Monetary Policy and

Economic Developments
Monetary Policy and the Economic Outlook

The U.S. economy turned in another

solid performance in 2006, although the

pattern of growth was uneven. After

rebounding in the early part of the year

from hurricane-related disruptions in the

autumn of 2005, the pace of expansion

during the remaining three quarters

averaged somewhat below that of the

preceding two years, responding in part

to the removal of monetary policy accommodation since 2004. The housing

market cooled substantially, and, in the

latter part of 2006, the production of

light motor vehicles also stepped down.

Elsewhere in the economy, activity

remained strong. Consumer spending

increased vigorously in 2006 as households’ real income made strong gains.

Business investment rose at a solid rate

for the year as a whole, although it

decelerated late in the year in part because of some softening in purchases of

equipment related to construction and

motor vehicle manufacturing. Demand

for U.S. exports rose at a robust pace in

2006, supported by strong economic activity abroad. Against this backdrop,

businesses continued to add jobs at a

steady rate, and the unemployment rate

decreased further.

Total consumer price infl

clined in 2006 from its elevate

2005, as energy prices fell, on 

rising rapidly over the precedi

of years. Crude oil prices ro

the first half of 2006 but tur

sharply later in the year. As 

consumer price inflation clim

first half of the year before s

the second half. The sharp m

in prices of crude oil appea

affected not only prices of ga

other petroleum-based types 

but also prices of a broader 

goods and services that use p

based inputs. Partly as a re

sumer price inflation excluding 

energy—so-called core consu

inflation—moved up during th

of the year but eased subsequ

balance, core inflation was a 

over the four quarters of 200

2005. Measures of long-term 

expectations, however, rema

anchored.

The monetary policy decisi

Federal Open Market C

(FOMC) in 2006 were intende

sustainable economic expansi

promote a return to low and st

tion. In that regard, the econ

look for this year and nex

favorable. Although the cont

homebuilding has been a 

growth, that restraint seems 

diminish over 2007. Further 

real wages as well as ongoing 

in employment should suppo

rise in consumer spending. In 

at the beginning of 2007, ho

balance sheets appeared to b

shape. Whereas gains in hom

slowed last year, household 

Note: The discussion here and in the next

chapter consists of the text, tables, and selected

charts from the Monetary Policy Report submitted

to the Congress on February 14, 2007, pursuant to

section 2B of the Federal Reserve Act; the complete set of charts is available on the Board’s web

site, at www.federalreserve.gov/boarddocs/hh.

Other materials in this annual report related to

the conduct of monetary policy include the minutes of the 2006 meetings of the Federal Open

Market Committee (see the ‘‘Records’’ section)

and statistical tables 1–4 (at the back of this

report).
increased moderately as stock market

wealth grew and households lessened

their accumulation of debt. Delinquency

rates on consumer loans and on most

types of mortgages remained low,

although they increased markedly for

subprime mortgages with variable interest rates. As for businesses, balance

sheets are quite liquid, credit quality is

good, and most firms enjoy ready access

to funds. These favorable financial conditions, along with further expansion in

business output, user costs of capital

equipment that remain attractive, and

the potential for further gains in efficiency, should continue to spur business

investment. In addition, sustained

expansion in foreign economies ought

to maintain demand for U.S. exports. On

balance, growth of real gross domestic

product in the United States appears

likely to run slightly below that of the

economy’s potential over the next few

quarters and then to rise to a pace

around that of the economy’s long-run

trend.

Regarding inflation, increases in core

consumer prices are expected to moderate, on balance, over the next two years.

