Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress
Submitted pursuant to section 2B of the Federal Reserve Act

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 2005
     
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

Monetary Policy Report to the Congress

SECTION 1

Report submitted to the Congress on July 20, 2005, pursuant to section 2B of the Federal Reserve Act 

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The U.S. economy continued to expand at a solid pace over the first half of 2005 despite the restraint 
imposed on aggregate demand by a further rise in crude oil prices. Household spending trended up, 
propelled by rising wealth and income and by low interest rates, and business outlays received ongoing 
support from favorable  
financial conditions, rising sales, and increased profitability. Moreover, the earlier declines in the foreign 
exchange value of the dollar shifted some domestic and foreign demand toward U.S. producers. Overall, 
the economic expansion was sufficient to create jobs at roughly the same pace as in late 2004 and to lower 
the unemployment rate further over the first half of this year. 

Higher oil prices boosted retail prices of a broad range of consumer energy products and, as a result, 
continued to hold up the rate of overall consumer price inflation in the first half of 2005. In addition, the 
rise in energy prices this year, coupled with increases in the prices of some other commodities, imported 
goods, and industrial materials, put upward pressure on the costs of many businesses. A portion of these 
costs was passed on to consumers, which contributed to a higher rate of inflation in core consumer prices 
(that is, total prices excluding the food and energy components, which are volatile). As measured by the 
price index for personal consumption expenditures excluding food and energy, core inflation increased 
from an annual rate of 1-1/2 percent in 2004 to about 2 percent between the fourth quarter of 2004 and May 
2005. While survey measures of near-term inflation expectations have edged up this year, surveys, as well 
as readings from financial markets, suggest that expected inflation at longer horizons has remained 
contained. 

With financial conditions advantageous for households and firms, a solid economic expansion in train, and 
some upward pressure on inflation, the Federal Open Market Committee (FOMC) continued to remove 
policy accommodation at a measured pace over the first half of the year, raising the intended federal funds 
rate an additional 1 percentage point, to 3-1/4 percent, by the end of June. At the most recent FOMC 
meeting, the Committee judged that policy remained accommodative. With appropriate monetary policy, 
however, the upside and downside risks to output and inflation were viewed as balanced, and the 
Committee underscored its commitment to respond to changes in economic prospects as needed to fulfill its 
obligation to maintain price stability. 

The fundamental factors that supported the U.S. economy in the first half of 2005 should continue to do so 
over the remainder of 2005 and in 2006. In the household sector, the combination of further gains in 
employment, favorable borrowing terms, and generally healthy balance sheets should keep consumer 
spending and residential investment on an upward path. In the business sector, expanding sales, the low 
cost of capital, and the replacement or upgrade of aging equipment and software should help to maintain 
increases in capital spending. And, although economic performance has been uneven across countries, 
continued growth overall in the economies of U.S. trading partners should sustain the demand for U.S. 
exports. In contrast, ongoing increases in imports will likely continue to subtract from the growth of U.S. 
gross domestic product. In addition, high energy prices remain a drag on aggregate demand both here and 
abroad, though this drag should lessen over time if prices for crude oil level out in line with quotes in 
futures markets. 

Despite the upward pressure on costs and prices over the past year or so, core consumer price inflation is 
likely to remain contained in 2005 and 2006. Longer-run inflation expectations are still well anchored, and 
because businesses are adding to their stocks of capital and are continuing to find ways to use their capital 
and work forces more effectively, structural productivity will likely rise at a solid pace over the foreseeable 
future. In addition, barring a further increase in oil prices, the boost that higher energy costs have given to 
core inflation should wane in coming quarters, while the recent appreciation of the dollar, as well as the 
deceleration in global materials prices, will likely reduce the impetus to inflation from  rising import prices. 

Of course, substantial uncertainties surround this economic outlook. A further sharp rise in crude oil prices 
would have undesirable consequences for both economic activity and inflation, and the possibility that 
housing prices, at least in some locales, have moved above levels that can be supported by fundamentals 
remains a concern. As another example, if the recent surge in measured unit labor costs were to prove more 
persistent than currently appears likely, the outlook for inflation would be adversely affected. Economic 
growth and inflation will also be shaped importantly by the evolution of the imbalance in the U.S. current 
account.
The Conduct of Monetary Policy over the First Half of 2005
Despite increases in the federal funds rate totaling1-1/4 percentage points in 2004, monetary policy was 
still judged to be accommodative at the start of 2005. At the time of the February FOMC meeting, the 
available information indicated that the economy had expanded at a robust pace through the end of 2004 
and retained considerable momentum. Accordingly, the Committee voted to raise its target for the federal 
funds rate from 2-1/4 percent to 2-1/2 percent and to make minimal changes to the text of the 
accompanying statement. The statement reiterated that the Committee believes that policy accommodation 
can be removed at a pace that is likely to be measured. Members noted, however, that this forward-
looking language was clearly conditioned on economic developments and therefore would not stand in the 
way of either a pause or a step-up in policy firming depending on events.

By March, the data were pointing to a further solid gain in activity during the first quarter, fueled especially 
by continued increases in consumption expenditures and residential investment. In addition, private 
nonfarm payrolls were posting widespread advances, and slack in resource utilization appeared to be 
diminishing. The Committee voted at its March meeting to raise the federal funds rate another 25 basis 
points, to 2-3/4 percent. In view of the rise in prices of energy and other commodities and recent elevated 
readings on inflation in core consumer prices, the Committee altered the text of the policy statement to note 
the pickup in inflationary pressures. The Committee also decided to modify the assessment of the balance 
of risks to make it explicitly conditional on an assumption of appropriate monetary policy, so as to 
underscore that maintaining balanced risks would likely require continued removal of policy 
accommodation. 

The evidence that had accumulated by the spring pointed to some moderation in the pace of activity. Retail 
spending flattened out for a time, likely in response to higher energy prices, and the growth of capital 
spending dropped back from its elevated pace of late last year. Nonetheless, with long-term interest rates 
still quite low and with employment and profits continuing to rise, economic activity appeared to retain 
considerable momentum, suggesting that the softness would be short lived. Against this backdrop, the 
FOMC decided to raise the federal funds rate another 25 basis points at its May meeting and to make few 
changes to the text of the accompanying statement. 

In the weeks after the May meeting, incoming indicators supported the view that the underlying pace of 
activity was not faltering. The information that the Committee reviewed at the time of the June FOMC 
meeting showed that consumer spending and business investment had turned up, on balance, and that 
demand for housing  
continued to be strong. With economic activity remaining firm and crude oil prices ratcheting higher, the 
FOMC voted to raise the funds rate an additional 25 basis points, to 3-1/4 percent, and to make only 
minimal changes to the text of the accompanying statement. This action brought the cumulative increase in 
the target federal funds rate since June 2004 to 2-1/4 percentage points.

