Monetary policy report to the Congress - Statistical Data Included

Federal Reserve Bulletin, August, 2002

Report submitted to the Congress on July 16, 2002, pursuant to section 2B of the Federal Reserve Act

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The pace of economic activity in the United States picked up noticeably in the first half of 2002 as some of the powerful forces that had been restraining spending for the preceding year and a half abated. With inventories in many industries having been brought into more comfortable alignment with sales, firms began boosting production around the turn of the year to stem further runoffs of their stocks. And while capital spending by businesses has yet to show any real vigor, the steep contraction of the past year or so appears to have come to an end. Household spending, as it has throughout this cyclical episode, continued to trend up in the first half. With employment stabilizing, the increases in real wages made possible by gains in labor productivity and the effects of a variety of fiscal actions have provided noticeable support to disposable incomes. At the same time, low interest rates have buoyed the purchase of durable goods and the demand for housing. Growth was not strong enough to forestall a rise in the unemployment rate, and slack in product and labor markets, along with declining unit costs as productivity has soared, has helped to keep core inflation low. The exceptionally strong performance of productivity over the past year provides further evidence of the U.S. economy's expanded capacity to provide growth over the longer haul.

The Federal Reserve had moved aggressively in 2001 to counter the weakness that had emerged in aggregate demand; by the end of the year, it had lowered the federal funds rate to 1 3/4 percent, the lowest level in forty years. With only tentative signs that activity was picking up, the Federal Open Market Committee (FOMC) decided to retain that unusual degree of monetary accommodation by leaving the federal funds rate unchanged at its January meeting. Confirmation of an improvement in activity was evident by the time of the March meeting, and the FOMC moved toward an assessment that the risks to the outlook were balanced between its long-run goals of price stability and maximum sustainable economic growth, a view maintained through its June meeting. The durability and strength of the expansion were recognized to depend on the trajectory of final sales. The extent of a prospective strengthening of final sales was--and still is--uncertain, however, and with inflation likely to remain contained, the Committee has chosen to maintain an accommodative stance of policy, leaving the federal funds rate at its level at the end of last year.

The economy expanded especially rapidly early in the year. As had been anticipated, much of the first quarter's strength in production resulted from the efforts of firms to limit a further drawdown of inventories after the enormous liquidation in the fourth quarter of 2001. With respect to first-quarter sales, purchases of light motor vehicles dropped back from their extraordinary fourth-quarter level, but other consumer spending increased substantially. Housing starts, too, jumped early in the year--albeit with the help of weather conditions favorable for building in many parts of the country--and spending on national defense moved sharply higher. All told, real GDP is now estimated to have increased at an annual rate in excess of 6 percent in the first quarter.

Economic activity appears to have moved up further in recent months but at a slower pace than earlier in the year. Industrial production has continued to post moderate gains, and nonfarm payrolls edged up in the second quarter after a year of nearly steady declines. However, several factors that had contributed importantly to the outsized gain of real output in the first quarter appear to have made more modest contributions to growth in the second quarter. Available data suggest that the swing in inventory investment was considerably smaller in the second quarter than in the first. Consumer spending has advanced more slowly of late, and while the construction of new homes has expanded further, its contribution to the growth of real output has not matched that of earlier in the year.

Notable crosscurrents remain at work in the outlook for economic activity. Although some of the most recent indicators have been encouraging, businesses still appear to be reluctant to add appreciably to workforces or to boost capital spending, presumably until they see clearer signs of improving prospects for sales and profits. These concerns, as well as ongoing disclosures of corporate accounting irregularities and lapses in corporate governance, have pulled down equity prices appreciably on balance this year. The accompanying decline in net worth is likely to continue to restrain household spending in the period ahead, and less favorable financial market conditions could reinforce business caution.

Nevertheless, a number of factors are likely to boost activity as the economy moves into the second half of 2002. With the inflation-adjusted federal funds rate barely positive, monetary policy should continue to provide substantial support to the growth of interest-sensitive spending. Low interest rates also have allowed businesses and households to strengthen balance sheets by refinancing debt on more favorable terms. Fiscal policy actions in the form of lower taxes, investment incentives, and higher spending are providing considerable stimulus to aggregate demand this year. Foreign economic growth has strengthened and, together with a decline in the foreign exchange value of the dollar, should bolster U.S. exports. Finally, the exceptional performance of productivity has supported household and business incomes while relieving pressures on price inflation, a combination that augurs well for the future.