economic Projections for 2004 Given the better outlook for sustained Federal Reserve policymakers expect economic growth, the possibility of per- that the economic expansion will con- nicious deflation associated with a pro- tinue at a brisk pace in 2004. The central nounced softening in real activity was tendency of the forecasts of the change seen as even more remote than it had in real gross domestic product made by been earlier in the year. The Committee the members of the Board of Governors indicated that keeping policy accommo- and the Federal Reserve Bank presi- dative for a considerable period was dents is 41⁄2 percent to 5 percent, mea- contingent on its expectation that infla- sured from the final quarter of 2003 to tion would remain low and that resource the final quarter of 2004. The full range use would remain slack. of these forecasts is somewhat wider— At its meeting on January 27Ð28, from 4 percent to 51⁄2 percent. The 2004, the Committee viewed a self- FOMC participants anticipate that the sustaining economic expansion as even projected increase in real economic more likely. Members drew particular activity will be associated with a further 8 90th Annual Report, 2003

Economic Projections for 2004 Percent

Federal Reserve Governors and Reserve Bank presidents Memo: Indicator 2003 actual Central Range tendency

Change, fourth quarter to fourth quarter1 Nominal GDP ...... 5.9 51⁄2Ð61⁄2 51⁄2Ð61⁄4 Real GDP ...... 4.3 4Ð51⁄2 41⁄2Ð5 PCE chain-type price index ...... 1.4 1Ð11⁄2 1Ð11⁄4 Average level, fourth quarter Civilian unemployment rate ...... 5.9 51⁄4Ð51⁄2 51⁄4Ð51⁄2

1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated. gradual decline in the unemployment that inflation will remain quite low this rate. They expect that the unemploy- year. The central tendency of their fore- ment rate, which has averaged 53⁄4 per- casts for the change in the chain-type cent in recent months, will be between price index for personal consumption 51⁄4 percent and 51⁄2 percent in the fourth expenditures (PCE) is 1 percent to quarter of the year. With rapid increases 11⁄4 percent; this measure of inflation in productivity likely to be sustained was 1.4 percent over the four quarters of and inflation expectations stable, Fed- 2003. eral Reserve policymakers anticipate 9

Economic and Financial Developments in 2003 and Early 2004

The pace of economic expansion seemed to recede. Real GDP increased strengthened considerably in the second at an annual rate of 6 percent, on aver- half of 2003 after almost two years age, in the third and fourth quarters of of uneven and, on balance, sluggish last year. In contrast, between late 2001 growth. In early 2003, accommodative and mid-2003, real GDP had risen at an monetary policy and stimulative fiscal annual rate of only 21⁄2 percent. policies were in place, but economic During the period of recession and activity still seemed to be weighed subpar economic expansion, consider- down by a number of factors that had able slack developed in labor and prod- restrained the recovery earlier: Geopo- uct markets. The firming of economic litical tensions were again heightened, activity in the second half of last year this time by the impending war in Iraq, produced modest increases in rates of businesses remained unusually cautious resource utilization. Sustained efforts by about the strength of the expansion, and businesses to control costs led to further economic activity abroad was still weak. rapid gains in productivity. As a result, In June the continued lackluster eco- unit labor costs declined, and core nomic growth and a further downshift in rates of inflation continued to slow in inflation from an already low level 2003; excluding food and energy, the prompted a further reduction in the fed- PCE chain-type price index increased eral funds rate. In addition, the tax cuts just 0.9 percent last year. Measures of that became effective at midyear pro- overall inflation, which were boosted vided a significant boost to disposable by movements in food and energy income. In the succeeding months, the prices, were higher than those for core macroeconomic stimulus began to show inflation. through clearly in sales and produc- Domestic financial market conditions tion, and some of the business caution appeared to become increasingly sup-

Change in Real GDP Change in PCE Chain-Type Price Index Percent, annual rate Percent

6 Total Excluding food and energy 3 4

2 2 + 0 _ 1

1997 1999 2001 2003 1997 1999 2001 2003 NOTE. Here and in subsequent charts, except as noted, change for a given period is measured to its final quarter NOTE. The data are for personal consumption expen- from the final quarter of the preceding period. ditures (PCE). 10 90th Annual Report, 2003 portive of economic growth last year. eligible for child tax credits provided The economic expansion lowered inves- a substantial boost to after-tax income. tors’ perception of, and perhaps aver- In 2003, real disposable personal sion to, risk, and continued disinflation income increased 31⁄4 percent, after hav- was interpreted as a sign that monetary ing risen 31⁄2 percent in 2002. Low inter- policy would remain on hold, even as est rates provided additional impetus the economy picked up steam. Although to household spending by reducing yields on Treasury coupon securities borrowing costs for new purchases of rose modestly on balance over the year, houses and durable goods; they also risk spreads on corporate debt narrowed indirectly stimulated spending by facili- to the point that yields on corporate tating an enormous amount of mortgage issues declined. The low-interest-rate refinancing. environment spurred considerable cor- The personal saving rate has fluctu- porate bond issuance and generated a ated within a fairly narrow range around massive wave of mortgage refinancing 2 percent over the past three years. activity by households. Equity markets Although households continued to see began to rally when the uncertainty over the value of their homes appreciate over the timing of military intervention in this period, they also were adjusting to Iraq was resolved. The climb in stock the substantial drop in equity wealth that prices continued for the rest of the year, occurred after the peak in the stock mar- driven by improving corporate earnings ket in 2000. By itself, a fall in the ratio reports and growing optimism about the of household wealth to income of the prospects for the economy. At the same magnitude that households experienced time, with economic conditions abroad between 2000 and 2002 might have trig- improving and with concerns about the gered a noticeable increase in the per- financing burden of the U.S. current sonal saving rate. However, in this case, account deficit gaining increased atten- the tendency for households to save tion in financial markets, the dollar fell more as their wealth declines appears to appreciably on a trade-weighted basis. have been tempered in part by their will- ingness to take advantage of the attrac- tive pricing and financing environment The Household Sector for consumer goods. Real consumer expenditures for dura- Consumer Spending ble goods surged more than 11 percent Early in 2003, consumer spending was in 2003. Sales of new motor vehicles still rising at about the same moderate pace as in 2001 and 2002. In the late Change in Real Income and Consumption spring and in the summer, however, households stepped up their spending Percent, annual rate sharply. As a result, in the second half Disposable personal income of last year, real personal consumption Personal consumption 8 expenditures rose at an annual rate of expenditures 6 43⁄4 percent after having increased at a rate of just under 3 percent in the first 4 half. Although wage and salary earnings rose slowly during most of the year, 2 the midyear reductions in tax rates and the advance of rebates to households 1997 1999 2001 2003 Economic and Financial Developments in 2003 and Early 2004 11 remained brisk as many consumers rates in more than forty years, which, responded to the low financing rates and according to the Michigan SRC’s sur- various incentive deals that manufactur- vey of consumer sentiment, buoyed con- ers offered throughout the year. Falling sumer attitudes toward homebuying prices also made electronic equipment throughout the year. The average rate on attractive to consumers, and spending thirty-year fixed-rate mortgages dropped on home furnishings likely received a sharply during the first half of 2003 and boost from the strength of home sales. reached a low of 51⁄4 percent in June. Altogether, real outlays for furniture and Although the thirty-year rate subse- household equipment jumped 131⁄2 per- quently firmed somewhat, it remained cent in 2003. below 6 percent, on average, in the sec- In contrast, real consumer expendi- ond half of last year. tures on nondurable goods and on ser- Construction of new single-family vices continued to rise at a moderate homes accelerated during 2003, and for pace, on balance, last year. Outlays for the year as a whole, starts averaged food and apparel increased a bit faster 1.5 million units, an increase of 10 per- than in 2002, and the steady uptrend cent compared with the level in 2002. in spending for medical services was Sales of both new and existing single- well maintained. However, consumers family homes also picked up sharply responded to the higher cost of energy further last year. The brisk demand by cutting back their real spending on for homes was accompanied by rapid gasoline, fuel oil, and natural gas and increases in the average price paid for electricity services. them. The average price paid for new Consumer confidence was shaken homes rose 10 percent over the four temporarily early in 2003 by concerns quarters of 2003, and the average price about the consequences of a war in of existing homes was up 73⁄4 percent Iraq, but it snapped back in the spring. over the same period. However, house Toward year-end, sentiment appeared to price inflation was lower after adjusting brighten more as households saw their for shifts in the composition of trans- current financial conditions improve and actions toward more expensive homes. gained confidence that business condi- The constant-quality price index for tions would be better during the year new homes, which eliminates the influ- ahead. Those positive views became ence of changes in their amenities and more widely held in January, and the their geographic distribution, increased index of consumer sentiment prepared 43⁄4 percent over the four quarters of by the Michigan Survey Research Cen- 2003—down from an increase of 6 per- ter (SRC) reached its highest level in cent during 2002. The year-over-year three years. increase in Freddie Mac’s index of the prices paid in repeat sales of existing homes stood at 51⁄2 percent as of the Residential Investment third quarter of 2003, compared with a Housing activity was robust for a sec- rise of 71⁄4 percent as of the third quarter ond consecutive year in 2003. After hav- of 2002. ing risen 7 percent in 2002, real expen- Starts in the multifamily sector totaled ditures on residential construction 350,000 units in 2003, a pace little jumped more than 10 percent in 2003. changed from that of the past several These gains were fueled importantly by years. Vacancy rates for these units rose the lowest levels of mortgage interest and rents fell during the year, but falling 12 90th Annual Report, 2003 mortgage rates apparently helped to Mortgage Rates maintain building activity. Percent

Household Finance Fixed rate 9 Household debt increased 103⁄4 percent 7 last year, in large part because of the surge in mortgage borrowing induced Adjustable rate 5 by record-low mortgage interest rates. Refinancing activity was torrid in the 3 first half of the year, as mortgage rates declined. Some of the equity that house- 2000 2001 2002 2003 2004 holds extracted from their homes dur- NOTE. The data, which are monthly and extend through January 2004, are contract rates on thirty-year ing refinancings was apparently used mortgages. to fund home improvements and to pay SOURCE. Federal Home Loan Mortgage Corporation. down higher-interest consumer debt. When mortgage rates rebounded in the second half of the year, mortgage bor- Although the companies directly impli- rowing slowed from the extremely rapid cated in wrongdoing experienced heavy clip of the first half, but it remained outflows from their funds, most of these brisk through year-end. Consumer credit withdrawals apparently were transferred increased at a pace of 51⁄4 percent in to other mutual funds with little effect 2003, a little faster than a year earlier, as on the industry as a whole. A consider- revolving credit picked up somewhat able rise in real estate wealth further from the slow rise recorded in 2002. augmented household assets. Although Despite the pickup in household bor- prices of existing homes climbed more rowing, low interest rates kept the slowly than they had in the previous household debt-service and financial- year, the rate of increase remained siz- obligation ratios—which gauge pre- able. Overall, the advance in the value committed expenditures relative to dis- of household assets outstripped the posable income—at roughly the levels accumulation of household debt by posted in 2002. Most measures of delin- enough to boost the ratio of net worth to quencies on consumer loans and home disposable income over the year. mortgages changed little on net last year, and household bankruptcies held roughly steady near their elevated level The Business Sector in 2002. Even with the rapid expansion in Fixed Investment debt, net worth of the household sec- Business spending on equipment and tor increased as the value of household software was still sluggish at the begin- assets rose noticeably. Stock prices were ning of 2003. However, it accelerated boosted by the rise in corporate earn- noticeably over the course of the year as ings and the ebbing of uncertainty profits and cash flow rebounded and about future economic growth. House- as businesses gained confidence in the holds directed substantial flows into strength of the economic expansion and stock mutual funds in the third and in the prospective payoffs from new fourth quarters despite highly publicized investment. At the same time, business scandals in the mutual fund industry. financing conditions were very favor- Economic and Financial Developments in 2003 and Early 2004 13

Change in Real Business Fixed Investment communications equipment, which had continued to contract in 2002 after hav- Percent, annual rate ing plummeted a year earlier, turned up Structures markedly. Equipment and software 20 In contrast, the recovery in spending 10 on non-high-tech equipment was, on + balance, more muted, in part because _0 outlays for transportation equipment 10 continued to fall. The prolonged slump 20 in business purchases of new aircraft continued in 2003 as domestic air carri- ers grappled with overcapacity and high High-tech equipment fixed costs. By the fourth quarter, real and software 60 Other equipment outlays for aircraft had dropped to their excluding transportation 40 lowest level in ten years. In the market for heavy (class 8) trucks, sales were 20 + quite slow in early 2003 when busi- _0 nesses were concerned about the perfor- mance of models with engines that met 1997 1999 2001 2003 new emission standards. But as poten- tial buyers overcame those concerns, NOTE. High-tech equipment consists of computers and peripheral equipment, software, and communi- sales recovered. By the fourth quarter of cations equipment. 2003, sales of medium and heavy trucks had moved noticeably above the slow able: Interest rates remained low, equity pace of 2001 and 2002. Apart from values rallied, and the enhanced partial- outlays for transportation equipment, expensing tax provision gave a spe- investment in other types of non-high- cial incentive for the purchase of new tech equipment was, on balance, little equipment and software. After having changed during the first half of the year. changed little in the first quarter of the Demand was strong for medical equip- year, real outlays for equipment and ment, instruments, and mining and oil- software increased at an annual rate of field machinery, but sales of industrial 113⁄4 percent over the remaining three equipment and farm and construction quarters of the year. machinery were sluggish. In the second Outlays for high-technology items— half of the year, however, the firming computers and peripherals, software, in business spending for non-high-tech and communications equipment—which items became more broadly based. had risen a moderate 41⁄2 percent in The steep downturn in nonresidential 2002, posted a significantly more robust construction that began in 2001 moder- increase of more than 20 percent in ated noticeably in 2003, although mar- 2003. That gain contributed importantly ket conditions generally remained weak. to the pickup in overall business outlays After having contracted at an average for equipment and software and pushed annual rate of 131⁄2 percent during 2001 the level of real high-tech outlays above and 2002, real expenditures for nonresi- the previous peak at the end of 2000. dential construction slipped just 11⁄4 per- The increase in spending last year on cent, on balance, during 2003. Spending computing equipment marked the sharp- on office buildings and manufacturing est gain since 1998, and investment in structures, which had dropped sharply 14 90th Annual Report, 2003 over the preceding two years, fell again Corporate Profits and in 2003. The high office vacancy rates Business Finance in many areas and low rates of factory Higher profits allowed many firms to utilization implied little need for new finance capital spending with internal construction in these sectors even as funds, and business debt rose only economic activity firmed. Investment in slightly faster than the depressed rate communications infrastructure, where a in 2002. Moreover, a paucity of cash- glut of long-haul fiber-optic cable had financed merger and acquisition activity developed earlier, also continued to further limited the need to issue debt. shrink. In contrast, outlays for retail Gross equity issuance was extremely facilities, such as department stores and weak in the first half of the year but shopping malls, turned up last year, and perked up in the latter half in response the retrenchment in construction of new to the rally in equity prices. Neverthe- hotels and motels ended. In addition, less, for the year as a whole, firms extin- investment in drilling and mining struc- guished more equity than they issued. tures, which is strongly influenced by The pace of gross corporate bond the price levels for crude oil and natural issuance was moderate at the start of the gas, increased noticeably in 2003. year but shot up in late spring as firms took advantage of low bond yields to Inventory Investment pay down short-term debt, to refund During 2002, businesses appeared to existing long-term debt, and to raise have addressed most of the inventory cash in anticipation of future spending. imbalances that had developed a year Bond issuance by investment-grade earlier. But the moderate pace of firms slowed after midyear as firms final demand during the first half of accumulated a substantial cushion of 2003 apparently restrained firms from liquid assets and as interest rates on embarking on a new round of inventory higher-quality debt backed up. How- accumulation. Even though final sales ever, issuance by speculative-grade picked up in the second half of the year, firms continued apace, with the yields the restraint seemed to recede only on their debt continuing to decline dra- gradually. Over the first three quarters of 2003, nonfarm businesses trimmed Before-Tax Profits of Nonfinancial their inventories at an average annual Corporations as a Percent of Sector GDP rate of $23⁄4 billion in constant-dollar terms, and the preliminary estimate for Percent the final quarter of the year indicated only modest restocking. As a result, 14 most firms appear to have ended 12 the year with their inventories quite 10 lean relative to sales, even after tak- 8 ing into account the downward trend in inventoryÐsales ratios that has accom- 6 panied the ongoing shift to improved inventory management. Motor vehicle 1978 1983 1988 1993 1998 2003 dealers were an exception; their days’ NOTE. The data are quarterly and extend through 2003:Q3. Profits are from domestic operations of supply of new vehicles moved higher on nonfinancial corporations, with inventory valuation and average for a second year in a row. capital consumption adjustments. Economic and Financial Developments in 2003 and Early 2004 15

