Part 2: Recent Financial and Economic Developments

Monetary Policy Report submitted to the Congress on March 1, 2011, pursuant to section 2B of the Federal Reserve Act

Economic activity expanded at a moderate pace, on balance, in the second half of 2010. According to the currently available estimates from the Bureau of Economic Analysis, real gross domestic product (GDP) increased at an annual rate of about 2-3/4 percent, on average, over that period (figure 1). In the third quarter, as had been the case in the first half of the year, much of the increase was the result of inventory accumulation; in contrast, final sales continued to rise at a subdued rate. Meanwhile, several indicators of economic activity had softened from the readings observed earlier in the year, raising concerns about the durability of the recovery. Later in the year, however, the tone of the incoming data on economic activity brightened somewhat, final sales strengthened, and the recovery appeared to be on a firmer footing.

Since the middle of 2010, consumer spending has risen solidly on average, businesses have continued to increase their outlays for equipment and software, and exports have moved up further. In contrast, construction of new homes and nonresidential buildings remains exceptionally weak. Conditions in the labor market have improved only slowly, with payrolls increasing at a modest pace. Throughout nearly all of 2010, that pace of employment expansion was insufficient to bring the unemployment rate down meaningfully from its recent peak. In December 2010 and January of this year, however, the unemployment rate is estimated to have dropped more noticeably, even though payroll employment gains remained lackluster. Meanwhile, long-duration joblessness persisted at near-record levels. With regard to inflation developments, despite rapid increases in commodity prices, longer-term inflation expectations have remained stable and consumer price inflation has continued to trend downward on net (figure 2).

Conditions in financial markets generally improved over the course of the second half of 2010 and early 2011 and continued to be supportive of economic activity. This improvement reflected, in part, additional monetary policy stimulus provided by the Federal Reserve, as well as growing investor confidence in the sustainability of the economic recovery. Although yields on Treasury securities rose somewhat, on net, since mid-2010, yields on investment-grade corporate bonds were little changed at low levels, and yields on speculative-grade bonds declined. In equity markets, price indexes generally rose, buoyed by solid corporate earnings and a more positive economic outlook. Commercial banks reported that they had eased some of their lending standards and terms, though lending standards remained generally tight and some businesses and households continued to face difficulties obtaining credit. Changes in interest rates faced by households were mixed. The improvement in financial conditions was accompanied by some signs of a pickup in the demand for credit. Borrower credit quality generally improved, although problems persisted in some sectors of the economy. Concerns about European banking and fiscal strains increased again in late 2010 after having eased for a time; however, in contrast to what was observed in the spring, these concerns left little imprint on U.S. financial markets.

Domestic Developments

The Household Sector

Consumer Spending and Household Finance

Real personal consumption expenditures (PCE) increased at an annual rate of about 3-1/4 percent in the second half of 2010, with a particularly brisk rise in the fourth quarter (figure 3). The spending gains were supported by the continued, though modest, pickup in real household incomes, by some fading of the restraining effects of the earlier sharp declines in households' net worth, and by a modest improvement in the availability of consumer credit. Outlays for durable goods also may have been boosted to some extent by purchases that had been deferred during the recession. The increases in spending exceeded the rise in income, and the saving rate edged down during the second half of the year, though it remains well above levels that prevailed prior to the recession (figure 4).

The increase in consumer outlays in the second half of 2010 partly reflected a step-up in sales of new light motor vehicles (cars, sport utility vehicles, and pickup trucks). Sales of light vehicles rose from an annual rate of 11-1/4 million units in the second quarter of 2010 to more than 12-1/4 million units in the fourth quarter and moved up further in the first part of 2011. Sales were supported, in part, by further improvements in credit conditions for auto buyers as well as by more-generous sales incentives from the automakers. Real spending in other goods categories also rose appreciably, while the increase in outlays for services was more subdued.

The determinants of consumer outlays showed further, albeit gradual, improvement during the second half of 2010. The level of real disposable personal income (DPI)--after-tax income adjusted for inflation--which rose rapidly in the first half of the year, continued to advance in the second half, as real wages and salaries moved up at an annual rate of 2 percent (figure 5). The increase in real wage and salary income reflected the continued, though tepid, recoveries in both employment and hours worked; in contrast, hourly pay was little changed in real terms.

The ratio of household net worth to DPI moved up a little in the third quarter of 2010 and appears to have risen further since then, as increases in equity values likely more than offset further declines in house prices (figure 6). Although the wealth-to-income ratio has trended up since the beginning of 2009 and has returned to the levels that prevailed prior to the late 1990s, it remains well below its highs in 2006 and 2007. Consumer sentiment rose late in the year, boosted by gradual improvements in household assessments of financial and business conditions as well as job prospects; nevertheless, these gains only moved sentiment back to or a bit above the low levels that prevailed at the start of last year (figure 7).

Household debt likely fell at just under a 2 percent annual rate in the second half of 2010, a slightly slower pace than in the first half. The contraction for 2010 as a whole, which was due primarily to ongoing decreases in mortgage debt, marked the second consecutive annual decline. The reduction in overall household debt levels, combined with increases in personal income, resulted in a further decline in the ratio of household debt to income and in the debt service ratio--the required principal and interest payments on existing mortgage and consumer debt relative to income (figure 8).

The slowdown in the rate at which household debt contracted in the latter part of 2010 stemmed in large part from a modest recovery in consumer credit. Although revolving consumer credit--mostly credit card borrowing--continued to contract, the decline was at a slightly slower rate than in the first half of the year. Nonrevolving consumer credit, which consists largely of auto and student loans and accounts for about two-thirds of total consumer credit, rose 2 percent in the second half of 2010 after being about unchanged in the first half of the year. The pickup in nonrevolving consumer credit is consistent with responses to the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicating that banks have become increasingly willing to make consumer installment loans; however, lending standards for these loans likely remained fairly tight.² In addition, in the most recent survey, a small net fraction of respondents noted increased demand for consumer loans, the first time stronger demand was reported since mid-2005.

Some of the increased willingness to make consumer loans may reflect improvements in consumer credit quality. The delinquency rate on auto loans at captive finance companies moved down in the second half of 2010 to 2.6 percent, close to its longer-run historical average. Delinquency rates on credit cards at commercial banks and in securitized pools also moved down to around longer-run averages. However, charge-off rates on such loans remained well above historical norms despite having moved lower in the second half of the year.

Changes in interest rates on consumer loans were mixed. Interest rates on new auto loans were little changed, on net, in the second half of 2010 and into 2011. By contrast, interest rates on credit cards generally rose over the same period. A portion of the increase in credit card interest rates may be due to lingering adjustments by banks to the imposition of new rules under the Credit Card Accountability Responsibility and Disclosure Act (Credit Card Act).³

Issuance of consumer asset-backed securities (ABS) in the second half of 2010 occurred at about the same pace as in the first half of the year. Auto loan ABS issuance continued to be healthy, and the ability to securitize these loans likely held down interest rates on the underlying loans. Issuance of ABS backed by credit card loans, however, remained very weak, as the sharp contraction in credit card lending limited the need for new funding and accounting rule changes implemented at the beginning of 2010 made securitization of these loans less attractive.⁴ Yields on ABS securities and the spreads of such yields over comparable-maturity interest rate swap rates were not much changed, on net, over the second half of 2010 and early 2011 (figure 9).

Residential Investment and Housing Finance

Housing activity remained depressed in the second half of 2010. Homebuilding continues to be restrained by sluggish demand, the large inventory of foreclosed or distressed properties on the market, and the tight credit conditions faced by homebuilders. In the single-family sector, new units were started at an average annual rate of about 430,000 units from July 2010 to January 2011, just 70,000 units above the quarterly low reached in the first quarter of 2009 (figure 10). In the multifamily market, demand for apartments appears to be increasing and occupancy rates have been edging up, as some potential homebuyers may be choosing to rent rather than to purchase a home. Nevertheless, the inventory of unoccupied multifamily units continues to be elevated, and construction financing remains tight. As a result, starts in the multifamily sector have averaged an annual rate of only 135,000 units since the middle of 2010, well below the 300,000-unit rate that had prevailed for much of the previous decade.

