The rates of delinquency continued to rise in the first few months of 2008 across all categories of mortgage loans. Problems remained especially severe for subprime loans. However, the growth rate of subprime delinquencies has slowed this year, while that of prime and near-prime delinquencies--particularly on adjustable-rate loans--has picked up. Credit quality is strongly related to the origination date of mortgage loans, with loans originated in 2006 and 2007 much more likely to experience delinquency and default than loans originated in previous years. The poorer performance of the more recent loan vintages reflects a general deterioration in underwriting standards through early 2007 and the decline in house prices since 2007, which has increased the occurrence of negative homeowner equity for houses purchased near the peak of the real estate market.

New subprime mortgage loans remained largely unavailable in the first half of 2008, and borrowers with higher credit risk had to turn to government guarantee programs, such as that of the Federal Housing Administration, to obtain mortgage loans. The availability of prime mortgage credit has been held down by a further tightening of lending standards at many commercial banks, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices conducted in January and April. Securitization of mortgages by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, was robust through April, although the GSEs tightened standards and increased guarantee fees. For prime loans, interest rates on conforming fixed-rate mortgages were up slightly, on net, over the first half of 2008 after declining moderately late last year.⁴ Rates on conforming adjustable-rate mortgages dropped in January but have since reversed a portion of that decline. Offered rates on jumbo fixed-rate loans--which ran up in the second half of last year as the securitization market for such loans dried up--remained elevated in the first half of 2008, and spreads between rates offered on these loans and on conforming loans stayed unusually wide.⁵ To support the market for larger loans, the Congress raised the conforming loan limit temporarily for 2008, which allowed the GSEs to back these mortgages. However, because the prepayment characteristics of jumbo mortgage borrowers are different from those of other borrowers, the GSEs and other market participants decided not to pool these "jumbo conforming" mortgages with other mortgages when creating mortgage-backed securities (MBS). As a result, the secondary market for such mortgages has thus far failed to thrive. Concerns expressed by public policymakers persuaded Fannie Mae and Freddie Mac to make greater efforts to jump-start trading in the market for jumbo conforming loans, and the GSEs have recently taken a variety of actions to encourage the development of that market.

The weakness in the housing market was associated with a sharp slowing in the growth of household mortgage debt to an annual rate of 3 percent in the first quarter of 2008, down from 6-3/4 percent in 2007 and 11-1/4 percent in 2006. The available indicators suggest that mortgage debt likely slowed further in the second quarter.

Consumer Spending and Household Finance

The growth rate of consumer spending slowed some in the first half of 2008 from its solid pace in the second half of 2007. The slowing reflected a number of restraining influences. The growth rate of real labor income has stepped down substantially since last summer as labor market conditions have weakened and as rising prices for food and energy have put a sizable dent in consumers' purchasing power. At the same time, household wealth has been reduced by declining values of both equities and houses. In addition, borrowing at banks to finance outlays has become more difficult as terms and standards on consumer credit have been tightened. Although the tax rebates that households began receiving in the spring are likely cushioning these effects to some extent, consumers appear to be quite downbeat. Measures of consumer confidence, which had dropped sharply in the second half of 2007, plunged further in the first half of this year and now stand at or below the low levels reached in the early 1990s.

Real personal consumption expenditures (PCE) rose at a modest annual rate of 1 percent in the first quarter. The available data suggest that spending picked up in the second quarter, reportedly boosted by tax rebates. Spending on light motor vehicles was lackluster in the first half of the year, as high gasoline prices curbed demand for sport-utility vehicles and pickup trucks. Outlays for other types of goods fell slightly in the first quarter but appear to have turned back up in recent months. Spending on services has held up well in recent quarters.

Following a sharp deceleration in the second half of last year, real labor income has been flat so far this year, as nominal wage gains have been eroded by rising consumer prices. Average hourly earnings, a measure of wages for production or nonsupervisory workers, rose at the same rate as the PCE price index in the five months through May; thus, wages were unchanged in real terms. In the past couple of months, part of the strain on household incomes caused by the stagnation in real wages was likely alleviated temporarily by the tax rebates that were paid out in May and June. As a result of these rebates, growth in real disposable personal income (DPI)--that is, after-tax income adjusted for inflation--which was subpar in the fourth quarter of 2007 and the first quarter of 2008, likely jumped in the second quarter. Despite an increase in transfers reflecting the recently passed extension of unemployment insurance benefits, real DPI is likely to fall back in the third quarter as the disbursement of rebates slows considerably.

After several years of providing an impetus to spending, household wealth has been a negative influence this year. Changes in household net worth tend to influence consumer spending most heavily over a period of a year or two. Accordingly, the drop last year in the ratio of household net worth relative to income probably weighed on consumption outlays in the first half of 2008. Moreover, this year's declines in residential real estate values and in equity prices have exacerbated the situation. Flagging wealth has likely left households less inclined to raise their spending at a rate that exceeds income growth, and the personal saving rate has flattened out over the past few quarters. In May, the saving rate jumped to 5 percent, as the immediate effect of tax rebates in many households was to boost savings.

Overall household debt increased at an annual rate of about 3-1/2 percent in the first quarter of 2008, a notable deceleration from the 6-3/4 percent advance in 2007. Household debt appears to have slowed further in the second quarter. Because the growth of household debt was slightly less than the growth in nominal DPI in the first quarter and interest rates on mortgage and consumer debt declined a bit, the ratio of financial obligations to DPI ticked down.

Consumer (nonmortgage) debt expanded at an annual rate of 5-3/4 percent in the first quarter, about the same pace as in 2007. Consumer debt growth held up despite a reported tightening of lending terms and standards at banks. In part, this pattern may reflect some substitution away from mortgage credit. Also, interest rates on auto loans and on credit cards generally declined in the first half of this year but by less than short-term market interest rates.

Overall credit quality of consumer loans has deteriorated somewhat in recent months. Delinquency rates on consumer loans at commercial banks and captive auto finance companies rose in the first quarter but stayed within the range experienced over the past 10 years. Although household bankruptcy filings remained low relative to the levels seen before the changes in bankruptcy law implemented in late 2005, the bankruptcy rate rose modestly in the first few months of 2008.

Secondary-market data suggest that funding for credit card and auto loans has been well maintained in recent months. Notably, issuance of asset-backed securities (ABS) tied to credit card loans and auto loans has remained robust, despite spreads of yields on these securities over comparable-maturity swap rates that continue to be near historically high levels. In contrast, pressures in secondary markets for student loan ABS have reportedly affected the availability of such credit. The reimbursement formula for government-guaranteed student loans did not adequately compensate lenders for the higher funding cost in securitization markets, and issuance of guaranteed student loan ABS dropped sharply early in 2008. Legislation enacted in May gave the Department of Education and the Treasury the authority to provide short-term liquidity to institutions that lend to students, and availability of student loans appears to have improved. However, concerns persist about access to loans by students at community and career colleges, as these loans tend to be less profitable for lenders.

The Business Sector

Fixed Investment

After having posted robust gains in the middle of last year, real business fixed investment lost some steam in the fourth quarter and eked out only a small advance in the first quarter of 2008. Economic and financial conditions that influence capital spending deteriorated appreciably late last year and early this year: Business sales slowed, corporate profits fell, and credit conditions for some borrowers tightened. In addition, the heightened concern about the economic outlook may have caused some firms to postpone or abandon plans for capital expansion this year.

Real business outlays for equipment and software were flat in the first quarter. Growth in real spending on high-tech equipment and software slowed to an annual rate of about 10 percent, down from the 13 percent pace recorded in 2007. In addition, business spending on motor vehicles tumbled. Investment in equipment other than high tech and transportation dropped at an annual rate of 3-3/4 percent in the first quarter after a smaller decline in the previous quarter. The available indicators suggest that capital spending on equipment and software fell in the second quarter: Business purchases of new motor vehicles reportedly slipped again; shipments of nondefense capital goods (adjusted to exclude both transportation items and goods that were sent abroad) were lower, on average, in April and May than in the first quarter; and the tone of recent surveys of business conditions remained downbeat.

