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Monetary Policy Report submitted to the Congress on February 11, 2004, pursuant to section 2B of the Federal Reserve Act


Section 2

ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2003 AND EARLY 2004

The pace of economic expansion strengthened considerably in the second half of 2003 after almost two years of uneven and, on balance, sluggish growth. In early 2003, accommodative monetary policy and stimulative fiscal policies were in place, but economic activity still seemed to be weighed down by a number of factors that had restrained the recovery earlier: Geopolitical tensions were again heightened, this time by the impending war in Iraq, businesses remained unusually cautious about the strength of the expansion, and economic activity abroad was still weak. In June the continued lackluster economic growth and a further downshift in inflation from an already low level prompted a further reduction in the federal funds rate. In addition, the tax cuts that became effective at midyear provided a significant boost to disposable income. In the succeeding months, the macroeconomic stimulus began to show through clearly in sales and production, and some of the business caution seemed to recede. Real GDP increased at an annual rate of 6 percent, on average, in the third and fourth quarters of last year. In contrast, between late 2001 and mid-2003, real GDP had risen at an annual rate of only 2-1/2 percent.

Change in real GDP. Percent, annual rate. Bar chart. Date range is 1997 to 2003. Change in real GDP begins at about 4.7 percent, it then decreases to about 3.8 percent in the first half of 1998. Then it increases to about 6 percent by the end of 1999. In the first half of 2001 it decreases to about negative 3 percent and then it increases and ends at about 6.2 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.

During the period of recession and subpar economic expansion, considerable slack developed in labor and product markets. The firming of economic activity in the second half of last year produced modest increases in rates of resource utilization. Sustained efforts by businesses to control costs led to further rapid gains in productivity. As a result, unit labor costs declined, and core rates of inflation continued to slow in 2003; excluding food and energy, the PCE chain-type price index increased just 0.9 percent last year. Measures of overall inflation, which were boosted by movements in food and energy prices, were higher than those for core inflation.

Change in PCE chain-type price index. Percent, annual rate. Bar chart. There are two series (Total and Excluding food and energy). Date range is 1997 to 2003. As shown in the figure, total begins at about 1.25 percent, then it decreases to about 1.9 percent in 1998. In 2000 it increases to about 2.3 percent and it ends at about 1.5 percent in 2003. Excluding food begins at about 1.3 percent in 1997, it then increases to about 2.1 percent in 2001. It then decreases and ends about 0.8 percent. NOTE: The data are for personal consumption expenditures (PCE).

Domestic financial market conditions appeared to become increasingly supportive of economic growth last year. The economic expansion lowered investors’ perception of, and perhaps aversion to, risk, and continued disinflation was interpreted as a sign that monetary policy would remain on hold, even as the economy picked up steam. Although yields on Treasury coupon securities rose modestly on balance over the year, risk spreads on corporate debt narrowed to the point that yields on corporate issues declined. The low-interest-rate environment spurred considerable corporate bond issuance and generated a massive wave of mortgage refinancing activity by households. Equity markets began to rally when the uncertainty over the timing of military intervention in Iraq was resolved. The climb in stock prices continued for the rest of the year, driven by improving corporate earnings reports and growing optimism about the prospects for the economy. At the same time, with economic conditions abroad improving and with concerns about the financing burden of the U.S. current account deficit gaining increased attention in financial markets, the dollar fell appreciably on a trade-weighted basis.

The Household Sector

Consumer Spending

Early in 2003, consumer spending was still rising at about the same moderate pace as in 2001 and 2002. In the late spring and in the summer, however, households stepped up their spending sharply. As a result, in the second half of last year, real personal consumption expenditures rose at an annual rate of 4-3/4 percent after having increased at a rate of just under 3 percent in the first half. Although wage and salary earnings rose slowly during most of the year, the midyear reductions in tax rates and the advance of rebates to households eligible for child tax credits provided a substantial boost to after-tax income. In 2003, real disposable personal income increased 3-1/4 percent, after having risen 3-1/2 percent in 2002. Low interest rates provided additional impetus to household spending by reducing borrowing costs for new purchases of houses and durable goods; they also indirectly stimulated spending by facilitating an enormous amount of mortgage refinancing.

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 1997 to 2003. As shown in the figure, disposable personal income begins at about 4.2 percent, then it increases to about 5.5 percent in 1998. From 1999 to first half of 2003 it fluctuates within the range of about 4.5 and about 1.2 percent. It ends at about 2.9 percent.

The personal saving rate has fluctuated within a fairly narrow range around 2 percent over the past three years. Although households continued to see the value of their homes appreciate over this period, they also were adjusting to the substantial drop in equity wealth that occurred after the peak in the stock market in 2000. By itself, a fall in the ratio of household wealth to income of the magnitude that households experienced between 2000 and 2002 might have triggered a noticeable increase in the personal saving rate. However, in this case, the tendency for households to save more as their wealth declines appears to have been tempered in part by their willingness to take advantage of the attractive pricing and financing environment for consumer goods.

Personal saving rate. By percent. Line chart. Date range is 1981 to 2003. As shown in the figure, series begins at about 10 percent, then it generally increases to about 12 percent in 1982, then it decreases to about 8.5 percent in 1983. Then increases to about 11 percent in 1984. Then it generally decreases and ends at about 1.4 percent. NOTE: The data are quarterly and extend through 2003:Q4.

Wealth-to-income ratio. Ratio. Line chart. Date range is 1981 to 2003. As shown in the figure, series begins at about 4.5. During 1992-1995 it fluctuates within the range of about 4.3 to about 4.9. It generally increases to about 6.3 in 2000, then it decreases and ends at about 5.1. NOTE: The data are quarterly and extend through 2003:Q3. The wealth-to-income ratio is the ratio of household net worth to disposable personal income.

Real consumer expenditures for durable goods surged more than 11 percent in 2003. Sales of new motor vehicles remained brisk as many consumers responded to the low financing rates and various incentive deals that manufacturers offered throughout the year. Falling prices also made electronic equipment attractive to consumers, and spending on home furnishings likely received a boost from the strength of home sales. Altogether, real outlays for furniture and household equipment jumped 13-1/2 percent in 2003.

In contrast, real consumer expenditures on nondurable goods and on services continued to rise at a moderate pace, on balance, last year. Outlays for food and apparel increased a bit faster than in 2002, and the steady uptrend in spending for medical services was well maintained. However, consumers responded to the higher cost of energy by cutting back their real spending on gasoline, fuel oil, and natural gas and electricity services.

Consumer confidence was shaken temporarily early in 2003 by concerns about the consequences of a war in Iraq, but it snapped back in the spring. Toward year-end, sentiment appeared to brighten more as households saw their current financial conditions improve and gained confidence that business conditions would be better during the year ahead. Those positive views became more widely held in January, and the index of consumer sentiment prepared by the Michigan Survey Research Center (SRC) reached its highest level in three years.

Consumer sentiment. Line chart. There are two series Conference Board (1985 = 100) and Michigan SRC (1966 = 100). Date range is 1990 to 2004. Conference Board begins at about 106, then it fluctuates within the range of about 84 and about 45 from 1990-1994. In 2000 it increases to about 145, then it decreases to about 84 in 2001. Then increases to about 110 in 2002. In 2003 it decreases to about 60. Then increases and ends at about 98. Michigan SRC begins at about 93, then it fluctuates within the range of about 90 and about 62 from 1990-1994. In 2000 it increases to about 106, then it increases to about 112 in 2000. In 2003 it decreases to about 79 and then it increases and ends at about 105. NOTE: The data are monthly and extend through January 2004. SOURCE: University of Michigan Survey Research Center and The Conference Board.

Residential Investment

Housing activity was robust for a second consecutive year in 2003. After having risen 7 percent in 2002, real expenditures on residential construction jumped more than 10 percent in 2003. These gains were fueled importantly by the lowest levels of mortgage interest rates in more than forty years, which, according to the Michigan SRC's survey of consumer sentiment, buoyed consumer attitudes toward homebuying throughout the year. The average rate on thirty-year fixed-rate mortgages dropped sharply during the first half of 2003 and reached a low of 5-1/4 percent in June. Although the thirty-year rate subsequently firmed somewhat, it remained below 6 percent, on average, in the second half of last year.

Construction of new single-family homes accelerated during 2003, and for the year as a whole, starts averaged 1.5 million units, an increase of 10 percent compared with the level in 2002. Sales of both new and existing single-family homes also picked up sharply further last year. The brisk demand for homes was accompanied by rapid increases in the average price paid for them. The average price paid for new homes rose 10 percent over the four quarters of 2003, and the average price of existing homes was up 7-3/4 percent over the same period. However, house price inflation was lower after adjusting for shifts in the composition of transactions toward more expensive homes. The constant-quality price index for new homes, which eliminates the influence of changes in their amenities and their geographic distribution, increased 4-3/4 percent over the four quarters of 2003--down from an increase of 6 percent during 2002. The year-over-year increase in Freddie Mac’s index of the prices paid in repeat sales of existing homes stood at 5-1/2 percent as of the third quarter of 2003, compared with a rise of 7-1/4 percent as of the third quarter of 2002.

Private housing starts. Millions of units, annual rate. Line chart. There are two series (Single-family and Multifamily). Date range is 1991-2003. As shown in the figure, single-family begins at about 0.7 then it generally increases to about 1.3 in 1993. From 1994 through 2002 it fluctuates within the range of about 1 percent and about 1.4. The series ends at about 1.65. Multifamily starts at about 0.2 in early 1991, it than increases to end at about 0.4. NOTE: The data are quarterly and extend through 2003:Q4.

Starts in the multifamily sector totaled 350,000 units in 2003, a pace little changed from that of the past several years. Vacancy rates for these units rose and rents fell during the year, but falling mortgage rates apparently helped to maintain building activity.

Household Finance

Household debt increased 10-3/4 percent last year, in large part because of the surge in mortgage borrowing induced by record-low mortgage interest rates. Refinancing activity was torrid in the first half of the year, as mortgage rates declined. Some of the equity that households extracted from their homes during refinancings was apparently used to fund home improvements and to pay down higher-interest consumer debt. When mortgage rates rebounded in the second half of the year, mortgage borrowing slowed from the extremely rapid clip of the first half, but it remained brisk through year-end. Consumer credit increased at a pace of 5-1/4 percent in 2003, a little faster than a year earlier, as revolving credit picked up somewhat from the slow rise recorded in 2002. Despite the pickup in household borrowing, low interest rates kept the household debt-service and financial-obligation ratios--which gauge pre-committed expenditures relative to disposable income--at roughly the levels posted in 2002. Most measures of delinquencies on consumer loans and home mortgages changed little on net last year, and household bankruptcies held roughly steady near their elevated level in 2002.