Home sales surged in the spring ahead of the expiration of the homebuyer tax credit, plunged for a few months during a payback period, and then recovered somewhat as the payback effect waned.⁵ By late 2010 and early 2011, sales of existing single-family homes were a bit above levels that prevailed in mid-2009, before the enactment of the first homebuyer tax credit, while sales of new single-family homes remained below their mid-2009 levels. Housing demand has been held back by tight mortgage credit availability, uncertainty about future real estate values, and continued household concerns about the outlook for employment and income. Nonetheless, other determinants of housing demand are favorable and hold the potential to provide support to home sales as the economic recovery proceeds. In particular, the low level of mortgage rates and the earlier declines in house prices have made housing more affordable for those able to obtain mortgages.

House prices, as measured by several national indexes, decreased in the latter half of 2010 after having shown tentative signs of leveling off earlier in the year (figure 11). According to one measure with wide geographic coverage--the CoreLogic repeat-sales index--house prices fell 6 percent between June and December and moved below their mid-2009 trough. House prices continued to be weighed down by the large inventory of unsold homes--especially distressed properties--and by the sluggish demand for housing.

Indicators of credit quality in this sector pointed to continued difficulties amid depressed home values and elevated unemployment. Serious delinquency rates on prime and near-prime mortgages edged down to around 15 percent for adjustable-rate loans and to about 5 percent for fixed-rate loans--levels that remain high by historical standards (figure 12). Delinquency rates for subprime mortgages moved up slightly toward the end of the year and remained extremely elevated. One sign of improvement, however, was that the rate at which mortgages transitioned from being current to being newly delinquent trended lower toward the end of 2010.

Reflecting the ongoing credit quality issues, the number of homes that entered foreclosure in the third quarter of 2010 jumped to more than 700,000, well above the pace seen earlier in the year. Late in the third quarter, concerns about the mishandling of documentation led some institutions to temporarily suspend some or all of their foreclosure proceedings.⁶ Despite these announced moratoriums, the pace of new foreclosures dipped only slightly in the fourth quarter. Moreover, these moratoriums will likely only extend, and not put an end to, the foreclosure process in most cases.

Interest rates on fixed-rate mortgages remained quite low, on net, by historical standards during the second half of 2010 and reached record lows in the fourth quarter (figure 13). The very low levels of mortgage rates prompted a sizable pickup in refinancing activity for a time, although some households were unable to refinance because of depressed home values, weak credit scores, and tight lending standards for mortgages. Mortgage applications for home purchases were generally subdued in the second half of the year. Overall, mortgage debt outstanding likely declined in the second half of 2010 at a pace only slightly slower than that of the first half.

Net issuance of mortgage-backed securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae was fairly low in the second half of 2010, consistent with the subdued originations of mortgages used to finance home purchases. The securitization market for mortgage loans not guaranteed by a housing-related government-sponsored enterprise (GSE) or the Federal Housing Administration remained essentially closed.

The Business Sector

Fixed Investment

Real business spending on equipment and software, which surged in the first half of 2010, rose further in the second half (figure 14). Firms were likely motivated partly by a desire to replace aging equipment and to undertake capital spending that had been deferred during the recession. Improving business prospects also appear to have been a factor boosting capital expenditures. As a group, large firms continue to have ample internal funds, and those with access to capital markets generally have been able to obtain bond financing at favorable terms. Although credit availability for smaller firms and other bank-dependent businesses remains constricted, some tentative signs of easing lending standards have emerged.

Overall spending on equipment and software rose at an annual rate of about 10 percent in the second half of 2010. Although business outlays in the volatile transportation equipment category plunged in the fourth quarter, that decline came in the wake of several quarters of sharp increases when vehicle rental firms were rebuilding their fleets of cars and light trucks. Meanwhile, spending on information technology (IT) capital--computers, software, and communications equipment--increased appreciably throughout the second half. Gains were apparently spurred by outlays to replace older, less-efficient IT capital as well as continued investments by wireless service providers to upgrade their networks. In addition, spending increases for equipment other than transportation and IT--nearly one-half of total equipment outlays--were well maintained and broad based. More recently, new orders for nondefense capital goods other than transportation and IT items were little changed, on net, in December and January; however, the level of orders remains above shipments, and business surveys suggest that respondents are upbeat about business conditions as well as their equipment spending plans.

Real spending on nonresidential structures other than those used for drilling and mining remained depressed, with the level of investment at the end of 2010 down almost 40 percent from its peak in early 2008. However, the rate of decline appears to be abating: Spending fell at an annual rate of nearly 10 percent in the second half of 2010 after plunging at a 25 percent rate in the first half. Although outlays for new power facilities jumped in the second half of the year, construction of office buildings, commercial structures, and manufacturing plants all moved down further. A large overhang of vacant space, depressed property prices, and an unwillingness of banks to add to their already high construction loan exposure still weighed heavily on the sector. In contrast, spending on drilling and mining structures continued to rise sharply in response to elevated energy prices.

Inventory Investment

Stockbuilding continued in the second half of 2010 at an average pace about in line with the growth of final sales (figure 15). Inventory investment surged in the third quarter, but the pace of accumulation slowed sharply in the fourth quarter, with the swing magnified by developments in the motor vehicle sector. Vehicle stocks rose appreciably in the third quarter as dealers attempted to rebuild inventories that had become depleted earlier in the year, but inventories fell in the fourth quarter as auto sales moved up more rapidly than expected near the end of the year. As for other items aside from motor vehicles, inventory investment rose during the second half of the year, albeit more rapidly in the third quarter than in the fourth. The inventory-to-sales ratios for most industries covered by the Census Bureau's book-value data, which had risen significantly in 2009, have moved back to levels that prevailed before the recession, and surveys suggest that inventory positions for most businesses generally are in a comfortable range.

Corporate Profits and Business Finance

Operating earnings per share for S&P 500 firms continued to increase at a solid pace in the third and fourth quarters of 2010. Most industry groups reported gains. In aggregate, earnings per share climbed to near the levels posted in mid-2007, just prior to the financial crisis.

The already sturdy credit quality of nonfinancial corporations improved further in the second half of 2010. The aggregate debt-to-asset ratio, which provides an indication of corporate leverage, moved down in the third quarter, as nonfinancial corporations increased their assets by more than they increased their debt. Credit rating upgrades again outpaced downgrades and corporate bond defaults remained sparse. The delinquency rate on commercial and industrial (C&I) loans at commercial banks moved down in the second half of 2010 to 3 percent. By contrast, with fundamentals remaining weak, delinquency and charge-off rates on commercial real estate (CRE) loans at commercial banks decreased only modestly from quite elevated levels (figure 16). Moreover, the delinquency rate on CRE loans in securitized pools continued to rise sharply.

Borrowing by nonfinancial corporations continued at a robust pace in the second half of 2010, driven by good corporate credit quality, attractive financing conditions, and an improving economic outlook (figure 17). Issuance of corporate bonds was heavy for both investment-grade and high-yield issues. Borrowing in the syndicated loan market was also sizable, particularly by speculative-grade borrowers, with the dollar volume of such loans rebounding sharply from the low levels seen in 2008 and 2009 (not shown in figure). Demand for such loans from institutional investors was strong. Some of the strength in debt origination was reportedly due to corporations taking advantage of low interest rates to reduce debt service costs and extend maturities by refinancing; issuance to finance mergers and acquisitions also reportedly picked up in the second half of the year. Meanwhile, commercial paper outstanding remained about flat. C&I loans on banks' books decreased during the third quarter but started expanding toward the end of the year, consistent with responses to the January 2011 SLOOS that reported some easing of standards and terms and some firming of demand for C&I loans from large firms over the previous three months. Relatively large fractions of respondents to the most recent survey indicated that they narrowed the spread of C&I loan rates over their cost of funds somewhat further during the second half of 2010 (figure 18). Nevertheless, lending standards reportedly remained tight; about one-half of the respondents to special questions included in the October 2010 survey indicated that their lending standards on C&I loans were tighter than longer-run averages and were likely to remain so until at least 2012.

Borrowing conditions for small businesses continued to be tighter than for larger firms, although some signs of easing began to emerge. In particular, surveys conducted by the National Federation of Independent Business (NFIB) showed a gradual decline in the share of respondents reporting that credit was more difficult to obtain than three months previously (figure 19). Similarly, in the past several surveys, moderate net fractions of SLOOS respondents have indicated that banks have eased some loan terms for smaller borrowers. Judging from responses to both the NFIB survey and the SLOOS, loan demand by small businesses remained subdued.

