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Monetary Policy Report submitted to the Congress on February 16, 2005, pursuant to section 2B of the Federal Reserve Act


Section 2

ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2004 AND EARLY 2005

The economy proved to be sufficiently resilient to maintain solid growth and moderate core inflation in 2004 even as higher oil prices drained consumers' purchasing power and boosted firms' costs. Real GDP rose 3-3/4 percent last year after having increased 4-1/2 percent in 2003. Activity was supported by continued robust advances in household spending. In addition, capital spending by businesses increased notably. Labor market conditions improved significantly, though at an uneven pace over the course of the year. Private payrolls, which turned up in late 2003, rose 170,000 per month last year, on average, and the unemployment rate declined below 5-1/2 percent by year-end and to 5-1/4 percent in January 2005--the lowest rates since 2001.

Change in real GDP. Percent, annual rate. Bar chart. Date range is 1998 to 2004. As shown in the figure, change in real GDP begins at about 3.8 percent, it then increases to about 5.6 percent in the second half of 1998. Then it decreases to about 3.7 percent in the beginning of 1999. In the second half of 1999 it increases to about 6 percent. In the second half of 2001 it decreases to about 0.2 percent and then it increases to 5.8 percent in the second half of 2003 and it ends at about 3.8 percent. NOTE. Here and in subsequent charts, except as noted, change for a given period is measured to its final quarter from the final quarter of the preceding period. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Consumer price inflation was driven higher last year by the sharp rise in energy prices. Although core consumer price inflation moved up somewhat from unusually low levels recorded in 2003, it remained well contained. Price increases were restrained by continuing, though diminishing, slack in labor and product markets, which tended to offset the effects of higher energy and commodity prices, as well as the weaker dollar, on firms' overall costs. In addition, solid productivity gains implied that unit labor costs rose only modestly, even if up from the declines in the preceding two years. The decline in crude oil prices, on balance, since October points to some easing of cost pressures on firms from that source in the period ahead.

Change in PCE price index. Percent. Bar chart. There are two series (Total and Excluding food and energy). Date range is 1998 to 2004. As shown in the figure, total begins at about 0.9 percent in 1998, then it increases to about 2.2 percent in 2000. In 2003 it decreases to about 1.8 percent and it ends at about 2.6 percent. Excluding food and energy starts at about 1.5 percent in 1998, it then increases to about 2.2 percent in 2001.It then decreases to about 1.2 percent in 2003. It ends at about 1.5 percent. NOTE. The data are for personal consumption expenditures (PCE). SOURCE. Department of Commerce, Bureau of Economic Analysis.

Several forces likely contributed to last year's impressive economic performance in the face of the sizable adverse oil shock. The growth of real output continued to be undergirded by gains in structural labor productivity. Moreover, fiscal policy remained stimulative last year through the combination of the lagged effect of earlier cuts in personal tax rates, the rise in defense spending, and perhaps also the partial-expensing tax incentives for business investment. Monetary policy was highly accommodative in the early part of the year and remained accommodative, though progressively less so throughout the year, and credit remained readily available at favorable terms. Consumer demand was also boosted by the strong increases in asset values during the past two years.

Financial conditions remained stimulative last year even as market participants revised up their expectations for the near-term path of monetary policy. Interest rates on longer-term Treasury securities remained low, risk spreads on corporate bonds narrowed, and commercial banks eased terms and standards on business loans. In this environment, household debt again increased briskly. The borrowing needs of nonfinancial businesses were damped by their strong cash flows. Equity values rose, especially toward the end of the year. At the same time, the exchange value of the dollar declined, on net, over the year as market participants apparently focused on the financing implications of the large and growing U.S. current account deficit.

The Household Sector

Consumer Spending

Consumer spending grew substantially last year. Personal consumption expenditures (PCE) advanced nearly 4 percent in real terms, about the same as the increase in 2003. Sales of new motor vehicles remained brisk, on average, at 16-3/4 million units. Excluding motor vehicles, consumer spending on most categories of durable and nondurable goods rose rapidly, as gains in real expenditures for food and clothing both exceeded 5 percent; however, spending on computing equipment increased less in 2004 than in preceding years, and consumers responded to the high cost of gasoline and heating fuel by cutting back on real spending for these items. Real outlays for services also increased rapidly last year, and medical services posted especially large gains.

Change in real income and consumption. Percent, annual rate. Bar chart. There are two series (Disposable personal income and Personal consumption expenditures). Date range is 1998 to 2004. As shown in the figure, disposable personal income begins at about 5.8 percent, then it decreases to about 2.4 percent in 1999. In 2000 it increases to about 4.2 percent, then it decreases to about 1.3 percent in 2001. It then increases to end at about 5.1percent. Personal consumption expenditures starts at about 5.5 percent, then it decreases to 2.3 percent in 2002. Then it increases to end at about 4.9 percent. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Real disposable personal income (DPI) rose nearly 4 percent last year, but this figure is exaggerated by Microsoft's $32 billion special dividend payment in December (the bulk of which is estimated to have accrued to U.S. households). If this one-time event is excluded from the calculation, real DPI rose only 2-3/4 percent in 2004, well below the increase posted in 2003. Faster job growth helped to support increases in households' incomes last year in nominal terms, and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which brought lower personal tax rates forward into 2003, led to larger refunds and smaller final payments in the spring of 2004. However, real income gains were held down, as higher oil prices siphoned off household purchasing power.

With the growth of real consumption spending outpacing that of real income through most of last year, the personal saving rate moved lower, from 1-1/2 percent, on average, in 2003 to only 1/2 percent in the third quarter of last year. (The fourth-quarter surge in income associated with the Microsoft dividend payments pushed the saving rate back up to 1-1/4 percent, but this increase will likely be reversed early this year as dividend income falls back. Because the company's share price declined in step with the dividend payouts, the dividends had no effect on shareholders' overall financial resources and so probably had little effect on consumption.)

Personal saving rate. By percent. Line chart. Date range is 1981 to 2004. As shown in the figure, the series begins at about 11.5 percent ,then it generally decreases to about 8 percent in 1983, then it increases to about 11 percent in 1984. Then decreases to end at about 1 percent. NOTE. The data are quarterly and extend through 2004:Q4. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Low interest rates were one factor that helped to support consumption growth--especially for durable goods--despite comparatively slow gains in real income. Higher household wealth was also an important force that propelled consumer spending last year. According to the Federal Reserve's flow of funds accounts, the ratio of household net worth to disposable income rose sharply in 2003, as corporate equity values rebounded and home prices continued to rise. Moreover, although equity values were little changed, on net, through much of 2004 before rising notably in the final quarter, home prices continued to rise throughout the year, and the wealth-to-income ratio moved up further; by the third quarter (the most recent period for which the complete wealth data are available), the ratio had reversed nearly half its decline since the stock market peak in 2000. Because wealth feeds through into household spending over a period of several quarters, the wealth increases in both 2003 and 2004 were important in supporting consumer spending last year. The rise in house prices, together with continued low interest rates, also led consumers to extract additional equity from their homes, in particular through home equity loans. Such actions provided many households with a readily available and relatively low-cost source of funds for financing consumption.

Wealth-to-income ratio. Ratio. Line chart. Date range is 1982 to 2004. As shown in the figure, the series begins at about 4.3. During 1983-1994 it fluctuates within the range of about 4.2 to about 4.9. It generally increases to about 6.2 in 2000, then it decreases to about 5 in 2002.It increases to end at about 5.5. NOTE. The data are quarterly and extend through 2004:Q3. The wealth-to-income ratio is the ratio of household net worth to disposable personal income. SOURCE. For net worth, Federal Reserve Board, flow of funds data; for income, Department of Commerce, Bureau of Economic Analysis.

Consumer confidence, which had improved in 2003, remained at generally favorable levels last year, according to surveys by both the Michigan Survey Research Center (SRC) and the Conference Board. Confidence tended to dip at times during the year when energy prices were moving up most rapidly, but it recovered soon after those episodes.

Consumer sentiment. Two lines chart. Date range is 1991 to 2005. Conference Board (1985 = 100) begins at about 57. From 1992-1993 it fluctuates within the range of about 49 and about 80. It generally increases to about 145 in 2000. Then it decreases to about 60 in 2003, then it increases to end at about 102. Michigan SRC (1966 = 100) starts at about 70. Then it increases 112 in 2000. In 2003 it decreases to about 60 and then it increases to end at about 99. SOURCE. The Conference Board and University of Michigan Survey Research Center.

Residential Investment

Residential investment remained robust last year. Real expenditures increased 5-3/4 percent in 2004--the third straight year of strong gains. Demand for housing was influenced by the same factors that affected household spending more generally, but it was especially supported by nominal mortgage interest rates that have remained near their lowest levels since the late 1960s. Rates on thirty-year fixed-rate mortgages fluctuated between about 5-1/2 percent and 6-1/4 percent over the past two years; they edged up to the high end of that range during the spring but dropped back to under 6 percent by the end of summer and now stand below 5-3/4 percent.

Mortgage rates. Line chart. By Percent. There are two series (Fixed rate and Adjustable rate). Date range is 2001 to 2005. As shown in the figure Fixed rate begins at about 7 percent, then it decreases to about 5.1 percent in 2003 and then it increases to about 6.5 percent by the end of 2003. It ends at about 5.3 percent. Adjustable rate begins at about 6.8 percent, then it generally decreases to about 3.3 percent in 2003. Then it increases to end at about 4 percent. NOTE. The data, which are weekly and extend through February 9, 2005, are contract rates on thirty-year mortgages. SOURCE. Federal Home Loan Mortgage Corporation.

In the single-family sector, housing starts amounted to 1.6 million units last year, a rate faster than the already rapid pace of 1.5 million units started in 2003. In the multifamily sector, starts totaled a solid 350,000 units last year, a figure in line with that of the preceding several years. Sales of both new and existing single-family homes hit new highs last year, and home prices moved up sharply. The repeat-transactions price index for existing homes (limited to purchase transactions only), which is published by the Office of Federal Housing Enterprise Oversight, climbed more than 10 percent over the four quarters ending in the third quarter of last year (the latest quarter for which data are available) and is up a cumulative 65 percent since 1997, when it started to rise notably more rapidly than overall inflation. These price increases have also outstripped by a wide margin the increases in household incomes and rents. Another nationwide price index, the Census Bureau's constant-quality price index for new homes, rose only 6-3/4 percent last year. Because this index does not adjust for the location of new homes within metropolitan areas, and because new homes constitute only a small fraction of the overall housing stock, this index is probably a less reliable indicator of overall home values than is the repeat-transactions index.

