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 The Household Sector
      The Business Sector
      The Government Sector
      The External Sector
      The Labor Market
      Prices
      U.S. Financial Markets
      International Developments
 Economic and Financial Developments 
      in 2006 and Early 2007
 The especially brisk pace of economic activity in
      early 2006 primarily reflected a rebound after hurricane-related
      disruptions in the autumn of 2005. During the rest of the year,
      however, economic activity slowed to a pace somewhat below the average
      rate of recent years. Real GDP
      
      is reported to have
      increased at an average annual rate of 2-3/4 percent over the
      final three quarters of 2006, down from the average 3-1/4 percent
      pace in 2004 and 2005. The slowdown principally was the result of the
      contraction in residential construction, which intensified later in the
      year, and the marked decline in production of light motor vehicles in
      the second half of the year as manufacturers took steps to trim
      dealers' inventories. In other sectors of the economy, consumer
      spending remained strong as employment and income made further solid
      gains, and business outlays for new structures and equipment rose
      considerably over much of the year. Financial market conditions were
      generally supportive of economic expansion in 2006. Equity markets
      recorded sizable gains, and long-term interest rates rose only modestly
      from historically low levels. Risk spreads on corporate bonds remained
      narrow or declined further. Overall economic conditions were such that
      businesses maintained a steady pace of hiring, and the unemployment
      rate moved down further.  *d*  Return to text
 Consumer price inflation, as measured by the rise in the
      PCE price index,
      
      moved down in the second half of 2006
      after having stepped up in the first half. Energy prices, which rose
      during the first half and turned sharply downward later in the year,
      played an important role in shaping the contour of total consumer
      price inflation. In addition, core PCE price inflation eased modestly
      over the second half of 2006. Apparently influenced by incoming data on
      inflation and economic activity, measures of long-term inflation
      expectations rose early in the year but ended the year slightly lower
      than at the beginning. Nonetheless, core PCE price inflation for the
      year as a whole--at 2-1/4 percent--was a bit higher
      than in the preceding year, which perhaps reflected in part the
      high level of resource utilization.  *d*  Return to text
 The Household Sector Consumer Spending The rapid increase in consumer spending in 2006 was supported by
      rising employment, gains in real income, increases in household wealth,
      and favorable financial conditions. Over the four quarters of 2006,
      real PCE rose 3-3/4 percent--faster than in 2005 and at
      roughly the same rate as in 2004. The rise in consumer outlays was
      particularly robust in the first quarter of 2006 but then moderated in
      the middle of the year, when households' gains in real
      
      income slowed and consumer sentiment softened. Consumer spending rose
      briskly again in the fourth quarter of the year as gains in real income
      picked up and consumer confidence improved.  *d*  Return to text
 Household spending for new motor vehicles slowed in 2006;
      sales of 16.5 million new light vehicles (cars, sport-utility
      vehicles, and pickup trucks) were below the average of nearly 17 million sold in the preceding two years. Moreover, households' apparent
      concerns about elevated gasoline prices, particularly early in the
      year, shifted the composition of light vehicle sales toward more
      fuel-efficient autos and away from light trucks and SUVs. The shift
      helped boost the share of total sales captured by foreign producers
      because they tend to offer more fuel-efficient vehicles. Real PCE for goods other than motor vehicles rose
      4-3/4 percent over the four quarters of 2006, about in line with
      the brisk average pace in the preceding two years. Households increased
      their spending for a broad range of consumer goods, though the rise was
      particularly strong for electronic equipment and other durables. Real
      spending on gasoline remained about constant in the first half of the
      year but increased in the second half as prices fell. Consumer spending
      for services maintained a moderate pace of growth; expenditures in this
      category rose 2-3/4 percent in 2006, about the same average pace
      as in 2004 and 2005. In 2006, real household income was boosted by gains in wage and
      salary income and the increased purchasing power resulting from the
      deceleration in overall consumer prices. Labor income received by
      households rose both because of gains in real hourly wages and because
      of sustained increases in employment. However, the pickup in real
      after-tax income was damped because tax payments made by households
      increased at a rate greater than that for income. The acceleration in
      tax payments likely reflected, at least in part, several factors: tax
      payments on larger capital gains realizations, which are excluded from
      income in the national income and product accounts (NIPA); gains in
      real income that moved some households into higher tax brackets; and
      possibly a further shift in the distribution of income toward
      high-income households that typically face higher tax rates. All told,
      real after-tax income rose 3 percent over the four quarters of 2006, up
      from the negligible gain posted in 2005 but a little below the average
      rate of increase in 2003 and 2004. The rise in after-tax income in 2006 was outpaced by increases in
      household spending. As a result, the personal saving rate declined
      further in 2006 and averaged negative 1 percent for the year as a
      whole. Households apparently were inclined to increase their spending
      further above their disposable income, at least in part, because their
      wealth continued to rise. The ratio of household net worth to income,
      which has been trending higher since 2003, inched up further in 2006.
      Although increases in the value of homes slowed significantly, the
      value of corporate equities held by households both indirectly--such as
      in mutual funds and retirement accounts--and directly appreciated
      considerably. Consumer sentiment deteriorated in the first half of 2006,
      according to the Reuters/University of Michigan Surveys of Consumers
      (Reuters/Michigan). In the spring, consumer confidence had moved to its
      lowest level for the year, probably in part because energy prices had
      surged. The subsequent decline in energy prices, along with the rise in
      the stock market and reductions in the unemployment rate, boosted
      consumer confidence in the second half of the year. On net, the
      Reuters/Michigan index of consumer sentiment was a shade higher at the
      end of 2006 than at the beginning of the year; sentiment moved up
      further in early 2007 to near the upper end of its range since 2003. Residential Investment The deterioration of conditions in the housing market played a
      significant role in restraining the pace of economic expansion in 2006.
      The demand for new and existing homes began to weaken in the middle of
      2005, and the subsequent decline steepened through the first half of
      2006. As a result, the inventory of unsold new homes relative to sales
      rose sharply. Apparently prompted by lower demand and excessive
      inventories, homebuilders began to cut back on the pace of new
      construction near the beginning of 2006, and the decline in activity
      continued throughout the year. Later in the year, however, some
      indicators were hinting that the demand for housing was starting to
      stabilize. By the middle of 2006, sales of both new and existing homes had
      fallen dramatically to a pace that was about 15 percent below
      that of a year earlier. Concurrently, inventories of unsold homes
      relative to sales rose considerably above the level that had prevailed
      during the period of robust housing demand from the late 1990s into
      2005. By the third quarter of 2006, the backlog of unsold new homes had
      reached 6-3/4 months' supply, and the stock of existing
      homes for sale had risen to about 7 months' supply--both well above the
      average of about 4-1/2 months' supply of new and existing homes
      in 2005. By the end of 2006, however, there were tentative signs that
      the demand for homes was stabilizing. The decline in sales of new and
      existing homes appeared to bottom out in the summer, and sales were
      roughly constant over the later part of the year. In the fourth
      quarter, builders' inventories of unsold new homes were reported to
      have edged down a bit from their third-quarter level, while the stock
      of existing homes for sale remained about the same as in the third
      quarter. Despite these developments, the extent of any improvement in
      the inventories of unsold homes is obscured by the failure of these
      figures to account for recorded sales of new homes that are
      subsequently canceled.  *d*  Return to text
 The drag on new residential construction in 2006 imposed by the
      contraction in home sales and the buildup of inventories was
      significant. Both the number of permits issued for new single-family
      homes and the number of home starts dropped sharply. As of the fourth
      quarter of 2006, new single-family homes
      
