For use at 2:30 p.m., EDT
Tuesday
July 20, 2004

Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress

July 20, 2004

Letter of Transmittal

Board of Governors of the
Federal Reserve System
Washington, D.C., July 20, 2004

The President of the Senate
The Speaker of the House of Representatives

The Board of Governors is pleased to submit its Monetary
Policy Report to the Congress
pursuant to section 2B of the Federal Reserve Act.

Sincerely,
Alan Greenspan, Chairman

SECTION 1

Report submitted to the Congress on July 20, 2004,
pursuant to section 2B of the Federal Reserve Act


Monetary Policy and the Economic Outlook

The economic expansion in the United States became
increasingly well established in the first half of 2004, but
the pace of inflation picked up from its very low rate in
2003. At the time of the February Monetary Policy Report to
the Congress, considerable evidence was already in hand
indicating that the U.S. economy had made the transition
from a period of subpar growth to one of more-vigorous
expansion. Nevertheless, job creation remained limited, and
gains in investment, although sizable, still seemed
restrained by a lingering caution on the part of some
businesses. In the event, businesses stepped up their hiring
in the spring, and capital spending seems to have continued
apace.

Over the first half of this year, energy prices soared;
moreover, inflation in core consumer prices--as measured by
the price index for personal consumption expenditures
excluding the direct effects of movements in food and energy
prices--increased from an exceptionally low rate of 1 percent
over the four quarters of 2003 to an annual rate of a little
more than 2 percent. To some extent, the upturn in core
inflation reflected the indirect effects of higher energy
prices, but other forces also played a role. Strengthening
aggregate demand both at home and abroad induced a surge in
the prices of many primary commodities and industrial
materials. In addition, the decline in the foreign exchange
value of the dollar in 2003 put upward pressure on the
prices of imported goods and services. With strong demand in
the United States and increased utilization of the
productive capacity of the economy, firms were better able
to pass on the higher costs of  imports, raise the prices of
domestically produced items that compete with imports, and
in many cases boost their profit margins. Likely in response
to the faster rate of price increases experienced this year,
surveys suggest that near-term inflation expectations have
moved up somewhat; still, expectations for price inflation
over the longer term have remained in their recent range.

Monetary policy was very accommodative at the start of 2004
as the Federal Open Market Committee (FOMC) sought to
provide continuing support to an economic expansion that had
yet to produce a sustained improvement in the labor market
and to ensure that the previous year's threat of an
unwelcome disinflation would continue to recede. Although
real GDP had accelerated sharply in the second half of 2003,
the incoming data through the time of the March meeting
suggested that employment was growing only slowly, as
employers were relying on increased production efficiencies
to satisfy considerable gains in aggregate demand. Surging
oil prices were boosting overall inflation, while core
inflation--though no longer declining--was still low. With
subsequent labor market reports suggesting that hiring was
on a stronger track, growth in output continuing at a solid
pace, and core consumer price inflation possibly running
higher, the FOMC announced in May that it saw the risks to
the goal of price stability as having moved into balance.
Even so, the Committee stated that it believed that the
monetary policy accommodation then in place could be
"removed at a pace that is likely to be measured." Indeed,
at its June meeting, the FOMC decided that sufficient
evidence was in hand to begin moving the federal funds rate
back toward a more neutral setting and raised the federal
funds rate 1/4 percentage point to 1-1/4 percent, a decision that
was widely anticipated by market participants.

Although some of the recent data have been on the soft side,
the available information on the outlook for the U.S.
economy is, on balance, positive. Households are enjoying a
generally improving job market, rising real incomes, and
greater wealth, all of which are providing them with the
confidence and wherewithal to spend. In the business sector,
capital spending apparently is continuing to increase
briskly, bolstered by expectations of strong sales as well
as by booming profits and supportive financial conditions;
investment should also continue to be buoyed by firms'
adoption of productivity-enhancing technologies. Moreover,
inventories appear to be lean relative to sales even after
taking account of the substantial improvements firms have
made in managing their stocks, suggesting that stock
building may provide some impetus to production in the near
term. The brightening outlook for economic activity abroad
suggests that
demand for U.S. exports should grow and provide a further
lift to domestic production.

The prospects also seem favorable for inflation to remain
contained in the period ahead. For one reason, some of the
forces that contributed to the upturn in core inflation in
the first half of 2004 are likely to prove transitory. In
particular, the upward impetus from the rise in energy and
commodity prices is likely to lessen in coming quarters. For
another reason, the evidence suggests that the productive
capacity of the economy is still not being fully used and
that the attendant slack is probably exerting some downward
pressure on inflation. If--as seems likely--the economy
approaches full utilization of its productive capacity only
gradually, that downward pressure should persist for a time.
Moreover, productivity remains on a solid uptrend and should
continue to restrain costs. To date, the gains in
productivity have helped to boost profit margins. As firms
compete to take advantage of profit opportunities, they may
eventually be forced to absorb a portion of any increases in
labor and other costs that occur. But history suggests that
the absorption of costs has limits. Indeed, unit labor costs
have turned up of late, as productivity growth has slowed
below the rate of increase in hourly compensation. If
increases in those costs were to develop any upward
momentum, the well-behaved nature of inflation in recent
years could be jeopardized.



Monetary Policy, Financial Markets, and the Economy over the
First Half of 2004

At the beginning of 2004, the FOMC was growing more
confident that the economic expansion was likely to be self-
sustaining, particularly in light of the significant firming
of business outlays and the continued strength in household
spending. Moreover, stimulative fiscal and monetary
policies, in conjunction with receptive financial markets,
appeared likely to provide substantial support to economic
activity and to ward off any further disinflation. However,
the Committee remained concerned about the persistent
weakness in the labor market. At its January meeting, the
FOMC left the target for the federal funds rate at 1
percent. The Committee generally felt that the apparent
slack in labor and product markets and continued strong
productivity growth were likely to keep the underlying trend
in inflation subdued, but it nevertheless was cognizant that
a highly accommodative stance for monetary policy could not
be maintained
indefinitely. Given these considerations, the Committee
modified the language of its policy statement to gain
greater flexibility to firm policy should circumstances
warrant. The Committee achieved this added flexibility by
removing its assessment that monetary policy would be
accommodative for "a considerable period" and instead saying
that the Committee could be "patient" in removing its policy
accommodation.

At the time of the March FOMC meeting, the Committee
believed that conditions were mostly in place for further
solid economic growth. Industrial production had picked up
broadly, and consumer and business spending continued to
expand briskly. However, the employment reports for January
and February still painted a picture of subdued hiring. With
financial markets quite accommodative, the Committee
recognized that maintaining the current stance of policy
could fuel inflation pressures and perhaps encourage
excessive risk-taking by financial market participants. The
Committee concluded that the low level of core consumer
price inflation and continued evidence of weak hiring argued
for the retention of both its 1 percent target for the
federal funds rate and the wording in its statement that the
Committee could be "patient" with respect to changes in
monetary policy.