Economic Projections for 2005 and 2006

In conjunction with the FOMC meeting at the end of June, the members of the Board of Governors and the 
Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, were asked to 
provide economic projections for 2005 and 2006. In general, Federal Reserve policymakers expect the 
economy to continue to expand at a moderate pace and core inflation to remain roughly stable over this 
period. The central tendency of the FOMC participants forecasts for the increase in real (that is, inflation 
adjusted) GDP is 3-1/2 percent over the four quarters of 2005 and 3-1/4 percent to 3-1/2 percent in 2006. 
The civilian unemployment rate is expected to average 5 percent in both the fourth quarter of 2005 and the 
fourth quarter of 2006. FOMC participants project that the chain-type price index for personal consumption 
expenditures excluding food and energy will increase between 1-3/4 percent and 2 percent both this year 
and next.

SECTION 2

ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2005

The economic expansion entered 2005 on a solid footing and was led by ongoing increases in consumption, 
residential investment, and business spending on equipment and software. Although the pace of expansion 
slowed somewhat in the early spring, activity has picked up again more recently. On average, real GDP 
appears to have  
increased a little less rapidly over the first half of 2005 than in the second half of 2004, a reflection in part 
of reduced fiscal stimulus and the drag on economic activity from higher energy prices. Industrial 
production has also risen more slowly so far this year than in 2004: The increase totaled 3 percent at an 
annual rate between December 2004 and June 2005, down from 5 percent during the previous six months. 
Nevertheless, the economic expansion has been sufficient to gradually absorb slack in labor and product 
markets. Nonfarm payroll employment has continued to increase, and the unemployment rate has moved 
down further since the beginning of the year, to 5 percent in June. Similarly, the rate of capacity utilization 
in the manufacturing sector stood at 78.4 percent in June, up from 77.9 percent at the end of 2004 and just a 
little below its long-term historical average.

Rising energy prices continued to boost consumer price inflation in the first half of 2005. With consumer 
energy prices having climbed more than 13 percent at an annual rate so far this year, the price index for 
personal consumption expenditures (PCE) increased at an annual rate of about 2-1/2 percent between the 
fourth quarter of 2004 and May 2005, the same pace as in 2004. Meanwhile, the core PCE price index rose 
at an annual rate of about 2 percent in the first half of 2005, up from 1-1/2 percent in 2004. 

The Household Sector

Consumer Spending
Consumer spending continued to move higher in the first half of this year, though not as rapidly as in the 
second half of 2004. After increasing at an average annual rate of 4-1/2 percent in the third and fourth 
quarters of last year, real personal consumption expenditures rose at a 3-1/2 percent rate in the first quarter 
and appear to have advanced at a roughly similar pace in the second quarter. Household spending this year 
has been supported by rising employment and household wealth as well as by the low level of interest rates. 
However, higher costs for consumer energy products have eroded households purchasing power.

Sales of light motor vehicles, which had been buoyed in the second half of last year by a variety of sales 
inducements, dropped back in the first quarter after many of the inducements expired. However, sales 
firmed again in the second quarter to an average annual pace of more than 17 million units, a level similar 
to that in the fourth quarter of last year. Underlying demand for light motor vehicles has remained 
relatively strong, though sales likely have also been boosted recently by sizable price discounts.

Excluding motor vehicles, consumer spending posted strong gains in early 2005, flattened out in March, 
and picked up again in the spring. On a quarterly average basis, the rate of increase in non-auto spending 
appears to have stepped down in the second quarter, largely because of a deceleration in outlays for 
consumer goods. Meanwhile, real outlays for services rose at an annual rate of about 3 percent in the first 
quarter, and the available data point to an increase of about the same magnitude in the second  
quarter.

If the effect of Microsofts $32 billion special dividend payment in December 2004 is excluded from the 
calculation, real disposable personal income (that is, after-tax income adjusted for inflation) rose at an 
annual rate of about 2 percent between the fourth quarter of 2004 and May 2005, a slower pace than in 
2004. Although increases in employment and earnings pushed up wage and salary income over the first half 
of 2005, the rise in real income was damped to some degree by the energy-driven increase in consumer 
prices. Higher energy prices also appear to have weighed on consumer confidence for much of this year. 
Surveys by both the Michigan Survey Research Center (SRC) and the Conference Board indicate that 
household sentiment edged down through the early spring, though readings from these surveys turned up 
again more recently.

Household wealth appears to have increased a bit faster than nominal disposable income over the first half 
of this year; the small increase in the wealth-to-income ratio comes on the heels of substantial increases in 
2003 and 2004. Although stock prices have changed little, on net, thus far this year, home prices have 
continued to rise sharply. Because changes in wealth influence consumer spending with a lag, both the 
earlier and the more-recent increases in household net worth have supported consumption this year. As 
wealth increased and interest rates remained quite low, the personal saving rate edged down to just 1/2 
percent of disposable income in April and May. Over the previous two decades, the personal saving rate 
averaged close to 5 percent. 

Residential Investment

Activity in the housing market continued at a strong pace in the first half of 2005. Real expenditures on 
residential structures increased at an annual rate of 11-1/2 percent in the first quarter and appear to have 
posted another gain in the second quarter. In the single-family sector, starts of new units averaged 1.69 
million at an annual rate between January and Junenearly 4 percent above the pace posted over the 
second half of 2004. Similarly, starts of multifamily units averaged 360,000 over the first six months of 
2005, about 3-1/4 percent higher than in the previous six months.

As in 2004, the demand for housing during the first half of 2005 was supported by rising employment and 
income and by low mortgage rates. Rates on thirty-year fixed-rate mortgages have fluctuated between 5-1/2 
percent and 6 percent in recent months and are currently near the low end of that range. In addition, 
demand reportedly has been boosted by a rise in purchases of second homeseither as vacation units or as 
investmentsand by the greater availability of less-conventional financing instruments. These financing 
instruments, including interest-only mortgages and adjustable-rate mortgages that allow borrowers a degree 
of flexibility in the size of their monthly payments, have enabled some households to buy homes that would 
otherwise have been unaffordable. As a result, both new and existing home sales have remained remarkably 
robust this year, and both were at or near record levels in May.

The strong demand for housing has continued to push up home prices this year. Although rates of house 
price appreciation were a little slower in the first quarter of this year than in 2004, the repeat-transactions 
price index for existing homes (limited to purchase- 
transactions only), which is published by the Office of Federal Housing Enterprise Oversight and partially 
adjusts for changes in the quality of homes sold, was nonetheless up 10 percent relative to its year-earlier 
level. Price appreciation has been especially sharp over the past year in some large metropolitan areas, 
including Las Vegas, Miami, San Francisco, and New York, but rapid increases in home prices have been 
observed in other areas as well. In many of these locales, recent price increases have far exceeded the 
increases in rents and household incomes. 

Household Finance

Supported by rising house prices and continued economic expansion, household debt increased at an annual 
rate of about 9-1/4 percent in the first quarter of 2005. This advance was paced by a rise in mortgage debt 
of 10-1/2 percent at an annual rate. However, even that rapid rise in mortgage debt represented a slight 
deceleration from the torrid pace in 2004, a development in line with the small slowdown in the pace of 
house price appreciation. Despite the increase in mortgage debt, net housing wealth rose. Refinancing 
activity has remained subdued, as rates on fixed-rate mortgages are a little above levels at which many 
households would currently find refinancing to be attractive. 