      were started at
      an annual rate of 1.23 million units, almost 30 percent below the
      average pace in 2005; permits were down by a similar amount. In
      contrast to the marked slackening in construction of new single-family
      homes, the rate of starts of new multifamily homes in 2006, at 337,000
      units, was about the same as in the preceding several years. Housing activity, as measured by real expenditures on residential
      structures in the NIPA, trimmed 1/4 percentage point from the
      rate of real GDP growth in the first half of 2006, but the drag
      intensified to subtract about 1-1/4 percentage points from the
      annual rate of increase in real GDP in the second half. For 2006 as a
      whole, the contraction in real residential investment lowered the
      annual rate of growth in real GDP 3/4 percentage point after
      having added 1/2 percentage point, on average, to the rate from
      2003 through 2005. The rate of house-price appreciation slowed substantially in 2006
      after several years of very rapid gains. The repeat-transactions index
      of home prices published by the Office of Federal Housing Enterprise
      Oversight (OFHEO) increased at an annual rate of only 1-1/2
      percent in the third quarter of 2006, down substantially from average
      gains of about 10 percent in 2004 and 2005. The OFHEO index attempts to
      control for the quality of existing single-family homes sold by using
      prices of homes involved in repeat transactions. The increase in the
      OFHEO house-price index over the four quarters ending in the third
      quarter of 2006 (a calculation that smoothes through some of the
      quarterly volatility in the data) was 6 percent, the smallest
      four-quarter increase since the late 1990s. The average price of
      existing single-family homes sold, which is published by the National
      Association of Realtors (NAR) and does not control for the types of
      homes sold, declined about 2 percent over the four quarters of 2006,
      compared with average gains of roughly 9 percent in 2004 and 2005. The
      outright decline in the NAR index of home prices relative to the
      deceleration in the constant-quality OFHEO home-price index suggests
      that the composition of existing homes sold shifted toward lower-priced
      homes. The cost of mortgage financing increased in the first half of
      2006, but rates decreased in the second half. The average rate for a
      thirty-year fixed-rate mortgage was 6-1/4 percent at the end of
      2006, about the same as at the beginning of the year. The average for a
      one-year adjustable-rate mortgage declined also in the second half and
      stood at 5-1/2 percent at the end of 2006, about 1/4
      percentage point above the level at the start of the year. According to
      respondents to the Reuters/Michigan survey, relatively low mortgage
      rates and the perception that purchase prices were more favorable
      improved their assessment of homebuying conditions in the second half
      of 2006. Household Finance Household sector debt is estimated to have slowed from the robust
      11-3/4 percent increase posted in 2005 to a still-vigorous
      8-1/4 percent in 2006. The deceleration reflected a drop in the
      pace of mortgage debt growth from about 14 percent in 2005 to
      less than 9 percent in 2006. Despite the reduction in mortgage
      borrowing, home equity lending remained active, and the gross volume of
      cash-out refinancing exceeded 2005 levels. Meanwhile, consumer debt
      expanded only moderately in 2006. Although household indebtedness increased less rapidly in 2006
      than in 2005, it still outpaced the growth of disposable personal
      income. In addition, the rise in interest rates contributed to higher
      debt service payments, and the household financial obligations ratio
      continued its upward trend of the past decade to reach a record high.
      Evidence to date suggests that most households have been able to meet
      their debt service obligations, although there are indications of
      growing strains among some borrowers. Delinquency rates on subprime
      residential mortgages with variable interest rates have increased
      markedly; still, delinquency rates on other mortgages and consumer
      loans have remained low. Household bankruptcy filings during 2006 ran
      at a pace well below the average of the preceding several years.
      Bankruptcies likely were damped in 2006 by the decisions of some
      households to file before the implementation of more-stringent
      bankruptcy requirements in October 2005. However, even allowing for
      such an effect, the recent pace is low relative to pre-reform norms. Return to menu The Business Sector Fixed Investment  *d*  Return to text
 Total real business fixed investment rose 6-3/4 percent
      over the four quarters
      
      of 2006, up from a 5-1/2
      percent increase in 2005 and about the same pace as in 2004. In
      general, the fundamentals supporting business capital spending remained
      favorable in 2006: The strong rise in profits continued to help firms
      maintain substantial liquid assets, user costs for equipment declined
      further, and interest rates and credit spreads remained relatively
      low. Although the pace of real business outlays for equipment and
      software slowed somewhat in 2006, investment in nonresidential
      structures rose 11-3/4 percent. Capital spending was quite robust
      during most of the year, adding about 1 percentage point to the annual
      rate of increase in real GDP over the first three quarters, but it
      decelerated sharply in the fourth quarter. The deceleration reflected,
      in part, a slowing in spending for business structures from its brisk
      pace earlier in the year, a drop in outlays for transportation
      equipment, and some weakness in purchases of equipment related to
      construction and motor vehicle manufacturing. Real investment in high-technology equipment rose 9 percent in
      2006, about the same average annual pace as in the preceding two years.
      Further decreases in the prices of high-technology equipment continued
      to reduce the user cost of this type of equipment. Real business
      spending for computing equipment increased 14-1/2 percent, and
      software spending posted an 8 percent gain, both roughly comparable to
      their average rates of increase in the previous two years. Business
      outlays for communications equipment rose almost 7 percent in 2006.
      Spending for communications equipment was particularly robust in the
      early part of the year and was likely boosted in part by spending to
      replace equipment damaged by the hurricanes in the autumn of 2005.
      Investment in communications equipment last year continued to be
      supported by demand from telecommunications service providers that were
      expanding their broadband networks. Real business investment in transportation equipment--typically a
      volatile category of investment--was about unchanged on net in 2006.
      For motor vehicles, business spending increased less than 1 percent
      over the year. Purchases of light vehicles weakened, partly because of
      cutbacks in sales to rental companies. In contrast, business outlays
      for medium and heavy trucks accelerated in 2006, reportedly in
      anticipation of new emissions regulations by the Environmental
      Protection Agency that went into effect at the beginning of 2007. New
      orders for medium and heavy trucks reached new highs early in 2006, and
      production and sales remained strong through the end of the year.
      Outlays for new aircraft were brisk in early 2006, but they were
      depressed over the remainder of the year; all told, aircraft investment
      declined more than 15 percent for the year as a whole. Real investment in equipment other than high-tech and
      transportation goods--a broad category that represents about half of
      total nominal business spending for equipment and software--rose at an
      average annual rate of 5-1/2 percent during the first three
      quarters of 2006. However, spending for these capital goods softened in
      the final quarter of the year. Although the declines in the fourth
      quarter were generally broad based, they were led by decreases in
      spending for equipment related to construction and motor vehicle
      manufacturing. However, the backlog of orders for capital goods such as
      industrial machinery and other types of heavy equipment remained
      substantial at the end of 2006, and it should sustain production and
      shipments of these items in early 2007. Real outlays for nonresidential construction increased
      11-3/4 percent in 2006 after having been little changed since
      2003. However, the rise in business construction spending slowed near
      the end of 2006 from its rapid pace earlier in the year; outlays
      increased at an annual rate of only about 3 percent in the fourth
      quarter. For 2006 as a whole, sizable gains were posted for office,
      retail, and industrial buildings. In addition, outlays for drilling and
      mining structures associated with energy exploration were strong. At
      the end of 2006, forward-looking indicators for nonresidential
      construction activity appeared to be favorable: Vacancy rates for
      buildings in both the office and industrial sectors, which peaked a few
      years ago, continued to drift down, and the vacancy rate for retail
      buildings remained at the low level that has prevailed since 2000. Inventory Investment In the first half of 2006, dealer stocks of motor vehicles rose
      noticeably as sales slowed, particularly for light trucks. The increase
      in the prices of gasoline earlier in the year appeared to have reduced
      consumers' demand for light trucks and SUVs, which tend to be less fuel
      efficient. Dealers' inventories of these vehicles reached an elevated
      90 days' supply at the end of the second quarter. As a result, motor
      vehicle manufacturers scaled back the production of light trucks over
      the second half of 2006, which helped to reduce dealers' inventories
      during that period. Nonetheless, at the end of 2006, inventories of
      light vehicles still appeared to be above desired levels. Manufacturers
      cut production further in January of this year, helping them make
      additional progress in reducing the stock overhang. Excluding motor vehicles, inventories held by businesses in the
      manufacturing and trade sectors appeared generally to be well aligned
      with sales in the first half of 2006. However, later in the year, a
      variety of indicators suggested that some businesses accumulated an
      unde-sired level of stocks. The book value of manufacturing and
      trade inventories (excluding motor vehicles) rose relative to sales
      from September through November. The increases were particularly
      noticeable for firms that supply the construction and motor vehicle
      sectors, although increases were apparent in a few other sectors as
      well. Survey data also suggested that inventories for some businesses
      were viewed as too high. However, manufacturers outside of the motor
      vehicles sector appear to be making relatively prompt adjustments to
      their production, which to date seem to be limiting the extent of
      undesired stockbuilding. Corporate Profits and Business Finance Profits of nonfinancial corporations extended their upward move,
      pushing the ratio of before-tax profits to income in this sector to
      nearly 14 percent, the highest level reached since 1969. In the third
      quarter, operating earnings per share for S&P 500 firms came in
      20 percent above levels of a year earlier. About two-thirds of
      firms in the S&P 500 have reported earnings for the fourth quarter.
      Current market estimates of earnings per share for S&P 500 firms call
      for roughly 10 percent growth in the fourth quarter over
      year-earlier levels. Earnings growth was widespread across sectors in
      2006 but was particularly strong for financial firms.  *d*  Return to text
 Firms' capital expenditures exceeded internal funds raised in
      2006, an indication that businesses funded investments not only with
      current cash flow but also with external funds and liquid assets.
      Borrowing by nonfinancial firms picked up in 2006
      