Banks' holdings of CRE loans continued to contract fairly sharply throughout the second half of 2010. Overall commercial mortgage debt declined at an annual rate of 6 percent in the third quarter, about the same pace as in the previous quarter. Responses to the January SLOOS suggest that banks have not yet started reversing their tight lending standards in this sector and that demand, while starting to pick up, likely remained weak. Despite the strains in CRE markets, the commercial mortgage-backed securities (CMBS) market showed tentative signs of improvement in the second half of 2010 and early 2011. Prices for some of the more highly rated tranches of existing CMBS rose. Although issuance of new securities remained tepid, the pace has been picking up. Responses to special questions on the September Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) indicated that demand for warehousing of CRE loans for securitization had increased since the beginning of 2010, and that the willingness to fund CRE loans on an interim basis had increased somewhat.

A substantial number of initial and secondary equity offerings for nonfinancial firms were brought to market in the second half of 2010. Deals included an initial public offering by General Motors that was used to repay a portion of the government's capital infusion. Nevertheless, equity retirements in the third quarter through cash-financed mergers and acquisitions and share repurchases once again outpaced issuance; preliminary data for the fourth quarter (not shown) suggest a similar pattern (figure 20).

The Government Sector

Federal Government

The deficit in the federal unified budget has remained very wide. The budget deficit for fiscal year 2010, although down somewhat from fiscal 2009, was $1.3 trillion. The fiscal 2010 figure was equal to 8-3/4 percent of nominal GDP, substantially above the average value of 2 percent recorded during the three-year period prior to the onset of the recession. The budget deficit continued to be boosted by spending commitments from the American Recovery and Reinvestment Act (ARRA) and other stimulus policy actions and by the weakness of the economy, which has reduced tax revenues and boosted payments for income support. By contrast, the budget effects of several financial transactions reduced the deficit in 2010: Outlays related to the Troubled Asset Relief Program (TARP), which added significantly to the deficit in 2009, helped to shrink the deficit in 2010 as estimated losses were revised down when many of the larger TARP recipients repaid their obligations to the Treasury; in addition, new assistance for the mortgage-related GSEs was extended at a slower pace, and depository institutions prepaid three years' worth of federal deposit insurance premiums. Moreover, the nascent recovery in the economy led to a small increase in revenues. The deficit is projected by the Congressional Budget Office to widen in fiscal 2011 to a level similar to the shortfall recorded in fiscal 2009.

Despite increasing 3 percent in fiscal 2010, tax receipts remained at very low levels; indeed, at less than 15 percent of GDP, the ratio of receipts to national income was at its lowest level in 60 years (figure 21). Corporate income taxes surged nearly 40 percent in fiscal 2010 as profits increased briskly, and Federal Reserve remittances to the Treasury rose markedly owing to the expansion of its balance sheet. By contrast, despite rising household incomes, individual income and payroll taxes moved down in fiscal 2010, reflecting the tax cuts put in place by the ARRA. Total tax receipts increased nearly 10 percent over the first four months of fiscal 2011 relative to the comparable year-earlier period; individual income and payroll taxes turned up, a consequence of the further recovery in household incomes, and corporate income taxes continued to rise.

Outlays decreased 2 percent in fiscal 2010, a development attributable to financial transactions. Excluding financial transactions, spending rose 9 percent compared with fiscal 2009, mainly because of the effects of the weak labor market on outlays for income support programs (such as unemployment insurance and food stamps) as well as increases in Medicaid expenditures and spending associated with the ARRA and other stimulus-related policies. Net interest payments rose 5 percent in fiscal 2010, and Social Security spending increased 3-1/2 percent--its smallest rise in 11 years--as the low rate of consumer price inflation in the previous year resulted in no cost of living adjustment. In the first four months of fiscal 2011, total federal outlays rose nearly 5 percent relative to the comparable year-earlier period. Excluding financial transactions, outlays were up about 1 percent. The relatively small increase so far this fiscal year for outlays excluding financial transactions reflects a flattening out of ARRA spending and income support payments; by contrast, other spending has been increasing at rates comparable to those recorded during fiscal 2010.

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--rose at an annual rate of about 4 percent in the second half of 2010, a bit less than in the first half of the year (figure 22). Nondefense outlays increased more slowly than in the first half of the year--when spending for the decennial census ramped up--while defense spending rose at roughly the same pace as in the first half.

Federal Borrowing

Federal debt expanded appreciably in the second half of last year, though at a slightly slower pace than in the first half. The ratio of Federal debt held by the public to nominal GDP rose to more than 60 percent at the end of 2010 and is projected to reach nearly 70 percent by the end of 2011 (figure 23). Demand for Treasury securities has been well maintained. Bid-to-cover ratios at auctions, although somewhat mixed, were generally within historical ranges during the second half of 2010 and early 2011. Indicators of foreign participation at auctions as well as a rise in foreign custody holdings of Treasury securities by the Federal Reserve Bank of New York pointed to steady demand from abroad. Demand for these securities may have been supported by a heightened desire for relatively safe and liquid assets in light of fiscal troubles in some European countries.

State and Local Government

Despite the substantial federal aid provided by the ARRA, state and local governments remained under significant fiscal pressure in the second half of 2010. The strains reflect several factors, including a sharp drop in tax revenues in late 2008 and 2009 and increased commitments for Medicaid outlays--a cyclically sensitive transfer program--all in the context of balanced budget requirements. To address their budget shortfalls, these governments have been paring back operating expenditures. Indeed, real consumption expenditures of state and local governments, as measured in the NIPA, fell about 1 percent in 2010 after decreasing a similar amount in 2009. The weakness in spending was reflected in the continued reductions in payrolls. Total employment of state and local governments fell 250,000 during 2010, with nearly all of the cutbacks at the local level. Construction spending undertaken by these governments was volatile during 2010 but, on net, was down a bit for the year and remained below the level that prevailed before the recession despite the infrastructure grants provided by the federal government as part of the ARRA. While most capital expenditures are not subject to balanced budget requirements, some of these expenditures are funded out of operating budgets subject to these requirements. In addition, a substantial share of debt service payments on the bonds used to finance capital projects is made out of operating budgets--a factor that may be limiting the willingness of governments to undertake some new infrastructure projects.

With overall economic activity recovering, state government revenues from income, business, and sales taxes rose in the second half of 2010. Nevertheless, state tax collections remain well below their pre-recession levels, and available balances in reserve funds are low. Tax collections at the local level have fared relatively better. In particular, some localities appear to have adjusted statutory tax rates so that declining real estate assessments, which typically significantly lag market prices, are holding down property tax revenues by less than they otherwise would. However, many localities have seen sharp cutbacks in their grants-in-aid from state governments, and thus have experienced significant fiscal pressures. State and local governments will continue to face considerable budget strains, in part because federal stimulus grants will be winding down. Moreover, many state and local governments will need to set aside additional resources in coming years both to meet their pension obligations and to pay for health benefits provided to their retired employees.

State and Local Government Borrowing

Issuance of securities by state and local governments was robust during the latter half of 2010; it surged near the end of the year as state governments sought to take advantage of the Build America Bond program before the program expired.⁷ Issuance of short-term municipal securities was also strong.

Yields on state and local government bonds rose noticeably more than those on comparable-maturity Treasury securities in the second half of 2010 and early 2011. The rise in yields on municipal securities may have reflected increased concerns about the fiscal position and financial health of state and local governments, although the heavy supply of these securities coming to market likely also played a role. Spreads on credit default swaps for some states remained volatile but narrowed, on net, from their peak levels last summer. Downgrades of the credit ratings of state and local governments continued to outpace upgrades during the second half of 2010. Nonetheless, the pace of actual defaults on municipal issues continued to come down from its peak in 2008. In recent months, there were substantial outflows from long-term mutual funds that invest in municipal bonds.

The External Sector

Supported by the expansion of foreign economic activity, real exports of goods and services continued to increase at a solid pace in the second half of 2010, rising at an annual rate of 8-1/4 percent (figure 24). Nearly all major categories of exports rose, with exports of machinery, agricultural goods, and services registering the largest gains. Moreover, the increase in export demand was broad based across trading partners.

Real imports of goods and services decelerated considerably in the second half of 2010, increasing at an annual rate of only 1-1/4 percent after surging more than 20 percent during the first half of last year. The sharp step-down partly reflected an unusually large decline in real oil imports, but more important, the growth in non-oil imports moderated to a pace more in line with the expansion in U.S. economic activity. During the second half of 2010, imports of consumer goods, machinery, and services posted the largest increases. As with exports, the increase in imports occurred across a wide range of trading partners.

