Monetary Policy Report submitted to the Congress on February 27, 2002, pursuant to section 2B of the Federal Reserve Act
MONETARY POLICY AND THE ECONOMIC OUTLOOK
Last year was a difficult one for the economy of the United States. The slowdown in the growth of economic activity that had become apparent in late 2000 intensified in the first half of the year. Businesses slashed investment spending--making especially deep cuts in outlays for high-technology equipment--in response to weakening final demand, an oversupply of some types of capital, and declining profits. As actual and prospective sales deteriorated, many firms in the factory sector struggled with uncomfortably high levels of inventories, and the accompanying declines in manufacturing output steepened. At the same time, foreign economies also slowed, further reducing the demand for U.S. production. The aggressive actions by the Federal Reserve to ease the stance of monetary policy in the first half of the year provided support to consumer spending and the housing sector. Nevertheless, the weakening in activity became more widespread through the summer, job losses mounted further, and the unemployment rate moved higher. With few indications that economic conditions were about to improve, with underlying inflation moderate and edging lower, and with inflation expectations well contained, the Federal Reserve continued its efforts to counter the ongoing weakness by cutting the federal funds rate, bringing the cumulative reduction in that rate to 3 percentage points by August.
The devastating events of September 11 further set back an already fragile economy. Heightened uncertainty and badly shaken confidence caused a widespread pullback from economic activity and from risk-taking in financial markets, where equity prices fell sharply for several weeks and credit risk spreads widened appreciably. The most pressing concern of the Federal Reserve in the first few days following the attacks was to help shore up the infrastructure of financial markets and to provide massive quantities of liquidity to limit potential disruptions to the functioning of those markets. The economic fallout of the events of September 11 led the Federal Open Market Committee (FOMC) to cut the target federal funds rate after a conference call early the following week and again at each meeting through the end of the year (see box "Monetary Policy after the Terrorist Attacks").
Displaying the same swift response to economic developments that appears to have characterized much business behavior in the current cyclical episode, firms moved quickly to reduce payrolls and cut production after mid-September. Although these adjustments occurred across a broad swath of the economy, manufacturing and industries related to travel, hospitality, and entertainment bore the brunt of the downturn. Measures of consumer confidence fell sharply in the first few weeks after the attacks, but the deterioration was not especially large by cyclical standards, and improvement in some of these indexes was evident in October. Similarly, equity prices started to rebound in late September, and risk spreads began to narrow somewhat by early November, when it became apparent that the economic effects of the attacks were proving less severe than many had feared.
Consumer spending remained surprisingly solid over the final three months of the year in the face of enormous economic uncertainty, widespread job losses, and further deterioration of household balance sheets from the sharp drop in equity prices immediately following September 11. Several factors were at work in support of household spending during this period. Low and declining interest rates provided a lift to outlays for durable goods and to activity in housing markets. Nowhere was the boost from low interest rates more apparent than in the sales of new motor vehicles, which soared in response to the financing incentives offered by manufacturers. Low mortgage interest rates not only sustained high levels of new home construction but also allowed households to refinance mortgages and extract equity from homes to pay down other debts or to increase spending. Fiscal policy provided additional support to consumer spending. The cuts in taxes enacted last year, including the rebates paid out over the summer, cushioned the loss of income from the deterioration in labor markets. And the purchasing power of household income was further enhanced by the sharp drop in energy prices during the autumn. With businesses having positioned themselves to absorb a falloff of demand, the surprising strength in household spending late in the year resulted in a dramatic liquidation of inventories. In the end, real gross domestic product posted a much better performance than had been anticipated in the immediate aftermath of the attacks.
More recently, there have been encouraging signs that economic activity is beginning to firm. Job losses diminished considerably in December and January, and initial claims for unemployment insurance and the level of insured unemployment have reversed their earlier sharp increases. Although motor vehicle purchases have declined appreciably from their blistering fourth-quarter pace, early readings suggest that consumer spending overall has remained very strong early this year. In the business sector, new orders for capital equipment have provided some tentative indications that the deep retrenchment in investment spending could be abating. Meanwhile, purchasing managers in the manufacturing sector report that orders have strengthened and that they view the level of their customers' inventories as being in better balance. Indeed, the increasingly rapid pace of inventory runoff over the course of the last year has left the level of production well below that of sales, suggesting scope for a recovery in output given the current sales pace. Against this backdrop, the FOMC left its target for the federal funds rate unchanged in January. However, reflecting a concern that growth could be weaker than the economy's potential for a time, the FOMC retained its assessment that the risks were tilted unacceptably toward economic weakness.
