Monetary Policy, Financial Markets, and the Economy over 2002 and Early 2003As economic growth picked up during the early months of 2002, the FOMC maintained its target for the federal funds rate at 1-3/4 percent. A sharply reduced pace of inventory liquidation accounted for a significant portion of the step-up in real GDP growth, but other indicators also suggested that the economy was gaining momentum. Reductions in business outlays on equipment and software had moderated significantly after dropping precipitously in 2001, and consumer spending was well maintained by sizable gains in real disposable personal income. Residential construction activity was spurred by low home mortgage interest rates. The improvement in economic conditions sparked a rally in equity markets late in the first quarter and pushed up yields on longer-term Treasury instruments and investment-grade corporate bonds; yields on speculative-grade bonds declined in reaction to brighter economic prospects and the perceived reduction in credit risk. Meanwhile, surging energy prices exerted upward pressure on overall inflation, but still-appreciable slack in resource utilization and a strong upward trend in private-sector productivity were holding down core price inflation.
At both its March and May meetings, the FOMC noted that the apparent vigor of the economy was importantly attributable to a slowdown in the pace of inventory liquidation and that considerable uncertainty surrounded the outlook for final sales over the next several quarters. The Committee was especially concerned about prospects for a rebound in business fixed investment, which it viewed as key to ensuring sustainable economic expansion. Although the decline in investment spending during the first quarter of 2002 was the smallest in a year, gloomy business sentiment and large margins of excess capacity in numerous industries were likely to hamper capital expenditures. According to anecdotal reports, many firms were unwilling to expand capacity until they saw more conclusive evidence of growing sales and profits. At the same time, however, the FOMC noted that, with the federal funds rate unusually low on an inflation-adjusted basis and considerable fiscal stimulus in train, macroeconomic policies would provide strong support to further economic expansion. Against this backdrop, the Committee at the March 19 meeting judged the accommodative stance of monetary policy to be appropriate and announced that it considered the risks to achieving its long-run objectives as being balanced over the foreseeable future, judgments it retained at its meeting in early May. |
The information reviewed at the June 25-26 FOMC meeting confirmed that the economy was expanding but at a slower pace than earlier in the year. As expected, the degree of impetus to economic activity from decelerating inventory liquidation had moderated. Residential investment and consumer spending also had slowed appreciably after surging earlier in the year. The most recent data on orders and shipments suggested a small upturn in business spending on equipment and software, but the improvement in capital spending appeared to be limited, unevenly distributed across industries, and not yet firmly indicative of sustained advance. Industrial production continued to increase, and the unemployment rate declined somewhat. In financial markets, investors and lenders had apparently become more risk averse in reaction to the mixed tone of economic data releases, growing geopolitical tensions, further warnings about terrorist attacks, and additional revelations of dubious corporate accounting practices. In concert, these developments pushed down yields on longer-term Treasury securities, while interest rates on lower-quality corporate bonds rose notably, and equity prices dropped sharply. Although the economy continued to expand and the prospects for accelerating aggregate demand remained favorable, downbeat business sentiment and skittish financial markets rendered the timing and extent of the expected strengthening of the expansion subject to considerable uncertainty. In these circumstances, the FOMC left the federal funds rate unchanged to keep monetary policy very accommodative and once again assessed the risks to the outlook as being balanced. By the time of the August 13 FOMC meeting, it had become apparent that economic activity had lost some of its earlier momentum. Turbulence in financial markets appeared to be holding back the pace of the economic expansion. Market participants focused their attention on the lack of convincing evidence that the recovery was gaining traction and the possibility that more news of corporate misdeeds would surface in the run-up to the Securities and Exchange Commission's August 14 deadline for the certification of financial statements by corporate executives. Although the cumulative losses in financial wealth since 2000 were restraining expenditures by households, very low mortgage interest rates were helping to sustain robust demand for housing. Moreover, the financial resources made available by a rapid pace of mortgage refinancing activity, in combination with attractive incentives offered by auto manufacturers, supported other consumer spending. The Committee continued to judge the prevailing degree of monetary accommodation as appropriate to foster a solid expansion that would bring the economy to fuller resource utilization. At the same time, the Committee recognized the considerable risks to that outlook and the potential adverse consequences for economic prospects from possible additional deterioration of financial conditions. The members noted, however, that a further easing of monetary policy, if it came to be viewed as appropriate, could be accomplished in a timely manner. In light of these considerations, the FOMC opted to retain a target rate of 1-3/4 percent for the federal funds rate, but it viewed the risks to the economy as having shifted from balanced to being tilted toward economic weakness. When the FOMC met on September 24, data indicated that economic growth had picked up in the third quarter, on average, buoyed in part by a surge in motor vehicle production. The uneventful passing of the mid-August deadline for recertification of corporate financial statements briefly alleviated investors' skittishness in debt and equity markets. However, the most timely information suggested that some softening in economic activity had occurred late in the summer. Those economic reports, along with a darker outlook for corporate profits and escalating fears of a possible war against Iraq, led market participants to revise down their expectations for the economy. Equity prices and yields on both longer-term Treasury and private securities moved sharply lower in early autumn. In the Committee's view, heightened geopolitical tensions constituted a significant additional source of uncertainty clouding the economic outlook. Still, fundamentals suggested reasonable prospects for continued expansion. Accordingly, the FOMC left the federal funds rate unchanged at the close of the September meeting but also reiterated its view that the risks to the outlook were weighted toward economic