All told, net exports shaved 1/2 percentage point off real GDP growth last year as the rebound in imports outpaced the recovery in exports for the year as a whole. The current account deficit widened from $378 billion in 2009 to an average of $479 billion at an annual rate, or about 3-1/4 percent of nominal GDP, in the first three quarters of 2010 (figure 25).

The spot price of West Texas Intermediate (WTI) crude oil moved higher over the second half of the year, rising to an average of $89 per barrel in December, about $11 above the average price that prevailed over the first six months of the year (figure 26). The upward movement in oil prices during the second half of the year largely reflected a widespread strengthening in global oil demand, particularly in emerging market economies (EMEs), against a backdrop of constrained supply. The depreciation of the dollar over this period also contributed somewhat to the rise in the price of oil. Spot WTI continued to fluctuate around its December average for much of the first two months of this year but moved up sharply in late February.⁸ Unrest in several Middle Eastern and North African countries, and uncertainty about its potential implications for global oil supply, has put considerable upward pressure on oil prices in recent weeks.

The price of the long-term futures contract for crude oil (expiring in December 2019) has generally fluctuated in the neighborhood of $95 per barrel over the past six months, not much different from the average over the first half of 2010, although it has moved up some recently. Accordingly, the sharply upward sloping futures curve that characterized the oil market since the onset of the financial crisis has flattened considerably. Concurrent with this flattening of the futures curve, measured global inventories of crude oil have declined in recent months, although they remain high by historical standards.

Nonfuel commodity prices also rose markedly over the second half of the year and into early 2011, with increases broad based across a variety of commodities. As with oil, these prices have been supported by strengthening global economic activity, primarily in China as well as in other EMEs, and, to a lesser extent, by the lower dollar. In addition, adverse weather conditions have reduced harvests and curtailed supplies of important agricultural products in a number of key exporting countries, including Russia, Ukraine, and the United States.

Prices of non-oil imported goods rose 1-1/4 percent at an annual rate over the second half of 2010 and have increased at an accelerated pace in January, boosted by higher commodity prices, the depreciation of the U.S. dollar, and foreign inflation. On net, non-oil import prices rose a bit more slowly over the second half of 2010 than in the first half and finished the year 2 percent higher than at the end of 2009.

National Saving

Total net national saving--that is, the saving of households, businesses, and governments excluding depreciation charges--remains low by historical standards (figure 27). After having reached 3-3/4 percent of nominal GDP in 2006, net national saving dropped steadily over the subsequent three years, reaching roughly negative 3 percent in the third quarter of 2009. The widening of the federal budget deficit during the course of the recession more than accounted for the downswing in net saving. Since late 2009, net national saving has moved up, reflecting a sharp rise in private saving. Nonetheless, the total averaged about negative 1 percent in the third quarter of 2010 (the latest available data), and the large federal deficit will likely keep it at low levels in the near term. Currently, real interest rates are still low despite the depressed rate of national saving.  If national saving were to remain low as the economy recovers, interest rates would likely experience upward pressure, capital formation rates would likely be low, and borrowing from abroad would likely be heavy. In combination, such developments would limit the rise in the standard of living of U.S. residents and hamper the ability of the nation to meet the retirement needs of an aging population.

The Labor Market

Employment and Unemployment

Conditions in the labor market have continued to improve only slowly since the middle of 2010. Private payroll employment rose just 120,000 per month, on average, over the second half of last year, and payroll employment gains remained lackluster in January of 2011 (figure 28).⁹ All told, only about one-seventh of the 8-3/4 million jobs lost from the beginning of 2008 to the trough in private payrolls in February 2010 have been recovered. Rather than adding jobs briskly, businesses have been achieving much of their desired increases in labor input over the past year by lengthening the hours worked by their employees; indeed, by January, the average workweek had recouped more than one-half of its decrease during the recession.

For most of last year, the overall net increase in hiring was barely sufficient to accommodate the increase in the size of the labor force, and the unemployment rate remained at or above 9-1/2 percent through November (figure 29). However, the unemployment rate is estimated to have moved down noticeably in December and January, reaching 9.0 percent--about 1 percentage point below the highest reading during this episode. The recent decline in the jobless rate is encouraging, but the extent of the improvement in underlying labor-market conditions is, as yet, difficult to judge. The level of unemployment remains very elevated, and long-duration joblessness continues to account for an especially large share of the total. Indeed, in January, nearly 6-1/4 million persons among those counted as unemployed--about 44 percent of the total--had been out of work for more than six months, figures that were only a little below record levels observed in the middle of 2010 (figure 30).¹⁰ Moreover, the number of individuals who are working part time for economic reasons--another indicator of the underutilization of labor--remained roughly twice its pre-recession value. Meanwhile, the labor force participation rate moved down further in the second half of the year (figure 31). The decline in participation was mainly concentrated among men aged 25 and over without a college degree.

Several other indicators of labor market conditions, however, have brightened a bit recently. After showing little progress over the first half of the year, initial claims for unemployment insurance (an indicator of the pace of layoffs) generally have trended down in recent months. Moreover, survey measures of labor market expectations--such as business plans for future hiring and consumer attitudes about future labor market conditions--improved, on net, over the second half of 2010 and early this year after having softened around the middle of last year.

Productivity and Labor Compensation

Labor productivity rose further in the second half of 2010. According to the most recent published data, output per hour in the nonfarm business sector increased at an annual rate of about 2-1/2 percent over that period (figure 32). Productivity had surged in 2009 as firms aggressively eliminated many operational inefficiencies and reduced their labor input in an environment of severe economic stress. Although the recent gains in productivity have been less rapid, firms nonetheless continue to make efforts to improve the efficiency of their operations, and they appear to remain reluctant to increase staffing levels in a climate of lingering economic uncertainty.

Increases in hourly compensation remained subdued in 2010, restrained by the wide margin of labor market slack (figure 33). The employment cost index (ECI) for private industry workers, which measures both wages and the cost to employers of providing benefits, rose just 2 percent in nominal terms in 2010--up from an especially small increase in 2009 but still lower than the roughly 3 percent pace averaged in the several years preceding the recession. The rise in the ECI last year reflected a pickup in the growth of benefits, after a subdued increase in 2009, and a modest acceleration in wages and salaries. Nominal compensation per hour in the nonfarm business sector--derived from the labor compensation data in the NIPA--increased only 1-1/2 percent in 2010, well below the average gain of about 4 percent in the years before the recession. After adjusting for the rise in consumer prices, hourly compensation was little changed in 2010. Because nominal hourly compensation and labor productivity in the nonfarm business sector rose at roughly the same pace in 2010, unit labor costs were about flat last year. During the preceding year, unit labor costs had plunged 3-1/2 percent as a result of the moderate rise in nominal hourly compensation and the sizable advance in output per hour.

Prices

Consumer price inflation has been trending downward, on net, and survey measures of longer-term inflation expectations have remained stable, despite the rapid increases in a variety of commodity prices during the second half of 2010. Overall prices for personal consumption expenditures increased 1-1/4 percent over the 12 months ending in January 2011, compared with a rise of 2-1/2 percent in the preceding 12-month period (figure 2). The core PCE price index--which excludes the prices of energy items as well as those of food and beverages--increased just 3/4 percent over the 12 months ending in January, down from a 1-3/4 percent rise over the preceding 12 months.

The index of consumer energy prices, which declined in the first half of 2010, rose rapidly during the second half of the year and early 2011. The index was boosted by a surge in the prices of gasoline and home heating oil, which reflected the run-up in the price of crude oil that began in late summer. In contrast, consumer natural gas prices fell as increases in supply from new domestic wells helped boost inventories above typical levels. All told, the overall index of consumer energy prices rose nearly 7 percent during the 12 months ending in January 2011.

The index of consumer food prices rose 1-3/4 percent over the 12 months ending in January 2011 as the prices of beef and pork posted sizable increases. The price of fruits and vegetables ran up briskly early in 2010 following a couple of damaging freezes, but these prices turned down in the second half of the year, leaving them up only slightly for the year as a whole. However, spot prices in commodity markets for crops and for livestock moved up sharply toward the end of last year, pointing to some upward pressure on consumer food prices in the first part of 2011.

