Board of Governors of the Federal Reserve System

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

Letter of Transmittal

Board of Governors of the
Federal Reserve System
Washington, D.C., February 11, 2004

The President of the Senate
The Speaker of the House of Representatives

The Board of Governors is pleased to submit its Monetary Policy Report 
to the Congress pursuant to section 2B of the Federal Reserve Act.

Sincerely,
Alan Greenspan, Chairman

SECTION 1

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


Monetary Policy and the Economic Outlook

The economic expansion in the United States gathered strength during 
2003 while price inflation remained quite low. At the beginning of the 
year, uncertainties about the economic outlook and about the prospects 
of war in Iraq apparently weighed on spending decisions and extended 
the period of subpar economic performance that had begun more than two 
years earlier. However, with the support of stimulative monetary and 
fiscal policies, the nation’s economy weathered that period of 
heightened uncertainty to post a marked acceleration in economic 
activity over the second half of 2003. Still, slack in resource 
utilization remained substantial, unit labor costs continued to decline 
as productivity surged, and core inflation moved lower. The performance 
of the economy last year further bolstered the case that the faster 
rate of increase in productivity, which began to emerge in the late 
1990s, would persist. The combination of that favorable productivity 
trend and stimulative macroeconomic policies is likely to sustain 
robust economic expansion and low inflation in 2004.        

At the time of our last Monetary Policy Report to the Congress, in 
July, near-term prospects for U.S. economic activity remained unclear. 
Although the Federal Open Market Committee (FOMC) believed that policy 
stimulus and rapid gains in productivity would eventually lead to a 
pickup in the pace of the expansion, the timing and extent of the 
improvement were uncertain. During the spring, the rally that occurred 
in equity markets when the war-related uncertainties lifted suggested 
that market participants viewed the economic outlook as generally 
positive. By then, the restraints imparted by the earlier sharp decline 
in equity prices, the retrenchment in capital spending, and lapses in 
corporate governance were receding. As the price of crude oil dropped 
back and consumer confidence rebounded last spring, household spending 
seemed to be rising once again at a moderate rate. Businesses, however, 
remained cautious; although the deterioration in the labor market 
showed signs of abating, private payroll employment was still 
declining, and capital spending continued to be weak. In addition, 
economic activity abroad gave few signs of bouncing back, even though 
long-term interest rates in major foreign economies had declined 
sharply. At its June meeting, the FOMC provided additional policy 
accommodation, given that, as yet, it had seen no clear evidence of an 
acceleration of U.S. economic activity and faced the possibility that 
inflation might fall further from an already low level.

During the next several months, evidence was accumulating that the 
economy was strengthening. The improvement was initially most apparent 
in financial markets, where prospects for stronger economic activity 
and corporate earnings gave a further lift to equity prices. Interest 
rates rose as well, but financial conditions appeared to remain, on 
net, stimulative to spending, and additional impetus from the midyear 
changes in federal taxes was in train. Over the remainder of the year, 
in the absence of new shocks to economic activity and with gathering 
confidence in the durability of the economic expansion, the stimulus 
from monetary and fiscal policies showed through more readily in an 
improvement in domestic demand. Consumer spending and residential 
construction, which had provided solid support for the expansion over 
the preceding two years, rose more rapidly, and business investment 
revived. Spurred by the global recovery in the high-tech sector and by 
a pickup in economic activity abroad, U.S. exports also posted solid 
increases in the second half of the year. Businesses began to add to 
their payrolls, but only at a modest pace that implied additional 
sizable gains in productivity. 

The fundamental factors underlying the strengthening of economic 
activity during the second half of 2003 should continue to promote 
brisk expansion in 2004. Monetary policy remains accommodative. 
Financial conditions for businesses are quite favorable: Profits have 
been rising rapidly, and corporate borrowing costs are at low levels. 
In the household sector, last year’s rise in the value of equities and 
real estate exceeded the further accumulation of debt by enough to 
raise the ratio of household net worth to disposable income after three 
consecutive years of decline. In addition, federal spending and tax 
policies are slated to remain stimulative during the current fiscal 
year, while the restraint from the state and local sector should 
diminish. Lastly, the lower foreign exchange value of the dollar and a 
sustained economic expansion among our trading partners are likely to 
boost the demand for U.S. production. Considerable uncertainty, of 
course, still attends the economic outlook despite these generally 
favorable fundamentals. In particular, questions remain as to how 
willing businesses will be to spend and hire and how durable will be 
the pickup in economic growth among our trading partners. At its 
meeting on January 27–28, 2004, the Committee perceived that upside and 
downside risks to the attainment of sustainable growth for the next few 
quarters are roughly equal. 