Mortgage rates. By Percent. Line chart. There are two series (Fixed rate and Adjustable rate). Date range is 2000 to 2004. As shown in the figure Fixed rate begins at about 8.2 percent then it increases to about 8.5 percent in Q2 2000 and then it generally decreases to about 5 percent in Q2 2003. In Q3 2003 it increases to about 6.3 percent, then it decreases and ends at about 5.8 percent. Adjustable rate begins at about 6.7 percent, then it increases to about 7.2 percent in Q3 2000. Then it generally decreases and ends at about 3.5 percent. NOTE: The data, which are monthly and extend through January 2004, are contract rates on thirty-year mortgages. SOURCE. Federal Home Loan Mortgage Corporation.

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 1991 to 2003. All series begin in early 1991. As shown in the figure, mortgages begin at about 1.6 percent, then it fluctuates but stays at about 1.6 percent by the end. Credit card pools begins at about 6 percent, then it decreases to about 4 percent in 1995. Then it increases to about 5.25 in 1997. In 2000 it decreases to about 4.5 percent. The series ends at about 5.25 percent. Auto loans at domestic auto finance companies begins at about 2.6 percent, then it increases to about 3.5 percent in 1997. It decreases and ends at about 2 percent. NOTE. The data are quarterly. The rates for credit card pools and mortgages extend through 2003:Q3; the rate for auto loans extends through 2003:Q4. SOURCE: For mortgages, the Mortgage Bankers Association; for auto loans, the Big Three automakers; for credit cards, Moody's Investors Service.

Even with the rapid expansion in debt, net worth of the household sector increased as the value of household assets rose noticeably. Stock prices were boosted by the rise in corporate earnings and the ebbing of uncertainty about future economic growth. Households directed substantial flows into stock mutual funds in the third and fourth quarters despite highly publicized scandals in the mutual fund industry. Although the companies directly implicated in wrongdoing experienced heavy outflows from their funds, most of these withdrawals apparently were transferred to other mutual funds with little effect on the industry as a whole. A considerable rise in real estate wealth further augmented household assets. Although prices of existing homes climbed more slowly than they had in the previous year, the rate of increase remained sizable. Overall, the advance in the value of household assets outstripped the accumulation of household debt by enough to boost the ratio of net worth to disposable income over the year.

The Business Sector

Fixed Investment

Business spending on equipment and software was still sluggish at the beginning of 2003. However, it accelerated noticeably over the course of the year as profits and cash flow rebounded and as businesses gained confidence in the strength of the economic expansion and in the prospective payoffs from new investment. At the same time, business financing conditions were very favorable: Interest rates remained low, equity values rallied, and the enhanced partial-expensing tax provision gave a special incentive for the purchase of new equipment and software. After having changed little in the first quarter of the year, real outlays for equipment and software increased at an annual rate of 11-3/4 percent over the remaining three quarters of the year.

Change in real business fixed investment. Percent, annual rate. Bar chart. There are four series (Structures, Equipment and software, High-tech equipment and software, Other equipment excluding transportation). Date range is 1997 to 2003. Structures begins at about 4 percent, then it decreases to about negative 1 percent in 1999. In 2000 it increases to about 9 percent in 2000 and then it decreases and ends at about negative 3. Equipment and software begins at about 14 percent, then it decreases to about negative 8 percent in 2001. It ends at about negative 3 percent in 2003. High-tech equipment begins at about 31 percent, then it decreases to about negative 11 percent. Then it increases and ends at about 23 percent. Other equipment excluding transportation begins at about 6 percent, and then it decreases to about 2 percent in 1999. From 2000 to 2002 it fluctuates within the range of about 5 and about negative 10. It ends at about 9 percent. NOTE: High-tech equipment consists of computers and peripheral equipment, software, and communications equipment.

Outlays for high-technology items--computers and peripherals, software, and communications equipment--which had risen a moderate 4-1/2 percent in 2002, posted a significantly more robust increase of more than 20 percent in 2003. That gain contributed importantly to the pickup in overall business outlays for equipment and software and pushed the level of real high-tech outlays above the previous peak at the end of 2000. The increase in spending last year on computing equipment marked the sharpest gain since 1998, and investment in communications equipment, which had continued to contract in 2002 after having plummeted a year earlier, turned up markedly.

In contrast, the recovery in spending on non-high-tech equipment was, on balance, more muted, in part because outlays for transportation equipment continued to fall. The prolonged slump in business purchases of new aircraft continued in 2003 as domestic air carriers grappled with overcapacity and high fixed costs. By the fourth quarter, real outlays for aircraft had dropped to their lowest level in ten years. In the market for heavy (class 8) trucks, sales were quite slow in early 2003 when businesses were concerned about the performance of models with engines that met new emission standards. But as potential buyers overcame those concerns, sales recovered. By the fourth quarter of 2003, sales of medium and heavy trucks had moved noticeably above the slow pace of 2001 and 2002. Apart from outlays for transportation equipment, investment in other types of non-high-tech equipment was, on balance, little changed during the first half of the year. Demand was strong for medical equipment, instruments, and mining and oilfield machinery, but sales of industrial equipment and farm and construction machinery were sluggish. In the second half of the year, however, the firming in business spending for non-high-tech items became more broadly based.

The steep downturn in nonresidential construction that began in 2001 moderated noticeably in 2003, although market conditions generally remained weak. After having contracted at an average annual rate of 13-1/2 percent during 2001 and 2002, real expenditures for nonresidential construction slipped just 1-1/4 percent, on balance, during 2003. Spending on office buildings and manufacturing structures, which had dropped sharply over the preceding two years, fell again in 2003. The high office vacancy rates in many areas and low rates of factory utilization implied little need for new construction in these sectors even as economic activity firmed. Investment in communications infrastructure, where a glut of long-haul fiber-optic cable had developed earlier, also continued to shrink. In contrast, outlays for retail facilities, such as department stores and shopping malls, turned up last year, and the retrenchment in construction of new hotels and motels ended. In addition, investment in drilling and mining structures, which is strongly influenced by the price levels for crude oil and natural gas, increased noticeably in 2003.

Inventory Investment

During 2002, businesses appeared to have addressed most of the inventory imbalances that had developed a year earlier. But the moderate pace of final demand during the first half of 2003 apparently restrained firms from embarking on a new round of inventory accumulation. Even though final sales picked up in the second half of the year, the restraint seemed to recede only gradually. Over the first three quarters of 2003, nonfarm businesses trimmed their inventories at an average annual rate of $2-3/4 billion in constant-dollar terms, and the preliminary estimate for the final quarter of the year indicated only modest restocking. As a result, most firms appear to have ended the year with their inventories quite lean relative to sales, even after taking into account the downward trend in inventory-sales ratios that has accompanied the ongoing shift to improved inventory management. Motor vehicle dealers were an exception; their days' supply of new vehicles moved higher on average for a second year in a row.

Change in real business inventories. Billions of chained 2000 dollars, annual rate. Bar chart. Date range is 1997 to 2003. It begins at about 70 and then it increases to about 74 in 1998. Then it decreases to about negative 35 in 2001. It then increases and ends at about 5.

Corporate Profits and Business Finance

Higher profits allowed many firms to finance capital spending with internal funds, and business debt rose only slightly faster than the depressed rate in 2002. Moreover, a paucity of cash-financed merger and acquisition activity further limited the need to issue debt. Gross equity issuance was extremely weak in the first half of the year but perked up in the latter half in response to the rally in equity prices. Nevertheless, for the year as a whole, firms extinguished more equity than they issued.

Before-tax profits of nonfinancial corporations as a percent of sector GDP. By percent. Line chart. Date range is 1977-2003. As shown in the figure, the series begins at about 11.7 percent in the beginning of 1977. It increases to about 12.5 percent in early 1978. Then it generally decreases to about 8 percent in 1980. From 1981 through 1997 it fluctuates within the range of about 8.3 and about 13.2 percent. It generally decreases to about 7 percent in 2001. Then it increases and ends at about 11.9 percent. NOTE: The data are quarterly and extend through 2003:Q3. Profits are from domestic operations of nonfinancial corporations, with inventory valuation and capital consumption adjustments.

The pace of gross corporate bond issuance was moderate at the start of the year but shot up in late spring as firms took advantage of low bond yields to pay down short-term debt, to refund existing long-term debt, and to raise cash in anticipation of future spending. Bond issuance by investment-grade firms slowed after midyear as firms accumulated a substantial cushion of liquid assets and as interest rates on higher-quality debt backed up. However, issuance by speculative-grade firms continued apace, with the yields on their debt continuing to decline dramatically presumably because of investors’ increased optimism about the economic outlook and greater willingness to take on risk. The sum of bank loans and commercial paper outstanding, which represent the major components of short-term business debt, contracted throughout the year. In large part, this decline reflected ongoing substitution toward bond financing, but it also was driven by the softness of fixed investment early in the year and the liquidation of inventories over much of the year.

Corporate bond yields. By percent. Line chart. There are two lines (High yield and AA). Date range is 1990-2004. Both lines start in early 1990. High yield begins at about 16 percent. Then it generally increases to about 21 percent in the second half of 1990. Then it decreases to about 10 percent in 1994. From 1995-2003 it fluctuates within the range of about 9 and about 13 percent. Then it generally decreases and ends at about 7.5 percent. AA begins at about 9 percent, then it decreases and ends at about 4.9 percent. NOTE. The data are monthly averages and extend through January 2004. The AA rate is calculated from bonds in the Merrill Lynch AA index with a remaining maturity of seven to ten years. The high-yield rate is the yield on the Merrill Lynch 175 high-yield index.

Financing gap and net equity retirement at nonfarm nonfinancial corporations. In billions of dollars. Line chart. There are two series (Net equity retirement and Financing gap). Date range is 1990 to 2003. They start in 1990 at about 60 percent. 'Net equity retirement' decreases to about negative 25 in 1992. Then it generally increases to about 220 by the middle of 1998. It then decreases and ends at about 50. Financing gap increases to about 310 billions of dollars in 2000. Then it generally decreases and ends at about negative 50. NOTE: The data are annual; 2003 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.

Major 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 2001 to 2003. Bank loans begins at about negative $40 billion in 2001. From Q2 2001-Q3 2003 it fluctuates but stays at about negative $50 billion. It ends at about negative $40 billion. Bonds begins at about $420 billion in 2001. Then it decreases to about $40 billion in the second half of 2002. In Q2 2003 it increases to about $300 billion, then it decreases and ends at about $40 billion. Commercial paper begins at about negative$90 billion in 2001. From second half of 2001 through Q2 2003 it fluctuates within the range of about negative 10 and about negative $60 billion. Series ends at about negative$40 billion. 'Sum of major components' begins at about $200 billion in early 2001, then it decreases to about negative $100 billion in the middle of 2001. In the second half of 2001 it generally increases to about $240 billion and then decreases to about negative $60 billion. It then increases to about $150 billion in Q2 2003. Series ends at about negative$ 100 billion. NOTE: Seasonally adjusted annual rate for nonfinancial corporate business. The data for the sum of major components are quarterly. The data for 2003:Q4 are estimated.

Respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices noted that terms and standards on business loans were tightened during the first half of the year but that both had been eased considerably by year-end. They also reported that demand for business loans was quite weak for much of the year. However, despite the fact that outstanding levels of business loans continued to decline, survey responses in the last quarter of the year indicated that demand for loans had begun to stabilize. Many banks cited customers’ increased investment and inventory spending as factors helping to generate the increase in loan demand toward the end of the year. The apparent divergence between survey responses and data on actual loan volumes may suggest that demand for lines of credit has increased but that these lines have not yet been drawn. In other short-term financing developments, nonfinancial firms that issued commercial paper in 2003 found a very receptive market, in large part because of the scarcity of outstanding issues. Many of the riskiest borrowers had exited the market in 2002, and remaining issuers improved their attractiveness to investors by continuing to restructure their balance sheets.

Spread of low-tier CP rate over high-tier CP rate. In basis points. Line chart. Date range is 1997 to 2004. As shown in the figure it starts in the beginning of 1997 at about 20. It fluctuates within the range of 20 and 40 from 1997-2004. Five times it increases and then quickly decreases. In the end of 1998 (to about 90), in 1999 (to about 110), in 2000 (to about 140), in early 2002 (to about 100), in early 2003 (to about 70). It ends at about 5. NOTE: The data are daily and extend through February 4, 2004. The series shown is the difference between the rate on A2/P2 nonfinancial commercial paper and the AA rate.

Gross equity issuance rose over the course of 2003 as the economic outlook strengthened and stock prices moved higher. The market for initial public offerings continued to languish in the first half of the year but showed signs of life by the end of the summer. The volume of seasoned offerings also picked up in the second half of the year. On the other side of the ledger, merger and acquisition activity again extinguished shares in 2003, although only at a subdued pace. In addition, firms continued to retire a considerable volume of equity through share repurchases. For the year as a whole, net equity issuance was negative.

Corporate credit quality improved, on balance, over the year. Notably, the default rate on corporate bonds declined sharply, delinquency rates on commercial and industrial (C&I) loans at commercial banks turned down, and the pace of bond-rating downgrades slowed considerably. Low interest rates and the resulting restructuring of debt obligations toward longer terms also importantly contributed to improved business credit quality. Bank loan officers noted that the aggressive tightening of lending standards in earlier years was an important factor accounting for the lower delinquency and charge-off rates in recent quarters.

Default rate on outstanding. By percent. Line chart. Date range is 1991 to 2003. Series begins at about 2.3 percent, then it decreases to about 0.3 percent in early 1993. From 1993-1998 it fluctuates but stays at about 0.4 percent, then it generally increases to about 3.7 percent in 2002. It then decreases and ends at about 0.7 percent. NOTE: The default rate is monthly and extends through December 2003. 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.

Ratings changes of nonfinancial corporations. By percent. Bar chart. There are two series (Upgrades and Downgrades). Date range is 1995 to 2003. Upgrades begin at about 20 percent, then it decreases to about 9 percent in 1997. Then it increases to about 15 percent in 1998 and then it decreases and ends at about 4 percent. Downgrades begin at about negative 8, then it decreases to about negative 36 in 2002. It ends at about negative 18 percent. NOTE: For a given year, the percentage is calculated as the par value of bonds that were upgraded or downgraded in that year and outstanding in the fourth quarter of the previous year divided by the par value of the outstanding bonds of all nonfinancial corporations in that quarter: SOURCE. Moody's Investors Service.

Net interest payments of nonfinancial corporations as a percent of cash flow. By percent. Line chart. Date range is 1977-2003. As shown in the figure, the series begins at about 8 percent, then increases to about 21 percent in 1989. In 1996 it decreases to about 11.5 percent and increases to about 20 percent in 2002. Then series generally decreases and ends at about 16 percent. NOTE: The data are quarterly and extend through 2003:Q3. SOURCE: Bureau of Economic Analysis.

Commercial mortgage debt increased noticeably during most of 2003 despite persistently high vacancy rates, falling rents, and sluggish growth in construction expenditures. Low interest rates on this type of collateralized debt may have induced some corporate borrowers to tap the market to pay down more-costly unsecured debt. Delinquency rates on commercial mortgages generally remained low throughout 2003, and risk spreads were relatively narrow. Loan performance has held up well because of low carrying costs for property owners and because the outstanding loans generally had been structured to include a sizable equity contribution, which makes default less attractive to borrowers.

The Government Sector

Federal Government

The federal budget deficit continued to widen in fiscal year 2003 as a result of the slow increase in nominal incomes, outlays associated with the war in Iraq, and legislative actions that reduced taxes and boosted spending. The deficit in the unified budget totaled $375 billion, up substantially from the deficit of $158 billion recorded in fiscal 2002. The Congressional Budget Office is projecting that the unified federal deficit will increase further in fiscal 2004, to more than $475 billion.

Federal receipts have fallen in each of the past three years; the drop of nearly 4 percent in fiscal 2003 brought the ratio of receipts to GDP to 16-1/2 percent, 2 percentage points below the average for the past thirty years. About half of the decrease in receipts last year was a consequence of legislation that shifted due dates for corporate payments between fiscal years. In addition, personal income tax collections dropped sharply because of the slow rise in nominal wages and salaries, diminished capital gains realizations in 2002, and the tax cuts enacted under the Jobs and Growth Tax Relief Reconciliation Act of 2003. The act advanced refund checks to households eligible for the 2003 increment to the child tax credit and resulted in lower withholding schedules for individual taxpayers. The act also expanded the partial-expensing incentive for businesses, but because corporate profits accelerated sharply last year, corporate tax receipts rose appreciably after adjusting for the shifts in the timing of payments.

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 2003. Expenditures and Expenditures excluding net interest generally moving together with Expenditures excluding net interest being about 2.5 percent lower. Expenditures begins at about 23 percent in early 1985 and Receipts and Expenditures excluding net interest begins at about 19 percent. Then during 1986-1999 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 ends at about 18.5 percent. Receipts start at about 17.5 percent. From 1985 to 2001 it increases to about 21 percent, then it generally decreases to end at about 17 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.

At the same time, federal outlays other than for interest expense rose rapidly for the second consecutive year in fiscal 2003; these outlays increased about 9 percent after having risen 11 percent in fiscal 2002. Spurred by operations in Iraq, defense spending soared again, and outlays for homeland security rose further. Spending for income support, such as unemployment insurance, food stamps, and child credits under the earned income tax credit program, also posted a sizable increase. The ongoing rise in the cost and utilization of medical services continued to push up spending for Medicare and Medicaid. Overall, real federal consumption and investment (the measure of federal spending that is included in real GDP) increased 6 percent over the four quarters of 2003, after having risen 10 percent a year earlier.

Change in real government expenditures on consumption and investment. Percent. Bar chart. There are two series (Federal and State and local). Date range is 1997 to 2003. Federal begins at about negative 1 percent, then it increases to about 4 percent in 1999. In 2000 it decreases to about negative 2 percent. In 2002 increases to about 10 percent. It ends at about 6 percent. State and local begins at about 2 percent. Then it generally increases to about 5 percent in 1998. From 1999 it decreases and ends about 0.5 percent.

The federal government had contributed increasingly to national saving in the late 1990s and 2000 as budget deficits gave way to accumulating surpluses. However, with the swing back to large deficits in recent years, the federal government has again become a drain on national saving. Using the accounting practices followed in the national income and product accounts (NIPA), gross federal saving as a percent of GDP dropped sharply in late 2001 and has trended down since then; the drop contributed to a decline in overall gross national saving as a percent of GDP from 18 percent in calendar year 2000 to 13 percent, on average, in the first three quarters of 2003. Federal saving net of estimated depreciation fell from its recent peak of 2-1/2 percent of GDP in 2000 to negative 4 percent of GDP, on average, in the first three quarters of 2003. As a result, despite a noticeable pickup in saving from domestic nonfederal sources, overall net national saving, which is an important determinant of private capital formation, fell to less than 1-1/2 percent of GDP, on average, in the first three quarters of 2003, compared with a recent high of 6-1/2 percent of GDP in 1998.

Net national saving. By percent of nominal GDP. Line chart. There are three series (Nonfederal saving, Total, and Federal saving). Date range is 1984 to 2003. All series start in early 1994. Nonfederal saving and Total generally moving together with Total being about 4 percent lower. Nonfederal saving begins at about 10.5 percent, then it generally decreases to about 7 percent in 1986. Total begins at about 6.5 percent, then it generally decreases to about 3 percent in 1986. From 1987 to 1997 they fluctuate within the range of about 9 and about 6 percent, with total being about 4 percent lower. In 1998 they split. Total decreases to end at about 1.5 percent. Nonfederal saving decreases to about 3 percent in 2001, then increases and ends about 6 percent. Federal saving begins at about negative 4 percent, then it increases to about 2.5 percent in 2000, then it decreases and ends at about negative 5 percent. NOTE. The data are quarterly and extend through 2003:Q3. Nonfederal saving is the sum of personal and net business saving and the net saving of state and local governments.

Federal Borrowing

The Treasury ramped up borrowing in 2003 in response to the sharply widening federal budget deficit, and federal debt held by the public as a percent of nominal GDP increased for a second year in a row after having trended down over the previous decade. As had been the case in 2002, the Treasury was forced to resort temporarily to accounting devices in the spring of 2003 when the statutory debt ceiling became a constraint, but debt markets were not disrupted noticeably. In May, the Congress raised the debt ceiling from $6.4 trillion to $7.4 trillion. With large deficits expected to persist, the Treasury made a number of adjustments to its regular borrowing program, including reintroducing the three-year note, increasing to monthly the frequency of five-year note auctions, reopening the ten-year note in the month following each new quarterly offering, and adding another auction of ten-year inflation-indexed debt. As a result of these changes, the average maturity of outstanding Treasury debt, which had reached its lowest level in decades, began to rise in the latter half of 2003.

Federal government debt held by the public. By Percent of nominal GDP. Line chart. Date range of 1962 to 2003. As shown in the figure, the series begins at about 40 percent in early 1962. In 1973 it decreases to about 23 percent. In 1994 it increases to about 50 percent, then it decreases to end at about 35 percent. NOTE: Through 2002, 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 2003:Q3. Excludes securities held as investments of federal government accounts.

State and Local Governments

State and local governments faced another difficult year in 2003. Tax receipts on income and sales continued to be restrained by the subdued performance of the economy. Despite further efforts to rein in spending, the sector’s aggregate net saving, as measured in the NIPA, reached a low of negative $40 billion (at an annual rate), or negative 0.4 percent of GDP, in the first quarter of the year. Most of these jurisdictions are subject to balanced-budget requirements and other rules that require them to respond to fiscal imbalances. Thus, in addition to reducing operating expenses, governments drew on reserves, issued bonds, sold assets, and made various one-time adjustments in the timing of payments to balance their books. In recent years, many have also increased taxes and fees, thereby reversing the trend toward lower taxes that prevailed during the late 1990s.

