Section 1

MONETARY POLICY AND THE ECONOMIC OUTLOOK

When the Federal Reserve submitted its report on monetary policy in mid-February, the Federal Open Market Committee (FOMC) had already reduced its target for the federal funds rate twice to counter emerging weakness in the economy. As the year has unfolded, the weakness has become more persistent and widespread than had seemed likely last autumn. The shakeout in the high-technology sector has been especially severe, and with overall sales and profits continuing to disappoint, businesses are curtailing purchases of other types of capital equipment as well. The slump in demand for capital goods has also worked against businesses' efforts to correct the inventory imbalances that emerged in the second half of last year and has contributed to sizable declines in manufacturing output this year. At the same time, foreign economies have slowed, limiting the demand for U.S. exports.

To foster financial conditions that will support strengthening economic growth, the FOMC has lowered its target for the federal funds rate four times since February, bringing the cumulative decline this year to 2-3/4 percentage points. A number of factors spurred this unusually steep reduction in the federal funds rate. In particular, the slowdown in growth was rapid and substantial and carried considerable risks that the sluggish performance of the economy in the first half of this year would persist. Among other things, the abruptness of the slowing, by jarring consumer and business confidence, raised the possibility of becoming increasingly self-reinforcing were households and businesses to postpone spending while reassessing their situations. In addition, other financial developments, including a higher foreign exchange value of the dollar, lower equity prices, and tighter lending terms and standards at banks, were tending to restrain aggregate demand and thus were offsetting some of the influence of the lower federal funds rate. Finally, despite some worrisome readings early in the year, price increases remained fairly well contained, and prospects for inflation have become less of a concern as rates of resource utilization have declined and energy prices have shown signs of turning down.

The information available at midyear for the recent performance of both the U.S. economy and some of our key trading partners remains somewhat downbeat, on balance. Moreover, with inventories still excessive in some sectors, orders for capital goods very soft, and the effects of lower stock prices and the weaker job market weighing on consumers, the economy may expand only slowly, if at all, for a while longer. Nonetheless, a number of factors are in place that should set the stage for stronger growth later this year and in 2002. In particular, interest rates have declined since last fall; the lower rates have helped businesses and households strengthen their financial positions and should show through to aggregate demand in coming quarters. The recently enacted tax cuts and the apparent cresting of energy prices should also bolster aggregate demand fairly soon. In addition, as firms at some point become more satisfied with their inventory holdings, the cessation of liquidation will boost production and, in turn, provide a lift to employment and incomes; a subsequent shift to inventory accumulation in association with the projected strengthening in demand should provide additional impetus to production. Moreover, with no apparent sign of abatement in the rapid pace of technological innovation, the outlook for productivity growth over the longer run remains favorable. The efficiency gains made possible by these innovations should spur demand for the capital equipment that embodies the new technologies once the overall economic situation starts to improve and should support consumption by leading to solid increases in real incomes over time.

Even though an appreciable recovery in the growth of economic activity by early next year seems the most likely outcome, there is as yet no hard evidence that this improvement is in train, and the situation remains very uncertain. In these circumstances, the FOMC continues to believe that the risks are weighted toward conditions that may generate economic weakness in the foreseeable future. At the same time, the FOMC recognizes the importance of sustaining the environment of low inflation and well-anchored inflation expectations that enabled the Federal Reserve to react rapidly and forcefully to the slowing in real GDP growth over the past several quarters. When, as the FOMC expects, activity begins to firm, the Committee will continue to ensure that financial conditions remain consistent with holding inflation in check, a key requirement for maximum sustainable growth.

Monetary Policy, Financial Markets, and the Economy over the First Half of 2001

By the time of the FOMC meeting on December 19, 2000, it had become evident that economic growth had downshifted considerably, but the extent of that slowing was only beginning to come into focus. At that meeting, the FOMC concluded that the risks to the economy in the foreseeable future had shifted to being weighted mainly toward conditions that may generate economic weakness and that economic and financial developments could warrant further close review of the stance of policy well before the next scheduled meeting. Subsequent data indicated that holiday retail sales had come in below expectations and that conditions in the manufacturing sector had deteriorated. Corporate profit forecasts had also been marked down, and it seemed possible that the resulting decline in equity values, along with the expense of higher energy costs, could damp future business investment and household spending. In response, the FOMC held a telephone conference on January 3, 2001, and decided to reduce the target federal funds rate 1/2 percentage point, to 6 percent, and indicated that the risks to the outlook remained weighted toward economic weakness.