Nonresidential construction activity, which exhibited considerable vigor in 2006 and 2007, slowed appreciably in the first quarter of 2008. Real outlays for new commercial buildings declined sharply in the first quarter, and increases in outlays for most other types of building stepped down. More-recent data on construction expenditures suggest that spending on nonresidential structures may have bounced back in the second quarter. However, deteriorating economic and financial conditions indicate that this rebound may be short-lived. In addition to the weakening of business sales and profits, vacancy rates turned up in the first quarter (the latest available data). Moreover, the financing environment has remained difficult; bank lending officers have reported a significant tightening of terms and standards for commercial real estate loans, and funding through the commercial mortgage-backed securities (CMBS) market has continued to be extremely limited.

Inventory Investment

Despite sluggish final sales, inventories declined again in the first quarter of 2008 as firms acted promptly to prevent inventory imbalances from arising. Automakers, which had worked to bring days' supply down to a sustainable level last year, have moved aggressively to keep production aligned with demand in recent quarters. Excluding motor vehicles, real inventory investment fell in the fourth quarter of 2007 to its lowest level in several years and then turned negative in the first quarter of this year. According to the limited available data, nonauto businesses continued to liquidate real inventories early in the second quarter. Business surveys suggest that companies are generally comfortable with their current stock levels. Nonetheless, a few industries, most notably those producing construction supplies, are showing some evidence of inventory overhangs.

Corporate Profits and Business Finance

The sluggish pace of business investment in recent months is due in part to the weakening of domestic profitability and the tighter credit conditions faced by some businesses. In the first quarter of 2008, total economic profits for all U.S. corporations were down slightly from their level four quarters earlier; a nearly 20 percent rise in receipts from foreign subsidiaries was not sufficient to offset a 2-1/2 percent fall in domestically generated profits. Although profits as a share of output in the nonfinancial corporate sector have declined in recent quarters, they remain well above previous cyclical lows. For companies in the S&P 500, operating earnings per share fell 17 percent over the year ending in the first quarter. This decline was more than accounted for by plummeting earnings at financial firms, which reported large write-downs on leveraged loans and mortgage-related assets.⁶ For nonfinancial firms in the S&P 500, earnings rose nearly 11 percent over the four quarters ending in the first quarter of 2008; energy-sector firms had a strong 31 percent increase in earnings, whereas earnings at other nonfinancial firms rose 4-1/2 percent.

Although credit has remained available to the business sector, yields on corporate bonds increased significantly over the first half of the year, and banks reported tighter terms and standards on commercial and industrial loans and on commercial real estate loans. All told, the growth rate of the debt of nonfinancial businesses fell from 11-3/4 percent in 2007 to 9-1/4 percent in the first quarter of 2008; the available data point to a further deceleration in the second quarter of this year.

On balance, the composition of borrowing by nonfinancial businesses has shifted this year toward longer-maturity debt. Net bond issuance by nonfinancial firms has been strong. Speculative-grade issuance, which dropped sharply late last year and was practically nil in the first quarter, rebounded markedly in the second quarter, while investment-grade issuance has continued to be robust. Spreads between yields on investment- and speculative-grade bonds and those on comparable-maturity Treasury securities climbed in January and then surged in March. After narrowing in April and May, bond spreads jumped again in late June. Outstanding commercial paper (CP) for nonfinancial firms has been little changed, on net, this year. Yields on nonfinancial CP have moved down since the beginning of the year, roughly in line with other short-term interest rates, although spreads between yields on lower-rated and higher-rated nonfinancial CP remain well above the levels prevailing before the onset of the financial difficulties last summer.

Commercial and industrial (C&I) loans at banks expanded briskly in the first quarter and then slowed markedly in the second quarter. In the Senior Loan Officer Opinion Survey taken in January and April, considerable net fractions of banks reported that they had tightened credit standards and boosted spreads on C&I loans. According to the respondent banks, the move to a more stringent lending posture mainly reflected a less favorable or more uncertain economic outlook and a reduced tolerance for risk; a significant fraction also noted concerns about the capital position of their own bank as a reason for tightening standards. The secondary market for syndicated leveraged loans remained relatively weak, but loans associated with some prominent buyouts were sold, albeit at a discount.

Gross equity issuance by nonfinancial firms dipped in the first quarter and rebounded in the second quarter. A sharp decline in share repurchases and cash mergers led to a notable reduction of net equity retirement in the first quarter.

The credit quality of nonfinancial corporations generally has remained solid. The six-month trailing bond default rate was very low despite a small tick up in June. The delinquency rate on C&I loans at commercial banks continued the mild increase that began last year, but it remained subdued by historical standards. Ratings downgrades in the first five months of this year were modest, only slightly exceeding upgrades. Balance sheet liquidity at nonfinancial corporations remained high through the first quarter of 2008, and leverage stayed very low.

In the April 2008 Senior Loan Officer Opinion Survey, a large fraction of banks reported having tightened credit standards on commercial real estate loans. Delinquency rates on commercial real estate loans for construction and land development projects extended by commercial banks moved sharply higher in the first quarter of 2008 after rising noticeably last year. In contrast, delinquency rates on bank loans that finance existing commercial properties moved up only slightly. Delinquency rates on commercial mortgages held by life insurance companies and those in CMBS pools, which mostly finance existing commercial properties, remained low.

Despite the generally solid performance of commercial mortgages in securitized pools, spreads of yields on CMBS over comparable-maturity swap rates soared to unprecedented levels early in 2008. In recent months, these spreads have narrowed somewhat, but they remain well above levels seen before this year. The widening of spreads reportedly reflected heightened concerns regarding standards for underwriting commercial mortgages over the past few years and likely also investors' wariness of structured finance products more generally. After hitting a record level in early 2007, issuance of CMBS dropped sharply late last year and slowed to a trickle so far this year.

The Government Sector

Federal Government

The deficit in the federal unified budget has widened during the current fiscal year after having narrowed in the preceding few years. A substantial portion of the rebates authorized by the Economic Stimulus Act of 2008 was distributed in May and June, which caused a significant widening of the deficit. In addition, the growth of receipts has slowed in response to the weaker pace of economic activity, and the growth of outlays has stepped up. Over the first nine months of fiscal year 2008--from October through June--the unified budget recorded a deficit that was $148 billion greater than during the comparable period ending in June 2007. When measured relative to nominal GDP, the deficit moved up from 1-1/4 percent in fiscal 2007 to 2-1/4 percent during the 12 months ending in June 2008; a continued slow pace of economic activity and additional revenue losses associated with the Stimulus Act are expected to widen the deficit further in the final three months of fiscal 2008.

The Economic Stimulus Act is estimated to result in about $115 billion of rebates being sent to households in 2008 and 2009. The rebates began to be distributed in the last few days of April, and by the end of June, approximately $80 billion worth of rebates had been disbursed, accounting for more than half of the widening of the budget deficit in the first nine months of fiscal 2008 relative to the same period in fiscal 2007.

The slower pace of economic activity has cut into receipts. Excluding the budgetary effects of stimulus rebates, federal revenues in the first nine months of fiscal 2008 were only 2 percent higher than in the same period in fiscal 2007, down from a rise of 6-3/4 percent in fiscal 2007 and considerably smaller than the double-digit gains recorded in fiscal 2005 and fiscal 2006. The slowdown in federal revenues has been most pronounced for corporate receipts, reflecting the decline in corporate profits since the middle of 2007. Individual income and payroll tax receipts--excluding the stimulus rebates--also have slowed, likely because of the smaller gains in personal income during the current fiscal year.