State and local government net saving. By percent of GDP. Line chart. Date range is 1980 to 2003. As shown in the figure, the series begins at about 0.4 percent in early 1980. In 1983 it decreases to about negative 0.3 percent. In 1984 it generally increases to about 0.65 percent. During 1995-1993 it decreases to about negative 0.2 percent. In 1998 it increases to about 0.7 percent. Then it decreases to about 0.4 percent. Series ends at about 0.1 percent. NOTE: The data, which are quarterly, are on a national income and product account basis and extend through 2003:Q3.

Recent indications are that the fiscal stress in this sector is beginning to ease. The improvement reflects a noticeable upturn in tax collections in recent quarters while restraint on operating expenditures largely remains in place. On a NIPA basis, real spending on compensation and on goods and services purchased by state and local governments was little changed in the second half of 2003, as it was over the preceding year. However, investment in infrastructure, most of which is funded in the capital markets, accelerated in the second half of 2003. As of the third quarter of 2003, state and local net saving had moved back into positive territory.

State and Local Government Borrowing

Gross issuance of debt by state and local governments was quite robust last year. Weak tax receipts from a sluggish economy, significant demands for infrastructure spending, and low interest rates all contributed to the heavy pace of borrowing. Borrowing was strongest in the second quarter of the year, as governments took advantage of the extraordinarily low longer-term rates to fund capital expenditures and to advance refund existing higher-cost debt. Because of the financial stresses facing these governments, the credit ratings of several states, most notably California, were lowered last year. Although bond downgrades outnumbered upgrades for the sector as a whole, the imbalance between the two was smaller than it was in 2002.

The External Sector

Over the first three quarters of 2003, the U.S. current account deficit widened relative to the comparable period in 2002, a move largely reflecting developments in the deficit on trade in goods and services. Net investment income rose over the same period, as receipts from abroad increased and payments to foreign investors in the United States declined.

U.S. trade and current account balances. Billions of dollars, annual rate. Line chart. There are two lines (Trade and Current account). Date range of 1996 to 2003. They start at about negative $100 billion in early 1996. Both series generally move together with Current account being slightly lower. They decrease to about negative $400 billion in 2000, then they increase to about negative $350 billion in 2001. Current account ends at about negative $550 billion and trade ends at about negative $500 billion. NOTE: The data are quarterly and extend through 2003:Q3.

International Trade

The trade deficit widened considerably in the first half of 2003 but narrowed slightly in the third quarter, as the value of exports rebounded in response to strengthening foreign economic activity and the depreciation of the dollar. Available trade data through November suggest that the trade deficit narrowed further in the fourth quarter, as an additional strong increase in exports outweighed an increase in imports.

Change in real imports and exports of goods and services. Percent, annual rate. Bar chart with 2 series ('Imports' and 'Exports'). Date range of 1996 to 2003. All series start in the beginning of 1996. 'Imports' begins at about 11 percent. During 1997-2000 it fluctuates within the range of about 14 and about 11 percent. Then it decreases to about negative 8 percent in 2001. Then it increases to about 13 percent in 2002. It ends at about 6 percent. 'Exports' begins at about 10 percent and decreases to 2.5 percent in 1998. From 1999 to 2002 it fluctuates within the range of about 7.5 and about negative 12 percent. It ends at about 14 percent.

Real exports of goods and services increased about 6 percent in 2003. Exports of services rose about 5 percent. They were held down early in the year by a drop in receipts from foreign travelers, owing to the effects of the SARS (severe acute respiratory syndrome) epidemic and the war in Iraq; services exports rebounded strongly later in the year as those concerns receded. Exports of goods rose about 6-3/4 percent over the course of the year--considerably faster than in 2002. Exports increased in all major end-use categories of trade, with particularly strong gains in capital goods and consumer goods. Reflecting the global recovery in the high-tech sector, exports of computers and semiconductors picked up markedly in 2003, particularly in the second half. By geographic area, exports of goods increased to Western Europe, Canada, and, particularly, to developing countries in East Asia--a region where economic activity expanded at a rapid pace last year. Prices of exported goods rose in 2003, with prices of agricultural exports recording particularly large increases. In response to poor crops and strong demand, prices for cotton and soybeans increased sharply. For beef, disruptions in supply led to notably higher prices through much of 2003. Beef prices, however, fell back in late December after a case of mad cow disease was discovered in the state of Washington and most countries imposed bans on beef imports from the United States.

Real imports of goods and services rose about 3-1/2 percent in 2003. Imports of services fell in the first half of the year but bounced back in the second half, as concerns about the SARS epidemic and the war in Iraq came and went; for the year as a whole, real imports of services were about unchanged from the previous year. Real imports of goods expanded about 4 percent in response to the strengthening of U.S. demand, but the pattern was choppy, with large gains in the second and fourth quarters partially offset by declines in the first and third. Despite a surge in the second quarter, the volume of oil imports increased modestly, on balance, over the course of the year. Real non-oil imports were up about 4-1/2 percent, with the largest increases in capital goods and consumer goods. Imports of computers posted solid gains, whereas imports of semiconductors were flat.

Despite a substantial decline in the value of the dollar, the prices of imported non-oil goods rose only moderately in 2003. By category, the prices of consumer goods were unchanged last year, and prices of capital goods excluding aircraft, computers, and semiconductors increased only a little more than 1 percent. Price increases were larger for industrial supplies. The price of imported natural gas spiked in March and rose again late in the year; these fluctuations were large enough to show through to the overall price index for imported goods. At year-end, prices of industrial metals rose sharply, with the spot price of copper reaching the highest level in six and one-half years. The strength in metals and other commodity prices has been attributed, at least in part, to depreciation of the dollar and strong global demand, particularly from China.

Prices of oil and of nonfuel commodities. Two lines chart. Date range of 2001 to 2004. Nonfuel (January 2001 = 100) begins at about 100 in early 2001, then it decreases to about 89 in Q4 2001. Then it increases and ends at about 118. Oil (Dollars per barrel) begins at about 30 in early 2001, then it decreases to about 20 in Q4 2001. It increases and ends at about 35. NOTE: The data are monthly and extend through January 2004. The oil price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is a weighted average of thirty-nine primary-commodity prices from the International Monetary Fund.

In 2003, the spot price of West Texas intermediate (WTI) crude oil averaged more than $31 per barrel--the highest annual average since the early 1980s. The spot price of oil began to rise at the end of 2002 when ethnic unrest in Nigeria and a nationwide strike in Venezuela sharply limited oil supplies from those two countries. In the first quarter of 2003, geopolitical uncertainty in the period leading up to the war in Iraq also added upward pressure on oil prices. On March 12, the spot price of WTI closed at $37.83 per barrel, the highest level since the Gulf War in 1990. When the main Iraqi oil fields had been secured and it became apparent that the risks to oil supplies had subsided, the spot price of WTI fell sharply to a low of $25.23 per barrel on April 29. However, oil prices began rising again when, because of difficult security conditions, the recovery of oil exports from Iraq was slower than expected. Prices also were boosted in September by the surprise reduction in OPEC’s production target. In the fourth quarter of 2003 and early 2004, strengthening economic activity, falling oil inventories, and the continued depreciation of the dollar contributed to a further run-up in oil prices.

The Financial Account

The financing counterpart to the current account deficit experienced a sizable shift in 2003, as net private inflows fell while foreign official inflows increased. Private foreign purchases of U.S. securities were at an annual rate of about $350 billion through November, about $50 billion lower than in the previous year. Private foreign purchases of U.S. equities continued to recede, and, although the level of bond purchases was little changed in the aggregate, foreign purchases shifted somewhat away from agency bonds and toward corporate bonds. Over the same period, purchases by private U.S. investors of foreign securities increased nearly $80 billion. Accordingly, net inflows through private securities transactions decreased markedly. In contrast, foreign official purchases of U.S. assets surged to record levels in 2003, with the accumulation of dollar reserves particularly high in China and Japan.

U.S. net financial inflows. Billions of dollars. Bar chart with 2 series (Official and Private). Date range of 2000 to 2003. Private begins at about $6 billion in Q1 2000, then it generally increases to about $125 billion in Q2 2000. From Q3 2000-Q3 2002 it fluctuates within the range of about $50 billion and $165 billion. From Q4 2002 to end series decreases to about $80 billion. Official begins at about $25 billion, then it decreases to about negative $10 billion in Q4 2000. From Q1 2001-Q3 2002 it fluctuates within the range of about negative $20 billion and about $45 billion. In Q4 2002 it is about $30 billion. Then it increases and ends at about 40 billions of dollars. SOURCE: Department of Commerce.

U.S. 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 2000 to 2003. Bonds starts at about $42 billion. Then it fluctuates between about $ 21 billion and about $90 billion from Q2 2000 to Q1 2002. In Q2 2002 it increases to about $150 billion, then it decreases to about $71 billion in Q1 2003. It ends at about $60 billion. Equities start at about$ 68 billion. It then decreases to about $10 billion in Q3 2001 and then it increases to about$ 32 billion in Q4 2001 and then it decreases and ends at about negative $5 billion. Net private U.S. purchases of foreign securities. Billions of dollars. Data range is 2000 to 2003. Bar chart with 2 series (Bonds and Equities). Bonds begins in the first quarter of 2000 at about $12.5 billion. It decreases to about negative $10 billion in the second quarter of 2000. It fluctuates within the range of about $15 billion and about negative $25 billion from Q3 2000 to Q2 2003.It ends at about negative $8 billion. Equities starts in the first quarter of 2000 at about $20 billion. It increases to about $49 billion in Q2 2000. Then it fluctuates within the range of about $60 billion and about negative $15 billion during Q3 2000 and Q2 2003. It ends at about $32 billion. SOURCE: Department of Commerce and the Federal Reserve Board.

Compared with the pace in 2002, foreign direct investment in the United States increased, as merger activity picked up and corporate profits improved. U.S. direct investment abroad held relatively steady at a high level that was largely the result of continued retained earnings. On net, foreign direct investment outflows fell about $50 billion through the first three quarters of 2003.

The Labor Market

Employment and Unemployment

With economic activity still sluggish during the first half of 2003, the labor market continued to weaken. Over the first eight months of the year, private nonfarm payroll employment fell, on average, more than 35,000 per month, extending the prolonged period of cutbacks that began in early 2001. The civilian unemployment rate, which had hovered around 5-3/4 percent for much of 2002, moved up to 6-1/4 percent by June. However, by late in the summer, the labor market began to recover slowly. Declines in private payrolls gave way to moderate increases in employment; over the five months ending in January, private nonfarm establishments added, on average, about 85,000 jobs per month. By January, the unemployment rate moved back down to 5.6 percent.