The slowdown in core PCE price inflation over the past year was particularly evident in the prices of goods other than food and energy, which fell 0.6 percent over the 12 months ending in January 2011. The decline in these core goods prices occurred despite sizable increases in the prices of some industrial commodities and materials; the modest degree of pass-through from commodity input costs to retail prices reflects the relatively small weight of materials inputs in total production costs. Prices for services other than energy rose about 1-1/4 percent over the 12 months ending in January, down from an increase of almost 2 percent in the preceding 12 months, as the continued weakness in the housing market put downward pressure on the rise in housing costs and as the wide margin of economic slack continued to restrain price increases for other services.

The widespread slowing in inflation over the past year is also apparent in a variety of alternative indicators of the underlying trend in inflation (figure 34). These indicators include trimmed-mean price indexes, which exclude the most extreme price increases and price declines in each period, and market-based measures of core prices, which exclude prices that must be imputed. These imputed prices (often referred to as "nonmarket" prices) tend to be highly erratic.

Survey-based measures of near-term inflation expectations have increased in recent months, likely reflecting the recent run-up in energy and food prices; in contrast, survey-based measures of longer-term inflation expectations have remained relatively stable over the past year. In the Thomson Reuters/University of Michigan Surveys of Consumers, median year-ahead inflation remained between 2-3/4 percent and 3 percent for most of 2010 but then rose above 3 percent in early 2011. Longer-term expectations in the survey, at 2.9 percent in February, remained in the narrow range that has prevailed over the past few years. In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, expectations for the increase in the consumer price index over the next 10 years edged down, on balance, during 2010 after having been essentially unchanged for many years.

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Financial Developments

In light of the disappointing pace of the progress toward the Federal Reserve's dual objectives of maximum employment and price stability, the Federal Open Market Committee (FOMC) took steps in the second half of the year to reduce downside risk to the sustainability of the recovery and to provide further support to economic activity. At its August 2010 meeting, the FOMC decided to keep the Federal Reserve's holdings of longer-term securities constant at their then-current level by reinvesting principal payments from holdings of agency debt and agency MBS in longer-term Treasury securities. In November, the FOMC announced its intention to purchase a further $600 billion in longer-term Treasury securities by the end of the second quarter of 2011 (see box "The Effects of Federal Reserve Asset Purchases").

 

Financial market conditions, which had worsened early in the summer as a result of developments in Europe and concerns about the durability of the global recovery, subsequently improved as investors increasingly priced in further monetary policy accommodation. Accordingly, real Treasury yields declined, asset prices increased, and credit spreads narrowed. A brightening tone to the economic news starting in the fall bolstered investor sentiment and, together with a reassessment on the part of investors of the ultimate size of Federal Reserve Treasury purchases, contributed to a backup in interest rates and in measures of inflation compensation that continued through year-end. In contrast to the developments earlier in the year, the reemergence later in the year of concerns about the financial situation in Europe left little imprint on domestic financial markets.

Monetary Policy Expectations and Treasury Rates

In response to indications of a slowing pace of recovery in U.S. output and employment and a continued downward trend in measures of underlying inflation, expectations regarding the path for the federal funds rate during 2011 and 2012 were revised down sharply in the third quarter and investors came to anticipate further Federal Reserve asset purchases. The FOMC's decision to begin additional purchases of longer-term Treasury securities occurred against the backdrop of this downward shift in expectations about monetary policy. Subsequently, expectations regarding the ultimate size of such purchases were scaled back as the recovery appeared to strengthen, downside risks to the outlook seemed to recede somewhat, and a tax-cut deal that was seen as supportive of economic activity was passed into law.

The current target range for the federal funds rate of 0 to 1/4 percent is consistent with the level that investors expected at the end of June 2010. However, the date at which monetary policy tightening is expected to commence has moved back somewhat since the time of the July 2010 Monetary Policy Report to the Congress. Quotes on money market futures contracts indicate that, as of late February, investors anticipate that the federal funds rate will rise above its current range in the first quarter of 2012, about a year later than the date implied in July 2010. By the end of 2012, investors expect that the effective federal funds rate will be around 1.3 percent, fairly similar to the level anticipated in mid-2010.¹¹

Yields on nominal Treasury securities fluctuated considerably in the second half of 2010 and in early 2011 due to shifts in investors' expectations regarding the prospects for economic growth and the size of any asset purchase program that would be conducted by the Federal Reserve (figure 35). Recently, Treasury yields declined as investors increased their demand for the relative safety and liquidity of Treasury securities following political turmoil in the Middle East and North Africa. On net, yields on 2-year Treasury notes were up a bit from their levels in mid-2010, while those on 10-year Treasury securities rose approximately 40 basis points. Nonetheless, yields on Treasury securities remained quite low by historical standards. Uncertainty about longer-term interest rates, as measured by the implied volatility on 10-year Treasury securities, rose significantly from November to mid-December, likely in part because of increased uncertainty about the ultimate size of the Federal Reserve's asset purchase program. Interest rate uncertainty declined subsequently and by early 2011 was only a bit higher, on net, than in mid-2010, apparently reflecting coalescing market expectations regarding Federal Reserve purchases.

Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds rose, on balance, during the second half of 2010 but remained within their historical ranges. Both medium- and long-term measures of inflation compensation fell early in the third quarter as investors grew more concerned about the durability of the economic recovery, but they then moved back up as the FOMC was seen as taking additional steps to help move inflation back toward levels more consistent with its mandate and as economic prospects improved. Rising energy prices may also have contributed to the increases in medium-term inflation compensation.

Corporate Debt and Equity Markets

During the second half of 2010 and early 2011, the spreads between the yields on investment-grade corporate bonds and those on comparable-maturity Treasury securities narrowed modestly (figure 36). Similar risk spreads on corporate bonds with below-investment-grade ratings narrowed more substantially--as much as 200 basis points. This spread compression was consistent with continued improvements in corporate credit quality as well as increased investor confidence in the durability of the recovery. Nonetheless, bond spreads now stand near the lower end of their historical ranges. In the secondary market for syndicated leveraged loans, the average bid price moved up further, a development that reflected strong investor demand as well as improved fundamentals (figure 37). A notable share of loans traded at or above par in early 2011.

Equity prices have risen sharply since mid-2010 (figure 38). The rally began amid expectations of further monetary policy accommodation and was further supported by robust corporate earnings and an improved economic outlook. The gains in equity prices were broad based. Implied volatility for the S&P 500, calculated from options prices, generally trended down in the second half of 2010 and early 2011 and reached fairly low levels, although it increased recently against a backdrop of rising political turmoil in the Middle East and North Africa (figure 39).

With some investors apparently seeking to boost returns in an environment of low interest rates, net inflows into mutual funds that invest in higher-yielding fixed-income instruments, including speculative-grade bonds and leveraged loans, were robust in the second half of 2010 and early 2011. These inflows likely supported strong issuance and contributed to the narrowing of bond spreads during this period. Mutual funds focusing on international debt securities also attracted strong inflows. Inflows to other categories of bond funds were more modest so that overall inflows to bond funds in the second half of 2010 were similar to those in the first half of the year (figure 40). Despite the strong gains in U.S. equity markets, mutual funds investing in domestic equities experienced sizable outflows for much of the second half of last year, but these funds attracted net inflows in early 2011. Investments in money market mutual funds changed little in the second half of 2010--following notable outflows earlier in the year--as the assets held by these funds continued to generate very low yields.

Market Functioning and Dealer-Intermediated Credit

Conditions in short-term funding markets, which had experienced notable strains in the spring when investors became concerned about European sovereign debt and banking issues, generally improved early in the second half of 2010. Spreads of London interbank offered rates, or Libor, over comparable-maturity overnight index swap rates--a measure of stress in short-term bank funding markets--reversed the widening observed in the spring and then remained fairly narrow despite the reemergence of concerns about the situation in Europe in the fall (figure 41). Nevertheless, amid the renewed concerns, tiering was reportedly evident in dollar funding markets abroad, as institutions located in peripheral European countries apparently faced reduced access to funding. Issuance of commercial paper in the United States by institutions headquartered in peripheral Europe declined as investors required notably higher rates to hold this paper.