The extent and persistence of any recovery in production will, of course, depend critically on the trajectory of final demand in the period ahead. Several factors are providing impetus to such a recovery in the coming year. With the real federal funds rate hovering around zero, monetary policy should be positioned to support growth in spending. Money and credit expanded fairly rapidly through the end of the year, and many households and businesses have strengthened their finances by locking in relatively low-cost long-term credit. The second installment of personal income tax cuts and scheduled increases in government spending on homeland security and national defense also will provide some stimulus to activity this year. Perhaps the most significant potential support to the economy could come from further gains in private-sector productivity. Despite the pronounced slowdown in real GDP growth last year, output per hour in the nonfarm business sector increased impressively. Continued robust gains in productivity, stemming from likely advances in technology, should provide a considerable boost to household and business incomes and spending and contribute to a sustained, noninflationary recovery.
Still, the economy faces considerable risk of subpar economic performance in the period ahead. Because outlays for durable goods and for new homes have been relatively well maintained in this cycle, the scope for strong upward impetus from household spending seems more limited than has often been the case in past recoveries. Moreover, the net decline in household net worth relative to income over the past two years is likely to continue to restrain the growth of spending in coming quarters. To be sure, the contraction in business capital spending appears to be waning. But spending on some types of equipment, most notably communications equipment, continues to decline, and there are few signs yet of a broad-based upturn in capital outlays. Activity abroad remains subdued, and a rebound of foreign output is likely to follow, not lead, a rebound in the United States. Furthermore, lenders and equity investors remain quite cautious. Banks have continued to tighten terms and standards on loans, and risk spreads have increased a little this year. Stock prices have retreated from recent highs as earnings continue to fall amid concerns about the transparency of corporate financial reports and uncertainty about the pace at which profitability will improve.
Monetary Policy, Financial Markets, and the Economy over 2001 and Early 2002
As economic weakness spread and intensified over the first half of 2001, the FOMC aggressively lowered its target for the federal funds rate. Because firms reacted unusually swiftly to indicators that inventories were uncomfortably high and capital was becoming underutilized, the drop in production and business capital spending was especially steep. Moreover, sharp downward revisions in corporate profit expectations caused equity prices to plunge, which, along with a decline in consumer confidence, pointed to vulnerability in household spending. Meanwhile, a significant deceleration in energy prices, after a surge early in the year, began to hold down overall inflation; the restraining effect of energy prices, combined with the moderation of resource utilization, also promised to reduce core inflation. Responding to the rapid deterioration in economic conditions, the FOMC cut its target for the federal funds rate 2-1/2 percentage points--in 5 half-point steps--by the middle of May. Moreover, the FOMC indicated throughout this period that it judged the balance of risks to the outlook as weighted toward economic weakness. The Board of Governors of the Federal Reserve System approved reductions in the discount rate that matched the Committee's cuts in the target federal funds rate. As a result, the discount rate declined from 6 percent to 3-1/2 percent over the period.
At its June and August meetings, the FOMC noted information suggesting continued softening in the economy and a lack of convincing evidence that the end of the slide in activity was in sight. Although consumer spending on both housing and nonhousing items--buoyed by the tax cuts and rebates, low mortgage interest rates, declining energy prices, and realized capital gains from home sales--remained fairly resilient, economic conditions in manufacturing deteriorated further. Firms continued to reduce payrolls, work off excess inventories, and cut back capital equipment expenditures amid sluggish growth in business sales, significantly lower corporate profits, and greater uncertainty about future sales and earnings. With energy prices in retreat, price inflation remained subdued. In reaching its policy decisions at its June and August meetings, the FOMC took into account the substantial monetary policy stimulus already implemented since the start of the year--but not yet fully absorbed by the economy--and the oncoming effects of stimulative fiscal policy measures recently enacted by the Congress. Consequently, the Committee opted for smaller interest rate cuts of 1/4 percentage point at both the June and August meetings, which brought the target federal funds rate down to 3-1/2 percent; as earlier in the year, the FOMC continued to indicate that it judged the balance of risks to the outlook as weighted toward economic weakness. After both meetings, the Board of Governors of the Federal Reserve System also approved similar reductions in the discount rate, which moved down to 3 percent.
After the terrorist attacks on September 11, the available Committee members held a telephone conference on September 13, during which they agreed that the financial markets were too disrupted to allow for an immediate alteration in the stance of monetary policy. However, the members were in agreement that the attacks' potential effects on asset prices and on the performance of the economy, and the resulting uncertainty, would likely warrant some policy easing in the very near future. Accordingly, the FOMC, at a telephone conference on September 17, voted to reduce its target for the federal funds rate 1/2 percentage point, to 3 percent, and stated that it continued to judge the risks to the outlook to be weighted toward economic weakness.