Consumer credit expanded at an annual rate of about 4-1/2 percent over the first quarter of the year and was 
about unchanged in April and May. The growth of consumer credit has continued to be restrained by 
substitution toward home equity debt as a means to finance household expenditures. 

Measures of household credit quality have remained favorable. Delinquency rates on credit card debt and 
auto loans have continued to decline from already low levels. The pace of bankruptcy filings has run a little 
higher than at the same time last year; however, that pace has probably been boosted by a rush to file before 
the new rules in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 take effect in 
October. Reflecting the rapid pace of household debt growth, the ratio of household financial obligations to 
disposable personal income has edged up from a year earlier, though this ratio remains a bit below the peak 
level reached in late 2002. 

The Business Sector

Fixed Investment

After posting a robust gain in the second half of 2004, real business fixed investment rose at a more 
moderate pace over the first half of 2005, as the rate of increase in  
expenditures on equipment and software (E&S) dropped back and outlays for nonresidential structures 
remained lackluster. Nonetheless, economic and financial conditions appear to be supportive of capital 
spending: Sales and corporate profits have continued to increase, businesses have ample liquid assets at 
their disposal, and  
financial market participants appear willing to finance new investment projects at favorable terms. 

Real E&S spending rose at an annual rate of 6 percent in the first quarter after having advanced at an 18 
percent pace in the second half of 2004. Led by large increases in purchases of computers and 
communications equipment, spending on high-tech equipment posted a sizable gain in the first quarter. In 
contrast, outlays for transportation equipment dropped back early in the year because of a small decline in 
business expenditures on motor vehicles and a sharp drop in aircraft purchases after a surge in the fourth 
quarter of 2004. Investment in equipment other than high-tech and transportation goods, a category that 
accounts for about 40 percent of E&S in nominal terms, also edged down in the first quarter after 
registering a sizable gain in the second half of last year. The types of equipment in this category of 
investment tend to be sensitive to trends in business sales, but the timing of business spending may have 
been influenced by the provisions of the partial-expensing tax incentive, which encouraged capital 
spending to be pulled forward in advance of the incentives expiration at the end of 2004.

More-recent indicators of E&S spending point to another moderate rise in investment in the second quarter. 
In particular, outlays for transportation equipment appear to have turned up, on net, as a step-up in 
purchases of aircraft more than offset a further decline in business spending on motor vehicles. At the same 
time, the evidence on high-tech spending has been mixed: Real spending on computers appears to have 
registered  
another large gain in the second quarter, while the rate of increase in outlays for communications 
equipment apparently fell back. Indicators of spending on equipment other than transportation and high 
tech have looked more favorable recently, as shipments and imports for this broad category increased 
noticeably, on balance, in April and May. In addition, unfilled orders for such equipment remain at high 
levels. 

Real nonresidential construction continued at a low level in the first half of this year, but fundamentals are 
starting to show signs of improvement. The construction of office buildings and industrial facilities has 
been restrained for some time by elevated vacancy rates, weak demand, and higher costs for construction 
materials. However, vacancy rates in these sectors have recently turned down, and construction outlays for 
these types of buildings appear to have edged higher, on net, so far this year. Commercial buildingwhich 
includes retail outlets and warehousesalso appears to have increased this year, in part because of strong 
growth in the construction of large retail stores. Meanwhile, investment in the drilling and mining sector 
has trended up, on balance, over the past year, as higher prices for natural gas boosted the demand for new 
drilling rigs. 

Inventory Investment

As in 2004, businesses accumulated inventories at an appreciable pace early this year. Outside the motor 
vehicle industry, nonfarm inventories increased at an annual rate of $66 billion in real terms in the first 
quarter of 2005. The rapid rate of inventory accumulation late last year and early in 2005 appears primarily 
to have been the result of efforts by firms to replenish stocks that had been depleted by the strong pace of 
sales in 2003 and 2004; apart from firms in a limited number of sectors, such as steel and paper, most 
businesses do not appear to be holding excess stocks, even taking into account the downward trend in 
inventorysales ratios that has resulted from the improvement in supply-chain management capabilities. 
The rebuilding of inventories in most industries appears to have been largely completed, and the available 
data for April and May point to a noticeable step-down in the pace of stockbuilding. Indeed, in recent 
surveys, businesses have been reporting that they and their customers are increasingly comfortable with 
current levels of stocks, whereas in 2004 and early 2005, many were still characterizing inventory positions 
as too lean. 

One important exception to this characterization is the motor vehicle industry, for which dealer stocks
especially of light truckswere high by historical standards in recent months. In response, several major 
motor vehicle manufacturers reduced production in the second quarter, and, more recently, some have 
introduced price discounts on many 2005 models. These efforts appear to have helped, in that inventories 
of light vehicles at the end of June fell to sixty-five days of supply, a level more in line with historical 
norms. 

Corporate Profits and Business Finance

Corporate profits have continued to rise so far this year, though at a slower pace than in 2003 and 2004. 
Earnings per share for S&P 500 firms in the first quarter of 2005 were up about 13 percent since the same 
time last year, a pace in line with the profit figures reported in the national income and product accounts 
(NIPA). The ratio of before-tax profits of nonfinancial corporations to that sectors gross value added was 
about flat in the first quarter after having moved up in 2003 and 2004. In the first half of this year, the 
petroleum and gas industries benefited from higher oil prices, but corporate earnings in the automobile 
sector declined sharply. 

Given continued strong corporate profits and the accompanying strength in cash flow, nonfinancial firms 
demand for external financing to fund capital expenditures has remained somewhat subdued. Net equity 
issuance has stayed negative so far this year, and share retirements have been boosted by considerable stock 
buybacks and cash-financed merger and acquisition activity. Gross corporate bond issuance has been 
limited, and the proceeds have been used mainly to pay down existing debt. Short-term debt financing, 
however, continued to pick up in the first half of 2005. Both commercial and industrial loans and 
commercial paper expanded at a brisk pace that was likely in part the result of firms need to fund the rapid 
rate of inventory accumulation earlier in the year. The Federal Reserves Senior Loan Officer Opinion 
Survey on Bank Lending Practices conducted in April 2005 indicated that demand for business loans had 
strengthened over the previous three months and that substantial fractions of banks had eased standards and 
terms on these loans. In response to special questions regarding longer-term changes in lending practices, 
most banks reported that standards on business loans were somewhat tighter, but that terms were somewhat 
easier, than they had been in 1996 and 1997.

Indicators of credit quality in the nonfinancial business sector have stayed generally very strong amid 
continued growth of profits and corporate balance sheets that remain flush with liquid assets. Both the 
default rate on outstanding corporate bonds and the delinquency rate on business loans stand at the low end 
of their historical ranges. However, the automobile sector has been an exception to the pattern of solid 
corporate credit quality. All three major credit rating agencies downgraded the debt of both Ford and 
General Motors this year in response to disappointing earnings news. General  
Motors debt now has a below-investment-grade rating from both Standard & Poors and Fitch, though it is 
still rated as investment-grade by Moodys. Ford retains an investment-grade rating with all the rating 
agencies except Standard & Poors.

