Section 1

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.

Monetary Policy, Financial Markets, and the Economy over the First Half of 2002

The information reviewed by the FOMC at its meeting of January 29 and 30 seemed on the whole to indicate that economic activity was bottoming out and that a recovery might already be under way. Consumer spending had held up remarkably well, and the rates of decline in manufacturing production and business purchases of durable equipment and software had apparently moderated toward the end of 2001. In addition, the expectation that the pace of inventory runoff would slow after several quarters of substantial and growing liquidation constituted another reason for anticipating that economic activity would improve in the period immediately ahead. Nonetheless, looking beyond the near term, the FOMC faced considerable uncertainty about the strength of final demand. Because household spending had not softened to the usual extent during the recession, it appeared likely to have only limited room to pick up over coming quarters. Intense competitive pressures were thought to be constraining the growth of profits, which could damp investment and equity prices. At the same time, the outlook for continued subdued inflation remained favorable given the reduced utilization of resources and the further passthrough of earlier declines in energy prices. Taken together, these conditions led the FOMC to leave the stance of monetary policy unchanged, keeping its target for the federal funds rate at 1-3/4 percent. In light of the tentative nature of the evidence suggesting that the upturn in final demand would be sustained, the FOMC decided to retain its assessment that the more important risk to achieving its long-run objectives remained economic weakness--the possibility that growth would fall short of the rate of increase in the economy's potential and that resource utilization would fall further.

When the FOMC met on March 19, economic indicators had turned even more positive, providing encouraging evidence that the economy was recovering from last year's recession. Consumer spending had remained brisk in the early part of the year, the decline in business expenditures on equipment and software appeared to have about run its course, and housing starts had turned back up. Industrial production, which had been falling for nearly a year and a half, increased in January and February as businesses began to meet more of the rise in sales from current production and less from drawing down inventories. Indications that an expansion had taken hold led to noticeable increases in broad stock indexes and in long-term interest rates. But the strength of the recovery remained unclear. The outlook for business fixed investment--which would be one key to the strength of economic activity once the thrust from inventory restocking came to an end--was especially uncertain, with anecdotal reports indicating that businesses remained hesitant to enter into major long-term commitments. While the FOMC believed that the fiscal and monetary policies already in place would continue to stimulate economic activity, it considered the questions surrounding the outlook for final demand over the quarters ahead still substantial enough to justify the retention of the current accommodative stance of monetary policy, particularly in light of the relatively high unemployment rate and the prospect that the lack of price pressures would persist. Given the positive tone of the available economic indicators, the FOMC announced that it considered the risks to achieving its long-run objectives as now being balanced over the foreseeable future.

By the time of the May 7 FOMC meeting, it had become evident that economic activity had expanded rapidly early in 2002. But the latest statistical data and anecdotal reports suggested that the expansion was moderating considerably in the second quarter and that the extent to which final demand would strengthen was still unresolved. Business sentiment remained gloomy as many firms had significantly marked down their own forecasts of growth in sales and profits over coming quarters. These revised projections, along with the uncertainty surrounding the robustness of the overall economic recovery, had contributed to sizable declines in market interest rates and weighed heavily on equity prices, which had dropped substantially between the March and May meetings. The outlook for inflation had remained benign despite some firming in energy prices, as excess capacity in labor and product markets held the pricing power of many firms in check, and the apparent strong uptrend in productivity reduced cost pressures. In these circumstances, the FOMC decided to keep the federal funds rate at its accommodative level of 1-3/4 percent and maintained its view that, against the background of its long-run goals of price stability and sustainable economic growth, the risks to the outlook remained balanced.

Over the next seven weeks, news on the economy did little to clarify questions regarding the vigor of the ongoing recovery. The information received in advance of the June 25-26 meeting of the FOMC continued to suggest that economic activity had expanded in the second quarter, but both the upward impetus from the swing in inventory investment and the growth in final demand appeared to have diminished. In financial markets, heightened concerns about accounting irregularities at prominent corporations and about the outlook for profits had contributed to a substantial decline in equity prices and correspondingly to a further erosion in household wealth. But some cushion to the effects on aggregate demand of the decline in share prices had been provided by the fall in the foreign exchange value of the dollar and the drop in long-term interest rates. Although the FOMC believed that robust underlying growth in productivity, as well as accommodative fiscal and monetary policies, would continue to support a pickup in the rate of increase of final demand over coming quarters, the likely degree of the strengthening remained uncertain. The FOMC decided to keep unchanged its monetary policy stance and its view that the risks to the economic outlook remained balanced.

Economic Projections for 2002 and 2003

The members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect the economy to expand rapidly enough over the next six quarters to erode current margins of underutilized capital and labor resources. The central tendency of the forecasts for the increase in real GDP over the four quarters of 2002 is 3-1/2 percent to 3-3/4 percent, and the central tendency for real GDP growth in 2003 is 3-1/2 percent to 4 percent. The central tendency of the projections of the civilian unemployment rate, which averaged just under 6 percent in the second quarter of 2002, is that it stays close to this figure for the remainder of the year and then moves down to between 5-1/4 percent and 5-1/2 percent by the end of 2003.