      in
      association with increased real investment as well as with extensive
      retirements of equity, which resulted
      
      from record share
      repurchases and heavy merger and acquisition activity. Net bond
      issuance proceeded at a faster clip than in the past several years.
      Similarly, commercial paper issuance was the strongest it had been
      since 2000, and commercial and industrial lending by banks was rapid as
      well. The Federal Reserve's Senior Loan Officer Opinion Survey on Bank
      Lending Practices revealed that a significant net fraction of
      respondents to that survey eased credit standards and terms on
      commercial and industrial loans during 2006. Bankers indicated that
      they were responding to more-aggressive competition and greater
      liquidity in the secondary market for such loans. Loan officers also
      reported that a contributing factor was an increased tolerance for
      risk.  *d*  Return to text
 The expansion of commercial mortgage debt in 2006 remained
      rapid by historical standards but fell off from the swift pace of 2005.
      The deceleration likely reflected the rise in mortgage rates and a net
      tightening of credit standards for these loans--an explanation
      consistent with responses to the loan officer survey. Gross public issuance of equity by nonfinancial corporations in
      2006 roughly maintained the moderate pace of the past couple of years,
      and private equity issuance appears to have risen a bit to finance
      buyouts and other restructurings. Still, net equity issuance turned
      more negative as equity retirements from cash-financed mergers and
      acquisitions and share repurchases increased considerably. On balance, despite increased borrowing and net equity
      retirements, the strength of corporate earnings growth has left the
      credit quality of nonfinancial firms solid. Balance sheet liquidity
      remains high, and corporate leverage is near historical lows. In
      addition, net interest payments relative to cash flow remained near the
      low end of the range seen over the past two decades. The six-month
      trailing bond default rate fell during the first half of the year as
      defaults by some large firms in the troubled airline and automobile
      sectors in late 2005 dropped out of the series, and it was near zero
      throughout the second half of 2006. Delinquency rates on business loans
      remained quite low. Return to menu The Government Sector Federal Government  *d*  Return to text
 The deficit in the federal unified budget narrowed further during
      the past year. The unified budget recorded a deficit of $248 billion in
      fiscal year 2006--$70 billion smaller than in the previous
      fiscal year. The federal deficit in fiscal 2006 was a bit less than 2 percent of nominal GDP, significantly lower than its recent fiscal year
      peak of more than 3-1/2 percent of GDP in 2004. In fiscal 2006,
      outlays rose about in line with nominal GDP,
      
      but
      receipts increased at a faster pace. From October through December--the
      first quarter of fiscal 2007--the federal deficit was almost $40 billion less than in the same period a year earlier, as the rise in
      receipts continued to outpace the growth in outlays. The latest
      projections from the Congressional Budget Office and the Administration
      anticipate that the unified deficit in fiscal 2007 will be smaller as a
      percentage of nominal GDP than it was in fiscal 2006. Although the
      unified deficit has improved recently, the federal budget will face the
      mounting pressures of providing Social Security and health benefits to
      a rapidly growing number of beneficiaries as the baby-boom generation
      ages in coming years. In fiscal 2006, nominal federal receipts rose 11-3/4
      percent and were equivalent to almost 18-1/2 percent of nominal
      GDP, substantially higher than their recent fiscal year low of
      16-1/4 percent of GDP in 2004. Income tax receipts from
      individuals outpaced the rise in taxable personal income (as measured
      in the NIPA), while surging corporate tax payments about matched the
      robust growth in profits. As noted above, the increase in individual
      income tax liabilities relative to taxable income in the NIPA appears
      to have reflected, at least in part, taxes on larger capital gains
      realizations (which are excluded from NIPA income), the effect of some
      taxpayers moving into higher tax brackets as their real incomes
      increased, and possibly a further shift in the distribution of income
      toward high-income households that typically face higher tax rates. In
      the first quarter of fiscal 2007, revenues were more than 8 percent
      greater than in the same period a year earlier, as both individual and
      corporate tax payments continued to rise briskly. Nominal federal outlays increased about 7-1/2 percent in
      fiscal 2006 and were about 20-1/4 percent of nominal GDP, well
      above their most recent fiscal year low of less than 18-1/2
      percent of GDP in 2000. Net interest payments increased 23 percent in
      fiscal 2006, as interest rates rose and federal debt continued to grow.
      Outlays for Medicare increased 10-1/2 percent, reflecting in part
      new benefits payments associated with the Part D prescription drug
      program, which started in January 2006. At the same time, outlays for
      Medicaid declined a bit, to some extent because of a shift of some
      Medicaid payments to Medicare Part D. Spending for disaster relief and
      national flood insurance was almost $28 billion greater in fiscal 2006
      than in the previous fiscal year, primarily owing to the federal
      government's response to the hurricanes in the autumn of 2005. Outlays
      for defense in fiscal 2006 slowed to their lowest rate of increase
      since fiscal 2001, although the rise was still about 6 percent. In the
      first quarter of fiscal 2007, total federal outlays were only 1 percent
      greater than those in the same period a year earlier; in this period,
      defense spending was 12 percent above its year-earlier level, but
      outlays related to disaster relief and flood insurance were markedly
      lower than they were a year earlier. As measured in the NIPA, real federal expenditures on consumption
      and gross investment--the part of federal spending that is a direct
      component of real GDP--increased 2-1/2 percent over the four
      quarters of calendar year 2006 and contributed about 1/4
      percentage point to the growth rate of real GDP in that year. The
      increase was the result of a pickup in real defense purchases, which
      rose more than 4 percent during calendar 2006 after two years of
      smaller increases. At the same time, real nondefense purchases declined
      more than 1 percent after having risen, on average, about 2 percent per year over the preceding two years. The reduction in the unified deficit in the past two years
      implies that the federal government required less national saving to
      finance its operations. However, nonfederal saving, which excludes
      borrowing by the federal government from total net national saving,
      remained relatively low. Although the saving rate for private business
      and state and local governments has increased in recent years, the
      improvement has been offset by declines in the personal saving rate.
      Total national saving, net of depreciation, was 2 percent of nominal
      GDP in the third quarter of 2006. The recent national saving rate is an
      improvement from the lows of a few years ago, but it has been
      insufficient to avoid an increasing reliance on borrowing from abroad
      to finance the nation's capital spending. Federal Borrowing  *d*  Return to text
 The Treasury responded to the reduction in the federal deficit in
      2006 by paying down Treasury bills over the course of the year and by
      trimming the gross issuance of marketable Treasury coupon securities.
      As of the third quarter of 2006, the quantity of federal debt
      held
      
