Monetary Policy Report submitted to the Congress on February 11, 2003, pursuant to section 2B of the Federal Reserve Act

Section 1


The economy of the United States has suffered a series of blows in the past few years, including the fall in equity market values that began in 2000, cutbacks in capital spending in 2001, the horrific terrorist attacks of September 11, the emergence of disturbing evidence of corporate malfeasance, and an escalation of geopolitical risks. Despite these adversities, the nation's economy emerged from its downturn in 2001 to post moderate economic growth last year. The recovery was supported by accommodative monetary and fiscal policies and undergirded by unusually rapid productivity growth that boosted household incomes and held down business costs. The productivity performance was also associated with a rapid expansion of the economy's potential, and economic slack increased over the year despite the growth in aggregate demand.

After turning up in late 2001, activity began to strengthen more noticeably early last year. Sharp inventory cutbacks in 2001 had brought stocks into better alignment with gradually rising final sales, and firms began to increase production in the first quarter of 2002 to curtail further inventory runoffs. Moreover, businesses slowed their contraction of investment spending and began to increase outlays for some types of capital equipment. Household spending on both personal consumption items and housing remained solid and was supported by another installment of tax reductions, widespread price discounting, and low mortgage interest rates. By midyear, the cutbacks in employment came to an end, and private payrolls started to edge higher.

Although economic performance appeared to be gradually improving, the tentative nature of this improvement warranted the continuation of a highly accommodative stance of monetary policy. Accordingly, the Federal Open Market Committee (FOMC) held the federal funds rate at 1-3/4 percent through the first part of the year. In March, however, the FOMC shifted from an assessment that the risks over the foreseeable future to its goals of maximum sustainable growth and price stability were tilted toward economic weakness to an assessment that the risks were balanced.

Around midyear, the economy began to struggle again. Concerns about corporate governance came to weigh heavily on investors' confidence, and geopolitical tensions, especially the situation in Iraq, elevated uncertainties about the future economic climate. Equity prices fell during the summer, liquidity eroded in corporate debt markets, and risk spreads widened. Businesses once again became hesitant to spend and to hire, and both manufacturing output and private payrolls began to decline. State and local governments struggled to cope with deteriorating fiscal positions, and the economies of some of our major trading partners remained weak. Although the already accommodative stance of monetary policy and strong upward trend of productivity were providing important support to spending, the Committee perceived a risk that the near-term weakening could become entrenched. In August, the FOMC adjusted its weighting of risks toward economic weakness, and in November, it reduced the targeted federal funds rate 50 basis points, to 1-1/4 percent. The policy easing allowed the Committee to return to an assessment that the risks to its goals were balanced. With inflation expectations well contained, this additional monetary stimulus seemed to offer worthwhile insurance against the threat of persistent economic weakness and substantial declines in inflation from already low levels.

On net, the economy remained sluggish at the end of 2002 and early this year. The household sector continued to be a solid source of demand. Motor vehicle sales surged at year-end on the tide of another round of aggressive discounting by the manufacturers, other consumer outlays trended higher, and activity in housing markets remained exceptionally strong. Concerns about corporate governance appeared to recede somewhat late last year, in part because no new revelations of major wrongdoing had emerged. However, the ongoing situation in Iraq, civil strife in Venezuela that has curtailed oil production, and tensions on the Korean peninsula have sustained investors' uncertainty about economic prospects and have pushed prices higher on world oil markets. Faced with this uncertainty, businesses have been cautious in spending and changed payrolls little, on net, over December and January.

Mindful of the especially high degree of uncertainty attending the economic outlook in the current geopolitical environment, the members of the FOMC believe the most likely outcome to be that fundamentals will support a strengthening of economic growth. Business caution is anticipated to give way over the course of the year to clearer signs of improving sales. Inventories are lean relative to sales at present, and restocking is likely to provide an additional impetus to production in the period ahead. The rapid expansion of productivity, the waning effects of earlier declines in household wealth, and the highly accommodative stance of monetary policy should also continue to boost activity. Although state and local governments face budgetary problems, their restraint is likely to offset only a part of the stimulus from past and prospective fiscal policy actions at the federal level. In addition, the strengthening economies of our major trading partners along with the improving competitiveness of U.S. products ought to support demand for our exports. Taken together, these factors are expected to lead to a faster pace of economic expansion, while inflation pressures are anticipated to remain well contained.