Private housing starts. Line chart. Millions of units, annual rate. There are two series (Single-family and Multifamily). Date range is 1992-2004. As shown in the figure, single-family begins at about 1. From 1993 through 2000 it fluctuates between about 1 percent and about 1.4. Then it increases to end at about 1.6. Multifamily begins at about 0.2 in early 1992, it than increases to end at about 0.39. NOTE. The data are quarterly and extend through 2004:Q4. SOURCE. Department of Commerce, Bureau of the Census.

Change in house prices. Line chart. By Percent. There are two lines (Repeat-transactions index and New home price index). Date range is 1982 to 2004. Both lines start at about 5 percent in early 1982. Repeat-transactions index decreases to about 4 percent in 1982. Series generally increases to about 9 percent in 1987, then it generally decreases to about negative 0.5 percent in 1991. Then it generally increases to end at about 10.5 percent. New home price index fluctuates within the range of about negative 0.5 percent and about 6.5 percent from 1983 to 2003. Then it increases to about 9 percent in 2004, and then decreases to end at about 7 percent. NOTE. The repeat-transactions index includes purchase transactions only and extends through 2004:Q3. The new home price index extends through 2004:Q4. Change is over four quarters. SOURCE. For repeat transactions, Office of Federal Housing Enterprise Oversight; for new home prices, Department of Commerce, Bureau of the Census.

Household Finance

Household debt is estimated to have increased about 9-3/4 percent in 2004, a touch less than in the previous year. Mortgage debt again paced this advance. The brisk expansion of mortgages reflected continued strong activity in housing markets and rising house prices. However, the growth rate of mortgage debt did not quite match that registered in 2003. Refinancing activity fell off sharply last year, as the pool of outstanding mortgages with interest rates above current market rates shrank considerably. Mortgages with adjustable interest rates, including hybrids that feature both fixed and adjustable interest rate components, were increasingly popular in 2004. Consumer credit continued to expand at a moderate pace by historical standards, restrained in part by the substitution of other forms of debt, such as home equity loans. Higher interest rates on some consumer loans and credit cards in the second half of 2004 may have also damped the growth of consumer credit.

Relatively low interest rates and further gains in disposable personal income limited pressures on household balance sheets in 2004. Measures of aggregate household financial obligations and debt service, which capture pre-committed expenditures relative to disposable income, were little changed last year, on balance, though they remained high by historical standards. Nevertheless, measures of household credit quality either held steady or improved during the course of the year. The latest available data indicate that delinquency rates on credit card loans, consumer loans, and residential mortgages at commercial banks declined, while those on auto loans at captive finance companies were about unchanged at a low level. Household bankruptcy filings ran below the elevated levels of 2003, although they stayed generally above the rates posted in earlier years.

Household financial obligations ratio. By Percent. Line chart. Date range is 1991 to 2004. The series begins at about 17.5 percent, then it deceases 16.1 percent in 1993. From 1994-2001 it increases to about 18.5 percent. Then it decreases to end at about 18 percent. NOTE. The data are quarterly and extend through 2004:Q4. The final observation, 2004:Q4, is a projection. The financial obligations ratio equals the sum of required payments on mortgage and consumer debt, automobile leases, rent on tenant-occupied property, homeowners’ insurance, and property taxes, all divided by disposable personal income.

Delinquency rates on selected types of household loans. By Percent. Line chart. There are three series (Mortgages, Credit card pools and Auto loans at domestic auto finance companies ). Date range is 1992 to 2004. All series start in the beginning of 1992. As shown in the figure, mortgages begins at about 1.6 percent, then it fluctuates but stays at about 1.6 percent by the end . Credit card pools begin at about 6 percent , then it decreases to about 4 percent in 1995. Then it increases to about 5.5 in 1997. In 2000 it decreases to about 4.5 percent. The series ends at about 4.5 percent. Auto loans at domestic auto finance companies starts at about 2.5 percent , then it increases to about 3.5 percent in 1997. It then decreases to end at about 2 percent. NOTE. The data are quarterly. The rates for credit card pools and mortgages extend through 2004:Q3; the rate for auto loans extends through 2004:Q4. SOURCE. For credit cards, Moody’s Investors Service; for auto loans, Big Three automakers; for mortgages, Mortgage Bankers Association.

The Business Sector

Fixed Investment

Business fixed investment rose robustly for a second consecutive year in 2004. Real spending on equipment and software (E&S) increased 13-1/2 percent, about as much as in 2003, as firms' final sales continued to increase, profits and cash flow rose further, and many businesses reported a need to replace or upgrade existing equipment and software. Although many firms had little need to seek outside financing given their flush cash situation, those that did generally found financial markets to be receptive--interest rates remained low and other terms and conditions stayed relatively favorable. The partial-expensing tax incentives, which covered new equipment and software installed by the end of 2004, boosted profits and cash flow and may have also stimulated some investment spending.

Change in real business fixed investment. Percent, annual rate. Bar chart. There are four series (Structures, Equipment and software and High-tech equipment and software, Other equipment excluding transportation). Date range is 1998 to 2004. Structures start at about 4 percent, then it decreases to about negative 1 percent in 1999. In 2000 it increases to about 9 percent and then it decreases to about negative 15 percent in 2002.Series ends at about negative 3 percent. Equipment and software begins at about 14 percent, then it decreases to about negative 8 percent in 2001. Then it generally increases to end at about 17 percent. High-tech equipment begins at about 25 percent, then it decreases to about negative 11 percent in 2001. Then it increases to end at about 15 percent. Other equipment excluding transportation starts at about 2 percent, then it increases to about 4 percent in 2000. Series generally decreases to about negative 10 percent in 2001, then it increases to end at about 14 percent. NOTE. High-tech equipment consists of computers and peripheral equipment, software, and communications equipment. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Increases in E&S spending were fairly widespread across categories of capital goods. Spending on high-technology equipment increased 15-1/2 percent last year after having risen 19 percent in 2003; these gains followed two years of declines. Although the pattern of spending was uneven over the four quarters of 2004, for the year as a whole, business outlays for computing equipment rose 25 percent in real terms, while spending on software and communications equipment posted increases of 13 percent and 10 percent respectively. Outside of the high-tech sector, business spending on aircraft moved lower for the third consecutive year, as airlines continued to struggle with a highly competitive market environment and high fuel prices. In contrast, business outlays on motor vehicles rose substantially last year, with the demand for trucks exceptionally strong. Investment in equipment other than high-tech and transportation goods--a category that includes industrial machinery and a wide range of other types of equipment--moved up 11 percent last year, the most in more than ten years.

In contrast to the rebound in equipment spending, real outlays in the nonresidential construction sector were about unchanged for a second year in 2004 and have yet to recover from their sharp downturn during 2001 and 2002. In the office sector, where construction increased rapidly in the late 1990s, spending has remained especially weak; vacancy rates for these properties, although down a touch over the past year, are still quite elevated. Construction of industrial buildings has also remained low as a result of high vacancy rates. In contrast, demand for new retail and wholesale properties has been firmer, reportedly a reflection of the steady increases in consumer spending, and outlays for these types of buildings moved higher last year. In addition, investment in the drilling and mining sector rose last year in response to high prices for natural gas.

Inventory Investment

Businesses added appreciably to inventories last year for the first time since running down their holdings sharply in 2001. As economic activity strengthened during 2002 and 2003, many businesses chose to operate with inventories that were increasingly lean relative to sales. In 2004, when stocks had become quite spare--even after taking into account the ongoing improvements in inventory management that have allowed firms to economize on stockholding--and businesses had apparently grown more confident in the durability of the recovery, businesses accumulated $45 billion of inventories (in real terms), according to preliminary data. The step-up in the pace of stockbuilding contributed about 1/4 percentage point to GDP growth last year.

Change in real business fixed inventories. Billions of chained (2000) dollars, annual rate. Bar chart. Date range is 1998 to 2004. Series starts at about $70 billion, then it decreases to about negative $35 billion in 2001. In early 2004 it increases to about $50 billion. Then it decreases to end at about $40 billion. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Corporate Profits and Business Finance

Strong growth of corporate profits again allowed many firms to finance capital spending with internal funds last year. As a result, nonfinancial business debt rose at only a moderate pace. Net equity issuance dropped further into negative territory in 2004, and on balance nonfinancial corporations are estimated to have raised no net funds in credit and equity markets. However, short-term business debt, including commercial paper and commercial and industrial (C&I) loans, expanded last year after three years of contraction, and commercial mortgage debt continued to increase rapidly. The credit quality of businesses remained strong.

Corporate profits held up well in 2004 after surging in the previous year. The ratio of before-tax profits of nonfinancial corporations to that sector's gross value added increased for a second consecutive year. In the fourth quarter of 2004, operating earnings per share for S&P 500 firms were nearly 20 percent above their level four quarters earlier. Analysts' earnings forecasts began to moderate somewhat in the second half of 2004 after several months of strong upward revisions.

Before-tax profits of nonfinancial corporations as a percent of sector GDP. Line chart. By percent . Date range is 1978-2004. As shown in the figure, the series begins at about 11.7 percent in the beginning of 1978. It increases to about 12.5 percent in 1978 . From 1980 to 1997 it fluctuates between about 7.9 percent and about 13.5 percent. In 2001 it generally decreases to about 6 percent, then it increases to end at about 11 percent. NOTE. The data are quarterly and extend through 2004:Q3. Profits are from domestic operations of nonfinancial corporations, with inventory valuation and capital consumption adjustments. SOURCE. Department of Commerce, Bureau of Economic Analysis.

In equity markets, net issuance of shares by nonfinancial firms turned more negative in 2004. Although initial public offerings rebounded from the sluggish pace of the past two years, ample profits and sizable cash holdings helped boost share retirements from mergers and repurchases.