At the May FOMC meeting, members noted a distinct
improvement in the economic outlook. The labor market
figures reported for March had proved to be strong, and the
reports for the two previous months had been revised upward
significantly. Consumer price inflation in the first quarter
of the year was faster than it had been in the previous
quarter. Although much of this rise was due to escalating
energy costs, core inflation also stepped up, and survey-
based measures of near-term inflation expectations had edged
higher. In response to the indications of rising aggregate
demand and a strengthening job market, yields on Treasury
securities had risen appreciably. Accordingly, the Committee
was of the view that the expansion would be vigorous and
believed that the odds of any further disinflation had been
substantially reduced. On the basis of the evolving outlook
for economic activity and prices, the Committee revised its
assessment of risks to indicate that the upside and downside
risks for inflation had moved into balance. To underscore
its
belief that policy would probably soon need to move toward a
more neutral stance while emphasizing that this process was
not expected to be rapid, the Committee stated its judgment
that monetary policy accommodation "can be removed at a pace
that is likely to be measured."

At the time of the June FOMC meeting, incoming information
tended to confirm that the economy was
expanding at a solid pace but also indicated that inflation
was higher than had been anticipated. Quotes on near-term
money market futures and options suggested that market
participants were nearly certain of an increase of 25 basis
points in the target for the federal funds rate at that
meeting and had priced in a cumulative increase of about 2-1/4
percentage points in the federal funds rate over the next
year. The Committee agreed that the current substantial
degree of policy accommodation was no longer warranted and
decided to increase its target for the federal funds rate 25
basis points. The Committee noted that it considered the
risks to both sustainable economic growth and stable prices
to be roughly balanced and maintained its appraisal that
policy accommodation "can be removed at a pace that is
likely to be measured" but also emphasized that it will
"respond to changes in economic prospects as needed to
fulfill its obligation to maintain price stability."


Economic Projections for 2004 and 2005

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 2004 and 2005. The central tendency of the
FOMC participants' forecasts for the increase in real GDP is
4-1/2 percent to 4-3/4 percent over the four quarters of 2004 and
3-1/2 percent to 4 percent in 2005. The civilian unemployment
rate is expected to lie between 5-1/4 percent and 5-1/2 percent in
the fourth quarter of 2004 and to decline to between 5
percent and 5-1/4  percent by the fourth quarter of 2005.

Starting with this report, the Federal Reserve will provide
projections for the price index for personal consumption
expenditures excluding food and energy (core PCE), which the
Committee believes is better as an indicator of underlying
inflation trends than is the overall PCE price measure
previously featured. Core PCE inflation appears to have run
a little above an annual rate of 2 percent in the first half
of 2004; for 2004 as a whole, most FOMC participants expect
it to lie between 1-3/4 percent and 2 percent. For 2005, the
central tendency of the projections for core PCE inflation
is 1-1/2 percent to
2 percent.


SECTION 2


Economic and Financial Developments
in 2004

After having surged in the second half of 2003, economic
activity continued to expand at a solid pace in the first
half of 2004. In the labor market, payroll employment
started to increase last fall after a long string of
declines and picked up further during the first half of this
year. Headline inflation has been boosted significantly by
the jump in energy prices this year, but core inflation has
also moved up from the exceptionally low levels of late
2003.


The Household Sector

Consumer Spending

Consumer spending, which had gathered a good bit of steam in
the second half of 2003, continued to move higher in the
first half of 2004. The growth in spending was spurred by
substantial gains in income. In addition, household wealth
has risen sharply over the past year, and consumer surveys
indicate that individuals are generally upbeat in their
assessments of the economy's prospects and of their own
situations.

Personal consumption expenditures rose at an annual rate of
3-3/4 percent in real terms in the first quarter. Spending on
light motor vehicles, which had been supported in late 2003
by aggressive price and financing incentives, slipped
somewhat in early 2004. But outlays for goods other than
motor vehicles, which had risen 6-1/2 percent in real terms in
2003, posted another huge increase in the first quarter;
spending on services also perked up after having advanced
only modestly in 2003. The available data point to a much
smaller increase in consumer spending in the second quarter;
the deceleration mainly reflects a sharp slowing in the
growth of outlays on goods other than motor vehicles.

Real disposable personal income (DPI)--that is, after-tax
income adjusted for inflation--rose at an
annual rate of nearly 4 percent between the fourth quarter
of 2003 and May 2004, a gain about in line with its rate of
growth last year. To be sure, the rise in energy prices cut
into the growth of real income in the first half of the
year. However, aggregate wages and salaries, boosted by
increases in both employment and earnings, rose appreciably
in nominal terms. In addition, last year's tax legislation,
which had already reduced withholding rates in mid-2003,
added further to households' cash flow by increasing refunds
and lowering final settlements this spring.

Household wealth increased only about in line with nominal
DPI in the first quarter of 2004, and the wealth-to-income
ratio was likely little changed in the second quarter as
well. Nonetheless, the increase in wealth over the past year
has been considerable--and probably large enough to more or
less offset any lingering restraint on spending growth from
the earlier declines in stock prices. Thus, with wealth
approximately a neutral influence on the growth of spending
of late, the personal saving rate has held fairly steady. In
fact, the average saving rate over the first five months of
the year--at 2-1/4 percent of DPI--was very close to the annual
figures for 2002 and 2003.

Residential Investment

Activity in the housing sector remained torrid in the first
half of 2004. Although starts in the single-family sector
faltered a bit early in the year, in part because of
unusually adverse weather, they subsequently snapped back
and reached an annual rate of more than 1.6 million units in
April and May--8-1/2 percent greater than the already rapid pace
for 2003 as a whole. Sales of new and existing homes have
also been exceptionally strong, and they hit record highs in
May. In general, housing activity has been supported by the
favorable developments regarding jobs and income and,
especially early in the year, by low mortgage rates. Rates
on thirty-year fixed-rate mortgages, which had dipped to 5-1/2
percent in March, rose markedly in the spring; they have
edged down in recent weeks and now stand at 6 percent, a
level still quite low by historical standards.

Home prices have continued to rise rapidly. For example, the
national repeat-sales price index from the Office of Federal
Housing Enterprise Oversight--which partially adjusts for
shifts in the quality of homes sold--rose 7-3/4 percent over the
year ending in the first quarter (the latest available
data), a rate similar to the average annual gain since late
2000. By this measure--and many others--house price increases
have outstripped gains in incomes as well as in rents in
recent years.

Starts in the multifamily sector averaged an annual rate of
360,000 units over the first five months of the year, a pace
slightly faster than that of the past several years. Low
interest rates have apparently helped maintain the
profitability of apartment construction, given that other
fundamental determinants of activity in the sector have been
weak: In particular, rents have remained soft, and in the
first quarter, vacancy rates for multifamily rental
properties reached a new high.

