Note. Changes
are based on quarterly averages and are |
Survey measures of expected inflation were little changed, on balance, in 2003. According to the Federal Reserve Bank of Philadelphia's survey of professional forecasters, expectations for CPI inflation ten years ahead remained at 2-1/2 percent last year. As measured by the Michigan Survey Research Center survey of households, median five- to ten-year inflation expectations, which averaged 3 percent in 2001, were steady at 2-3/4 percent in 2003 for a second consecutive year. Inflation compensation as measured by the spread between the yield on nominal Treasury securities and their indexed counterparts varied over a wide range in 2003, settling at just under 2-1/2 percent at year-end. Shorter-term inflation expectations also posted some wide swings during 2003; year-ahead expectations in the Michigan SRC survey spiked early in the year with the sharp increase in energy prices and dipped briefly to an unusually low level at midyear as actual inflation eased in response to lower energy prices. However, year-ahead inflation expectations settled back to just over 2-1/2 percent at the end of the year, about the same as at the end of 2002.
The PPI for crude materials excluding food and energy products, which had dropped 10 percent in 2001, rose 11-3/4 percent in 2002 and another 17-1/2 percent in 2003. The upswing was driven by the pickup in demand associated with the acceleration in both domestic and worldwide industrial activity and by the pass-through of higher energy costs. Such wide cyclical swings in commodity prices have only a small effect on movements in the prices of intermediate and finished goods. At later stages of production and distribution, commodity costs represent only a small share of overall costs, and some portion of the change in commodity prices tends to be absorbed in firms' profit margins. Thus, the recent pickup in prices at the intermediate stage of processing has been more muted; after having fallen almost 1-1/2 percent in 2001, the PPI for core intermediate materials rose 1-1/4 percent in 2002 and 2 percent in 2003.
On balance, financial market conditions became increasingly supportive of growth over 2003 as investors became more assured that the economy was on solid footing. Equity prices marched up after the first quarter of the year in response to the initiation and swift conclusion of major combat operations in Iraq, positive earnings reports, and--in the second half of the year--a stronger pace of economic growth. Risk spreads on corporate debt declined, with the spreads on the debt of both investment-grade firms and speculative-grade firms ending 2003 at their lowest levels since 1998. Thus, although Treasury coupon yields ended the year 30–40 basis points higher, yields on many corporate bonds ended the year lower. Commercial banks appeared somewhat slower than bond investors to lend at more favorable terms; nevertheless, by late in the year, banks had eased both standards and terms on C&I loans.
Demand for short-term debt, however, remained very weak, and business loans and outstanding commercial paper continued to run off. In response to a widening budget deficit and a rapid expansion of federal debt, the Treasury increased the frequency of its debt auctions. Declines in mortgage interest rates over the first half of the year led to an extraordinary increase in mortgage debt, as originations for home purchase and for refinancings both climbed to record levels.
Interest rates fell for most of the first half of 2003, primarily in response to continuing weak economic data and an associated marking down of expectations for the federal funds rate. Global uncertainty ran high, particularly surrounding the timing of military intervention in Iraq, which elevated safe-haven demands and depressed yields on Treasury securities. Moreover, the weak March employment report and other disappointing news about economic activity seemed to cause a substantial shift in views about monetary policy. Data from the federal funds futures market suggested a significant probability of a further easing of policy and did not imply any tightening before early 2004. Even as geopolitical tensions eased, weaker-than-expected economic data continued to hold down Treasury yields. The FOMC’s statement following its May meeting that an "unwelcome fall in inflation" remained a risk reinforced the notion that monetary policy would stay accommodative, and, indeed, judging from market quotes on federal funds futures, market participants anticipated further easing. Mortgage rates followed Treasury yields lower, precipitating a huge surge of mortgage refinancing. To offset the decline in the duration of their portfolios stemming from the jump in prepayments, mortgage investors reportedly bought large quantities of longer-dated Treasuries, amplifying the fall in yields. Interest rates on corporate bonds also declined in the first half of the year, prompting many firms to issue long-term debt to pay down other, more expensive forms of debt and build up cash assets. Growing confidence that the frequency and severity of corporate accounting scandals were waning likely contributed to the narrowing in risk spreads. By the end of spring, default rates on corporate bonds had begun to decline, and corporate credit quality appeared to stabilize.