Financing gap and net equity retirement at nonfinancial corporations. Line chart. Billions of dollars. There are two lines (Net equity retirement and Financing gap). Both lines covering the date range of 1990 to 2004. Net equity retirement begins at about $63 billion, then it decreases to about negative $25 billion. Then it generally increases to about $220 billion in 1998. In 2002 series decreases to about $40 billion, then it increases to end at about $150 billion. Financing gap begins at about $75 billion, then it generally increases to about $310 billion. Series decreases to end at about negative $15 billion. NOTE. The data are annual; 2004 is based on partially estimated data. The financing gap is the difference between capital expenditures and internally generated funds. Net equity retirement is the difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued in public or private markets, including funds invested by venture capital partnerships.

Net corporate bond issuance was sluggish in 2004, as firms evidently relied heavily on their considerable profits to fund investment in fixed capital and inventories. The timing of gross bond issuance was influenced by interest rate movements during the year, as firms took advantage of occasional dips in longer-term yields to issue bonds. Firms reportedly used a large portion of the proceeds to pay down existing debt, although some companies used the funds raised in the bond market to repurchase equity shares or to finance mergers.

Selected components of net business financing. Billions of dollars. Bar chart. There are three series (Commercial paper, Bonds and Bank loans) and one line” Sum of major components”. Date range is 2002 to 2004. Bank loans starts at about negative $100 billion in the first half of 2002. From Q2 2002 to Q1 2004 it fluctuates but stays at about negative $50 billion . Then it increases to end at about $ 50 billion in Q4 2004.Bonds start at about $220 billion in Q1 2002. Then it decreases to about $40 billion in the second half of 2002. In the first half of 2003 it increases to about $230 billion. From Q2 2003 to Q3 2004 it fluctuates within the range of about $110 billion and about $10 billion, it ends at about 110 billion. Commercial paper starts at about negative $100 billion in the first half of 2002. In Q3 2004 it generally increases to about $20 billion . Then it decreases to end at about negative $20 billion.” Sum of major components” starts at about 60 billion of dollars in early 2002, then it decreases to about negative 100 in Q2 2002. In Q1 of 2003 it generally increases to about $180 billion and then decreases to about negative $40 billion in Q2 2003. It then increases to about $90 billion in Q1 2004. Series ends at about $160 billion in Q4 2004. NOTE. Seasonally adjusted annual rate for nonfinancial corporate business. The data for the sum of selected components are quarterly. The data for 2004:Q4 are estimated. SOURCE. Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report).

Short-term business borrowing revived in 2004 after a prolonged contraction. Commercial paper outstanding turned up in the first half of the year, although it flattened out over the second half. Business loans at banks rebounded over the course of last year. According to results from the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, commercial banks eased terms and standards on business loans during the course of 2004 in response to the improved economic outlook and to increased competition from other banks and nonbank lenders. Survey responses also indicated an increase in demand for C&I loans that reflected firms' need to fund rising accounts receivable, inventories, capital expenditures, and merger activity. Concerns over loan quality seemed to diminish further in 2004, as spreads on leveraged deals in the syndicated loan market edged down from already low levels.

Net percentage of domestic banks tightening standards on commercial and industrial loans to large and medium-sized firms. By percent. Line chart. Date range is 1990-2005. As shown in the figure the series begins at about 59 percent, then it generally decreases to about negative 20 percent in 1993. From 1994-1997 it fluctuates within the range of about negative 22 and about 7 percent, then it increases to about 37 percent in 1998. In 1999 it decreases to about 5 percent, then increases to about 60 percent in 2001. During 2002-2005 it generally decreases to end at about negative 15 percent. NOTE. The data are based on a survey generally conducted four times per year; the last reading is from the January 2005 survey. Large and medium-sized firms are those with annual sales of $50 million or more. Net percentage is the percentage reporting a tightening less the percentage reporting an easing. SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank Lending Practices.

Corporate credit quality remained solid in 2004 amid strong earnings, low interest rates, and a further buildup of already substantial cash positions on firms' balance sheets. The delinquency rate on C&I loans declined further, and the twelve-month trailing default rate on corporate bonds fell to historically low levels before edging up late in the year. Net upgrades of bonds by Moody's Investor Service for both investment- and speculative-grade nonfinancial firms increased last year.

Net interest payments of nonfinancial corporations as a percent of cash flow. By percent. Line chart. Date range is 1978-2004. As shown in the figure the series begins at about 12 percent, then it increases to about 20 percent in 1989. Then it decreases to about 10 percent in 1996. In 2002 it increases to about 17.5 percent, then it decreases to end at about 11.5 percent. NOTE. The data are quarterly and extend through 2004:Q3. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Default rate on outstanding corporate bonds. By percent. Line chart. Date range is 1991-2004. As shown in the figure the series begins at about 2.2 percent , then it decreases to about 0.2 percent in 1993. From 1994 to 1998 it fluctuates but stays at about 0.3 percent. In 2002 it generally increases to about 3.7 percent, then it decreases to end at about 0.4 percent. NOTE. The data are monthly and extend through December 2004. The rate for a given month is the face value of bonds that defaulted in the twelve months ending in that month divided by the face value of all bonds outstanding at the end of the calendar quarter immediately preceding the twelve-month period. SOURCE. Moody’s Investors Service.

The stock of commercial mortgage debt outstanding grew at a rapid pace in 2004. Some firms reportedly continued to find mortgages an attractive source of long-term funding. The expansion of commercial mortgage credit helped propel issuance of commercial-mortgage-backed securities (CMBS) to near-record levels. Delinquency rates on commercial mortgages on the books of banks and insurance companies remained low throughout the year, and those on loans backing mortgage securities fell. Considerable gains in commercial real estate prices increased owners' equity and largely kept pace with the sizable increase in mortgage debt obligations. Yield spreads of CMBS over comparable Treasury securities remained moderate.

The Government Sector

Federal Government

The federal budget position deteriorated slightly further in 2004, as spending increases and further tax reductions offset the effects of stronger economic growth on revenues. The unified budget deficit widened from $378 billion in fiscal 2003 to $412 billion in fiscal 2004. As a share of GDP, the federal unified deficit stood close to 3-1/2 percent in both years. Receipts increased 5-1/2 percent in fiscal 2004 after two years of declines. Corporate receipts surged more than 40 percent, or $58 billion, reflecting the improvement in corporate profits; individual tax receipts--restrained by JGTRRA, which pulled forward reductions of personal tax rates that had been scheduled for the second half of the decade--rose only about 2 percent. Overall federal receipts increased less rapidly than nominal GDP, and the ratio of receipts to GDP edged down to 16-1/4 percent, the lowest level in more than forty years.

Federal receipts and expenditures. By percent of nominal GDP. line chart. There are three series (Expenditures, Receipts and Expenditures excluding net interest). Date range is 1985 to 2004. Expenditures and Expenditures excluding net interest generally moving together with Expenditures excluding net interest being about 3 percent lower . Expenditures starts at about 23 percent in early 1985 and Receipts and Expenditures excluding net interest starts at about 20 percent. Then during 1986 -2000 they generally decrease. Expenditures to about 18.5 percent and Expenditures excluding net interest to about 16 percent. Expenditures end at about 20 percent and Expenditures excluding net interest end at about 18.5 percent. Receipts start at about 17.5 percent. From 1986 to 2000 it increases to about 21 percent, then it generally decreases to end at about 16 percent. NOTE. The budget data are from the unified budget and are for fiscal years (October through September); GDP is for the year ending in Q3. SOURCE. Office of Management and Budget.

Meanwhile, nominal federal outlays increased about 6 percent in fiscal 2004. Spending for national defense increased especially sharply, but spending also increased notably for Medicare and Medicaid. Debt service costs, which fell sharply from 1997 through 2003 as a result of reduced debt and declining interest rates, edged higher last year. Federal government purchases of goods and services--the part of spending that is counted in GDP--rose about 4 percent in real terms in 2004 after larger increases in the preceding two years. (Government spending on items such as interest payments and transfers is excluded from GDP because these items do not constitute a direct purchase of final production.)

Change in real government expenditures on consumption and investment. Bar chart. By percent. There are two series (Federal and State and local). Date range is 1998 to 2004. Federal begins at about 0.1 percent ,then it generally increases to about 4.5 percent. In 2000 it decreases to about negative 2 percent. In 2002 it generally increases to about 8.5 percent. Then it decreases to end at about 4 percent. State and local begins at about 5 percent .In 2000 it decreases to about 1.9 percent. Series increases to about 4.25 in 2001, then it generally decreases by the end to about negative 0.5 percent. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Regarding legislative initiatives, two new tax bills were enacted in the fall of 2004. First, the Working Families Tax Relief Act extended through 2010 a variety of personal tax reductions that had previously been set to expire earlier. Second, the American Jobs Creation Act replaced the exclusion of extraterritorial income (which the World Trade Organization had declared an illegal export subsidy) with numerous other tax reductions for domestic manufacturers and U.S. multinationals. The first bill is expected to have a ten-year budget cost of around $150 billion, while the second bill was scored as being revenue neutral. As for federal spending in fiscal 2005, the regular appropriations bills provided for sizable increases in spending on defense and homeland security and for modest increases in nondefense discretionary expenditures. In addition, emergency legislation passed in the autumn provided disaster aid for victims of hurricanes and for ranchers and farmers affected by drought conditions.

The recent sizable deficits in the unified budget mean that the federal government, which had been contributing to the pool of national saving from 1997 through 2000, has been drawing on that pool since 2001. Net federal saving--essentially the unified budget balance adjusted to the accounting practices of the national income and product accounts (NIPA)--dropped from positive 2 percent of GDP in 2000 to a level below negative 3 percent of GDP in 2003 and 2004. Personal saving moved lower over this period as well, while business net saving rose with the rebound in corporate profits. In all, net national saving edged up in 2004 but remained near its postwar lows. Because net national saving has fallen increasingly short of net domestic investment over the past several years, the inflow of foreign funds needed to finance that investment has risen. The growing inflow of foreign capital is mirrored in the widening of the nation's current account deficit. Over time, the low national saving rate could eventually slow the rise in living standards either by increasing the burden of servicing U.S. foreign debt or by impinging on domestic capital formation.