Nominal federal outlays in the first nine months of fiscal 2008 were 6-1/2 percent above their level in the comparable period in fiscal 2007, a faster pace of increase than was recorded in fiscal 2007 but generally below the rapid increases seen in fiscal 2002 through 2006. So far this fiscal year, the growth of outlays for defense has stepped up relative to fiscal 2006 and 2007, and spending has continued to rise apace in most major nondefense categories. In the months ahead, outlays will be bumped up further by the extension of eligibility for unemployment insurance benefits to individuals who have exhausted their benefits.

As measured in the national income and product accounts (NIPA), real federal expenditures on consumption and gross investment--the part of federal spending that is a direct component of GDP--increased at an annual rate of 4-1/4 percent in the first quarter, a contribution of 0.3 percentage point to real GDP growth. Real defense spending accounted for almost the entire rise, as nondefense outlays only edged up. In the second quarter, defense spending appears to have posted another sizable increase, and given currently enacted appropriations, it is likely to rise further in coming quarters.

Federal Borrowing

Federal debt rose at an annual rate of 7-1/2 percent in the first two quarters of fiscal year 2008--from October through March--a notable step-up from the 4-1/4 percent pace in fiscal 2007. As of the end of March, the ratio of federal debt held by the public to nominal GDP was about 37 percent, slightly higher than in recent years.

The deterioration in the budget position of the federal government led the Treasury to reintroduce the one-year Treasury bill, which was last issued in 2001. The initial auction on June 3 was very well received, with a bid-to-cover ratio above 3. Issuance also increased for both shorter- and longer-maturity Treasury securities. The proportion of nominal coupon securities purchased at Treasury auctions by foreign investors changed little over the first half of 2008 and remains in the range of 10 percent to 25 percent observed over the past several years. However, holdings of Treasury securities by foreign official institutions at the Federal Reserve Bank of New York increased more rapidly in the first half of 2008 than over any of the previous three years.

State and Local Government

The fiscal positions of state and local governments began to weaken last year and have continued to deteriorate in 2008. After having improved significantly from 2003 to 2006, net saving by the sector--which is broadly similar to the surplus in an operating budget--turned slightly negative in 2007, and this measure moved further into negative territory in the first quarter of 2008. The deterioration in budget conditions has occurred as increases in revenues have slowed while nominal expenditures have risen at a brisk pace. The slowdown in state income tax revenues has followed a pattern similar to the one that has emerged at the federal level. Corporate receipts have declined, and the rise in individual income taxes has become more subdued. At the same time, state receipts from sales taxes have softened markedly. At the local level, the decline in house prices has not yet begun to curb local property tax revenues appreciably, but increases in local receipts from this source seem likely to slow more noticeably in the next few years.

On the outlays side of the accounts, nominal spending has continued to rise, particularly for expenditures on health care and energy items. In real terms, expenditures on consumption and gross investment by state and local governments (as measured in the NIPA) rose only a bit in the first quarter, as increases in expenditures on current operations were largely offset by a decline in outlays on structures. However, construction expenditures are volatile from quarter to quarter, and the data through May suggest that real state and local expenditures for structures picked up in the second quarter. Meanwhile, state and local hiring remained elevated through June.

State and Local Government Borrowing

Bond issuance by state and local governments slowed moderately in the first quarter of 2008 as the cost of borrowing rose. Investors demanded higher returns, in part because of concerns about the strength of financial guarantors that insure many municipal bonds and in part because of concerns about the effect of a potential economic slowdown on state and local government revenues.⁷ Beginning in February, these investor apprehensions also led to widespread failures of rate-resetting auctions for auction rate securities (ARS) issued by state and local governments.⁸ Pressures in the municipal securities market eased somewhat in the second quarter, along with the broader relaxation of financial market strains. In addition, ratings upgrades of municipalities greatly exceeded downgrades in the second quarter. Since March, municipal bond issuance has rebounded, and a significant fraction of failing ARS issues have been paid down with the proceeds of standard bond issues.

National Saving

Total net national saving--that is, the saving of households, businesses, and governments excluding depreciation charges--dipped below zero in the first quarter of 2008. After having stood at an already low rate of 1-3/4 percent of nominal GDP in the second quarter of 2007, the national saving rate declined steadily over the subsequent three quarters, as the federal budget deficit widened, the fiscal positions of state and local governments deteriorated, and business saving decreased. Accordingly, total national saving as a share of nominal GDP, which has been declining, on balance, since the late 1990s, has fallen to a historic low (apart from the third quarter of 2005, which was marked by sizable hurricane-related property losses). If not reversed over the longer run, persistent low levels of saving will be associated with either slower capital formation or continued heavy borrowing from abroad, either of which would retard the rise in the standard of living of U.S. residents over time and hamper the ability of the nation to meet the retirement needs of its aging population.

The External Sector

International Trade

Foreign demand has continued to be an important source of strength for the U.S. economy. Net exports contributed 3/4 percentage point to the growth of real GDP in the first quarter of 2008 after adding a similar amount to growth in 2007. The growth of real exports of goods and services expanded at a 5-1/2 percent pace in the first quarter, moderating from the 12-1/2 percent surge recorded in the second half of 2007. Export growth in the first quarter was supported by higher exports of agricultural products, consumer goods, industrial supplies, and services. In contrast, exports of both aircraft and automobiles moved down after rising rapidly in the second half of 2007. Exports to Europe and Latin America rose robustly (in current dollars), while exports to Canada and to OPEC countries fell back. Data for April and May suggest that exports continued to expand in the second quarter, with exports of industrial supplies showing particular strength.

The positive contribution of net exports in the first quarter reflected, in part, a 3/4 percent decline in real imports of goods and services. Imports of automotive products and consumer goods fell in line with slowing U.S. domestic demand, more than offsetting higher real imports of oil and a slight increase in imports of capital goods. Imports from China and Mexico declined (in current dollars), whereas imports from Canada, Japan, and OPEC countries expanded. After falling sharply in March, imports rebounded, on average, in April and May, as imports of capital equipment and consumer goods increased strongly.

In the first quarter of 2008, the U.S. current account deficit was $706 billion at an annual rate, or 5 percent of GDP, $25 billion narrower than its level in 2007; the narrowing largely reflects higher net investment income. A large improvement in the non-oil trade deficit was offset by a sharp increase in the bill for imported oil, which resulted from the jump in oil prices.

Compared with 2007, prices for imports of both material-intensive and finished goods are increasing at much faster rates so far this year. Although import price increases also reflect the depreciation of the dollar, rising commodity prices (discussed in more detail in the box entitled ("Commodity Prices" ) have significantly boosted the rate of import price inflation. In the first quarter, prices of imported goods excluding oil and natural gas rose at an annual rate of about 7-1/2 percent, a pace more than twice that of the previous year. Available data suggest that import price inflation was sharply higher in the second quarter.

The Financial Account

In late 2007 and the first quarter of 2008, the U.S. current account deficit was financed primarily by foreign purchases of U.S. securities, as has been the norm in recent years. The global financial turmoil has continued to leave an imprint on both the sources and composition of cross-border financial flows, including a net private outflow in the first quarter. Meanwhile, foreign official inflows provided all of the financing from abroad during the first quarter, driven by net purchases of U.S. Treasury and agency securities by Asian institutions. Unusually large net purchases of corporate securities also contributed to foreign official inflows, likely reflecting sovereign wealth fund activity.

Foreign private demand appeared to remain robust for the safest U.S. investments--net private purchases of U.S. Treasury securities, which surged in the third quarter of 2007 when the turmoil began, remained at near-record levels through April 2008. In contrast, corporate bond purchases by foreign private investors have been weaker in each quarter of the turmoil than in any previous quarter since 2002. Corporate equity purchases have also been very weak in 2008 through April after a strong rebound in the fourth quarter of 2007. Overall, total inflows from foreign private acquisitions of U.S. securities were well below average in the first quarter of 2008 but slightly above the nine-year low set in the third quarter of 2007 as the turmoil began.