Net change in payroll employment. Private nonfarm. Thousands of jobs, monthly average. Bar chart. Data range is 1992 to January 2004. The series begins at about 80 in 1992. Then it increases to about 300 in 1994. Then it decreases to about 180 in 1995. In 1997 it increases to about 270, then it generally decreases to about negative 200 in 2001. In 2002 series starts to increase and ends at about 130.

Civilian unemployment rate. By percent. Line chart. Date range is 1971-2004. As shown in the figure, the series begins at about 5.9 percent. From 1973 to 1995 it fluctuates within the range of about 5.3 and 10.5 percent. Then it decreases to about 4 percent in 2001 and then it increases and ends at about 5.8 percent. NOTE: The data are monthly and extend through January 2004.

During the late summer and early fall, prospects for business sales and production brightened, and firms began to lay off fewer workers. Initial claims for unemployment insurance dropped back, and the monthly Current Population Survey (CPS) of households reported a decline in the number of workers who had lost their last job. However, for many unemployed workers, jobs continued to be difficult to find, and the number of unemployed who had been out of work for twenty-seven weeks or more remained persistently high. The labor force participation rate, which tends to be sensitive to workers’ perceptions of the strength of labor demand, drifted lower. Although the CPS indicated a somewhat greater improvement in employment than the payroll report--even after adjusting for conceptual differences between the two measures--the increase in household employment lagged the rise in the working-age population, and the ratio of employment to population fell further during 2003.

The modest upturn in private payroll employment that began in September was marked by a step-up in hiring at businesses supplying professional, business, and education services, and medical services continued to add jobs. Employment in both the construction industry and the real estate industry rose further, although the number of jobs in related financial services dropped back a bit as mortgage refinancing activity slackened. At the same time, although manufacturers were still laying off workers, the monthly declines in factory employment became smaller and less widespread than earlier. Employment stabilized in many industries that produce durable goods, such as metals, furniture, and wood products, as well as in a number of related industries that store and transport goods. In several other areas, employment remained weak. Manufacturers of nondurables, such as chemicals, paper, apparel, and textiles, continued to cut jobs. Employment in retail trade remained, on net, little changed.

Productivity and Labor Costs

Business efforts to increase efficiency and control costs led to another impressive gain in labor productivity last year. Output per hour in the nonfarm business sector surged 5-1/4 percent in 2003 after having risen a robust 4 percent in 2002 and 2-3/4 percent in 2001. What is particularly remarkable about this period is that productivity did not decelerate significantly when output declined in 2001, and it posted persistently strong gains while the recovery in aggregate demand was sluggish. Typically, the outsized increases in productivity that have occurred during cyclical recoveries have followed a period of declines or very weak increases in productivity during the recession and have been associated with rebounds in economic activity that were stronger than has been the case, until recently, in this expansion.

Change in output per hour. By percent, annual rate. Bar chart. Date range is 1992-2003Q1. As shown in the figure, Change in output per hour begins at about 4 percent in 1992. Then it generally decreases to about negative 0.5 percent by 1993. In 1994 it is at about 3 percent, then it increases by the end to about 5.3 percent. NOTE: Nonfarm business sector.

On balance, since the business cycle peak in early 2001, output per hour has risen at an average annual rate of 4 percent--noticeably above the average increase of 2-1/2 percent that prevailed between 1996 and 2000. In the earlier period, an expansion of the capital stock was an important element in boosting the efficiency of workers and their firms; that impetus to productivity has weakened in the recent period as a result of the steep cutbacks in business investment in 2001 and 2002. Instead, the recent gains appear to be grounded in organizational changes and innovations in the use of existing resources--which are referred to as multifactor productivity. The persistence of a rapid rise in multifactor productivity in recent years, along with signs of a pickup in capital spending, suggests that part of the step-up in the rate of increase of labor productivity may be sustained for some time.

In 2003, the employment cost index (ECI) for private nonfarm businesses, which is based on a survey conducted quarterly by the Bureau of Labor Statistics, rose 4 percent--about 3/4 percentage point more than the increase in 2002. Compensation per hour in the nonfarm business sector, which is based on data constructed for the NIPA, is estimated to have increased 3-1/4 percent in 2003, up from 1-1/2 percent in 2002. In recent years, the NIPA-derived series has shown much wider fluctuations in hourly compensation than the ECI, in part because it includes the value of stock option exercises, which are excluded from the ECI. The value of options exercised shot up in 2000 and then dropped over the next two years.

Measures of change in hourly compensation. By percent. Bar chart. There are two series (Nonfarm compensation per hour and Employment cost index). Date range is 1994-2003. Both series start in early 1994. Nonfarm compensation per hour begins at about 2.3 percent. Then it increases to about 6 percent in 1998. Then it decreases to about 4 percent in 1999. Then it generally increases to about 8 percent in 2000. In 2002 it decreases to about 1.7 percent. It ends at about 3.5 percent. Employment cost index begins at about 3.7 percent in early 1994. Then fluctuates within the range of about 2.7 and about 4.3 percent from 1994 through 2001 and ends at about 4 percent. NOTE. The data are quarterly and extend through 2003: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.

Most of the acceleration in hourly compensation in 2003 was the result of larger increases in the costs of employee benefits. The ECI for wages and salaries rose 3 percent--up slightly from the pace in 2002 but still well below the rates of increase in the preceding six years. Wage gains last year likely were restrained by persistent slack in the demand for labor as well as by the pressure on employers to control overall labor costs in the face of the rapidly rising cost of benefits. Employer costs for benefits, which had risen 4-3/4 percent in 2002, climbed another 6-1/2 percent in 2003. The cost of health insurance as measured by the ECI has been moving up at close to a double-digit rate for three consecutive years. In addition, in late 2002 and early 2003, employers needed to substantially boost their contributions to defined-benefit retirement plans to cover the declines in the market value of plan assets.

Prices

Headline consumer price inflation in 2003 was maintained by an acceleration in food prices and another sizable increase in energy prices, but core rates of inflation fell for a second year. Although the strong upturn in economic activity in the second half of last year began to reduce unemployment and to boost industrial utilization rates, considerable slack in labor and product markets continued to restrain inflation throughout the year. A further moderation in the costs of production also helped to check inflation: As a result of another rapid rise in productivity, businesses saw their unit labor costs decline in 2003 for a second consecutive year. In contrast, prices for imported goods excluding petroleum, computers, and semiconductors increased at about the same rate as prices more generally; between 1996 and 2002, these import prices fell relative to overall prices for personal consumption expenditures (PCE). The chain-type price index for PCE excluding food and energy rose just under 1 percent in 2003, about 3/4 percentage point less than in 2002. A broader measure of inflation, the chain-type price index for GDP, increased 1-1/2 percent in 2003, the same slow pace as in 2002. Both measures of inflation were roughly a percentage point lower than in 2001.

Change in unit labor costs. By percent. Bar chart. Date range is 1992-2003. Series starts at about 0.5 percent. From 1993 to 2001 it fluctuates within the range of about 0.5 and about 4.2 percent. Then it generally decreases to end at about negative 2 percent. NOTE: Nonfarm business sector.

Change in consumer prices. By percent. Bar chart with 2 series (Chain-type price index for PCE and CPI). Date range is 1993-2003. Both series generally move together with Chain-type price index for PCE being lower. CPI begins at about 2.7 percent. Chain-type price index for PCE begins at about 2 percent. They then decrease until 1998, when Chain-type price index for PCE at about 2.4 and CPI at about 3.3 percent. In 1998 Chain-type price index for PCE at about 0.9 percent and CPI at about 1.6 percent. Then they start to increase Chain-type price index for PCE to about 2.4 and CPI to about 3.5 in 2000. They end in 2003 Chain-type price index for PCE at about 1.4 and CPI at about 1.9 percent.

Change in consumer prices excluding food and energy. By percent. Line chart with 2 series (Chain-type price index for PCE and CPI). Date range is 1993-2003. Both series generally move together with Chain-type price index for PCE generally being about 1 percent lower during the entire period. They start at about 3.5 percent in 1993, with Chain-type price index for PCE being lower. They then decrease until 1998. Chain-type price index for PCE to about 1.2 percent and CPI to about 2.5 percent. Then in 2002 they decrease Chain-type price index for PCE to about 2.1 and CPI at about 2.8 percent. Chain-type price index for PCE ends at about 0.9 percent. CPI ends at about 1.2 percent. NOTE: Change is over four quarters, and the data extend through 2003:Q4.

Consumer energy prices fluctuated widely over the four quarters of 2003, and the PCE index for energy was up 7-1/4 percent over the period. In the first quarter of the year, the combination of a further rise in the cost of crude oil, increased wholesale margins for gasoline, and unusually tight supplies of natural gas pushed up consumer energy prices sharply. Although the prices of petroleum-based products turned down when the price of crude oil fell back in March, a number of supply disruptions in late summer resulted in another temporary run-up in the retail price of gasoline. In the spring, the price of natural gas began to ease as supplies improved, but it remained high relative to the level in recent years. Electricity prices also moved up during 2003, in part because of the higher input costs of natural gas. In January 2004, a cold wave in the Northeast, together with the rise in the price of crude oil since early December, once again led to spikes in the prices of gasoline and natural gas.

The PCE price index for food and beverages increased 2-3/4 percent in 2003 after having risen just 1-1/4 percent a year earlier. Much of the acceleration can be traced to strong demand for farm products, but prices paid by consumers for food away from home--which depend much more heavily on the cost of labor than on prices of food products--were up 3 percent in 2003, also somewhat more than overall consumer price inflation. Poor harvests abroad, especially in Europe, contributed importantly to the heightened demand for U.S. farm products. Thus, despite a bumper crop of corn and some other grains in the United States, world stocks were tight and prices remained high. In addition, the U.S. soybean crop was crimped by late-season heat and dryness, which further tightened world supplies. Concerns about the cases of mad cow disease that were identified in herds in Japan and Canada supported strong domestic and export demand for U.S. beef for most of last year while supplies edged down. But, at year-end, when a case of mad cow disease was discovered in a domestic herd, export demand for U.S. beef plunged and drove the price of live cattle down sharply. A portion of the drop in cattle prices likely will show through to consumer prices for beef early this year.

The decline in core inflation in 2003 was broadly based. Prices of core consumer goods fell somewhat faster than a year earlier; the declines were led by larger cuts in prices of apparel, motor vehicles, electronic equipment, and a variety of other durable goods. At the same time, prices of non-energy services rose less rapidly. The deceleration in core consumer prices measured by the CPI is somewhat greater than that measured by the PCE index. In each index, the costs of housing services to tenants and owners rose less in 2003 than in 2002, but because these costs receive a larger weight in the CPI, their slowing contributed a greater amount to the CPI’s deceleration. In addition, the different measurement of the prices of medical services in the two series contributed to the smaller deceleration in non-energy services in the PCE. The medical services component of the CPI, which measures out-of-pocket expenses paid by consumers, increased 4 percent in 2003, down from 5-1/2 percent a year earlier. Alternatively, the PCE for medical services is a broader measure that uses producer price indexes (PPI) to capture the costs of services provided by hospitals and doctors; it continued to increase more slowly than the CPI for medical services last year, 3-1/4 percent, but it was up slightly from its increase of 2-1/2 percent in 2002.