Expansion of commercial-mortgage debt continued apace in the first half of the year and was accompanied 
by record issuance of commercial-mortgage-backed securities. Likely because of that heavy issuance, 
spreads of yields on commercial-mortgage-backed securities over those on comparable-maturity Treasuries 
have turned up recently, but these spreads remain relatively low. The credit quality of commercial-
mortgage debt remains quite strong, as delinquency rates on holdings of commercial mortgages at banks 
and insurance companies and on loans that back mortgage securities have been declining from already low 
levels.

The Government Sector

Federal Government

The deficit in the federal unified budget narrowed over the past year. Over the twelve months ending in 
June, the unified budget recorded a deficit of $336 billion,  
$99 billion less than during the comparable period last year. Both revenues and outlays rose faster than did 
nominal GDP over this period, but the rise in receipts was especially strong. Even at its lower level, the 
deficit was still equal to about 2-3/4 percent of nominal GDP. 

Nominal federal receipts during the twelve months ending in June were 14 percent higher than during the 
same period a year earlier and reached 17 percent of nominal GDP. Revenues were boosted by a large 
increase in corporate receipts that was driven by the strength of corporate profits. In addition, individual 
income and payroll taxes rose nearly 12 percent, twice as fast as the growth of household income. 
However, some of this rise was due to the features of the Jobs and Growth Tax Relief Reconciliation Act of 
2003 that altered the timing of tax payments in a way that temporarily reduced the level of tax collections 
last year. 

Nominal federal outlays during the twelve months ending in June were 7 percent higher than during the 
same period a year ago and stood at 20 percent of nominal GDP. Spending for national defense continued 
to trend up at a rapid clip, and outlays for Medicare also posted a sizable increase. In addition, federal net 
interest payments, boosted both by higher interest rates and by the higher level of federal debt, rose more 
than 13 percent over this period. Real federal expenditures for consumption and investmentthe part of 
government spending that is a component of real GDPincreased at an annual rate of just 1/2 percent in 
the first calendar quarter of 2005 after having risen 4 percent in 2004. Although defense spending changed 
little in real terms in the first quarter, it has risen considerably in recent years and is likely to increase 
further in coming quarters. Nondefense spending in the first quarter edged up in line with its recent trend, 
and enacted legislation is consistent with its continuing to rise at a subdued pace.

The deficit in the federal budget has depressed national saving in the past few years. The narrowing of the 
deficit of late has lessened this reduction in national saving from a little more than 3 percent of nominal 
GDP in 2003 and 2004 to roughly 2 percent in the first quarter of 2005. Even so, as business and personal 
saving rates changed little, on average, over the past year, net national saving rose to just 3-1/4 percent of 
nominal GDP in the first quarter, well below the long-term historical average of about 7 percent and below 
recent levels of net domestic investment. If not reversed, such a low level of net national saving will 
necessitate either slower capital formation or continued heavy borrowing from abroad. The pressures on 
national saving will intensify greatly with the retirement of the baby-boom generation and the associated 
increases in Social Security and Medicare benefit payments.

Federal Borrowing

Because of the need to finance the sizable federal budget deficit, federal debt held by the public expanded 
at a seasonally adjusted annual rate of 13-3/4 percent in the first quarter of the year. The ratio of this debt to 
nominal GDP increased to more than 37 percent for the first time since 2000. The average maturity of 
outstanding marketable Treasury debt has been declining for several years and reached fifty-three months 
at the end of the first quarter of 2005, down from about seventy months in 2000. However, in the May mid-
quarter refunding statement, the Treasury announced that it was considering reintroducing regular issuance 
of a thirty-year nominal bond in February 2006, a move that would presumably slow or arrest this 
downtrend. 

Indicators of demand for Treasury securities by foreign investors have been mixed so far this year; demand 
by foreign official institutions seems to have moderated, but demand by foreign private investors appears to 
have remained robust. Indirect bidders at Treasury auctionswhich include foreign official institutions that 
place bids through the Federal Reserve Bank of New Yorkhave been awarded an average of 33 percent 
of coupon securities issued at auctions held so far this year, down from 42 percent in 2004. Treasury 
securities held in custody at the Federal Reserve Bank of New York on behalf of foreign official 
institutions have grown only about $25 billion so far this year after an increase of more than $200 billion in 
2004. Data from the Treasury International Capital System also suggest an ebbing of demand for Treasury 
securities from foreign official investors during the first five months of the year. These data, however, 
indicate that foreign private investors have continued to accumulate Treasury securities at a rapid pace.

State and Local Governments

The fiscal positions of states and localities have improved this year. Ongoing gains in income and 
consumer spending, along with sharp increases in property values, have continued to boost tax receipts. 
Although many jurisdictions have increased their spending moderately, some are also using the additional 
revenues to rebuild reserve funds. On a NIPA basis, net saving by state and local governments equaled $34 
billion at an annual rate in the first quarter (roughly 1/4 percent of nominal GDP), double the 2004 average. 
In addition, virtually all states registered surpluses in their general fund budgets in fiscal year 2005, which 
ended on June 30 for all but four states. Nevertheless, lingering fiscal concerns are still evident in some 
jurisdictions; these concerns are related primarily to rising Medicaid costs, the termination of temporary 
federal grants that were appropriated in fiscal year 2004, and pressures to restore funding to programs
such as  
elementary and secondary educationthat were cut back earlier in the decade.

Real consumption and investment spending by state and local governments edged down in the first quarter 
of 2005 after having changed little in 2004. Real outlays for consumption items increased at an annual rate 
of less than 1/2 percent, a reflection of some slowing in the pace of hiring. Nominal spending on 
investment rose at a moderate rate in the first quarter, but because construction costs escalated, investment 
spending declined a little in real terms. 

State and Local Government Borrowing

State and local government debt held by the public expanded at a rapid pace in the first quarter of the year, 
rising at a seasonally adjusted annual rate of 16-1/4 percent, up from 5-1/2 percent in the fourth quarter of 
last year. However, much of this borrowing was for the advance refunding of existing debt, as state and 
local governments continued to take advantage of low long-term interest rates. A significant portion of the 
proceeds of these  
advance refundings were invested in U.S. Treasury instruments tailored to meet the cash management 
needs of municipal governments. In addition, financing of transportation- and education-related projects 
boosted issuance of long-term municipal bonds for new capital. 

The credit quality of municipal borrowers improved last year, and this trend has generally continued so far 
in 2005, as upgrades of municipal bonds by Standard & Poors continued to outpace downgrades.

The External Sector

The U.S. current account deficit expanded in the first quarter of 2005 to $780 billion at an annual rate, or 
about 6.4 percent of nominal GDP. The deficit in trade in goods continued to widen, increasing $17 billion 
from the previous quarter. The deficit on net unilateral transfers also widened in the first quarter, largely 
because of an increase in government grants. In contrast, the surplus on trade in services rose $7 billion, 
and the surplus on net investment income rose $2 billion. 

International Trade

Real exports of goods and services accelerated in the first quarter of 2005 to an annual rate of about 9 
percent, roughly twice as fast as the rate in the second half of last year. The dollars decline in recent years 
has raised the competitiveness of U.S. relative prices and has continued to provide a mounting boost to 
exports. Support from foreign economic activity, though still substantial, moderated after the first half of 
2004 as growth abroad slowed. Increases in exports of U.S. goods were widespread across major U.S. 
trading partners, with the exception of Japan, and were concentrated in capital goods and consumer goods. 
Real exports of services rose at an annual rate of about 13-1/4 percent.