Inflows from private purchases of U.S. securities in the first quarter of 2008 were offset by strong outflows associated with U.S. direct investment abroad and by interbank flows. Somewhat surprisingly given the global financial turmoil, the strength seen in U.S. direct investment abroad in 2007 persisted through the fourth quarter and into the first quarter of 2008. In addition, net lending abroad by U.S.-resident banks, which tends to be quite volatile, has increased with unusual consistency since the turmoil began; these outflows, primarily from foreign-owned banks to their European affiliates, were particularly large in March as conditions in U.S. and European interbank funding markets re-intensified.

The Labor Market

Employment and Unemployment

The demand for labor has been contracting this year. After having increased 54,000 per month, on average, in the second half of 2007, private payroll employment declined at an average monthly pace of 94,000 in the first half of 2008. Over the same period, the civilian unemployment rate moved up more than 1/2 percentage point, to 5-1/2 percent.

Job losses in the first half of 2008 were concentrated in the construction and manufacturing sectors. Although businesses in these industries have been trimming payrolls for more than two years, the downsizing has intensified during the past several months. In addition, job losses have begun to mount this year in the wholesale and retail trade sectors and in the professional and business services category. Even among the many sectors in which payrolls have continued to expand, such as technical services providers and eating and drinking establishments, job gains have been less robust so far this year than in 2007. A notable exception has been hiring by providers of health and education services, which has remained strong.

The unemployment rate, which rose 1/2 percentage point in 2007, increased another 1/2 percentage point in the first half of this year. Initial claims for unemployment insurance and the number of individuals receiving unemployment insurance benefits moved up considerably over the six months ending in June; accordingly, the share of unemployed workers who lost their last jobs (as opposed to those who voluntarily left their jobs or were new entrants to the labor force) rose, on net, this spring. In addition, the percentage of persons who reported that they were working part time for economic reasons increased sharply. Thus far, the labor force participation rate, which typically falls during periods of labor market weakness, has remained steady and stood at 66.1 percent in June, near the middle of the range that has prevailed since early 2007.

Other indicators also point to further deterioration in labor market conditions this year: Private surveys of businesses suggest that firms plan to continue cutting back on hiring in the near term. At the same time, according to surveys of consumers, assessments of labor market prospects in the year ahead, which had worsened late last year, slipped further in the first half of 2008.

Productivity and Labor Compensation

Gains in labor productivity have moved up significantly of late. According to the latest available published data, output per hour in the nonfarm business sector rose 3-1/4 percent during the year ending in the first quarter of 2008, up from the 1/2 percent increase recorded over the preceding four quarters. On average, the rise in productivity over the past two years, although less than the outsized increases posted earlier in the decade, suggest that the fundamental forces that in recent years have supported a solid uptrend in underlying productivity remain in place. Those forces include the rapid pace of technological change and the ongoing efforts by firms to use information technology to improve the efficiency of their operations. Increases in the amount of capital, especially high-tech capital, available to each worker also appear to be providing considerable impetus to productivity growth.

Broad measures of hourly labor compensation have not kept pace with the rapid increases in both overall consumer prices and labor productivity, despite a labor market that, until recently, had been generally tight. The employment cost index (ECI) for private industry workers, which measures both wages and the cost to employers of providing benefits, rose 3-1/4 percent in nominal terms between March 2007 and March 2008 (the latest available data), the same gain as was recorded over the preceding 12 months. Although the increase in the wage and salary component of the ECI edged down, the rise in benefits costs picked up markedly. Benefits costs were pushed up by a sharp rise in employer contributions to retirement plans, which likely reflected, in part, the weak performance of the stock market and an atypically small increase in employer contributions in the preceding year.

According to preliminary data, compensation per hour in the nonfarm business (NFB) sector--an alternative measure of hourly compensation derived from the data in the NIPA--rose 4 percent over the year ending in the first quarter of 2008, down from a 5 percent gain in the previous year. Because of the slower growth in NFB hourly compensation and the faster growth in productivity over the period, unit labor costs rose just 3/4 percent over the year ending in the first quarter of 2008 after having increased 4-1/4 percent over the preceding year. On average, the rise in unit labor costs over the past two years is about on par with the increases recorded in the preceding two years.

Prices

Headline inflation remained elevated in the first half of 2008, as prices for both food and energy continued to surge. The chain-type price index for personal consumption expenditures increased at an annual rate of 3.4 percent between December 2007 and May 2008, about the same as the brisk pace registered over the 12 months of 2007. Excluding food and energy items, the PCE price index rose at an annual rate of 1.9 percent over the first 5 months of the year, down from the 2.2 percent increase over the 12 months of 2007.

Energy prices, which jumped 20 percent over 2007, continued to soar in the first five months of this year. Spurred by rising crude oil costs, motor fuel prices continued to move up through May, and increases in prices of heating fuel and natural gas also jumped appreciably. Furthermore, the pass-through of the record-high levels of crude oil prices into retail gasoline prices was only partial, and wholesale and retail margins were unusually compressed in May. As these margins return to more typical levels, retail prices are likely to rise further. Indeed, survey evidence suggests that prices at the pump jumped again in June and early July. The recent pickup in natural gas prices apparently reflected substitution by utilities and other users away from relatively expensive crude oil as well as the unexpected shutdown of some production in the Gulf of Mexico during the spring.

Food prices have also picked up further this year. After climbing 4-3/4 percent in 2007, the PCE price index for food and beverages increased at an annual rate of more than 6 percent between December 2007 and May 2008. High grain prices and strong export demand have been primarily responsible for sizable increases in the retail prices of poultry, fish, eggs, cereal and bakery items, fats and oils, and a variety of other prepared foods. In addition, the index for fruits and vegetables rose at an annual rate of 7-1/4 percent over the first five months of the year, likely reflecting, in part, higher input costs. Although world grain production improved this spring, excessively wet weather and flooding in the Midwest boosted spot prices for corn and soybeans in June.

The small decline in core PCE price inflation this year masked some substantial--but largely offsetting--cross-currents. Shelter costs have continued to decelerate as housing markets have softened further. In addition, a moderation in the pace of medical care price increases has also held down core price inflation this year. In contrast, prices of core services besides medical and shelter costs have increased more rapidly. Similarly, prices of core goods, which declined some in 2007, were about flat, on net, over the first five months of this year.

More fundamentally, increased slack in labor and product markets is likely damping price increases this year. However, a number of other factors are putting upward pressure on core inflation. Higher prices for energy and other industrial commodities continue to add to the cost of producing a wide variety of goods, and increases in the prices of non-oil imports have picked up appreciably. Moreover, inflation expectations, especially for the near term, have moved up since the turn of the year. Probably reflecting the elevated level of actual headline inflation, the median expectation for year-ahead inflation in the Reuters/University of Michigan Surveys of Consumers moved up to about 3-1/2 percent at the end of 2007 and then continued to rise in 2008; it reached 5.3 percent in the preliminary July estimate. However, the upward movement in longer-run inflation expectations has been much less pronounced. According to the preliminary July result in the Reuters/University of Michigan survey, median 5- to 10-year inflation expectations were 3.4 percent for a third consecutive month, compared with the readings in the range of 3 percent to 3-1/4 percent that had prevailed for the preceding few years. Similarly, estimates of 10-year inflation compensation, as measured by the spreads of yields on nominal Treasury securities over those on their inflation-protected counterparts, have moved up about 20 basis points, on balance, since the turn of the year. However, most of that increase reflected higher inflation compensation over the next 5 years; estimates of inflation compensation 5 to 10 years ahead were up only 10 basis points by early July. According to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, expectations of inflation over the next 10 years ticked up in the first half of 2008, though they remain essentially unchanged since 1998.