Monetary Policy, Financial Markets, and the Economy over 2002 and Early 2003

As economic growth picked up during the early months of 2002, the FOMC maintained its target for the federal funds rate at 1-3/4 percent. A sharply reduced pace of inventory liquidation accounted for a significant portion of the step-up in real GDP growth, but other indicators also suggested that the economy was gaining momentum. Reductions in business outlays on equipment and software had moderated significantly after dropping precipitously in 2001, and consumer spending was well maintained by sizable gains in real disposable personal income. Residential construction activity was spurred by low home mortgage interest rates. The improvement in economic conditions sparked a rally in equity markets late in the first quarter and pushed up yields on longer-term Treasury instruments and investment-grade corporate bonds; yields on speculative-grade bonds declined in reaction to brighter economic prospects and the perceived reduction in credit risk. Meanwhile, surging energy prices exerted upward pressure on overall inflation, but still-appreciable slack in resource utilization and a strong upward trend in private-sector productivity were holding down core price inflation.

Selected interest rates. By percent. Line chart with 5 series (discount rate (adjustment credit), intended federal funds rate, discount rate (primary credit), two-year Treasury, and ten-year Treasury). Date range is January 2001 to February 2003. Discount rate (adjustment credit) starts at 6 percent, increasing to 1.3 percent in December 2001, remaining at about 1.3 percent until November 2002, and then decreasing to end at about 0.8 percent. Discount rate (primary credit) starts in the beginning of 2003 at about 2.2 percent and remains constant to end at about 2.2 percent. Intended federal funds rate closely tracks the discount rate, usually being about a half percent higher than the discount rate at any given time. Two-year and ten-year Treasury rates closely track each other through much of the chart. They begin at about 5 percent. Ten-year Treasury fluctuates between about 4.25 and about 5.5 percent from January 2001 to June 2002 and ends at about 4 percent. Two-year Treasury decreases to about 2.3 percent in December 2001, increasing to about 3.9 percent in March 2002, and then decreasing to end at about 1.6 percent. Note: The data are daily and extend through February 5, 2003. The dates on the horizontal axis those of scheduled FOMC meetings and of any intermeeting policy actions. On January 9, 2003, the Federal Reserve changed the main credit program offered at the discount window by terminating the adjustment credit program and beginning the primary credit program.

At both its March and May meetings, the FOMC noted that the apparent vigor of the economy was importantly attributable to a slowdown in the pace of inventory liquidation and that considerable uncertainty surrounded the outlook for final sales over the next several quarters. The Committee was especially concerned about prospects for a rebound in business fixed investment, which it viewed as key to ensuring sustainable economic expansion. Although the decline in investment spending during the first quarter of 2002 was the smallest in a year, gloomy business sentiment and large margins of excess capacity in numerous industries were likely to hamper capital expenditures. According to anecdotal reports, many firms were unwilling to expand capacity until they saw more conclusive evidence of growing sales and profits. At the same time, however, the FOMC noted that, with the federal funds rate unusually low on an inflation-adjusted basis and considerable fiscal stimulus in train, macroeconomic policies would provide strong support to further economic expansion. Against this backdrop, the Committee at the March 19 meeting judged the accommodative stance of monetary policy to be appropriate and announced that it considered the risks to achieving its long-run objectives as being balanced over the foreseeable future, judgments it retained at its meeting in early May.

The information reviewed at the June 25-26 FOMC meeting confirmed that the economy was expanding but at a slower pace than earlier in the year. As expected, the degree of impetus to economic activity from decelerating inventory liquidation had moderated. Residential investment and consumer spending also had slowed appreciably after surging earlier in the year. The most recent data on orders and shipments suggested a small upturn in business spending on equipment and software, but the improvement in capital spending appeared to be limited, unevenly distributed across industries, and not yet firmly indicative of sustained advance. Industrial production continued to increase, and the unemployment rate declined somewhat.

In financial markets, investors and lenders had apparently become more risk averse in reaction to the mixed tone of economic data releases, growing geopolitical tensions, further warnings about terrorist attacks, and additional revelations of dubious corporate accounting practices. In concert, these developments pushed down yields on longer-term Treasury securities, while interest rates on lower-quality corporate bonds rose notably, and equity prices dropped sharply. Although the economy continued to expand and the prospects for accelerating aggregate demand remained favorable, downbeat business sentiment and skittish financial markets rendered the timing and extent of the expected strengthening of the expansion subject to considerable uncertainty. In these circumstances, the FOMC left the federal funds rate unchanged to keep monetary policy very accommodative and once again assessed the risks to the outlook as being balanced.