weakness. The information reviewed at the November 6 meeting indicated a more persistent spell of below-par economic performance than the FOMC had anticipated earlier. With home mortgage rates at very low levels, residential construction activity remained high. But consumer spending had decelerated noticeably since midsummer under the combined weight of stagnant employment and declining household wealth resulting from further decreases in equity prices. Worries about the potential for war against Iraq, as well as persistent concerns about the course of economic activity and corporate earnings, were apparently engendering a high degree of risk aversion among business executives that was constraining capital spending and hiring. Despite a weakening in the exchange value of the dollar, sluggish economic growth among major trading partners spelled difficulties for U.S. exports, and a rebound in foreign output seemed more likely to follow than to lead a rebound at home. Moreover, economic slack that was larger and more persistent than previously anticipated ran the risk of reducing core inflation appreciably further from already low levels. Given these considerations, the Committee lowered its target for the federal funds rate 1/2 percentage point, to 1-1/4 percent. The relatively aggressive adjustment in the stance of monetary policy was deemed to offset the potential for greater economic weakness, and the Committee accordingly announced that it judged risks to the outlook as balanced with respect to its long-run goals of price stability and sustainable economic growth. When the FOMC met on December 10, overall conditions in financial markets had calmed considerably. Indicators of production and spending, however, remained mixed. The manufacturing sector registered large job losses in the autumn, and industrial production continued its slide, which had begun around midyear. A more vigorous rebound in business fixed investment was not evident, and indeed the recent data on orders and shipments and anecdotal reports from business contacts generally signaled continued softness in capital spending. Very low home mortgage interest rates were supporting residential construction activity, but consumption expenditures were sluggish. On balance, the Committee's view was that in the absence of major shocks to consumer and business confidence, a gradual strengthening of the economic expansion was likely over the coming quarters, especially given the very accommodative stance of monetary policy and probable further fiscal stimulus. The FOMC left the federal funds rate unchanged and indicated that it continued to view the risks to the outlook as balanced over the foreseeable future. By the time of the FOMC meeting on January 28-29, 2003, it had become apparent that the economy had grown only slowly in the fourth quarter of last year, but little evidence of cumulating weakness appeared in the most recent data, and final demand had held up reasonably well. The escalation of global tensions weighed heavily on business and investor sentiment. Firms apparently were remaining very cautious in their hiring and capital spending, and equity prices had declined on balance since the December meeting. But yield spreads on corporate debt-especially for riskier credits-narrowed further, and longer-term Treasury yields declined slightly. Although the fundamentals still pointed to favorable prospects for economic growth beyond the near term, geopolitical developments were making it especially difficult to gauge the underlying strength of the economy, and uncertainties about the economic outlook remained substantial. Against this background, the Committee decided to leave the federal funds rate unchanged and stated that it continued to judge the risks to the outlook as balanced. |
Economic Projections for 2003An unusual degree of uncertainty attends the economic outlook at present, in large measure, but not exclusively, because of potential geopolitical developments. But Federal Reserve policymakers believe the most probable outcome for this year to be a pickup in the pace of economic expansion. The central tendency of the real GDP forecasts made by the members of the Board of Governors and the Federal Reserve Bank presidents is 3-1/4 percent to 3-1/2 percent, measured as the change between the final quarter of 2002 and the final quarter of this year. The full range of these forecasts is 3 percent to 3-3/4 percent. Of course, neither the central tendency nor the range is intended to convey the uncertainties surrounding the individual forecasts of the members. The civilian unemployment rate is expected to end the year in the 5-3/4 percent to 6 percent range.
Apart from the geopolitical and other uncertainties, the forces affecting demand this year appear, on balance, conducive to a strengthening of the economic expansion. Monetary policy remains highly accommodative, and federal fiscal policy is and likely will be stimulative. However, spending by many state and local governments will continue to be restrained by considerable budget difficulties. Activity abroad is expected to improve this year, even if at a less robust pace than in the United States; such growth together with the improving competitiveness of U.S. products should generate stronger demand for our exports. Furthermore, robust gains in productivity, though unlikely to be as large as in 2002, ought to continue to promote both household and business spending. Household purchasing power should be supported as well by a retreat in the price of imported energy products that is suggested by the oil futures market. And the adverse effects on household spending from past declines in equity wealth probably will begin to wane. |
A reduction of businesses' hesitancy to expand investment and hiring is critical to the durability of the expansion, and such a reduction should occur gradually if geopolitical risks ease and profitability improves. Inventories are relatively lean, and some restocking ought to help boost production this year, albeit to a much smaller extent than did last year's cessation of sharp inventory liquidations. In addition, the continued growth of final sales, the tax law provision for partial expensing of equipment purchases, replacement demand, and a more hospitable financial environment should induce many firms to increase their capital spending. The growth of investment likely will be tempered, however, by the persistence of excess capital in some areas, notably the telecommunications sector, and reductions in business spending on many types of new structures may continue this year. Federal Reserve policymakers believe that consumer prices will increase less this year than in 2002, especially if energy prices partly reverse last year's sharp rise. In addition, resource utilization likely will remain sufficiently slack to exert further downward pressure on underlying inflation. The central tendency of FOMC members' projections for increases in the chain-type price index for personal consumption expenditures (PCE) is 1-1/4 percent to 1-1/2 percent this year, lower than the actual increase of about 2 percent in 2002. |
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