Household Finance

Household debt rose at an annual rate of about 10-3/4 percent
in the first quarter of 2004. The especially rapid growth of
mortgage debt was driven by the strong pace of activity in
the housing market and the renewed wave of mortgage
refinancing. However, the second-quarter rise in interest
rates appears to have slowed the rate of refinancing and,
consequently, the amount of equity being extracted from the
value of homes through such transactions. Consumer
credit--which constitutes the bulk of household debt aside
from mortgage borrowing--expanded at an annual rate of about
6 percent over the first quarter of the year and at roughly
a 4 percent pace in April and May. The growth of consumer
credit likely has continued to be restrained by the
substitution toward mortgage debt as a means to finance
household expenditures.

Low interest rates, in concert with strong growth in
disposable personal income, have helped to keep financial
obligations manageable for most households. In the first
quarter of the year, the debt service ratio and the
financial obligations ratio for the household sector in the
aggregate, both of which gauge pre-committed expenditures
relative to disposable income, continued to edge down from
their peaks in 2001. Other indicators also suggest that the
financial well-being of households has stabilized and may be
improving. Delinquencies on credit card and auto loans
generally declined in the first three months of the year,
and bankruptcy rates, while still high, stepped down in the
first quarter from their recent peak.

Rapid increases in home prices have  continued to buoy
household net worth this year. In contrast, stock prices are
about unchanged. Although news on earnings and economic
activity has generally been favorable, rising oil prices and
interest rates and, perhaps, heightened geopolitical
concerns have weighed on investor sentiment. Nevertheless,
inflows into equity mutual funds have been even stronger
thus far in 2004 than they were last year.


The Business Sector

Fixed Investment

For the most part, businesses appear to be shaking off the
extraordinary reluctance to undertake new investment
projects that was evident in 2002 and 2003. Indeed, although
outlays on nonresidential construction have not yet turned
up decisively, real spending on equipment and software (E&S)
has been advancing briskly. The broadly based growth in E&S
spending has been driven by increasingly favorable
fundamentals: positive expectations for sales, high levels
of corporate profits and cash flow, a desire to replace or
upgrade aging equipment after a period of weak investment
spending, and the continued low cost of capital.

Real E&S spending rose at an annual rate of more than 15
percent in the second half of last year, and it posted
another sizable increase in the first quarter of 2004
despite flat business purchases of motor vehicles and a dip
in deliveries of aircraft. Excluding transportation
equipment, real spending on E&S rose at an annual rate of
13-1/2 percent in the first quarter. In the high-tech category,
real purchases of computers and software remained on the
solid uptrend that has been evident for the past couple of
years, and real outlays on communications equipment
increased further, reaching a level about 20 percent above
the low in the fourth quarter of 2002. Spending for
equipment other than high-tech and transportation, which
accounts for about 40 percent of E&S (measured in nominal
terms), also rose markedly in the first quarter. Such
spending tends to be particularly sensitive to the prospects
for aggregate demand. In addition, it may be receiving a
lift from the partial-expensing tax provision, which is
especially valuable for equipment with relatively long
service lives for tax purposes; that provision is slated to
expire at the end of 2004.

Equipment spending appears to have posted another solid
increase in the second quarter. Outlays on transportation
equipment seem to have rebounded, and the incoming data on
high-tech equipment point to robust real expenditures. Some
indicators for spending on other nontransportation equipment
have been a bit soft recently. But the May level of
shipments for this broad category was still above that of
the first quarter, and backlogs of unfilled orders, which
have risen impressively over the past year, continued to
build.

Real nonresidential construction has remained about
unchanged, on net, since the steep decline in 2001 and 2002.
Construction of office buildings is still running at roughly
half the pace of 2000, although vacancy rates have
stabilized--albeit at very high levels--and the decline in
rents has slowed. Factory construction also remains
sluggish. Construction of retail and wholesale facilities,
in contrast, has held up fairly well, a performance
consistent with the strength in consumer spending. Outlays
on buildings for health care and education also have been
reasonably well sustained.


Inventory Investment

Inventory investment has generally remained subdued even as
final sales have strengthened. Although real nonfarm
inventory investment picked up to an annual rate of $30
billion in the first quarter, the accumulation occurred
almost entirely in the motor vehicle sector, in which
sagging sales and a high level of production early in the
year created a noticeable bulge in dealer stocks, especially
of light trucks. In the second quarter, the automakers
reduced assemblies; but with sales running only a little
above their first-quarter pace on average, inventories of
motor vehicles remained elevated. Outside the motor vehicle
industry, nonfarm inventories increased at a meager $6
billion annual rate in real terms in the first quarter, and
the available data point to only a moderate step-up in real
stockbuilding, on balance, in April and May. In general, non-
auto inventories appear lean relative to sales, even after
factoring in the downward trend in inventory-sales ratios
that has accompanied the ongoing improvements in supply-
chain and logistics management.


Corporate Profits and Business Finance

Continuing the gains of last year, profits of the business
sector to date have remained strong. In the first quarter of
2004, earnings per share for S&P 500 firms were about 26
percent higher than their level four quarters earlier, and
before-tax profits of nonfinancial corporations as a share
of GDP from that sector edged up following a steep increase
in 2003. A jump in profits in the petroleum and gas
industries owing to higher oil prices was responsible for
much of the rise in earnings. However, firms across many
industries, with the notable exception of telecommunication
services, registered solid gains in earnings. In response to
this pattern of higher profits, analysts have been steadily
marking up their forecasts for earnings in subsequent
quarters.

Net equity issuance has remained negative this year.
Seasoned offerings have been scarce, the pace of initial
public offerings has only inched up, and share retirements
have continued to be strong. Corporations have continued to
repurchase shares at a rapid rate to manage their cash
positions, even as they have increased dividend payments.

Firms relied heavily on their elevated profits and
substantial cash holdings to finance their investment in
inventories and fixed capital in the first half of 2004. As
a result, the growth of nonfinancial business debt remained
modest. Much of the proceeds from bond issuance was used to
pay down higher-cost debt, and the timing of the issuance of
investment-grade bonds in particular was influenced by
movements in interest rates; issuance spiked in March in the
wake of the drop in yields but subsided in April as rates
rebounded. Short-term debt financing showed signs of turning
around after contracting over the previous three years.
Commercial paper outstanding expanded in the first two
quarters of 2004.  Business loans at banks have fallen on
balance so far this year but at a much slower pace than in
2003. The Federal Reserve's Senior Loan Officer Opinion
Survey conducted in April 2004 indicated that demand for
business loans had begun to expand and that commercial banks
had again eased both standards and terms on these loans over
the previous three months.

Strong profits, low interest rates, and continued
deleveraging helped improve the credit quality of
nonfinancial firms over the first half of the year. In the
second quarter, the delinquency rate on business loans
dropped for the sixth consecutive quarter; the continued
decline has reversed a large part of the preceding run-up.
Early in the year the twelve-month trailing default rate on
outstanding bonds fell into the relatively low range
observed over much of the 1990s, and in June it registered
another decline. Moreover, in the first part of the year,
the pace of upgrades of bond ratings by Moody's Investors
Service rose while the pace of downgrades fell.