Besides these strains and some modest, short-lived year-end pressures, conditions in short-term funding markets continued to be stable. The spreads between yields on lower-quality A2/P2-rated paper and AA-rated asset-backed commercial paper over those on higher-quality AA-rated nonfinancial paper remained narrow through the fall and into 2011 (figure 42). Since last summer, haircuts on securities used as collateral in repurchase agreements (repos), while exhibiting some volatility in the fourth quarter and early 2011, were generally little changed.

Information from the Federal Reserve's quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms suggested that the major dealers eased credit terms to most types of counterparties during the second half of 2010, primarily in response to more-aggressive competition from other institutions and to an improvement in the current or expected financial strength of the counterparties. The easing of terms occurred primarily for securities-financing transactions, while nonprice terms for over-the-counter derivatives transactions were reportedly little changed on net. Survey respondents also noted a general increase in the demand for funding for all types of securities covered in the survey.

While remaining well below pre-crisis levels, the use of dealer-intermediated leverage appears to have gradually increased since the end of the summer, interrupted by a brief retrenchment in early December when concerns about developments in Europe intensified. This trend is reflected in the increased funding of equities by hedge funds and other levered investors and in an uptick in demand for the funding of some other types of securities. In addition, recent leveraged finance deals--involving the new issuance of high-yield corporate bonds and syndicated leveraged loans--on average reflected greater levering of the underlying corporate assets, but they nonetheless generated strong interest on the part of investors in a very low interest rate environment. However, there was little evidence that dealer-intermediated funding of less-liquid assets increased materially, and new issuance of structured products that embed leverage and were originated in large volumes prior to the crisis--including, for example, complex mortgage derivatives--has not resumed on any significant scale. In general, the appetite for additional leverage on the part of most market participants--as reflected in responses to special questions on the September SCOOS, triparty repo market volumes, and other indicators--appears to have remained generally muted, with most investors not fully utilizing their existing funding capacity.

Measures of liquidity and functioning in most financial markets pointed to generally stable conditions since mid-2010. In the Treasury market, various indicators, such as differences in prices of securities with similar remaining maturities and spreads between yields on on- and off-the-run issues, suggest that the market continued to operate normally, including during the period when the Federal Reserve was implementing its new asset purchase program. Bid-asked spreads were generally about in line with historical averages, and dealer transaction volumes have continued to reverse the declines observed during the financial crisis. In the syndicated loan market, bid-asked spreads trended down further in the second half of 2010 and in early 2011 as the market continued to recover, although they remained above the levels observed prior to 2007. Estimates of bid-asked spreads in corporate bond markets were within historical ranges, as was the dispersion of dealer quotes in the credit default swap market.

Banking Institutions

Returns on equity and returns on assets for commercial banks in the second half of 2010 improved moderately from earlier in the year but remained well below the levels that prevailed before the financial crisis (figure 43). Profits for the industry as a whole have benefitted considerably in recent quarters from reductions in loan loss provisioning. However, pre-provision net revenue decreased over the second half of the year as net interest margins slid and income from both deposit fees and trading activities declined.¹² About 70 of the more than 6,500 commercial banks in the United States failed between July and December 2010, down slightly from the 86 failures that occurred in the first half of the year.

Spreads on credit default swaps written on banking organizations generally held steady or moved down, on net, since mid-2010 (figure 44). Moreover, indicators of credit quality at commercial banks showed signs of improvement. Aggregate delinquency and charge-off rates moved down, although they remain high. Loss provisioning stayed elevated, but the recent reductions generally exceeded the declines in charge-offs, which suggests that banks expect credit quality to improve further in coming quarters. Indeed, for every major loan type, significant net fractions of banks reported on the January Senior Loan Officer Opinion Survey that they expect credit quality to improve during the current year if economic activity progresses in line with consensus forecasts.

Equity prices of commercial banks moved higher, on net, since mid-2010 (figure 45). During this period, large commercial banks generally reported earnings that beat analysts' expectations, and improved economic prospects were seen as boosting loan demand and supporting loan quality going forward, developments that would buoy banks' profitability. Nevertheless, investors were anxious about the degree to which future profitability might be negatively affected by a number of factors, including the quality of assets on banks' books, changes in the regulatory landscape, mortgage documentation and foreclosure issues, and the potential for some nonperforming mortgages in securitized pools to be put back to some of the large banks.

Total assets of commercial banks changed little, on net, during the second half of 2010, although there were notable compositional shifts. With demand weak and lending standards tight, total loans contracted (figure 46). Nevertheless, the pace at which loans decreased was not as rapid as in the first half of the year, in part because banks' holdings of commercial and industrial loans picked up and their holdings of closed-end residential mortgages grew steadily. Partly offsetting the declines in total loans, banks expanded their holdings of Treasury securities and agency MBS, although the growth in their securities holdings slowed late in the year and into 2011.

Regulatory capital ratios at commercial banks moved higher, on balance, over the second half of 2010. The upward trend in capital ratios over the past several years has been most pronounced at the largest banks as they accumulated capital while risk-weighted assets decreased and tangible assets were about unchanged. Capital requirements for many of these banks will increase significantly under the new international capital standards, which will restrict the definition of regulatory capital and increase the risk weights assigned to some assets and off-balance-sheet exposures. In addition, the Dodd–Frank Wall Street Reform and Consumer Protection Act requires that the Federal Reserve issue rules by January 31, 2012, that will subject bank holding companies with more than $50 billion in assets to additional capital and liquidity requirements.

Monetary Aggregates and the Federal Reserve's Balance Sheet

The M2 monetary aggregate has expanded at a moderate pace since mid-2010 after rising only slightly in the first half of last year (figure 47); for the year as a whole, M2 grew 3.2 percent, the slowest annual increase since 1994.¹³ As has been the case for some time, the strongest increase was in liquid deposits, the largest component of M2, while small time deposits and retail money market mutual fund assets continued to contract. Liquid deposits tended to pay slightly more-favorable interest rates than did their close substitutes. The currency component of the money stock expanded at a faster rate in the second half of 2010 than it had earlier in the year. The monetary base--essentially equal to the sum of currency in circulation and the reserve balances of depository institutions held at the Federal Reserve--contracted slightly during the second half of 2010, although the downward trend started to reverse late in the period in response to the Federal Reserve's new Treasury security purchase program.

The size of the Federal Reserve's balance sheet remained at a historically high level throughout the second half of 2010. In early 2011, the balance sheet stood at about $2.5 trillion, an increase of around $200 billion from its level in early July (table 1). The expansion of the balance sheet was more than accounted for by an increase in holdings of Treasury securities, which were up nearly $450 billion since the summer. The additional holdings of Treasury securities resulted from the FOMC's August decision to reinvest the proceeds from paydowns of agency debt and MBS in longer-term Treasury securities and the asset purchase program announced at the November FOMC meeting. To provide operational flexibility and to ensure that it is able to purchase the most attractive securities on a relative-value basis, the Federal Reserve temporarily relaxed its 35 percent per-issue limit on System Open Market Account (SOMA) holdings of individual Treasury securities and will allow SOMA holdings to rise above the previous threshold in modest increments up to a 70 percent per-issue limit; holdings of particular issues exceed the previous limit for only a small number of securities. In contrast, holdings of agency debt and agency MBS declined about $180 billion between early July and early 2011. The wave of mortgage refinancing that occurred in the autumn in the wake of the drop in mortgage rates contributed notably to the sharp decline in Federal Reserve holdings of MBS. In addition, holdings of agency debt declined as these securities matured.