Major Components of Net Business the increase in loan demand toward the Financing end of the year. The apparent divergence between survey responses and data on Billions of dollars actual loan volumes may suggest that Commercial paper 800 demand for lines of credit has increased Bonds but that these lines have not yet been 600 Bank loans Sum of major drawn. In other short-term financing components 400 developments, nonfinancial firms that 200 + issued commercial paper in 2003 found _0 a very receptive market, in large part 200 because of the scarcity of outstanding issues. Many of the riskiest borrow- 2001 2002 2003 ers had exited the market in 2002, and NOTE. Seasonally adjusted annual rate for non- remaining issuers improved their attrac- financial corporate business. The data for the sum of major components are quarterly. The data for 2003:Q4 tiveness to investors by continuing to are estimated. restructure their balance sheets. Gross equity issuance rose over the course of 2003 as the economic outlook matically presumably because of inves- strengthened and stock prices moved tors’ increased optimism about the eco- higher. The market for initial public nomic outlook and greater willingness offerings continued to languish in the to take on risk. The sum of bank loans first half of the year but showed signs of and commercial paper outstanding, life by the end of the summer. The vol- which represent the major components ume of seasoned offerings also picked of short-term business debt, contracted up in the second half of the year. On the throughout the year. In large part, this other side of the ledger, merger and decline reflected ongoing substitution acquisition activity again extinguished toward bond financing, but it also was shares in 2003, although only at a sub- driven by the softness of fixed invest- dued pace. In addition, firms continued ment early in the year and the liquida- to retire a considerable volume of equity tion of inventories over much of the through share repurchases. For the year year. as a whole, net equity issuance was Respondents to the Senior Loan Offi- negative. cer Opinion Survey on Bank Lending Corporate credit quality improved, Practices noted that terms and standards on balance, over the year. Notably, the on business loans were tightened during default rate on corporate bonds declined the first half of the year but that both sharply, delinquency rates on commer- had been eased considerably by year- cial and industrial (C&I) loans at com- end. They also reported that demand for mercial banks turned down, and the pace business loans was quite weak for much of bond-rating downgrades slowed of the year. However, despite the fact considerably. Low interest rates and the that outstanding levels of business loans resulting restructuring of debt obliga- continued to decline, survey responses tions toward longer terms also impor- in the last quarter of the year indicated tantly contributed to improved business that demand for loans had begun to sta- credit quality. Bank loan officers noted bilize. Many banks cited customers’ that the aggressive tightening of lending increased investment and inventory standards in earlier years was an impor- spending as factors helping to generate tant factor accounting for the lower 16 90th Annual Report, 2003 delinquency and charge-off rates in between fiscal years. In addition, per- recent quarters. sonal income tax collections dropped Commercial mortgage debt increased sharply because of the slow rise in noticeably during most of 2003 despite nominal wages and salaries, diminished persistently high vacancy rates, falling capital gains realizations in 2002, and rents, and sluggish growth in construc- the tax cuts enacted under the Jobs tion expenditures. Low interest rates and Growth Tax Relief Reconciliation on this type of collateralized debt may Act of 2003. The act advanced refund have induced some corporate borrowers checks to households eligible for the to tap the market to pay down more- 2003 increment to the child tax credit costly unsecured debt. Delinquency and resulted in lower withholding sched- rates on commercial mortgages gener- ules for individual taxpayers. The act ally remained low throughout 2003, and also expanded the partial-expensing risk spreads were relatively narrow. incentive for businesses, but because Loan performance has held up well corporate profits accelerated sharply last because of low carrying costs for prop- year, corporate tax receipts rose appre- erty owners and because the outstanding ciably after adjusting for the shifts in the loans generally had been structured to timing of payments. include a sizable equity contribution, At the same time, federal outlays which makes default less attractive to other than for interest expense rose rap- borrowers. idly for the second consecutive year in fiscal 2003; these outlays increased about 9 percent after having risen The Government Sector 11 percent in fiscal 2002. Spurred by operations in Iraq, defense spending Federal Government soared again, and outlays for homeland The federal budget deficit continued to security rose further. Spending for widen in fiscal year 2003 as a result of income support, such as unemployment the slow increase in nominal incomes, insurance, food stamps, and child cred- outlays associated with the war in Iraq, its under the earned income tax credit and legislative actions that reduced taxes program, also posted a sizable increase. and boosted spending. The deficit in The ongoing rise in the cost and utili- the unified budget totaled $375 billion, zation of medical services continued up substantially from the deficit of $158 billion recorded in fiscal 2002. Federal Receipts and Expenditures The Congressional Budget Office is pro- jecting that the unified federal deficit Percent of nominal GDP will increase further in fiscal 2004, to 24 more than $475 billion. Expenditures Federal receipts have fallen in each of Receipts 22 Expenditures the past three years; the drop of nearly ex. net interest 20 4 percent in fiscal 2003 brought the ratio 18 of receipts to GDP to 161⁄2 percent, 2 percentage points below the average 16 for the past thirty years. About half of 1985 1988 1991 1994 1997 2000 2003 the decrease in receipts last year was a NOTE. The budget data are from the unified budget consequence of legislation that shifted and are for fiscal years (October through September); due dates for corporate payments GDP is for the year ending in Q3. Economic and Financial Developments in 2003 and Early 2004 17 to push up spending for Medicare and Federal Government Debt Held Medicaid. Overall, real federal con- by the Public sumption and investment (the measure of federal spending that is included in Percent of nominal GDP real GDP) increased 6 percent over the four quarters of 2003, after having risen 55 10 percent a year earlier. 45 The federal government had contrib- uted increasingly to national saving in 35 the late 1990s and 2000 as budget defi- 25 cits gave way to accumulating surpluses. However, with the swing back to large 1963 1973 1983 1993 2003 deficits in recent years, the federal government has again become a drain NOTE. Through 2002, the data for debt are year-end figures, and the corresponding value for GDP is for Q4 on national saving. Using the account- at an annual rate; the final observation is for 2003:Q3. ing practices followed in the national Excludes securities held as investments of federal gov- income and product accounts (NIPA), ernment accounts. gross federal saving as a percent of GDP dropped sharply in late 2001 and has the case in 2002, the Treasury was trended down since then; the drop con- forced to resort temporarily to account- tributed to a decline in overall gross ing devices in the spring of 2003 when national saving as a percent of GDP the statutory debt ceiling became a con- from 18 percent in calendar year 2000 to straint, but debt markets were not dis- 13 percent, on average, in the first three rupted noticeably. In May, the Congress quarters of 2003. Federal saving net raised the debt ceiling from $6.4 tril- of estimated depreciation fell from its lion to $7.4 trillion. With large deficits recent peak of 21⁄2 percent of GDP in expected to persist, the Treasury made a 2000 to negative 4 percent of GDP, on number of adjustments to its regular bor- average, in the first three quarters of rowing program, including reintroduc- 2003. As a result, despite a noticeable ing the three-year note, increasing to pickup in saving from domestic nonfed- monthly the frequency of five-year note eral sources, overall net national saving, auctions, reopening the ten-year note in which is an important determinant of the month following each new quarterly private capital formation, fell to less offering, and adding another auction than 11⁄2 percent of GDP, on average, in of ten-year inflation-indexed debt. As the first three quarters of 2003, com- a result of these changes, the average pared with a recent high of 61⁄2 percent maturity of outstanding Treasury debt, of GDP in 1998. which had reached its lowest level in decades, began to rise in the latter half Federal Borrowing of 2003. The Treasury ramped up borrowing in 2003 in response to the sharply widen- State and Local Governments ing federal budget deficit, and federal State and local governments faced debt held by the public as a percent another difficult year in 2003. Tax of nominal GDP increased for a second receipts on income and sales continued year in a row after having trended down to be restrained by the subdued perfor- over the previous decade. As had been mance of the economy. Despite further 18 90th Annual Report, 2003 efforts to rein in spending, the sector’s low longer-term rates to fund capital aggregate net saving, as measured in the expenditures and to advance refund NIPA, reached a low of negative $40 bil- existing higher-cost debt. Because of lion (at an annual rate), or negative the financial stresses facing these gov- 0.4 percent of GDP, in the first quarter ernments, the credit ratings of several of the year. Most of these jurisdictions states, most notably California, were are subject to balanced-budget require- lowered last year. Although bond down- ments and other rules that require them grades outnumbered upgrades for the to respond to fiscal imbalances. Thus, in sector as a whole, the imbalance addition to reducing operating expenses, between the two was smaller than it was governments drew on reserves, issued in 2002. bonds, sold assets, and made various one-time adjustments in the timing of payments to balance their books. In The External Sector recent years, many have also increased Over the first three quarters of 2003, the taxes and fees, thereby reversing the U.S. current account deficit widened trend toward lower taxes that prevailed relative to the comparable period in during the late 1990s. 2002, a move largely reflecting develop- Recent indications are that the fiscal ments in the deficit on trade in goods stress in this sector is beginning to ease. and services. Net investment income The improvement reflects a noticeable rose over the same period, as receipts upturn in tax collections in recent quar- from abroad increased and payments to ters while restraint on operating expen- foreign investors in the United States ditures largely remains in place. On a declined. NIPA basis, real spending on compen- sation and on goods and services pur- chased by state and local governments International Trade was little changed in the second half of The trade deficit widened considerably 2003, as it was over the preceding year. in the first half of 2003 but narrowed However, investment in infrastructure, slightly in the third quarter, as the value most of which is funded in the capital of exports rebounded in response to markets, accelerated in the second half strengthening foreign economic activ- of 2003. As of the third quarter of 2003, ity and the depreciation of the dollar. state and local net saving had moved back into positive territory. U.S. Trade and Current Account Balances

State and Local Government Billions of dollars, annual rate Borrowing

Gross issuance of debt by state and local Trade 200 governments was quite robust last year. Current account Weak tax receipts from a sluggish econ- 400 omy, significant demands for infrastruc- ture spending, and low interest rates all 600 contributed to the heavy pace of borrow- ing. Borrowing was strongest in the sec- 1997 1999 2001 2003 ond quarter of the year, as governments NOTE. The data are quarterly and extend through took advantage of the extraordinarily 2003:Q3. Economic and Financial Developments in 2003 and Early 2004 19

