Section 1

MONETARY POLICY AND THE ECONOMIC OUTLOOK

When the Federal Reserve submitted its previous Monetary Policy Report to the Congress, in July of 2000, tentative signs of a moderation in the growth of economic activity were emerging following several quarters of extraordinarily rapid expansion. After having increased the interest rate on federal funds through the spring to bring the growth of aggregate demand and potential supply into better alignment and thus contain inflationary pressures, the Federal Reserve had stopped tightening as evidence of an easing of economic growth began to appear.

Indications that the expansion had moderated from its earlier rapid pace gradually accumulated during the summer and into the autumn. For a time, this downshifting of growth seemed likely to leave the economy expanding at a pace roughly in line with that of its potential. Over the last few months of the year, however, elements of economic restraint emerged from several directions to slow growth even more. Energy prices, rather than turning down as had been anticipated, kept climbing, raising costs throughout the economy, squeezing business profits, and eroding the income available for discretionary expenditures. Equity prices, after coming off their highs earlier in the year, slumped sharply starting in September, slicing away a portion of household net worth and discouraging the initial offering of new shares by firms. Many businesses encountered tightening credit conditions, including a widening of risk spreads on corporate debt issuance and bank loans. Foreign economic activity decelerated noticeably in the latter part of the year, contributing to a weakening of the demand for U.S. exports, which also was being restrained by an earlier appreciation in the exchange value of the U.S. dollar.

The dimensions of the economic slowdown were obscured for a time by the usual lags in the receipt of economic data, but the situation began to come into sharper focus late in the year as the deceleration steepened. Spending on business capital, which had been rising rapidly for several years, elevating stocks of these assets, flattened abruptly in the fourth quarter. Consumers clamped down on their outlays for motor vehicles and other durables, the stocks of which also had climbed to high levels. As the demand for goods softened, manufacturers adjusted production quickly to counter a buildup in inventories. Rising concern about slower growth and worker layoffs contributed to a sharp deterioration of consumer confidence. In response to the accumulating weakness, the Federal Open Market Committee (FOMC) lowered the intended interest rate on federal funds 1/2 percentage point on January 3 of this year. Another rate reduction of that same size was implemented at the close of the most recent meeting of the FOMC at the end of last month.

As weak economic data induced investors to revise down their expectations of future short-term interest rates in recent months and as the Federal Reserve eased policy, financial market conditions became more accommodative. Since the November FOMC meeting, yields on many long-term corporate bonds have dropped on the order of a full percentage point, with the largest declines taking place on riskier bonds as the yield spreads on those securities narrowed considerably from their elevated levels. In response, borrowing in long-term credit markets has strengthened appreciably so far in 2001. The less restrictive conditions in financial markets should help lay the groundwork for a rebound in economic growth.

That rebound should also be encouraged by underlying strengths of the economy that still appear to be present despite the sluggishness encountered of late. The most notable of these strengths is the remarkable step-up in structural productivity growth since the mid-1990s, which seems to be closely related to the spread of new technologies. Even as the economy slowed in 2000, evidence of ongoing efficiency gains were apparent in the form of another year of rapid advance in output per worker hour in the nonfarm business sector. With households and businesses still in the process of putting recent innovations in place and with technological breakthroughs still occurring, an end to profitable investment opportunities in the technology area does not yet seem to be in sight. Should investors continue to seek out emerging opportunities, the ongoing transformation and expansion of the capital stock will be maintained, thereby laying the groundwork for further gains in productivity and ongoing advances in real income and spending. The impressive performance of productivity and the accompanying environment of low and stable underlying inflation suggest that the longer-run outlook for the economy is still quite favorable, even though downside risks may remain prominent in the period immediately ahead.

Monetary Policy, Financial Markets, and the Economy over the Second Half of 2000 and Early 2001

As described in the preceding Monetary Policy Report to the Congress, the very rapid pace of economic growth over the first half of 2000 was threatening to place additional strains on the economy's resources, which already appeared to be stretched thin. Private long-term interest rates had risen considerably in response to the strong economy, and, in an effort to slow the growth of aggregate demand and thereby prevent a buildup of inflationary pressures, the Federal Reserve had tightened its policy settings substantially through its meeting in May 2000. Over subsequent weeks, preliminary signs began to emerge suggesting that growth in aggregate demand might be slowing, and at its June meeting the FOMC left the federal funds rate unchanged.

Further evidence accumulated over the summer to indicate that demand growth was moderating. The rise in mortgage interest rates over the previous year seemed to be damping activity in the housing sector. Moreover, the growth of consumer spending had slowed from the exceptional pace of earlier in the year; the impetus to spending from outsized equity price gains in 1999 and early 2000 appeared to be partly wearing off, and rising energy prices were continuing to erode the purchasing power of households. By contrast, business fixed investment still was increasing very rapidly, and strong growth of foreign economies was fostering greater demand for U.S. exports. Weighing this evidence and recognizing that the effects of previous tightenings had not yet been fully felt, the FOMC decided at its meeting in August to hold the federal funds rate unchanged. The Committee remained concerned that demand could continue to grow faster than potential supply at a time when the labor market was already taut, and it saw the balance of risks still tilted toward heightened inflation pressures.