 

Alternative measures of price change
Percent  
Chart of table rule
Price measure
2001
2002
2003
Chain-type
Gross domestic product 2.4 1.4 1.5
Gross domestic purchases
 1.6 1.7 1.6
Personal consumption expenditures 1.6 1.8 1.4
    Excluding food and energy 2.1 1.6 0.9
Chained CPI 1.5 1.8 1.4
    Excluding food and energy 2.1 1.6 0.6
Fixed-weight
Consumer price index 1.8 2.2 1.9
    Excluding food and energy 2.7 2.1 1.2
Chart of table rule

          Note.  Changes are based on quarterly averages and are
measured to the fourth quarter of the year indicated from the
fourth quarter of the preceding year.
 

Survey measures of expected inflation were little changed, on balance, in 2003. According to the Federal Reserve Bank of Philadelphia's survey of professional forecasters, expectations for CPI inflation ten years ahead remained at 2-1/2 percent last year. As measured by the Michigan Survey Research Center survey of households, median five- to ten-year inflation expectations, which averaged 3 percent in 2001, were steady at 2-3/4 percent in 2003 for a second consecutive year. Inflation compensation as measured by the spread between the yield on nominal Treasury securities and their indexed counterparts varied over a wide range in 2003, settling at just under 2-1/2 percent at year-end. Shorter-term inflation expectations also posted some wide swings during 2003; year-ahead expectations in the Michigan SRC survey spiked early in the year with the sharp increase in energy prices and dipped briefly to an unusually low level at midyear as actual inflation eased in response to lower energy prices. However, year-ahead inflation expectations settled back to just over 2-1/2 percent at the end of the year, about the same as at the end of 2002.

The PPI for crude materials excluding food and energy products, which had dropped 10 percent in 2001, rose 11-3/4 percent in 2002 and another 17-1/2 percent in 2003. The upswing was driven by the pickup in demand associated with the acceleration in both domestic and worldwide industrial activity and by the pass-through of higher energy costs. Such wide cyclical swings in commodity prices have only a small effect on movements in the prices of intermediate and finished goods. At later stages of production and distribution, commodity costs represent only a small share of overall costs, and some portion of the change in commodity prices tends to be absorbed in firms' profit margins. Thus, the recent pickup in prices at the intermediate stage of processing has been more muted; after having fallen almost 1-1/2 percent in 2001, the PPI for core intermediate materials rose 1-1/4 percent in 2002 and 2 percent in 2003.

U.S. Financial Markets

On balance, financial market conditions became increasingly supportive of growth over 2003 as investors became more assured that the economy was on solid footing. Equity prices marched up after the first quarter of the year in response to the initiation and swift conclusion of major combat operations in Iraq, positive earnings reports, and--in the second half of the year--a stronger pace of economic growth. Risk spreads on corporate debt declined, with the spreads on the debt of both investment-grade firms and speculative-grade firms ending 2003 at their lowest levels since 1998. Thus, although Treasury coupon yields ended the year 30–40 basis points higher, yields on many corporate bonds ended the year lower. Commercial banks appeared somewhat slower than bond investors to lend at more favorable terms; nevertheless, by late in the year, banks had eased both standards and terms on C&I loans.

Demand for short-term debt, however, remained very weak, and business loans and outstanding commercial paper continued to run off. In response to a widening budget deficit and a rapid expansion of federal debt, the Treasury increased the frequency of its debt auctions. Declines in mortgage interest rates over the first half of the year led to an extraordinary increase in mortgage debt, as originations for home purchase and for refinancings both climbed to record levels.

Interest Rates

Interest rates fell for most of the first half of 2003, primarily in response to continuing weak economic data and an associated marking down of expectations for the federal funds rate. Global uncertainty ran high, particularly surrounding the timing of military intervention in Iraq, which elevated safe-haven demands and depressed yields on Treasury securities. Moreover, the weak March employment report and other disappointing news about economic activity seemed to cause a substantial shift in views about monetary policy. Data from the federal funds futures market suggested a significant probability of a further easing of policy and did not imply any tightening before early 2004. Even as geopolitical tensions eased, weaker-than-expected economic data continued to hold down Treasury yields. The FOMC’s statement following its May meeting that an "unwelcome fall in inflation" remained a risk reinforced the notion that monetary policy would stay accommodative, and, indeed, judging from market quotes on federal funds futures, market participants anticipated further easing. Mortgage rates followed Treasury yields lower, precipitating a huge surge of mortgage refinancing. To offset the decline in the duration of their portfolios stemming from the jump in prepayments, mortgage investors reportedly bought large quantities of longer-dated Treasuries, amplifying the fall in yields. Interest rates on corporate bonds also declined in the first half of the year, prompting many firms to issue long-term debt to pay down other, more expensive forms of debt and build up cash assets. Growing confidence that the frequency and severity of corporate accounting scandals were waning likely contributed to the narrowing in risk spreads. By the end of spring, default rates on corporate bonds had begun to decline, and corporate credit quality appeared to stabilize.

Interest rates on selected Treasury securities. By percent. Line chart. There are three series (Ten-year, Two-year, and Three-month). Date range is 2001-2003. All series start in early 2000. Ten-year begins at about 6 percent. It decreases to about 4.3 percent in Q4 2001. Then it increases to about 5.4 percent in Q1 2002. Then it decreases to end at about 4.2 percent. Two-year begins at about 5 percent. Then it decreases to about 2.3 percent in Q4 2001. In Q1 2002 it increases to about 3.5 percent, then decreases to end at about 1.8 percent. Three-month begins at about 5.8 percent, then it decreases to about 1.6 percent in Q1 2002, then it decreases and ends at about 1 percent. NOTE: The data are daily and extend through February 4, 2004.

Implied volatility of short-term interest rates. By basis points. Line chart. Date range is 1997-2004. The series begins at about 290 in early 1997. From 1997 to 2001 it fluctuates within the range of about 200 and about 350. Then it decreases to and at about 125. NOTE: The data are daily and extend through February 4, 2004. The series shown is the implied volatility of the three-month Eurodollar rate over the coming four month, as calculated from option prices.

By the time of the June FOMC meeting, federal funds futures data implied that market participants had generally come to expect an aggressive reduction in the target federal funds rate, so the Committee’s decision to lower the target rate by only 25 basis points came as a surprise to some. In addition, some investors were reportedly disappointed that the statement following this meeting included no mention of "unconventional" monetary policy actions that would be aimed at lowering longer-term yields more directly than through changes in the federal funds rate target alone. As a result, market interest rates backed up, with the move probably amplified by the unwinding of mortgage-related hedging activity. The Chairman's monetary policy testimony in July, and the FOMC's statements at subsequent meetings that noted that policy could remain accommodative for "a considerable period," apparently provided an anchor for the front end of the yield curve. At the same time, increasingly positive economic reports bolstered confidence in the markets, and longer-dated Treasury securities ended the year about 40 basis points above their year-earlier levels. But, with the expansion evidently gaining traction and investors becoming more willing to take on risk, corporate risk spreads, particularly those on speculative-grade issues, continued to fall over the second half of the year. Treasury yields fell early in 2004, largely in response to the weaker-than-expected December labor market report. After the release of the Committee's statement following its January meeting, Treasury yields backed up a bit as futures market prices implied an expectation of an earlier onset of tightening than had been previously anticipated.

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 2001to 2004. High yield begins at about 8 percent in early 2001. Then it generally increases to about 8.8 percent by the end of Q4 2001. Then it decreases to about 6.2 percent in Q2 2002. In Q4 2002 it increases to about 9.9 percent. Then it decreases and ends at about 3.8 percent. BBB begins at about 2.2 percent. Then it increases to about 3.2 percent in Q4 2002 and then it decreases and ends at about 1 percent. AA begins at about 1.1 percent and during Q2 2000–Q2 2002 increases and ends at about 0.3 percent. NOTE: The data are daily and extend through February 4, 2004. The spreads compare the yields on the Merrill Lynch AA, BBB. And 175 high yield indexes with the yield on the ten-year off-the-run Treasury note.

Equity Markets

Broad equity price indexes ended the year 25 percent to 30 percent higher. Early in the year, stock prices were buffeted by mixed news about the pace of economic expansion and by heightened geopolitical tensions. Rising oil prices boosted the shares of energy companies very early in the year while, by and large, stocks in other sectors were stumbling. By spring, however, positive news on corporate earnings--often exceeding expectations--and easing of geopolitical tensions associated with the initiation of military action in Iraq boosted equity prices significantly. Subsequently, the swift end to major combat operations in Iraq caused implied volatility on the S&P 500 index to fall substantially. Over the rest of the year, increasingly positive earnings results contributed to a sustained rally in stock prices, and implied volatility in equity markets fell further. Corporate scandals--albeit on a smaller scale than in previous years--continued to emerge in 2003, but these revelations appeared to leave little lasting imprint on broad measures of stock prices. For the year as a whole, the Russell 2000 index of small-cap stocks and the technology-laden Nasdaq composite index, which rose 45 percent and 50 percent, respectively, noticeably outpaced broader indexes. To date in 2004, equity markets have continued to rally.

Major stock price indexes. Week of January 2, 2002 = 100. There are two series (Wilshire 5000 and Russell 2000). Date range is 2002-2004. Both series generally move together with Wilshire 5000 being lower. They start in early 2002 at about 100. Then they decrease to about 68 in Q4 2002. In Q2 2003 they split and increase to end. Russell 2000 ends at about 117. Wilshire 5000 ends at about 103. NOTE: The data are daily and extend through February 4, 2004.

Implied S&P 500 volatility. By percent. Line chart. Date range is 1997-2004. Series begins at about 19 percent in early 1997, then it generally increases to about 43 percent by the end of 1997. In the middle of 1998 it decreases to about 12 percent, then generally increases to about 42 percent. From 1999-2001 it fluctuates within the range of about 12 and about 30 percent. In 2002 it generally increases to about 42 percent and then it decreases and ends at about 15 percent. NOTE: The data are daily and extend through February 4, 2004. The series shown is the implied volatility of the S&P 500 stock price index as calculated from the prices of options that expire over the next several months. SOURCE: Chicago Board Options Exchange.

With the sustained rise in stock prices, the ratio of expected year-ahead earnings to stock prices for firms in the S&P 500 edged down over 2003. The gap between this ratio and the real ten-year Treasury yield--a crude measure of the equity risk premium--narrowed a bit over the course of the year, though it remains in the upper part of the range observed over the past two decades.