Along with inflation expectations that

are well anchored, some of the factors

that boosted inflation in recent years

seem likely to lessen. In particular, the

paths for prices of energy and other

commodities embedded in futures markets suggest that the impetus to core

inflation from these influences will diminish further. In addition, the outsized

increases in shelter costs that boosted

core inflation last year are not expected

to persist. Although unit labor costs in

the nonfarm business sector have been

rising, the average markup of prices

over such costs is high by historical

standards. The relatively high markup

suggests that further increases in costs

could be absorbed, at least to some

extent, by a narrowing of firms’ profit

margins rather than by passi

costs in the form of higher 

prices, especially if pressure

sources ease modestly as antic

The outlook for real econo

ity is uncertain. An upside ri

consumer spending, which 

especially buoyant in recen

may continue to expand at a 

would ultimately lead to an 

of pressures on resources an

Alternatively, prospects for r

construction, which are di

assess, may pose some down

Although residential real estat

have shown some recent 

stabilizing, homebuilders’ inve

unsold homes remain elevate

cutbacks in construction t

inventories toward more-co

levels could become steeper 

persistent than currently an

Moreover, if home values 

depreciate sharply, the resultin

of household wealth could 

appreciable restraint on 

spending.

Whether inflation will 

gradually as expected is also 

On the one hand, the nation’s 

to produce could increase mo

than anticipated, or product 

markets could work efficiently 

rates of utilization, either of wh

lead to a lower trajectory for 

than currently forecast. On 

hand, expanding global dem

threats to supply from actual a

tial disruptions pose upside 

energy prices. In addition, br

demand for non-energy mate

commodities could lead t

upward pressures on busine

Also, if inflation were to pers

the elevated average level o

three years, longer-run inflatio

tions could deteriorate, parti

pressures on resources were to 
At recent meetings, the FOMC indicated

that the risk that inflation will fail to

moderate as expected is its predominant

policy concern.

Monetary Policy, Financial

Markets, and the Economy

in 2006 and Early 2007

The FOMC firmed the stance of monetary policy 25 basis points at each of its

four meetings over the first half of

2006. The Committee raised its target

for the federal funds rate at its January

and March meetings as available information pointed to accumulating pressures on inflation and solid economic

growth. Although readings on core

inflation had remained favorable,

increases in energy prices and the relatively high level of resource utilization

threatened to add to existing inflation

pressures. Meanwhile, underlying aggregate demand, supported by robust

consumer spending and accelerating

business investment, appear

growing at a solid rate. By th

the May and June meetin

pointed to a moderation in the 

consumer spending and a fur

ing in the housing market. 

core consumer prices had ri

rapidly. Although the Committ

inflation expectations still to 

tained, it was mindful that 

prices of energy and other com

could impart greater in

momentum. Against this back

FOMC voted to increase the p

a further 25 basis points at bot

and June meetings, bringing t

funds rate to 51⁄4 percent. In 

ment accompanying its June 

the FOMC indicated that it bel

the moderation in economi

would help to limit inflation

sures over time but also noted 

upside inflation risks remain

had in its May statement, th

made clear in June that the e

1/28

3/16

5/4

6/30

8/10

9/21

11/10

12/14

2/2

3/22

5/3

6/30

8/9

9/20

11/1

12/13

1/31

3/28

5/10

6/29

8/8

9/20

10/25

12/1

2004 2005 2006 

Selected Interest Rates, 2004–07 

Target federal funds rate

Ten-year Treasury

NOTE: The data are daily and extend through February 7, 2007. The ten-year Treasury rate is 

maturity yield based on the most actively traded securities. The dates on the horizontal axis are th

meetings. 

SOURCE: Department of the Treasury and the Federal Reserve. 
timing of additional firming would

depend on the evolution of the outlook

for both inflation and economic growth

as implied by incoming information.

In the second half of the year, a further slowdown in residential construction activity and a contraction in motor

vehicle production created a significant

drag on economic activity. However,

consumer spending held up, and employment rose at a solid pace. Meanwhile, energy prices reversed much of

their increases of the first half of the

year, sending headline inflation lower.

Core inflation also eased somewhat, albeit to a rate above its year-earlier level.

Against this backdrop, the FOMC left

the stance of policy unchanged at its

final four meetings of 2006. Committee

discussions in those meetings focused in

part on developments in the housing

market and their implications for the

broader economy. Although the housing

market was weakening throughout this

period, the Committee judged that the

downturn had not spilled over significantly to consumer spending. The economy was expected to expand over coming quarters at a rate close to or a little

below its long-run sustainable pace. At

the same time, FOMC members noted

that, even though core inflation had

slowed from the very rapid rates of the

spring and summer, current rates remained undesirably high. Most members expected core inflation to moderate

gradually, but they were uncertain about

the likely pace and extent of that moderation. Thus, in statements accompanying each rate announcement over this

period, the FOMC reiterated that inflation risks remained and that the extent

and timing of any additional policy firming would depend on the outlook for

both inflation and economic growth implied by incoming information.