Broader, NIPA-based measures of inflation, which are available only through the first quarter of this year, slowed relative to the pace of the past couple of years. The latest data show a rise in the price index for GDP less food and energy of about 2 percent over the year ending in the first quarter, down about 1 percentage point from the figure for the year ending in the first quarter of 2007. In addition to a lower reading for core PCE inflation over the past four quarters, prices for some other components of final demand, especially construction, decelerated.

Financial Markets

The elevated risk spreads, high volatility, and impaired functioning that characterized domestic and international financial markets in the second half of 2007 continued through the first half of 2008. Spillovers from the slumping U.S. housing market were the largest direct source of these pressures, but a generalized flight from riskier assets--particularly structured credit products--and worries about a global economic slowdown also contributed to financial strains.⁹ The Federal Reserve lowered the target federal funds rate an additional 225 basis points over the first four months of 2008 in response to a deteriorating outlook for economic activity.

Financial strains increased significantly during the first quarter, leading to a liquidity crisis in March at The Bear Stearns Companies, Inc., a major investment bank, and to its subsequent acquisition by JPMorgan Chase & Co. Additional actions taken by the Federal Reserve to improve market functioning and liquidity, including the introduction of liquidity facilities for primary dealers, appeared to have an ameliorative effect, and tensions eased somewhat in the second quarter. (See the box entitled "The Federal Reserve's Liquidity Operations." ) Nevertheless, conditions in a broad range of domestic and international financial markets remained strained relative to previous years. This week, the Board of Governors announced a temporary arrangement that allows the Federal Reserve to extend credit to Fannie Mae and Freddie Mac, if necessary.

Market Functioning and Financial Stability

The deteriorating performance of subprime mortgages in the United States prompted widespread strains and turbulence in domestic and international financial markets in the second half of 2007. Substantial losses on even the highest-rated structured products based on subprime mortgages caused market participants to reassess the risks associated with other structured financial instruments and raised concerns about the exposures of major financial institutions to these assets. As liquidity in markets for structured products evaporated, banks were forced, at least temporarily, to hold more assets on their balance sheets than they anticipated. In addition, banks' losses on mortgage-related securities and other assets prompted credit concerns among counterparties. Both of these factors contributed to strains in bank funding markets. The resulting deleveraging in the financial sector reduced the availability of credit to the overall economy. By late 2007, U.S. house prices had begun to fall, residential investment was contracting sharply, and indicators of overall economic activity had softened noticeably. These developments induced investors to pull back from a broader range of financial assets, leading to impaired liquidity conditions in many markets, with widened risk spreads and elevated volatilities.

This market turbulence continued into early 2008, as liquidity in many financial markets continued to be impaired and risk spreads remained wide. After declining sharply late last year, issuance of non-agency-sponsored mortgage-backed securities essentially came to a halt by the beginning of 2008, and secondary-market trades of these assets were rare. Price indexes of non-agency-sponsored subprime MBS based on derivatives markets declined further. However, the unusual pressures that had been apparent in short-term investment-grade funding markets in December eased considerably in January, owing to a combination of the passing of year-end balance sheet concerns and the provision of additional liquidity by the Federal Reserve and foreign central banks.

In February and March, short- and long-term funding markets came under renewed pressure after reports of further losses and write-downs at major banks, broker-dealers, and the government-sponsored enterprises. Fears of a weakening economy exacerbated a generalized flight from all but the safest assets. Repurchase agreement (repo) market investors exhibited a marked preference for Treasury collateral and pushed rates on Treasury general collateral repos to historical lows that were well below the target federal funds rate. As liquidity for MBS not sponsored by the GSEs and for other private-label asset-backed securities dried up, the heightened uncertainty regarding values of these instruments led to an unprecedented increase in the margin, or "haircut," required on repos based on such collateral; the interest rate spread on these repos also rose. Spreads of corporate and GSE bond yields over yields on comparable-maturity Treasury securities jumped to multiyear highs. Ratios of yields on municipal bonds to yields on Treasury securities spiked, and failures were widespread in the auction rate securities markets for municipal securities, student loans, and other assets. Prices fell in the secondary market for leveraged loans, and implied spreads on indexes of loan-only credit default swaps, or LCDX, reached record levels in February. Liquidity was strained in many markets; for example, in the market for Treasury coupon securities, bid-asked spreads and spreads between yields on off-the-run and on-the-run securities reached multiyear highs. Bid-asked spreads in the leveraged loan market also widened noticeably. The orderly resolution of the Bear Stearns situation along with the implementation of the Primary Dealer Credit Facility and the Term Securities Lending Facility in March appeared to reduce strains in short-term funding markets and to relieve liquidity pressures more broadly across fixed-income markets (see the box entitled "The Federal Reserve's Liquidity Operations.")

Even though conditions in several markets improved somewhat after mid-March, pressures in some short-term funding markets continued to intensify into April. Yield spreads rose in April on unsecured financial, asset-backed, and lower-rated nonfinancial commercial paper. Interbank term funding pressures, as measured by spreads of term London interbank offered rates over comparable-maturity overnight index swap rates, peaked in April but have since moved somewhat lower, at least for terms of three months and less. The expansion in May of the Federal Reserve's Term Auction Facility and of the associated swap lines with the European Central Bank and the Swiss National Bank appears to have contributed to this easing of pressures. However, for interbank funding at terms greater than three months, transaction volumes are reportedly low, and spreads remain high.

In longer-term financial markets, pressures generally eased in April and May. Spreads of conforming mortgage rates and corporate bond yields over yields on comparable-maturity Treasury securities narrowed, and prices and liquidity in the secondary market for leveraged loans increased. However, yield spreads for corporate bonds and mortgages moved higher in June. Equity prices of financial intermediaries, including the housing-related GSEs, Fannie Mae and Freddie Mac, dropped sharply in June and early July as concerns mounted both about their losses and longer-term profitability and about the prospects for earnings dilution given the considerable new capital that may need to be raised. Overall, indicators of financial market strains remain elevated compared with their levels in previous years.

Debt and Financial Intermediation

The total debt of the domestic nonfinancial sector expanded at an annual rate of 6-1/2 percent in the first quarter of 2008, a somewhat slower pace than in 2007. The moderation in borrowing was mainly accounted for by a slowdown in the growth of household debt, particularly mortgage debt. Borrowing by nonfinancial businesses also decelerated, but at a 9-1/4 percent pace, it was still high by historical standards. Preliminary data suggest that overall debt growth slowed further in the second quarter.

Commercial bank credit increased at an annual rate of 4-3/4 percent in the first half of 2008, down significantly from the 10-1/4 percent expansion registered in 2007.¹⁰ Commercial and industrial loans decelerated sharply after growing at an annual rate of more than 25 percent in the fourth quarter of 2007. The surge in C&I loans late last year reportedly reflected, in part, the difficulties that banks faced in selling syndicated loans to nonbank investors; as a result, banks had to fund a number of previously committed large syndicated deals on their balance sheets. In the first quarter of 2008, C&I loans grew at a lower but still quite fast rate of 16-1/4 percent, with part of the strength reportedly due to increased utilization of existing credit lines, the pricing of which reflected previous lending practices. In the second quarter, C&I lending moderated significantly further, a pattern consistent with reports from the April Senior Loan Officer Opinion Survey, which indicated a further tightening of credit standards and terms and weakening of demand for C&I loans. Commercial real estate loans grew at an annual rate of about 9-3/4 percent in the first half of 2008, only slightly slower than their pace in 2007.