      by the public as a percentage of nominal GDP had
      declined about 1/2 percentage point, to about 36 percent. Early in the first quarter of 2006, federal debt subject to the
      statutory limit reached the then-current ceiling of $8.2 trillion. The Treasury employed various methods to avoid breaching the
      limit until the Congress increased it to nearly $9 trillion in March.
      As of the end of December, the total amount of federal debt subject to
      the limit was $8.6 trillion. In February, the Treasury auctioned thirty-year bonds for the
      first time since 2001. The offering was apparently well received, as
      was the reopening of the issue in August. The Treasury announced in
      August that it would issue thirty-year bonds on a quarterly basis
      beginning in 2007. The acquisition of Treasury debt by foreigners slowed further in
      2006 from its peak in 2004. However, outstanding Treasury debt also
      grew more slowly, leaving the share of outstanding debt held by foreign
      investors little changed, on balance, from its average level over the
      preceding two years. According to Treasury data on international
      capital flows, foreigners (official and other) purchased considerably
      fewer U.S. Treasury coupon securities in 2006 than in 2005. The average
      proportion of nominal coupon securities purchased by foreign and
      international investors at auctions in 2006 about matched the average
      from the previous year at 16 percent, but it was down noticeably from
      an average level of 25 percent in 2004. State and Local Government The fiscal positions of state and local governments improved
      further in 2006. Apart from federal grants-in-aid, revenues rose at an
      annual rate of 7 percent over the first three quarters of 2006 after
      posting relatively strong gains in the preceding two years. Receipts
      from taxes on retail sales and on individual and corporate incomes
      continued to rise at a brisk pace; however, decreasing gains in house
      prices slowed the rise in property tax revenues in the third quarter of
      2006 from the rapid pace in the previous two years. The sustained
      strength in total revenues, along with the efforts of states and
      localities to restrain spending for health care, has enabled these
      jurisdictions to step up spending on other programs and still rebuild
      their reserve funds. As measured in the NIPA, net saving by state and
      local governments excluding social insurance funds--a measure that is
      broadly similar to the surplus in an operating budget--was almost $4 billion during the first three quarters of 2006. States and localities
      generally have seen improvement in their fiscal positions recently, but
      in coming years most governments will have to face the budget pressures
      of providing pension and health benefits to an expanding number of
      retired employees, and the states' costs for Medicaid are expected to
      rise substantially as the baby-boom generation ages. Real expenditures by state and local governments on consumption
      and gross investment, the component of these governments' spending that
      enters directly into the calculation of real GDP, rose 3 percent
      over the four quarters of 2006. That increase was the largest since
      2001 and contributed about 1/4 percentage point to the change in
      real GDP during the year. Real expenditures for investment rose
      4-3/4 percent, largely because of a strong increase in real
      construction spending in the first half of the year. Spending for
      current consumption in real terms increased 2-1/2 percent over
      the four quarters of 2006. Hiring by state and local governments
      stepped up last year. Of the cumulative increase in employment of
      254,000 in 2006, about two-thirds of the jobs were in education. State and Local Government Borrowing Borrowing by state and local governments dropped below its rapid
      2005 pace amid improved fiscal positions and fewer advance refunding
      issues. Nonetheless, bond issuance for new capital expenditures,
      particularly for education and transportation, boosted long-term
      borrowing. Credit quality in the state and local sector rose
      substantially in 2006, as the number of credit-rating upgrades far
      exceeded the small number of downgrades. Return to menu The External Sector  *d*  Return to text
 The U.S. current account deficit averaged $875 billion
      
      at an annual rate, or about 6-1/2
      percent of nominal GDP, in the first three quarters of 2006 (the latest
      available data). The deficit was wider than in 2005, partly because of
      a larger deficit on trade of goods and services. In addition, net
      investment income, which turned negative in the fourth quarter of 2005,
      remained negative in the first three quarters of last year, further
      expanding the current account deficit. International Trade After widening through most of 2005, the nominal trade deficit
      leveled out in the first half of 2006, rose to a record high in August,
      and then narrowed noticeably through November (the latest available
      data). On average, the nominal trade deficit was wider in 2006 than in
      the previous year. Nominal imports of goods grew more slowly than
      exports did early last year and, after reaching late-summer peaks,
      dropped because of declines in both the price and volume of imported
      oil. Meanwhile, imports of services decelerated sharply in the second
      half of last year. In contrast, nominal exports of goods and services
      pushed upward steadily throughout the year and grew significantly
      faster than did nominal imports. Given that the level of exports was
      smaller than the level of imports, the faster export growth during 2006
      was not enough to narrow the nominal trade deficit. Although the
      nominal trade deficit last year (through November, annualized) was
      wider in dollar terms, the trade deficit as a share of GDP, at just
      under 6 percent, was about the same as in 2005. Real exports of goods and services grew a robust 9-1/4
      percent last year. In the first quarter, growth was boosted by a
      catch-up of exports affected by hurricane damage in late 2005.
      Throughout the year, exports were supported by strong foreign economic
      activity. Real exports of goods rose 10-1/4 percent last year, a
      little faster than in the previous year. Export growth was spread
      fairly evenly across all major end-use categories, though exports of
      computers and semiconductors expanded noticeably more slowly than in
      2005. By destination, exports to China and other emerging Asian
      economies grew very rapidly, as did those to South America. Exports to
      Mexico and western Europe rose at a more modest pace. Real exports of
      services were up a solid 6-3/4 percent for the year, double the
      pace of 2005. Prices of exported goods rose at a 3-1/2 percent rate
      last year, a little faster than their pace in 2005. Reflecting the
      effects of very large jumps in prices of industrial supplies,
      particularly fuels and metals, export prices moved up sharply in the
      second and third quarters; they decelerated toward the end of the year
      as prices of exported fuels retreated from their high levels and as
      prices of exported metals moved up more slowly. Real imports of goods and services rose 3 percent last year, more
      slowly than in the previous year. As with the growth in real exports,
      real import growth got off to a quick start last year amid robust
      domestic growth. But import growth slowed, on average, in the middle
      quarters of the year, along with U.S. real GDP growth, and real imports
      fell in the fourth quarter as a result of a sharp drop in oil and
      natural gas imports. Despite some fourth-quarter declines, for the year
      imports increased in every major end-use category except petroleum and
      natural gas. Imports of services rose more than 5 percent last year, a
      step-up from the previous year's sluggish pace.  *d*  Return to text
 Prices of imported non-oil goods increased less than 1 percent,
      