Over the period between the December 2006 and January 2007 FOMC

meetings, incoming data on inf

economic activity were gener

favorable. Core inflation reced

from the elevated levels reache

2006, and some indicators 

that the demand for housing 

stabilizing. Business investm

softened in the fourth quarter, a

trial production decelerated s

the fall, but consumer spendi

robust gains in the final month

At its January 2007 meeting, 

mittee again decided to leave 

for the federal funds rate u

reiterated concern about infla

and again cited the role of 

data in determining the exten

ing of any additional firming.

In recent years, the FO

worked to improve the transp

its decisionmaking process, 

Committee continues to 

whether further changes woul

its communications with the 

spring 2006, the Chairman ap

subcommittee to help the 

organize the discussion of a br

of communication issues. Th

began its consideration of th

at its August meeting and has 

them at several meetings sinc

Economic Projections

for 2007 and 2008

In conjunction with the FOMC 

in January, the members of the 

Governors and the Federal 

Bank presidents, all of whom p

in the deliberations of the FO

vided economic projections 

and 2008. The projections ind

the participants expect s

expansion of real economic ac

ing the next two years, ass

appropriate course for moneta

The central tendency of the FO

ticipants’ forecasts for the in
real GDP is 21⁄2 percent to 3 percent

over the four quarters of 2007 and

23⁄4 percent to 3 percent over the four

quarters of 2008. The central tendency

of their forecasts for the civilian unemployment rate is 41⁄2 percent to 43⁄4 percent in the fourth quarter both of this

year and of 2008. For inflation, the central tendency of the forecasts anticipates

an increase in the price index for personal consumption expenditures excluding food and energy—the so-called core

PCE price index—of 2 percent to

21⁄4 percent over the four quarters of

2007 and 13⁄4 percent to 2 percent over

the four quarters of 2008.

The economy is projected to expand

at a moderate rate. Although the cooling

of the housing market continues to damp

economic activity, the drag on economic

growth from declining construction activity is expected to diminish later this

year. Household spending for goods and

services should rise at a solid 

part as a result of ongoing ga

wages and employment and of 

strong household balance she

ness outlays for new equip

software are expected to incr

rate consistent with a modera

sion in business output and t

ported by continuing declines i

cost of high-technology capi

ment and by favorable financ

tions. In addition, the solid exp

economic activity abroad sho

tain the rising demand for U.

of goods and services.

Decreased pressures from th

energy and other commoditi

environment of moderate 

expansion and well-anchored l

inflation expectations, are ex

contribute to further easing in 

In addition, increases in pr

should help to limit cost press

Economic Projections of Federal Reserve Governors and Reserve Bank Presiden

for 2007 and 2008

Percent

Indicator Memo:

2006 actual

2007 2008

Range Central

tendency Range 

Change, fourth quarter

to fourth quarter1

Nominal GDP . . . . . . . . . . . . . . . . . 5.9 43⁄4–51⁄2 5–51⁄2 43⁄4–51⁄2 

Real GDP . . . . . . . . . . . . . . . . . . . . . 3.4 21⁄4–31⁄4 21⁄2–3 21⁄2–31⁄4 

PCE price index excluding

food and energy . . . . . . . . . . . 2.3 2–21⁄4 2–21⁄4 11⁄2–21⁄4 

Average level, fourth quarter

Civilian unemployment rate . . . . 4.5 41⁄2–43⁄4 41⁄2–43⁄4 41⁄2–5 

1. Change from average for fourth quarter of previous

year to average for fourth quarter of year indicated.
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 23⁄4 percent over

the final three quarters of 2006, down

from the average 31⁄4 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 

Financial market conditions w

ally supportive of economic 

in 2006. Equity markets reco

able gains, and long-term inte

rose only modestly from histor

levels. Risk spreads on corpor

remained narrow or decline

Overall economic conditions 

that businesses maintained a st

of hiring, and the unemploy

moved down further.