Net saving. By percent of nominal GDP. line chart. There are three series (Nonfederal saving, Total and Federal saving). All series covering the date range of 1985 to 2004. Nonfederal saving and Total generally moving together with Total being about 4 percent lower . Nonfederal saving starts at about 10.5 percent, then it generally decreases to about 7.3 percent in 1987. Total starts at about 7 percent ,then it generally decreases to about 3.2 percent in 1986. From 1987 to 1997 they fluctuate between about 9 and about 2 percent, with total being about 4 percent lower . In 1998 they split. Total decreases to end at about 1 percent. Nonfederal saving decreases to about 2.8 percent in 2001,then increases to end at about 4 percent. Federal saving starts at about negative 3.2 percent, then it increases to about 2.3 percent in 2000, then it decreases to end at about negative 3 percent. NOTE. The data are quarterly and extend through 2004:Q3. Nonfederal saving is the sum of personal and net business saving and the net saving of state and local governments. SOURCE. Department of Commerce, Bureau of Economic Analysis.

The growth rate of Treasury debt moderated slightly last year after increasing substantially in 2003. Nonetheless, federal debt held by the public as a percentage of GDP continued to edge higher over the course of 2004 and currently stands at about 36-1/2 percent. To help finance substantial budget deficits, the Treasury issued a considerable volume of bills as well as two-, three-, five-, and ten-year nominal notes. In addition, the Treasury expanded its borrowing program in 2004 by adding semiannual auctions of twenty-year inflation-protected bonds and five-year inflation-protected notes.

Federal government debt held by the public. By Percent of nominal GDP. Line chart. Date range of 1963 to 2004. As shown in the figure, the series begins at about 40 percent in early 1963. In 1974 it decreases to about 23 percent. In 1994 it increases to about 50 percent, then it decreases to end at about 36 percent. NOTE. Through 2003, the data for debt are year-end figures, and the corresponding value for GDP is for Q4 at an annual rate; the final observation is for 2004:Q3. Excludes securities held as investments of federal government accounts.

Various indicators suggested a continued strong appetite for Treasury securities among foreign investors last year. Indirect bidding at Treasury auctions, which includes bidding by the Federal Reserve Bank of New York on behalf of foreign official institutions, remained robust, and Treasury securities held in custody at the Federal Reserve Bank of New York on behalf of such institutions increased just over $200 billion in 2004. Also, data from the Treasury International Capital System showed a substantial increase in holdings of Treasury securities by foreign official and private investors, particularly those in Japan. The proportion of Treasury securities held by foreign investors is estimated to have risen to a record 43-1/2 percent by the third quarter of 2004.

Treasury securities held by foreign investors as a share of total outstanding. By percent. Date range of 1997 to 2004. As shown in the figure, the series begins at about 28 percent. From 1998 to 2001 it fluctuates between about 32 and about 29 percent. Then it increases to end at about 43 percent. NOTE. The data are quarterly and extend through 2004:Q3.

Treasury debt reached its statutory ceiling late last year. To cope with the constraint, the Treasury temporarily resorted to accounting devices, suspended issuance of state and local government series securities, and postponed a four-week bill auction. In mid-November, Congress raised the debt ceiling from $7.4 trillion to $8.1 trillion, and the Treasury subsequently resumed normal financing operations.

State and Local Governments

Pressures on the budgets of state and local governments have eased as economic activity has strengthened. Tax receipts have been spurred by the increases in household income, consumer spending, and property values. As a result, many states seem to be on track to meet balanced budget requirements in the current fiscal year (which ends June 30 for all but a few states) without using as much borrowing or other extraordinary measures as in recent years. Nevertheless, a number of states still must deal with lingering fiscal problems, particularly depleted reserve funds, the expiration of temporary tax hikes, and rising Medicaid costs. In addition, several states still face serious structural imbalances in their budgets.

State and local government net saving. By percent of GDP. line chart. Date range is 1981 to 2004. As shown in the figure, the series begins at about 0.35 percent in early 1981. In 1983 it generally decreases to about negative 0.25 percent. In 1984 it generally increases to about 0.65 percent. During 1985 to 1993 it generally decrease to about negative 0.2 percent, then from 1994 to 1998 series increases to about 0.7 percent. In 2002 it generally decreases to about negative 0.5 percent, then it increases to about 0.3 percent in 2003. Then it decreases to end at about 0 percent. NOTE. The data, which are quarterly, are on a national income and product account basis and extend through 2004:Q3. Net saving excludes social insurance funds. SOURCE. Department of Commerce, Bureau of Economic Analysis.

Real expenditures by state and local governments as measured in the NIPAs remained about flat for a second year in 2004. Real spending on current operations rose less than 1 percent last year, while real investment spending declined. However, even as they were holding the line on spending increases, states and localities were able to resume net hiring in 2004 after having left employment about unchanged in 2003.

Net issuance of debt by state and local governments edged down from the rapid pace set in 2003, as improved budget positions permitted some contraction in short-term debt. Advance refunding offerings were again strong during the year, as states and municipalities took advantage of low long-term interest rates and moderate credit spreads. Credit quality of tax-exempt borrowers improved in 2004. Rating upgrades of tax-exempt bonds outpaced downgrades, especially later in the year.

The External Sector

After narrowing in 2003, the U.S. current account deficit widened again last year and was $660 billion (annual rate), or 5.6 percent of GDP, in both the second and third quarters. Much of this widening reflected a considerable increase in the deficit on goods and services trade, as a marked rise in imports more than offset solid increases in exports. The trade deficit expanded from $500 billion during the fourth quarter of 2003 to more than $650 billion, on average, during the second half of 2004.

U.S. trade and current account balances. Percent of nominal GDP. Line chart. There are two lines (Trade and Current account). Date range of 1997 to 2004. They start at about negative 1.5 percent in early 1997. Both series generally move together with Current account being slightly lower. They decrease to about negative 4 percent in 2000, then they increase to about negative 4.5 in 2001. Current account ends at about negative 6.3 percent and trade ends at about negative 5.7 percent. NOTE. The data are quarterly. The trade data extend through 2004:Q4 and the current account data extend through 2004:Q3. SOURCE. Department of Commerce.

International Trade

Real exports of goods and services rose an estimated 5-1/2 percent in 2004 despite a deceleration in the fourth quarter. In the first half, exports were supported by the lagged effect of the fall in the dollar's value in 2003. Strong expansion of foreign economic activity also helped boost exports in the first half, but that stimulus diminished in the second half of the year when foreign growth slowed. For the year as a whole, exports of industrial supplies and capital goods posted solid growth. Exports to Canada, Mexico, and western Europe rose smartly in 2004, whereas exports to Japan were relatively weak. Real exports of services increased about 3-1/2 percent through 2004 as a whole.

After increasing at an annual rate of almost 6 percent in the first half of 2004, prices of exported goods moved up at just a 2-1/2 percent rate in the second half. This deceleration was due in large part to a reversal of the run-up in the prices of agricultural products that had occurred in late 2003 and early 2004. Better harvests last year returned prices of agricultural products to levels near those that had prevailed before the spike.

Change in real imports and exports of goods and services. By percent. Bar chart with 2 series (‘Imports’ and ‘Exports’). Date range of 1997 to Q1 2004 . Both series start in the beginning of 1997. ‘Imports’ begins at about 14 percent .During 1998 -2001 it decreases to about negative 7.5 percent. Then it increases to end at about 10 percent . ‘Exports’ starts at about 8 percent and decreases to 2.5 percent in 1998. From 1999 to 2003 it fluctuates between about 7.5 and about negative 12 percent. It ends at about 5 percent. SOURCE. Department of Commerce and Federal Reserve staff estimates.

Solid growth in income in the United States spurred growth of real imports of 9-1/2 percent in 2004. The increase primarily reflected higher imports of goods that occurred despite a notable rise in their prices. Real oil imports expanded almost 10 percent in 2004. Imports of capital equipment increased throughout the year, but imports of consumer goods suffered a period of weakness through the middle of the year before rebounding in the fourth quarter. Imports of services moved up only 1-3/4 percent in 2004.

Prices of imported non-oil goods increased at an annual rate of just over 4 percent in the first half of 2004, but the pace slowed to 2 percent in the second half. This step-down largely reflected a deceleration in the prices of industrial supplies, driven by a leveling off of nonfuel commodity prices at the elevated levels reached in March. Declines in the prices of foods offset continued price increases for metals.

The spot price of West Texas intermediate (WTI) crude oil moved up during most of 2004 and surged temporarily to a record high of $55 per barrel in October. Since then, it has fluctuated somewhat below that peak but still at levels well above $33 per barrel, the price at which it started 2004. Oil prices were driven up by intensified concerns that oil supply would not keep pace with surprisingly strong global demand. Oil consumption in China grew nearly 15 percent in 2004, pushing that economy past Japan as the world's second-largest consumer. As oil prices rose, OPEC increased its oil production, diminishing the cartel's estimated spare capacity to historically low levels. Increased OPEC production damped particularly the rise in prices of heavier, more sulfurous grades of crude oil but had less effect on prices of lighter grades like WTI. Supply disruptions also played a role in the run-up of oil prices. In October, Hurricane Ivan extensively damaged oil and gas production facilities in the Gulf of Mexico, boosting the price of WTI relative to other grades of crude oil. Sabotage of production and distribution facilities in Iraq hindered oil exports from that country, which remain below pre-war levels. In Nigeria, ethnic violence and community protests shut down some production. Russian oil output, however, continued despite the breakup of Yukos, formerly Russia's largest oil company. Late in the year, oil prices declined from their October highs, as production recovered in the Gulf of Mexico and OPEC added new capacity. The price of the far-dated NYMEX oil futures contract (currently for delivery in December 2011) rose about $10 per barrel during 2004, possibly reflecting expectations of greater oil demand in Asian emerging-market economies. The far-dated futures contract averaged about $38 per barrel in January 2005, while the spot price of WTI averaged about $48 per barrel.

Prices of oil and of nonfuel commodities. Two lines chart. Date range of 2001 to 2005. ‘Nonfuel ‘ (January 2001 = 100 ) begins at about 100 in early 2001, then it decreases to about 89 in Q4 2001. Then it increases to end at about 122. ‘Oil ‘(Dollars per barrel) begins at about 30 in early 2001, then it decreases to about 20 in Q4 2001.It increases to end at about 47. NOTE. The data are monthly and extend through January 2005. The oil price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices. SOURCE. For oil, Wall Street Journal; for nonfuel commodities, Inter-national Monetary Fund.