Real imports of goods and services rose at an annual rate of about 9-1/2 percent in the first quarter, a pace 
similar to the average in 2004. The growth of real oil imports ebbed after surging late last year. Increases in 
imports of non-oil goods were widespread across categories. The expiration of the Multifibre Arrangement 
and the resulting elimination of quotas shifted the source of some U.S. textile and apparel imports among 
U.S. trading partners, but these events appear to have had a limited effect on the overall level of imports of 
these goods. Real imports of services reversed their fourth-quarter decline, posting a gain of 7 percent at an 
annual rate, as some travel-related expenditures and also royalties and license fees recovered from a very 
weak fourth quarter.

Boosted by substantial increases in the prices of primary commodities and industrial supplies, prices of 
total exports rose at an annual rate of 4-1/4 percent in the first quarter. Prices of U.S. agricultural exports 
rebounded in the first quarter after good harvests in the second half of 2004 had caused prices to fall 
sharply. The available data for the second quarter point to continued increases in export prices.

Prices of imported non-oil goods rose at an annual rate of 3-3/4 percent in the first quarter, almost 1-1/2 
percentage points faster than in the second half of 2004. Prices of material-intensive items, such as 
industrial supplies and foods, steadily increased in the last quarter of 2004 and in the first quarter of 2005. 
In part, this rise reflected higher prices for nonfuel primary commodities, as strength in global demand for 
many commodities outstripped a slow expansion of supply. Prices for finished goods, such as consumer 
goods and many kinds of capital goods, also turned noticeably higher. Available data for the second quarter 
show that the increases in prices of both  
material-intensive and finished goods have slowed.

The spot price of West Texas intermediate (WTI) crude oil began 2005 near $43 per barrel, but it climbed 
above $50 per barrel in late February and breached $60 per barrel in late June. The increase in the spot 
price of WTI largely reflects several global factors: continued strong demand for oil, limited spare 
production capacity, and concerns about the reliability of supply from some foreign sources. In contrast to 
the market outlook during last Octobers peak in oil prices, futures contracts indicate that market 
participants now expect oil prices to remain near their current high levels, a view consistent with the belief 
that demand will remain strong and production will have difficulty keeping pace. The price of the far-dated 
NYMEX oil futures contract (currently for delivery in December 2011) rose from about $38 per barrel as of 
last October to about $56 per barrel in late June.

OPEC spare production capacity appears to be near historical lows, with only Saudi Arabia able to increase 
production substantially. Many other OPEC producers are either pumping close to capacity or encountering 
production problems. Venezuela and Indonesia cannot meet their production quotas, and Iraqi production 
this year has averaged less than in 2004. In addition, several governments have moved to increase their 
control of the energy industry as oil prices have risen. Russian oil production, which had provided most of 
the growth in non-OPEC supply over the previous five years, has stagnated since last September amid the 
partial nationalization of Yukos, formerly Russias largest oil company. Venezuela has also increased the 
taxes and royalty payments of foreign oil firms.

The Financial Account

Foreign official inflows, which accounted for more than half of all net financial inflows to the United States 
in 2004, slowed significantly in the first quarter but showed signs of renewed strength in April and May. In 
contrast, private inflows moderated in April and May after having increased substantially in the preceding 
six months. As has been the case for several years, the U.S. current account has been financed primarily by 
foreign purchases of U.S. debt securities. U.S. residents purchases of foreign securities increased after a 
temporary lull in the fourth quarter and have been more heavily weighted toward purchases of equities.

Net direct investment outflows in the first quarter were well below their levels in the fourth quarter; direct 
investment into the United States was roughly unchanged, but U.S. direct investment abroad fell back after 
a surge in new equity late last year. There is little evidence to date that U.S. companies have repatriated 
earnings from their foreign subsidiaries using the temporarily reduced tax rate available under the 
American Jobs Creation Act of 2004. However, there are indications that these remittances may pick up in 
the second half of this year. 

The Labor Market

Employment and Unemployment

Labor markets have continued to improve this year, albeit at an uneven pace from month to month. On 
average, nonfarm payroll employment expanded roughly 180,000 per month over the first half of 2005, 
about the same pace as in the fourth quarter of 2004. At the same time, the civilian unemployment rate, 
which had declined from 5-3/4 percent to just below 5-1/2 percent over 2004, continued to move down. 
The jobless rate stood at  
5 percent in June, the lowest level since September 2001.

The increases in payrolls over the first half of 2005 were relatively widespread across industries. 
Particularly sizable gains were registered at providers of health-care services and leisure and hospitality 
services and at establishments that provide business services, such as professional and technical assistance 
and administrative and support services (a category that includes temporary help). In addition, construction 
employment continued to climb at a steady pace, a reflection of the buoyant residential housing market and 
increased spending on infrastructure by state and local governments. In contrast, manufacturing 
employment continued to trend down, as cutbacks in industries that produce wood products, furniture, and 
a variety of nondurable goods more than offset hiring at producers of fabricated metals and machinery. 
Employment in retail trade has advanced at a moderate pace this year. Increases in employment at state and 
local governments slowed somewhat in the first half of this year from the pace in the second half of last 
year, and federal civilian employment changed little.

The gradual rise in job opportunities appears to be attracting some potential workers back into the labor 
market. The labor force participation rate, which had declined noticeably between 2000 and 2004, edged up 
over the first half of 2005. Nevertheless, the participation rate in June, at 66 percent, remained well below 
the high of 67-1/4 percent reached in early 2000. To some extent, both the high level of the participation 
rate in 2000 and the more recent decline are likely related to cyclical developments in the economy: The 
tight labor markets of the late 1990s, perhaps coupled with the introduction of work requirements for many 
welfare recipients, undoubtedly drew additional people into the labor force at that time, while the 
subsequent recession and slow recovery in the labor market have discouraged many job seekers in recent 
years. However, the downtrend in the aggregate participation rate also appears to be associated with 
structural developments that seem likely to limit future increases. For example, the large baby-boom 
cohorts are now entering ages at which labor force participation rates typically drop off sharply. And, in 
contrast to patterns observed in previous decades, participation rates for women between 25 and 54 years of 
age no longer appear to be trending up.

Productivity and Labor Costs

Gains in labor productivity have slowed, on balance, in recent quarters. According to currently published 
data, output per hour in the nonfarm business sector rose  
2-1/2 percent over the year ending in the first quarter of 2005, down from the 5-1/2 percent pace registered 
in the comparable period a year earlier. A deceleration in productivity is not unusual as an economic 
expansion matures and as businesseswhich become increasingly confident about future prospects for 
salesstep up their pace of hiring. In addition, the recent slowdown in productivity growth was from the 
unusually rapid average rate that prevailed between 2002 and early 2004. That elevated rate likely reflected 
both an atypical reluctance to hireas employers reacted to a succession of economic and geopolitical 
shocksand newfound efficiencies brought about by the better use of high-tech capital purchased by 
businesses in earlier years and by organizational changes implemented to maintain profitability when the 
economy was relatively weak. As the impetus from these influences has waned, productivity growth has 
fallen back.