Borrowing against commercial real estate assets continued at
a rapid pace during the first half of this year. Anecdotal
reports suggest that some firms were using mortgages on
commercial property to lock in low-cost, long-term funding.
Despite the persistently high vacancy rates for most types
of commercial property, the loans backed by these assets
have continued to perform well. Delinquency rates on
commercial mortgages held by banks and insurance companies
remained very low in the first quarter. A drop in
delinquencies on commercial-mortgage-backed securities
(CMBS) in recent months has partially reversed last year's
rise, and the narrow risk spreads on CMBS suggest that
investors have limited concerns about loan quality.


The Government Sector

Federal Government

The deficit in the federal unified budget has continued to
widen. Over the twelve months ending in June, the unified
budget recorded a deficit of $431 billion, $120 billion more
than during the comparable period last year and equal to
nearly 4 percent of nominal GDP. In large part, the rise in
the deficit is attributable to further rapid increases in
spending on defense and other programs and the loss of
revenues resulting from the tax legislation enacted in
recent years. In addition, interest costs, which fell
sharply between fiscal 1997 and fiscal 2003 as a result of
budget surpluses and declining interest rates, have leveled
off and thus are no longer a significant factor helping to
restrain the deficit. The primary deficit, which excludes
net interest, totaled $276 billion over the twelve months
ending in June, also approximately $120 billion more than
over the year ending in June 2003.

Over the twelve months ending in June, nominal federal
spending was nearly 7 percent higher than during the same
period a year earlier and stood at about 20 percent of
nominal GDP--virtually the same as in fiscal 2003 but 1-1/2
percentage points above the recent low in fiscal 2000.
Spurred by the war in Iraq, defense spending ramped up
another 14 percent; outlays for nondefense discretionary
programs, which include homeland security, moved up further
as well. Spending on the major health programs rose at a
rapid clip, in part because the Jobs and Growth Tax Relief
Reconciliation Act of 2003 (JGTRRA) temporarily increased
grants to the states under the Medicaid program and boosted
payments to some Medicare providers. In addition, as noted,
net interest payments, which had plummeted between 1997 and
2003, flattened out. Real federal expenditures for
consumption and gross investment--the part of government
spending that is a component of real GDP--rose at an annual
rate of 8-1/2 percent in the first calendar quarter of 2004;
that increase reflected a surge in real defense spending,
which now stands more than 30 percent above the levels that
prevailed, on average, from 1997 to 2000.

Federal receipts in the twelve months ending in June were 1-1/2
percent higher than during the comparable
period of the previous year after having fallen markedly
between fiscal 2000 and fiscal 2003. Receipts received a
substantial boost over the past year from a strong gain in
corporate taxes, which were lifted by robust profits. Social
insurance taxes, which tend to move in line with wages and
salaries, also increased. But individual income taxes were
below last year's level: Although taxable incomes rose
moderately, collections were reduced by the lower
withholding rates in place since mid-2003 and by the effects
of JGTRRA on refunds and final settlements this spring.

The deterioration in the unified budget since 2000 has been
mirrored in a sharp downswing in federal saving--essentially,
the unified surplus or deficit adjusted to conform to the
accounting practices followed in the national income and
product accounts (NIPA). Gross federal saving fell from a
high of nearly 3 percent of nominal GDP in 2000 to negative
3 percent of GDP in the first quarter of 2004; measured net
of estimated depreciation, federal saving fell from 2
percent of GDP to negative 4 percent of GDP over this
period. In the past couple of years, the rise in business
saving from the rebound in profits and reductions in
corporate taxes has cushioned to some extent the effect of
growing budget deficits on national saving. In fact, because
of the dramatic increase in business saving in recent
quarters, national saving has recovered some from the
extreme lows of early 2003. Even so, as of the first quarter
of 2004, national saving (measured net of estimated
depreciation) was still equal to just about 2-1/2 percent of
GDP, compared with a recent high of 6-1/2 percent in 1998. If
not reversed over the longer haul, such low levels of
national saving could eventually impinge on private capital
formation and thus slow the rise of living standards.

Reflecting the need to finance the sizable federal budget
deficit, federal debt held by the public expanded at an
annual rate of 11-3/4 percent in the first half of the year.
The ratio of this debt to nominal GDP now exceeds 36
percent. The Treasury tilted its issuance toward longer-term
and inflation-indexed securities somewhat, and announced
semiannual issuance of a twenty-year inflation-protected
bond beginning in July and a five-year inflation-protected
note beginning in October.


State and Local Governments

States and localities have started to see some improvement
in their budget positions after having gone through several
difficult years. Strong growth in household income and
consumer spending has boosted revenues in recent quarters,
as have the additional federal grants authorized under
JGTRRA. And although rising medical costs and security needs
have continued to put upward pressure on spending, state and
local governments have generally held the line on hiring and
have kept other outlays in check. The restraint on spending,
in combination with a drawdown of reserve funds and some
increases in taxes, has helped states and localities satisfy
their balanced-budget requirements. In fact, between the
third quarter of 2003 and the first quarter of 2004, NIPA
net saving (excluding social insurance funds) for this
sector averaged $21 billion at an annual rate (1/4 percent of
nominal GDP), compared with negative $7 billion in 2002 and
negative $31 billion in the first half of 2003. (Net saving
is roughly similar to the surplus or deficit in an operating
budget.)  Although a few states are still struggling with
strained fiscal situations, most have entered fiscal 2005
(which started on July 1 in all but four states) with
expectations of respectable growth in revenues and with
budgets in place that allow for some increases in spending
on high-priority services and some rebuilding of reserve
funds.

Real consumption and investment spending by state and local
governments was essentially flat in the first quarter of
2004; available indicators point to a moderate increase in
the second quarter. Outlays for consumption items, which
were little changed in 2003, appear to have remained subdued
throughout the first half of the year. Investment
expenditures also were about unchanged in the first quarter,
but they turned up sharply in the spring, mainly because of
a jump in spending on highways.

Significant demand for infrastructure spending and favorable
interest rates led to robust issuance of state and local
government debt to finance capital expenditures and to
advance refund higher-cost debt. Nevertheless, over the
first half of the year, net issuance edged down from its
rapid pace in 2003 to about a 6 percent annual rate. The
deceleration reflected a decline in short-term borrowing as
improvements in the fiscal positions of state and local
governments lessened the need for temporary funding of
budget shortfalls.

The credit quality of municipal borrowers has stabilized
after two years of deterioration; for the year to date,
upgrades and downgrades of credit ratings have been roughly
equal. In a marked change from last year's sentiment, rating
agencies have begun to express guarded optimism about the
credit quality of states because of improvements in state
revenue flows and restraint on spending.