The timing and size of the cut in the target rate seemed to ease somewhat the concerns of financial market participants about the longer-term outlook for the economy. Equity prices generally rose in January, risk spreads on lower-rated corporate bonds narrowed significantly, and the yield curve steepened. However, incoming data over the month revealed that the slowing in consumer and business spending late last year had been sizable. Furthermore, a sharp erosion in survey measures of consumer confidence, a backup of inventories, and a steep decline in capacity utilization posed the risk that spending could remain depressed for some time. In light of these developments, the FOMC at its scheduled meeting on January 30 and 31 cut its target for the federal funds rate another 1/2 percentage point, to 5-1/2 percent, and stated that it continued to judge the risks to be weighted mainly toward economic weakness.

The information reviewed by the FOMC at its meeting on March 20 suggested that economic activity continued to expand, but slowly. Although consumer spending seemed to be rising moderately and housing had remained relatively firm, stock prices had declined substantially in February and early March, and reduced equity wealth and lower consumer confidence had the potential to damp household spending going forward. Moreover, manufacturing output had contracted further, as businesses continued to work down their excess inventories and cut back on capital equipment expenditures. In addition, economic softness abroad raised the likelihood of a weakening in U.S. exports. Core inflation had picked up a bit in January, but some of the increase reflected the pass-through of a rise in energy prices that was unlikely to continue, and the FOMC judged that the slowdown in the growth of aggregate demand would ease inflationary pressures on labor and other resources. Accordingly, the FOMC on March 20 lowered its target for the federal funds rate another 1/2 percentage point, to 5 percent. The members also continued to see the risks to the outlook as remaining weighted mainly toward economic weakness. Furthermore, the FOMC recognized that in a rapidly evolving economic situation, it would need to be alert to the possibility that a conference call would be desirable during the relatively long interval before the next scheduled meeting to discuss the possible need for a further policy adjustment.

Capital markets continued to soften in late March and early April, in part because corporate profits and economic activity remained quite weak. Although equity prices and bond yields began to rise in mid-April as financial market investors became more confident that a cumulative downward spiral in activity could be avoided, reports continued to suggest flagging economic performance and risks of extended weakness ahead. In particular, spending by consumers had leveled out and their confidence had fallen further. The FOMC discussed economic developments in conference calls on April 11 and April 18, deciding on the latter occasion to reduce its target for the federal funds rate another 1/2 percentage point, to 4-1/2 percent. The Committee again indicated that it judged the balance of risks to the outlook as weighted toward economic weakness.

When the FOMC met on May 15, economic conditions remained quite sluggish, especially in manufacturing, where production and employment had declined further. Although members were concerned that some indicators of core inflation had moved up in the early months of the year and that part of the recent backup in longer-term interest rates may have owed to increased inflation expectations, most saw underlying price increases as likely to remain damped as continued subpar growth relieved pressures on resources. In light of the prospect of continued weakness in the economy and the significant risks to the economic expansion, the FOMC reduced its target for the federal funds rate an additional 1/2 percentage point, to 4 percent. With the softening in aggregate demand still of unknown persistence and dimension, the FOMC continued to view the risks to the outlook as weighted toward economic weakness. Still, the FOMC recognized that it had eased policy substantially this year and that, in the absence of further sizable adverse shocks to the economy, at future meetings it might need to consider adopting a more cautious approach to further policy actions.

Subsequent news on economic activity and corporate profits failed to point to a rebound. In June, interest rates on longer-term Treasuries and on higher-quality private securities declined, some risk spreads widened, and stock prices fell as financial market participants trimmed their expectations for economic activity and profits. When the FOMC met on June 26 and 27, conditions in manufacturing appeared to have worsened still more. It also seemed likely that slower growth abroad would restrain demand for exports and that weakening labor markets would hold down growth in consumer spending. In light of these developments, but also taking into account the cumulative 250 basis points of easing already undertaken and the other forces likely to be stimulating spending in the future, the FOMC lowered its target for the federal funds rate 1/4 percentage point, to 3-3/4 percent, and continued to view the risks to the outlook as weighted toward economic weakness.

The Board of Governors of the Federal Reserve System approved cuts in the discount rate in the first half of the year that matched the FOMC's cuts in the target federal funds rate. As a result, the discount rate declined from 6 percent to 3-1/4 percent over the period.

Economic Projections for 2001 and 2002

The members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect economic growth to remain slow in the near term, though most anticipate that it will pick up later this year at least a little. The central tendency of the forecasts for the increase in real GDP over the four quarters of 2001 spans a range of 1-1/4 percent to 2 percent, and the central tendency of the forecasts for real GDP growth in 2002 is 3 percent to 3-1/4 percent. The civilian unemployment rate, which averaged 4-1/2 percent in the second quarter of 2001, is expected to move up to the area of 4-3/4 percent to 5 percent by the end of this year. In 2002, with the economy projected to expand at closer to its trend rate, the unemployment rate is expected to hold steady or perhaps to edge higher. With pressures in labor and product markets abating and with energy prices no longer soaring, inflation is expected to be well contained over the next year and a half.