By the time of the June FOMC meeting, federal funds futures data implied that market participants had generally come to expect an aggressive reduction in the target federal funds rate, so the Committee’s decision to lower the target rate by only 25 basis points came as a surprise to some. In addition, some investors were reportedly disappointed that the statement following this meeting included no mention of "unconventional" monetary policy actions that would be aimed at lowering longer-term yields more directly than through changes in the federal funds rate target alone. As a result, market interest rates backed up, with the move probably amplified by the unwinding of mortgage-related hedging activity. The Chairman's monetary policy testimony in July, and the FOMC's statements at subsequent meetings that noted that policy could remain accommodative for "a considerable period," apparently provided an anchor for the front end of the yield curve. At the same time, increasingly positive economic reports bolstered confidence in the markets, and longer-dated Treasury securities ended the year about 40 basis points above their year-earlier levels. But, with the expansion evidently gaining traction and investors becoming more willing to take on risk, corporate risk spreads, particularly those on speculative-grade issues, continued to fall over the second half of the year. Treasury yields fell early in 2004, largely in response to the weaker-than-expected December labor market report. After the release of the Committee's statement following its January meeting, Treasury yields backed up a bit as futures market prices implied an expectation of an earlier onset of tightening than had been previously anticipated.
Broad equity price indexes ended the year 25 percent to 30 percent higher. Early in the year, stock prices were buffeted by mixed news about the pace of economic expansion and by heightened geopolitical tensions. Rising oil prices boosted the shares of energy companies very early in the year while, by and large, stocks in other sectors were stumbling. By spring, however, positive news on corporate earnings--often exceeding expectations--and easing of geopolitical tensions associated with the initiation of military action in Iraq boosted equity prices significantly. Subsequently, the swift end to major combat operations in Iraq caused implied volatility on the S&P 500 index to fall substantially. Over the rest of the year, increasingly positive earnings results contributed to a sustained rally in stock prices, and implied volatility in equity markets fell further. Corporate scandals--albeit on a smaller scale than in previous years--continued to emerge in 2003, but these revelations appeared to leave little lasting imprint on broad measures of stock prices. For the year as a whole, the Russell 2000 index of small-cap stocks and the technology-laden Nasdaq composite index, which rose 45 percent and 50 percent, respectively, noticeably outpaced broader indexes. To date in 2004, equity markets have continued to rally.
With the sustained rise in stock prices, the ratio of expected year-ahead earnings to stock prices for firms in the S&P 500 edged down over 2003. The gap between this ratio and the real ten-year Treasury yield--a crude measure of the equity risk premium--narrowed a bit over the course of the year, though it remains in the upper part of the range observed over the past two decades.
Aggregate debt of the domestic nonfinancial sectors is estimated to have increased about 8-1/4 percent in 2003, just over a percentage point faster than in 2002. Federal debt accelerated sharply, rising 11 percent, owing to the larger budget deficit. Household debt rose almost as rapidly, and the increase in state and local government debt also was substantial. In contrast, business borrowing remained subdued last year.
In the business sector, investment spending, particularly in the beginning of the year, was mainly financed with internal funds, limiting, though not eliminating, businesses’ need to increase debt. With long-term rates falling through midyear and credit spreads--especially for riskier borrowers--narrowing, corporate treasurers shifted their debt issuance toward bond financing and away from shorter-term debt. Household borrowing also shifted in response to lower longer-term rates. Mortgage rates followed Treasury rates lower in the spring, and mortgage originations for both home purchases and refinancings surged. Refinancing activity appears to have held down growth of consumer credit as households extracted equity from their homes and used the proceeds, in part, to pay down higher-cost consumer debt. Nevertheless, consumer credit posted a moderate advance in 2003, buoyed by heavy spending on autos and other durables. A substantial widening of the federal deficit forced the Treasury to increase its borrowing significantly. To facilitate the pickup in borrowing, the Treasury altered its auction cycle to increase the frequency of certain issues and reintroduced the three-year note.
Depository credit rose 6 percent in 2003 and was driven by mortgage lending and the acquisition of mortgage-backed securities by both banks and thrift institutions. Consumer lending also was substantial, as lower interest rates and auto incentives spurred spending on durable goods. In contrast, business loans fell 7-1/4 percent over 2003, a drop similar to the runoff in 2002. Survey evidence suggests that the decline in business lending at banks was primarily the result of decreased demand for these loans, with respondent banks often citing weak investment and inventory spending. Moreover, the contraction was concentrated at large banks, whose customers tend to be larger corporations that have access to bond markets, and the proceeds of bond issuance were apparently used, in part, to pay down bank loans. The January 2004 Senior Loan Officer Opinion Survey reported a pickup in business loan demand arising mainly from increased spending on plant and equipment and on inventories. Supply conditions apparently played a secondary role in the weakness in business loans in 2003. Banks tightened standards and terms on business loans somewhat in the first half of the year, but by year-end they had begun to ease terms and standards considerably, in part because of reduced concern about the economic outlook.