Consumer price inflation, 

sured by the rise in the PCE pr

moved down in the second ha

after having stepped up in the 

Energy prices, which rose d

first half and turned sharply d

later in the year, played an 

role in shaping the contour 

consumer price inflation. In 

core PCE price inflation eased 

over the second half of 200

1

2

3

4

5

Percent, annual rate

2000 2002 2004 2006

Change in Real GDP, 2000–06 

NOTE: Here and in subsequent figures, except as

noted, change for a given period is measured to its final

quarter from the final quarter of the preceding period. 

SOURCE: Department of Commerce, Bureau of Economic Analysis. 

2000 2002 2004 

Change in PCE Chain-Type Price 

2000–06 

NOTE: The data are for personal 

expenditures (PCE). 

SOURCE: Department of Commerce, B

nomic Analysis. 

Total

Excluding food and energy
ently 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

21⁄4 percent—was a bit higher than in

the preceding year, which perhaps reflected in part the high level of resource

utilization.

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

33⁄4 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.

Household spending for n

vehicles slowed in 2006; 

16.5 million new light vehic

sport-utility vehicles, and pick

were below the average o

17 million sold in the prece

years. Moreover, households’ 

concerns about elevated gasol

particularly early in the year, s

composition of light vehi

toward more fuel-efficient a

away from light trucks and S

shift helped boost the share 

sales captured by foreign 

because they tend to offer m

efficient vehicles.

Real PCE for goods other th

vehicles rose 43⁄4 percent ove

quarters of 2006, about in lin

brisk average pace in the prec

years. Households increas

spending for a broad range of 

goods, though the rise was p

strong for electronic equipm

other durables. Real spending 

line remained about constant i

half of the year but increased i

ond half as prices fell. Consum

ing for services maintained a 

pace of growth; expenditure

category rose 23⁄4 percent in 20

the same average pace as in 

2005.

In 2006, real household in

boosted by gains in wage a

income and the increased p

power resulting from the dece

overall consumer prices. Labo

received by households rose 

cause of gains in real hourly w

because of sustained increase

ployment. However, the pick

after-tax income was damped 

tax payments made by h

increased at a rate greater tha

income. The acceleration in 

ments likely reflected, at lea

several factors: tax payments 

2

4

6

Percent, annual rate

2000 2002 2004 2006

Change in Real Income and Consumption, 

2000–06 

SOURCE: Department of Commerce, Bureau of Economic Analysis. 

Disposable personal income

Personal consumption 

expenditures
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 

upper end of its range since 2

Residential Investment

The deterioration of conditio

housing market played a signi

in restraining the pace of 

expansion in 2006. The deman

and existing homes began to w

the middle of 2005, and the s

decline steepened through the 

of 2006. As a result, the inv

unsold new homes relative to 

sharply. Apparently prompted 

demand and excessive in

homebuilders began to cut ba

pace of new construction near 

ning of 2006, and the decline 

continued throughout the year

the year, however, some indica

hinting that the demand for ho

starting to stabilize.

By the middle of 2006, sal

new and existing homes had f

matically to a pace that w

15 percent below that of a ye

Concurrently, inventories o

homes relative to sales rose 

ably above the level that had 

during the period of robust ho

mand from the late 1990s into 

the third quarter of 2006, the b

unsold new homes had 

63⁄4 months’ supply, and the 

existing homes for sale had 

about 7 months’ supply—b

above the average of about 41⁄

supply of new and existing 

2005. By the end of 2006, 

there were tentative signs th

mand for homes was stabili

decline in sales of new and 

homes appeared to bottom o

summer, and sales were rou

stant over the later part of th

the fourth quarter, builders’ in

of unsold new homes were re
have edged down a bit from their thirdquarter 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.

