Section 1

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The U.S. economy delivered a solid performance in 2005 despite a further sharp increase in energy prices and devastating hurricanes that claimed many lives, destroyed homes and businesses, and displaced more than 1 million persons. Real gross domestic product is estimated to have risen a little more than 3 percent over the four quarters of 2005 even though growth slowed significantly in the fourth quarter as a result of storm-related disruptions and other factors that are likely to prove transitory. The increase in real GDP in 2005 was sufficient to add 2 million new jobs, on net, to employers' payrolls and to further reduce slack in labor and product markets. As in 2004, overall consumer price inflation was boosted by the surge in energy prices. Core consumer price inflation (as measured by the price index for personal consumption expenditures excluding the direct effects of movements in food and energy prices) picked up early in the year, but it subsequently eased and totaled less than 2 percent over the year as a whole. The dollar appreciated against most major currencies in 2005, and, with domestic demand expanding strongly, the U.S. current account deficit widened further.

In 2005, energy prices were up substantially for a second year in a row. Crude oil costs climbed further, on net, and prices of refined petroleum products and natural gas came under additional upward pressure for a time after supplies were curtailed by hurricane damage to production facilities in the Gulf Coast region. As a result, households in the United States faced steep increases in gasoline and home heating expenses, and many firms were likewise burdened with rising energy costs.

The resilience of the U.S. economy in the face of these major shocks likely reflects, in part, improvements in energy efficiency over the past several decades. A number of other factors also helped to keep economic activity moving forward in 2005. For one, the rapid gain in real estate values in the past few years, in combination with the rise in stock prices since 2002, has encouraged households to sustain their spending through a period of relatively weak growth in real income. For another, credit conditions remained supportive for businesses last year, facilitating a brisk expansion of capital spending. In addition, labor productivity has been on a strong uptrend in recent years, which has fostered substantial growth in the economy's productive capacity and no doubt lifted households' and businesses' assessments of their long-term income prospects.

In light of elevated inflation pressures and shrinking margins of unutilized resources, and with short-term interest rates relatively low, the Federal Open Market Committee (FOMC) continued to remove monetary policy accommodation gradually in 2005, raising the target federal funds rate 25 basis points at each of its eight meetings. This cumulative policy firming of 2 percentage points was substantially greater than market participants had expected at the start of the year. But each action was anticipated by the time of the meeting at which it was taken, as the Committee's communications, policy strategy, and responses to incoming economic data appear to have been well understood. At its meeting in January 2006, the FOMC increased the target federal funds rate another 25 basis points, bringing it to 4-1/2 percent. The Committee indicated that possible increases in resource utilization as well as elevated energy prices had the potential to add to inflation pressures and that, as a result, some further policy tightening may be needed.

The U.S. economy should continue to perform well in 2006 and 2007. To be sure, higher energy prices will probably exert some restraint on activity for a while longer. But so long as energy price increases slow, as is suggested by futures prices, this restraint should diminish as 2006 progresses. In addition, economic activity should receive some impetus from post-hurricane recovery efforts. Although progress to date has been uneven in the affected regions, the reopening of facilities shut down by the hurricanes is already being reflected in a rebound in industrial production. Federal assistance will buttress rebuilding activity in coming quarters.

More broadly, the major factors that contributed to the favorable performance of the U.S. economy in 2005 remain in place. Long-term interest rates are low, and conditions in corporate credit markets are generally positive. The household sector is also in good financial shape overall and should stay so even if--as expected--the housing sector cools. In addition, the improved outlook for economic growth abroad bodes well for U.S. exports. However, the effects of the cumulative tightening in monetary policy should keep the growth in aggregate output close to that of its longer-run potential.

Core inflation is likely to remain under some upward pressure in the near term from rising costs as the pass-through of higher energy prices runs its course. But those cost pressures should wane as the year progresses. Moreover, strength in labor productivity should continue to damp business costs more generally. With little evidence to date that resource utilization has put appreciable upward pressure on prices, and with longer-run inflation expectations continuing to be well anchored, core inflation should remain contained in 2006 and 2007.

Nonetheless, significant risks attend this economic outlook. Some of the uncertainty is centered on the prospects for the housing sector. On the one hand, some observers believe that home values have moved above levels that can be supported by fundamentals and that some realignment is warranted. Such a realignment--if abrupt--could materially sap household wealth and confidence and, in turn, depress consumer spending. On the other hand, if home values continue to register outsized increases, the accompanying increment to household wealth would stimulate aggregate demand and raise resource utilization further. With the economy already operating in the neighborhood of its productive potential, this higher resource utilization would risk adding to inflation pressures. Another major source of uncertainty is the price of energy, which continues to be buffeted by concerns about future supply disruptions. Additional steep increases in the price of energy would intensify cost pressures and weigh on economic activity.

