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Monetary Policy and Economic Developments 3 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 24–25 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.
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