The External Sector

In the first quarter of 2004, the U.S. current account
deficit expanded to an annual rate of $580 billion, or about
5 percent of GDP. As in the past, the widening was driven
primarily by a larger deficit in trade of goods and
services. The surplus on net investment income declined in
the first quarter but remained well above its average value
in the previous year. The deficit on net unilateral
transfers rose because of a concentration of disbursements
of government grants in the first quarter.


International Trade

The U.S. trade deficit in goods and services registered $548
billion at an annual rate in the first quarter, about
$46 billion larger than in the fourth quarter of 2003. On
average, data for April and May suggest that the trade
deficit continued to widen in the second quarter.

Real exports of goods and services increased at an annual
rate of 7-1/2 percent in the first quarter of 2004, well off
the blistering 20 percent pace of the fourth quarter but
still above the average for 2003. Solid gains in exports
since mid-2003 arose in part from the strong economic
performance of many of our major trading partners. In
addition, the net decline in the exchange value of the
dollar since 2002 continued to make U.S. goods and services
more competitive abroad. Increases in exports of U.S. goods
were widespread across our major trading partners, with the
exception of Japan, and were concentrated in real exports of
capital goods, industrial supplies, and consumer goods. Real
exports of agricultural products fell sharply, hurt by
foreign bans on U.S. beef products following reports of mad
cow disease in a U.S. herd. Exports of services rose
moderately.

Prices of total exports rose at an annual rate of 5-3/4
 percent in the first quarter, boosted by another jump in
agricultural prices along with substantial increases in the
prices of other primary commodities and industrial supplies.
Prices of U.S. agricultural exports have been pushed up by
very strong global demand, particularly from China. For
specific products, such as cotton and soybeans, lower
production in some countries also contributed to price run-
ups. More recently, prices of soybeans and other
agricultural products have eased in the face of a slowing in
the growth of demand from China and the anticipation of
larger harvests. Even so, available data point to continued
strong increases in export prices in the second
quarter.

Supported by solid U.S. economic growth, real imports of
goods and services rose at an annual rate of 10-1/2 percent in
the first quarter. This increase was below the fourth-
quarter pace but still roughly double the rate of increase
for 2003 as a whole. Real imports of goods were boosted by a
sharp increase in oil imports. Gains in imports of non-oil
goods were also sizable and widespread across categories.
Imports of services grew slightly in the first quarter.

The spot price of West Texas intermediate (WTI) crude oil
surged above $40 per barrel in May and has since fluctuated
close to that level. The run-up in the price since the
beginning of the year has been driven by surprisingly strong
global demand for oil. Supply issues have been  important as
well. These were mainly continued violence in Iraq,
including the sabotage of oil facilities, attacks on
foreigners in Saudi Arabia, ongoing unrest in Nigeria,
political turmoil in Venezuela, and tax payment difficulties
at a major Russian oil company. The recent increase in OPEC
production (mainly by Saudi Arabia) has eased the upward
pressure on prices a bit, but they have remained elevated.

Prices of imported non-oil goods rose at an annual rate of
5-1/2 percent in the first quarter after minimal
increases in the second half of 2003. Prices for imported
consumer goods rose at an annual rate of 2-3/4 percent after
being flat in 2003. Skyrocketing global commodity prices
last year and early this year boosted prices of imported
industrial supplies (especially metals) and of foods, feed,
and beverages. The jump in commodity prices reflected strong
demand, the net depreciation of the dollar over the past two
years, and the limited expansion in supply of many
commodities since the 2001 trough in commodity prices.
Available data suggest a modest step-down in the rate of
increase of import prices in the second quarter; the move in
part reflects a flattening of consumer goods prices.

The Financial Account

The U.S. current account deficit has continued to be
financed largely by foreign flows into U.S. bonds. Foreign
official inflows, already sizable in 2003, rose sharply in
the first quarter of 2004 and then moderated somewhat.
Similarly, private foreign purchases of U.S. bonds, which
were significant in 2003, increased sharply in the first
quarter and also appear to have moderated in the second
quarter. In contrast, foreign demand for U.S. equities was
weak in 2003 and has remained so in 2004. Purchases of
foreign equities by private U.S. investors appear to be
strengthening, but U.S. investors still show no appetite for
foreign bonds.

Direct investment into the United States in the first
quarter continued to be restrained by the slowdown of global
mergers and acquisitions since 2002. In contrast, U.S.
direct investment abroad was strong in 2003 and in the first
quarter of 2004, as the effect of fewer mergers and
acquisitions was offset by sizable reinvested earnings.


The Labor Market

Employment and Unemployment

The demand for labor turned up in late 2003 after an
extended period of weakness, and it has gathered additional
steam this year. After averaging about 60,000 per month in
the fourth quarter of 2003, gains in private nonfarm payroll
employment rose to an average of about 200,000 per month in
the first half of 2004. The job gains were especially large
in March, April, and May but ebbed somewhat in June. The
civilian unemployment rate, which had fallen from a recent
peak of 6.3 percent in June 2003 to 5.7 percent in December
2003, was little changed over the first half of the year. In
June, it stood at 5.6 percent.

The increases in payrolls over the first half of 2004 were
widespread. Especially notable was the turnaround in the
manufacturing sector, in which employment bottomed out in
January and then rose a cumulative 65,000 jobs through June.
The rise in manufacturing jobs was concentrated in the
durable goods industries--in particular, those making
fabricated metals and other construction-related products,
computers and electronic equipment, and machinery. After a
long string of declines, employment at producers of
nondurable goods was little changed, on net, over the first
half. Job gains in virtually all other major sectors have
been greater this year than last. In particular, hiring in
retail trade, which had been lackluster in 2003, turned up
appreciably, and construction employment increased further.
The professional and business services sector also posted a
sizable rise, in part because the rebound in manufacturing
activity lifted hiring at temporary-help firms. A clear
indication of the breadth of the employment increases is
provided by the six-month diffusion index compiled by the
Bureau of Labor Statistics (BLS). The index is equal to the
percentage of industries that increased employment over the
most recent six months plus one-half the percentage with
unchanged employment; in June, the index moved up to its
highest level since April 2000.


Productivity and Labor Costs

Gains in labor productivity have slowed somewhat in recent
quarters after the spectacular increases of mid-2003. Still,
according to the currently published data, output per hour
in the nonfarm business sector rose a remarkable 5-1/2 percent
over the year ending in the first quarter. Over the past
three years, increases in productivity have averaged more
than 4 percent per year, compared with average increases of
about 2-1/2 percent per year in the second half of the 1990s.
During that earlier period, an expansion of the capital
stock was an important source of productivity growth.
However, in the more recent period, when the business
environment--at least until the past few quarters--was
characterized by sluggish demand, lean capital budgets, and
an extraordinary reluctance of firms to add to payrolls,
businesses appear to have raised their productivity mainly
through changes in organizational structures and better use
of the capital already in place. With hiring having picked
up of late, measured productivity growth may slow in coming
quarters; but if recent experience is any guide, businesses
will continue to focus on achieving structural improvements
in the efficiency of their operations. The upswing in
investment spending now under way also bodes well for
sustained favorable productivity performance in the period
ahead.