Measures of labor compensation for recent quarters suggest that the remaining slack in labor markets 
continued to restrain increases in base wage rates but that large increases in some of the more flexible 
components of worker pay and for some types of employer-provided benefits added to labor costs. In 
particular, compensation per hour in the nonfarm business sector, which is based on the data from the 
national income and product accounts, rose 7 percent over the four quarters ending in the first quarter of 
this year, having registered a particularly large bulge in the final quarter of 2004. Much of this sharp rise 
may be the result of the exercise of a large number of stock options late last year, a development perhaps 
induced by an increase in equity prices that boosted the number of options that were in the money and by 
a proposed change in accounting regulations that led some companies to accelerate the vesting of options 
that had been previously granted. In addition, the strong performance of profits in 2004 may have been 
associated with sizable nonproduction bonus payments at the end of last year. 

A more modest rate of increase in hourly compensation is indicated by the employment cost index (ECI), 
which is based on a quarterly survey of private nonfarm establishments conducted by the Bureau of Labor 
Statistics and which excludes income received from the exercise of stock options. In particular, the ECI 
measure of hourly compensation rose 3-1/2 percent over the twelve months ending in March 2005, about  
percentage point less than the increases over the preceding two years. The wages and salaries component of 
the ECI was up just 2-1/2 percent over the twelve months ending in March, a pace similar to that in the 
preceding year, while employer costs for benefits increased 5-3/4 percent, a bit below the pace of the 
previous year but a sizable gain nonetheless. Part of the outsized rise in benefit costs stemmed from the 
need by many companies to rebuild their defined-benefit pension assets to make up for earlier losses in 
those plans. In addition, health insurance costs have continued to rise more rapidly than wages, although 
the 7-1/2 percent increase in these costs over the year ending in March of this year was down from the 
double-digit rates of growth in 2002 and 2003. 

The acceleration in the nonfarm business measure of hourly compensation, coupled with the deceleration in 
productivity, has contributed to a noticeable pickup in unit labor costs in recent quarters. In particular, unit 
labor costs rose 4-1/4 percent over the four quarters ending in the first quarter of 2005 after having declined 
1 percent over the preceding four quarters. However, to the extent that the acceleration in compensation 
was the result of a temporary bulge in stock option exercises in late 2004, unit labor costs should moderate 
significantly this year. Moreover, the implications of such a spike in unit labor costs for price inflation are 
probably minimal, at least as judged by previous spikes of this nature. For example, the sharp rise in unit 
labor costs in 2000 had little or no subsequent effect on price inflation.

Prices

Higher energy prices continued to show through to overall consumer price inflation this year. The chain-
type price index for personal consumption expenditures rose at an annual rate of about 2-1/2 percent 
between the fourth quarter of 2004 and May 2005, a rate of increase similar to that over the four quarters of 
2004. Within that total, core PCE prices accelerated over that period to an annual rate of about 2 percent, 
from 1-1/2 percent in 2004. However, data for the consumer price index (CPI), which are available through 
June, suggest that core inflation has moderated in recent months; the core CPI rose at an  
annual rate of 1-1/4 percent in the three months ending in June after having increased at a 3-1/4 percent 
pace over the first three months of this year.

The PCE price index for energy, which moved up more than 18 percent in 2004, increased at an annual rate 
of nearly 14 percent between the fourth quarter of 2004 and May 2005, having been pushed higher by a 
further run-up in crude oil prices. Gasoline prices climbed especially rapidly between February and April, 
when higher crude costs were accompanied by a significant widening in retail margins. Although these 
margins subsequently dropped back, retail gasoline prices in June were still nearly 10 percent above their 
level at the end of last year, and they moved up further in early July. Electricity prices also rose sharply 
over the first half of 2005 because of higher input costs for electricity generation.

Consumer food prices increased at an annual rate of about 2-1/2 percent over the first half of 2005, a bit 
less than in 2004. Prices for fruits and vegetables dropped back early in the year, as supplies recovered 
from the damage associated with last years succession of hurricanes. Although these prices turned up a 
little in the spring, they remain below their fourth-quarter levels. In contrast, meat prices rose at an annual 
rate of 3 percent over the first half of the year; relatively strong domestic demand has lifted prices despite 
increases in the number of cattle being fed for slaughter and ample supplies of other meats and poultry. 
Prices for beef were also influenced by a variety of trade restrictions associated with concerns about mad 
cow disease: Both the full resumption of imports from Canada (which would tend to push down prices) and 
the resumption of exports to other important trading partners (which would tend to push up prices) were 
delayed. Prices of food away from home, for which labor costs are more important than raw food costs, 
rose at an annual rate of about 3-1/2 percent over the first half of this year, a little higher than the recent 
trend. 	

The pickup in core PCE inflation this year is due both to the sharp run-up in energy prices and to higher 
prices for other intermediate materials; these developments have raised production and distribution costs 
for a wide range of domestically produced goods and services. In addition, the decline in the exchange 
value of the dollar into early 2005 continued to push up prices of core nonfuel imports this year, both for 
items used in the domestic production of other goods and services and for items sold directly to consumers. 
Partially offsetting these influences have been the gains in productivity, which have enabled firms to absorb 
a portion of the higher costs. Moreover, although the price of crude oil remains high, prices for some other 
industrial materials have decelerated or edged down of late: The Journal of Commerce industrial price 
indexwhich excludes energy itemshas fallen 6 percent since the beginning of April, while the producer 
price index for core intermediate materials rose at an annual rate of just 1-1/4 percent in the second quarter 
of this year after having increased at roughly a 7 percent pace, on average, in the preceding few quarters.

Measures of shorter-term inflation expectations have edged higher this year, while those of longer-term 
expectations have held steady or moved lower. Most notably, the Michigan SRC survey indicates that 
households median expectations for inflation over the next twelve months have ranged between 3 percent 
and 3-1/4 percent in recent months, up from just under 3 percent at the beginning of the year. In contrast, 
households median expectations for inflation over the next five to ten years, at a little under 3 percent, are 
similar to readings in recent years. The latest Survey of Professional Forecasters likewise shows that 
inflation is expected to average 2-1/2 percent over the next ten years, a figure unchanged since 2001. 
Readings of longer-term inflation compensation from financial markets show a more pronounced decline: 
Inflation compensation as measured by the spread of the yield on nominal Treasury securities over their 
indexed counterparts for the period five to ten years ahead has fallen about 50 basis points since the end of 
2004. 

U.S. Financial Markets

Financial market conditions remained generally accommodative during the first half of 2005, as Treasury 
and private interest rates stayed low. Risk spreads on speculative-grade debt had become very tight by the 
end of the first quarter, but they subsequently rose, on balance, after the downgrades of Ford and General 
Motors; current levels suggest more-typical compensation for default risk. Banks continued easing terms 
and standards on lending to businesses. The pace of business borrowing, which had been sluggish, picked 
up last year and remained fairly robust in the first half of 2005. Nevertheless, strong corporate profits and 
the large stockpile of liquid assets already on firms balance sheets continued to limit their demand for 
external financing. Debt of the federal government, of state and local governments, and of households 
continued to expand briskly. Broad equity price indexes were little changed on net; higher oil prices 
boosted share prices in the energy sector but weighed on other stocks. 