Available trade data through November epidemic and the war in Iraq came suggest that the trade deficit narrowed and went; for the year as a whole, further in the fourth quarter, as an addi- real imports of services were about tional strong increase in exports out- unchanged from the previous year. Real weighed an increase in imports. imports of goods expanded about 4 per- Real exports of goods and services cent in response to the strengthening increased about 6 percent in 2003. of U.S. demand, but the pattern was Exports of services rose about 5 percent. choppy, with large gains in the second They were held down early in the year and fourth quarters partially offset by by a drop in receipts from foreign travel- declines in the first and third. Despite a ers, owing to the effects of the SARS surge in the second quarter, the volume (severe acute respiratory syndrome) epi- of oil imports increased modestly, on demic and the war in Iraq; services balance, over the course of the year. exports rebounded strongly later in the Real non-oil imports were up about year as those concerns receded. Exports 41⁄2 percent, with the largest increases of goods rose about 63⁄4 percent over the in capital goods and consumer goods. course of the year—considerably faster Imports of computers posted solid gains, than in 2002. Exports increased in all whereas imports of semiconductors major end-use categories of trade, with were flat. particularly strong gains in capital goods Despite a substantial decline in the and consumer goods. Reflecting the glo- value of the dollar, the prices of bal recovery in the high-tech sector, imported non-oil goods rose only mod- exports of computers and semiconduc- erately in 2003. By category, the prices tors picked up markedly in 2003, par- of consumer goods were unchanged last ticularly in the second half. By geo- year, and prices of capital goods exclud- graphic area, exports of goods increased ing aircraft, computers, and semicon- to Western Europe, Canada, and, par- ductors increased only a little more than ticularly, to developing countries in East 1 percent. Price increases were larger Asia—a region where economic activity for industrial supplies. The price of expanded at a rapid pace last year. Prices imported natural gas spiked in March of exported goods rose in 2003, with and rose again late in the year; these prices of agricultural exports recording fluctuations were large enough to show particularly large increases. In response through to the overall price index for to poor crops and strong demand, prices imported goods. At year-end, prices of for cotton and soybeans increased industrial metals rose sharply, with the sharply. For beef, disruptions in supply spot price of copper reaching the highest led to notably higher prices through level in six and one-half years. The much of 2003. Beef prices, however, fell strength in metals and other commodity back in late December after a case of prices has been attributed, at least in mad cow disease was discovered in the part, to depreciation of the dollar and state of Washington and most countries strong global demand, particularly from imposed bans on beef imports from the China. United States. In 2003, the spot price of West Texas Real imports of goods and services intermediate (WTI) crude oil averaged rose about 31⁄2 percent in 2003. Imports more than $31 per barrel—the highest of services fell in the first half of the annual average since the early 1980s. year but bounced back in the second The spot price of oil began to rise at the half, as concerns about the SARS end of 2002 when ethnic unrest in Nige- 20 90th Annual Report, 2003 ria and a nationwide strike in Venezuela official purchases of U.S. assets surged sharply limited oil supplies from those to record levels in 2003, with the accu- two countries. In the first quarter of mulation of dollar reserves particularly 2003, geopolitical uncertainty in the high in China and Japan. period leading up to the war in Iraq also Compared with the pace in 2002, added upward pressure on oil prices. On foreign direct investment in the March 12, the spot price of WTI closed United States increased, as merger activ- at $37.83 per barrel, the highest level ity picked up and corporate profits since the Gulf War in 1990. When the improved. U.S. direct investment abroad main Iraqi oil fields had been secured held relatively steady at a high level and it became apparent that the risks that was largely the result of continued to oil supplies had subsided, the spot retained earnings. On net, foreign direct price of WTI fell sharply to a low of investment outflows fell about $50 bil- $25.23 per barrel on April 29. However, lion through the first three quarters of oil prices began rising again when, 2003. because of difficult security conditions, the recovery of oil exports from Iraq was slower than expected. Prices also The Labor Market were boosted in September by the sur- prise reduction in OPEC’s production Employment and Unemployment target. In the fourth quarter of 2003 and With economic activity still sluggish early 2004, strengthening economic during the first half of 2003, the labor activity, falling oil inventories, and the market continued to weaken. Over the continued depreciation of the dollar con- first eight months of the year, private tributed to a further run-up in oil prices. nonfarm payroll employment fell, on average, more than 35,000 per month, extending the prolonged period of cut- The Financial Account backs that began in early 2001. The The financing counterpart to the current civilian unemployment rate, which had account deficit experienced a sizable hovered around 53⁄4 percent for much of shift in 2003, as net private inflows fell 2002, moved up to 61⁄4 percent by June. while foreign official inflows increased. However, by late in the summer, the Private foreign purchases of U.S. securi- labor market began to recover slowly. ties were at an annual rate of about Declines in private payrolls gave way to $350 billion through November, about $50 billion lower than in the previous year. Private foreign purchases of U.S. Net Change in Payroll Employment equities continued to recede, and, although the level of bond purchases Thousands of jobs, monthly average was little changed in the aggregate, Private nonfarm foreign purchases shifted somewhat 400 away from agency bonds and toward Jan. 200 corporate bonds. Over the same period, + purchases by private U.S. investors of _0 foreign securities increased nearly $80 billion. Accordingly, net inflows 200 through private securities transactions decreased markedly. In contrast, foreign 1992 1994 1996 1998 2000 2002 2004 Economic and Financial Developments in 2003 and Early 2004 21 moderate increases in employment; over stabilized in many industries that pro- the five months ending in January, pri- duce durable goods, such as metals, fur- vate nonfarm establishments added, on niture, and wood products, as well as average, about 85,000 jobs per month. in a number of related industries that By January, the unemployment rate store and transport goods. In several moved back down to 5.6 percent. other areas, employment remained During the late summer and early fall, weak. Manufacturers of nondurables, prospects for business sales and pro- such as chemicals, paper, apparel, and duction brightened, and firms began to textiles, continued to cut jobs. Employ- lay off fewer workers. Initial claims for ment in retail trade remained, on net, unemployment insurance dropped back, little changed. and the monthly Current Population Survey (CPS) of households reported a decline in the number of workers who Productivity and Labor Costs had lost their last job. However, for Business efforts to increase efficiency many unemployed workers, jobs contin- and control costs led to another impres- ued to be difficult to find, and the num- sive gain in labor productivity last year. ber of unemployed who had been out of Output per hour in the nonfarm business work for twenty-seven weeks or more sector surged 51⁄4 percent in 2003 after remained persistently high. The labor having risen a robust 4 percent in 2002 force participation rate, which tends to and 23⁄4 percent in 2001. What is par- be sensitive to workers’ perceptions of ticularly remarkable about this period is the strength of labor demand, drifted that productivity did not decelerate sig- lower. Although the CPS indicated nificantly when output declined in 2001, a somewhat greater improvement in and it posted persistently strong gains employment than the payroll report— while the recovery in aggregate demand even after adjusting for conceptual dif- was sluggish. Typically, the outsized ferences between the two measures— increases in productivity that have the increase in household employment occurred during cyclical recoveries have lagged the rise in the working-age popu- followed a period of declines or very lation, and the ratio of employment to weak increases in productivity during population fell further during 2003. the recession and have been associated The modest upturn in private payroll with rebounds in economic activity that employment that began in September was marked by a step-up in hiring at businesses supplying professional, busi- Change in Output per Hour ness, and education services, and medi- cal services continued to add jobs. Percent Employment in both the construction industry and the real estate industry rose 6 further, although the number of jobs in related financial services dropped back 4 a bit as mortgage refinancing activity 2 slackened. At the same time, although + manufacturers were still laying off _0 workers, the monthly declines in factory employment became smaller and less 1993 1995 1997 1999 2001 2003 widespread than earlier. Employment NOTE. Nonfarm business sector. 22 90th Annual Report, 2003 were stronger than has been the case, benefits. The ECI for wages and salaries until recently, in this expansion. rose 3 percent—up slightly from the On balance, since the business cycle pace in 2002 but still well below the peak in early 2001, output per hour has rates of increase in the preceding six risen at an average annual rate of 4 per- years. Wage gains last year likely were cent—noticeably above the average restrained by persistent slack in the increase of 21⁄2 percent that prevailed demand for labor as well as by the pres- between 1996 and 2000. In the earlier sure on employers to control overall period, an expansion of the capital stock labor costs in the face of the rapidly was an important element in boosting rising cost of benefits. Employer costs the efficiency of workers and their firms; for benefits, which had risen 43⁄4 percent that impetus to productivity has weak- in 2002, climbed another 61⁄2 percent in ened in the recent period as a result of 2003. The cost of health insurance as the steep cutbacks in business invest- measured by the ECI has been moving ment in 2001 and 2002. Instead, the up at close to a double-digit rate for recent gains appear to be grounded in three consecutive years. In addition, organizational changes and innovations in late 2002 and early 2003, employers in the use of existing resources—which needed to substantially boost their con- are referred to as multifactor productiv- tributions to defined-benefit retirement ity. The persistence of a rapid rise in plans to cover the declines in the market multifactor productivity in recent years, value of plan assets. along with signs of a pickup in capital spending, suggests that part of the step-up in the rate of increase of labor Prices productivity may be sustained for some Headline consumer price inflation in time. 2003 was maintained by an accelera- In 2003, the employment cost index tion in food prices and another sizable (ECI) for private nonfarm businesses, increase in energy prices, but core rates which is based on a survey conducted of inflation fell for a second year. quarterly by the Bureau of Labor Statis- Although the strong upturn in economic tics, rose 4 percent—about 3⁄4 percent- activity in the second half of last year age point more than the increase in began to reduce unemployment and to 2002. Compensation per hour in the boost industrial utilization rates, con- nonfarm business sector, which is based siderable slack in labor and product on data constructed for the NIPA, is markets continued to restrain inflation estimated to have increased 31⁄4 percent throughout the year. A further modera- in 2003, up from 11⁄2 percent in 2002. In tion in the costs of production also recent years, the NIPA-derived series helped to check inflation: As a result of has shown much wider fluctuations in another rapid rise in productivity, busi- hourly compensation than the ECI, in nesses saw their unit labor costs decline part because it includes the value of in 2003 for a second consecutive year. stock option exercises, which are In contrast, prices for imported goods excluded from the ECI. The value of excluding petroleum, computers, and options exercised shot up in 2000 and semiconductors increased at about the then dropped over the next two years. same rate as prices more generally; Most of the acceleration in hourly between 1996 and 2002, these import compensation in 2003 was the result of prices fell relative to overall prices for larger increases in the costs of employee personal consumption expenditures Economic and Financial Developments in 2003 and Early 2004 23

(PCE). The chain-type price index for Europe, contributed importantly to the PCE excluding food and energy rose heightened demand for U.S. farm prod- just under 1 percent in 2003, about ucts. Thus, despite a bumper crop of 3⁄4 percentage point less than in 2002. A corn and some other grains in the United broader measure of inflation, the chain- States, world stocks were tight and type price index for GDP, increased prices remained high. In addition, the 11⁄2 percent in 2003, the same slow pace U.S. soybean crop was crimped by late- as in 2002. Both measures of inflation season heat and dryness, which further were roughly a percentage point lower tightened world supplies. Concerns than in 2001. about the cases of mad cow disease that Consumer energy prices fluctuated were identified in herds in Japan and widely over the four quarters of 2003, Canada supported strong domestic and and the PCE index for energy was up export demand for U.S. beef for most of 71⁄4 percent over the period. In the first last year while supplies edged down. quarter of the year, the combination of But, at year-end, when a case of mad a further rise in the cost of crude oil, cow disease was discovered in a domes- increased wholesale margins for gaso- tic herd, export demand for U.S. beef line, and unusually tight supplies of plunged and drove the price of live natural gas pushed up consumer energy cattle down sharply. A portion of the prices sharply. Although the prices of drop in cattle prices likely will show petroleum-based products turned down through to consumer prices for beef when the price of crude oil fell back in early this year. March, a number of supply disruptions The decline in core inflation in 2003 in late summer resulted in another tem- was broadly based. Prices of core con- porary run-up in the retail price of gaso- sumer goods fell somewhat faster than line. In the spring, the price of natural a year earlier; the declines were led by gas began to ease as supplies improved, larger cuts in prices of apparel, motor but it remained high relative to the level vehicles, electronic equipment, and a in recent years. Electricity prices also variety of other durable goods. At the moved up during 2003, in part because same time, prices of non-energy ser- of the higher input costs of natural gas. vices rose less rapidly. The deceleration In January 2004, a cold wave in the in core consumer prices measured by Northeast, together with the rise in the the CPI is somewhat greater than that price of crude oil since early December, measured by the PCE index. In each once again led to spikes in the prices of index, the costs of housing services to gasoline and natural gas. tenants and owners rose less in 2003 The PCE price index for food and than in 2002, but because these costs beverages increased 23⁄4 percent in 2003 receive a larger weight in the CPI, their after having risen just 11⁄4 percent a year slowing contributed a greater amount to earlier. Much of the acceleration can be the CPI’s deceleration. In addition, the traced to strong demand for farm prod- different measurement of the prices of ucts, but prices paid by consumers for medical services in the two series con- food away from home—which depend tributed to the smaller deceleration in much more heavily on the cost of labor non-energy services in the PCE. The than on prices of food products—were medical services component of the CPI, up 3 percent in 2003, also somewhat which measures out-of-pocket expenses more than overall consumer price infla- paid by consumers, increased 4 percent tion. Poor harvests abroad, especially in in 2003, down from 51⁄2 percent a year 24 90th Annual Report, 2003

Alternative Measures of Price Change with the sharp increase in energy prices Percent and dipped briefly to an unusually low level at midyear as actual inflation eased Price measure 2001 2002 2003 in response to lower energy prices. However, year-ahead inflation expecta- Chain-type Gross domestic product ...... 2.4 1.4 1.5 tions settled back to just over 21⁄2 per- Gross domestic purchases ...... 1.6 1.7 1.6 Personal consumption cent at the end of the year, about the expenditures ...... 1.6 1.8 1.4 same as at the end of 2002. Excluding food and energy . . . 2.1 1.6 .9 Chained CPI ...... 1.5 1.8 1.4 The PPI for crude materials exclud- Excluding food and energy . . . 2.1 1.6 .6 ing food and energy products, which Fixed-weight had dropped 10 percent in 2001, rose Consumer price index ...... 1.8 2.2 1.9 113⁄4 percent in 2002 and another Excluding food and energy . . . 2.7 2.1 1.2 171⁄2 percent in 2003. The upswing was Note. Changes are based on quarterly averages and driven by the pickup in demand asso- are measured to the fourth quarter of the year indicated ciated with the acceleration in both from the fourth quarter of the preceding year. domestic and worldwide industrial activity and by the pass-through of earlier. Alternatively, the PCE for medi- higher energy costs. Such wide cyclical cal services is a broader measure that swings in commodity prices have only a uses producer price indexes (PPI) to small effect on movements in the prices capture the costs of services provided by of intermediate and finished goods. At hospitals and doctors; it continued to later stages of production and distribu- increase more slowly than the CPI for tion, commodity costs represent only a medical services last year, 31⁄4 percent, small share of overall costs, and some but it was up slightly from its increase portion of the change in commodity of 21⁄2 percent in 2002. prices tends to be absorbed in firms’ Survey measures of expected infla- profit margins. Thus, the recent pickup tion were little changed, on balance, in in prices at the intermediate stage of 2003. According to the Federal Reserve processing has been more muted; after Bank of Philadelphia’s survey of profes- having fallen almost 11⁄2 percent in sional forecasters, expectations for CPI 2001, the PPI for core intermediate inflation ten years ahead remained at materials rose 11⁄4 percent in 2002 and 21⁄2 percent last year. As measured by 2 percent in 2003. the Michigan Survey Research Center survey of households, median five- to U.S. Financial Markets ten-year inflation expectations, which averaged 3 percent in 2001, were steady On balance, financial market condi- at 23⁄4 percent in 2003 for a second tions became increasingly supportive of consecutive year. Inflation compensa- growth over 2003 as investors became tion as measured by the spread between more assured that the economy was on the yield on nominal Treasury securities solid footing. Equity prices marched and their indexed counterparts varied up after the first quarter of the year in over a wide range in 2003, settling at response to the initiation and swift con- just under 21⁄2 percent at year-end. clusion of major combat operations in Shorter-term inflation expectations also Iraq, positive earnings reports, and—in posted some wide swings during 2003; the second half of the year—a stronger year-ahead expectations in the Michigan pace of economic growth. Risk spreads SRC survey spiked early in the year on corporate debt declined, with the Economic and Financial Developments in 2003 and Early 2004 25 spreads on the debt of both investment- Interest Rates on Selected grade firms and speculative-grade firms Treasury Securities ending 2003 at their lowest levels since Percent 1998. Thus, although Treasury coupon yields ended the year 30Ð40 basis points Ten-year 6 higher, yields on many corporate bonds 5 ended the year lower. Commercial banks 4 appeared somewhat slower than bond 3 investors to lend at more favorable Two-year 2 terms; nevertheless, by late in the year, Three-month banks had eased both standards and 1 terms on C&I loans. 2001 2002 2003 2004 Demand for short-term debt, how- NOTE. The data are daily and extend through Feb- ever, remained very weak, and business ruary 4, 2004. loans and outstanding commercial paper continued to run off. In response to a widening budget deficit and a rapid ued to hold down Treasury yields. The expansion of federal debt, the Treasury FOMC’s statement following its May increased the frequency of its debt auc- meeting that an ‘‘unwelcome fall in tions. Declines in mortgage interest rates inflation’’ remained a risk reinforced the over the first half of the year led to an notion that monetary policy would stay extraordinary increase in mortgage debt, accommodative, and, indeed, judging as originations for home purchase and from market quotes on federal funds for refinancings both climbed to record futures, market participants anticipated levels. further easing. Mortgage rates followed Treasury yields lower, precipitating a Interest Rates huge surge of mortgage refinancing. To offset the decline in the duration of their Interest rates fell for most of the first portfolios stemming from the jump in half of 2003, primarily in response to prepayments, mortgage investors report- continuing weak economic data and an edly bought large quantities of longer- associated marking down of expecta- dated Treasuries, amplifying the fall in tions for the federal funds rate. Global yields. Interest rates on corporate bonds uncertainty ran high, particularly sur- also declined in the first half of the year, rounding the timing of military interven- prompting many firms to issue long- tion in Iraq, which elevated safe-haven term debt to pay down other, more demands and depressed yields on Trea- expensive forms of debt and build up sury securities. Moreover, the weak cash assets. Growing confidence that March employment report and other dis- the frequency and severity of corporate appointing news about economic activ- accounting scandals were waning likely ity seemed to cause a substantial shift in contributed to the narrowing in risk views about monetary policy. Data from spreads. By the end of spring, default the federal funds futures market sug- rates on corporate bonds had begun to gested a significant probability of a fur- decline, and corporate credit quality ther easing of policy and did not imply appeared to stabilize. any tightening before early 2004. Even By the time of the June FOMC meet- as geopolitical tensions eased, weaker- ing, federal funds futures data implied than-expected economic data contin- that market participants had generally 26 90th Annual Report, 2003 come to expect an aggressive reduction larly those on speculative-grade issues, in the target federal funds rate, so the continued to fall over the second half of Committee’s decision to lower the tar- the year. Treasury yields fell early in get rate by only 25 basis points came as 2004, largely in response to the weaker- a surprise to some. In addition, some than-expected December labor market investors were reportedly disappointed report. After the release of the Commit- that the statement following this meet- tee’s statement following its January ing included no mention of ‘‘unconven- meeting, Treasury yields backed up tional’’ monetary policy actions that a bit as futures market prices implied would be aimed at lowering longer- an expectation of an earlier onset of term yields more directly than through tightening than had been previously changes in the federal funds rate tar- anticipated. get alone. As a result, market interest rates backed up, with the move prob- ably amplified by the unwinding of Equity Markets mortgage-related hedging activity. The Broad equity price indexes ended the Chairman’s monetary policy testimony year 25 percent to 30 percent higher. in July, and the FOMC’s statements at Early in the year, stock prices were buf- subsequent meetings that noted that feted by mixed news about the pace of policy could remain accommodative for economic expansion and by heightened ‘‘a considerable period,’’ apparently pro- geopolitical tensions. Rising oil prices vided an anchor for the front end of the boosted the shares of energy companies yield curve. At the same time, increas- very early in the year while, by and ingly positive economic reports bol- large, stocks in other sectors were stum- stered confidence in the markets, and bling. By spring, however, positive news longer-dated Treasury securities ended on corporate earnings—often exceeding the year about 40 basis points above expectations—and easing of geopoliti- their year-earlier levels. But, with the cal tensions associated with the initia- expansion evidently gaining traction and tion of military action in Iraq boosted investors becoming more willing to take equity prices significantly. Subse- on risk, corporate risk spreads, particu- quently, the swift end to major combat operations in Iraq caused implied vola- Spreads of Corporate Bond Yields over tility on the S&P 500 index to fall sub- the Ten-Year Treasury Yield stantially. Over the rest of the year, increasingly positive earnings results Percentage points contributed to a sustained rally in stock prices, and implied volatility in 10 equity markets fell further. Corporate High-yield 8 scandals—albeit on a smaller scale than 6 in previous years—continued to emerge BBB 4 in 2003, but these revelations appeared 2 AA + to leave little lasting imprint on broad _0 measures of stock prices. For the year as a whole, the Russell 2000 index of 2001 2002 2003 2004 small-cap stocks and the technology- NOTE. The data are daily and extend through laden Nasdaq composite index, which February 4, 2004. The spreads compare the yields on the Merrill Lynch AA, BBB, and 175 high-yield indexes rose 45 percent and 50 percent, respec- with the yield on the ten-year off-the-run Treasury note. tively, noticeably outpaced broader Economic and Financial Developments in 2003 and Early 2004 27