By the time of the August 13 FOMC meeting, it had become apparent that economic activity had lost some of its earlier momentum. Turbulence in financial markets appeared to be holding back the pace of the economic expansion. Market participants focused their attention on the lack of convincing evidence that the recovery was gaining traction and the possibility that more news of corporate misdeeds would surface in the run-up to the Securities and Exchange Commission's August 14 deadline for the certification of financial statements by corporate executives. Although the cumulative losses in financial wealth since 2000 were restraining expenditures by households, very low mortgage interest rates were helping to sustain robust demand for housing. Moreover, the financial resources made available by a rapid pace of mortgage refinancing activity, in combination with attractive incentives offered by auto manufacturers, supported other consumer spending. The Committee continued to judge the prevailing degree of monetary accommodation as appropriate to foster a solid expansion that would bring the economy to fuller resource utilization. At the same time, the Committee recognized the considerable risks to that outlook and the potential adverse consequences for economic prospects from possible additional deterioration of financial conditions. The members noted, however, that a further easing of monetary policy, if it came to be viewed as appropriate, could be accomplished in a timely manner. In light of these considerations, the FOMC opted to retain a target rate of 1-3/4 percent for the federal funds rate, but it viewed the risks to the economy as having shifted from balanced to being tilted toward economic weakness.

When the FOMC met on September 24, data indicated that economic growth had picked up in the third quarter, on average, buoyed in part by a surge in motor vehicle production. The uneventful passing of the mid-August deadline for recertification of corporate financial statements briefly alleviated investors' skittishness in debt and equity markets. However, the most timely information suggested that some softening in economic activity had occurred late in the summer. Those economic reports, along with a darker outlook for corporate profits and escalating fears of a possible war against Iraq, led market participants to revise down their expectations for the economy. Equity prices and yields on both longer-term Treasury and private securities moved sharply lower in early autumn. In the Committee's view, heightened geopolitical tensions constituted a significant additional source of uncertainty clouding the economic outlook. Still, fundamentals suggested reasonable prospects for continued expansion. Accordingly, the FOMC left the federal funds rate unchanged at the close of the September meeting but also reiterated its view that the risks to the outlook were weighted toward economic weakness.

The information reviewed at the November 6 meeting indicated a more persistent spell of below-par economic performance than the FOMC had anticipated earlier. With home mortgage rates at very low levels, residential construction activity remained high. But consumer spending had decelerated noticeably since midsummer under the combined weight of stagnant employment and declining household wealth resulting from further decreases in equity prices. Worries about the potential for war against Iraq, as well as persistent concerns about the course of economic activity and corporate earnings, were apparently engendering a high degree of risk aversion among business executives that was constraining capital spending and hiring. Despite a weakening in the exchange value of the dollar, sluggish economic growth among major trading partners spelled difficulties for U.S. exports, and a rebound in foreign output seemed more likely to follow than to lead a rebound at home. Moreover, economic slack that was larger and more persistent than previously anticipated ran the risk of reducing core inflation appreciably further from already low levels. Given these considerations, the Committee lowered its target for the federal funds rate 1/2 percentage point, to 1-1/4 percent. The relatively aggressive adjustment in the stance of monetary policy was deemed to offset the potential for greater economic weakness, and the Committee accordingly announced that it judged risks to the outlook as balanced with respect to its long-run goals of price stability and sustainable economic growth.

When the FOMC met on December 10, overall conditions in financial markets had calmed considerably. Indicators of production and spending, however, remained mixed. The manufacturing sector registered large job losses in the autumn, and industrial production continued its slide, which had begun around midyear. A more vigorous rebound in business fixed investment was not evident, and indeed the recent data on orders and shipments and anecdotal reports from business contacts generally signaled continued softness in capital spending. Very low home mortgage interest rates were supporting residential construction activity, but consumption expenditures were sluggish. On balance, the Committee's view was that in the absence of major shocks to consumer and business confidence, a gradual strengthening of the economic expansion was likely over the coming quarters, especially given the very accommodative stance of monetary policy and probable further fiscal stimulus. The FOMC left the federal funds rate unchanged and indicated that it continued to view the risks to the outlook as balanced over the foreseeable future.