S&P 500 forward earnings–price ratio and the real interest rate. Line chart. By percent. There are two lines (S&P 500 earnings–price ratio and Real interest rate). Date range is 1990-2003. Both lines start in early 1990. S&P 500 earnings–price ratio begins at about 8.5 percent, then it increases to about 9.8 percent in 1990. Then it decreases to about 6.3 percent in 1993. Then it increases to about 8.3 percent in 1995. It then decreases to about 4 percent in 2000. In 2003 it ends at about 5.9 percent. Real interest rate begins at about 4.2 percent. From 1991-2000 it fluctuates within the range of about 4.3 and about 1.9 percent. Then it decreases and ends at about 1.9 percent. NOTE: The data are monthly and extend through December 2003. The forward earnings–price ratio is based on I/B/E/S consensus estimates of earnings over the coming year. The real interest rate is estimated as the difference between the ten-year Treasury rate and the expected ten-year inflation rate reported in the survey by the Federal Reserve Bank of Philadelphia.

Debt and Financial Intermediation

Aggregate debt of the domestic nonfinancial sectors is estimated to have increased about 8-1/4 percent in 2003, just over a percentage point faster than in 2002. Federal debt accelerated sharply, rising 11 percent, owing to the larger budget deficit. Household debt rose almost as rapidly, and the increase in state and local government debt also was substantial. In contrast, business borrowing remained subdued last year.

Change in domestic nonfinancial debt. By percent. Line chart. There are three lines (Total, Nonfederal, and Federal, held by public). Date range is 1988-2003. Total begins at about 9 percent in 1989, it then generally decreases to about 4.2 percent in 1991. From 1991 to 1998 it increases to about 7 percent, then in 2000 it decreases to about 5 and it ends at about 8.7 percent. Nonfederal begins at about 9 percent, then it decreases to about 3 percent in 1991. From 1992 to 1998 it increases to about 9 percent. Then it decreases to end at about 8 percent. Federal, held by public begins at about 8 percent, then it increases to about 11 percent in 1992. From 1993 to 2000 it generally decreases to about negative 8 percent. Then it generally increases and ends at about 11 percent. NOTE: For 2003, change is from 2002:Q4 to 2003: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.

In the business sector, investment spending, particularly in the beginning of the year, was mainly financed with internal funds, limiting, though not eliminating, businesses’ need to increase debt. With long-term rates falling through midyear and credit spreads--especially for riskier borrowers--narrowing, corporate treasurers shifted their debt issuance toward bond financing and away from shorter-term debt. Household borrowing also shifted in response to lower longer-term rates. Mortgage rates followed Treasury rates lower in the spring, and mortgage originations for both home purchases and refinancings surged. Refinancing activity appears to have held down growth of consumer credit as households extracted equity from their homes and used the proceeds, in part, to pay down higher-cost consumer debt. Nevertheless, consumer credit posted a moderate advance in 2003, buoyed by heavy spending on autos and other durables. A substantial widening of the federal deficit forced the Treasury to increase its borrowing significantly. To facilitate the pickup in borrowing, the Treasury altered its auction cycle to increase the frequency of certain issues and reintroduced the three-year note.

Depository credit rose 6 percent in 2003 and was driven by mortgage lending and the acquisition of mortgage-backed securities by both banks and thrift institutions. Consumer lending also was substantial, as lower interest rates and auto incentives spurred spending on durable goods. In contrast, business loans fell 7-1/4 percent over 2003, a drop similar to the runoff in 2002. Survey evidence suggests that the decline in business lending at banks was primarily the result of decreased demand for these loans, with respondent banks often citing weak investment and inventory spending. Moreover, the contraction was concentrated at large banks, whose customers tend to be larger corporations that have access to bond markets, and the proceeds of bond issuance were apparently used, in part, to pay down bank loans. The January 2004 Senior Loan Officer Opinion Survey reported a pickup in business loan demand arising mainly from increased spending on plant and equipment and on inventories. Supply conditions apparently played a secondary role in the weakness in business loans in 2003. Banks tightened standards and terms on business loans somewhat in the first half of the year, but by year-end they had begun to ease terms and standards considerably, in part because of reduced concern about the economic outlook.

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 1990-2004. Series begins at about 59 percent, then it generally decreases to about negative 20 percent. From 1994-1998 it increases to about 38 percent, then it decreases to about 6 percent in 1999. In 2001 it generally increases to about 60 percent, then it generally decreases and ends at about negative 20 percent. NOTE: The data are based on a survey generally conducted four times per year; the last reading is from the January 2004 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.

Delinquency rates on selected types of loans at banks. By percent. Line chart. There are three lines (Commercial and industrial, Consumer and Residential real estate). Date range is 1991-2003. Commercial and industrial begins at about 6 percent, then it decreases to about 1.6 percent in 1998. In 2002 it increases to about 4 percent, then generally decreases and ends at about 2.3 percent. Residential real estate begins at about 3.2 percent, during 1992-2002 it decreases and ends at about 2 percent. Consumer begins at about 4 percent, then it decreases to about 2.8 percent in 1994. During 1995-2002 it increases to end at about 3.2 percent. NOTE: The data, from bank Call Reports, are quarterly, seasonally adjusted, and extend through 2003:Q4.

The M2 Monetary Aggregate

M2 increased 5-1/4 percent in 2003, a pace somewhat slower than in 2002 and a bit below the rate of expansion of nominal income. The deceleration in M2 largely reflected a considerable contraction in the final quarter of the year after three quarters of rapid growth. The robust growth in money around midyear was concentrated in liquid deposits and likely resulted in large part from the wave of mortgage refinancings, which tend to boost M2 as the proceeds are temporarily placed in non-interest-bearing accounts pending disbursement to the holders of mortgage-backed securities. Moreover, around the middle of the year, the equity that was extracted from home values during refinancings probably provided an additional boost to deposits for a time, as households temporarily parked these funds in M2 accounts before paying down other debt or spending them. In the fourth quarter, M2 contracted at an annual rate of 2 percent, the largest quarterly decline since consistent data collection began in 1959. As mortgage rates backed up and the pace of refinancing slowed, the funds that had been swelling deposits flowed out, depressing M2. The sustained rally in equity markets after the first quarter of the year may also have slowed M2 growth, as expectations of continued higher returns led households to shift funds from M2 assets to equities, a view reinforced by the strong flows into equity mutual funds.

M2 growth rate. By percent. Bar chart. Date range is 1990-2003. M2 growth rate begins at about 4.1. It decreases to about 0.5 percent in 1994. Then it increases to about 8.8 percent in 1998. It decreases to about 6.2 by 2000. Then it increases to about 10.2 percent and ends at about 5.3 percent in 2003. NOTE: 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.

M2 velocity and opportunity cost. Line chart with two lines (M2 velocity and M2 opportunity cost). Date range is 1993-2003. M2 velocity (Ratio, ratio scale). Series begins at about 1.9 in early 1993, then it increases to about 2.1 in 1997. Then it decreases to end at about 1.9. M2 opportunity cost (percentage points, ratio scale) begins at about 0.7 percent, then it increases to about 3 percent in early 1995. During 1995-early 2001 it fluctuates within the range of about 1.9 and about 3 percent. In 2001 it generally decreases to end at about 0.2 percent. NOTE: The data are quarterly and extend through 2003:Q4. The velocity of M2 is the ratio of nominal gross domestic product to the stock of M2. The opportunity cost of holding M2 is a two-quarter moving average of the difference between the three-month Treasury bill rate and the weighted average return on assets included in M2.

Mortgage refinancing application index. March 16, 1990 = 100. Line chat. Date range is 1993-2004. Series begins at about 500 in early 1993. From 1994 to 2001 it fluctuates within the range of 0 and 3,000. In 2003 it generally increases to about 8,400 in 2002. Then it decreases and ends at about 2,200. NOTE: The data are monthly and extend through January 2004 market funds. SOURCE: Mortgage Bankers Association.

International Developments

Economic growth abroad rebounded in the second half of last year as factors that weighed on the global economy in the first half--including the SARS epidemic and uncertainty surrounding the war in Iraq--dissipated. Foreign growth also was boosted by the strong rebound in the U.S. economy, the revival of the global high-tech sector, and, in many countries, ample policy stimulus.

Strong second-half growth in China stimulated activity in other emerging Asian economies and Japan by raising the demand for their exports. Growth in Japan also was spurred by a recovery in private spending there on capital goods. Economic activity in Europe picked up in the second half, as export growth resumed. Economic growth in Latin America has been less robust; the Mexican economic upturn has lagged that of the United States, and Brazil's economy has only recently begun to recover from the effects of its 2002 financial crisis.

Monetary authorities abroad generally eased their policies during the first half of 2003 as economic activity stagnated. In the second half, market participants began to build in expectations of eventual monetary tightening abroad, and official interest rates were raised by year-end in the United Kingdom and Australia. Canadian monetary policy followed a different pattern; the Bank of Canada raised official interest rates in the spring as inflation moved well above its 1 percent to 3 percent target range but cut rates later in the year and again early this year as slack emerged and inflation moderated. Similarly, lower inflation in Mexico and Brazil allowed authorities to ease monetary policy during 2003. The Bank of Japan maintained official interest rates near zero and continued to increase the monetary base.

Official interest rates in selected foreign industrial countries. By percent. Line chart. There are four lines (United Kingdom, Euro area, Canada, and Japan). Date range is 2001-2004. United Kingdom begins at about 6 percent, then it decreases to about 4 percent in Q4 2001. During 2002-2004 it fluctuates but stays at about 4 percent by the end. Euro area begins at about 5.6 percent. In Q4 2001 it decreases to about 3.2 percent. During 2002 it stays at about 3.2 percent. Then it decreases and ends at about 2 percent. 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 and ends at about 2.5 percent. Japan begins at about 0.2 percent, then it decreases to 0 percent in Q2 2001. Series begins at about 0 percent by the end. NOTE: The data are as of month-end; the last observations are for February 5, 2004, when the Bank of England raised its official rate. 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.

In foreign financial markets, equity prices fell, on average, until mid-March but since then have risen in reaction to indications of stronger-than-expected global economic activity. Emerging-market equity indexes outpaced those in the industrial countries in 2003, with markets in Latin America posting particularly strong gains. Around midyear, long-term interest rates declined to multiyear lows in many countries as economic growth slowed and inflationary pressures diminished, but those rates moved higher in the second half as growth prospects improved. Bond spreads came down substantially during the year, both for industrial-country corporate debt and for emerging- market sovereign debt; spreads of the J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. Treasury securities fell to their lowest levels since before the Russian crisis of 1998. Gross capital flows to emerging markets, however, remained well below their 1997 peak.

Equity indexes in selected foreign industrial countries. Line chart. Week ending January 5, 2001 = 100. There are four series (Japan, Canada, Euro area, and United Kingdom). Date range is 2001 to 2004. All series start at about 100 in early 2001. Japan increases to about 110 in Q2 2001. Then it decreases to about 72 in Q1 2002. In the middle of 2002 it increases to 84, then it decreases to about 62 in Q2 2003. It ends at about 82. Canada decreases to about 80 in Q3 2001. In early 2002 it increases to about 90, it then decreases to about 67 in the middle of 2002. It then increases and ends at about 100. Euro area decreases to about 57 in Q1 2003. Then it increases and ends to about 77. United Kingdom decreases to about 59 in Q2 2003, then it increases and ends at about 76. NOTE: The data are weekly. The last observations are the average of trading days through February 4, 2004.