Major Stock Price Indexes especially for riskier borrowers— narrowing, corporate treasurers shifted January 2, 2002 = 100 their debt issuance toward bond financ- ing and away from shorter-term debt. 120 Russell 2000 Household borrowing also shifted in 110 response to lower longer-term rates. 100 Mortgage rates followed Treasury rates 90 lower in the spring, and mortgage origi- Wilshire 5000 80 nations for both home purchases and 70 refinancings surged. Refinancing activ- ity appears to have held down growth of 2002 2003 2004 consumer credit as households extracted NOTE. The data are daily and extend through Feb- equity from their homes and used the ruary 4, 2004. proceeds, in part, to pay down higher- cost consumer debt. Nevertheless, con- indexes. To date in 2004, equity markets sumer credit posted a moderate advance have continued to rally. in 2003, buoyed by heavy spending on With the sustained rise in stock autos and other durables. A substantial prices, the ratio of expected year-ahead widening of the federal deficit forced earnings to stock prices for firms in the the Treasury to increase its borrowing S&P 500 edged down over 2003. The significantly. To facilitate the pickup in gap between this ratio and the real ten- borrowing, the Treasury altered its auc- year Treasury yield—a crude measure tion cycle to increase the frequency of of the equity risk premium—narrowed a certain issues and reintroduced the bit over the course of the year, though it three-year note. remains in the upper part of the range Depository credit rose 6 percent in observed over the past two decades. 2003 and was driven by mortgage lend- ing and the acquisition of mortgage- backed securities by both banks and Debt and Financial Intermediation thrift institutions. Consumer lending Aggregate debt of the domestic non- also was substantial, as lower interest financial sectors is estimated to have rates and auto incentives spurred spend- increased about 81⁄4 percent in 2003, just ing on durable goods. In contrast, busi- over a percentage point faster than in ness loans fell 71⁄4 percent over 2003, a 2002. Federal debt accelerated sharply, drop similar to the runoff in 2002. Sur- rising 11 percent, owing to the larger vey evidence suggests that the decline in budget deficit. Household debt rose business lending at banks was primarily almost as rapidly, and the increase in the result of decreased demand for these state and local government debt also loans, with respondent banks often cit- was substantial. In contrast, business ing weak investment and inventory borrowing remained subdued last year. spending. Moreover, the contraction was In the business sector, investment concentrated at large banks, whose cus- spending, particularly in the beginning tomers tend to be larger corporations of the year, was mainly financed with that have access to bond markets, and internal funds, limiting, though not the proceeds of bond issuance were eliminating, businesses’ need to increase apparently used, in part, to pay down debt. With long-term rates falling bank loans. The January 2004 Senior through midyear and credit spreads— Loan Officer Opinion Survey reported a 28 90th Annual Report, 2003 pickup in business loan demand arising higher returns led households to shift mainly from increased spending on plant funds from M2 assets to equities, a view and equipment and on inventories. Sup- reinforced by the strong flows into ply conditions apparently played a sec- equity mutual funds. ondary role in the weakness in business loans in 2003. Banks tightened stan- dards and terms on business loans some- International Developments what in the first half of the year, but by Economic growth abroad rebounded in year-end they had begun to ease terms the second half of last year as factors and standards considerably, in part that weighed on the global economy in because of reduced concern about the the first half—including the SARS epi- economic outlook. demic and uncertainty surrounding the war in Iraq—dissipated. Foreign growth also was boosted by the strong rebound The M2 Monetary Aggregate in the U.S. economy, the revival of the M2 increased 51⁄4 percent in 2003, a global high-tech sector, and, in many pace somewhat slower than in 2002 and countries, ample policy stimulus. a bit below the rate of expansion of Strong second-half growth in China nominal income. The deceleration in M2 stimulated activity in other emerging largely reflected a considerable contrac- Asian economies and Japan by raising tion in the final quarter of the year after the demand for their exports. Growth in three quarters of rapid growth. The Japan also was spurred by a recovery in robust growth in money around mid- private spending there on capital goods. year was concentrated in liquid deposits Economic activity in Europe picked up and likely resulted in large part from in the second half, as export growth the wave of mortgage refinancings, resumed. Economic growth in Latin which tend to boost M2 as the proceeds America has been less robust; the Mexi- are temporarily placed in non-interest- can economic upturn has lagged that of bearing accounts pending disbursement the United States, and Brazil’s economy to the holders of mortgage-backed secu- has only recently begun to recover from rities. Moreover, around the middle of the effects of its 2002 financial crisis. the year, the equity that was extracted Monetary authorities abroad gener- from home values during refinancings ally eased their policies during the first probably provided an additional boost half of 2003 as economic activity stag- to deposits for a time, as households nated. In the second half, market partici- temporarily parked these funds in M2 pants began to build in expectations of accounts before paying down other debt eventual monetary tightening abroad, or spending them. In the fourth quarter, and official interest rates were raised M2 contracted at an annual rate of 2 per- by year-end in the United Kingdom and cent, the largest quarterly decline since Australia. Canadian monetary policy consistent data collection began in 1959. followed a different pattern; the Bank of As mortgage rates backed up and the Canada raised official interest rates in pace of refinancing slowed, the funds the spring as inflation moved well above that had been swelling deposits flowed its 1 percent to 3 percent target range out, depressing M2. The sustained rally but cut rates later in the year and again in equity markets after the first quarter early this year as slack emerged and of the year may also have slowed M2 inflation moderated. Similarly, lower growth, as expectations of continued inflation in Mexico and Brazil allowed Economic and Financial Developments in 2003 and Early 2004 29 authorities to ease monetary policy dur- U.S. Dollar Exchange Rate against ing 2003. The Bank of Japan maintained Selected Major Currencies official interest rates near zero and con- tinued to increase the monetary base. Week ending January 5, 2001 = 100 In foreign financial markets, equity Japanese yen prices fell, on average, until mid-March 110 but since then have risen in reaction U.K. 100 to indications of stronger-than-expected pound global economic activity. Emerging- Canadian 90 dollar Euro market equity indexes outpaced those 80 in the industrial countries in 2003, with markets in Latin America posting par- 2001 2002 2003 2004 ticularly strong gains. Around midyear, long-term interest rates declined to NOTE. The data are weekly and are in foreign currency units per dollar. Last observations are the multiyear lows in many countries as average of trading days through February 4, 2004. economic growth slowed and inflation- ary pressures diminished, but those rates moved higher in the second half against the Mexican peso. On balance, as growth prospects improved. Bond the dollar depreciated 9 percent during spreads came down substantially during 2003 on a trade-weighted basis against the year, both for industrial-country cor- the currencies of a broad group of U.S. porate debt and for emerging-market trading partners. sovereign debt; spreads of the J.P. Mor- gan Emerging Market Bond Index (EMBI+) over U.S. Treasury securities Industrial Economies fell to their lowest levels since before The euro-area economy contracted in the Russian crisis of 1998. Gross capital the first half of 2003, weighed down flows to emerging markets, however, in part by geopolitical uncertainty and remained well below their 1997 peak. higher oil prices. In the second half, The foreign exchange value of the economic activity in the euro area began dollar continued to decline last year as to grow as the global pickup in activity concerns over the financing of the large spurred a recovery of euro-area exports and growing U.S. current account deficit despite the continued appreciation of the took on greater prominence. The dollar euro. The monetary policy of the Euro- declined 18 percent against the Cana- pean Central Bank (ECB) was support- dian dollar, 17 percent against the euro, ive of growth, with the policy interest and 10 percent against the British pound rate lowered to 2 percent by midyear. and the Japanese yen. In contrast, the Consumer price inflation slowed to value of the dollar was little changed, around 2 percent, the upper limit of on net, against the currencies of our the ECB’s definition of price stability. other important trading partners, in part Despite increased economic slack, infla- because officials of China and of some tion moved down only a little, partly other emerging Asian economies man- because the summer drought boosted aged their exchange rates so as to main- food prices. For the second straight tain stability in terms of the dollar. year, the governments of Germany and Among Latin American currencies, the France each recorded budget deficits dollar declined against the Brazilian and in excess of the 3 percent deficit-to- Argentine currencies but appreciated GDP limit specified by the Stability 30 90th Annual Report, 2003 and Growth Pact. However, in light of Japanese real GDP recorded signifi- economic conditions, European Union cant growth in 2003 for the second finance ministers chose not to impose straight year. Private investment spend- sanctions. ing made the largest contribution to After a sluggish first quarter, the U.K. the expansion. Consumer spending economy expanded at a solid pace for remained sluggish as labor market con- the remainder of 2003, supported by ditions continued to be soft. However, robust consumption spending and con- nominal wages stabilized following a siderable government expenditure. The sharp drop in 2002, and leading indi- Bank of England cut rates in the first cators of employment moved higher. half of the year but reversed some of Despite an appreciation of the yen late that easing later in the year and early in the year, Japanese exports posted this year as the economy picked up a strong increase in 2003 primarily and housing prices continued to rise at because of gains in exports to China and a rapid, albeit slower, pace. In June, other emerging Asian economies. With the British government announced its consumer prices continuing to decline, assessment that conditions still were the Bank of Japan (BOJ) maintained not right for the United Kingdom to its policy interest rate near zero and adopt the euro. In December, the Brit- eased monetary policy several times ish government changed the inflation during 2003 by increasing the target measure to be targeted by the Bank of range for the outstanding balance of England from the retail prices index reserve accounts held by private finan- excluding mortgage interest (RPIX) to cial institutions at the BOJ. The BOJ the consumer prices index. U.K. infla- also took other initiatives last year to tion currently is well below the objec- support the Japanese economy, includ- tive of 2 percent on the new target ing launching a program to purchase index. securities backed by the assets of small- The Canadian economy contracted in and medium-sized enterprises. Japanese the second quarter owing to the impact banks continued to be weighed down by of the SARS outbreak in Toronto on large amounts of bad debt, but some travel and tourism, but it rebounded in progress was made in resolving prob- the latter half of the year. Canadian eco- lems of insufficient bank capital and nomic growth continued to be led by in reducing bad-debt levels from their strong domestic demand; consumption previous-year highs. remained robust and investment spend- ing accelerated, offsetting the negative effect of Canadian dollar appreciation Emerging-Market Economies on both exports and import-competing industries. Canadian consumer price Growth in the Asian developing econo- inflation swung widely last year, rising mies rebounded sharply in the second to 41⁄2 percent on a twelve-month basis half of 2003 after having contracted in in February before falling to 11⁄2 per- the first half. The outbreak of SARS cent in November and ending the year in China and its spread to other Asian at 2 percent. The swing partly reflected economies was the primary factor movements in energy prices, but depressing growth in the first half, and changes in auto insurance premiums and the subsequent recovery of retail sales cigarette taxes also played an important and tourism after the epidemic was con- role. tained was an important factor in the Economic and Financial Developments in 2003 and Early 2004 31

U.S. Dollar Exchange Rates and Bond markets in Beijing and Shanghai, may Spreads for Selected Emerging Markets be overheating. Korean economic growth turned January 5, 2001 = 100 January 5, 2001 = 100 negative in the first half, as the high Exchange rates level of household debt, labor unrest, 440 220 Brazilian and concerns over North Korea’s 360 Argentine real 180 peso nuclear development depressed private- 280 140 sector spending. A sharp rise in exports Mexican peso 200 100 spurred a revival of growth in the Korean won second half even as domestic demand 120 60 remained subdued. The Mexican economy remained Percentage points Percentage points sluggish through much of the year but Bond spreads recently has shown some signs of 80 Brazil 20 improvement. After lagging the rise in U.S. production, Mexican industrial 60 Argentina 15 production posted strong gains in Octo- 40 10 ber and November, although it remains Mexico well below the peak it reached in 2000. 20 5 Exports rose late last year to almost the peak they had reached in 2000. Con- 2001 2002 2003 2004 sumer price inflation came down over NOTE. The exchange rate data are weekly averages the course of 2003 to 4 percent, the indexed to the week ending January 5, 2001. Last observations are the average of trading days through upper bound of the 2 percent to 4 per- February 4, 2004. Exchange rates (top panel) are in cent target range. The Bank of Mexico foreign currency units per dollar. Bond spreads (bottom has left policy unchanged since tighten- panel) are the spreads of the J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. Treasury ing five times between September 2002 securities. and March 2003, but market interest rates have fallen owing to weakness in economic activity. sharp rebound. The pattern of Asian The Brazilian economy contracted in growth also reflected the sharp recovery the first half of 2003 partly as a result of of the global high-tech sector in the the 2002 financial crisis and the con- second half after a prolonged period of sequent monetary policy tightening. It weakness. Exports continued to be the then expanded moderately in the second main engine of growth for the region. half, boosted by strong export growth However, domestic demand contributed and a recovery in investment spending. importantly to growth in China, where Brazilian financial indicators improved state-sector investment increased at a significantly in 2003, in part because the rapid clip and a boom in construction Brazilian government began to run a activity continued. Supply problems substantial primary budget surplus and caused food prices and overall con- to reform the public-sector pension sys- sumer prices in China to rise on a tem. The Brazilian stock market soared twelve-month basis last year, following nearly 100 percent last year, and Bra- a period of price deflation during the zil’s EMBI+ bond spread narrowed by previous year. In addition, concerns nearly two-thirds. As the Brazilian cur- emerged that some sectors of the Chi- rency stabilized and began to appreciate, nese economy, particularly the property Brazil’s inflation outlook improved, 32 90th Annual Report, 2003 allowing the central bank to reverse and many of Argentina’s structural fully its earlier rate hikes and to reduce problems have not been addressed. With the overnight interest rate to a multi- the government still in default to its year low, although real interest rates bondholders, the country’s sovereign remained high. debt continued to carry a very low credit The Argentine economy rebounded rating, and its EMBI+ spread remained in 2003 from the sharp contraction that extremely high. Even so, the Argentine occurred in the wake of its financial peso appreciated on balance in 2003, crisis in 2001Ð02. Still, economic activ- and the Merval stock index nearly ity remains far below pre-crisis levels, doubled over the course of the year. 33