      on balance, in 2006 despite some wide
      gyrations. After falling in the first quarter, prices reversed course,
      surged upward, and then cooled in the fourth quarter. The quarterly
      pattern was driven by movements in nonfuel commodity prices, which
      soared in the second and third quarters before leveling off in the
      fourth quarter. Metals figured prominently among the nonfuel commodities that
      boosted trade prices last year. Prices for a variety of
      metals--including copper, aluminum, nickel, and zinc--skyrocketed in
      the second quarter. Factors contributing to the surge in prices
      included growing demand, particularly from developing countries, low
      levels of inventories for some metals, and perhaps increased
      speculative demand. Prices for nickel and zinc continued to move up
      throughout the year. In the second half of the year, aluminum prices
      trended sideways, and copper prices moved down from their peaks as
      inventory and supply conditions improved somewhat. For most of these
      metals, those price trends have continued this year. An exception is
      zinc, the price of which has plummeted. The spot price of West Texas intermediate crude oil averaged $66
      per barrel in 2006, nearly $10 per barrel higher than in 2005;
      moreover, crude oil prices were especially volatile last year. The spot
      price climbed from around $61 per barrel at the end of 2005 to a peak
      of $77 per barrel in August as violence in the Middle East, a shutdown
      of the Prudhoe Bay oil field in Alaska, and forecasts of an active
      hurricane season led to increased demand. In the event, oil supply was
      affected far less than anticipated by these factors, and oil prices
      declined over the next few months as demand dropped and elevated
      petroleum inventories were drawn down. Oil demand for heating was
      depressed by above-average temperatures in the Northern Hemisphere in
      the fourth quarter and in the early weeks of 2007, and the spot price
      fell further, to around $50 per barrel in mid-January, before moving
      back up to $58 per barrel at the end of the month. Far-dated futures
      prices began last year at about $60 per barrel, moved in a
      pattern similar to spot prices throughout most of the year, and
      averaged just over $61 per barrel in January 2007. Notwithstanding the decrease of global oil prices since August,
      several factors continue to support these prices at historically
      elevated levels. Ongoing violence has diminished oil production in Iraq
      and Nigeria. The continuing dispute with Iran over its nuclear program
      threatens a possible curtailment of Iranian exports. Energy investment
      by international oil companies has been hampered in some countries,
      such as Russia and Venezuela, by increased government control of
      domestic energy industries. Moreover, in response to the recent decline
      in oil prices, OPEC has reduced its crude oil production to the lowest
      level since 2004. Oil demand over the past year has also increased
      modestly in developing countries despite high prices. The Financial Account Foreign official inflows in the first three quarters of 2006 were
      above their 2005 pace but remained below the record levels of 2004.
      Most of these official inflows were attributable to Asian central banks
      and took the form of purchases of U.S. government securities, primarily
      bonds and mortgage-backed securities issued by government-sponsored
      enterprises (GSEs). Preliminary data indicate a slight easing of
      official purchases in the fourth quarter of 2006. Net private inflows
      slowed in the first quarter but have changed little since then. Foreign private purchases of U.S. securities in the second and
      third quarters of 2006 slowed slightly from the extraordinary pace set
      in the second half of 2005 and early 2006, but preliminary
      fourth-quarter data show recent demand to have been strong. More than
      half of private flows last year took the form of purchases of corporate
      bonds, and most of the remainder went toward investment in GSE bonds
      and corporate equities. On net, private foreigners purchased few U.S.
      Treasuries. Foreign direct investment flows into the United States
      remained robust. Net purchases of foreign securities by U.S. residents, a
      financial outflow, set a record pace in the first three quarters of
      2006. Preliminary data show a further surge in net purchases in the
      fourth quarter. Demand for foreign bonds by U.S. residents slightly
      exceeded that for foreign equities. After the expiration of the partial
      tax holiday implemented in the Homeland Investment Act of 2004, U.S.
      direct investment abroad dropped back to more normal levels. Return to menu The Labor Market Employment and Unemployment  *d*  Return to text
 Labor markets remained strong in 2006. Nonfarm payroll
      employment
      
      increased 186,000 per month, on average,
      during the second half of 2006, a rate essentially the same as in the
      first half of the year. Employment rose 111,000 in January of 2007. The
      unemployment rate in the fourth quarter of last
      year--4-1/2 percent--was at its lowest quarterly level
      since 2001, and it was little changed in January 2007. In response to the contraction in homebuilding, hiring in the
      construction sector slowed considerably in the second and third
      quarters of 2006, and this sector shed workers in the fourth quarter.
      Although hiring for nonresidential building construction remained brisk
      for most of the year, the steep decline in housing starts curtailed the
      overall demand for construction workers. Employment in the
      manufacturing sector, which rose in the first half of 2006, declined in
      the second half as factory output slowed. From July to December, many
      of the factory layoffs were at makers of motor vehicles and parts and
      at producers closely tied to the construction industry. Outside of the
      construction and manufacturing sectors, employment generally increased
      at a solid pace in the second half of 2006, and hiring was particularly
      rapid in a number of service industries--especially those providing
      education and health services, professional and technical business
      services, and financial services. As a result of the continued expansion of labor demand in 2006,
      the unemployment rate fell further. After remaining around 4-3/4
      percent in the first three quarters of 2006, the unemployment rate
      edged down to 4-1/2 percent in the fourth quarter. The tighter
      labor market was associated with a noticeable increase in employment
      among individuals who had not been participating in the labor force. In
      line with this cyclical tightening of the labor market, the labor force
      participation rate ticked up during 2006, from 66 percent in the first
      quarter to 66-1/4 percent in the fourth quarter, after a
      1/4 percentage point rise during 2005. The recent rise in the
      participation rate follows a period of decline beginning in the late
      1990s that in part reflected some longer-term secular trends in labor
      force behavior. Those trends included a leveling off in the
      participation rate of women and an increase in the proportion of the
      workforce in older age groups, which have lower average participation
      rates. Other indicators also suggest that labor market conditions
      remained generally favorable during the second half of 2006. Layoffs
      remained low as new claims for unemployment insurance fluctuated around
      a relatively subdued level of 315,000 per week. In addition, data
      reported by the Bureau of Labor Statistics showed a further increase
      during the later part of the year in the rate of job openings as a
      percentage of private-sector employment. Productivity and Labor Compensation  *d*  Return to text
 The growth rate of labor productivity in the nonfarm business
      sector, which had slowed in 2004 and 2005 from an exceptionally rapid
      pace earlier in the decade, remained relatively subdued in 2006. Over
      the four quarters of 2006, output per hour of work
      
