Section 1

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The subpar performance of the U.S. economy extended into the first half of 2003. Although accommodative macroeconomic policies and continued robust productivity growth helped to sustain aggregate demand, businesses remained cautious about spending and hiring. All told, real gross domestic product continued to rise in the first half of the year but less quickly than the economy�s productive capacity was increasing, and margins of slack in labor and product markets thereby widened further. As a result, underlying inflation remained low--and, indeed, seems to have moved down another notch. In financial markets, longer-term interest rates fell, on net, over the first half of the year as the decline in inflation and the subdued performance of the economy led market participants to conclude that short-term interest rates would be lower than previously anticipated. These lower interest rates helped to sustain a rally in equity prices that had begun in mid-March.

During the first quarter of the year, the economy�s prospects were clouded by the uncertainties surrounding the onset, duration, and potential consequences of war in Iraq. War-related concerns provided a sizable boost to crude oil prices; as a result, households faced higher bills for gasoline and heating oil, and many firms were burdened with rising energy costs. These concerns also caused consumer confidence to sag and added to a general disinclination of firms to spend, hire, and accumulate inventories. Caution was apparent in financial markets as well, and investors bid down the prices of equities in favor of less-risky securities.

The swift prosecution of the war in Iraq resolved some of these exceptional uncertainties but by no means all of them. Nonetheless, oil prices receded, and the improvement in the economic climate was sufficient to cause stock prices to rally, risk spreads on corporate securities to narrow, and consumer confidence to rebound. At the same time, the incoming economic data--much of which reflected decisions made before the war--remained mixed, and inflation trended lower. At the conclusion of its May meeting, the Federal Open Market Committee (FOMC) indicated that, whereas the risks to the outlook for economic growth were balanced, the risk of an unwelcome substantial fall in inflation from its already low level, though minor, exceeded that of a pickup in inflation. In the weeks that followed, market participants pushed down the expected future path of the federal funds rate, which contributed to the fall in longer-term interest rates and a further rise in equity prices.

At the time of the June FOMC meeting, the available evidence did not yet compellingly demonstrate that a material step-up in economic growth was under way, though some indicators did point to a firming in spending and a stabilization in the labor and product markets. The Committee concluded that a slightly more expansive monetary policy would be warranted to add further support to the economic expansion. The Committee�s assessment and ranking of the risks to the outlook for economic growth and inflation were the same as in May.

The Federal Reserve expects economic activity to strengthen later this year and in 2004, in part because of the accommodative stance of monetary policy and the broad-based improvement in financial conditions. In addition, fiscal policy is likely to be stimulative as the provisions of the Jobs and Growth Tax Relief Reconciliation Act of 2003 go into effect and as defense spending continues to ramp up. Severe budgetary pressures are causing state and local governments to cut spending and to increase taxes and fees, but these actions should offset only a portion of the impetus from the federal sector. Moreover, the continued favorable performance of productivity growth should lift household and business incomes and thereby encourage capital spending. Given the ongoing gains in productivity and the existing margin of resource slack, aggregate demand could grow at a solid pace for some time before generating upward pressure on inflation.

Monetary Policy, Financial Markets, and the Economy over the First Half of 2003

During the weeks before the January meeting of the FOMC, geopolitical developments and the uneven tone of economic data releases created substantial uncertainty. Businesses had continued to reduce their payrolls and postpone capital expenditures. However, the absence of fresh revelations of lapses in corporate governance or accounting problems and some increased appetite for risk on the part of investors helped push down yields on corporate debt, which encouraged firms to issue bonds to reduce their financing costs and restructure their balance sheets. Meanwhile, moderate gains in household income and historically low mortgage rates underpinned still-considerable demand for housing. Retail sales, particularly those of motor vehicles, also were strong at the end of 2002 despite some drop-off in consumer confidence. Core inflation seemed to be on a declining trend, although the foreign exchange value of the dollar had depreciated, and top-line inflation was being boosted by a sizable run-up in energy prices. The substantial slack in resource utilization, as well as the solid gains in labor productivity, led members to the view that consumer price inflation--by then already very low--was unlikely to increase meaningfully. Against that backdrop, the Committee members continued to believe that economic fundamentals were in place to support a pickup in the growth of economic activity during the year ahead. Accordingly, the FOMC decided at the January meeting to leave interest rates unchanged and assessed the risks as balanced with respect to its dual goals of sustainable economic growth and price stability.

In subsequent weeks, economic performance proved disappointing. The increasing likelihood of war in Iraq was accompanied by a steep rise in crude oil prices and considerable volatility in financial markets. For much of that period, investors sought the relative safety of fixed-income instruments; that preference induced declines in yields on Treasury securities and high-quality corporate bonds and a drop in stock prices. Consumer outlays also softened after January, although low mortgage rates and rising incomes were still providing support for household spending. Businesses continued to trim workforces and cut capital spending.

When the Committee met on March 18, full-scale military conflict in Iraq seemed imminent. In an environment of considerable uncertainty, the FOMC had to weigh whether economic sluggishness was largely related to worries about the war, and hence would lift once the outcome was decided, or was indicative of deep-seated restraints on economic activity. The Committee, which reasoned that it could not make such a distinction in the presence of so much uncertainty, left the funds rate unchanged and declined to characterize the balance of risks with respect to its dual goals. However, the Committee noted that, given the circumstances, heightened surveillance would be particularly informative, and it held a series of conference calls during late March and April to discuss the latest economic developments.