Monetary Policy Report of July 2003

Monetary Policy and the rising energy costs. These concerns also Economic Outlook caused consumer confidence to sag and added to a general disinclination of The subpar performance of the U.S. firms to spend, hire, and accumulate economy extended into the first half of inventories. Caution was apparent in 2003. Although accommodative macro- financial markets as well, and investors economic policies and continued robust bid down the prices of equities in favor productivity growth helped to sustain of less-risky securities. aggregate demand, businesses remained The swift prosecution of the war in cautious about spending and hiring. All Iraq resolved some of these exceptional told, real gross domestic product contin- uncertainties but by no means all of ued to rise in the first half of the year them. Nonetheless, oil prices receded, but less quickly than the economy’s pro- and the improvement in the economic ductive capacity was increasing, and climate was sufficient to cause stock margins of slack in labor and product prices to rally, risk spreads on corporate markets thereby widened further. As a securities to narrow, and consumer con- result, underlying inflation remained fidence to rebound. At the same time, low—and, indeed, seems to have moved the incoming economic data—much of down another notch. In financial mar- which reflected decisions made before kets, longer-term interest rates fell, on the war—remained mixed, and inflation net, over the first half of the year as the trended lower. At the conclusion of its decline in inflation and the subdued per- May meeting, the Federal Open Market formance of the economy led market Committee (FOMC) indicated that, participants to conclude that short-term whereas the risks to the outlook for eco- interest rates would be lower than pre- nomic growth were balanced, the risk of viously anticipated. These lower interest an unwelcome substantial fall in infla- rates helped to sustain a rally in equity tion from its already low level, though prices that had begun in mid-March. minor, exceeded that of a pickup in During the first quarter of the year, inflation. In the weeks that followed, the economy’s prospects were clouded market participants pushed down the by the uncertainties surrounding the expected future path of the federal funds onset, duration, and potential conse- rate, which contributed to the fall in quences of war in Iraq. War-related con- longer-term interest rates and a further cerns provided a sizable boost to crude rise in equity prices. oil prices; as a result, households faced At the time of the June FOMC meet- higher bills for gasoline and heating oil, ing, the available evidence did not yet and many firms were burdened with compellingly demonstrate that a mate- rial step-up in economic growth was Note. The discussion in this section consists under way, though some indicators did of the text and tables from the Monetary Policy point to a firming in spending and a Report submitted to the Congress on July 15, 2003; the charts from this report (as well as earlier stabilization in the labor and product reports) are available on the Board’s web site, at markets. The Committee concluded that www.federalreserve.gov/boarddocs/hh. a slightly more expansive monetary pol- 34 90th Annual Report, 2003 icy would be warranted to add further which encouraged firms to issue bonds support to the economic expansion. The to reduce their financing costs and Committee’s assessment and ranking of restructure their balance sheets. Mean- the risks to the outlook for economic while, moderate gains in household growth and inflation were the same as in income and historically low mortgage May. rates underpinned still-considerable The Federal Reserve expects eco- demand for housing. Retail sales, par- nomic activity to strengthen later this ticularly those of motor vehicles, also year and in 2004, in part because of the were strong at the end of 2002 despite accommodative stance of monetary pol- some drop-off in consumer confidence. icy and the broad-based improvement in Core inflation seemed to be on a declin- financial conditions. In addition, fiscal ing trend, although the foreign exchange policy is likely to be stimulative as the value of the dollar had depreciated, and provisions of the Jobs and Growth Tax top-line inflation was being boosted by Relief Reconciliation Act of 2003 go a sizable run-up in energy prices. The into effect and as defense spending con- substantial slack in resource utilization, tinues to ramp up. Severe budgetary as well as the solid gains in labor pro- pressures are causing state and local ductivity, led members to the view governments to cut spending and to that consumer price inflation—by then increase taxes and fees, but these actions already very low—was unlikely to should offset only a portion of the impe- increase meaningfully. Against that tus from the federal sector. Moreover, backdrop, the Committee members con- the continued favorable performance of tinued to believe that economic fun- productivity growth should lift house- damentals were in place to support a hold and business incomes and thereby pickup in the growth of economic activ- encourage capital spending. Given the ity during the year ahead. Accordingly, ongoing gains in productivity and the the FOMC decided at the January meet- existing margin of resource slack, aggre- ing to leave interest rates unchanged and gate demand could grow at a solid pace assessed the risks as balanced with for some time before generating upward respect to its dual goals of sustainable pressure on inflation. economic growth and price stability. In subsequent weeks, economic per- formance proved disappointing. The Monetary Policy, Financial increasing likelihood of war in Iraq was Markets, and the Economy accompanied by a steep rise in crude over the First Half of 2003 oil prices and considerable volatility During the weeks before the January in financial markets. For much of that meeting of the FOMC, geopolitical period, investors sought the relative developments and the uneven tone of safety of fixed-income instruments; that economic data releases created substan- preference induced declines in yields on tial uncertainty. Businesses had contin- Treasury securities and high-quality cor- ued to reduce their payrolls and post- porate bonds and a drop in stock prices. pone capital expenditures. However, the Consumer outlays also softened after absence of fresh revelations of lapses January, although low mortgage rates in corporate governance or accounting and rising incomes were still providing problems and some increased appetite support for household spending. Busi- for risk on the part of investors helped nesses continued to trim workforces and push down yields on corporate debt, cut capital spending. Monetary Policy Report of July 2003 35