Prices of major nonfuel commodities. Lines chart. January 2001 = 100. There are four lines charts (Metals, Food, Beverages and Agricultural raw materials). Date range of 2001 to 2005. All series start at about 100 in the beginning of 2001. Metals decreases to about 85 in the second half of 2001,then it increases to about 132 in the first half of 2004, then it decreases to about 130 and increases to end at about 145. Agricultural raw materials decreases to about 85 in the second half of 2001, then it increases to end at about 113 . Food decreases to 98 in 2002. Then it increases to about 131. Beverages decreases to about 85 in the second half of 2001, then it increases to about 130.Then it decreases to end at about 144. NOTE. The data are monthly and extend through January 2005. The metals category includes aluminum, copper, and iron ore; food includes cereals, vegetable oils and protein meals, seafood, and meat; agricultural raw materials consists of timber, cotton, wool, rubber, and hides; beverages consists of coffee, cocoa beans, and tea. SOURCE. International Monetary Fund.

The Financial Account

In 2004, the U.S. current account deficit was financed once again largely by foreign purchases of U.S. bonds. Foreign official inflows picked up further last year and were especially strong in the first quarter, reflecting sizable bond purchases by Asian central banks. Private foreign purchases of U.S. bonds rebounded in 2004 from a slight decline in 2003, with especially large purchases coming late in the fourth quarter. In contrast, foreign demand for U.S. equities weakened further in 2004, although this also picked up late in the year. Net purchases of foreign securities by U.S. investors remained strong in 2004, with most of the strength coming in the second half of the year.

U.S. net financial inflows. Bar chart with 2 series (Official and Private). Billions of dollars. Date range of 2001 to 2004. Private starts at about 100 billions of dollars in Q1 2001, then it increases to about 148 billions of dollars in Q2 2001. From Q3 2001-Q1 2004 it fluctuates within the range of about $15 billion and about $160 billion. It ends at about $90 billion in Q3 2004. Official starts at about $25 billion, then it decreases to about negative $25 billion in Q2 2001. From Q3 2002 to Q1 2004 it fluctuates within the range of about $27 billion and about $126 billion. Series ends at about $65 billion. SOURCE. Department of Commerce.

U.S.net international securities transactions. Net private foreign purchases of U.S. securities. Billions of dollars. Bar chart with 2 series (Bonds and Equities ). Data range is 2001 to 2004. Bonds begins at about $ 87.5 billion .Then it fluctuates within the range of about $137.5 billion and about$ 37.5 billion from Q2 2001 to Q3 2004. It ends at about $100 billion. ‘Equities‘ starts at about $40 billion. It then decreases to about $15 billion in Q3 2001 and then it fluctuates within the range of about $30 billion and about negative $10 billion. It ends at about $25 billion. SOURCE. Department of Commerce and the Federal Reserve Bank of New York.

U.S. direct investment abroad continued at a strong pace, as reinvested earnings remained sizable. Direct investment into the United States rebounded in the first three quarters of 2004 from its anemic pace in 2003; global mergers and acquisitions revived, and reinvested earnings picked up. Overall, net direct investment outflows continued over the first three quarters of 2004 but at a lower pace than in 2003.

Net inflows of portfolio capital exceeded net outflows of direct investment and represented the financial counterpart to the U.S. current account deficit. These net financial inflows imply a further decline in the U.S. net international investment position, which began 2004 at a reported level of negative $2.4 trillion (22 percent of GDP).

The Labor Market

Employment and Unemployment

The labor market improved notably in 2004. Private payrolls, which began to post sustained increases in late 2003, rose an average of 170,000 per month last year. Progress was not steady over the course of the year, however. Employment growth stepped up sharply in the spring to a pace of almost 300,000 per month in March, April, and May; net hiring then dropped back to subpar rates of about 100,000 per month in June through September. In the four months since then, increases in private payrolls have averaged 165,000 per month.

Net change in payroll employment. Thousands of jobs, monthly average. Bar chart. Data range is 1998 to January 2005. As shown in the figure, the series begins at about 210 in 1998. Then it decreases to about negative 200 in 2001. Then it increases to about 200 in 2004 . It ends at about 140. SOURCE. Department of Labor, Bureau of Labor Statistics.

The improved pace of hiring was widespread, as all major industry groups contributed to faster employment growth relative to that of the latter part of 2003. The largest gains were in professional and business services and health services. The construction sector also posted substantial gains. In the manufacturing sector--where employment had declined almost continuously since early 2000--payrolls increased in the spring when overall employment was rising sharply but were about unchanged, on net, over the second half of the year. Employment gains in retail trade and in food services were also brisk over the first half of the year but tapered off in the second half. Meanwhile, state and local governments added substantially to their payrolls last year, especially for education, but civilian employment in the federal government edged lower.

The unemployment rate fell from near 6 percent in late 2003 to less than 5-1/2 percent by late last year; joblessness fell further in January 2005, to 5-1/4 percent. The decline in the unemployment rate over the past year reflected both the pickup in hiring and a labor force participation rate that remained surprisingly low. From 2001 through 2003, the participation rate declined by more than would have been predicted on the basis of past relationships with indicators of labor demand, and in 2004, when the pace of hiring increased, the participation rate leveled off but failed to rise. These considerations suggest that there may be a persistent component to the recent softness in participation. However, participation had been quite strong through 2000, when the labor market was extremely tight, and the fact that participation turned down at the same time that labor demand weakened suggests that at least some of the recent low participation is cyclical. To the extent that some of this low participation proves to be transitory, the resumption of more-rapid labor force growth will limit the speed at which employment gains further push down the unemployment rate.

Civilian unemployment rate. Line chart. By percent. Date range is 1973-2005. As shown in the figure, the series begins at about 5 percent. From 1974 to 1995 it fluctuates within the range of about 5 and 11.5 percent. Then it decreases to about 4 percent in 2000 and then it increases to end at about 5 percent. NOTE. The data are monthly and extend through January 2005. SOURCE. Department of Labor, Bureau of Labor Statistics.

Labor force participation rate. Line chart. By percent. Date range is 1973-2005. As shown in the figure, the series begins at about 60 percent. Then it increases to about 67.5 in 2000. Series decreases to end atabout 66 percent in 2005. NOTE. The data are monthly and extend through January 2005. SOURCE. Department of Labor, Bureau of Labor Statistics.

Productivity and Labor Costs

Labor productivity rose solidly again last year. Output per hour in the nonfarm business sector increased an estimated 2-1/2 percent over the year. This increase was somewhat below the outsized 4 percent average pace of increase from 2001 through 2003. Those earlier huge productivity gains were not associated with especially large accumulations of new capital equipment, as had been the case during the late 1990s; instead, to a large degree, the gains seem to have been related to more effective use of capital equipment that had been acquired earlier and to one-time organizational innovations induced by firms' earlier reluctance to commit to increased hiring. Still, last year's 2-1/2 percent increase in productivity was impressive by long-run standards: It was in line with the pace of the late 1990s and well above rates that had prevailed during the preceding two decades.

Change in output per hour. By percent, annual rate. Bar chart. Date range is 1948-1973 to 2004. As shown in the figure, in 1948-1973 ‘Change in output per hour ‘ at about 2.7 percent . In 1973-1995 series at about 1.5 percent. In 1995–2000 it is at about 2.6 percent. In 2003 it generally increases to about 5.7 percent, then it decreases to end at about 2.5 percent. NOTE. Nonfarm business sector. SOURCE. Department of Labor, Bureau of Labor Statistics.

Increases in hourly labor compensation remained moderate last year. As measured by the employment cost index (ECI), which is based on a quarterly survey from the Bureau of Labor Statistics, hourly compensation in private nonfarm businesses increased 3-3/4 percent in 2004, a bit less than in 2003. An alternative measure is compensation per hour in the nonfarm business sector as derived from compensation data in the NIPAs. This measure of hourly compensation rose 3-1/2 percent last year, an increase similar to that in the ECI but substantially less than the 5-1/2 percent rise in 2003.

Measures of change in hourly compensation. By percent. Line chart. There are two series (‘Nonfarm compensation per hour’ and ‘Employment cost index’). Date range is 1995-2004. Both series start in the beginning of 1995. ‘Nonfarm compensation per hour’ begins at about 1 percent . Then it increases to about 6.2 percent in 1998.Then it decreases to about 4 percent in 1999. Then it generally increases to about 8 percent in 2000.In 2003 it decreases to about 3 percent. It increases to about 5.5 percent in 2004, then it decreases to end at about 3.8 percent. ‘Employment cost index’ begins at about 3 percent in early 1995. Then fluctuates between about 2.7 and about 4.3 percent from 1995 through 2003 and ends at about 4 percent. NOTE. The data are quarterly and extend through 2004:Q4. For nonfarm compensation, change is over four quarters; for the employment cost index (ECI), change is over the twelve months ending in the last month of each quarter. Nonfarm compensation is for the nonfarm business sector; the ECI is for private industry excluding farm and household workers. SOURCE. Department of Labor, Bureau of Labor Statistics.

As has been the case for several years, the cost of employee benefits rose considerably more than did wages and salaries last year. The benefits component of the ECI increased nearly 7 percent, while the wages and salaries component posted a much more moderate 3 percent increase. The rise in hourly wages and salaries was about the same as increases in the preceding two years; although probably boosted by last year's higher rate of price inflation, wages were likely held down by the continued, though diminishing, labor market slack and also by employers' attempts to offset continued large increases in benefits costs. Health insurance costs continued to rise rapidly. As measured by the ECI, employers' costs of health insurance, which account for about 6 percent of overall compensation costs, rose 7 percent last year after having increased more than 10 percent per year in 2002 and 2003.

Prices

Overall consumer prices rose notably more in 2004 than they did in 2003, and the sharp increase in energy prices accounted for much of the step-up. The chain-type price index for personal consumption expenditures (PCE) rose 2-1/2 percent last year, compared with an increase of 1-3/4 percent in 2003. The increase in PCE prices excluding food and energy was considerably smaller--only 1-1/2 percent, up a little more than 1/4 percentage point from the increase in 2003. Inflation as measured by the market-based component of core PCE prices--which excludes a collection of erratic prices that are unobservable from market transactions and which the Bureau of Economic Analysis began to publish early last year--was in line with overall core PCE inflation last year. The core consumer price index (CPI) rose about 2 percent last year after having increased 1-1/4 percent in 2003. (The CPI differs from PCE prices in a number of respects, but one factor that boosted CPI inflation relative to PCE inflation last year was a difference in the way the two indexes measure the prices of medical services, especially physicians' services, which rose much more rapidly in the CPI than in the PCE index.) The rise in core consumer prices was largest in the early months of 2004: Core PCE prices increased at an annual rate of nearly 2 percent over the first half of the year and then decelerated to a 1-1/4 percent rate of increase in the second half.