After contracting sharply in the final quarter of 2007, the outstanding stock of residential mortgages at commercial banks rose 3-1/2 percent in the first quarter, in part because of a sluggish pace of securitization. In the second quarter, however, banks' holdings of residential mortgage loans fell again, a pattern consistent with the ongoing weakness in the housing market and the reduced availability of mortgage credit. Growth of home equity lines of credit picked up significantly in the first half of 2008, likely because of the decline in short-term market rates to which such loans are generally tied. However, commercial banks have taken steps to limit their exposure to these loans; according to the April Senior Loan Officer Opinion Survey, a significant portion of respondents indicated that they had tightened their credit standards for approving new applications for home equity lines of credit, and a notable proportion reported that they had also firmed lending terms on existing lines, mainly in response to declines in property values. Despite the reported tightening of credit conditions in the household sector, consumer loans grew at a moderate pace in the first half of 2008.

Profitability of the commercial banking sector improved somewhat in the first quarter of 2008 but remained well below the levels seen before the summer of 2007. Many large banks received a significant boost to their first-quarter profits as a result of their stakes in Visa--the initial public offering of which occurred in March. However, continued write-downs of mortgage-related assets and leveraged loans, along with increasing loan-loss provisions, held profits down in the first quarter. Concerns about recent and potential losses have weighed heavily on bank stock prices this year. The median spread on credit default swaps on the senior debt of major banks climbed from 50 basis points at the end of 2007 to more than 100 basis points in mid-March. After declining noticeably in April and May, it returned close to the March peak in late June.

The overall delinquency rate on loans held by commercial banks rose in the first quarter to its highest level since the early 1990s, and the charge-off rate increased to the upper end of its range since 2000. The deterioration in credit quality was accounted for primarily by continued erosion in the performance of residential mortgages and a considerable worsening in construction and land development loans, but performance of most other types of loans also weakened. To bolster equity positions diminished by asset write-downs and loan-loss provisions, commercial banks raised a substantial volume of capital in the first half of 2008; some banks reduced dividends to further shore up their capital.

Equity Markets

Overall, share prices have dropped about 15 percent from the end of 2007. The declines were led by the financial sector, especially depository institutions and broker-dealers, which fell 37 percent and 41 percent, on average, respectively. The energy and basic materials sectors avoided the downtrend and have changed little on net.

Actual and implied volatilities of broad equity price indexes shot up last year with the onset of financial strains. The partial easing of financial strains in the second quarter was associated with modest declines in the actual and implied volatilities of equity prices to levels still above those of the past few years. The 12-month-forward expected earnings-price ratio for S&P 500 firms jumped in the first half of 2008, while the long-term real Treasury yield rose only slightly. The difference between these two values--a rough measure of the premium that investors require for holding equity shares--has reached the high end of its range over the past 20 years.

Policy Expectations and Interest Rates

The current target for the federal funds rate, at 2 percent, is substantially below the level that investors expected as of late December 2007. According to futures quotes at that time, market participants expected that the federal funds rate would be around 3-1/2 percent by July. Looking forward, however, investors now expect that the next policy move will be up, and a small degree of tightening has been priced in by the end of 2008. Measures of uncertainty about the path of policy rose with the onset of financial turbulence last year and are currently near the high end of their range over the past 10 years.

Treasury yields fell sharply from the end of 2007 through March amid concerns about the health of financial firms, severe strains in financial markets, a weakening economic outlook, and lower expectations for future policy rates. Since late March, yields have risen across the curve as fears of a deep economic contraction have receded and concerns about the inflation outlook have increased. On net, 2-year yields are down 65 basis points, and 10-year yields are down 20 basis points since the start of the year.

Yields on Treasury inflation-protected securities largely moved in line with nominal yields--that is, they fell through mid-March and then rose--but the rise since March has been somewhat less than that of nominal yields. In addition, shifting liquidity conditions in the markets for nominal and indexed Treasury securities at times affected the spreads between nominal and indexed yields, also known as inflation compensation. On net, 10-year inflation compensation has risen about 20 basis points since the end of 2007, suggesting some increase in investors' concerns about the inflation outlook. Inflation compensation rose over both the near term and the longer term, but the increase was larger over the near term, as compensation over the next 5 years rose about 30 basis points whereas compensation over the period from 5 years ahead to 10 years ahead rose only 10 basis points. In part because of a lag in the indexation of inflation-protected securities, near-term inflation compensation can be strongly affected by the latest movements in energy and food prices; these prices have risen sharply in recent months.

Money and Reserves

M2 is estimated to have expanded at an annual rate of 7-3/4 percent over the first half of 2008, notably faster than the likely growth rate of nominal GDP. Demand for money balances was supported by declines in the opportunity cost of holding money relative to other financial assets and by strong demand for safe and liquid assets amid volatility and strains in financial markets. Money market mutual fund shares grew particularly rapidly in the first quarter. However, growth of money market mutual funds dropped considerably in the second quarter, and small time deposits contracted; M2 slowed accordingly. Demand for currency continued to be lackluster for the most of the first half-year, but it picked up noticeably late in the second quarter as domestic demand grew and foreign demand was estimated to be less weak.

The strains in bank funding markets over recent months have posed challenges for the implementation of monetary policy. Banks generally have seemed more cautious in their activity in the federal funds market and less willing to take advantage of potential arbitrage opportunities in that market over the course of a day and across the days of a reserve maintenance period. In this environment, the Open Market Desk's decisions regarding the appropriate quantity of reserves to be supplied each day through open market operations have been complicated, and volatility in the federal funds rate has been elevated. The authority to pay interest on reserves could be helpful to the Federal Reserve in limiting the volatility in the federal funds rate. The ability to pay interest on reserves would also allow the Federal Reserve to manage its balance sheet more efficiently in circumstances in which promoting financial stability required the provision of substantial amounts of discount window credit to the financial sector. In light of these considerations, the Federal Reserve has asked the Congress to accelerate the effective date of statutory authority to pay interest on reserve balances, which is currently October 2011.

International Developments

International Financial Markets

Global financial markets remained distressed over the first half of 2008, primarily because of concerns about weakness in real estate and slowing global economic growth. Amid heightened market turbulence in March, the European Central Bank (ECB), Bank of England, Bank of Canada, and Swiss National Bank (SNB) announced a further set of joint actions with the Federal Reserve to help improve the functioning of short-term funding markets. The Federal Open Market Committee increased its temporary swap line to the ECB in March from $20 billion to $30 billion and its line to the SNB from $4 billion to $6 billion. In May, these amounts were increased further to $50 billion and $12 billion, respectively, and the lines were extended through January 2009. Meanwhile, the Bank of England and the Bank of Canada each introduced new term funding arrangements in their domestic currencies, and the Bank of England also established a facility to swap government bonds for banks' mortgage-backed securities for a term of one to three years. The ECB has also continued to offer longer-term funding in euros, auctioning three-month funds totaling €270 billion in the first quarter and €250 billion in the second quarter and adding a new long-term refinancing operation with a six-month maturity.

Market volatility has persisted in recent months, with ongoing concerns about the balance sheets of financial institutions. Since the middle of last year, European banks have announced about $200 billion in write-downs--largely as a result of indirect exposure to U.S. credit markets through both sponsorship of and investments in structured credit products--and further losses may be recognized in second-quarter financial statements. In addition, mortgage lenders in the United Kingdom have been affected by weakness in property prices there and by reduced access to capital market funding. In general, the institutions that have recognized significant losses have taken prompt steps to replenish capital from a variety of sources; more than $140 billion had been raised by the end of June.

On net, most major equity indexes in the advanced foreign economies stand 12 percent to 25 percent lower in local currency terms compared with the end of 2007. European stock indexes were led lower by the stock prices of financial firms, which declined 34 percent (measured in euros); Japanese financial stocks are down 9 percent on the year. The financial turbulence has had less impact on Latin American stock prices. Equity indexes in Mexico and Brazil were virtually unchanged, on balance, over the first half of 2008. However, Chinese stock prices have tumbled 44 percent since the end of 2007, virtually erasing last year's gains, and other major emerging Asian equity indexes are also down, but to a lesser extent.