M2 increased 5-1/4 percent in 2003, a pace somewhat slower than in 2002 and a bit below the rate of expansion of nominal income. The deceleration in M2 largely reflected a considerable contraction in the final quarter of the year after three quarters of rapid growth. The robust growth in money around midyear was concentrated in liquid deposits and likely resulted in large part from the wave of mortgage refinancings, which tend to boost M2 as the proceeds are temporarily placed in non-interest-bearing accounts pending disbursement to the holders of mortgage-backed securities. Moreover, around the middle of the year, the equity that was extracted from home values during refinancings probably provided an additional boost to deposits for a time, as households temporarily parked these funds in M2 accounts before paying down other debt or spending them. In the fourth quarter, M2 contracted at an annual rate of 2 percent, the largest quarterly decline since consistent data collection began in 1959. As mortgage rates backed up and the pace of refinancing slowed, the funds that had been swelling deposits flowed out, depressing M2. The sustained rally in equity markets after the first quarter of the year may also have slowed M2 growth, as expectations of continued higher returns led households to shift funds from M2 assets to equities, a view reinforced by the strong flows into equity mutual funds.
Economic growth abroad rebounded in the second half of last year as factors that weighed on the global economy in the first half--including the SARS epidemic and uncertainty surrounding the war in Iraq--dissipated. Foreign growth also was boosted by the strong rebound in the U.S. economy, the revival of the global high-tech sector, and, in many countries, ample policy stimulus.
Strong second-half growth in China stimulated activity in other emerging Asian economies and Japan by raising the demand for their exports. Growth in Japan also was spurred by a recovery in private spending there on capital goods. Economic activity in Europe picked up in the second half, as export growth resumed. Economic growth in Latin America has been less robust; the Mexican economic upturn has lagged that of the United States, and Brazil's economy has only recently begun to recover from the effects of its 2002 financial crisis.
Monetary authorities abroad generally eased their policies during the first half of 2003 as economic activity stagnated. In the second half, market participants began to build in expectations of eventual monetary tightening abroad, and official interest rates were raised by year-end in the United Kingdom and Australia. Canadian monetary policy followed a different pattern; the Bank of Canada raised official interest rates in the spring as inflation moved well above its 1 percent to 3 percent target range but cut rates later in the year and again early this year as slack emerged and inflation moderated. Similarly, lower inflation in Mexico and Brazil allowed authorities to ease monetary policy during 2003. The Bank of Japan maintained official interest rates near zero and continued to increase the monetary base.
In foreign financial markets, equity prices fell, on average, until mid-March but since then have risen in reaction to indications of stronger-than-expected global economic activity. Emerging-market equity indexes outpaced those in the industrial countries in 2003, with markets in Latin America posting particularly strong gains. Around midyear, long-term interest rates declined to multiyear lows in many countries as economic growth slowed and inflationary pressures diminished, but those rates moved higher in the second half as growth prospects improved. Bond spreads came down substantially during the year, both for industrial-country corporate debt and for emerging- market sovereign debt; spreads of the J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. Treasury securities fell to their lowest levels since before the Russian crisis of 1998. Gross capital flows to emerging markets, however, remained well below their 1997 peak.
The foreign exchange value of the dollar continued to decline last year as concerns over the financing of the large and growing U.S. current account deficit took on greater prominence. The dollar declined 18 percent against the Canadian dollar, 17 percent against the euro, and 10 percent against the British pound and the Japanese yen. In contrast, the value of the dollar was little changed, on net, against the currencies of our other important trading partners, in part because officials of China and of some other emerging Asian economies managed their exchange rates so as to maintain stability in terms of the dollar. Among Latin American currencies, the dollar declined against the Brazilian and Argentine currencies but appreciated against the Mexican peso. On balance, the dollar depreciated 9 percent during 2003 on a trade-weighted basis against the currencies of a broad group of U.S. trading partners.
The euro-area economy contracted in the first half of 2003, weighed down in part by geopolitical uncertainty and higher oil prices. In the second half, economic activity in the euro area began to grow as the global pickup in activity spurred a recovery of euro-area exports despite the continued appreciation of the euro. The monetary policy of the European Central Bank (ECB) was supportive of growth, with the policy interest rate lowered to 2 percent by midyear. Consumer price inflation slowed to around 2 percent, the upper limit of the ECB’s definition of price stability. Despite increased economic slack, inflation moved down only a little, partly because the summer drought boosted food prices. For the second straight year, the governments of Germany and France each recorded budget deficits in excess of the 3 percent deficit-to-GDP limit specified by the Stability and Growth Pact. However, in light of economic conditions, European Union finance ministers chose not to impose sanctions.