Change in consumer prices. By percent. Bar chart. There are two series( Consumer price index and Chain-type price index for PCE ). Both series covering the date range of 1998 to 2004. Consumer price index and Chain-type price index for PCE generally moving together with Chain-type price index for PCE being lower. Consumer price index starts at about 1.7 percent, then it generally increases to about 3.7 percent in 2000. Series decreases to about 1.9 percent in 2003. Then it generally increases to end at about 3.5 percent. Chain-type price index for PCE starts at about 0.9 percent, then it increases to about 2.2 percent in 2000. In 2003 it decreases to about 1.8 percent. Series increases to end at about 2.5 percent. SOURCE. For consumer price index, Department of Labor, Bureau of Labor Statistics; for chain-type measure, Department of Commerce, Bureau of Economic Analysis.

Change in PCE prices excluding food and energy. By percent annual rate. Bar chart. Data range is 1998-2004. As shown in the figure, the series begins at about1.5 percent, then it increases to about 2.2 percent in 2001. In 2003 it decreases to about 1.2 percent, then increases to about 1.9 percent. Series ends at about 1.2 percent. SOURCE. Department of Labor, Bureau of Labor Statistics.

The price index for GDP was less affected by last year's rise in energy prices than was the PCE measure; much of the energy price increase was attributable to the higher prices of imported oil, which are excluded from GDP because they are not part of domestic production. GDP prices increased 2-1/2 percent last year, 3/4 percentage point faster than in 2003. In addition to the rise in PCE prices (excluding the influence of imported oil), GDP prices were affected by a sizable increase in construction prices for residential and nonresidential structures.

 

Alternative measures of price change
Percent  
Chart of table rule
Price measure
2002
2003
2004
Chain-type
Gross domestic product 1.6 1.7 2.4
Gross domestic purchases
1.8 1.8 2.9
Personal consumption expenditures 1.8 1.7 2.5
    Excluding food and energy 1.5 1.2 1.6
Market-based PCE excluding food and energy 1.4 1.0 1.6
Fixed-weight
Consumer price index 2.2 1.9 3.4
    Excluding food and energy 2.0 1.2 2.1
Chart of table rule

      Note.  Changes are based on quarterly averages of
seasonally adjusted data.
      Source.  For chain-type measures, Department of Commerce,
Bureau of Economic Analyis; for fixed-weight measures,
Department of Labor, Bureau of Labor Statistics.
 

The jump in consumer energy prices in 2004 was driven by the run-up in crude oil prices. The prices of both gasoline and fuel oil increased approximately 30 percent over the year, and higher oil costs accounted for the bulk of the increase. Prices of natural gas, which can often substitute for fuel oil in the industrial sector, rose notably as well last year despite the restraining influence of ample inventories. Electricity prices, which tend to reflect fuel costs with a lag, also moved higher through most of the year but dropped back some near year-end.

Consumer food prices rose around 3 percent for a second consecutive year in 2004. Exports of beef dropped sharply last year when most of the largest importing countries placed restrictions on U.S. beef after a case of mad cow disease was discovered. Nevertheless, domestic demand was sufficiently strong to support consumer meat prices last year. Fruit and vegetable prices trended sideways through most of the year but then rose sharply in the fall because of crop damage associated with the series of hurricanes that hit the Southeast in August and September. In addition, prices for food away from home, which are driven more by labor costs than by raw food prices, increased more rapidly last year than in 2003.

Core consumer prices were influenced by a variety of forces last year. Price increases were likely restrained by continuing slack in labor markets and in some product markets, but businesses faced considerable pressure from several sources of increased costs. First, the indirect effects of the large jump in energy prices fed through to businesses throughout the economy and were especially important for firms in energy-intensive industries, such as those that produce plastics and fertilizers. Second, prices were up sharply for a number of other industrial commodities, including lumber and a variety of metals. These price increases reflected strengthening economic activity abroad as well as in the United States. Although these non-oil commodities represent a small part of businesses' overall costs, some businesses likely felt the pinch of sustained price increases in these areas. Third, the declining exchange value of the dollar boosted import prices, including those of many inputs to production. Finally, the deceleration in labor productivity boosted unit labor costs after two years of declines; nevertheless, last year's 1 percent rise in unit labor costs was quite modest.

Change in unit labor costs. By percent. Bar chart. Date range is 1998- 2004. As shown in the figure, the series begins at about 2.8 percent . From 1998 to 2003 it fluctuates within the range of about 4.3 and about negative 0.5 percent. Series ends at about 1 percent. NOTE. Nonfarm business sector. SOURCE. Department of Labor, Bureau of Labor Statistics.

Taken together, these influences left their clearest mark on the prices of goods rather than services. Core goods prices were about unchanged, on average, last year, but this period of stability followed a period of unusually large declines in 2003. In particular, the prices of new motor vehicles leveled off after falling notably in 2003, and the prices of used vehicles reversed some of their sharp 2003 declines. Prices of non-energy PCE services rose about 2 percent in 2004--a smaller increase than in 2003.

Last year's rise in inflation showed through to short-term measures of expected inflation, but longer-term measures remained stable. According to the Michigan SRC, households' median expectations for inflation over the next year moved up considerably in the spring as inflation was rising, but then they eased back and ended the year near 3 percent--up from around 2-1/2 percent in late 2003. In contrast, the median expectation for inflation over the next five to ten years held about steady near 2-3/4 percent throughout this period. Inflation compensation as measured by spreads between yields on nominal Treasury securities and inflation-indexed securities--another indicator of expected inflation, albeit one that is also influenced by perceptions of inflation risk and perhaps also by the development of the market for inflation-indexed debt--showed a similar pattern. Inflation compensation over the next five years moved up about 1/2 percentage point during 2004, to 2-1/2 percent, while compensation at the five- to ten-year horizon edged lower, on net, over the year.

TIPS-based inflation compensation. By percentage points. Line chart. There are two lines (Five-year, five-year ahead and Five-year). Date range is 2002- 2005. Both start in the beginning of 2002. Five-year, five-year ahead begins at about 2.7 percent. During 2002 it fluctuates within the range of about 2.5 and about 3.1 percent. In the middle of 2003 it decreases to about 2.4 percent. Then it increases to about 3.5 percent in the middle of 2004. Then it decreases to end at about2.6 percent. Five-year starts at about 1.3 percent, then it increases to about 2 percent in early 2002. It decreases to about 1 percent by the end of 2002. Then series increases to end at about 2.6 percent. NOTE. The data are daily and extend through February 9, 2005. Based on a comparison of the yield curve for Treasury Inflation-Protected Securities (TIPS) to the nominal off-the-run Treasury yield curve.

U.S. Financial Markets

Domestic financial conditions were supportive of economic growth in 2004. Interest rates on longer-term Treasury securities remained low, corporate risk spreads fell, and stock prices, on balance, registered gains. These developments occurred even as market participants revised up their expectations for the path of the federal funds rate. At the beginning of 2004, futures market quotes implied that investors expected a 1-3/4 percent target for the federal funds rate at year-end, 50 basis points below the target actually established at the FOMC meeting in December 2004. Consistent with the revision in policy expectations, yields on two-year Treasury notes increased about 1-1/4 percentage points in 2004. Yields on longer-dated Treasury securities, however, ended the year essentially unchanged. Despite the run-up in oil prices, equity prices registered solid gains in 2004 after rising sharply the year before. Risk spreads on investment-grade corporate debt declined a touch, and those on speculative-grade debt fell more noticeably. Moreover, banks appreciably eased terms and standards for lending to businesses.

Interest rates on selected Treasury securities. By percent . Line chart. There are three series (Ten-year, Two-year and Three-month). Date range is 2002-2005. All series start in the beginning of 2002. Ten-year begins at about 5.1 percent. It decreases to about 3.6 percent in the second part of 2002. From 2003 to 2004 it fluctuates within the range of about 3.2 and about 4.9 percent. It ends at about 4 percent. Two-year begins at about 3.2 percent. Then it decreases to about 1.2 percent in 2003. Then it increases to end at about 3.3 percent. Three-month begins at about 1.8 percent , then it decreases to about 1 percent in 2004, then series increases to end at about 2.5 percent. NOTE. The data are daily and extend through February 9, 2005. SOURCE. Department of the Treasury.

Interest Rates

Most market interest rates rose, on balance, over the first half of 2004, particularly at shorter maturities. The FOMC's decision at its January meeting to shift from a statement that monetary policy could remain accommodative for "a considerable period" to an indication that it could be "patient" in removing policy accommodation prompted a rise in market interest rates. In early February and March, yields fell substantially in response to employment reports that indicated tepid job growth. Prices of federal funds and Eurodollar futures contracts implied that investors placed only small odds on an increase in the target funds rate before late 2004 and that they envisioned only moderate monetary policy tightening thereafter. Longer-term interest rates and the expected path for the federal funds rate were considerably marked up later in the spring in response to data suggesting a pickup in aggregate demand and hiring, readings on core inflation that came in above expectations, and rising oil prices. In the statement released after its May meeting, the Committee indicated that policy accommodation was likely to be removed at a "measured" pace. At its June meeting, the Committee raised the target for the federal funds rate from 1 percent to 1-1/4 percent, but it continued to assess the risks to sustainable growth and to price stability as balanced and reiterated the "measured pace" language. Interest rates across the term structure declined somewhat immediately after the announcement, reportedly because some market participants had expected the FOMC to mention upside risks to growth or inflation in its statement.

Chairman Greenspan's congressional testimony in July on monetary policy, which suggested that recent softness in consumer spending would likely prove short lived, sparked a jump in yields on Treasury securities. However, interest rates subsequently moved lower, on balance, as incoming data pointed to weaker spending and employment than investors had expected as well as to more-subdued core inflation. Apart from the August employment report, which seemed to hint that the economy was emerging from its "soft patch," incoming economic news remained somewhat lackluster through the end of the third quarter. However, investors reportedly viewed FOMC statements and comments by FOMC officials as more sanguine on near-term prospects for the economy than they had expected. In particular, the release of the minutes from the August FOMC meeting, which referenced the probable need for "significant cumulative tightening," prompted investors to mark up their expectations for the near-term path of monetary policy.