Liquidity in European government bond markets was impaired in March but seems to have improved in recent months. Long-term bond yields in the advanced foreign economies fell in the first quarter but have more than reversed these declines as investors no longer expect the ECB and the Bank of England to ease their policy rates. Since the end of 2007, long-term rates have risen, on net, 11 basis points in Germany, 38 basis points in the United Kingdom, and 12 basis points in Japan, and nominal yield curves have flattened. Meanwhile, implied long-term inflation compensation has increased 10 basis points in Japan and nearly 30 basis points in Germany and Canada.

The Federal Reserve's broadest measure of the nominal trade-weighted foreign exchange value of the dollar has declined about 3 percent, on net, since the end of last year. Over the same period, the major currencies index of the dollar has also declined about 3 percent. The dollar depreciated sharply against the euro and the yen in February and March but has recovered some in recent months. On net thus far this year, the dollar is down about 4 percent against the yen and 7 percent against the euro. The dollar is 2 percent higher against the Canadian dollar and slightly higher against sterling. The dollar has declined 6 percent against the Chinese renminbi since the end of 2007.

Advanced Foreign Economies

Economic growth in the major advanced foreign economies appears to have slowed somewhat this year. Although both the euro area and Japan posted strong first-quarter GDP growth rates, recent monthly indicators have been more subdued. In other countries, growth rates declined in the first quarter, and first-quarter real GDP even contracted slightly in Canada, where trade and financial ties to the United States are strong. Surveys of banks in Europe show a further tightening of credit standards in the first half of 2008 for both households and businesses. Lending to businesses appears to have remained solid, but household borrowing has slowed. Housing markets in a number of countries--including Ireland, Spain, and the United Kingdom--have continued to soften.

Since the beginning of the year, headline rates of inflation have continued to move up, on balance, in most economies, mainly because of increasing prices for food and energy. The 12-month change in consumer prices in both the euro area and the United Kingdom increased further from January to mid-2008, while core inflation rates (which exclude the changes in the prices of energy and unprocessed food) have increased much less. In Canada, where food price increases have been muted, inflation is little changed, on balance, since the beginning of the year but has risen in the past couple of months. Japanese consumer prices are roughly unchanged on a 12-month basis when both food and energy prices are excluded.

Over the first half of this year, the focus of the major foreign central banks appears to have shifted somewhat from the impact of financial market strains on growth to the effect of higher commodity prices on inflation. After initially lowering official interest rates, the Bank of Canada and the Bank of England have held their target rates steady since April, and the Bank of Japan has kept its policy rate unchanged at 0.5 percent all year. Recent inflation rates and statements from all of these central banks have led market participants to expect policy rates to increase slightly or to remain on hold. On July 3, the ECB raised its policy rate 25 basis points, to 4.25 percent, but it hinted that further rate hikes were not in the offing.

Emerging Market Economies

Recent data suggest that real GDP growth in China remained strong in the first half of this year. Although export growth slowed, domestic demand appears to have accelerated.

Elsewhere in emerging Asia, recent performance has varied but, on balance, indicators suggest that activity has remained solid in the region. In the first quarter, real GDP growth moderated in Korea, Malaysia, and Thailand but was strong in Hong Kong and Singapore. Exports of the region have generally slowed along with the deceleration in global economic activity; however, domestic demand strengthened in a number of countries.

Economic activity has decelerated in Latin America. In Mexico, output growth slowed to about 2 percent in the first quarter, in line with the step-down in the pace of activity in the United States that began toward the end of last year. In other Latin American countries, notably Brazil and Venezuela, growth also moderated.

Higher prices for food and energy have continued to exert upward pressures on inflation across emerging market economies. In China, headline inflation has risen, reaching roughly 8 percent in recent months. In response to the inflationary pressures, the Chinese authorities have allowed the renminbi to appreciate at a more rapid pace, and the People's Bank of China has further tightened monetary policy. The Bank has raised the required reserve ratio five times this year by a total of 300 basis points, to 17-1/2 percent. Elsewhere in emerging market economies, 12-month headline inflation in a number of countries continued to rise in recent months, thereby prompting many central banks to tighten monetary policy. In some cases, governments also instituted export restrictions or reduced import duties for some food products. The rising cost of energy subsidies has led governments in China, India, Malaysia, Indonesia, and Taiwan to raise administered gasoline prices roughly 10 percent to 40 percent in recent months.

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Part 3
Monetary Policy over the First Half of 2008

After easing the stance of monetary policy 100 basis points over the second half of 2007, the Federal Open Market Committee (FOMC) lowered the target federal funds rate 225 basis points further in the first half of 2008.¹¹ The Federal Reserve also took a number of additional actions to increase liquidity and to improve the functioning of financial markets.

In a conference call on January 9, the Committee reviewed recent economic data and financial market developments. The information, which included weaker-than-expected data on home sales and employment for December as well as a sharp decline in equity prices since the beginning of the year, suggested that the downside risks to growth had increased significantly since the time of the December FOMC meeting. Participants cited concerns that the slowing of economic growth could lead to a further tightening of financial conditions, which in turn could reinforce the economic slowdown. However, core inflation had edged up in recent months, and considerable uncertainty surrounded the inflation outlook. On balance, participants were generally of the view that substantial additional policy easing might well be necessary to support economic activity and reduce the downside risks to growth, and they discussed the possible timing of such actions.

On January 21, the Committee held another conference call. Strains in some financial markets had intensified, and incoming evidence had reinforced the view that the outlook for economic activity was weak. Participants observed that investors apparently were becoming increasingly concerned about the economic outlook and downside risks to activity and that these developments could lead to an excessive pullback in credit availability. In light of these developments, all members judged that a substantial easing in policy was appropriate to foster moderate economic growth and reduce the downside risks to economic activity. The Committee decided to lower the target for the federal funds rate 75 basis points, to 3-1/2 percent, and judged that appreciable downside risks to growth remained. Although inflation was expected to edge lower over the course of 2008, participants underscored their view that this assessment was conditioned upon inflation expectations remaining well anchored and stressed that the inflation situation should continue to be monitored carefully.

The data reviewed at the regularly scheduled FOMC meeting on January 29 and 30 confirmed a sharp deceleration in economic growth during the fourth quarter of 2007 and a continued tightening of financial conditions. With the contraction in the housing sector intensifying and a range of financial markets remaining under pressure, economic growth was expected to stay soft in the first half of 2008 before picking up strength in the second half. However, the ongoing weaknesses in home sales and house prices, as well as the tightening of credit conditions for households and businesses, were seen as posing downside risks to the near-term outlook for economic growth. Moreover, the potential for adverse feedback between the financial markets and the economy was a significant risk. Participants expressed some concern about the disappointing inflation data received over the latter part of 2007. Although many expected that a leveling-out of prices for energy and other commodities, such as that embedded in futures markets, and a period of below-trend growth would contribute to some moderation in inflation pressures over time, the Committee believed that it remained necessary to monitor inflation developments carefully. Against that backdrop, the FOMC decided to lower the target for the federal funds rate 50 basis points, to 3 percent. The Committee believed that this policy action, combined with those taken earlier, would help promote moderate growth over time and mitigate the risks to economic activity. However, members judged that downside risks to growth remained.

In a conference call on March 10, the Committee reviewed financial market developments and considered proposals aimed at supporting the liquidity and orderly functioning of those markets. In light of the sharp deterioration of some key money and credit markets, the Committee approved the establishment of the Term Securities Lending Facility, under which primary dealers would be able to borrow Treasury securities from the System Open Market Account for a term of approximately one month against any collateral eligible for open market operations and the highest-quality private residential mortgage-backed securities (MBS).¹² The new facility was designed to alleviate pressures in the financing markets for securities. In addition, the Committee agreed to expand the existing reciprocal currency agreements with the European Central Bank and the Swiss National Bank to $30 billion and $6 billion, respectively, and to extend the terms of these agreements through September 2008. Over the next few days, financial market strains intensified further. On March 16, the Federal Reserve announced emergency measures to bolster liquidity and promote orderly functioning in financial markets, including the approval of the financing arrangement associated with the acquisition of The Bear Stearns Companies, Inc., by JPMorgan Chase & Co. and the establishment of the Primary Dealer Credit Facility to improve the ability of primary dealers to provide financing to participants in securitization markets. In addition, the primary credit rate was lowered 25 basis points, and the maximum term of primary credit loans was extended to 90 days.

