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Board of Governors of the Federal Reserve System
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Board of Governors of the Federal Reserve System

Part 1: Overview: Monetary Policy and the Economic Outlook

Monetary Policy Report submitted to the Congress on July 21, 2010, pursuant to section 2B of the Federal Reserve Act

Economic activity expanded at a moderate pace in the first half of 2010 after picking up in the second half of 2009. Some of the increase in real gross domestic product (GDP) in the first half of the year came from a continued turn in the inventory cycle. But more broadly, activity was bolstered by ongoing stimulus from monetary and fiscal policies and generally supportive financial conditions. In the labor market, payrolls rose modestly and hours per worker increased; nevertheless, employment remained significantly below pre-recession levels and unemployment receded only slightly from its recent high. Meanwhile, consumer price inflation edged lower.

Financial markets, although volatile, generally supported economic growth in the first half of 2010. Bank credit, however, remained tight for many borrowers. Moreover, in the second quarter, uncertainty about the consequences of the fiscal pressures in a number of European countries and about the durability of the global recovery led to large declines in equity prices around the world and produced strains in some short-term funding markets. According to the projections prepared in conjunction with the June meeting of the Federal Open Market Committee (FOMC), meeting participants (members of the Board of Governors and presidents of the Federal Reserve Banks) continue to expect that economic activity will expand at a moderate rate over the second half of 2010 and in 2011. However, participants' current projections for economic growth are somewhat weaker than those prepared for the April FOMC meeting, and unemployment is expected to fall even more slowly than had been anticipated in April. Largely because of uncertainty about the implications of developments abroad, the participants also indicated somewhat greater concern about the downside risks to the economic outlook than they had at the time of the April meeting.

After rising at an annual rate of about 4 percent, on average, in the second half of 2009, U.S. real GDP increased at a rate of 2-3/4 percent in the first quarter of 2010, and available information points to another moderate gain in the second quarter. Some of the impetus to the continued recovery in economic activity during the first half of the year came from inventory investment as businesses started to rebuild stocks after the massive liquidation in the latter part of 2008 and in 2009. In addition, final sales continued to firm as personal consumption expenditures (PCE) rose and as business fixed investment was spurred by capital outlays that had been deferred during the downturn and by the need of many businesses to replace aging equipment. In the external sector, exports continued to rebound, providing impetus to domestic production, while imports were lifted by the recovery in domestic demand. On the less favorable side, outlays for nonresidential construction have declined further this year, and despite a transitory boost from the homebuyer tax credit, housing construction has continued to be weighed down by weak demand, a large inventory of distressed or vacant houses, and tight credit conditions for builders and some potential buyers. In addition, state and local governments are still cutting spending in response to ongoing fiscal pressures.

The upturn in economic activity has been accompanied by a modest improvement in labor market conditions. On average, private-sector employment rose 100,000 per month over the first half of 2010, with increases across a wide range of industries; businesses also raised their labor input by increasing hours per worker. Nonetheless, the pace of hiring to date has not been sufficient to bring about a significant reduction in the unemployment rate, which averaged 9-3/4 percent in the second quarter, only slightly below its recession high of 10 percent in the fourth quarter of 2009. Long-term unemployment has continued to worsen.

On the inflation front, prices of energy and other commodities have declined in recent months, and underlying inflation has trended lower. The overall PCE price index rose at an annual rate of about 3/4 percent over the first five months of 2010 (compared with an increase of about 2 percent over the 12 months of 2009), while price increases for consumer expenditures other than food and energy items--so-called core PCE--slowed from 1-1/2 percent over the 12 months of 2009 to an annual rate of 1 percent over the first five months of 2010. FOMC participants expect that, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

Domestic financial conditions generally showed improvement through the first quarter of 2010, but the fiscal strains in Europe and the uncertainty they engendered subsequently weighed on financial markets. As a result, foreign and domestic equity price indexes fell appreciably in the second quarter, and pressures emerged in dollar funding markets; safe-haven flows lowered sovereign yields in most of the major advanced economies and boosted the foreign exchange value of the dollar and the Japanese yen.

Over the first half of the year, investors marked down expectations for the path of U.S. monetary policy in response to economic and financial developments and to the FOMC's continued indication that it expected economic conditions to warrant exceptionally low levels of the federal funds rate for an extended period. These same factors, as well as safe-haven flows, contributed to a decline in Treasury rates. Some private borrowing rates, including mortgage rates, also fell. Broad equity price indexes declined, on net, over the first half of 2010.

Consumer credit outstanding continued to fall, though at a less rapid pace than in the second half of last year. Larger corporations with access to capital markets were able to issue bonds to meet their financing needs, although some smaller businesses reportedly had considerable difficulties obtaining credit. Standards on many categories of bank loans remained tight, and loans on banks' books continued to contract, although somewhat less rapidly than around year-end. Commercial bank profitability stayed low by historical standards, as loan losses remained at very high levels.

To support the economic expansion, the FOMC maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the first half of 2010. To complete the purchases previously announced, over the first three months of the year, the Federal Reserve also conducted large-scale purchases of agency mortgage-backed securities and agency debt in order to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets. In light of improved functioning of financial markets, the Federal Reserve closed by the end of June all of the special liquidity facilities that it had created to support markets in late 2007 and in 2008. However, in response to renewed dollar funding pressures abroad, in May the Federal Reserve reestablished swap lines with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. The Federal Reserve continued to develop its tools for draining reserves from the banking system to support the withdrawal of policy accommodation when such action becomes appropriate. The Committee is monitoring the economic outlook and financial developments, and it will employ its policy tools as necessary to promote economic recovery and price stability.

The economic projections prepared in conjunction with the June FOMC meeting are presented in Part 4 of this report. In general, FOMC participants anticipated that the economic recovery would proceed at a moderate pace. The expansion was expected to be restrained in part by household and business uncertainty, persistent weakness in real estate markets, only gradual improvement in labor market conditions, waning fiscal stimulus, and slow easing of credit conditions in the banking sector. The projected increase in real GDP was only a little faster than the economy's longer-run sustainable growth rate, and thus the unemployment rate was anticipated to fall only slowly over the next few years. Inflation was expected to remain subdued over this period. The participants' projections for economic activity and inflation were both somewhat lower than those prepared in conjunction with the April FOMC meeting, mainly because of the incoming economic data and the anticipated effects of developments abroad on the U.S. economy.

Participants generally judged that the degree of uncertainty surrounding the outlook for both economic activity and inflation was greater than historical norms. About one-half of the participants viewed the risks to the growth outlook as tilted to the downside, whereas in April, a large majority had seen the risks to growth as balanced; most continued to see balanced risks surrounding their inflation projections. Participants also reported their assessments of the rates to which macroeconomic variables would be expected to converge over the longer run under appropriate monetary policy and in the absence of further shocks to the economy. The central tendencies of these longer-run projections were 2.5 to 2.8 percent for real GDP growth, 5.0 to 5.3 percent for the unemployment rate, and 1.7 to 2.0 percent for the inflation rate.

Last update: July 21, 2010