When the Committee met on In light of the financial and policy March 18, full-scale military conflict in stimulus already in place, the FOMC Iraq seemed imminent. In an environ- left the federal funds rate unchanged ment of considerable uncertainty, the at its May meeting. To provide more FOMC had to weigh whether economic specific guidance about its views, the sluggishness was largely related to FOMC included in its announcement worries about the war, and hence would separate assessments of the risks to lift once the outcome was decided, or the outlook for economic growth and was indicative of deep-seated restraints inflation as well as the overall bal- on economic activity. The Committee, ance between the two. The Committee which reasoned that it could not make viewed the upside and downside risks to such a distinction in the presence of so economic growth as balanced, but it per- much uncertainty, left the funds rate ceived a higher probability of an unwel- unchanged and declined to character- come substantial fall in inflation than ize the balance of risks with respect to of a pickup in inflation from its current its dual goals. However, the Commit- low level. The Committee considered tee noted that, given the circumstances, that the overall balance of risks to its heightened surveillance would be par- dual objectives was weighted toward ticularly informative, and it held a series weakness. That said, members con- of conference calls during late March cluded that there was only a remote and April to discuss the latest economic possibility that resource utilization developments. would remain so low that the disinfla- Some of the uncertainty was resolved tion process would cumulate to produce by the quick end to major military a declining overall price level for an action in Iraq. Equity prices and con- extended period. sumer confidence rose while oil prices Financial market participants reacted and risk spreads on corporate debt strongly to this characterization of risks, fell. Fiscal policy seemed set to become believing that the Committee’s focus on even more stimulative given the pros- leaning against appreciable disinflation pect of increased spending on defense implied that monetary policy would be and homeland security as well as more accommodative and remain so for the likely enactment of additional tax longer than previously thought. Inves- cuts. Part of the federal stimulus, tors pushed down the expected path of however, was thought likely to be the federal funds rate in the weeks fol- offset by the efforts of state and local lowing the meeting. Intermediate- and governments to close their budget long-term interest rates fell significantly gaps. and spurred another round of long-term Economic reports were generally bond issuance. The resulting decline in disappointing. Industrial production real interest rates helped sustain the rally declined in March, and capacity utili- in equity prices. zation fell to a twenty-year low. The Between the May and June meetings, employment reports for March and April a few tentative signs suggested that indicated that private nonfarm payrolls the pace of economic activity might had continued to fall. Although order be firming. Industrial production and backlogs for nondefense capital goods retail sales edged up in May, available had risen recently, businesses generally data indicated that employment had remained reluctant to invest in new stopped declining, residential invest- capacity. ment remained strong, and survey mea- 36 90th Annual Report, 2003 sures of consumer sentiment and busi- Economic Projections for 2003 and 2004 ness conditions were well above the Percent levels of earlier in the year. Financial Federal Reserve Governors conditions had improved markedly, but and businesses reportedly remained some- Reserve Bank presidents Indicator what averse to new investment projects, Central in part because of significant unused Range tendency capacity. They also seemed reluctant to expand their workforces until they 2003 viewed a sustained pickup in aggregate Change, fourth quarter demand as more certain. to fourth quarter1 With inflation already low and infla- Nominal GDP ...... 31⁄2Ð43⁄4 33⁄4Ð41⁄2 Real GDP ...... 21⁄4Ð3 21⁄2Ð23⁄4 tion expectations subdued, the Commit- PCE chain-type price tee judged that it would be prudent to index ...... 1Ð13⁄4 11⁄4Ð11⁄2 add further support for economic expan- Average level, fourth quarter sion, and it lowered the target for the Civilian unemployment federal funds rate 25 basis points, to rate...... 6Ð61⁄4 6Ð61⁄4 1 percent. The FOMC continued to view the risks to economic growth as bal- 2004 anced and again noted that the minor Change, fourth quarter probability of substantial further dis- to fourth quarter1 inflation exceeded the probability of a Nominal GDP ...... 43⁄4Ð61⁄2 51⁄4Ð61⁄4 Real GDP ...... 31⁄2Ð51⁄4 33⁄4Ð43⁄4 pickup in inflation from its current low PCE chain-type price level. But because of the considerable index ...... 3⁄4Ð2 1Ð11⁄2 amount of economic slack prevailing Average level, fourth quarter and the economy’s ability to expand Civilian unemployment without putting upward pressure on rate...... 51⁄2Ð61⁄4 51⁄2Ð6 prices, the Committee indicated that the 1. Change from average for fourth quarter of previous small chance of an unwelcome substan- year to average for fourth quarter of year indicated. tial decline in the inflation rate was likely to remain its predominant concern for the foreseeable future. cent, which, given the modest increase in real GDP in the first quarter, implies a noticeable pickup in growth as the year Economic Projections progresses. The central tendency for for 2003 and 2004 projections of real GDP growth in 2004 spans a range of 33⁄4 percent to 43⁄4 per- The members of the Board of Governors cent. The civilian unemployment rate is and the Federal Reserve Bank presi- expected to be between 6 percent and dents, all of whom participate in the 61⁄4 percent in the fourth quarter of 2003 deliberations of the FOMC, expect eco- and to decline to between 51⁄2 percent nomic activity to accelerate in the sec- and 6 percent by the fourth quarter of ond half of this year and to gather addi- 2004. tional momentum in 2004. The central Inflation is anticipated to be quite low tendency of the FOMC participants’ over the next year and a half. The chain- forecasts for the increase in real GDP type price index for personal consump- over the four quarters of 2003 spans a tion expenditures (PCE) rose 13⁄4 per- narrow range of 21⁄2 percent to 23⁄4 per- cent over the four quarters of 2002, and Monetary Policy Report of July 2003 37 most FOMC participants expect infla- longer-term yields declined, in some tion to run somewhat lower this year cases to their lowest levels on record. and then to hold fairly steady in 2004. Equity prices, which through mid- The central tendency of projections for March had fallen in response to weaker- PCE inflation is 11⁄4 percent to 11⁄2 per- than-expected economic news and ris- cent in 2003 and 1 percent to 11⁄2 per- ing geopolitical tensions, began a broad cent in 2004. rally as it became clear that the war in Iraq would begin imminently. The apparent increase in investors’ appetite Economic and Financial for risk also helped push down risk Developments in 2003 spreads on corporate bonds and trig- Economic activity in the United States gered inflows to equity and high-yield remained sluggish in the first half of bond mutual funds. Since the beginning 2003. Businesses continued to be reluc- of the year, the foreign exchange value tant to undertake new projects given the of the dollar has depreciated nearly unusual degree of uncertainty in the eco- 5 percent against the broad group of nomic environment, and the softness in currencies of our major trading partners. activity abroad crimped the demand for Households and businesses have U.S. exports. However, consumer spend- taken advantage of the decline in ing grew moderately, housing activity intermediate-term and long-term inter- retained considerable vigor, and defense est rates from their already low levels, spending picked up. Real GDP rose at mostly by refinancing debt at ever more an annual rate of just 11⁄2 percent in the favorable rates. Partly as a result, house- first quarter and appears to have posted hold credit quality was little changed another modest gain in the second quar- over the first half of the year, and house- ter. With output growth remaining tepid hold debt continued to expand at a rapid and labor productivity rising at a fairly pace as mortgage interest rates fell robust pace, firms continued to trim pay- to their lowest levels in more than rolls in the first half of 2003, though job three decades. Business balance sheets losses in the private sector were a little strengthened noticeably, and many mea- smaller than they had been, on average, sures of corporate credit performance in 2002. showed some improvement. Still, net For much of the first half of the year, borrowing by businesses continued to headline inflation news was shaped be damped by the softness in investment by movements in energy prices, which spending. soared during the winter, retreated during the spring, and more recently firmed. Core inflation—which excludes The Household Sector the direct effects of food and energy Consumer Spending prices—was held to a low level by slack in resource utilization and continued siz- Consumer spending continued to in- able advances in labor productivity. crease in the first half of 2003, though As a result of slow economic growth not as quickly as in the past few years. and the prospect that inflation would In total, real personal consumption remain very subdued, the federal funds expenditures (PCE) rose at an annual rate was maintained at the accommoda- rate of 2 percent in the first quarter and tive level of 11⁄4 percent for much of the likely posted another moderate advance first half of the year. Intermediate- and in the second quarter. Purchases of new 38 90th Annual Report, 2003 light motor vehicles were sustained past few years. Reflecting these influ- by the automakers’ use of increasingly ences, the personal saving rate averaged aggressive price and financing incen- 31⁄2 percent over the first five months of tives. Spending on goods other than the year—about the same as the annual motor vehicles rose briskly in the first average for 2002 but more than 1 per- quarter, though that was largely because centage point above that for 2001. of the high level of spending around the Consumer confidence, which has turn of the year; the data through May exhibited some sharp swings in recent suggest a further increase for this cate- years, remained volatile in the first half gory in the second quarter. In contrast, of 2003. After having declined mark- outlays on services rose only slowly edly over the second half of 2002, sur- over the first five months of the year vey readings from both the Michigan as weakness lingered in a number of Survey Research Center and the Con- categories, including air travel and ference Board took another tumble early recreation. this year on concerns about the potential The rise in real consumption expendi- consequences of a war in Iraq. With the tures so far in 2003 has about matched combat in Iraq largely over and the the growth in real disposable personal stock market recovering, confidence income (DPI), which has been restrained rose appreciably, on net, in the spring. by the poor job market and by the surge in consumer energy prices early in the Residential Investment year. Real DPI rose about 21⁄4 percent at an annual rate between the fourth Housing activity remained robust in the quarter of 2002 and May after having first half of this year, as very low mort- increased at a considerably faster pace gage interest rates apparently offset in 2002; the larger increase in real DPI much of the downward pressure from in 2002 in part reflected the effects of the soft labor market. In the single- the tax cuts enacted in 2001. family sector, starts averaged an annual Among other key influences on con- rate of 1.39 million units over the first sumption, household wealth grew about five months of the year—2 percent in line with nominal DPI in the fourth greater than the rapid pace for 2002 as quarter of 2002 and the first quarter of a whole. In addition, sales of new and 2003 after having fallen sharply over the existing homes moved to exceptionally preceding two years. While the rebound high levels. According to the Michi- in the stock market in the second quarter gan survey, consumers’ assessments of should help the wealth-to-income ratio homebuying conditions currently are recoup some of the ground it lost earlier, very favorable, mainly because of the households likely have not yet com- low mortgage rates. pleted the adjustment of their spending The available indicators provide dif- to the earlier drop in wealth. Mean- fering signals on the magnitude of recent while, the high level of mortgage refi- increases in home prices, but, in general, nancing in recent quarters has bolstered they point to smaller gains than those consumer spending by allowing home- recorded a year or two ago. Notably, owners to reduce their monthly pay- over the year ending in the first quarter, ments, pay down more costly consumer the constant-quality price index for new debt, and in many cases cash out some homes rose just 21⁄2 percent, one of the of the equity that has accumulated dur- lowest readings of the past few years. ing the upswing in house prices over the Meanwhile, the four-quarter increase in Monetary Policy Report of July 2003 39 the repeat-sales price index for existing quarters of 2003 in response to the homes, which topped out at 81⁄2 per- declines in mortgage rates. According cent in 2001, was 61⁄2 percent in the to Freddie Mac, more than 40 percent first quarter. Still, the share of income of the refinancings in the first quarter required to finance the purchase of a were ‘‘cash-out’’ refinancings, and the new home, adjusted for variations over amount of equity extracted likely set a time in structural characteristics, has record in the first half of this year. The continued to move down as mortgage combination of rising home prices and rates have dropped, and it is now very low interest rates also energized home low by historical standards. equity lending during the first half of Activity in the multifamily sector 2003. appears to have slipped somewhat this A major use of the proceeds from year, perhaps in part because the strong both cash-out refinancing and home demand for single-family homes may equity loans reportedly has been to pay be cutting into the demand for apart- down credit card and other higher-cost ments. Multifamily starts totaled consumer debt. Indeed, in line with 325,000 units at an annual rate over the those reports, consumer debt advanced first five months of the year, a pace at a relatively subdued 41⁄2 percent 6 percent below that for 2002 as a annual rate in the first quarter. The whole. In addition, vacancy rates for growth of revolving debt was about multifamily rental properties rose fur- 5 percent at an annual rate, and nonre- ther in the first quarter, and apartment volving debt expanded at a 31⁄2 percent rents continued to fall. annual rate. The growth of consumer debt picked up in the spring; the accel- eration in part reflected somewhat Household Finance higher motor vehicle sales that boosted Household real estate debt grew rapidly the nonrevolving component, which in in the first half of the year with the turn offset a deceleration in revolving support of the brisk pace of home sales, credit. Meanwhile, the average interest rising home prices, and falling mort- rates charged on credit cards and on new gage interest rates. Indeed, according to car loans at auto finance companies this Freddie Mac, the average rate on thirty- year have remained near the low end of year conventional home mortgages fell their recent ranges. sharply until June, though it has edged In total, household debt grew at a back up in recent weeks and now stands 10 percent annual rate in the first quar- at about 51⁄2 percent. Applications for ter, a pace about unchanged from last mortgages to purchase homes rose well year’s. Despite the marked rise of this above the already elevated level of last debt over the past several quarters, the year. Sales of existing homes, in par- aggregate debt-service burden of house- ticular, add significantly to the level of holds ticked down in both the fourth mortgage debt because the purchaser’s quarter of 2002 and the first quarter of mortgage is typically much larger than this year—periods during which bor- the seller’s had been. The pace of rowing rates fell and the average matu- mortgage refinancing—which adds to rity of household debt rose. Although borrowing because households often households continued to borrow at a increase the size of their mortgages rapid pace in the second quarter, the when they refinance—set consecutive declines in mortgage interest rates and quarterly records in the first and second an elevated level of refinancing imply 40 90th Annual Report, 2003 that the debt-service burden was likely tainty about the economic outlook little changed. and heightened risk aversion in the The credit quality of household debt wake of last year’s corporate gover- remained fairly stable in the first quar- nance and accounting problems. Excess ter. The delinquency rates both on resi- capacity—in addition to being a dential mortgages and on credit card factor weighing on nonresidential loans edged down in the first quarter, construction—also is limiting demand though persistently high delinquencies for some types of equipment, most nota- among subprime borrowers remain a bly in the telecommunications area. But problem area. Delinquency rates on auto other key determinants of equipment loans at captive finance companies have spending are reasonably favorable. The edged up in recent months from their aggressive actions taken by firms over very low levels of the past few years. the past few years to boost productivity However, lenders probably anticipated and trim costs have provided a lift to some increase as the plethora of new corporate profits and cash flow. In addi- vehicle loans issued in late 2001 and tion, low interest rates and a rising stock early 2002 seasoned. The fact that a market are helping hold down firms’ large number of households declared cost of capital, as is the partial- bankruptcy in the first half of the year expensing investment tax incentive. In suggests that some households continue addition, technological advances con- to experience considerable distress. tinue to depress the relative price of In a continuation of the trend during computers at a time when stretched-out the second half of 2002, households replacement cycles have apparently wid- invested heavily in bond mutual funds— ened the gap between the latest technol- and relatively safe bond funds at that— ogy and that embodied in many of the during the first quarter of 2003 and dis- machines currently in use. invested from equity funds. However, Real spending on E&S fell at an starting in March, households showed a annual rate of nearly 5 percent in the growing willingness to purchase shares first quarter. The outlays were restrained of riskier funds. As corporate credit by a sharp decline in spending on trans- quality improved and risk-free interest portation equipment, especially motor rates fell to record lows, a significantly vehicles; excluding that category, spend- larger portion of the investment in bond ing posted a small gain. Real outlays on mutual funds flowed into corporate bond high-tech equipment and software rose funds—including high-yield funds—at at an annual rate of about 11 percent in the expense of government bond funds. the first quarter, a bit faster than they Inflows to equity mutual funds report- had in 2002. Real purchases of comput- edly resumed in mid-March and contin- ers and peripheral equipment remained ued through June. on the moderate uptrend that has been evident since such spending bottomed out in 2001, and outlays on communica- The Business Sector tions equipment picked up after an Fixed Investment extended period of weakness. Mean- while, investment outside the transporta- Investment in equipment and software tion and high-tech areas dropped back a (E&S) continues to languish. Firms bit. reportedly remain reluctant to under- Real E&S spending appears to have take new projects because of the uncer- turned up in the second quarter, in part Monetary Policy Report of July 2003 41 because of a step-up in the pace of real investment in the first quarter was a computer investment. However, incom- meager $5 billion at an annual rate and ing data suggest that outlays on com- occurred entirely in the motor vehicle munications equipment did not repeat industry, where sagging sales and ambi- their first-quarter spurt. The data on tious production early in the year cre- shipments of capital goods point to mod- ated a noticeable bulge in dealer stocks, erate increases in spending outside of especially of light trucks. In the second high-tech and transportation in the quarter, the automakers reduced assem- second quarter; moreover, backlogs of blies and expanded incentives to bolster unfilled orders for equipment in this sales, but these steps were sufficient broad category have risen some this year only to reduce stocks a little, and inven- after having declined over the preceding tories remained high relative to sales two years. through June. Apart from the motor Nonresidential construction remained vehicle industry, firms reduced stocks, weak in the first half of 2003. Although on net, over the first five months of real construction outlays were off only a 2003, and, with only a few exceptions, little in the first quarter, they had fallen inventories appear reasonably well nearly 16 percent in 2002, and partial aligned with sales. data for the second quarter point to con- tinued softness. The downturn in spend- Corporate Profits ing has been especially pronounced in and Business Finance the office sector, where vacancy rates have surged and rents have plunged. Before-tax profits of nonfarm, nonfinan- Spending on industrial facilities also has cial corporations grew at a 61⁄2 percent fallen dramatically over the past couple annual rate in the first quarter of 2003, of years; it has continued to contract and they constituted 81⁄2 percent of the in recent quarters and is unlikely to sector’s first-quarter GDP, the highest improve much in the absence of a sig- proportion since the third quarter of nificant rise in factory operating rates. 2000. Focusing on the companies that Construction expenditures on other make up the S&P 500, earnings per commercial buildings (such as those for share for the first quarter were up about retail, wholesale, and warehouse space), 7 percent at a quarterly rate from the which had declined less than did outlays fourth quarter of 2002 and were 11 per- for other major categories of nonresi- cent higher than four quarters earlier. dential construction over the past couple Although oil companies accounted for of years, moved up in the first quarter of the majority of the four-quarter increase, 2003, but they too have shown some earnings from the financial, utility, and renewed softness lately. One bright spot consumer durable sectors were also is the drilling and mining sector, in strong and exceeded the market’s con- which outlays have risen sharply this servative expectations by larger-than- year in response to higher natural gas usual margins. The recent depreciation prices. of the dollar substantially boosted reve- nues of U.S. multinational corporations, but the hedging of currency risk likely Inventory Investment limited the extent to which sales gains Most businesses have continued to keep showed through to profits. a tight rein on inventories after the mas- Net equity retirements in the first sive liquidation in 2001. Real inventory quarter of 2003 were probably a shade 42 90th Annual Report, 2003 larger than in the fourth quarter of 2002, Senior Loan Officer Opinion Survey on as the decline in gross new issuance Bank Lending Practices. more than offset lower gross retire- The runoff in C&I loans appears ments. Equity retirements from cash- related more to a decrease in demand financed mergers were a bit below their than to a tightening of supply condi- pace in the past two years, and share tions, and bank credit appears to remain repurchases appear to be running some- available for qualified business borrow- what slower as well. Volatile and declin- ers. The net fraction of banks in the ing equity prices in the first quarter Senior Loan Officer Opinion Survey that brought initial public offerings (IPOs) to reported having tightened lending stan- a standstill during the first four months dards and terms on C&I loans during the of this year. One small IPO was under- first part of the year decreased mark- taken in May, and another one came to edly, and the Survey of Small Business market in June. With regard to seasoned by the National Federation of Indepen- equity offerings, a war-related lull in dent Business showed that the net per- March and April held the average centage of small businesses believing monthly pace of issuance this year well credit had become more difficult to below last year’s level. Most of these obtain hovered near the middle of its offerings have been from energy firms recent range. Moreover, in the April and utilities that have used the proceeds Senior Loan Officer Opinion Survey, a primarily to reduce leverage and number of banks reported that they had increase liquidity. eased lending terms in response to The net debt growth of nonfinancial increased competition for C&I loans corporate business was just 3 percent at from nonbank lenders. Indeed, data from an annual rate in the first quarter, as Loan Pricing Corporation indicate that rising profits and lower outlays for fixed nonbank financial institutions purchased and working capital held down corpo- a record amount of new syndicated loans rations’ need for external funds. None- during the first quarter of this year; the theless, low interest rates continued to buyers were reportedly attracted in part attract firms to the bond market during by improving liquidity in the secondary the first half of 2003, and issuance ran loan market. well ahead of its rate of the second half The decline in both short- and long- of 2002. Moreover, a large fraction of term interest rates, combined with slow the issues were from below-investment- increases in total business debt, con- grade firms, which likely were respond- tributed to a further reduction in the net ing to the even sharper fall in their interest burden of nonfinancial corpora- borrowing rates than investment-grade tions during the first quarter. Moreover, firms enjoyed. A substantial portion of by issuing bonds and paying down the proceeds of recent bond issues have short-term debt, businesses have sub- been slated to pay down commercial stantially lengthened the overall matu- paper and commercial and industrial rity of their debt, thus reducing their (C&I) loans, and each of those com- near-term repayment obligations. These ponents contracted markedly during the developments, together with higher first half of the year. Another factor profitability, have helped most measures contributing to the weakening in of corporate credit performance to demand for C&I loans this year was the improve this year. The number of rat- absence of merger and acquisition activ- ings downgrades continued to exceed ity, according to the Federal Reserve’s upgrades but by a notably smaller mar- Monetary Policy Report of July 2003 43 gin than last year. The six-month trail- to refinance at lower interest rates; they ing bond default rate declined consider- also mentioned that the many borrow- ably in the first half of the year. The ers with substantial equity positions in four-quarter moving average of recov- the mortgaged properties have an extra ery rates on defaulted bonds improved incentive to remain current. Banks also a bit in the first quarter, although it pointed to their having tightened lend- remained at the low end of its range of ing standards and terms, including the past several years. The delinquency maximum loan-to-value ratios, well in rate on C&I loans at commercial banks advance of the current downturn. also moved down some in the first quar- In line with the assessment that, to ter, albeit to a level well above that of date, credit quality in the sector remains the late 1990s. good, spreads on CMBS over Treasuries have remained in the lower half of the Commercial Real Estate ranges observed over the past few years. Market reports indicate that CMBS issu- The growth of debt backed by commer- ers generally have had access to terror- cial real estate remained robust this year ism insurance for the underlying proper- despite some deterioration in that sec- ties, and the cost of that insurance has tor’s underlying fundamentals. In the come down significantly. In addition, first quarter of 2003, the expansion of newly formed pools that include high- debt was driven by lending at commer- profile properties reportedly have been cial banks and was spread about equally diversified to further protect investors across broadly defined types of commer- from losses due to acts of terrorism. cial real estate loans. Although the issu- ance of commercial-mortgage-backed securities (CMBS) slowed somewhat in The Government Sector the first quarter from the rapid pace of Federal Government the second half of last year, issuance appears to have rebounded strongly in The federal budget deficit has widened the second quarter. significantly as a consequence of the Despite continued increases in va- persistent softness in receipts and legis- cancy rates and declines in the rents lative actions affecting both spending charged for various types of commercial and taxes. Over the first eight months properties, the credit quality of commer- of the current fiscal year—October to cial mortgages has yet to show appre- May—the deficit in the unified budget ciable signs of deterioration. At com- was $292 billion, nearly $150 billion mercial banks, delinquency rates on larger than that recorded during the commercial mortgages edged up only comparable period last year. Moreover, slightly in the first quarter of 2003 from recent policy actions are projected to their historically low levels of recent boost the deficit significantly over the years. Delinquency rates on CMBS, remainder of the fiscal year. In particu- which were stable in 2002 at about the lar, receipts will be reduced appreciably midpoint of their recent range, have also by several provisions of the Jobs and risen just a bit this year. Respondents Growth Tax Relief Reconciliation Act to the April 2003 Senior Loan Officer of 2003, including advance refund Opinion Survey attributed the resiliency checks for the 2003 increment to the of the credit quality of commercial real child tax credit, downward adjustments estate loans in part to borrowers’ ability to withholding schedules for individual 44 90th Annual Report, 2003 taxpayers, and the sweetening of the sensitive to capital income, dropped partial-expensing investment incentive sharply. This spring’s net final pay- for businesses. In addition, outlays will ments, which are largely payments on be boosted by the supplemental appro- the previous year’s liabilities, were priations for defense and foreign aid and exceptionally soft for a second year in by additional grants to the states. If the a row; in combination with the infor- latest projection from the Congressional mation on withheld and estimated Budget Office is realized, the unified payments, they imply that individual lia- deficit will increase from $158 billion in bilities continued to shrink as a percent- fiscal 2002 to more than $400 billion in age of the NIPA tax base in 2002. The fiscal 2003. substantial drop in the ratio of liabilities The deterioration in the unified bud- to NIPA income over the past couple get has been mirrored in a sharp down- of years reflects in part a reversal of swing in federal saving—essentially, the the capital gains bonanza of the late unified surplus or deficit adjusted to 1990s and the tax reductions enacted in conform to the accounting practices fol- 2001. (Capital gains are not included in lowed in the national income and prod- the NIPA income measure, which, by uct accounts (NIPA). Indeed, net federal design, includes only income from cur- saving, which accounts for the depre- rent production.) In addition, the change ciation of government capital, fell from in the distribution of income in the late a high of a positive 2 percent of GDP 1990s, which concentrated more income in 2000 to a negative 21⁄2 percent of in the upper tax brackets, may have been GDP in the first quarter of 2003. With reversed some during the past couple of little change, on balance, in nonfederal years. domestic saving over this period, the Federal spending during the first eight downswing in federal saving showed months of fiscal year 2003 was 61⁄2 per- through into net national saving, which cent higher than during the same period was equal to less than 1 percent of GDP last year; excluding the drop in net inter- in the first quarter, compared with the est outlays, spending was more than recent high of 61⁄2 percent of GDP in 71⁄2 percent higher. Spurred by the war 1998. If not reversed over the longer in Iraq, defense spending has moved up haul, such low levels of national saving another 15 percent thus far this year; could eventually impinge on the forma- outlays for homeland security have tion of private capital that contributed to risen briskly as well. Expenditures the improved productivity performance for income security programs, which of the past half-decade. include the temporary extended unem- Federal receipts in the first eight ployment compensation program, also months of the current fiscal year were have risen at a fairly rapid rate. Though nearly 3 percent lower than during the growth in spending on Medicare and comparable period of fiscal 2002 after Medicaid, taken together, has slowed a adjusting for some shifts in the timing of bit this year, the rising cost and utili- payments during the fall of 2001. Indi- zation of medical care continue to put vidual receipts were especially weak: upward pressure on these programs. Although withheld taxes, which tend to Expenditures for consumption and move in line with wages and salaries, gross investment, the part of federal held up fairly well (after adjusting for spending that is included in GDP, rose changes in tax law) during this period, just slightly in real terms in the first nonwithheld payments, which are more quarter as a sizable increase in non- Monetary Policy Report of July 2003 45 defense purchases was nearly offset by able budgetary surpluses in the late a surprising decline in defense spending. 1990s and now face large deficits. After The dip in defense spending followed having enacted a series of tax reductions several quarters of large increases; with in the second half of the 1990s, they the supplemental appropriation in place, subsequently saw their receipts eroded defense spending in the second quar- by weak incomes and the falling stock ter appears to have resumed its rapid market. At the same time, these enti- growth. ties boosted their outlays considerably, Federal debt held by the public in large part because of rising health advanced at a 21⁄4 percent annual rate care costs and increased demands for in the first quarter and remained at just security-related spending. The fiscal below 35 percent of nominal GDP. Dur- difficulties have been especially acute at ing the first half of the year, the Trea- the state level. And although local gov- sury announced several changes in its ernments generally have fared some- debt management, including the reintro- what better, many are now facing reduc- duction of three-year notes and regular tions in assistance from cash-strapped reopenings of certain five-year and ten- states. According to the NIPA, the state year notes, to position itself better to and local sector’s aggregate current defi- address the widening federal deficit. cit rose to about $50 billion in 2002—or These steps have the consequences of 1⁄2 percent of GDP, the largest annual lengthening the average maturity of its deficit relative to GDP on record—and outstanding debt and trimming the size that gap exceeded $65 billion at an of some of its auctions. The Treasury annual rate in the first quarter of 2003. also noted that it would be increasing Almost all states and most localities the frequency and size of its auctions of are subject to balanced budget and other inflation-indexed securities. statutory rules that force them to address Beginning in February 2003, the fiscal imbalances. These rules typically Treasury needed to take steps to avoid apply to operating budgets, and govern- exceeding the level of the statutory debt ments have taken a variety of actions to ceiling and employed several account- meet their budgetary requirements for ing devices to which market participants fiscal 2003 and to pass acceptable bud- have become accustomed. It also tempo- gets for fiscal 2004, which started on rarily suspended the issuance of the type July 1 in most states and many local- of Treasury debt instrument in which ities. Strategies have included draw- the proceeds of advance refundings by ing upon accumulated reserves, issuing state and local governments are allowed bonds, and, in some cases, using one- to be invested. No adverse reaction in time measures such as moving payments financial markets was apparent during into the next fiscal year and selling this period, however, and a bill increas- assets. Increases in taxes and fees also ing the debt ceiling $984 billion, to have become more widespread. Still, $7.384 trillion, was enacted on May 23. spending restraint has remained an important component of the adjustment. Governments—especially at the state State and Local Governments level—have held the line on hiring and On the whole, the budget situation at have limited their outlays for a variety state and local governments remains of other goods and services. In the grim. Like the federal government, NIPA, real expenditures for consump- states and localities were running siz- tion and gross investment in the state 46 90th Annual Report, 2003