The rapid productivity growth in recent years has helped to
bolster increases in hourly compensation in the face of the
soft labor market and the low consumer price inflation in
2003. As a result, increases in the employment cost index
(ECI) measure of hourly compensation, which is based on a
survey of private nonfarm businesses conducted quarterly by
the BLS, have held fairly steady of late. In fact, the rise
in the ECI over the twelve months ending in March--at a shade
less than 4 percent--was virtually the same as the increases
over the preceding two years. Benefit costs, which rose 7
percent over the year ending in March, have continued to be
the fastest rising portion of hourly compensation; health
insurance costs have remained on a steep uptrend, and
employers have boosted their contributions to defined-
benefit retirement plans to make up for earlier stock market
losses. The rising benefit costs have likely exerted some
downward pressure on wages, which rose just 2-1/2 percent over
the twelve months ending in March; the twelve-month change
in the wage component of the ECI, which was close to 4
percent in 2000 and 2001, has been in the range of 2-1/2
percent to 3 percent since late 2002.

The change in compensation per hour in the nonfarm business
(NFB) sector--an alternative measure of hourly compensation
based on data constructed for the NIPA--has swung widely in
recent years. Fluctuations in the value of stock option
exercises, which are excluded from the ECI but included in
the NFB measure, likely account for some of the differential
movements in the two series. The four-quarter change in the
NFB measure bottomed out at a bit less than 2 percent in
2002, when the value of exercised options was dropping; it
has moved up steadily since that time and, in the first
quarter, stood at 4-1/2 percent--a rate not much different from
the increase in the ECI. With productivity growth slowing to
a pace below that of NFB hourly compensation, unit labor
costs rose in both the fourth and first quarters after
having trended down over the preceding two years.


Prices

Inflation moved higher in the first half of 2004. After
rising just 1-1/2 percent over the four quarters of 2003, the
price index for personal consumption expenditures (PCE)
increased at an annual rate of 3-1/2 percent between the fourth
quarter of 2003 and May 2004. In that period, energy prices
soared, and increases in core consumer prices picked up to
an annual rate of 2-1/4 percent--more than 1 percentage point
faster than the increase in 2003. Data for the consumer
price index (CPI) are available through June and show some
moderation in the core component of the series. Over the
first half of the year, the core CPI rose at an annual rate
of 2-1/2 percent, compared with an increase of 1-1/4 percent over
the four quarters of 2003.

Reflecting the surge in crude oil prices, PCE energy prices
rose at an annual rate of more than 25 percent in the first
quarter; they apparently posted another outsized increase in
the second quarter. Gasoline prices increased rapidly
through May as crude oil costs rose and as price markups
were boosted by strong demand and lean inventories; although
gasoline prices have fallen on balance since late May, they
are currently nearly 30 percent above their level at the end
of last year. As for natural gas, which can often substitute
for fuel oil in the industrial sector, spot prices were
elevated at the start of the year, fell somewhat in February
and March, and trended up over the spring. The higher spot
prices for natural gas this spring pushed up prices paid by
consumers through June. PCE electricity prices appear to
have risen at an annual rate of 3 percent over the first
half of the year, a pace similar to that in 2003.

Although volatile from month to month, consumer food prices
rose moderately on balance over the first half of 2004 after
having moved up in late 2003. Robust global demand is
imparting upward impetus to food prices, but U.S. producers
are in the process of boosting supply, which should help
restrain increases in retail food prices in coming quarters.

The step-up in core PCE inflation this year has been
especially pronounced in a few categories. In particular,
prices of motor vehicles have firmed after a noticeable
decrease in 2003. In addition, increases in shelter costs,
which were surprisingly low in 2003, are now running more in
line with earlier trends. Core inflation has also been
lifted this year by substantial increases, on balance, in a
number of categories for which prices cannot be derived from
market transactions and thus must be
imputed by the Bureau of Economic Analysis--for example,
prices of financial services provided by banks without
explicit charge. These non-market-based prices, which were
about flat in 2003, are difficult to estimate, and the
imputed figures tend to be volatile.

A number of factors have contributed to the run-up in core
inflation this year. Higher oil prices have doubtless raised
the cost of producing other goods and services. So have the
steep increases in prices of non-oil commodities such as
copper and lumber, which came about as economic activity
strengthened worldwide and as industrial capacity
utilization both here and abroad tightened. Likewise, the
decline in the dollar has boosted non-oil import prices and
thus the costs of inputs for many domestic producers. The
weaker dollar has also likely lessened the pressure on firms
facing foreign competition to hold the line on prices--a
consideration that is probably contributing to the
widespread perception that firms' pricing power has
increased lately. Moreover, unit labor costs have edged up
recently after having declined noticeably in 2002 and 2003.

From a cyclical perspective, the sharp upturn in commodity
prices is not surprising, given the pickup in the growth of
industrial production. In fact, such large increases in
commodity prices are typical as economic activity
accelerates and capacity utilization rises--especially for
products for which the supply is relatively fixed in the
short run. Some portion of these increases usually proves
transitory. More important, cyclical swings in commodity
prices tend to have only a minor effect on overall
inflation, both because they account for a small share of
total costs and because changes in commodity prices tend to
be partly absorbed in firms' profit margins, at least for a
time.

The faster rate of inflation this year underscores the
difficulty of gauging price pressures. Nevertheless, on the
whole, the evidence suggests that slack remains in labor and
product markets, which should be exerting some downward
pressure on inflation. The unemployment rate--at 5-1/2 percent
currently--is not significantly lower than it was through
much of 2002 and 2003, when core inflation was trending
down. And despite the run-up this year, capacity utilization
in the manufacturing sector is still below its longer-run
average. In addition, the strong upward trend in
productivity is continuing to help keep the rise in labor
costs muted, and profit margins are sufficiently wide to
give firms scope to absorb cost increases for a while
without putting undue upward pressure on prices.

The upturn in actual inflation has been echoed in some
measures of inflation expectations. For example, according
to the Michigan Survey Research Center, the median
expectation for inflation over the coming year has averaged
slightly more than 3 percent since early spring after
hovering in the area of 2-1/4 percent to 2-3/4 percent in 2003 and
early 2004. The median expectation for inflation over the
next five to ten years has been running a bit below 3
percent in recent months, a reading similar to the figures
for 2002 and 2003. According to the Survey of Professional
Forecasters conducted by the Federal Reserve Bank of
Philadelphia, expectations of inflation over the next ten
years held steady in June at 2-1/2 percent. Inflation
compensation over the next five years as measured by the
spread between the yield on nominal Treasury
securities and their indexed counterparts rose noticeably
during the first half of 2004. To be sure, inflation
compensation is also influenced by perceptions of inflation
risk and the secular increase in demand for inflation-
indexed debt, but the rise in near-term inflation
compensation likely reflects, at least in part, higher
inflation expectations. Similar to the survey-based measures
of longer-run inflation expectations, inflation compensation
for the period five years to ten years ahead was little
changed on net over the first half of the year.