Short-term Treasury yields rose a bit further over the fall in association with actual and expected policy tightening, but long-term Treasury yields were little changed on net. Investors' expectations for the path of monetary policy firmed a bit more in the fourth quarter in response to higher-than-anticipated inflation and remarks from Federal Reserve officials that were reportedly interpreted as suggesting that an imminent pause in the tightening cycle was unlikely.

As the economic expansion gathered momentum and measures of corporate credit quality improved, investors' perception of risk seemed to diminish, and their willingness to bear risk apparently increased. Risk spreads on investment-grade corporate debt over comparable Treasuries ended the year slightly below their levels at the end of 2003. Spreads of speculative-grade yields declined further after narrowing sharply during 2003.

Spreads of corporate bond yields over the ten-year Treasury yield .Percentage points. Line chart. There are three series (High yield, BBB and AA). Date range is 1997 to 2005. High yield begins at about 3.9 percent in early 1997. Then it generally increases to about 7.8 percent in the end of 1998. Then it decreases about 5 percent in 2000.From 2001- 2003 it fluctuates within the range of about 6 and about 10 percent. In 2003 series decreases to end at about 3.9 percent. BBB starts at about 0.9 percent. Then it increases to about 3.2 percent in 2002 and then it decreases to end at about 1 percent. AA begins at about 0.5 percent. It fluctuates within the range of about 1.5 and about 0.1 percent during 1998-2004. Series ends at about 0.4 percent. NOTE. The data are daily and extend through February 9, 2005. The high-yield index is compared with the five-year Treasury yield, and the BBB and AA indexes are compared with the ten-year Treasury yield. SOURCE. Merrill Lynch AA and BBB indexes and Merrill Lynch Master II high-yield index.

In early 2005, market participants boosted their expectations for the path of the federal funds rate, partly in response to the publication of the minutes of the December FOMC meeting, which investors reportedly interpreted as pointing to greater concerns about inflation than had been expected. Short- and intermediate-term Treasury yields rose along with expectations for the path of monetary policy, but longer-term yields edged lower. Yields on investment- and speculative-grade corporate bonds largely moved with those on comparable Treasury securities, and hence risk spreads remained at low levels.

Equity Markets

After surging as much as 30 percent in 2003, broad stock market indexes climbed modestly over the first half of 2004. The boost to equity prices from robust earnings reports and analysts' upward revisions for future profits during this period was offset in part by rising interest rates in the second quarter, worries about geopolitical developments, and sharply higher oil prices. Stock prices dipped early in the second half in response to softer economic data, further concerns about energy prices, and guidance from corporations that pointed to a less optimistic trajectory for earnings than investors had reportedly been expecting. However, as oil prices pulled back toward the end of 2004 and news on the economy improved, stock prices rebounded to post solid gains for the year. The increases were led by stocks with comparatively small market capitalizations; the Russell 2000 index climbed 17 percent in 2004 to a record high. The S&P 500 and the technology-laden Nasdaq advanced about 9 percent and 8-1/2 percent respectively. To date in 2005, equity prices have edged lower, on balance, as investors have responded to a rebound in oil prices, lackluster earnings reports, cautious guidance for future profits, and indications of continued monetary policy tightening.

Stock price indexes. January 2, 2003 = 100. There are two series (Wilshire 5000 and Russell 2000 ). Date range is 2003-2005. Both series generally move together with Wilshire 5000 being lower .They start in early 2003 at about 100. Then in the first half of 2004 they increase. Russell 2000 increases to about 155 and Wilshire 5000 increases to about 130. In the second part of 2004 they decrease. Wilshire 5000 to about 120 and Russell 2000 to about 133. Then they decreases to end. Wilshire 5000 ends at about 138 and Russell 2000 ends at about160. NOTE. The data are daily and extend through February 9, 2005.

Expected volatility implied by options prices for both the Nasdaq 100 and the S&P 500 declined further in 2004 from already low levels. The difference between the earnings-price ratio and the real ten-year Treasury yield--a crude measure of the premium investors require for holding equity shares--changed little, on balance, remaining close to its average value over the past two decades but above its level during the late 1990s.

Implied S&P 500 volatility. By percent. line chart. Date range is 1998-2005. As shown in the figure, the series begins at about 21 percent. From 1999-2003 it fluctuates within the range of about 14 and about 42.5 percent .In 2003 it generally decreases to end at about 10 percent. NOTE. The data are daily and extend through February 9, 2005. The series shown is the implied thirty-day volatility of the S&P 500 stock price index as calculated from a weighted average of options prices. SOURCE. Chicago Board Options Exchange.

Debt, Bank Credit, and M2

The aggregate debt of domestic nonfinancial sectors is estimated to have increased about 7-3/4 percent in 2004, somewhat faster than nominal income but a bit slower than the pace set the year before. Household and federal debt expanded rapidly. Borrowing by nonfinancial businesses was moderate, although it picked up in the fourth quarter.

Growth of domestic nonfinancial debt. By percent. line chart. There are three series (Total, Federal held by public and Nonfederal). Date range is 1990-2004. All series start in the beginning of 1990. Total begins at about 6.9 percent, then it generally decreases to about 4.1 percent in 1991. In 1998 series increases to about 6.9 percent, then generally decreases to about 5 percent in 2000. Then it generally increases to end at about 8 percent. Nonfederal begins at about 6 percent, then it decreases to about 2 percent in 1991. Series increases to about 10 percent in 1998, then decreases to end at about 8 percent. Federal held by public starts at about 11 percent, then it generally decreases to about negative 8 percent in 2000. Series generally increases to end at about 10 percent. NOTE. For 2004, change is from 2003:Q4 to 2004:Q3 at an annual rate. For earlier years, the data are annual and are computed by dividing the annual flow for a given year by the level at the end of the preceding year. The total consists of nonfederal debt and federal debt held by the public. Nonfederal debt consists of the outstanding credit market debt of state and local governments, households, nonprofit organizations, and nonfinancial businesses. Federal debt held by the public excludes securities held as investments of federal government accounts.

Commercial bank credit rose about 9 percent in 2004, a larger advance than in the previous year. Expansion of mortgage and home equity loans on banks' books remained strong, as activity in the housing market stayed robust while mortgage originations shifted somewhat toward adjustable-rate products. After several years of runoffs, business loans began to grow in the second quarter of the year. According to survey evidence, commercial banks eased terms and standards on business loans as the economic outlook improved and competition from other banks and nonbank lenders intensified. Also, banks reported a pickup in demand for business loans that was said to be driven by customers' needs to fund rising accounts receivable, inventories, capital expenditures, and mergers. After adjusting for certain reclassifications of securities as loans, the growth of consumer loans on banks' books remained sluggish. Despite reports of increased competition among banks and nonbank intermediaries, bank profits were again strong in 2004. Banks experienced further improvements in asset quality and, as a result, reduced their provisions for loan losses.

M2 grew at a pace roughly in line with that of nominal GDP during the first half of 2004. A resurgence of mortgage refinancing spurred by the first-quarter decline in mortgage rates likely boosted liquid deposit growth, as proceeds from refinancing were temporarily held in deposit accounts pending disbursement to the holders of mortgage-backed securities. M2 growth slowed in the second half of the year in response to a drop in mortgage refinancing activity and the increased opportunity cost of holding M2 assets, as returns available on market instruments rose more than those on M2 components. For example, yields on retail money market mutual funds moved up more slowly than did short-term market interest rates, and assets of money funds accordingly continued to shrink. Small time deposits, which had contracted over the previous three years, resumed expansion in the second half of the year, as their yields began to rise in association with the increase in other market rates. Currency grew at its slowest rate since 2000, apparently reflecting sluggish demand by both domestic and foreign holders. On balance, M2 growth from the fourth quarter of 2003 to the fourth quarter of 2004 was about 5-1/4 percent. The velocity of M2 rose 1 percent, on net, roughly in line with the historical relationships among money, income, and opportunity cost.

M2 growth rate. By percent. line chart. Date range is 1990-2004. As shown in the figure, the series begins at about 4.2 percent, then it decreases to about 0.6 percent in 1994. In 1998 it increases to about 8.5 percent , then it decreases to about 6 percent in 2000. Series generally increases to about 11 percent in 2001, then it decreases to end at about 5 percent. NOTE. The data are annual and extend through 2004. M2 consists of currency, traveler’s checks, demand deposits, other checkable deposits, savings deposits (including money market deposit accounts), small-denomination time deposits, and balances in retail money market funds.

International Developments

Foreign economic activity expanded in 2004 at a faster pace than in the preceding three years. The pickup in growth was widespread--global manufacturing and trade rebounded across industrial and emerging economies, in part because of strong demand from the United States and China. In the second half of the year, trade and foreign GDP growth slowed, partly as a result of higher oil prices and the appreciation of some foreign currencies against the dollar. The run-up in oil prices and other commodity prices contributed to higher, though still moderate, inflation across industrial and emerging economies.

Official interest rates in selected foreign industrial countries. By percent. line chart. There are four series (United Kingdom, Canada, Euro area and Japan). Date range is 2001-2005. United Kingdom begins at about 6 percent, then it decreases to about 4 percent in Q4 2001.During Q4 2002-Q1 2003 it stays at about 4 percent. Then it increases to end at about 4.7 percent in Q1 2005. Euro area begins at about 4.8 percent. In Q4 2001 it decreases to about 3.2 percent. During 2002 it stays at about 3.2 percent. Then it decreases to about 2 percent in Q2 2003. Series stays at about 2percent by the end . Canada begins at about 5.6 percent, then it decreases to about 2 percent in Q1 2002.In Q2 2003 it increases to about 3.2 percent, then it decreases to end at about 2.5 percent. Japan begins at about 0.2 percent, then it decreases to 0 percent in Q2 2001. Series stays at about 0 percent by the end. NOTE. The data are as of month-end; the last observation for each series is the average of trading days through February 9, 2005. The data shown are the call money rate for Japan, the overnight rate for Canada, the refinancing rate for the euro area, and the repurchase rate for the United Kingdom.