and local sector rose only 1⁄2 percent imports rose more than that of exports. over the year ending in the first quar- U.S. net investment income registered a ter, compared with increases averaging $16 billion surplus in the first quarter, more than 31⁄2 percent per year over little changed from the previous quarter the preceding five years. Available data but significantly larger than the outcome point to continued softness in such for last year as a whole. The increase spending in the second quarter. over last year is attributable primarily The pace of gross issuance of munici- to lower net interest and dividend pay- pal bonds remained robust in the first ments. Net unilateral transfers and other half of the year; it was fueled in part by income were a negative $74 billion, the needs of state and local governments down from a negative $67 billion in the to finance capital spending, which is not fourth quarter. subject to balanced budget requirements. Real exports of goods and services Long-term debt issuance was heavily fell 11⁄4 percent at an annual rate in the used for new education and transpor- first quarter; this decline, like that in the tation projects. Declining yields on previous quarter, reflected in part slow municipal debt and high short-term bor- economic growth of our major trading rowing demands also provided impor- partners. Within this total, exports of tant impetus to debt issuance. Despite goods increased nearly 2 percent after continued fiscal pressures on many state declining sharply in the fourth quarter and local governments, the credit qual- of last year. Moderate increases in most ity of municipal bonds has shown some trade categories were partly offset by a signs of stabilizing. Although the spread decrease in exports of capital goods of BBB-rated over AAA-rated munici- (particularly aircraft and computers). pal bond yields has widened somewhat, Meanwhile, real exports of services the number of municipal bond upgrades declined about 8 percent in the first by S&P has slightly exceeded the num- quarter, mainly because of a drop in ber of downgrades so far this year. The receipts from foreign travelers. Prices of yields on municipal bonds declined exported goods and services, which rose more slowly than the yields on Trea- nearly 4 percent at an annual rate in the sury securities of comparable maturity first quarter, were boosted by rising over much of the first half of the year; prices of services and industrial sup- these moves lowered the yield differen- plies (mainly goods with a high energy tial from the tax-advantaged status of component). Prices of exported capital municipal securities. goods, automotive products, and con- sumer goods showed little change in the first quarter. The External Sector U.S. real imports of goods and ser- 1 Trade and the Current Account vices declined 6 ⁄4 percent at an annual rate in the first quarter following four In the first quarter of 2003, the U.S. quarters of increases. Imports of oil, current account deficit amounted to other industrial supplies, aircraft, and $544 billion at an annual rate, or about services (primarily U.S. travel abroad) 5 percent of GDP, a somewhat higher all dropped sharply. Imports of auto- percentage than in any quarter of last motive products decreased for the sec- year. The deficit on trade in goods and ond consecutive quarter, but imports of services widened $22 billion in the first machinery and consumer goods rose. quarter, to $486 billion, as the value of The price of imported goods jumped Monetary Policy Report of July 2003 47

12 percent at an annual rate in the first in response to downward pressures on quarter, mainly resulting from spikes in the foreign exchange value of the dollar. the prices of natural gas and oil. The U.S. residents, who had sold foreign price of imported goods excluding fuels securities on net last year, recorded siz- rose about 2 percent in the first quarter, able net purchases in the first quarter of the fourth consecutive quarter of small this year: Relatively large purchases of increases, in part because of the depre- foreign equities outweighed further sales ciation of the dollar since early 2002. of bonds. Slight declines in prices of imported Direct investment into the United capital goods, automotive products, and States, after being restrained in 2002 consumer goods were offset by small by a slowdown of global mergers and increases in other categories. acquisitions, picked up in the first quar- The spot price of West Texas inter- ter of 2003, as merger activity resumed. mediate crude oil rose to a twelve-year U.S. direct investment abroad was high of nearly $38 per barrel in mid- steady in 2002 and the first quarter of March as the United States moved closer 2003. to war in Iraq and as a nationwide strike slowed Venezuelan oil production to a trickle. With the commencement of The Labor Market military action in Iraq and the relatively rapid conclusion of the war, prices fell Employment and Unemployment to less than $26 per barrel by late April. Downward pressure on prices was also The demand for labor has weakened fur- exerted by increased production from ther this year, though the pace of job some OPEC countries, particularly losses appears to have slowed some- Saudi Arabia, Kuwait, and Venezuela, what. After having fallen an average of where oil production recovered substan- 55,000 per month in 2002, private pay- tially relative to the first quarter. In early roll employment declined 35,000 per June, oil prices moved back above $30 month, on average, in the first quarter of per barrel after it became apparent that 2003 and 21,000 per month in the sec- Iraqi exports of oil would return more ond quarter. The civilian unemployment slowly than market participants had pre- rate, which had been fluctuating around viously expected. 53⁄4 percent since late 2001, was little changed in the first quarter but moved up in the spring. In June, it stood at The Financial Account 6.4 percent. The U.S. current account deficit con- The manufacturing sector has contin- tinued to be financed in large part by ued to shed jobs this year. On average, private flows into U.S. bonds and by factory payrolls fell 55,000 per month foreign official inflows. Private for- over the first half of 2003—essentially eign purchases of U.S. securities, which as fast as over 2002 as a whole. Employ- slowed in the latter part of 2002, stepped ment declines were widespread, but down a bit more in the first quarter of the metals, machinery, and computers 2003, owing in part to weaker demand and electronics industries continued to for U.S. equities. In contrast, inflows be especially hard hit. The weakness in into the United States from official manufacturing also cut into employment sources, which surged in 2002, picked at help-supply firms and at wholesale up further in the first half of 2003 partly trade establishments, although help- 48 90th Annual Report, 2003 supply jobs increased noticeably in May demand. According to the currently pub- and June. lished data, output per hour worked in Apart from manufacturing and related the nonfarm business sector rose at an industries, private employment in- annual rate of 2 percent in the first quar- creased slightly, on net, in the first half ter and 21⁄2 percent over the four quar- after having been about unchanged in ters ending in the first quarter. Though 2002. Employment in the financial the recent gains are down from the very activities sector rose briskly, in part rapid increases in late 2001 and 2002, because of the boom in mortgage refi- they are similar to those achieved in nancings. Construction employment, the second half of the 1990s. However, which had been essentially unchanged, whereas the earlier productivity gains on net, since 1999, remained soft in the were driven importantly by an expan- first quarter but posted a sizable gain sion of the capital stock, the recent gains in the second quarter. Employment in appear to have come mainly from the information sector, which includes efficiency-enhancing changes in organi- telecommunications, publishing, and zational structures and better use of the Internet-related services, continued to capital already in place. decrease, though a shade less rapidly The employment cost index (ECI) for than over the preceding two years. private nonfarm businesses increased Demand for workers in retail trade, lei- about 33⁄4 percent over the twelve sure and hospitality, and transportation months ending in March—only a shade and utilities remained lackluster. less than over the preceding year but The unemployment rate was little more than 1⁄2 percentage point below the changed in the first quarter, but it subse- increases of a few years earlier. The quently turned up. In June, it stood at deceleration in hourly compensation 6.4 percent, 1⁄2 percentage point higher over the past few years has been concen- than the average in the fourth quarter of trated in wages, for which gains slowed 2002 and about 21⁄2 percentage points from about 4 percent per year in 2000 above the lows reached in 2000. The and 2001 to 3 percent over the year rise in the unemployment rate over the ending this March. The slowing in wage spring was chiefly driven by the ongo- growth primarily reflects the effects of ing softness in labor demand. Most the soft labor market and lower rates of recently, it also coincided with an uptick price inflation; in addition, employers in labor force participation. That uptick may be exerting more restraint on wages notwithstanding, the participation rate to offset some of the upward pressure on has trended down over the past couple total compensation from rising benefit of years, a slide mainly reflecting costs. The increase in benefits was espe- declines for adult men and younger cially sharp in the first quarter of 2003; persons. in that period, employers stepped up their contributions to defined-benefit Productivity and Labor Costs retirement plans in response to declines in the market value of plan assets, and Labor productivity has continued to post health insurance costs continued to solid gains in recent quarters as busi- increase rapidly. In total, benefit costs nesses have remained reluctant to rose 6 percent over the year ending in expand their payrolls and instead have March. focused on cutting costs in an envi- The growth in compensation per hour ronment of sluggish—and uncertain— in the nonfarm business sector—an Monetary Policy Report of July 2003 49 alternative measure of hourly compen- sure had been considerably higher sation based on the NIPA—has swung earlier in the year, when energy prices widely in recent years. Fluctuations in were rising, and it is difficult to know the value of stock option exercises, whether the decline of late was driven which are excluded from the ECI, likely chiefly by the retreat in energy prices have contributed importantly to these during the spring. Non-oil import prices swings. In any event, the increase in this posted a sizable increase in the first measure over the year ending in the first quarter after having been little changed quarter was 31⁄4 percent and roughly in in 2002, but the first-quarter rise was line with the rise indicated by the ECI. due largely to a spike in the price of imported natural gas, which should not have much effect on core consumer Prices price inflation. Given the decline in the Headline inflation numbers have been dollar from its peak in early 2002, non- heavily influenced by movements in oil import prices will probably trend up energy prices, but underlying inflation modestly in coming quarters. has remained subdued and according to PCE energy prices rose sharply in the some measures has even moved some- first quarter but turned down in the what lower. Reflecting the surge in spring, a pattern largely mirroring the energy prices, the chain-type price index swings in crude oil prices. Gasoline for personal consumption expenditures prices, which had already been elevated (PCE) increased at an annual rate of in late 2002 by weather-related supply 23⁄4 percent in the first quarter, about disruptions, increased further early this 1 percentage point faster than the year as crude oil costs rose and whole- increase over 2002 as a whole; this sale margins remained large; by June 1, index moved down in April and May as gasoline prices had reversed that energy prices retreated. PCE prices increase, and they have changed little, excluding food and energy—the so- on net, since that time. Natural gas called core PCE price index—were prices also soared in early 2003 as nearly unchanged during the spring, and tight inventories were depleted further the twelve-month change in this series by unusually cold weather; since the stood at 11⁄4 percent in May, compared unwinding of February’s dramatic spike, with a reading of 13⁄4 percent over the prices have held in a narrow range. preceding twelve months. Inventories of natural gas have increased In the main, the quiescence of under- significantly of late, but they are still lying inflation reflects continued slack low enough to raise concerns about the in labor and product markets and the possibility of future price spikes in the robust productivity gains of recent event of a heat wave later this summer years. In addition, inflation expectations or an unusually cold winter. Reflecting have remained in check—and, indeed, the higher natural gas input costs, PCE may have subsided a bit further. For electricity prices rose substantially over example, according to the Michigan the first five months of 2003 after hav- Survey Research Center, the median ing fallen some in 2002. expectation for inflation over the com- Increases in core consumer prices of ing year was running about 2 percent in both goods and services have slowed May and June, compared with 21⁄2 per- over the past year, with the deceleration cent to 3 percent over much of the pre- most pronounced for goods. Prices for ceding few years. Readings on this mea- core PCE goods fell 21⁄4 percent over 50 90th Annual Report, 2003 the year ending in May after having Alternative Measures of Price Change decreased 1 percent over the preceding Percent twelve months. Meanwhile, the rise in 2001 2002 prices for non-energy services totaled Price measure to to 23⁄4 percent over the year ending in May, 2002 2003 a little less than over the preceding Chain-type period. Among the major types of ser- Gross domestic product ...... 1.4 1.6 vices, the price of owner-occupied hous- Gross domestic purchases ...... 8 2.3 Personal consumption ing was up only 21⁄2 percent after having expenditures ...... 9 2.2 1 4 Excluding food and energy . . . 1.5 1.5 risen 4 ⁄ percent over the preceding Chained CPI ...... 9 2.5 period. But prices for some other types Excluding food and energy . . . 1.9 1.4 of services accelerated. Most notably, Fixed-weight the prices of financial services provided Consumer price index ...... 1.3 2.9 by banks without explicit charge turned Excluding food and energy . . . 2.5 1.8 up after having decreased over the pre- Note. Changes are based on quarterly averages and ceding two years; because these prices are measured from Q1 to Q1. cannot be derived from market transac- tions and thus must be imputed, they are difficult to measure and tend to be vola- in this category in 2001 and 2002 tended tile from year to year. to lift the CPI relative to the PCE Increases in the core consumer price index. index (CPI) also have been very small Broader price measures likewise point recently, and the twelve-month change to low inflation over the year ending in in this measure slowed from 21⁄2 percent the first quarter. In particular, the chain- in May 2002 to 11⁄2 percent in May type price index for GDP rose only 2003—a somewhat greater deceleration 11⁄2 percent over that period, about than in core PCE prices. The greater the same as during the comparable deceleration in the CPI is primarily period four quarters earlier. Meanwhile, accounted for by its narrower scope and the price index for gross domestic different weighting structure than the purchases—which is defined as the PCE measure. In particular, it excludes prices paid for consumption, investment, the imputed prices of financial services and government purchases—increased rendered without explicit charge as well 21⁄4 percent, up from 3⁄4 percent during as several other categories for which the preceding period. The upswing market prices are not available; these mainly reflects the effect of higher non-market-based prices have acceler- energy prices and roughly matches the ated notably recently. In fact, when the acceleration in total PCE prices; the nonmarket categories are stripped from price indexes for construction and gov- the core PCE index, the remaining com- ernment purchases also recorded some- ponents show a deceleration close to what larger increases than they had over that in the core CPI. Another consider- the preceding period. ation is that housing costs have a much larger weight in the CPI than in the PCE index, partly because of the CPI’s nar- U.S. Financial Markets rower coverage. Thus, the smaller price On balance, major stock indexes have increases for housing services of late climbed noticeably this year, govern- have a bigger damping effect on core ment and corporate interest rates have CPI inflation, just as the hefty increases declined, and risk spreads, which had Monetary Policy Report of July 2003 51 dropped significantly late last year, have grade bonds rose a bit, on balance, fallen further. between mid-January and mid-March, a move that left their risk spreads higher Before the War in Iraq as well. The year began on an optimistic note in After the War in Iraq financial markets, in part owing to the release of a surprisingly strong report Once it became clear that military action from the Institute for Supply Manage- in Iraq was imminent, a robust rally ment and the announcement of a larger- erupted in both the equity and bond than-expected package of proposed tax markets, as some of the uncertainties cuts, which included elimination of the apparently dissipated and investors personal federal income tax on many began to show a greater appetite for corporate dividend payments. In addi- riskier assets. Equity indexes jumped tion, yields and risk spreads on corpo- about 8 percent in the two weeks rate bonds had dropped significantly bracketing the President’s ultimatum to in the fourth quarter of 2002, partly in Saddam Hussein, and prices climbed an reaction to the absence of new reve- additional 3 percent through the end of lations of accounting irregularities and April, partly on the release of generally to the improved outlook for corporate better-than-expected earnings reports for credit quality. Money market futures the first quarter. Gains in share prices rates apparently embedded an expec- were fairly widespread and included tation that the FOMC would begin technology, defense, petroleum, and increasing the federal funds rate as early especially financial companies. as mid-summer 2003. The easing of tensions also put That short burst of optimism was upward pressure on Treasury yields, quickly damped by subsequent eco- but additional disappointing economic nomic reports that were decidedly less data offset the diminished safe-haven rosy, a jump in oil prices in response to demands and left those rates down, on the looming prospect of war in Iraq, and balance, during the period covering the increased tensions with North Korea. war in Iraq and its immediate aftermath. Measures of uncertainty, such as implied Yields on corporate bonds also declined, volatility, moved up in several markets. in part because of strengthened cor- Major equity indexes slid and by mid- porate balance sheets, the reduction in March were off about 4 percent to 9 per- uncertainty, and perhaps because inves- cent from the beginning of the year. tors began to search for higher returns. Investors also came to believe that the Moreover, according to one widely used onset of FOMC tightening would occur measure, spreads on speculative-grade later than they had earlier believed, a bonds tumbled about 150 basis points, shift in perception that was reflected in to about 520 basis points, from mid- lower yields on Treasury bonds. Yields March until mid-May, and then fluc- on investment-grade corporate bonds tuated somewhat before ending June fell about in line with those on Treasur- near that level. The rally in below- ies, and investors appeared to be substi- investment-grade bonds was particularly tuting high-quality bonds for equities evident in sectors that had previously as part of a broader flight to fixed- experienced some of the greatest widen- income securities over this period. By ing of spreads—telecom, energy trad- contrast, yields on below-investment- ing, and utilities; the interest in these 52 90th Annual Report, 2003 sectors further indicated investors’ in- suries over the same period, but yields creased appetite for risk. on speculative-grade bonds edged up A stubbornly sluggish economy and only slightly, and risk spreads nar- rapid growth of productivity muted both rowed further. Forward-looking eco- inflation and inflation expectations, nomic indicators were generally posi- inducing the FOMC to begin pointing to tive, and stock price indexes—the a further substantial decline in inflation Nasdaq, in particular—continued to as a concern at its May meeting. Market trend higher. participants took this to imply that short- On net, the constant-maturity yield on term rates would be held along a lower the two-year Treasury note has fallen path for longer than they had previously 24 basis points this year, to 1.37 per- expected. This shift in expectations trig- cent as of July 9, while the yield on gered a further decline in intermediate- the ten-year Treasury bond has fallen and long-term yields. With long-term 10 basis points, to 3.73 percent. Over inflation expectations apparently only the same period, the Wilshire 5000 is up little changed, the decline in yields 151⁄2 percent, and the Nasdaq has surged translated into a sizable decline in real more than 30 percent. As a result of the interest rates. decline in real interest rates, the spread That drop in real interest rates was between the twelve-month forward among several factors providing a boost earningsÐprice ratio for the S&P 500 to equity prices in May and June. and the real ten-year yield remains wide Implied volatility of the S&P 100 index, despite the run-up in stock prices. which had been elevated earlier in the year, fell substantially with the conclu- Shorter-Term Debt Markets sion of major hostilities in Iraq; it is now near the bottom of its range of the past The average interest rate on commercial several years. Moreover, downward and industrial loan originations—a sub- revisions to analysts’ earnings expecta- stantial majority of which have adjust- tions for the year ahead have been the able interest rates—has fallen to its low- smallest since early 2000. The tax pack- est level since the start of the Federal age passed in late May, which included Reserve’s Survey of Terms of Business a cut in taxes on capital gains and divi- Lending in 1977. The survey also indi- dends, may have provided some addi- cates that risk spreads on these loans tional impetus to equity prices. receded a bit over the first half of 2003 The FOMC decided on June 25 to after having trended up for most of the reduce the target federal funds rate past several years. Prices in the second- 25 basis points, to 1 percent, but some ary loan market have risen this year, observers had been anticipating a cut of reportedly in part because some of the 50 basis points. In addition, markets large inflows to high-yield mutual funds appeared to read the Committee’s were used to purchase distressed loans assessment of economic prospects as and because of the expectation that more upbeat than expected. Partly as a many outstanding loans would continue result, yields on longer-dated Treasury to be prepaid with the proceeds of bond securities reversed a portion of their pre- refinancing. vious decline in the weeks following the Interest rates on commercial paper meeting. Yields on high-quality corpo- also dropped to very low levels in the rate bonds rose about in line with Trea- first half of 2003. Risk spreads in this Monetary Policy Report of July 2003 53 market were relatively stable and near some time now in the Senior Loan Offi- the bottom of the range observed over cer Opinion Survey. On a seasonally the past several years, in part because adjusted basis, the ratio of loan-loss pro- of businesses’ efforts to strengthen visions to assets declined in the final their balance sheets and improve their quarter of last year, and it was about liquidity. unchanged from that still-elevated level in the first quarter of 2003. In addi- tion to the buffer against future losses Debt and Financial Intermediation provided by their high profitability The debt of all domestic nonfinancial and substantial provisions, virtually all sectors—government, businesses, and banks—98 percent by assets—remain households—grew at a 61⁄2 percent well capitalized. annual rate in the first quarter, down Among nondepository financial insti- from 8 percent in the fourth quarter of tutions, issuers of asset-backed securi- 2002 but still well in excess of the ties provided about 13 percent of the growth of nominal GDP. The proportion total credit extended to domestic non- of the new credit supplied by depository financial sectors in the first quarter. The institutions rose significantly in the sec- share of net lending supplied by mutual ond half of last year and remained at funds increased notably to almost about 25 percent in the first half of this 10 percent in the first quarter, and with year. In large part, the jump reflects the the continuation of strong flows to bond sector’s support of the booming mort- mutual funds, they likely were large gage market—through both direct lend- suppliers in the second quarter as well. ing and the acquisition of mortgage- Meanwhile, available data suggest that backed securities—which has more than insurance companies likely accounted offset weak business lending. At com- for about 7 percent of total credit mercial banks, revenues from mortgage- extended during the first half of the year, related activities reportedly helped sus- a proportion near the top of the range tain profits in the first quarter at the seen since the mid-1990s. elevated levels of the past several years Government-sponsored enterprises despite some erosion in net interest (GSEs) provided 11 percent of the net margins. lending (net acquisition of credit market The delinquency rate on all loans and instruments) in the first quarter, an leases at banks edged down further dur- amount roughly in line with their level ing the first quarter, to its lowest level in the second half of 2002. The dura- in two years. Increases in the delin- tion gaps in the portfolios of the hous- quency rates on commercial real estate ing GSEs were maintained near their loans and non-credit-card consumer targets. In early June, Freddie Mac loans were offset by declines in those on replaced its top three executives amid residential real estate loans, credit card questions about its accounting practices. loans, and business loans. For business The spreads on longer-term Freddie Mac and credit card loans, however, the debt widened a bit, and its stock price delinquency rates at banks remain ele- declined sharply; the prices of Fannie vated, and the recent improvement Mae securities also declined but to a likely reflects, in part, the effect of lesser extent. On net, there appears to be the tightening of lending standards little, if any, spillover into broader finan- and terms that has been reported for cial markets. 54 90th Annual Report, 2003