Broader NIPA price measures are available only through the
first quarter, and the four-quarter changes in these series
do not show the rise in inflation indicated by the monthly
data discussed above. In particular, the rate of increase in
the price index for GDP over the year ending in the first
quarter was just 1-3/4 percent, the same as over the preceding
year. The four-quarter change in the price index for gross
domestic purchases--which is defined as the prices paid for
purchases of domestic and imported consumption, investment,
and government goods and services--dropped from 2-1/4 percent to
1-3/4 percent over the same period; the deceleration reflects
mainly the effects of energy prices, which rose even more
rapidly over the year ending in the first quarter of 2003
than they did over the most recent year.


U.S. Financial Markets

As 2004 opened, financial market conditions were quite
accommodative, with low corporate bond yields, narrow risk
spreads, and relatively easy terms and standards on bank
lending. Although equity prices changed little, and interest
rates rose on balance in response to positive economic news
and expectations of a tightening of monetary policy,
financial conditions in the first half of the year remained
supportive of economic growth. Business borrowing
nevertheless remained tentative, while increases in the debt
of the federal government and of households were sizable.


Interest Rates

From the end of 2003 through the end of March, yields on
nominal Treasury coupon securities fell, on net, about 30 to
45 basis points. Although interest rates rose immediately
after the FOMC's January meeting in response to the
Committee's decision to remove its statement that monetary
policy could remain accommodative for "a considerable
period," the increase proved to be short lived. Weak
employment reports released in early February and early
March prompted yields to fall amid doubts about the strength
of the economic expansion. Federal funds futures contracts
at the end of March appeared to indicate that market
participants placed small odds on a tightening of monetary
policy before late 2004, and contracts also seemed to price
in only a gradual increase in the federal funds rate during
2005.

Interest rates backed up in the second quarter as data
releases increasingly suggested that the economic expansion
would remain vigorous. Yields on the two-year and ten-year
nominal Treasury notes ended the first half of the year 90
and 36 basis points higher, respectively, than at the end of
2003, as markets adjusted to the greater likelihood of an
earlier onset and more rapid pace of monetary policy
tightening. The surprisingly strong employment reports
published in April and May, higher-than-expected readings on
core inflation, and surging oil prices all spurred increases
in Treasury yields. After the release of the employment
report in May, federal funds futures contracts priced in a
hike in the target federal funds rate at the June FOMC
meeting and a more rapid tightening of monetary policy than
had been anticipated. With the evolving outlook for monetary
policy, the volatility of short-term interest rates implied
by option prices jumped in the first half of the year after
staying in a relatively low range in 2003. Near-term
interest rates declined a bit after the Committee's decision
at its June meeting to raise the intended federal funds rate
25 basis points; the Committee's reaffirmation that policy
accommodation likely could be removed at a "measured" pace
apparently reassured investors that a steep rise in the
federal funds rate probably was not in train.

Yields on investment-grade corporate debt moved roughly in
line with those on comparable nominal Treasury securities
over the first half of the year, producing little net change
in risk spreads from their level at the end of last year.
Spreads on speculative-grade debt over Treasury debt
declined a bit further after having narrowed sharply during
2003 as the economic expansion was seen as gathering steam.


Equity Markets

Over the first half of 2004, equity prices were subject to
the strong crosscurrents of robust earnings reports, rising
interest rates, fluctuating fears about geopolitical
developments, and sharply higher oil prices. On balance,
broad equity price indexes at the end of June had edged
about 2-1/2 percent to 3-1/4 percent above year-end levels after
having surged 25-30 percent over the course of 2003. Over
the first half, analysts raised their estimates of profits
for coming quarters; the upward revision outstripped the
more modest increase in equity prices and boosted the ratio
of expected year-ahead earnings to stock prices. With real
interest rates higher, however, the difference between the
earnings-price ratio and the real ten-year Treasury yield--a
crude measure of the equity risk premium--changed little to
remain close to its average value over the past two decades
and above its level during the late 1990s.


Debt and Financial Intermediation

Aggregate debt of the domestic nonfinancial sectors expanded
at an annual rate of about 8-1/2 percent in the first quarter
of 2004, a gain similar to last year's increase. Debt growth
in the business sector has remained subdued so far this
year, as ample internal funding has limited the need for
external finance. In contrast, household debt has continued
to expand rapidly, spurred by an elevated pace of home
purchases and cash-outs from mortgage refinancing. The large
federal budget deficit led to another sharp increase in
Treasury debt in the first half of this year. Municipal
borrowing moderated somewhat, on balance, in the first half
of the year, as the improving fiscal condition of state and
local governments reduced the need for short-term borrowing
to cover budget gaps.

The growth of credit on the books of depository institutions
picked up to an annual rate of 14 percent in the first
quarter of 2004. Financing secured by residential real
estate--including home mortgages, home equity loans, and
mortgage-backed securities--drove the expansion. In contrast,
business loans continued to run off, falling at an annual
rate of about  5 percent in the first half of the year after
a 10 percent drop in 2003. The deceleration was consistent
with some signs that demand for business loans was beginning
to recover as well as with an easing of standards and terms
on these loans.


The M2 Monetary Aggregate

In the first half of 2004, short-term interest rates were
stable and M2 grew at an annual rate of 6-1/2 percent--a pace
that was roughly in line with estimates of nominal GDP--after
contracting at a record rate in the fourth quarter of 2003.
Liquid deposits--the largest component of M2--had been
depressed late last year by the ebbing of last summer's
mortgage refinancing boom. Mortgage refinancings tend to
boost M2 as the proceeds are temporarily placed in non-
interest-bearing deposit accounts pending disbursement of
funds to the holders of mortgage-backed securities. When
refinancings slowed last year, the decline in such escrow
accounts held down the growth of liquid deposits. In the
first half of this year, M2 probably received a boost from
the new round of mortgage refinancings that followed the
first-quarter decline in mortgage interest rates. The
strength in liquid deposits was partly offset, however, by
continued weakness in money market mutual funds and small
time deposits. Given the recent very low yields on these two
components of M2, households likely viewed them as less
attractive savings vehicles than other assets.


International Developments

Foreign economic activity expanded in the first half of this
year at a pace only slightly below the rapid increase in the
second half of 2003. Global trade has been boosted by strong
demand, especially from the United States and China. The run-
up in oil and commodity prices has contributed to rising,
though still moderate, inflation across the industrial and
developing countries.

By the end of the first half of this year, monetary policy
in most major foreign economies had either tightened or
assumed a less accommodative tone. Citing high rates of
capacity utilization and mounting inflationary pressures,
the Bank of England has raised its target rate 100 basis
points since early November. Mexico and China also have
tightened policy. Elsewhere, including the euro area,
Canada, and Japan, central banks most recently have kept
policy unchanged after easing previously. In general,
official statements are expressing increasing concern over
the inflationary risks associated with stronger economic
activity and higher world energy and commodity prices.