Interest Rates

The FOMC boosted the intended federal funds rate 25 basis points at each of its four meetings in the first 
half of the year. Judging from federal funds futures quotes, these policy actions had all been widely 
anticipated by investors for some time before each meeting. Since the start of the year, rates on interest rate 
futures contracts that will expire at the end of 2005 have moved up about 60 basis points in response to 
evidence of robust economic growth and concerns about the possible emergence of inflationary pressures. 
Two-year nominal Treasury yields have risen about 80 basis points over that period, reflecting both the 
firming of policy expectations and actual monetary policy tightening.

Nevertheless, ten-year nominal Treasury yields have edged down so far this year and are now about 60 
basis points below their level just before the FOMC meeting in June 2004. Moreover, this fall in long-term 
yields is a global phenomenon: Long-term yields have declined in most foreign industrialized economies, 
in several cases by more than in the United States. From the term structure of interest rates, the ten-year 
Treasury yield can be decomposed into a series of ten consecutive one-year forward rates. The last of 
thesethe one-year forward rate ending ten years hencenow stands about 160 basis points below its 
level just before the June 2004 FOMC meeting. 

Several potential explanations have been offered for the decline in long-term yields and distant-horizon 
forward rates in the United States since mid-2004. Among these is the possibility that long-term inflation 
expectations have fallen and become more firmly anchored. Indeed, longer-term inflation compensation, 
measured by the spread between the yields on ten-year Treasury inflation-protected securities and their 
nominal counterparts, has fallen about 30 basis points over this period. A second possible explanation is 
investors willingness to accept smaller risk premiums on long-term securities amid declining 
macroeconomic and interest rate uncertainty. The volatility of short-term interest rates and Treasury yields 
implied by option prices has indeed declined to historically low levels. A third possibility is that several 
factors have spurred an excess of global saving over planned investment, such as rising incomes in 
countries with high saving rates, the desire by the aging citizens of many industrialized countries to save 
for retirement, and apparently diminished investment prospects in many  
industrialized and developing economies.

Spreads of yields on investment-grade corporate debt over those on comparable-maturity Treasury 
securities fell during the first quarter of 2005, and risk spreads on high-yield corporate debt reached very 
low levels. However, in March, news about difficulties in the domestic motor vehicle industry apparently 
became a focal point for a revision of investors assessment of risks. Further revelations of accounting 
irregularities in the insurance industry also seem to have made investors somewhat charier of risk. As a 
result, risk spreads on corporate bonds and credit default swaps have widened; speculative-grade bond 
spreads are now about 50 basis points higher than at the start of the year.

Equity Markets

Broad equity price indexes fell modestly in the first quarter, but they rebounded and are now little changed, 
on net, since the start of 2005. Thus far this year, stock prices have been buoyed by continued strong profits 
and low long-term interest rates, but higher oil prices and a few high-profile earnings disappointments have 
weighed on share prices outside the energy sector. The forward earningsprice ratio held about steady 
despite the fall in real interest rates. Equity price volatility implied by quotes on stock options declined, as 
the implied volatility on the S&P 500 index dropped to a record low level of less than 11 percent.

Net inflows into equity mutual funds were moderate in the first half of 2005, down from the rapid pace 
during the same period last year. These flows likely followed the pattern set by share prices, which surged 
about 30 percent in 2003, rose about 10 percent in 2004, and have been flat so far this year. 
     
Debt and Financial Intermediation

The aggregate debt of the domestic nonfinancial sectors expanded at an annual rate of about 10 percent in 
the first quarter of 2005, up from an 8-1/4 percent pace in the fourth quarter of 2004, mainly because of 
faster growth of federal government debt and state and local government debt. The mix of household and 
business debt growth has shifted modestly since the same time last year. Household debt decelerated, 
though it continued expanding at a rapid pace, and the growth of business-sector debt picked up even 
though ample internal funding continued to limit firms need for external financing.


Commercial bank credit expanded at an annual rate of 13 percent in the first quarter of 2005. Financing 
secured by residential real estate, including home mortgages, home equity loans, and mortgage-backed 
securities, extended its long, robust expansion. In May, the Federal Reserve Board and other federal 
agencies that regulate depository institutions issued guidance on sound underwriting and effective credit-
risk-management practices for home equity lending. Recently there has been increased use of potentially 
riskier types of mortgages, including adjustable-rate and interest-only loans, which could pose challenges to 
both lenders and borrowers. Business loans, which had begun to grow in 2004 after several years of 
runoffs, accelerated to a 15 percent annual rate of growth in the first quarter of 2005, supported in part by 
strong demand for short-term financing to fund rising accounts receivable, inventories, and merger and 
acquisition  
activity. 

Credit market assets held by government-sponsored enterprises declined in the first quarter of this year, as 
Freddie Mac and Fannie Mae reduced their outright holdings of mortgage-backed securities. 
     
The M2 Monetary Aggregate

In the first half of 2005, M2 grew at a 2-1/2 percent annual rateprobably slower than nominal GDP and 
down from a 5-1/4 percent pace last year. Slower growth in liquid  
depositslikely a consequence of their rising opportunity costaccounted for most of this deceleration. 
Yields on retail money market mutual funds rose noticeably in the first half but continued to lag interest 
rates on market instruments, and assets in these funds continued their prolonged runoff. Small time 
deposits, whose yields have better kept pace with rising market interest rates, rose briskly during the same 
period. Currency expanded at a slow rate, apparently a reflection in large measure of weak demand from 
abroad. On net, the velocity of M2 is estimated to have moved up in the first half at a somewhat slower 
pace than would be expected from the historical relationship between money, income, and opportunity cost. 

International Developments

Foreign economic activity has expanded a bit less rapidly this year than in the second half of 2004, as 
measured by an export-weighted average of growth among U.S. trading partners. The pace of expansion in 
the industrial economies has generally increased, but, with the important exception of China, this increase 
has been offset by moderating growth in many developing economies. Inflation has remained well 
contained in most  
countries.

The stance of monetary policy has not changed this year in most major foreign economies. The European 
Central Bank has held its policy rate constant since June 2003, and both the Bank of England and the Bank 
of Canada have kept policy rates unchanged after having raised them in the latter half of 2004. The Bank of 
Japan has maintained its commitment to a policy of quantitative easing until deflation ends, but in late May 
it made what it described as a technical change to allow temporary deviations below the target range for 
reserve accounts if banks demand for funds is too weak to satisfy the target. Reserve account balances 
temporarily fell below 30 trillion, the lower end of the target, in early June. Monetary policy has also 
remained unchanged in most emerging Asian economies; however, several Latin American monetary 
authorities have continued tightening cycles that began last year in efforts to restrain inflationary  
pressures.