1. Selected components of the Federal Reserve balance sheet, 2009-11
Millions of dollars

Balance sheet item	Dec. 30, 2009	July 7, 2010	Feb. 23, 2011
Total assets	2,237,258	2,335,457	2,537,175
Selected assets
Credit extended to depository institutions and dealers
Primary credit	19,111	17	24
Term auction credit	75,918	0	0
Primary Dealer Credit Facility and other broker-dealer credit	0	…	…
Central bank liquidity swaps	10,272	1,245	70
Credit extended to other market participants
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility	0	…	…
Net portfolio holdings of Commercial Paper Funding Facility LLC	14,072	1	…
Term Asset-Backed Securities Loan Facility	47,532	42,278	20,997
Support of critical institutions
Net portfolio holdings of Maiden Lane LLC, Maiden Lane II LLC, and Maiden Lane III LLC1	65,024	66,996	64,902
Credit extended to American International Group, Inc.	22,033	24,560	…
Preferred interests in AIA Aurora LLC and ALICO Holdings LLC	25,000	25,733	…
Securities held outright
U.S. Treasury securities	776,587	776,997	1,213,425
Agency debt securities	159,879	164,762	144,119
Agency mortgage-backed securities (MBS)2	908,257	1,118,290	958,201
Memo
Term Securities Lending Facility3	0	…	…
Total liabilities	2,185,139	2,278,523	2,484,141
Selected liabilities
Federal Reserve notes in circulation	889,678	907,698	956,012
Reverse repurchase agreements	70,450	62,904	59,484
Deposits held by depository institutions	1,025,271	1,061,239	1,297,905
Of which: Term deposits	…	2,122	5,070
U.S. Treasury, general account	149,819	16,475	23,123
U.S. Treasury, Supplementary Financing Account	5,001	199,963	124,976
Total capital	52,119	56,934	53,035

Use of regular discount window lending facilities, such as the primary credit facility, has been minimal for some time. The Term Asset-Backed Securities Loan Facility (TALF) was closed on June 30, 2010. Loans outstanding under the TALF declined from $42 billion in mid-2010 to $21 billion in early 2011 as improved conditions in some securitization markets resulted in prepayments of loans made under the facility. The other broad-based credit facilities that the Federal Reserve had introduced to provide liquidity to financial institutions and markets during the financial crisis were closed early in 2010. All loans extended through these programs had been repaid by the summer.

The portfolio holdings of Maiden Lane LLC, Maiden Lane II LLC, and Maiden Lane III LLC, which were created to acquire certain assets from troubled systemically important institutions during the crisis, have generally changed little, on net, since mid-2010. Current estimates of the fair values of the portfolios of the three Maiden Lane LLCs exceed the corresponding loan balances outstanding to each limited liability company from the Federal Reserve Bank of New York. Consistent with the terms of the Maiden Lane LLC transaction, on July 15, 2010, this limited liability company began making distributions to repay the loan received from the Federal Reserve Bank of New York. On January 14, 2011, American International Group, Inc., or AIG, repaid the credit extended by the Federal Reserve under the revolving credit line, and the Federal Reserve was paid in full for its preferred interests in the special purpose vehicles AIA Aurora LLC and ALICO Holdings LLC, thereby reducing the balances in these accounts to zero.

Stresses in European dollar funding markets in May led to the reestablishment of liquidity swap lines between the Federal Reserve and foreign central banks. Only a small amount of credit has been issued under the reestablished facilities, which in December were extended through August 1, 2011.

On the liability side, Federal Reserve notes in circulation increased a bit, from $908 billion to $956 billion. Reverse repos edged down. Deposits held at the Federal Reserve by depository institutions rose to about $1.3 trillion. The Supplementary Financing Account declined early in 2011 following the announcement by the Treasury that it was suspending new issuance under the Supplementary Financing Program and that it would allow that account to fall to $5 billion as part of its efforts to maximize flexibility in debt management as federal debt approached the statutory debt limit.

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International Developments

International Financial Markets

The foreign exchange value of the dollar declined over much of the third quarter of 2010 (figure 48). This decline was spurred in part by some reversal of flight-to-safety flows--as financial system strains in Europe temporarily diminished following the July release of the results of the European Union (EU) stress tests--and by fears that the recovery in the United States was slowing. Mounting expectations that the Federal Reserve might undertake further asset purchases in response to the weakening economic outlook also weighed on the dollar. Although the dollar initially dropped a bit more following the Federal Reserve's announcement in early November that it would purchase additional long-term Treasury securities, it subsequently reversed course as data on economic activity in the United States began to strengthen and as investors began to scale back their expectations of the ultimate size of the Federal Reserve's purchase program. In the first two months of this year, the dollar edged down again as the outlook for economic activity abroad appeared to strengthen and the financial situation in Europe stabilized. On net, the dollar declined 7 percent on a trade-weighted basis against a broad set of currencies over the second half of last year and into the first two months of this year.

Foreign benchmark sovereign yields also declined over much of the third quarter as concerns about the U.S. recovery and worries that China's economy might decelerate more quickly than had been expected led investors to question the overall strength of global economic growth (figure 49). However, foreign yields subsequently rose as confidence in the global recovery strengthened, leaving foreign benchmark yields 15 to 60 basis points higher on net.

Foreign equity markets rallied following the release of the EU stress tests in July, and, although those markets gave back part of these gains in August over heightened worries about the pace of global economic growth, they nonetheless ended the third quarter higher. Over the fourth quarter and into this year, foreign equity prices rose further as the global economic outlook improved, notwithstanding renewed stresses in peripheral Europe. On net, headline equity indexes in the euro area and Japan are up about 10 to 20 percent from their levels in mid-2010, while indexes in the major emerging market economies are about 20 percent higher; all those indexes increased, on balance, even after having declined a bit recently in the face of uncertainties about the Middle East and North Africa (figures 50 and 51).

Although some banks in the euro-area periphery countries, particularly in Spain, seemed to have better access to capital markets immediately following the stress test, their costs of funding rose again late in the year as market concerns about the Irish and Spanish banking sectors resurfaced. Banks in the euro-area periphery relied heavily on the weekly and longer-term funding operations of the European Central Bank (ECB) over much of this period. The strains nevertheless spilled over into increased funding costs in dollars for some European banks, although the reaction was less severe than it had been in May. Reportedly, many European banks had already met their dollar funding needs through year-end before these strains occurred. Market participants welcomed the announcement that the swap lines between the Federal Reserve and the ECB, the Bank of England, the Swiss National Bank, the Bank of Japan, and the Bank of Canada would be extended through August 1.

With the yen at a 15-year high against the dollar in nominal terms, Japanese authorities intervened in currency markets on September 15 (figure 52). Japan's Ministry of Finance purchased dollars overnight to weaken the value of the yen, its first intervention operation since March 2004. The operation caused the yen to depreciate immediately about 3 percent against the dollar, but this movement was fairly short lived, as the yen rose past its pre-intervention level within a month.

During the third quarter, the EMEs saw an increase in capital inflows, which added to upward pressures on their currencies and reportedly triggered further intervention in foreign exchange markets by EME authorities. Authorities in several EMEs also announced new measures to discourage portfolio capital inflows in an attempt to ease upward pressures on their currencies and in their asset markets. Although capital flows to EMEs appeared to moderate late in the year as long-term interest rates in the advanced economies rose, intervention and the imposition of capital control measures continued.

The Financial Account

Financial flows in 2010 reflected changes in investor sentiment over the course of the year, driven in part by concerns over fiscal difficulties in Europe. Foreign private investors made large purchases of U.S. Treasury securities in the first half of the year, but these "flight to quality" demands eased somewhat in the third quarter with the improvement in conditions in European markets (figure 53). Indicators for the fourth quarter are mixed but suggest that foreign private demand for U.S. Treasury securities picked up again late in the year as tensions in European markets reemerged. Foreign demand for other U.S. securities strengthened in the second half of the year. Net private purchases of both U.S. agency debt and U.S. equities were strong, and foreign investors made small net purchases of corporate debt securities, in contrast to net sales over the previous several quarters. U.S. residents continued to purchase sizable amounts of foreign bonds and equities, including both emerging market and European securities (figure 54).

Banks located in the United States continued to lend abroad, on net, in the third quarter, but at a slower pace than in the first half of the year, as dollar funding pressures in European interbank markets eased and banks abroad relied less on U.S. counterparties for funding. As a result, inflows from increased foreign private purchases of U.S. securities more than offset the banking outflows in the third quarter, generating net private financial inflows for the first time since late 2008 (figure 55).

Inflows from foreign official institutions increased in the third quarter, with inflows primarily coming from countries seeking to counteract upward pressure on their currencies by purchasing U.S. dollars in foreign currency markets. These countries then used the proceeds to acquire U.S. assets, primarily Treasury securities. Available data for the fourth quarter indicate that foreign official purchases of U.S. Treasury securities slowed as the dollar stabilized.

Advanced Foreign Economies

Economic growth in the advanced foreign economies stepped down in the second half of 2010. To a large extent, this slowdown reflected standard business cycle dynamics, as support from fiscal stimulus and the rebound in global trade and inventories diminished over the course of the year. In Canada, signs of the maturing recovery were most evident in the domestic sector, whereas in Japan, exports decelerated as growth in emerging Asian economies moderated. In Europe, the recovery was further restrained by a reemergence of concerns over fiscal sustainability and banking sector vulnerabilities in some countries. (See box "An Update on the European Fiscal Crisis and Policy Responses.") However, recent indicators of economic activity across the advanced foreign economies suggest that performance improved moderately toward the end of 2010. In the manufacturing sector, purchasing managers indexes have resumed rising and point to solid expansion. Moreover, the recovery appears to be gradually spilling over to the retail and service sectors, with household demand benefiting from improving labor market conditions and rising incomes.