Monetary policy in many foreign economies tightened over the course of 2004. Citing high rates of capacity utilization and mounting inflationary pressures, the Bank of England raised its target interest rate 100 basis points but has been on hold since August amid signs that housing prices and consumer spending are cooling. After cutting official interest rates earlier in the year, the Bank of Canada raised rates in the fall in response to diminishing slack in the economy. The Bank of Mexico tightened policy throughout the year to resist rising inflation, and Chinese authorities made monetary policy more restrictive to rein in soaring investment demand. In the euro area and Japan, central banks kept policy interest rates unchanged in 2004.

Foreign equity price indexes recorded moderate net gains last year after larger increases in 2003. Equity markets started the year strong, but prices declined in the spring as interest rates rose. The run-up in oil prices between July and October appeared to weigh on foreign equity prices, but the subsequent decline in oil prices helped support a rise in equity prices late in the year. Foreign long-term interest rates declined, on net, during 2004. Rates rose in the second quarter as new data (including reports from the United States) that showed faster growth and higher inflation led market participants to expect more-aggressive monetary tightening. However, foreign long-term interest rates slipped after midyear, when foreign growth slowed and foreign currencies appreciated against the dollar. Over the first half of the year, spreads on internationally issued sovereign debt of emerging-market economies over U.S. Treasuries moved up somewhat from low levels, but spreads more than reversed those increases in the second half.

Equity indexes in selected foreign industrial countries. Week ending January 4, 2002 = 100. Line chart. There are four series (Japan, Canada, Euro area and United Kingdom). Date range is 2002-2005. All series start at about 100 in the beginning of 2002. Japan increases to 107 in 2002, then it decreases to about 75.5 in 2003 and increases to end at about 110. Canada decreases to about 76 in 2002, then it increases to end at about 123. United Kingdom decreases to about 65 in 2003, then it increases to end at about 97. Euro area decreases to about 55 in 2003, then it increases to end at about 89. NOTE. The data are weekly. The last observation for each series is the average of trading days through February 9, 2005. SOURCE. Bloomberg L.P.

Spread on internationally issued sovereign debt of emerging-market economies. Line chart. Percentage points. Date range is 2002 to 2005. As shown in the figure, the series begins at about 7,2 percent in early 2002, then it decreases to about 6 percent by mid-2002. In second half of 2002 it increases to about 10 percent, then it decreases to end at about 3.8 percent. NOTE. The data are weekly averages. The last observation is the average of trading days through February 9, 2005. The series shown is the spread of the yield of certain dollar-denominated sovereign debt instruments of emerging-market economies over U.S. Treasury securities; over the period shown, the index encompassed nineteen countries.
SOURCE. J.P. Morgan Emerging Market Bond Index Plus (EMBI+).

The path of the exchange rate was uneven over the course of 2004. The dollar rose slightly in the first half of the year on perceptions that monetary policy would tighten more quickly in the United States than abroad. Beginning in September, however, the dollar resumed the depreciation that had started in 2002, as market participants focused on the financing implications of the large and growing U.S. current account deficit. In 2004, the dollar depreciated about 7 percent, on net, against the euro, the U.K. pound, and the Canadian dollar. The dollar declined 4 percent, on net, against the Japanese yen and 13 percent against the Korean won, but some other Asian central banks, most notably the People's Bank of China, kept their currencies stable against the dollar. So far in 2005, the dollar has rebounded, with market commentary focusing on the positive differential between U.S. economic growth and that in Europe and Japan.

U.S. dollar nominal exchange rate, broad index. Line chart. January 2001 = 100. Date range is 2001 to 2005. As shown in the figure, the series begins at about 100, then it increases to about 105 in 2002. Then it generally decreases to about 92 in the beginning of 2004. In the middle of 2004 it increases to about 95 and decreases to end at about 90. NOTE. The data are monthly and are in foreign currency units per dollar. The last observation is the average of trading days through February 9, 2005. The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares.

U.S. dollar exchange rate against selected major currencies. Date range is 2002-2005. Week ending January 4, 2002 = 100. Line chart with four lines (Japanese yen, Euro, Canadian dollar and U.K. pound). All series start at about 100 in early 2002. Japanese yen decreases to about 88 in the middle of 2002.From the middle of 2002 by mid-2003 it fluctuates within the range of about 89 and about 95. Then it decreases to end at about 80. Euro decreases to about 70 in the beginning of 2004, then it fluctuates within the range of about 65 and 75 during 2004. It ends at about 70.Canadian dollar decreases to about 96 in the middle of 2002. Series increases to about 100 in the beginning of 2003, then it decreases to end at about 79. U.K. pound decreases to about 92 in the middle of 2002. Then it fluctuates within the range of about 87 and about 92 from the middle of 2002 by mid-2003. In the beginning of 2004 it decreases to about 77. It ends at about 79. NOTE. The data are weekly and are in foreign currency units per dollar. The last observation for each series is the average of trading days through February 9, 2005. SOURCE. Bloomberg L.P.

Industrial Economies

After increasing strongly in the first quarter, Japanese GDP growth stagnated in the remainder of 2004. Growth in exports and business investment slowed over the year, and government investment contracted. However, corporate profits and balance sheets improved, and labor market conditions also brightened, with the job-offers-to-applicants ratio rising to a twelve-year high. Consumer prices continued to decline in 2004, though only slightly. In contrast, higher commodity prices helped push twelve-month wholesale price inflation up to 2 percent late in the year, its highest rate since 1990. The yield on the ten-year bellwether government bond rose from its June 2003 record low of about 1/2 percent to nearly 2 percent in midyear before retreating to about 1-1/2 percent recently. After making substantial sales of yen for dollars in the first quarter, Japanese authorities ceased intervention in mid-March and remained on the sidelines even as the yen appreciated significantly against the dollar in the fall.

Economic conditions in the euro area firmed during the first half of 2004 but weakened in the second half. Private consumption and investment spending continued to rise, but export growth slowed after midyear. German GDP growth slowed to a crawl in the second half, as German consumer spending remained anemic, held down by a weak labor market and low consumer confidence. In contrast, French GDP growth was strong in the fourth quarter. The euro-area unemployment rate has been near 9 percent since rising to that level in early 2003. Inflation for the euro area remained just above the European Central Bank's medium-term goal of less than, but close to, 2 percent.

With the exception of a slowdown in the third quarter, economic expansion in the United Kingdom stayed strong during 2004, largely because of the brisk growth of consumption and government spending. Labor markets remained tight in 2004; the unemployment rate ticked down to its lowest level in almost three decades, and labor earnings posted solid gains. Consumer price inflation over the twelve months ending in December was 1-1/2 percent, below the central bank's official target rate of 2 percent. Housing price rises slowed sharply from rapid rates and were muted during the second half of 2004. Household net mortgage borrowing declined to a level 20 percent below its 2003 peak.

The Canadian economy expanded at a healthy pace throughout 2004. Sizable gains in consumption and investment boosted output throughout the year. Export growth, supported by demand from the United States, was strong in the first half of the year but stagnated in the second half as U.S. manufacturing growth slowed and the Canadian dollar's appreciation hurt Canadian trade. The unemployment rate declined moderately over the year, and employment posted strong gains. Consumer price inflation has settled at about 2 percent, the midpoint of the Bank of Canada's inflation target range, whereas inflation excluding food, energy, and indirect taxes declined to around 1-1/2 percent by year-end.

Emerging-Market Economies

Growth of real GDP in China remained very robust in 2004, supported by strong domestic demand and exports. The Chinese government took steps early in the year to slow investment spending, curbing investment approvals and lending. Investment growth slowed significantly but remained rapid. At the same time, indicators of personal consumption spending strengthened, and Chinese exports and imports continued to soar in 2004. Consumer price inflation peaked at a twelve-month change of more than 5 percent in July but has fallen since then to less than 3 percent, as food prices have moderated. Inflation excluding food is only about 1 percent.

Supported by exports to China, economic growth in other Asian emerging-market economies was generally strong in 2004. Economic expansion in Korea remained heavily dependent on external demand because high levels of consumer debt continued to weigh on consumption spending. Inflation across emerging Asia, though still moderate, was pushed up by higher energy prices and strong aggregate demand.

The Mexican economy grew rapidly in the first half of the year in response to strong demand from the United States. In the third quarter, Mexican GDP growth slowed somewhat, as manufacturing exports stagnated, but domestic demand remained buoyant. Increases in energy and food prices pushed up twelve-month consumer price inflation to more than 5 percent, above the Bank of Mexico's target range of 2 percent to 4 percent. Monetary policy tightened throughout the year, and inflation began to fall near year-end. Oil revenues boosted the Mexican public-sector fiscal surplus and allowed Mexican government spending to provide stimulus while still meeting fiscal targets.

In Brazil, economic activity continued to expand robustly in 2004. Domestic demand was supported by the monetary loosening that occurred in the second half of 2003 and early 2004. Export growth was boosted by demand for commodities and the recovery in Argentina. Brazilian asset prices declined through May on expectations that higher global interest rates would make it more difficult for the Brazilian government to finance its debt, but stock prices have moved up sharply since May, and the currency has appreciated. Concerns over inflation pressures have prompted the central bank to tighten monetary policy since September.

Equity indexes in selected emerging-market economies. Line chart. Week ending January 3, 2003 = 100. There are four series (Argentina, Brazil, Mexico and Asian emerging-market economies). Date range is 2002 to 2005. Argentina begins at about 65, then it decreases to about 67 in the middle of 2002. In the beginnings of 2004 it increases to about 233,then it generally decreases to about 166.Series increases to end to about 278. Brazil begins at about 120. From the middle of 2002 by mid-2003 it fluctuates within the range of about 75 and about 120. In the beginnings of 2004 it increases to about 210,then it decreases to about 165 by mid-2004. Then it increases to end to about 232. Mexico begins at about 110. From the middle of 2002 by mid-2003 it fluctuates within the range of about 120 and about 97. Then it generally increases to end at about 222.Asian emerging-market economies begins at about 115. Then it decreases to about 97 by mid-2003. Series increases to end at about 165 in 2005. NOTE. The data are weekly. The last observation for each series is the average of trading days through February 9, 2005. SOURCE. Bloomberg L.P.

In Argentina, the economic recovery picked up steam last year, as exports were supported by strong demand for commodities. The country continues, however, to grapple with difficult structural problems. After more than three years in default, the government launched a debt swap in January with the goal of restructuring more than $80 billion in defaulted bonds.

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Last update: February 17, 2005