Monetary Policy, Financial Markets, and the Economy in 2005 and Early 2006

The year 2005 opened with the target federal funds rate at 2-1/4 percent, a level that Federal Reserve policymakers judged to be quite accommodative. During the first few months of the year, output appeared to be growing at a solid pace despite rising energy prices. Improving labor market conditions and favorable financing terms were providing considerable support to consumer outlays and homebuilding activity, while reasonably bright sales prospects and strong profitability were buoying business investment. Pressures on inflation appeared to be mounting, however, partly owing to increasing energy prices. Measures of inflation compensation derived from securities markets were on the rise as well. In these circumstances, the Committee firmed policy 25 basis points at both its February and March meetings and signaled that, if economic conditions progressed as anticipated, it would need to continue to remove policy accommodation gradually to keep inflation pressures contained.

In the spring, policymakers perceived some signs of softness in spending, which they attributed in part to the earlier step-up in energy prices. Nonetheless, the federal funds rate was still relatively low, and robust underlying growth in productivity was providing ongoing support to economic activity. Accordingly, the Committee anticipated some strengthening of activity, and it reduced policy accommodation further in May by lifting the target federal funds rate another quarter percentage point, to 3 percent.

In the event, the signs of softness proved transitory. Incoming data suggested that output, employment, and spending were growing moderately through midyear. Inflation expectations seemed to be well contained, but pressures on inflation remained elevated. With the stance of policy still accommodative, the Committee added another 25 basis points to the target federal funds rate at both its June and August meetings.

Subsequently, the devastation caused by Hurricane Katrina increased uncertainty about the vitality of the economic expansion in the near term. The destruction in the Gulf Coast region, the associated dislocation of economic activity--including considerable disruption of energy production--and the accompanying further boost to energy prices were expected to impose some restraint on spending, production, and employment in the near term. Although the region had been dealt a severe blow, the Committee did not see these developments as posing a more persistent threat to the overall economic expansion. Consequently, it decided to firm policy another 25 basis points at its September meeting.

Over the following weeks, the Gulf Coast region absorbed further setbacks from Hurricanes Rita and Wilma. The growth of economic activity dipped for a time--hiring slowed, consumer spending softened, and confidence declined. At the same time, however, soaring energy prices fed through to top-line consumer price inflation and pushed some survey measures of inflation expectations upward. With employment and growth expected to be supported by accommodative financial conditions, the FOMC continued the process of policy tightening at its November meeting.

By December, incoming data indicated that the overall expansion remained on track, although recovery from the damage in the hurricane-affected areas would apparently require considerable time. The Committee judged that possible increases in resource utilization as well as elevated energy prices had the potential to add to inflation pressures. Accordingly, policy was firmed another 25 basis points, bringing the target federal funds rate to 4-1/4 percent. In the accompanying statement, monetary policy was no longer characterized as "accommodative" because the federal funds rate had been boosted substantially and was now within the broad range of values that, in the judgment of the Committee, might turn out to be consistent with output remaining close to its potential. Indeed, because policy actions over the previous eighteen months had significantly reduced the degree of monetary accommodation, Committee members thought that the outlook for their near-term policy actions was becoming considerably less certain. In such an environment, policy decisions would increasingly depend on incoming data and their implications for future economic growth and inflation. Nonetheless, the Committee indicated that some further measured policy firming was likely to be needed to keep the risks to the attainment of its goals of sustainable economic growth and price stability roughly in balance.

Over the period leading up to the January 2006 meeting, incoming data on economic activity were uneven. The advance estimate of real GDP pointed to a slowing in the growth of output in the fourth quarter, but the underlying strength in consumer and business spending suggested that the economic expansion remained on solid footing. With the potential for added pressures on inflation still evident, the FOMC raised the target federal funds rate another 25 basis points, bringing its level to 4-1/2 percent. In its statement after the meeting, the Committee indicated that some further policy firming may be necessary and again noted that it would respond to changes in economic prospects as needed.

Economic Projections for 2006 and 2007

In conjunction with the FOMC meeting in January, the members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, provided economic projections for 2006 and 2007. The central tendency of the FOMC participants' forecasts for the increase in real GDP is about 3-1/2 percent over the four quarters of 2006 and 3 percent to 3-1/2 percent in 2007. The civilian unemployment rate is expected to lie between 4-3/4 percent and 5 percent in the fourth quarter of 2006 and to remain in that area in 2007. As for inflation, the FOMC participants expect that the price index for personal consumption expenditures excluding food and energy (core PCE) will rise about 2 percent in 2006 and between 1-3/4 percent and 2 percent in 2007.

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Last update: February 15, 2006