In foreign financial markets, equity price performance has
been more mixed so far in 2004 than during the second half
of 2003; sharply rising interest rates over the past few
months have weighed on equity valuations, damping the
effects of an improved earnings outlook. Since year-end,
stock prices in Europe and Canada have changed little, on
balance. In contrast, rapidly improving economic conditions
in Japan have helped boost Japanese equity prices about
10 percent. Other Asian stock price indexes have fallen, on
average, in part because of concerns about the possibility
of an acute slowdown in China. Mexican stocks have been
bolstered by strong earnings growth of leading Mexican
communications firms and, more generally, by the
strengthening U.S. expansion. Foreign long-term interest
rates rose rapidly in the second quarter as new data
(including from the United States) showing faster growth and
higher inflation led market participants to expect more-
aggressive monetary tightening. Over the first half of the
year, the spread on internationally issued sovereign debt of
emerging-market economies over U.S. Treasuries moved up
somewhat from its very low level.

After depreciating over the previous two years, the value of
the dollar rose slightly, on balance, in the first half of
2004. The firming of the dollar has been attributed to
perceptions by market participants that near-term monetary
tightening in the United States would be faster than such
tightening abroad.


Industrial Economies

A broadly based recovery appears to have been established in
Japan over the first half of 2004. Real GDP rose at an
annual rate of more than 6 percent in the first quarter
after an even greater increase in the fourth quarter. Aided
by demand from China, growth of Japanese real exports
remained robust. Personal consumption and business
investment also firmed. More-recent indicators show that
domestic strength continued in the spring with large gains
in household expenditures and improved labor market
conditions. Deflation continued to wane in Japan. Consumer
price deflation over the first half of the year was slight,
and wholesale prices increased. In financial markets, the
stronger economy boosted equity markets and helped drive up
the yield on the ten-year bellwether government bond to more
than 1-3/4 percent from its June 2003 record low of about
1/2 percent. After making substantial sales of yen for dollars
in the first quarter, Japanese authorities ceased
intervention in mid-March. Even so, the yen depreciated
early in the second quarter before appreciating to around
Y109 per dollar.

Economic conditions in the euro area firmed over the first
half of 2004, but performance varied across countries, and
the region as a whole continues to lag the global upturn.
Real GDP in the euro area increased at an annual rate of 2-1/4
percent in the first quarter; output in France, Spain, and
several smaller member countries rose relatively briskly,
while growth in Germany and Italy was less robust. In the
first quarter, domestic demand firmed noticeably, except in
Germany, where growth was due entirely to a spike in
exports. German consumer spending remains anemic, held down
by a weak labor market and low consumer confidence. Euro-
area indicators for the second quarter initially were
upbeat, but more-recent data have been mixed. Labor markets
have yet to benefit from the recovery, and the average
unemployment rate in the region edged up to 9 percent in the
spring. Inflation for the euro area over the twelve months
ending in June was near 2-1/2 percent, a rate above the
European Central Bank's medium-term goal of less than, but
close to, 2 percent. Excluding energy, food, alcohol, and
tobacco, prices rose slightly less than 2 percent over the
same period.

Economic expansion in the United Kingdom continued unabated
over the first half of 2004. Labor markets tightened
further; the unemployment rate edged down to its lowest
level in almost three decades, and labor earnings posted
solid gains. Despite the strong economy, consumer price
inflation over the twelve months ending in June was 1-1/2
percent, remaining  below the central bank's official target
rate of 2 percent. Conditions in the U.K. housing market,
however, remained red hot, with double-digit price
increases, high levels of household mortgage and consumer
borrowing, and sizable withdrawals of home equity.

The Canadian economy picked up steam in the first half of
2004 after a year plagued with difficulties including SARS,
mad cow disease, and a regional power outage. Sizable gains
in consumption and investment boosted output in the first
quarter, and indicators are pointing to continued good
performance in these sectors. Export growth was strong, as
the robust economic performance of the United States appears
to have outweighed the negative effect of Canadian dollar
appreciation on trade. The unemployment rate was relatively
stable over the first half, and employment bounced back in
the second quarter from a first-quarter lull. Consumer price
inflation decreased early in the year, but energy costs
helped drive up the rate to 2-1/2 percent over the twelve
months ending in June. Prices excluding food, energy, and
indirect taxes have remained more subdued, rising slightly
less than 1-1/2 percent over the same period.


Emerging-Market Economies

Estimates suggest that real GDP in China surged in the first
quarter with continued outsized gains in fixed-asset
investment. Fears of overinvestment, particularly in the
steel, cement, and aluminum industries, led Chinese
officials to intensify their tightening measures early in
the second quarter. These measures included increases in
reserve requirements and in some interest rates as well as
stricter criteria for the approval of investment projects. A
sharp slowdown in estimated real GDP for the second quarter
suggests that these steps are working. Despite the recent
slowing in growth, Chinese exports and imports soared in the
first half of the year, and trade was close to balanced.

Growth in the other Asian emerging-market economies slowed
only moderately in the first quarter from the fast pace at
the end of last year. Exports, which continued to be the
driving force behind that growth, were fueled by Chinese
demand as well as by the recovery in the global high-tech
market and stronger world demand overall. Consumer demand
generally rose across the region with the notable exception
of Korea, where high levels of consumer debt are weighing on
spending. Although still only moderate, inflation across the
Asian emerging-market economies is beginning to rise as
stronger aggregate demand takes hold and higher energy and
commodity prices pass through to prices more generally.

The Mexican economy has been propelled this year by strong
demand from the United States. Gains have been broadly
based, with sharp increases in industrial production,
exports, construction, and retail sales. Employment in the
industries most closely linked to U.S. trade also has
started to increase. Responding to a rise in twelve-month
inflation to slightly above its 2 percent to 4 percent
target range, the Bank of Mexico has tightened policy
several times so far this year. Elevated oil prices boosted
the Mexican public-sector fiscal surplus to a record high
during the first five months of the year and facilitated an
increase in federal transfers to state governments.

In Brazil, GDP grew robustly in the first quarter, and
indications are that economic activity continued to
expand in the second quarter with support from strong
external demand. Job growth has been robust, although
unemployment has remained high. Inflation, however,
continues to concern authorities. Asset prices weakened
earlier this year, in part because of rising global interest
rates but also because of market participants' unease about
the direction of structural and fiscal reforms; since then,
asset prices have partially rebounded.

The recovery in Argentina has continued at a rapid pace in
recent quarters, but limited investment in the
energy sector, reflecting a lack of structural reforms, has
forced the government to import electricity, natural gas,
and fuel oil from neighboring countries. Creditors have
shown little enthusiasm for the country's latest debt
restructuring plan, and the federal government faces
difficult challenges in normalizing its international
financial situation and reforming its fiscal relations with
the provinces.