Prospects for sustained high rates of increase in productivity are 
quite favorable. Businesses are likely to retain their focus on 
controlling costs and boosting efficiency by making organizational 
improvements and exploiting investments in new equipment. With the 
ongoing gains in productivity, the existing margins of slack in 
resource utilization should recede gradually, and any upward pressure 
on prices should remain well contained. The FOMC indicated at its 
January meeting that, with inflation low and resource use still slack, 
it can be patient in removing its policy accommodation.  


SECTION 2


Monetary Policy, Financial Markets, and the Economy over 2003 and Early 
2004

During the opening months of 2003, the softness in economic conditions 
was exacerbated by the substantial uncertainty surrounding the onset of 
war in Iraq. Private nonfarm businesses began again to cut payrolls 
substantially, consumer spending slowed, and business investment was 
muted. Although the jump in energy prices pushed up overall inflation, 
slack in resource utilization and the rapid rise in labor productivity 
pushed core inflation down. In financial markets, the heightened sense 
of caution among investors generated safe-haven demands for Treasury 
and other fixed-income securities, and equity prices declined.

At its meeting on March 18, the FOMC maintained its 1-1/4 percent 
target for the federal funds rate to provide support for a stronger 
economic expansion that appeared likely to materialize. The Committee 
noted that the prevailing high degree of geopolitical uncertainty 
complicated any assessment of prospects for the economy, and members 
refrained from making a determination about the balance of risks with 
regard to its goals of maximum employment and stable prices. At the 
same time, the Committee agreed to step up its surveillance of the 
economy, which took the form of a series of conference calls in late 
March and early April to consult about developments. When military 
action in Iraq became a certainty, financial markets began to rally, 
with risk spreads on corporate debt securities narrowing and broad 
equity indexes registering notable gains. Economic news, however, 
remained mixed.

Indicators of the economy at the time of the May 6 FOMC meeting 
continued to suggest only tepid growth. Uncertainty in financial 
markets had declined, and rising consumer confidence and a wave of 
mortgage refinancing appeared to be supporting consumer spending. 
However, persistent excess capacity evident in labor and product 
markets pointed to possible further disinflation. The lifting of some 
of the uncertainty clouding the economic outlook allowed the Committee 
to make the determination that the risks to economic growth were 
balanced but that the probability of an unwelcome substantial 
fall in inflation exceeded that of a pickup in inflation. The FOMC 
judged that, taken together, the balance of risks was weighted toward 
weakness. The Committee left the federal funds rate target at 1-1/4 
percent, but the Committee’s announcement prompted a rally in the 
Treasury market, and coupon yields fell substantially as market 
participants marked down their expectations for the path of the federal 
funds rate. 

By the time of the June 24–25 FOMC meeting, risk spreads had narrowed 
further and equity prices had extended their rise, but the prospects 
for sustained economic expansion still seemed tentative. Although 
Committee members referred to signs of improvement in some sectors of 
the economy, they saw no concrete evidence of an appreciable overall 
strengthening in the economic expansion and viewed the excess capacity 
in the economy as likely to keep inflation in check. The Committee 
lowered the target for the federal funds rate 1/4 percentage point, to 
1 percent, to add further support to the economic expansion and as a 
form of insurance against a further substantial drop in inflation, 
however unlikely. The members saw no serious obstacles to further 
conventional policy ease down to the zero lower bound on nominal 
interest rates should that prove to be necessary. The Committee also 
discussed alternative means of providing monetary stimulus should the 
target federal funds rate be reduced to a point at which they would 
have little or no latitude for additional easing through this 
traditional channel.

Longer-term interest rates backed up following the meeting, as 
investors had apparently placed substantial odds on a policy move 
larger than 25 basis points and may have been disappointed that the 
announcement failed to mention any potential “unconventional” monetary 
policy options. Ten-year Treasury yields rose sharply during the 
following weeks in reaction to interpretations of the Chairman’s 
congressional testimony, the release of Committee members’ economic 
projections, and positive incoming news about the economy and corporate 
profits. A substantial unwinding of hedging positions related to 
mortgage investments may well have amplified the upswing in market 
yields. Over the intermeeting period, labor markets continued to be 
soft, but industrial production, personal consumption expenditures, and 
business outlays all strengthened, and the housing market remained 
robust. By the time of the August 12 FOMC meeting, members generally 
perceived a firming in the economy, most encouragingly in business 
investment spending, and believed that, even after the rise in longer-
term rates, financial conditions were still supportive of vigorous 
economic growth. Given the continued slack in resource use across the 
economy, however, members saw little risk of inducing higher inflation 
by leaving the federal funds rate at its accommodative level. On the 
basis of the economic outlook, and to reassure market participants that 
policy would not reverse course soon, Committee members decided to 
include in the announcement a reference to their judgment that under 
the anticipated circumstances, policy accommodation could be maintained 
for a “considerable period.” 