Equity indexes in selected emerging markets. Line chart. Week ending January 5, 2001 = 100. There are four series (Asian emerging markets, Mexico, Argentina, and Brazil). Date range is 2001 to 2004. All series start in early 2001 at about 100. Mexico increases to about 130 in Q2 2002. Then it decreases to about 100 in Q1 2003. It increases and ends at about 170. Argentina decreases to about 50 in Q4 2001, then it increases to about 110 in Q1 2002. In Q2 2002 it decreases to about 70 and then increases and ends at about 255. Asian emerging markets fluctuates within the range of 75 and 110 until Q2 2003, then it increases and ends at about 125. Brazil decreases to about 50 in Q4 2002, then it increases and ends at about 145. NOTE: The data are weekly. The last observations are the average of trading days through February 4, 2004. Asian emerging markets are China, Hong Kong, India, Indonesia, Malaysia, Pakistan, the Philippines, Singapore, South Korea, Taiwan, and Thailand.

The foreign exchange value of the dollar continued to decline last year as concerns over the financing of the large and growing U.S. current account deficit took on greater prominence. The dollar declined 18 percent against the Canadian dollar, 17 percent against the euro, and 10 percent against the British pound and the Japanese yen. In contrast, the value of the dollar was little changed, on net, against the currencies of our other important trading partners, in part because officials of China and of some other emerging Asian economies managed their exchange rates so as to maintain stability in terms of the dollar. Among Latin American currencies, the dollar declined against the Brazilian and Argentine currencies but appreciated against the Mexican peso. On balance, the dollar depreciated 9 percent during 2003 on a trade-weighted basis against the currencies of a broad group of U.S. trading partners.

U.S. dollar nominal exchange rate, broad index. Line chart. January 2000 = 100. Date range is 2000 to 2004. Series begins at about 100, then it generally increases to about 112.5 in Q1 2002. Then it generally decreases and ends at about 99. NOTE: The data are monthly and are in foreign currency units per dollar. The last observation is the average of trading days through February 4, 2004. 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. Week ending January 5, 2001 = 100. Line chart with four lines (Japanese yen, Euro, Canadian dollar, and U.K. pound). Date range is 2001-2004. All series start at about 100 in early 2001. Japanese yen increases to about 117 in Q1 2002, then it decreases to about 101 in Q3 2002. From Q3 2002 to Q2 2003 it fluctuates within the range of about 102 and about 108. Then it decreases and ends at about 92. Euro increases to about 112 in the middle of 2001, then it decreases to about 102 in Q3 2001. In Q1 2002 it increases to about 110 and generally decreases and ends at about 75. Canadian dollar fluctuates within the range of about 107 and about 102 from 2000-2002. Then it decreases and ends at about 92. U.K. pound fluctuates within the range of about 106 and about 100 from 2001 to Q2 2002, then decreases and ends at about 82. NOTE: The data are weekly and are in foreign currency units per dollar. Last observations are the average of trading days through February 4, 2004.

Industrial Economies

The euro-area economy contracted in the first half of 2003, weighed down in part by geopolitical uncertainty and higher oil prices. In the second half, economic activity in the euro area began to grow as the global pickup in activity spurred a recovery of euro-area exports despite the continued appreciation of the euro. The monetary policy of the European Central Bank (ECB) was supportive of growth, with the policy interest rate lowered to 2 percent by midyear. Consumer price inflation slowed to around 2 percent, the upper limit of the ECB’s definition of price stability. Despite increased economic slack, inflation moved down only a little, partly because the summer drought boosted food prices. For the second straight year, the governments of Germany and France each recorded budget deficits in excess of the 3 percent deficit-to-GDP limit specified by the Stability and Growth Pact. However, in light of economic conditions, European Union finance ministers chose not to impose sanctions.

After a sluggish first quarter, the U.K. economy expanded at a solid pace for the remainder of 2003, supported by robust consumption spending and considerable government expenditure. The Bank of England cut rates in the first half of the year but reversed some of that easing later in the year and early this year as the economy picked up and housing prices continued to rise at a rapid, albeit slower, pace. In June, the British government announced its assessment that conditions still were not right for the United Kingdom to adopt the euro. In December, the British government changed the inflation measure to be targeted by the Bank of England from the retail prices index excluding mortgage interest (RPIX) to the consumer prices index. U.K. inflation currently is well below the objective of 2 percent on the new target index.

The Canadian economy contracted in the second quarter owing to the impact of the SARS outbreak in Toronto on travel and tourism, but it rebounded in the latter half of the year. Canadian economic growth continued to be led by strong domestic demand; consumption remained robust and investment spending accelerated, offsetting the negative effect of Canadian dollar appreciation on both exports and import-competing industries. Canadian consumer price inflation swung widely last year, rising to 4-1/2 percent on a twelve-month basis in February before falling to 1-1/2 percent in November and ending the year at 2 percent. The swing partly reflected movements in energy prices, but changes in auto insurance premiums and cigarette taxes also played an important role.

Japanese real GDP recorded significant growth in 2003 for the second straight year. Private investment spending made the largest contribution to the expansion. Consumer spending remained sluggish as labor market conditions continued to be soft. However, nominal wages stabilized following a sharp drop in 2002, and leading indicators of employment moved higher. Despite an appreciation of the yen late in the year, Japanese exports posted a strong increase in 2003 primarily because of gains in exports to China and other emerging Asian economies. With consumer prices continuing to decline, the Bank of Japan (BOJ) maintained its policy interest rate near zero and eased monetary policy several times during 2003 by increasing the target range for the outstanding balance of reserve accounts held by private financial institutions at the BOJ. The BOJ also took other initiatives last year to support the Japanese economy, including launching a program to purchase securities backed by the assets of small- and medium-sized enterprises. Japanese banks continued to be weighed down by large amounts of bad debt, but some progress was made in resolving problems of insufficient bank capital and in reducing bad-debt levels from their previous-year highs.

Emerging-Market Economies

Growth in the Asian developing economies rebounded sharply in the second half of 2003 after having contracted in the first half. The outbreak of SARS in China and its spread to other Asian economies was the primary factor depressing growth in the first half, and the subsequent recovery of retail sales and tourism after the epidemic was contained was an important factor in the sharp rebound. The pattern of Asian growth also reflected the sharp recovery of the global high-tech sector in the second half after a prolonged period of weakness. Exports continued to be the main engine of growth for the region. However, domestic demand contributed importantly to growth in China, where state-sector investment increased at a rapid clip and a boom in construction activity continued. Supply problems caused food prices and overall consumer prices in China to rise on a twelve-month basis last year, following a period of price deflation during the previous year. In addition, concerns emerged that some sectors of the Chinese economy, particularly the property markets in Beijing and Shanghai, may be overheating.

Korean economic growth turned negative in the first half, as the high level of household debt, labor unrest, and concerns over North Korea's nuclear development depressed private-sector spending. A sharp rise in exports spurred a revival of growth in the second half even as domestic demand remained subdued.

U.S. dollar exchange rates and bond spreads for selected emerging markets. Exchange rates. Week ending January 5, 2001 = 100. Line chart with four lines (Argentine peso, Mexican peso, Korean won, and Brazilian real). Date range is 2001-2004. All series start in early 2001. Mexican peso, Korean won, and Brazilian real start at about 100. Argentine peso starts at about 100. It stays at about 90 during 2001, then it generally increases to about 370 in the middle of 2002. Then decreases to end at about 290. Mexican peso fluctuates between about 90 and about 120 from 2001 to 2003. It ends at about 120. Korean won fluctuates between about 110 and about 90 from 2001 to 2003. It ends at about 90.Brazilian real increases to about 140 in Q4 2001. Then it decreases to about 120 in Q2 2002. Then it increases to about 190 in Q4 2002. Then it decreases to end at about 150. U.S. dollar exchange rates and bond spreads for selected emerging markets. Bond spreads. Percentage points. Line chart. There are three lines (Brazil, Argentina and Mexico). Date range is 2001-2003. All series start in early 2001.Brazil begins at about 7.5 percent, then it increases to about 12 percent in Q4 2001. In Q2 2002 it decreases to about 7 percent. In the first half of 2002 it generally increases to about 22.5, then generally decreases and ends at about 5 percent. Argentina begins at about 8 percent, then generally increases to about 72 percent in Q2 2002. Then it fluctuates within the range of about 70 percent and about 50 percent from Q3 2002 to Q4 2003. It ends at about 59 percent. Mexico begins at about 4 percent, then it fluctuates within the range of about 4.25 and about 2.2 percent from 2001 to 2003. It ends at about 2 percent. NOTE: The data are weekly averages. Last observations are the average of trading days through February 4, 2004. Exchange rates (top panel) are in foreign currency units per dollar. Bond spreads (bottom panel) are the spreads of the J.P. Morgan Emerging Market Bond Index (EMBI+) over U.S. Treasury securities.

The Mexican economy remained sluggish through much of the year but recently has shown some signs of improvement. After lagging the rise in U.S. production, Mexican industrial production posted strong gains in October and November, although it remains well below the peak it reached in 2000. Exports rose late last year to almost the peak they had reached in 2000. Consumer price inflation came down over the course of 2003 to 4 percent, the upper bound of the 2 percent to 4 percent target range. The Bank of Mexico has left policy unchanged since tightening five times between September 2002 and March 2003, but market interest rates have fallen owing to weakness in economic activity.

The Brazilian economy contracted in the first half of 2003 partly as a result of the 2002 financial crisis and the consequent monetary policy tightening. It then expanded moderately in the second half, boosted by strong export growth and a recovery in investment spending. Brazilian financial indicators improved significantly in 2003, in part because the Brazilian government began to run a substantial primary budget surplus and to reform the public-sector pension system. The Brazilian stock market soared nearly 100 percent last year, and Brazil's EMBI+ bond spread narrowed by nearly two-thirds. As the Brazilian currency stabilized and began to appreciate, Brazil's inflation outlook improved, allowing the central bank to reverse fully its earlier rate hikes and to reduce the overnight interest rate to a multiyear low, although real interest rates remained high.

The Argentine economy rebounded in 2003 from the sharp contraction that occurred in the wake of its financial crisis in 2001–02. Still, economic activity remains far below pre-crisis levels, and many of Argentina’s structural problems have not been addressed. With the government still in default to its bondholders, the country’s sovereign debt continued to carry a very low credit rating, and its EMBI+ spread remained extremely high. Even so, the Argentine peso appreciated on balance in 2003, and the Merval stock index nearly doubled over the course of the year.

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Last update: February 13, 2004