 

Toward year-end, consumer prices in the advanced foreign economies were boosted by a run-up in food and energy prices (figure 56). Japanese 12-month headline consumer price inflation turned slightly positive for the first time since early 2009, in part because of a hike in the tobacco tax, and headline inflation in Canada and the euro area recently moved above 2 percent. However, inflation in core consumer prices, which excludes food and energy prices, remained subdued amid considerable slack in these economies. One exception was the United Kingdom, where consumer price inflation--both headline and core--persisted above 3 percent throughout 2010, driven by prior exchange rate depreciation and increases in the value-added tax.

Major central banks in the advanced foreign economies have maintained an accommodative monetary policy stance (figure 57), although some have taken steps to remove the degree of accommodation. The Bank of Canada raised its target for the overnight rate 50 basis points in the third quarter but since then has held its policy rate at 1 percent. The ECB discontinued refinancing operations at 6- and 12-month maturities but extended fixed-rate refinancing at shorter maturities and kept its main refinancing rate at 1 percent. The Bank of England maintained its policy rate at 0.5 percent and the size of its Asset Purchase Facility at £200 billion. The Bank of Japan took additional steps to ease policy by cutting its target interest rate from 10 basis points to a range of 0 to 10 basis points. In addition, it extended from three to six months the term for its fixed-rate funds-supplying operation, and it established an asset purchase program of ¥5 trillion to buy a broad range of financial assets, including government securities, commercial paper, corporate bonds, exchange-traded funds, and real estate investment trusts.

Emerging Market Economies

After a robust expansion in the first half of 2010, economic activity in the EMEs stepped down in the third quarter before bouncing back to solid growth in the fourth. On average over the two quarters, real GDP growth in the EMEs was well above that observed in the advanced economies. Economic activity in the EMEs was boosted by domestic demand, supported by accommodative monetary and fiscal policies. However, with output appearing to approach capacity for most countries, authorities in many EMEs have begun to unwind the stimulus measures, both monetary and fiscal, put in place during the crisis. The withdrawal of monetary stimulus has also been driven by a recent pickup in consumer price inflation, which has reflected, in part, a rise in commodity prices.

Monetary policy tightening in the EMEs has likely been tempered by uncertainties about the pace and durability of the economic recovery in advanced economies, which remain an important source of demand for the EMEs. In addition, the exit from accommodative stances has been complicated by the return of private capital flows to these economies. Capital inflows appear to have exerted some upward pressure on currencies and have raised concerns about the possibility of an overheating in asset prices. EME authorities have so far adopted a variety of strategies to cope with increased capital flows, including intervention in foreign exchange markets to slow the upward movement of domestic currencies, prudential measures targeted to specific markets (such as the property market), and, in several cases, capital controls.

Real GDP growth in China slowed a bit in the first half of last year, but it moved back up in the second half along with a pickup in inflation, prompting Chinese authorities to continue to tighten monetary policy. Since last June, bank reserve requirements increased a total of 250 basis points for the largest banks, and the benchmark one-year bank lending rate has risen 75 basis points. Chinese authorities have also raised the minimum down payment required for residential property investment in order to slow rising property prices. Since the announcement last June by Chinese authorities that they would allow more exchange rate flexibility, the renminbi has appreciated about 4 percent against the dollar. However, on a real multilateral, trade-weighted basis, which gauges the renminbi's value against China's major trading partners and adjusts for differences in inflation rates, the renminbi has depreciated slightly.

In emerging Asia excluding China, the pace of economic growth softened in the third quarter of last year. There was a steep decline in Singapore's real GDP, which often exhibits wide quarterly swings. Considerable weakness in third-quarter economic activity was also observed in Malaysia, the Philippines, and Thailand. However, available indicators suggest that fourth-quarter GDP growth in the region has picked up again.

In Latin America, real GDP in Mexico and Brazil also decelerated in the third quarter. Mexican output has yet to recover fully from the financial crisis; total manufacturing output slowed over the final two quarters of the year, largely reflecting lower U.S. manufacturing growth, which has depressed demand for exports from Mexico. Economic activity in Brazil, though having slowed from a very brisk pace in the first half of the year, has remained solid, supported by continued fiscal stimulus and high commodity prices. Brazil's central bank tightened reserve requirements in December, prompted by concerns about both the pace of credit creation and the quality of the credit being extended. In addition, the Brazilian central bank raised its policy rate 50 basis points in January of this year. The new Brazilian government has announced some spending cuts to reduce aggregate demand and inflationary pressures.

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Footnotes

2. The SLOOS is available on the Federal Reserve Board's website at www.federalreserve.gov/boarddocs/SnLoanSurvey. Return to text

3. The Credit Card Act includes some provisions that place restrictions on issuers' ability to impose certain fees and to engage in risk-based pricing. Return to text

4. In June 2009, the Financial Accounting Standards Board (FASB) published Statements of Financial Accounting Standards Nos. 166 (Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140) and 167 (Amendments to FASB Interpretation No. 46(R)). The statements became effective at the start of a company's first fiscal year beginning after November 15, 2009, or, for companies reporting earnings on a calendar-year basis, after January 1, 2010. Return to text

5. In order to receive the homebuyer tax credit, a purchaser had to sign a sales agreement by the end of April 2010 and close on the property by the end of September. The first-time homebuyer tax credit, which was enacted in February 2009 as part of the American Recovery and Reinvestment Act, was originally scheduled to expire on November 30, 2009. Shortly before it expired, the Congress extended the credit to sales occurring through April 30, 2010, and expanded it to include repeat homebuyers who had owned and occupied a house for at least five of the past eight years. Sales of existing homes are measured at closing, while sales of new homes are measured at the time the contract is signed. Return to text

6. The Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation are conducting an in-depth interagency review of practices at the largest mortgage servicing operations to examine foreclosure practices generally, but with an emphasis on the breakdowns that led to inaccurate affidavits and other questionable legal documents being used in the foreclosure process. See Elizabeth A. Duke (2010), "Foreclosure Documentation Issues," statement before the Financial Services Subcommittee on Housing and Community Opportunity, U.S. House of Representatives, November 18, www.federalreserve.gov/newsevents/testimony/duke20101118a.htm. Return to text

7. The Build America Bond program allowed state and local governments to issue taxable bonds for capital projects and receive a subsidy payment from the Treasury for 35 percent of interest costs. Return to text

8. The prices of other grades of crude oil have risen by more over the first two months of this year as the high level of inventories accumulated at Cushing, Oklahoma, the delivery point for WTI, has depressed WTI prices. Return to text

9. Total employment--private plus government--exhibited sharp swings from March 2010 to September 2010 as a result of the hiring of temporary workers for the decennial census. Return to text

10. The data on the duration of unemployment begin in 1948. Return to text

11. When interest rates are close to zero, determining the point at which financial market quotes indicate that the federal funds rate will move above its current range can be challenging. The path described in the text is the mean of a distribution calculated from derivatives contracts on federal funds and Eurodollars. The skewness induced in this distribution by the zero lower bound causes the mean to be influenced strongly by changes in uncertainty regarding the policy path, complicating its interpretation. Alternatively, one can use similar derivatives to calculate the most likely--or "modal"--path of the federal funds rate, which tends to be more stable. This path has also moved down, on net, since last summer, but it suggests a flatter overall trajectory for the target federal funds rate, according to which the effective rate does not rise above its current level until around the middle of 2012. Return to text

12. Pre-provision net revenue is the sum of net interest income and noninterest income less noninterest expense. Return to text

13. M2 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; (4) other checkable deposits (negotiable order of withdrawal, or NOW, accounts and automatic transfer service accounts at depository institutions; credit union share draft accounts; and demand deposits at thrift institutions); (5) savings deposits (including money market deposit accounts); (6) small-denomination time deposits (time deposits issued in amounts of less than $100,000) less individual retirement account (IRA) and Keogh balances at depository institutions; and (7) balances in retail money market mutual funds less IRA and Keogh balances at money market mutual funds. Return to text

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