After having edged up during the first three months of this year, long-term interest rates in the major 
foreign industrial economies have fallen and now stand below their levels at the start of the year. As in the 
United States, the decline in foreign long-term interest rates continues a trend that began in mid-2004. 
However, long-term rates in the major foreign industrial economies have fallen more than rates in the 
United States this year. The decline in European long-term rates occurred amid weak economic news and a 
shift away from market expectations of a policy rate increase. In contrast, long-term rates in Canada and the 
United Kingdom have trended down despite policy rate increases in the second half of last year by both 
countries central banks, though market perceptions that the Bank of England may cut rates have recently 
increased. Although the decline in Japanese rates last year was consistent with both the weak performance 
of the economy and the persistence of deflation, long-term rates fell further this year despite solid growth in 
the first quarter.

As foreign interest rates have fallen in recent months, the value of the dollar has risen. Most of this rise has 
been against the currencies of the major industrial countries; the dollar is largely unchanged against the 
currencies of the United States other important trading partners. The dollar has appreciated about 12 
percent against the euro and about 9 percent against the yen and sterling since the start of the year. Some of 
the appreciation against the euro occurred after voters in France and the Netherlands rejected the proposed 
constitution for the European Union by unexpectedly large margins in May.
 
European, British, and Canadian stock indexes have risen more than 8 percent since the start of the year. 
The rise in European stock prices is notable because indicators of economic activity have been fairly weak. 
In contrast, Japanese stock prices are now little changed after having reversed first-quarter gains. Equity 
prices in the majority of emerging markets began the year on a strong note but reversed course late in the 
first quarter and currently stand close to their January levels. Despite these swings, intraday volatility has 
remained subdued in most equity markets. 

Industrial Economies

Real GDP in Japan increased at an annual rate of nearly 5 percent in the first quarter of 2005, bouncing 
back from last years recession. Personal consumption spending  
reversed its recent declines, pushing the household saving rate down further. Private investment also rose 
sharply after having grown tepidly in the second half of 2004. In contrast, the external sector made a small 
negative contribution to GDP, as imports rose modestly but exports fell. While Japanese manufacturers of 
high-tech goods reduced their levels of inventories from last years peak, inventory stocks of firms outside 
the high-tech sector increased, perhaps because of the slowdown in exports. The labor market has steadily 
improved: The unemployment rate has reached a seven-year low, and the ratio of job offers to job 
applicants is at a twelve-year high. Despite the pickup in economic activity and continuing inflation in 
wholesale prices, consumer price deflation has worsened slightly. The GDP price deflator returned to a 
year-over-year rate of deflation of more than 1 percent after having temporarily registered a more modest 
decline in the fourth quarter of 2004.

The pace of activity in the euro area appears to have slowed after a stronger start to the year. Real GDP 
grew at a 2 percent annual rate in the first quarter, as private consumption rose moderately and both 
households and firms switched expenditures away from imports and toward domestically produced goods. 
Both Germany and Spain grew at rates above the area average in the first quarter. In contrast, real GDP in 
both Italy and the Netherlands declined, while French growth was slower than in most of 2004. Measures 
of activity point toward slower growth in the euro area in the second quarter. Retail sales, which had risen 
in the first quarter, were roughly flat, on average, in April and May. The trade balance fell in April, 
threatening a main engine of growth, though the recent rise in the dollar against the euro should help 
stimulate export demand going forward. Twelve-month consumer price inflation edged up in June to just 
above the European Central Banks target ceiling of 2 percent for inflation over the medium term. The 
European Central Banks measure of core inflation, which excludes energy and  
unprocessed foods, has eased since January to an annual rate comfortably below 2 percent. 

Consumer spending in the United Kingdom increased only modestly in the first quarter, slowing real GDP 
growth to 1-1/2 percent. Nevertheless, the labor market  
remains tight, as unemployment is at its lowest levels since the mid-1970s and real earnings continue to 
trend up. The twelve-month rate of consumer price inflation ticked up in June to the Bank of Englands 
target of 2 percent. In its May Inflation Report, the Bank of England forecast that inflation would 
temporarily rise but stay near the target over a two-year period. House prices have been fairly stable this 
year, and household net mortgage borrowing has also been subdued.

Growth in Canada remains moderate. Continuing a pattern that has largely held for the past two years, 
private consumption and investment demand rose in the first quarter while net exports fell. Activity in the 
second quarter appears to have been solid. Data on housing starts indicate that construction spending grew 
further, and the merchandise trade surplus improved in April, as exports rose and imports decreased 
slightly. Twelve-month consumer price inflation fell in May to about 1-1/2 percent after having averaged 
slightly above 2 percent in the first quarter. The Bank of Canadas measure of core inflation has stayed 
below 2 percent throughout this year. 

Emerging-Market Economies

Chinese real GDP continues to rise rapidly following strong growth in 2004. Economic expansion has been 
led by investment, exports, and, more recently, a surge in domestic production of goods that had previously 
been imported. Investment expenditure has remained vigorous despite the governments attempts early last 
year to slow its rate of increase. Import growth slowed in the first quarter, but the rise of exports was 
unabated, leading to a significant widening of the trade surplus. Although recent attention has focused on 
Chinas exports of textiles, export growth has remained strong across most major categories of goods. The 
slowdown in imports has also been broadly based.  Despite Chinas strong rate of economic expansion, 
consumer price inflation fell to less than 3 percent in the first quarter and has remained low, as declining 
food prices have offset modest increases in nonfood prices.

Economic developments in other Asian emerging-market economies have varied. Hong Kong maintained 
its strong performance. As in China, growth in Hong Kong has been driven by both investment and exports. 
Export growth has also played an important role in supporting growth in most of the other countries in this 
region, but domestic demand, particularly inventory investment, has declined in many economies so far this 
year. Inflation has risen slightly, reflecting higher food and energy prices, but remains well contained and 
under 3 percent in most countries. 

The Mexican economy has slowed so far this year, as demand for its manufacturing exports has weakened 
and monetary tightening has tempered investment and consumption demand. The Bank of Mexico has left 
monetary policy unchanged since March, but its tightening over the preceding twelve months raised short-
term  
interest rates 500 basis points. Twelve-month consumer price inflation has fallen from its levels of late last 
year but still stands above the Bank of Mexicos target range of 2 percent to 4 percent. After having risen in 
the second half of last year, core inflation has also trended down in recent months.

Economic growth in most South American economies has also slowed compared with the pace of activity 
at the end of 2004. Brazils real GDP rose at only a 1-1/4 percent annual rate in the first quarter, as both 
private consumption and investment declined in the wake of the Brazilian central banks decision to begin 
raising its policy rate in the second half of 2004 to counter inflationary pressures. Exports, which rose 
rapidly and outpaced imports, provided the only bright spot. Twelve-month inflation has remained above 7 
percent, and the central bank has continued to raise its policy rate this year.  Argentina has gradually 
recovered from its 2001 crisis, but real GDP sharply decelerated in the first quarter. The unemployment 
rate, which had steadily fallen over the past few years, also edged up slightly. Twelve-month consumer 
price inflation appears to have stabilized after having been pushed up by food price increases earlier in the 
year, but it still lies above the central banks unofficial target range of 5 percent to 8 percent. The Argentine 
government recently completed the final settlement of its debt exchange but has not yet resolved the 
treatment of the remaining investors (holders of roughly one-fourth of all defaulted government bonds) 
who rejected the agreement.