Section 1

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The U.S. economy continued to expand at a solid pace over the first half of 2005 despite the restraint imposed on aggregate demand by a further rise in crude oil prices. Household spending trended up, propelled by rising wealth and income and by low interest rates, and business outlays received ongoing support from favorable financial conditions, rising sales, and increased profitability. Moreover, the earlier declines in the foreign exchange value of the dollar shifted some domestic and foreign demand toward U.S. producers. Overall, the economic expansion was sufficient to create jobs at roughly the same pace as in late 2004 and to lower the unemployment rate further over the first half of this year.

Higher oil prices boosted retail prices of a broad range of consumer energy products and, as a result, continued to hold up the rate of overall consumer price inflation in the first half of 2005. In addition, the rise in energy prices this year, coupled with increases in the prices of some other commodities, imported goods, and industrial materials, put upward pressure on the costs of many businesses. A portion of these costs was passed on to consumers, which contributed to a higher rate of inflation in core consumer prices (that is, total prices excluding the food and energy components, which are volatile). As measured by the price index for personal consumption expenditures excluding food and energy, core inflation increased from an annual rate of 1-1/2 percent in 2004 to about 2 percent between the fourth quarter of 2004 and May 2005. While survey measures of near- term inflation expectations have edged up this year, surveys, as well as readings from financial markets, suggest that expected inflation at longer horizons has remained contained.

With financial conditions advantageous for households and firms, a solid economic expansion in train, and some upward pressure on inflation, the Federal Open Market Committee (FOMC) continued to remove policy accommodation at a measured pace over the first half of the year, raising the intended federal funds rate an additional 1 percentage point, to 3-1/4 percent, by the end of June. At the most recent FOMC meeting, the Committee judged that policy remained accommodative. With appropriate monetary policy, however, the upside and downside risks to output and inflation were viewed as balanced, and the Committee underscored its commitment to respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

The fundamental factors that supported the U.S. economy in the first half of 2005 should continue to do so over the remainder of 2005 and in 2006. In the household sector, the combination of further gains in employment, favorable borrowing terms, and generally healthy balance sheets should keep consumer spending and residential investment on an upward path. In the business sector, expanding sales, the low cost of capital, and the replacement or upgrade of aging equipment and software should help to maintain increases in capital spending. And, although economic performance has been uneven across countries, continued growth overall in the economies of U.S. trading partners should sustain the demand for U.S. exports. In contrast, ongoing increases in imports will likely continue to subtract from the growth of U.S. gross domestic product. In addition, high energy prices remain a drag on aggregate demand both here and abroad, though this drag should lessen over time if prices for crude oil level out in line with quotes in futures markets.

Despite the upward pressure on costs and prices over the past year or so, core consumer price inflation is likely to remain contained in 2005 and 2006. Longer-run inflation expectations are still well anchored, and because businesses are adding to their stocks of capital and are continuing to find ways to use their capital and work forces more effectively, structural productivity will likely rise at a solid pace over the foreseeable future. In addition, barring a further increase in oil prices, the boost that higher energy costs have given to core inflation should wane in coming quarters, while the recent appreciation of the dollar, as well as the deceleration in global materials prices, will likely reduce the impetus to inflation from rising import prices.

Of course, substantial uncertainties surround this economic outlook. A further sharp rise in crude oil prices would have undesirable consequences for both economic activity and inflation, and the possibility that housing prices, at least in some locales, have moved above levels that can be supported by fundamentals remains a concern. As another example, if the recent surge in measured unit labor costs were to prove more persistent than currently appears likely, the outlook for inflation would be adversely affected. Economic growth and inflation will also be shaped importantly by the evolution of the imbalance in the U.S. current account.

The Conduct of Monetary Policy over the First Half of 2005

Despite increases in the federal funds rate totaling 1-1/4 percentage points in 2004, monetary policy was still judged to be accommodative at the start of 2005. At the time of the February FOMC meeting, the available information indicated that the economy had expanded at a robust pace through the end of 2004 and retained considerable momentum. Accordingly, the Committee voted to raise its target for the federal funds rate from 2-1/4 percent to 2-1/2 percent and to make minimal changes to the text of the accompanying statement. The statement reiterated that "the Committee believes that policy accommodation can be removed at a pace that is likely to be measured." Members noted, however, that this forward-looking language was clearly conditioned on economic developments and therefore would not stand in the way of either a pause or a step-up in policy firming depending on events.

By March, the data were pointing to a further solid gain in activity during the first quarter, fueled especially by continued increases in consumption expenditures and residential investment. In addition, private nonfarm payrolls were posting widespread advances, and slack in resource utilization appeared to be diminishing. The Committee voted at its March meeting to raise the federal funds rate another 25 basis points, to 2-3/4 percent. In view of the rise in prices of energy and other commodities and recent elevated readings on inflation in core consumer prices, the Committee altered the text of the policy statement to note the pickup in inflationary pressures. The Committee also decided to modify the assessment of the balance of risks to make it explicitly conditional on an assumption of "appropriate" monetary policy, so as to underscore that maintaining balanced risks would likely require continued removal of policy accommodation.

The evidence that had accumulated by the spring pointed to some moderation in the pace of activity. Retail spending flattened out for a time, likely in response to higher energy prices, and the growth of capital spending dropped back from its elevated pace of late last year. Nonetheless, with long-term interest rates still quite low and with employment and profits continuing to rise, economic activity appeared to retain considerable momentum, suggesting that the softness would be short lived. Against this backdrop, the FOMC decided to raise the federal funds rate another 25 basis points at its May meeting and to make few changes to the text of the accompanying statement.

In the weeks after the May meeting, incoming indicators supported the view that the underlying pace of activity was not faltering. The information that the Committee reviewed at the time of the June FOMC meeting showed that consumer spending and business investment had turned up, on balance, and that demand for housing continued to be strong. With economic activity remaining firm and crude oil prices ratcheting higher, the FOMC voted to raise the funds rate an additional 25 basis points, to 3- 1/4 percent, and to make only minimal changes to the text of the accompanying statement. This action brought the cumulative increase in the target federal funds rate since June 2004 to 2-1/4 percentage points.

Economic Projections for 2005 and 2006

In conjunction with the FOMC meeting at the end of June, the members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, were asked to provide economic projections for 2005 and 2006. In general, Federal Reserve policymakers expect the economy to continue to expand at a moderate pace and core inflation to remain roughly stable over this period. The central tendency of the FOMC participants' forecasts for the increase in real (that is, inflation adjusted) GDP is 3-1/2 percent over the four quarters of 2005 and 3-1/4 percent to 3-1/2 percent in 2006. The civilian unemployment rate is expected to average 5 percent in both the fourth quarter of 2005 and the fourth quarter of 2006. FOMC participants project that the chain-type price index for personal consumption expenditures excluding food and energy will increase between 1-3/4 percent and 2 percent both this year and next.

Section 2