      in
      the nonfarm business sector increased 2 percent, compared with about a
      3 percent average annual rate of increase during the first half of this
      decade and the second half of the 1990s. During that earlier period,
      productivity gains were spurred by the rapid pace of technological
      change, the growing ability of firms to use information and other
      technology to improve the efficiency of their operations, and increases
      in the amount of capital per worker. Despite the recent slowing in
      productivity growth, these underlying factors do not appear to have
      waned. Accordingly, the recent slowdown in labor productivity may be at
      least in part a temporary cyclical response to the moderation in the
      pace of economic activity in 2006 rather than a meaningful downshift in
      the longer-run trend. As the labor market tightened in 2006, the rise in hourly labor
      compensation, which includes both wages and employer payments for
      employee benefits, stepped up for workers in the nonfarm business
      sector. In nominal terms, compensation per hour increased almost 5 percent over the four quarters of 2006, compared with an average 4 percent rise in the preceding two years. After adjusting compensation
      for increases in the PCE price index, real compensation per hour rose 3 percent in 2006, up from an average gain of about 1 percent in 2004 and
      2005. An alternative measure of employee compensation is the employment
      cost index (ECI) for private nonfarm businesses, which is based on a
      survey of firms conducted by the Bureau of Labor Statistics. According
      to this measure, nominal hourly compensation increased 3-1/4
      percent in 2006, 1/4 percentage point faster than in 2005. In
      real terms, the ECI for hourly compensation rose 1-1/4
      percent last year after averaging a 1/2 percent increase
      over the preceding two years. The nominal wages and salaries component
      of the ECI rose 3-1/4 percent in 2006, while the benefits
      component advanced 3 percent. From the perspective of employers, the acceleration in hourly
      compensation in the nonfarm business sector last year boosted the
      average labor costs associated with producing a unit of output
      2-3/4 percent, up from increases of about 1-3/4
      percent in both 2004 and 2005. Although the rise in unit labor costs
      increased, firms' profit margins appeared to remain elevated in
      2006 relative to longer-run standards. Return to menu Prices Alternative Measures of Price Change, 2004-06
        PercentPrice measure
          2004
          2005
          2006Chain-typeGross domestic product (GDP)
          3.2
          3.1
          2.5Gross domestic purchases
          3.7
          3.6
          2.2Personal consumption expenditures (PCE)
          3.0
          3.1
          1.9Excluding food and energy
          2.2
          2.1
          2.3Market-based PCE excluding food and energy
          1.7
          1.8
          2.0Fixed-weightConsumer price index
          3.3
          3.7
          1.9Excluding food and energy
          2.1
          2.1
          2.6 Note:
        Changes are based on quarterly averages of seasonally adjusted data. Source:
        For chain-type measures, Department of Commerce, Bureau of Economic Analysis; for fixed-weight measures, Department of Labor, Bureau of Labor Statistics.
 Headline inflation slowed in 2006. The PCE
      chain-type price index rose 2 percent over the four quarters of 2006, a
      step-down from the 3 percent increase recorded in 2005. The drop in
      energy prices in the latter part of 2006 accounted for the deceleration
      in the headline number. Core inflation moved higher in the first part
      of 2006 but then eased toward the end of the year. On balance, core PCE
      prices rose about 2-1/4 percent over the four quarters of
      2006, a little faster than the 2 percent increase in 2005. The
      market-based component of the core PCE price index--which excludes
      imputed prices that are not observed in market transactions and that
      often change irregularly--increased 2 percent in 2006, about
      1/4 percentage point more than in the previous year. Energy prices recorded dramatic swings during 2006. PCE energy
      prices increased at an annual rate of about 15 percent in the
      first half of the year and declined at an annual rate of almost 17 percent in the second half. The sharp movements in consumer energy
      prices in 2006 were associated primarily with fluctuations in prices
      for crude oil. The changes in energy prices also were amplified by a
      widening in the margin of the retail price of gasoline over the
      associated cost of crude oil in the first half of the year and by some
      narrowing of that margin in the second half. On balance, the PCE energy
      price index decreased 4 percent over the four quarters of 2006. Food price inflation remained fairly moderate in 2006. The PCE
      index for food and beverages increased 2-1/4 percent, roughly the
      same pace as in the preceding year. Retail prices of meat and poultry
      rose modestly for 2006, as robust demand was met by ample supplies of
      meat. Prices of wheat rose over the course of the year, and prices of
      corn and soybeans spiked at the end of the year in the wake of downward
      revisions to estimates of crop production. Prices of corn also were
      boosted during the year by increased demand for corn to produce
      ethanol. But the small share of wheat, corn, and soybeans in the total
      value of food production limited their effect on retail food prices.
      Prices for food consumed away from home, which are influenced
      importantly by the costs of labor, energy, and other business inputs,
      increased 3-1/4 percent in 2006, a more rapid pace than that for
      prices of food consumed at home. The core PCE price index accelerated to an annual rate of about
      2-1/2 percent in the first half of 2006 on the strength of
      pickups in the price indexes for both goods and services. In the
      spring, increases in housing rents were particularly sharp. The rise
      may have reflected in part a shift in demand toward rental housing as
      rising mortgage rates and lofty home prices made home purchases less
      affordable. The pass-through of higher energy costs to a broad range of
      goods and services also probably contributed to the acceleration in
      core consumer price inflation in the first half of 2006. In the second half of 2006, core PCE price inflation edged down
      to an annual rate of just below 2-1/4 percent. The deceleration
      was the result of a decrease in core goods prices, which likely
      reflected in some measure the waning influence of energy prices. In
      contrast, core services inflation in the second half of the year
      remained at about the same pace as in the first half. Although housing
      rents rose more slowly in the second half of the year, their effect on
      the PCE for core services was mostly offset by faster price increases
      for medical care and a number of other services. The swings in energy costs in 2006 were apparent in the prices of
      inputs used in the production and sale of final goods and services,
      especially of items for which energy costs represent a relatively large
      share of total production costs, including industrial chemicals,
      plastics, fertilizer, and stone and clay products. In addition, the
      prices of some commodities, such as a variety of metals, rose
      significantly in 2006 in response to strong worldwide demand. As a
      result, the core producer price index for intermediate goods, which
      excludes food and energy, rose 5-1/4 percent in 2006, up from the
      4-3/4 percent increase in 2005. The index increased at an annual
      rate of 7-1/4 percent in the first half of 2006, but it
      decelerated to an annual rate of about 3-1/4 percent in the
      second half as energy costs declined. For the year as a whole, measures of long-term inflation
      expectations remained well anchored, although short-term
      expectations were heavily influenced by fluctuations in energy prices.
      The Reuters/Michigan survey measure of the median expectation of
      households for inflation over the next twelve months was about 3 percent in December, down from its peak of 3-3/4 percent in
      August. Longer-term inflation expectations recorded in the
      Reuters/Michigan survey showed less variability. The median survey
      respondent in December expected the rate of inflation during the next
      five to ten years to be 3 percent, down from its peak of 3-1/4
      percent in August. Other indicators likewise suggest that longer-run
      inflation expectations have remained contained. According to the Survey
      of Professional Forecasters, conducted by the Federal Reserve Bank of
      Philadelphia, expectations of inflation over the next ten years
      remained at 2-1/2 percent in 2006, a level that has been
      essentially unchanged since 1998. In addition, inflation compensation
      implied by the spread of yields on nominal Treasury securities over
      their inflation-protected counterparts stayed within the relatively
      narrow range of 2 percent to 2-3/4 percent during the year. Return to menu U.S. Financial Markets Financial conditions in the United States supported economic
      growth in 2006. Yields on long-term Treasury securities climbed a bit,
      on balance, but stayed low by historical standards, while strong
      corporate profits helped fuel substantial gains in equity markets.
      Liquid corporate balance sheets and low corporate leverage helped keep
      risk spreads on corporate bonds narrow. Meanwhile, business borrowing
      picked up to a rapid pace, spurred in part by a rise in merger and
      acquisition activity. In the residential real estate sector, mortgage
      borrowing slowed markedly, as house prices decelerated, especially in
      the second half of the year. Consumer credit expanded at a moderate
      pace. Nonetheless, household debt growth outpaced the growth of
      disposable personal income, and the financial obligations of households
      inched higher. Although households generally appeared able to meet
      their obligations, signs of financial strain were apparent in subprime
      variable-rate mortgages. The M2 monetary aggregate expanded at a
      moderate pace in 2006. Interest Rates  *d*  Return to text
 Market interest rates rose modestly, on balance, in 2006--yields
      on two- and ten-year nominal Treasury securities
      increased
      
      about 40 and 30 basis points respectively.
      Changes in interest rates seemed largely tied to changes in the outlook
      for economic growth and inflation. Rates across the maturity spectrum
      increased notably over the first half of the year, as incoming data on
      activity and inflation came in higher than markets had expected and as
      the FOMC raised the target federal funds rate 25 basis points at
      each of its first four meetings. At the time of the June FOMC meeting,
      interest rate futures market quotes indicated that market participants
      perceived considerable odds of an additional rate tightening by
      year-end. However, market interest rates declined, on net, over
      subsequent months in response to incoming data suggesting that
      inflation pressures were moderating and that economic growth was
      slowing. Market expectations for the trajectory of the federal funds
      rate over the next several years shifted down considerably during the
      second half of the year. More recently, market participants have backed
      away from expectations of a substantial easing of monetary policy as
      incoming data on economic activity have been stronger than expected.
      Investors now expect the FOMC to ease policy only slightly over the
      next two years. Although investors modestly revised their medium-term
      policy expectations over the course of the year, the Committee's
      interest rate decisions were largely anticipated in financial markets
      by the time of each meeting. Throughout the year, forward-looking
      measures of uncertainty about monetary policy inferred from interest
      rate options remained near the low end of historical ranges.  *d*  Return to text
 Yields on inflation-indexed Treasury securities increased about
      as much as those on their nominal counterparts in 2006. Medium- and
      long-term inflation compensation--measured from spreads between yields
      on nominal and inflation-indexed securities--were about unchanged to a
      little lower, on net, and during the year these measures exhibited only
      modest swings in response to incoming inflation data and oil price
      movements. In the corporate bond market, yields on investment-grade
      securities moved about in line
      
      with those on
      comparable-maturity Treasury securities. In contrast, yields on
      speculative-grade securities fell slightly, pulling risk spreads lower
      in that segment of the market. The narrowness of investment- and
      speculative-grade spreads seems to reflect investors' sanguine
      perceptions of corporate credit quality over the medium term, which
      likely reflect in large part the strength of business balance sheets
      and a benign economic outlook. The term structure of forward risk
      spreads for corporate bonds supports this view, as forward spreads one
      and two years ahead are low, while the spreads further out the curve
      are more in line with historical norms. Equity Markets  *d*  Return to text
 Broad equity indexes soared 10 percent to 20 percent in 2006,
      boosted by strong growth
      