Some of the uncertainty was resolved by the quick end to major military action in Iraq. Equity prices and consumer confidence rose while oil prices and risk spreads on corporate debt fell. Fiscal policy seemed set to become even more stimulative given the prospect of increased spending on defense and homeland security as well as the likely enactment of additional tax cuts. Part of the federal stimulus, however, was thought likely to be offset by the efforts of state and local governments to close their budget gaps.

Economic reports were generally disappointing. Industrial production declined in March, and capacity utilization fell to a twenty-year low. The employment reports for March and April indicated that private nonfarm payrolls had continued to fall. Although order backlogs for nondefense capital goods had risen recently, businesses generally remained reluctant to invest in new capacity.

In light of the financial and policy stimulus already in place, the FOMC left the federal funds rate unchanged at its May meeting. To provide more specific guidance about its views, the FOMC included in its announcement separate assessments of the risks to the outlook for economic growth and inflation as well as the overall balance between the two. The Committee viewed the upside and downside risks to economic growth as balanced, but it perceived a higher probability of an unwelcome substantial fall in inflation than of a pickup in inflation from its current low level. The Committee considered that the overall balance of risks to its dual objectives was weighted toward weakness. That said, members concluded that there was only a remote possibility that resource utilization would remain so low that the disinflation process would cumulate to produce a declining overall price level for an extended period.

Financial market participants reacted strongly to this characterization of risks, believing that the Committee�s focus on leaning against appreciable disinflation implied that monetary policy would be more accommodative and remain so for longer than previously thought. Investors pushed down the expected path of the federal funds rate in the weeks following the meeting. Intermediate- and long-term interest rates fell significantly and spurred another round of long-term bond issuance. The resulting decline in real interest rates helped sustain the rally in equity prices.

Between the May and June meetings, a few tentative signs suggested that the pace of economic activity might be firming. Industrial production and retail sales edged up in May, available data indicated that employment had stopped declining, residential investment remained strong, and survey measures of consumer sentiment and business conditions were well above the levels of earlier in the year. Financial conditions had improved markedly, but businesses reportedly remained somewhat averse to new investment projects, in part because of significant unused capacity. They also seemed reluctant to expand their workforces until they viewed a sustained pickup in aggregate demand as more certain.

With inflation already low and inflation expectations subdued, the Committee judged that it would be prudent to add further support for economic expansion, and it lowered the target for the federal funds rate 25 basis points, to 1 percent. The FOMC continued to view the risks to economic growth as balanced and again noted that the minor probability of substantial further disinflation exceeded the probability of a pickup in inflation from its current low level. But because of the considerable amount of economic slack prevailing and the economy�s ability to expand without putting upward pressure on prices, the Committee indicated that the small chance of an unwelcome substantial decline in the inflation rate was likely to remain its predominant concern for the foreseeable future.

Economic Projections for 2003 and 2004

The members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect economic activity to accelerate in the second half of this year and to gather additional momentum in 2004. The central tendency of the FOMC participants� forecasts for the increase in real GDP over the four quarters of 2003 spans a narrow range of 2-1/2 percent to 2-3/4 percent, which, given the modest increase in real GDP in the first quarter, implies a noticeable pickup in growth as the year progresses. The central tendency for projections of real GDP growth in 2004 spans a range of 3-3/4 percent to 4-3/4 percent. The civilian unemployment rate is expected to be between 6 percent and 6-1/4 percent in the fourth quarter of 2003 and to decline to between 5-1/2 percent and 6 percent by the fourth quarter of 2004.

Economic projections for 2003 and 2004 Percent   Accessible table

	Board of Governors and Reserve Bank presidents
Indicator	Range	Central tendency
	2003
Change, fourth quarter to fourth quarter1
Nominal GDP	3-1/2 to 4-3/4	3-3/4 to 4-1/2
Real GDP	2-1/4 to 3	2-1/2 to 2-3/4
PCE chain-type price index	1 to 1-3/4	1-1/4 to 1-1/2
Average level, fourth quarter
Civilian unemployment     rate	6 to 6-1/4	6 to 6-1/4
	2004
Change, fourth quarter to fourth quarter1
Nominal GDP	4-3/4 to 6-1/2	5-1/4 to 6-1/4
Real GDP	3-1/2 to 5-1/4	3-3/4 to 4-3/4
PCE chain-type price index	3/4 to 2	1 to 1-1/2
Average level, fourth quarter
Civilian unemployment     rate	5-1/2 to 6-1/4	5-1/2 to 6

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

Inflation is anticipated to be quite low over the next year and a half. The chain-type price index for personal consumption expenditures (PCE) rose 1-3/4 percent over the four quarters of 2002, and most FOMC participants expect inflation to run somewhat lower this year and then to hold fairly steady in 2004. The central tendency of projections for PCE inflation is 1-1/4 percent to 1-1/2 percent in 2003 and 1 percent to 1-1/2 percent in 2004.

Section 2