The FOMC faced fairly similar circumstances at its October meeting. By then, it had become more apparent that the growth in demand had fallen to a pace around that of potential supply. Although consumer spending had picked up again for a time, it did not regain the vigor it had displayed earlier in the year, and capital spending, while still growing briskly, had decelerated from its first-half pace. With increases in demand moderating, private employment gains slowed from the rates seen earlier in the year. However, labor markets remained exceptionally tight, and the hourly compensation of workers had accelerated to a point at which unit labor costs were edging up despite strong gains in productivity. In addition, sizable increases in energy prices were pushing broad inflation measures above the levels of recent years. Although core inflation measures were at most only creeping up, the Committee felt that there was some risk that the increase in energy prices, which was lasting longer than had seemed likely earlier in the year, would start to leave an imprint on business costs and longer-run inflation expectations, posing the risk that core inflation rates could rise more substantially. Weighing these considerations, the FOMC decided to hold the federal funds rate unchanged at its October meeting. While recognizing that the risks in the outlook were shifting, the FOMC believed that the tautness of labor markets and the rise in energy prices meant that the balance of those risks still was weighted towards heightened inflation pressures, and this assessment was noted in the balance-of-risks statement.

By the time of the November FOMC meeting, conditions in the financial markets were becoming less accommodative in some ways, even as the Federal Reserve held the federal funds rate steady. Equity prices had declined considerably over the previous several months, resulting in an erosion of household wealth that seemed likely to restrain consumer spending going forward. Those price declines, along with the elevated volatility of equity prices, also hampered the ability of firms to raise funds in equity markets and were likely discouraging business investment. Some firms faced more restrictive conditions in credit markets as well, as risk spreads in the corporate bond market widened significantly for firms with lower credit ratings and as banks tightened the standards and terms on their business loans. Meanwhile, incoming data indicated that the pace of economic activity had softened a bit further. Still, the growth of aggregate demand apparently had moved only modestly below that of potential supply. Moreover, while crude oil prices appeared to be topping out, additional inflationary pressures were arising in the energy sector in the form of surging prices for natural gas, and there had been no easing of the tightness in the labor market. In assessing the evidence, the members of the Committee felt that the risks to the outlook were coming into closer balance but had not yet shifted decisively. At the close of the meeting, the FOMC left the funds rate unchanged once again, and it stated that the balance of risks continued to point toward increased inflation. However, in the statement released after the meeting, the FOMC noted the possibility of subpar growth in the economy in the period ahead.

Toward the end of the year, the moderation of economic growth gave way, fairly abruptly, to more sluggish conditions. By the time of the December FOMC meeting, manufacturing activity had softened considerably, especially in motor vehicles and related industries, and a number of industries had accumulated excessive stocks of inventories. Across a broader set of firms, forecasts for corporate sales and profits in the fourth quarter and in 2001 were being slashed, contributing to a continued decline in equity prices and a further widening of risk spreads on lower-rated corporate bonds. In this environment, growth in business fixed investment appeared to be slowing appreciably. Consumer spending showed signs of decelerating further, as falling stock prices eroded household wealth and consumer confidence weakened. Moreover, growth in foreign economies seemed to be slowing, on balance, and U.S. export performance began to deteriorate. Market interest rates had declined sharply in response to these developments. Against this backdrop, the FOMC at its December meeting decided that the risks to the outlook had swung considerably and now were weighted toward economic weakness, although it decided to wait for additional evidence on the extent and persistence of the slowdown before moving to an easier policy stance. Recognizing that the current position of the economy was difficult to discern because of lags in the data and that prospects for the near term were particularly uncertain, the Committee agreed at the meeting that it would be especially attentive over coming weeks to signs that an intermeeting policy action was called for.

Additional evidence that economic activity was slowing significantly emerged not long after the December meeting. New data indicated a marked weakening in business investment, and retail sales over the holiday season were appreciably lower than businesses had expected. To contain the resulting buildup in inventories, activity in the manufacturing sector continued to drop. In addition, forecasts of near-term corporate profits were being marked down further, resulting in additional declines in equity prices and in business confidence. Market interest rates continued to fall, as investors became more pessimistic about the economic outlook. Based on these developments, the Committee held a telephone conference call on January 3, 2001, and decided to cut the intended federal funds rate 1/2 percentage point. Equity prices surged on the announcement, and the Treasury yield curve steepened considerably, apparently because market participants became more confident that a prolonged downturn in economic growth would likely be forestalled. Following the policy easing, the Board of Governors approved a decrease in the discount rate of a total of 1/2 percentage point.

The Committee's action improved financial conditions to a degree. Over the next few weeks, equity prices rose, on net. Investors seemed to become less wary of credit risk, and yield spreads narrowed across most corporate bonds even as the issuance of these securities picked up sharply. But in some other respects, investors remained cautious, as evidenced by widening spreads in commercial paper markets. Incoming data pointed to further weakness in the manufacturing sector and a sharp decline in consumer confidence. Moreover, slower U.S. growth appeared to be spilling over to several important trading partners. In late January, the FOMC cut the intended federal funds rate 1/2 percentage point while the Board of Governors approved a decrease in the discount rate of an equal amount. Because of the significant erosion of consumer and business confidence and the need for additional adjustments to production to work off elevated inventory levels, the FOMC indicated that the risks to the outlook continued to be weighted toward economic weakness.

Economic Projections for 2001

Although the economy appears likely to be sluggish over the near term, the members of the Board of Governors and the Reserve Bank presidents expect stronger conditions to emerge as the year progresses. For 2001 overall, the central tendency of their forecasts of real GDP growth is 2 percent to 2-1/2 percent, measured as the change from the fourth quarter of 2000 to the fourth quarter of 2001. With growth falling short of its potential rate, especially in the first half of this year, unemployment is expected to move up a little further. Most of the governors and Reserve Bank presidents are forecasting that the average unemployment rate in the fourth quarter of this year will be about 4-1/2 percent, still quite low by historical standards.