      in corporate earnings. Share
      prices rose across a wide range of sectors, but increases in
      telecommunications and security brokerage stocks were especially
      noteworthy. The difference between the twelve-month forward
      earnings-price ratio for the S&P 500 and the long-term real Treasury
      yield--a crude measure of the premium that investors require for
      holding equity shares--was little changed on balance. The implied
      volatility of the S&P 500 calculated from options prices spiked
      temporarily in the late spring in connection with a period of strain in
      several markets but remained near historical lows for the remainder of
      the year. Net inflows into domestic equity mutual funds were quite
      modest in 2006, while inflows into international equity funds were
      exceptionally strong. Market Functioning and Financial Stability Overall, financial markets functioned smoothly over the year and
      proved resilient to several shocks. Equity markets in the
      United States and currency and fixed-income markets in several
      emerging-market economies experienced heightened volatility late in the
      second quarter, but the turbulence was short lived. The liquidation of
      a few sizable hedge funds attracted considerable attention for a time
      but had little discernible effect on the broad functioning of markets.
      Even the liquidation of Amaranth--a hedge fund that was wound down in
      the fall after reporting a loss in excess of $6 billion, mostly in
      energy trades--left little imprint on financial markets, although it
      raised some concerns about risk-management practices. Implied
      volatilities, risk spreads, and various other potential measures of
      financial stress generally stayed at very low levels throughout the
      year, suggesting that investors were comfortable taking on risk, likely
      in part because they were confident about the economic and financial
      outlook. Throughout the year, bid-ask spreads on the most actively traded
      Treasury securities remained within narrow ranges. Some instances of
      questionable trading activities occurred in the secondary market for
      Treasury securities over the course of the year. The Interagency
      Working Group for Treasury Market Surveillance monitored these
      situations closely.
      1
      In November, the Federal Reserve Bank
      of New York arranged a meeting with all primary dealers to discuss
      developments in Treasury markets and to encourage the firms to review
      their internal oversight of trading operations. Subsequently, a
      private-sector group sponsored by the Federal Reserve Bank of New York
      released a draft report laying out a set of best practices for firms
      active in the Treasury market on topics such as appropriate trading
      strategies and internal controls. In July, the Federal Reserve Board implemented a revision to the
      treatment of GSEs and certain international organizations under its
      Policy on Payments System Risk. Under the change, interest and
      redemption payments on securities issued by these institutions are now
      released only when the issuer's Federal Reserve account contains
      sufficient funds to cover the payments; that is, these institutions no
      longer may employ daylight credit to fund such payments. The Board of
      Governors determined that the change represents an appropriate
      risk-management policy for the central bank and is consistent with the
      general practices of private issuing and paying agents. In addition,
      GSEs and international organizations are now subject to a penalty fee
      for daylight overdrafts resulting from general corporate payment
      activity (activity other than interest and redemption payments). This
      change aligns the policy for GSEs and international organizations with
      that for other Federal Reserve account holders that do not have regular
      access to the Federal Reserve's discount window and thus are not
      eligible for intraday credit. The transition to the new policy occurred
      smoothly with minimal effects on the functioning of the payments system
      and no notable adverse effects on short-term funding markets. Following up on a meeting with the Federal Reserve Bank of New
      York in the fall of 2005, the largest participants in the fast-growing
      market for credit derivatives agreed to a series of steps to strengthen
      that market's infrastructure. Over the course of 2006, credit
      derivatives dealers phased out the practice of transferring positions
      to a different counterparty without first obtaining the consent of the
      original counterparty. They also reduced by 85 percent the number of
      trade confirmations outstanding more than thirty days; they doubled the
      share of trades that are confirmed via an electronic platform, to 80 percent of total trade volume; and they agreed upon a new protocol for
      the settlement of such derivatives after a credit event. Debt and Financial Intermediation by Banks Total debt of the domestic nonfinancial sectors expanded an
      estimated 7-3/4 percent in 2006, well below the pace in 2005 but
      still faster than that of nominal income. Debt growth slowed markedly
      in the household and government sectors, but business debt accelerated. About 30 percent of the growth in nonfinancial sector debt in
      2006 was intermediated by the banking sector. This share is about even
      with the average over the past ten years and is about 5 percentage
      points above the average observed in the 1980s and early 1990s.
      Commercial bank credit expanded 9-1/2 percent in 2006,
      supported by brisk growth in loans to businesses. Bank credit also was
      boosted in the autumn by a consolidation of a substantial volume of
      thrift assets onto a commercial bank's balance sheet that had resulted
      from an internal reorganization at a large bank holding company. Bank lending to businesses through commercial and industrial
      loans increased at a rapid pace last year. The growth was fueled by
      vigorous merger and acquisition activity, rising outlays for investment
      goods, ongoing inventory accumulation, and an accommodative lending
      environment. Bank loans secured by commercial real estate, though
      strong, decelerated over the course of the year. The moderation in
      commercial real estate lending was consistent with responses by large
      and medium-sized banks to the Senior Loan Officer Opinion Survey on
      Bank Lending Practices, which pointed to slowing demand and a net
      tightening of credit standards for such loans in the second half of the
      year. Consumer loans and residential mortgages held by banks grew at a
      moderate rate for the year as a whole. However, excluding the effects
      of the thrift consolidation, residential real estate lending slowed
      considerably in the fourth quarter, no doubt reflecting in part the
      downturn in the housing market. Commercial bank profits as a percentage of average assets were
      strong in 2006 and rose slightly above 2005 levels. Net interest
      margins declined a bit further, likely in response to continued
      competitive pressures and a modest inversion of the yield curve, but
      bank profitability was supported by growth in non-interest income and
      by well-contained costs. Continued strong asset quality also helped to
      support profitability in 2006 by allowing banks to reduce their
      loan-loss provisioning. Robust asset quality was reflected in loan
      delinquency and charge-off rates that remained at low levels through
      the end of 2006. The M2 Monetary Aggregate and Reserves M2 expanded at a 5 percent rate last year, somewhat faster than
      in 2005. Typically, as short-term interest rates rise, deposit rates
      lag somewhat, increasing the opportunity cost of holding money. In
      2006, this effect apparently slowed money growth less than would have
      been expected on the basis of historical norms, and the velocity of M2
      rose only about 3/4 percent. Retail money market mutual funds
      and small time deposits, components of M2 whose yields move most
      closely with market rates, grew rapidly. However, liquid deposits,
      which constitute the largest component of M2, and whose yields adjust
      more gradually, were about flat on net. Currency expanded a modest
      3-1/2 percent, an increase similar to that in 2005,
      reflecting weak, possibly negative, net demand from overseas. Part of the Financial Services Regulatory Relief Act of 2006 gave
      the Federal Reserve authority, beginning in October 2011, to pay
      interest on reserve balances and to further reduce or eliminate reserve
      requirements. At the October FOMC meeting, the Chairman asked the staff
      to prepare for the implementation of this legislation. Return to menu International Developments Foreign economic growth was generally strong in 2006, as
      expansion continued in all major regions of the world. The Japanese
      economy decelerated somewhat but maintained positive growth, and the
      pace of activity in the euro area picked up. Labor market conditions in
      both areas improved. Emerging-market economies also recorded solid
      growth last year and experienced no apparent lasting ill effects from
      the brief period of financial market volatility that hit some of them
      particularly hard in the late spring. Although there are signs that
      steps taken to slow growth of investment in China have been effective,
      the Chinese economy continued to grow rapidly. Rising energy prices
      boosted consumer price inflation in many areas of the world early last
      year, but monetary tightening appears to have prevented inflation from
      moving significantly higher, and the effects of higher energy prices on
      core prices were modest. Industrial countries tightened monetary policy in 2006. Some
      countries paused around the same time as the Federal Reserve, and
      others continued to tighten throughout the year. After ending its
      policy of quantitative easing in the spring, the Bank of Japan (BOJ)
      raised its policy rate 25 basis points in July. Weak consumer spending
      and low inflation have apparently deterred the BOJ from tightening
      since then. With growth in the European economies firming, concerns
      over inflationary pressures prompted the European Central Bank to raise
      its policy rate five times last year, to 3.5 percent. The Bank of
      Canada tightened 75 basis points in several steps over the first half
      of the year but has left the overnight rate unchanged since then. After
      keeping its policy rate constant in the first half of the year, the
      Bank of England tightened policy 25 basis points in August and November
      2006 and in January 2007. The statements accompanying each tightening
      cited the upside risks to inflation posed by low levels of spare
      capacity. During the first half of 2006, ten-year sovereign yields in the
      euro area, Canada, and Japan rose sharply on balance: Increases ranged
      from 45 basis points in Japan to 75 basis points in Germany. Yields on
      inflation-protected long-term securities in these economies also rose
      during the first half of 2006 but not as much as nominal yields and
      thus implied a noteworthy rise in inflation compensation. These
      developments occurred largely in reaction to continuing upward
      pressures on inflation, which stemmed from a further run-up in energy
      prices and indications that global economic growth remained robust. From their midyear highs, nominal government benchmark bond
      yields fell noticeably until about the beginning of December in most
      major advanced economies, as investors reacted to moves in U.S. rates
      and evaluated the implications for the global economy of the economic
      slowdown that seemed to be under way in the United States. Over this
      period, yields on ten-year nominal bonds declined by amounts that
      ranged from about 25 basis points in the United Kingdom to about 70
      basis points in Canada. Yields on inflation-indexed securities declined
      less; modest declines in inflation breakeven rates were attributed in
      part to lower energy prices in the second half of the year. Since the beginning of December, however, nominal and
      indexed government bond yields have risen once again in most advanced
      economies, partly because new data releases appeared to alleviate
      investors' concerns that global economic growth might slow appreciably.
      Yields on both ten-year nominal and indexed securities have risen
      15 basis points in Japan and 25 to 50 basis points in the
      euro area, the United Kingdom, and Canada since their December lows. As
      a result, inflation breakeven rates have been little changed.  *d*  Return to text
 The Federal Reserve's broadest measure of the nominal
      trade-weighted exchange value of the dollar
      