When the Committee met on March 18, financial markets continued to be under great stress, particularly the markets for short-term collateralized and uncollateralized funding. Spreads on interbank loans and lower-rated commercial paper had widened over the intermeeting period, and obtaining credit through repurchase agreements backed by agency and private-label MBS had become more difficult amid reports of increased margin, or "haircuts," being required by lenders. Yields on Treasury bills and repurchase agreements backed by Treasury securities had plummeted, reflecting investors' heightened demand for the safest assets.

Participants at the March 18 FOMC meeting noted that prospects for both economic activity and near-term inflation had deteriorated since January, and many thought that some contraction in economic activity in the first half of 2008 was likely. Although the economy was expected to recover in the second half and to grow further in 2009, considerable uncertainty surrounded this forecast. Some participants expressed concern that falling house prices and financial market stress might lead to a more severe and protracted downturn than anticipated. Recent readings on inflation had been elevated, and some indicators of inflation expectations had risen. However, a flattening-out of prices for oil and other commodities--as implied by futures prices--and the projected easing of pressures on resources were expected to contribute to some moderation in inflation. All in all, most members judged that a 75 basis point reduction in the target federal funds rate, to 2-1/4 percent, was appropriate to address the combination of risks of slowing economic growth, inflationary pressures, and financial market disruptions. In its statement, the Committee highlighted the further weakening in the outlook for economic activity, but it also emphasized the importance of monitoring inflation developments carefully.

The data reviewed at the meeting on April 29 and 30 indicated that economic growth had been weak in the first three months of 2008 and that core consumer price inflation had slowed, but that overall inflation had remained elevated. FOMC participants indicated that these developments had been broadly consistent with their expectations. Conditions across a number of financial markets were judged to have improved since the March meeting, but financial markets remained under considerable stress. Although the likelihood that economic activity would be severely disrupted by a sharp deterioration in financial markets had apparently receded, most participants thought that the risks to economic growth were still skewed to the downside. All participants expressed concern about upside risks to inflation posed by rising commodity prices and the depreciation of the dollar, but some participants noted that the downside risks to economic activity also implied that there were downside risks to price pressures as well. Participants expressed significant uncertainty concerning the appropriate stance of monetary policy in these circumstances. Some participants noted that the level of the federal funds target, especially when compared with the current rate of inflation, was relatively low by historical standards. Others noted that financial market strains and elevated risk spreads had offset much of the effects of policy easing on the cost of credit to borrowers. On balance, most members agreed that the target for the federal funds rate should be lowered 25 basis points, to 2 percent. The Committee expected that the policy easing would help to foster moderate growth over time without impeding a moderation in inflation. The Committee agreed that, in light of the substantial policy easing to date and the ongoing measures to foster financial market liquidity, the risks to growth were now more closely balanced by the risks to inflation.

In view of persisting strains in funding markets, the FOMC also approved proposals to expand the liquidity arrangements that had been put in place in previous months. The reciprocal currency agreements with the European Central Bank and Swiss National Bank were increased to $50 billion and $12 billion, respectively, and both were extended through January 2009. The collateral accepted by the Term Securities Lending Facility was expanded to include all AAA-rated asset-backed securities. In addition, Chairman Bernanke announced his intention to expand the Term Auction Facility to $150 billion under authority previously delegated by the Board of Governors.

At the time of the meeting held June 24 and 25, the available indicators suggested that economic activity in the first half of the year had not been as weak as had been expected in April. Nevertheless, several factors were viewed as likely to restrain activity in the near term, including the contraction in the housing sector, sharply higher energy prices, and continued tight credit conditions. Although financial market conditions generally appeared to have improved modestly since the April meeting, participants noted that the potential for adverse financial market developments still posed significant downside risks to economic activity. The further large increase in energy prices also prompted an upward revision of projections for overall inflation in the second half of 2008. Most participants expected that a leveling-out of energy prices and continued slack in resource utilization would lead inflation to moderate in 2009 and 2010, but the persistent tendency in recent years for commodity prices to exceed the trajectory implied by futures market prices engendered considerable uncertainty around the projected moderation of inflation. Members generally agreed that the downside risks to growth had eased somewhat since the previous FOMC meeting while the upside risks to inflation had intensified. Against this backdrop, most members judged that maintaining the current stance of policy at this meeting represented an appropriate balancing of the risks to the economic outlook. Nonetheless, policymakers recognized that circumstances could change quickly and noted that they might need to respond promptly to incoming information about the evolution of risks.

Note: The discussion in this chapter consists of the text and tables from parts 1-3 of the Monetary Policy Report submitted to Congress on July 15, 2008 (the figures from that report are available on the Board's website, at www.federalreserve.gov/boarddocs/hh). Part 4 of that report is identical to the addendum to the minutes of the June 24-25, 2008, meeting of the Federal Open Market Committee and is presented with those minutes in the "Records" section of this annual report.Return to text
1. Primary dealers are firms that trade in U.S. government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed's Open Market Desk engages in such trades to implement monetary policy.Return to text
2. This index is the purchase-only version of the repeat-transactions price index for existing single-family homes published by the Office of Federal Housing Enterprise Oversight.Return to text
3. A loan may be modified by reducing the principal balance, reducing the interest rate, or extending the term so as to make monthly payments more affordable.Return to text
4. Conforming mortgages are those eligible for purchase by Fannie Mae and Freddie Mac; they must be equivalent in risk to a prime mortgage with an 80 percent loan-to-value ratio, and they cannot exceed the conforming loan limit.Return to text
5. Jumbo mortgages are those that exceed the maximum size of a conforming loan; they are typically extended to borrowers with relatively strong credit histories.Return to text
6. Asset write-downs and capital losses are generally excluded from the calculation of economic profits but are included as an expense in the operating earnings per share of financial firms.Return to text
7. Concerns about the financial guarantors arose in 2007, but significant downgrades did not occur until early this year. In June, Moody's and Standard & Poor's downgraded MBIA and Ambac, two of the largest guarantors, from AAA to AA or lower. New bond insurance business has shifted to guarantors that are viewed as financially stronger, and some municipalities have stated their intention to dispense with guarantors and issue on the strength of their own ratings.Return to text
8. ARS are long-term securities whose interest rates are reset through regularly scheduled auctions, typically every 7, 28, or 35 days. As of the end of 2007, the size of the ARS market in the United States was about $330 billion, about half of which was accounted for by municipal securities. A resetting auction fails when investors do not bid for the entire issue at an interest rate below the contract maximum. Upon auction failure, the asset holders from before the auction retain ownership of the securities and receive a specified ceiling interest rate, which is usually, but not necessarily, equal to the maximum bid rate.Return to text
9. In a structured credit product, the credit risk of a portfolio of underlying exposures is segmented into tranches of varying seniority and risk exposure.Return to text
10. The growth rate of bank credit in 2007 has been adjusted to remove the effects of the conversion of a large commercial bank to a thrift institution.Return to text
11. Members of the FOMC in 2008 consist of members of the Board of Governors of the Federal Reserve System plus the presidents of the Federal Reserve Banks of Cleveland, Dallas, Minneapolis, New York, and Philadelphia. Participants at FOMC meetings consist of members of the Board of Governors and all Reserve Bank presidents.Return to text
12. By notation vote completed on March 20, AAA-rated commercial MBS were added to the list of acceptable collateral.Return to text