Through the September 16 and October 28 FOMC meetings, the brightening 
prospects for future growth put upward pressure on equity prices and 
longer-term interest rates. The Committee’s retention of the phrase 
“considerable period” in the announcements following each of these 
meetings apparently provided an anchor for near-term interest rates. 
The Committee’s discussion at these two meetings focused on the 
increased evidence of a broadly based acceleration in economic activity 
and on the continued weakness in labor markets. Rising industrial 
production, increased personal consumption and business investment 
spending, higher profits, receptive financial markets, and a lower 
foreign exchange value of the dollar all suggested that sustained and 
robust economic growth was in train. The Committee’s decision to leave 
the stance of monetary policy unchanged over this period reflected, in 
part, a continuing confidence that gains in productivity would support 
economic growth and suppress inflationary pressures. In fact, the 
Committee generally viewed its goal of price stability as essentially 
having been achieved. 

By the time of the December 9 FOMC meeting, the economic expansion 
appeared likely to continue at a rate sufficient to begin to reduce 
slack in labor and product markets. Equity markets continued to rally, 
and risk spreads, particularly on the debt of speculative-grade firms, 
narrowed further. The labor market was finally showing some signs of 
improvement, and spending by households remained strong even as the 
impetus from earlier mortgage refinancings and tax cuts began to wane. 
The acceleration in capital spending and evidence that some firms were 
beginning to accumulate inventories seemed to signal that business 
confidence was on the mend. However, twelve-month core consumer price 
inflation was noticeably lower than in the previous year. Even though 
the unemployment rate was expected to move down gradually, continued 
slack in labor and product markets over the near term was viewed as 
sufficient to keep any nascent inflation subdued. Uncertainty about the 
pace at which slack would be worked down, however, made longer-run 
prospects for inflationary pressures difficult to gauge. Given the 
better outlook for sustained economic growth, the possibility of 
pernicious deflation associated with a pronounced softening in real 
activity was seen as even more remote than it had been earlier in the 
year. The Committee indicated that keeping policy accommodative for a 
considerable period was contingent on its expectation that inflation 
would remain low and that resource use would remain slack.

At its meeting on January 27–28, 2004, the Committee viewed a self-
sustaining economic expansion as even more likely. Members drew 
particular reassurance from reports of plans for stronger capital 
spending and the widespread distribution of increased activity across 
regions. Accommodative financial market conditions, including higher 
equity prices, narrower risk spreads on bonds, and eased standards on 
business loans, also seemed supportive of economic expansion. However, 
some risks remained in light of continued lackluster hiring evidenced 
by the surprisingly weak December payroll employment report. With the 
likelihood for rapid productivity growth seemingly more assured, 
Committee members generally agreed that inflation pressures showed no 
sign of increasing and that a bit more disinflation was possible. Under 
these circumstances, the Committee concluded that current conditions 
allowed monetary policy to remain patient. As to the degree of policy 
accommodation, the Committee left its target for the federal funds rate 
unchanged. The Committee’s characterization that policy could be 
patient instead of its use of the phrase “considerable period” in its 
announcement prompted a rise in Treasury yields across the yield curve 
and a fall in equity prices.


Economic Projections for 2004

Federal Reserve policymakers expect that the economic expansion will 
continue at a brisk pace in 2004. The central tendency of the forecasts 
of the change in real gross domestic product made by the members of the 
Board of Governors and the Federal Reserve Bank presidents is 4-1/2  
percent to 5 percent, measured from the final quarter of 2003 to the 
final quarter of 2004. The full range of these forecasts is somewhat 
wider-—from 4 percent to 5-1/2 percent. The FOMC participants anticipate 
that the projected increase in real economic activity will be 
associated with a further gradual decline in the unemployment rate. 
They expect that the unemployment rate, which has averaged 5-3/4 
percent in recent months, will be between 5-1/4 percent and 5-1/2 
percent in the fourth quarter of the year. With rapid increases in 
productivity likely to be sustained and inflation expectations stable, 
Federal Reserve policymakers anticipate that inflation will remain 
quite low this year. The central tendency of their forecasts for the 
change in the chain-type price index for personal consumption 
expenditures (PCE) is 1 percent to 1-1/4 percent; this measure of 
inflation was 1.4 percent over the four quarters of 2003.


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. 

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.

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.

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. 

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.


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. 

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.

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. 

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. 


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.

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.

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.

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.

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.

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. 

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.


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.


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.

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.


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.

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.

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.

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.

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.

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. 

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.

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. 

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.

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.


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.

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.


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. 

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.


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.


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. 

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.

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.


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.

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.