      declined
      3-3/4 percent from the beginning of last year through early
      February of this year. Over that period, the dollar appreciated
      2-1/4 percent against the yen and 1-1/2 percent
      against the Canadian dollar, but it depreciated about 9 percent, on
      net, against the euro, almost 13 percent against sterling, and 4 percent against the Chinese renminbi. The renminbi's rate of
      appreciation stepped up in late 2006 and early 2007, but daily
      fluctuations in the dollar-renminbi exchange rate were very small. Most of the dollar's overall decline in 2006 occurred between
      mid-April and early May. During this period, market participants
      reportedly sensed that the FOMC was approaching the end of its series
      of policy tightenings, and interest rate differentials moved against
      the dollar. Traders also refocused on the large and persistent U.S.
      current account deficit, which was further boosted by crude oil prices
      that had moved above $70 per barrel. To date in 2007, the dollar's
      broad nominal exchange value has risen 1 percent on balance. In the wake of strong advances in 2005, major global equity
      indexes posted solid gains, on balance, in 2006 and in early 2007.
      After rising 5 percent to 10 percent in the first quarter of 2006, most
      global indexes fell sharply beginning in early May to reach intra-year
      lows in mid-June. Market participants attributed the drops in share
      prices to increased uncertainty about prospective inflation, caused in
      part by the run-up in energy prices, and to a retreat from risk-taking.
      Broad-based gains in stock prices since midsummer appear to be
      associated with a scaling back of expectations for future tightening of
      monetary policy in several countries and with declines in energy
      prices. Since mid-June, broad stock market indexes have gained 10 percent to 20 percent in Europe, Japan, and Canada. Industrial Economies After increasing at an annual rate of roughly 2 percent in the
      first half of 2006, Japanese real GDP grew only 3/4
      percent in the third quarter, largely because of slower growth of
      consumption. Capital spending was an important contributor to
      growth of output throughout the year, supported by strong corporate
      profitability. Labor market conditions continued to improve; the
      unemployment rate was about 4 percent in December, its lowest level
      since 1998, and the ratio of job offers to applicants remained close to
      a thirteen-year high. However, wage growth was very subdued, as firms
      controlled cost increases, and unit labor costs continued to fall. In
      2006, consumer prices started to rise again, posting small twelve-month
      increases after June, and land prices in Japan's six largest cities
      rose for the first time since 1991. However, the GDP deflator continued
      to decline slowly. Real GDP in the euro area accelerated somewhat in 2006, posting
      average growth of 3-1/4 percent at an annual rate over the first
      three quarters. Output growth was supported in part by strong consumer
      spending, which grew substantially faster than in 2005. The stronger
      performance of the economy was reflected in improving labor market
      conditions: The unemployment rate in the euro area fell 0.8 percentage
      point during the year to reach 7.5 percent in December, continuing a
      downward movement that began in 2004. Wages and salaries in the
      manufacturing and services sector grew at an average annual rate of
      2-1/4 percent in the first three quarters of the year--a bit
      lower than their rate of growth in 2005. Higher energy prices boosted
      euro-area consumer price inflation, which rose to about 2-1/2
      percent in the first half of 2006; late in the year, it dropped below
      the European Central Bank's target ceiling of 2 percent. Core inflation
      remained near 1-1/2 percent. Real GDP in the United Kingdom grew 3 percent last year, and real
      GDP in Canada grew 3 percent, on average, through the first three
      quarters. Despite declining consumer confidence in the United Kingdom,
      the pace of consumption growth over the year was slightly higher than
      in 2005, and consumer spending in Canada, supported by moderate
      employment growth, also remained robust. Declines in energy prices
      brought Canadian consumer price inflation down after the middle of the
      year to a twelve-month change of about 1-1/2 percent in
      December, below the Bank of Canada's 2 percent inflation target.
      Inflation in the United Kingdom edged up throughout the year, partly
      because of increases in electricity and natural gas prices that were
      implemented in the fall. Emerging-Market Economies Real GDP growth in China remained strong but moderated a bit in
      the second half. The mild slowdown suggests that the administrative
      measures put in place by the Chinese authorities to cool investment
      have had an effect. The trade surplus recorded a substantial increase
      in 2006. Four-quarter inflation picked up near the end of last year to
      over 2 percent, reflecting higher food prices. Elsewhere in emerging Asia, economic performance was generally
      solid in 2006. In Korea, GDP growth slowed from the strong pace
      registered in 2005, partly because of monetary tightening, and consumer
      price inflation remained modest. The pace of growth in other countries
      stayed strong throughout 2006 as a result of robust exports and, in
      some cases, strengthening domestic demand. Four-quarter inflation
      moderated across the region. That moderation resulted from the waning
      effects of earlier reductions or removals of domestic fuel subsidies,
      but the previous tightening of monetary policy in the region and an
      appreciation of exchange rates also made a contribution. Capital
      inflows into several Asian emerging-market economies--particularly
      Thailand--in late 2006 and early this year put upward pressure on local
      currencies. Measures taken by Thai authorities seemed to succeed in
      limiting upward movement of the baht, but share prices in the Thai
      stock market fell sharply. Financial markets in other countries in the
      region were less affected and showed no noticeable spillovers from
      events in Thailand. Output growth in Mexico was exceptionally strong in the first
      half of last year, especially in the manufacturing, construction, and
      services sectors. Growth stepped down in the second half; construction
      activity remained robust but was offset by a slowdown in exports of
      manufactured goods to the United States. Mexican consumer price
      inflation was elevated during the second half by higher food prices and
      reached rates above the 4 percent upper limit of the central bank's
      inflation target range; at year-end, inflation was still at the top end
      of the range. Brazilian output growth was solid in the first quarter but slowed
      noticeably later in the year, partly because of weak manufacturing
      performance. Brazilian four-quarter inflation fell markedly, from
      almost 6 percent at the end of 2005 to just over 3 percent in December.
      In Argentina, steady growth in investment and consumption kept real GDP
      on a solid uptrend throughout 2006. The Argentine government continued
      to attempt to bring down inflation through voluntary price agreements
      with producers in several sectors; although inflation had edged down to
      the single-digit range by year-end, it was still high.  1. The group was established in 1992 and includes representatives
      from the Board of Governors of the Federal Reserve System, the
      Treasury, the Securities and Exchange Commission, the Commodity Futures
      Trading Commission, and the Federal Reserve Bank of New York.
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