By the time of the FOMC meeting on January 28-29, 2003, it had become apparent that the economy had grown only slowly in the fourth quarter of last year, but little evidence of cumulating weakness appeared in the most recent data, and final demand had held up reasonably well. The escalation of global tensions weighed heavily on business and investor sentiment. Firms apparently were remaining very cautious in their hiring and capital spending, and equity prices had declined on balance since the December meeting. But yield spreads on corporate debt-especially for riskier credits-narrowed further, and longer-term Treasury yields declined slightly. Although the fundamentals still pointed to favorable prospects for economic growth beyond the near term, geopolitical developments were making it especially difficult to gauge the underlying strength of the economy, and uncertainties about the economic outlook remained substantial. Against this background, the Committee decided to leave the federal funds rate unchanged and stated that it continued to judge the risks to the outlook as balanced.

Economic Projections for 2003

An unusual degree of uncertainty attends the economic outlook at present, in large measure, but not exclusively, because of potential geopolitical developments. But Federal Reserve policymakers believe the most probable outcome for this year to be a pickup in the pace of economic expansion. The central tendency of the real GDP forecasts made by the members of the Board of Governors and the Federal Reserve Bank presidents is 3-1/4 percent to 3-1/2 percent, measured as the change between the final quarter of 2002 and the final quarter of this year. The full range of these forecasts is 3 percent to 3-3/4 percent. Of course, neither the central tendency nor the range is intended to convey the uncertainties surrounding the individual forecasts of the members. The civilian unemployment rate is expected to end the year in the 5-3/4 percent to 6 percent range.

Economic projections for 2003
table rule
    Federal Reserve Governors
and Reserve Bank presidents
2002 actual
Central tendency
Change, fourth quarter
to fourth quarter
Nominal GDP 4.1 4-1/2 to 5-1/2 4-3/4 to 5
Real GDP 2.8 3 to 3-3/4 3-1/4 to 3-1/2
PCE chain-type price index 1.9 1-1/4 to 1-3/4 1-1/4 to 1-1/2

Average level, fourth quarter
Civilian unemployment
5.9 5-3/4 to 6 5-3/4 to 6
table rule

          1.  Change from average for fourth quarter of previous year to average for fourth quarter
of year indicated.


Apart from the geopolitical and other uncertainties, the forces affecting demand this year appear, on balance, conducive to a strengthening of the economic expansion. Monetary policy remains highly accommodative, and federal fiscal policy is and likely will be stimulative. However, spending by many state and local governments will continue to be restrained by considerable budget difficulties. Activity abroad is expected to improve this year, even if at a less robust pace than in the United States; such growth together with the improving competitiveness of U.S. products should generate stronger demand for our exports. Furthermore, robust gains in productivity, though unlikely to be as large as in 2002, ought to continue to promote both household and business spending. Household purchasing power should be supported as well by a retreat in the price of imported energy products that is suggested by the oil futures market. And the adverse effects on household spending from past declines in equity wealth probably will begin to wane.

A reduction of businesses' hesitancy to expand investment and hiring is critical to the durability of the expansion, and such a reduction should occur gradually if geopolitical risks ease and profitability improves. Inventories are relatively lean, and some restocking ought to help boost production this year, albeit to a much smaller extent than did last year's cessation of sharp inventory liquidations. In addition, the continued growth of final sales, the tax law provision for partial expensing of equipment purchases, replacement demand, and a more hospitable financial environment should induce many firms to increase their capital spending. The growth of investment likely will be tempered, however, by the persistence of excess capital in some areas, notably the telecommunications sector, and reductions in business spending on many types of new structures may continue this year.

Federal Reserve policymakers believe that consumer prices will increase less this year than in 2002, especially if energy prices partly reverse last year's sharp rise. In addition, resource utilization likely will remain sufficiently slack to exert further downward pressure on underlying inflation. The central tendency of FOMC members' projections for increases in the chain-type price index for personal consumption expenditures (PCE) is 1-1/4 percent to 1-1/2 percent this year, lower than the actual increase of about 2 percent in 2002.

Section 2

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Last update: February 11, 2003, 10:00 AM