Over subsequent weeks, heightened aversion to risk, which caused investors to flock from private to Treasury and federal agency debt, boosted risk spreads sharply, especially on lower-rated corporate debt. Increased demand for safe and liquid assets contributed to selling pressure in the stock market. At its October 2 meeting, the FOMC had little hard information available on economic developments since the attacks. However, evidence gleaned from surveys, anecdotes, and market contacts indicated that the events of September 11 had considerable adverse repercussions on an already weak economy: Survey indicators of consumer confidence had fallen, and consumer spending had apparently declined. At the same time, anecdotal information pointed to additional deep cutbacks in capital spending by many firms after an already-significant contraction in business fixed investment over the summer months.
When the FOMC met on November 6, scattered early data tended to confirm the information that the decline in production, employment, and final demand had steepened after the terrorist attacks. Although an economic turnaround beginning in the first half of 2002 was a reasonable expectation according to the Committee, concrete evidence that the economy was stabilizing had yet to emerge. Meanwhile, the marked decrease in energy prices since the spring had induced a decline in overall price inflation, and inflation expectations had fallen. Accordingly, the FOMC voted to lower its target for the federal funds rate 1/2 percentage point at both its October and November meetings and reiterated its view that the risks to the outlook were weighted toward economic weakness. The sizable adjustments in the stance of monetary policy in part reflected concerns that insufficient policy stimulus posed an unacceptably high risk of a more extended cyclical retrenchment that could prove progressively more difficult to counter, given that the federal funds rate--at 2 percent--was already at such a low level.
By the time of the December FOMC meeting, the most recent data were suggesting that the rate of economic decline might be moderating. After plunging earlier in the year, orders and shipments of nondefense capital goods had turned up early in the fourth quarter, and the most recent survey evidence for manufacturing also suggested that some expansion in that sector's activity might be in the offing. In the household sector, personal consumption expenditures appeared to have been quite well maintained, an outcome that reflected the continuation of zero-rate financing packages offered by the automakers, widespread price discounting, and low interest rates. In an environment of very low mortgage interest rates, household demand for housing remained at a relatively high level, and financial resources freed up by a rapid pace of mortgage refinancing activity also supported consumer spending.
Nonetheless, the evidence of emerging stabilization in the economy was quite tentative and limited, and the Committee saw subpar economic performance as likely to persist over the near term. Moreover, in the probable absence of significant inflationary pressures for some time, a modest easing action could be reversed in a timely manner if it turned out not to be needed. In view of these considerations, the FOMC lowered its target for the federal funds rate 1/4 percentage point, to 1-3/4 percent, on December 11, 2001, and stated that it continued to judge the risks to the outlook to be weighted mainly toward economic weakness. As had been the case throughout the year, the Board of Governors approved reductions in the discount rate that matched the FOMC's cuts in the target federal funds rate, bringing the discount rate to 1-1/4 percent, its lowest level since 1948.
Subsequent news on economic activity bolstered the view that the economy was beginning to stabilize. The information reviewed at the January 29-30, 2002, FOMC meeting indicated that consumer spending had held up remarkably well, investment orders had firmed further, and the rate of decline in manufacturing production had lessened toward the end of 2001. With weakness in business activity abating, and monetary policy already having been eased substantially, the FOMC left the federal funds rate unchanged at the close of its meeting, but it continued to see the risks to the outlook as weighted mainly toward economic weakness.
Economic Projections for 2002
Federal Reserve policymakers are expecting the economy to begin to recover this year from the mild downturn experienced in 2001, but the pace of expansion is not projected to be sufficient to cut into the margin of underutilized resources. The central tendency of the real GDP growth forecasts made by the members of the Board of Governors and the Federal Reserve Bank presidents is 2-1/2 percent to 3 percent, measured as the change between the final quarter of 2001 and the final quarter of this year. The pace of expansion is likely to increase only gradually over the course of the year, and the unemployment rate is expected to move higher for a time. The FOMC members project the civilian unemployment rate to stand at about 6 percent to 6-1/4 percent at the end of 2002.
A diminution of the rate of inventory liquidation is likely to be an important factor helping to buoy production this year. In 2001, businesses cut inventories sharply so as to avoid carrying excessive stocks relative to the weaker pace of sales, and although this process of liquidation probably is not yet complete in many industries, the overall pace of reduction is likely to slow. Then, as final demand strengthens, liquidation should give way to some restocking later in the year.
As noted above, the forces affecting demand this year are mixed. On the positive side are the stimulative effects of both fiscal policy and the earlier monetary policy actions. A gradual turnaround in employment and a strengthening of the economies of our major trading partners should provide some lift to final demand, and spending by both households and businesses ought to be supported by robust productivity growth. On the other hand, the problems facing the high-tech sector have not yet completely receded, and indications are that spending on other types of capital equipment remains lackluster. The surprising strength of household spending through this period of economic weakness suggests a lack of pent-up consumer demand going forward. In addition, consumers likely will not benefit from declining energy prices to the extent they did last year, and the net decline in equity values since mid-2000 will probably continue to weigh on consumption spending in the period ahead.