Monetary Aggregates output in the euro area and Japan little changed from the previous quarter. Geo- Through the first half of 2003, the political uncertainties, higher oil prices, growth rate of M2 was buoyed by slow growth in the United States, per- several factors and remained elevated. sistent weakness in global high-tech The rising level of mortgage refinanc- sectors, and continued negative wealth ing causes money growth to accelerate effects from past declines in equity because the associated prepayments on prices all weighed on foreign growth. mortgage-backed securities that are Foreign economic expansion appeared temporarily held in escrow accounts to remain weak in the second quarter increase liquid deposits. Demand for M2 despite the reduction in uncertainty was also supported by the decline in associated with Iraq. Indicators suggest short-term market interest rates, which that manufacturing activity abroad has further reduced the opportunity cost of not picked up; instead, industrial pro- holding money. Precautionary demand duction declined in April and May, on for safe and liquid M2 assets also likely average, relative to the first quarter in buttressed the growth of M2 in the Japan, Germany, and France. Concerns run-up to the war in Iraq. over the spread of the SARS virus In contrast, mutual fund flows related appear to have hurt growth in the second to the bond market rally and the post- quarter in several Asian developing war pickup in the stock market may economies and in Canada. have siphoned funds from M2. Retail Central banks in several major for- money market mutual funds and small eign industrial countries moved to ease time deposits both experienced net out- monetary policy during the first half flows during the first half of the year. of this year. The European Central Bank While some of that money continued to and the central banks of the United feed the extraordinary growth of liquid Kingdom, Sweden, Switzerland, Nor- deposits, it is likely that a portion was way, and New Zealand all cut official redirected to long-term mutual funds. interest rates. The pace of monetary eas- After having weakened significantly ing in Europe picked up toward mid- in 2002, growth of M3 slowed further year, when inflation pressures dissipated in the first half of 2003. Much of this amid growing slack, currency apprecia- year’s slowdown can be attributed to tion vis-a`-vis the dollar, and the decline rapid runoffs of institutional money mar- in oil prices after the conflict in Iraq. ket mutual funds. The runoffs were, in In contrast, the Bank of Canada raised turn, partially the result of an unwinding interest rates twice in the spring, in a of the strength late last year and the fact continued effort to contain inflation. The that interest rates paid by those funds Bank of Canada left rates unchanged in declined faster than the interest rates June, however, in response to a sharp paid by the underlying assets this year. appreciation of the Canadian dollar and The drop in institutional money funds a drop in Canadian inflation in April, has been offset by growth in eurodollar some slackening of demand in labor deposits and repurchase agreements. markets in May, and concerns about the pace of activity in the United States. International Developments The Bank of Japan (BOJ) maintained short-term interest rates at near-zero lev- Economic activity abroad was sluggish els, further expanded its target for cur- in the first quarter of 2003, with real rent account balances held by financial Monetary Policy Report of July 2003 55 institutions at the BOJ, and took some cerns appeared to abate. After the reso- additional measures to add stimulus to lution in April of major hostilities, the the economy. dollar fell further, and market commen- In the first quarter, foreign financial tary focused more on the financing markets were influenced by heightened needs posed by the large and growing anxieties ahead of the war in Iraq, but U.S. current account deficit. those concerns appeared to diminish as the war proceeded. Foreign equity prices Industrial Economies declined in the first quarter, but they have since recovered. Broad stock The euro-area economy stagnated in the indexes for the major industrial coun- first quarter of 2003. Consumer spend- tries are up on balance since the begin- ing continued to expand at a modest ning of the year but, with the exception rate and inventory investment grew, but of Japan, they have gained less than in business fixed investment fell sharply the United States. Long-term interest and exports declined. The German econ- rates in most foreign industrial coun- omy contracted in the first quarter and tries fell during the first half of the year continued to underperform the euro-area because prospects for inflation dimin- average, in part owing to a fiscal tight- ished, growth sputtered, and market par- ening undertaken to bring the budget ticipants began to expect that policy deficit into line with limits set out in the interest rates would remain low for an euro area’s Stability and Growth Pact. extended period. Asset prices in emerg- The rise in the exchange value of the ing markets, particularly in Latin euro over the past year has begun to America, picked up during the first half hurt euro-area manufacturers; exports of this year; equity prices rose signifi- have leveled off while imports have con- cantly, and risk spreads on emerging- tinued to rise. Recent indicators have market bonds narrowed. Bonds issued shown little rebound in the pace of euro- by a number of emerging-market econo- area activity following the conclusion of mies included collective action clauses the Iraq war, and business and consumer (CACs) that are designed to facilitate sentiment have remained sour. Core a debt restructuring in the event of inflation has slowed from its 2002 peak, default; this development had little and headline inflation, which was tem- noticeable effect on spreads. porarily boosted by oil prices, recently The dollar’s foreign exchange value has fallen to the 2 percent upper limit of continued to decrease in the first half of the ECB’s definition of price stability. 2003. Since the end of 2002, the dollar Economic growth in the United has depreciated on a trade-weighted Kingdom slowed to a crawl in the first basis nearly 5 percent against the curren- quarter, but recent indicators—such as cies of a broad group of U.S. trading consumer confidence and industrial partners. The dollar has declined 13 per- production—suggest that the pace has cent against the Canadian dollar and been somewhat stronger during the past more than 7 percent on net against the few months. Growth of consumption has euro but has fallen less than 1 percent slowed but continues to be held up by a versus the Japanese yen. During the first strong labor market and by past gains in quarter, the dollar appeared to react to housing prices, although lately these concerns about the war in Iraq, falling prices have decelerated. when news indicated a heightened risk The Japanese economy barely grew of hostilities and strengthening as con- in the first quarter after expanding 56 90th Annual Report, 2003

almost 21⁄2 percent in 2002. Business couple of months. The Hong Kong investment continued to grow in the economy also contracted, following first quarter, and private consumption strong growth in the second half of last increased despite stagnating incomes; year. The SARS outbreak held down however, residential and public invest- both personal consumption and tourism ment both fell sharply, and exports in the first quarter, and even more nega- declined because of the weak global tive effects are likely to be seen in the economy. The severity of consumer second-quarter data. Although the Chi- price deflation lessened somewhat, nese economy has also been adversely partly because of the spike in energy affected by SARS, it has been sustained prices. Japanese banks continued to be by strong export growth and investment. weighed down by bad loans. Chinese inflation has moved back into Canada’s economy maintained a positive territory on a twelve-month moderate pace of expansion in the first basis, largely owing to higher prices for quarter, but recent indicators suggest energy and food. that growth of real GDP slowed in the The Mexican economy contracted in second quarter. First-quarter growth was the first quarter, and exports and busi- supported by continued strength in ness confidence have declined in recent domestic demand, as Canada’s strong months. Consumer price inflation has labor and housing markets kept propel- come down recently, a decline helped in ling the economy. However, exports part by the net appreciation of the Mexi- declined in the first quarter, largely can peso since early March. Measures of because of a drop in exports of indus- inflation expectations suggest that mar- trial supplies and forestry products ket participants expect the central bank to the United States. More recently, to come close to achieving its inflation employment declined slightly in April target this year. and May, and the unemployment rate Brazilian economic growth stagnated moved up. The outbreak of the SARS in the first quarter largely as a result of virus in Toronto hurt Canadian travel the tightening of macroeconomic poli- and tourism, and weak U.S. demand cies in response to the financial crisis slowed the Canadian manufacturing sec- that erupted in mid-2002. The growth tor. In June, employment rebounded, but slowdown largely reflected a continued the gain was almost all in part-time weakening in domestic demand, but work, and manufacturing employment exports also deteriorated. Monthly infla- continued to fall. tion has come down since early this year, and Brazil’s central bank recently Emerging-Market Economies lowered slightly its benchmark interest rate. The Lula administration’s efforts Economic growth in the Asian develop- to implement social security and tax ing countries slowed in the first quarter, reforms have bolstered investor confi- brought down by weakness in business dence. Financial conditions in Brazil investment and consumer spending. In have improved markedly: Equity prices South Korea, growth of real GDP turned have risen more than 20 percent so far negative in the first quarter after a rapid this year, the real has gained more than expansion in 2002. Tensions with North 20 percent against the U.S. dollar, and Korea contributed to a decline in con- credit spreads on Brazilian government sumer and business sentiment, but these debt have narrowed more than 600 basis indicators have stabilized in the past points. Monetary Policy Report of July 2003 57

The Argentine economy has started to not been addressed. The Argentine peso turn around from the sharp contraction appreciated more than 20 percent that occurred in the wake of the devalu- against the dollar during the first half of ation and default in late 2001, but the the year. In July, Argentina implemented level of economic activity remains far controls on short-term capital inflows in below pre-crisis levels, and many of an effort to stabilize the appreciating Argentina’s structural problems have currency.