After a sluggish first quarter, the U.K. economy expanded at a solid pace for the remainder of 2003, supported by robust consumption spending and considerable government expenditure. The Bank of England cut rates in the first half of the year but reversed some of that easing later in the year and early this year as the economy picked up and housing prices continued to rise at a rapid, albeit slower, pace. In June, the British government announced its assessment that conditions still were not right for the United Kingdom to adopt the euro. In December, the British government changed the inflation measure to be targeted by the Bank of England from the retail prices index excluding mortgage interest (RPIX) to the consumer prices index. U.K. inflation currently is well below the objective of 2 percent on the new target index.
The Canadian economy contracted in the second quarter owing to the impact of the SARS outbreak in Toronto on travel and tourism, but it rebounded in the latter half of the year. Canadian economic growth continued to be led by strong domestic demand; consumption remained robust and investment spending accelerated, offsetting the negative effect of Canadian dollar appreciation on both exports and import-competing industries. Canadian consumer price inflation swung widely last year, rising to 4-1/2 percent on a twelve-month basis in February before falling to 1-1/2 percent in November and ending the year at 2 percent. The swing partly reflected movements in energy prices, but changes in auto insurance premiums and cigarette taxes also played an important role.
Japanese real GDP recorded significant growth in 2003 for the second straight year. Private investment spending made the largest contribution to the expansion. Consumer spending remained sluggish as labor market conditions continued to be soft. However, nominal wages stabilized following a sharp drop in 2002, and leading indicators of employment moved higher. Despite an appreciation of the yen late in the year, Japanese exports posted a strong increase in 2003 primarily because of gains in exports to China and other emerging Asian economies. With consumer prices continuing to decline, the Bank of Japan (BOJ) maintained its policy interest rate near zero and eased monetary policy several times during 2003 by increasing the target range for the outstanding balance of reserve accounts held by private financial institutions at the BOJ. The BOJ also took other initiatives last year to support the Japanese economy, including launching a program to purchase securities backed by the assets of small- and medium-sized enterprises. Japanese banks continued to be weighed down by large amounts of bad debt, but some progress was made in resolving problems of insufficient bank capital and in reducing bad-debt levels from their previous-year highs.
Growth in the Asian developing economies rebounded sharply in the second half of 2003 after having contracted in the first half. The outbreak of SARS in China and its spread to other Asian economies was the primary factor depressing growth in the first half, and the subsequent recovery of retail sales and tourism after the epidemic was contained was an important factor in the sharp rebound. The pattern of Asian growth also reflected the sharp recovery of the global high-tech sector in the second half after a prolonged period of weakness. Exports continued to be the main engine of growth for the region. However, domestic demand contributed importantly to growth in China, where state-sector investment increased at a rapid clip and a boom in construction activity continued. Supply problems caused food prices and overall consumer prices in China to rise on a twelve-month basis last year, following a period of price deflation during the previous year. In addition, concerns emerged that some sectors of the Chinese economy, particularly the property markets in Beijing and Shanghai, may be overheating.
Korean economic growth turned negative in the first half, as the high level of household debt, labor unrest, and concerns over North Korea's nuclear development depressed private-sector spending. A sharp rise in exports spurred a revival of growth in the second half even as domestic demand remained subdued.
The Mexican economy remained sluggish through much of the year but recently has shown some signs of improvement. After lagging the rise in U.S. production, Mexican industrial production posted strong gains in October and November, although it remains well below the peak it reached in 2000. Exports rose late last year to almost the peak they had reached in 2000. Consumer price inflation came down over the course of 2003 to 4 percent, the upper bound of the 2 percent to 4 percent target range. The Bank of Mexico has left policy unchanged since tightening five times between September 2002 and March 2003, but market interest rates have fallen owing to weakness in economic activity.
The Brazilian economy contracted in the first half of 2003 partly as a result of the 2002 financial crisis and the consequent monetary policy tightening. It then expanded moderately in the second half, boosted by strong export growth and a recovery in investment spending. Brazilian financial indicators improved significantly in 2003, in part because the Brazilian government began to run a substantial primary budget surplus and to reform the public-sector pension system. The Brazilian stock market soared nearly 100 percent last year, and Brazil's EMBI+ bond spread narrowed by nearly two-thirds. As the Brazilian currency stabilized and began to appreciate, Brazil's inflation outlook improved, allowing the central bank to reverse fully its earlier rate hikes and to reduce the overnight interest rate to a multiyear low, although real interest rates remained high.
The Argentine economy rebounded in 2003 from the sharp contraction that occurred in the wake of its financial crisis in 2001–02. Still, economic activity remains far below pre-crisis levels, and many of Argentina’s structural problems have not been addressed. With the government still in default to its bondholders, the country’s sovereign debt continued to carry a very low credit rating, and its EMBI+ spread remained extremely high. Even so, the Argentine peso appreciated on balance in 2003, and the Merval stock index nearly doubled over the course of the year.
Home | News and events |
Monetary policy |
February 2004 report |