Federal Reserve policymakers believe that consumer prices will increase slightly more rapidly in 2002 than in 2001, as last year's sharp decline in energy prices is unlikely to be repeated. The central tendency of the FOMC members' projections for increases in the chain-type price index for personal consumption expenditures (PCE) is about 1-1/2 percent; last year's actual increase was about 1-1/4 percent. Nevertheless, diminished levels of resource utilization, the indirect effects of previous declines in energy prices on firms' costs, and continued competitive pressures all ought to restrain the pace of price increases outside of the energy sector this year.
The terrorist attacks on September 11 destroyed a portion of the infrastructure of U.S. financial markets, disrupted communication networks, and forced some market participants to retreat to contingency sites in varying states of readiness. These developments, along with the tragic loss of life among the employees of a few major financial firms, greatly complicated trading, clearing, and settlement of many different classes of financial instruments. Direct dislocations elevated uncertainties about payment flows, making it difficult for the reserve market to channel funds where they were needed most. Depositories that held more reserve balances than they preferred had considerable difficulty unloading the excess in the market; by contrast, depositories awaiting funds had to scramble to cover overdraft positions. As a result, the effective demand for reserves ballooned.
The Federal Reserve accommodated the increase in the demand for reserves through a variety of means, the relative importance of which shifted through the week. On Tuesday morning, shortly after the attacks, the Federal Reserve issued a press release reassuring financial markets that the Federal Reserve System was functioning normally and stating that "the discount window is available to meet liquidity needs." Depository institutions took up the offer, and borrowing surged to a record $45-1/2 billion by Wednesday. Discount loans outstanding dropped off sharply on Thursday and returned to very low levels by Friday. Separately, overnight overdrafts on Tuesday and Wednesday rose to several billion dollars, as a handful of depository and other institutions with accounts at the Federal Reserve were forced into overdraft on their reserve accounts. Overnight overdrafts returned to negligible levels by the end of the week.
Like their U.S. counterparts, foreign financial institutions operating in the United States faced elevated dollar liquidity needs. In some cases, however, these institutions encountered difficulties positioning the collateral at their U.S. branches to secure Federal Reserve discount window credit. To be in a position to help meet those needs, three foreign central banks established new or expanded arrangements with the Federal Reserve to receive dollars in exchange for their respective currencies. These swap lines, which lasted for thirty days, consisted of $50 billion for the European Central Bank, $30 billion for the Bank of England, and an increase of $8 billion (from $2 billion to $10 billion) for the Bank of Canada. The European Central Bank drew on its line that week to channel the funds to institutions with a need for dollars.
By Thursday and Friday, the disruption in air traffic caused the Federal Reserve to extend record levels of credit to depository institutions in the form of check float. Float increased dramatically because the Federal Reserve continued to credit the accounts of banks for deposited checks even though the grounding of airplanes meant that checks normally shipped by air could not be presented to the checkwriters' banks on the usual schedule. Float declined to normal levels the following week once air traffic was permitted to recommence. Lastly, over the course of the week that included September 11, as the market for reserves began to function more normally, the Federal Reserve resumed the use of open market operations to provide the bulk of reserves. The open market Desk accommodated all propositions down to the target federal funds rate, operating exclusively through overnight transactions for several days. The injection of reserves through open market operations peaked at $81 billion on Friday. The combined infusion of liquidity from the various sources pushed the level of reserve balances at Federal Reserve Banks to more than $100 billion on Wednesday, September 12, about ten times the normal level. As anticipated by the FOMC, federal funds traded somewhat below their new target level for the rest of the week. By the end of the month, bid-asked spreads and trading volumes in the interbank and other markets receded to more normal levels, and federal funds consistently began to trade around the intended rate.
The Federal Reserve took several steps to facilitate market functioning in September in addition to accommodating the heightened demand for reserves. The hours of funds and securities transfer systems operated by the Federal Reserve were extended significantly for a week after the attacks. The Federal Reserve Bank of New York liberalized the terms under which it would lend the securities in the System portfolio, and the amount of securities lent rose to record levels in the second half of September. For the ten days following the attacks, the Federal Reserve reduced or eliminated the penalty charged on overnight overdrafts, largely because those overdrafts were almost entirely the result of extraordinary developments beyond the control of the account holders. In addition, the Federal Reserve helped restore communication between market participants and in some cases processed bilateral loans of reserves between account holders in lieu of market intermediation. Return to text
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Last update: February 27, 2002, 10:00 AM