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 dra

fied to subtract about 11⁄4 p

points from the annual rate o

in real GDP in the second half

as a whole, the contraction in 

dential investment lowered t

rate of growth in real GDP 3⁄

age point after having added 1⁄

age point, on average, to the 

2003 through 2005.

The rate of house-price ap

slowed substantially in 2006 

eral years of very rapid g

repeat-transactions index of ho

published by the Office of Fed

ing Enterprise Oversight 

increased at an annual rate 

11⁄2 percent in the third quarte

down substantially from aver

of about 10 percent in 2004 

The OFHEO index attempts 

for the quality of existing sing

homes sold by using prices 

involved in repeat transacti

increase in the OFHEO house

dex over the four quarters end

third quarter of 2006 (a calcu

smoothes through some of the 

volatility in the data) was 6 pe

smallest four-quarter increase 

late 1990s. The average price o

single-family homes sold, whi

lished by the National Asso

Realtors (NAR) and does not c

the types of homes sold, decli

2 percent over the four quarter

compared with average gains o

9 percent in 2004 and 2005. 

right decline in the NAR index 

prices relative to the decelerat

constant-quality OFHEO hom

dex suggests that the comp

existing homes sold shifte

lower-priced homes.

The cost of mortgage 

increased in the first half of 

rates decreased in the second 

average rate for a thirty-year 

.4

.8

1.2

1.6

Millions of units, annual rate

1994 1998 2002 2006

Private Housing Starts, 1993–2006 

Single-family

Multifamily

NOTE: The data are quarterly and extend through

2006:Q4. 

SOURCE: Department of Commerce, Bureau of the

Census. 
mortgage was 61⁄4 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 51⁄2 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 113⁄4 percent increase posted in 2005 to a stillvigorous 81⁄4 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 b

filings during 2006 ran at a 

below the average of the prece

eral years. Bankruptcies lik

damped in 2006 by the dec

some households to file b

implementation of more-string

ruptcy requirements in Octo

However, even allowing for 

effect, the recent pace is low 

pre-reform norms.

The Business Sector

Fixed Investment

Total real business fixed invest

63⁄4 percent over the four q

2006, up from a 51⁄2 percent i

2005 and about the same p

2004. In general, the fundame

porting business capital 

Perc

Change in Real Business Fixed In

2000–06 

Structures

Equipment and software

2000 2002 2004 2

NOTE: High-tech equipment consists 

and peripheral equipment and communi

ment. 

SOURCE: Department of Commerce, B

nomic Analysis. 

High-tech equipment 

and software

Other equipment excluding 

transportation
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 113⁄4 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 141⁄2 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 

tation equipment—typically 

category of investment—was 

changed on net in 2006. For m

cles, business spending incre

than 1 percent over the year. 

of light vehicles weakened, 

cause of cutbacks in sales to re

panies. In contrast, business o

medium and heavy trucks acce

2006, reportedly in anticipatio

emissions regulations by the 

mental Protection Agency that 

effect at the beginning of 20

orders for medium and hea

reached new highs early in 2

production and sales remain

through the end of the year. O

new aircraft were brisk in ea

but they were depressed ove

mainder of the year; all told

investment declined more tha

cent for the year as a whole.

Real investment in equipm

than high-tech and tran

goods—a broad category that 

about half of total nominal 

spending for equipment and s

rose at an average annual rate o

cent during the first three q

2006. However, spending for t

tal goods softened in the final 

the year. Although the declin

fourth quarter were genera

based, they were led by dec

spending for equipment relate

struction and motor vehicle m

ing. However, the backlog of 

capital goods such as industria

ery and other types of heavy e

remained substantial at the end 

and it should sustain produ

shipments of these items in ea

Real outlays for nonreside

struction increased 113⁄4 perce

after having been little chan

2003. However, the rise in bus

struction spending slowed nea
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, forwardlooking 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 undesired level of stocks. The boo

manufacturing and trade in

(excluding motor vehicles) ro

to sales from September 

November. The increases wer

larly noticeable for firms that 

construction and motor vehic

although increases were appa

few other sectors as well. Su

also suggested that inventories 

businesses were viewed as 

However, manufacturers outs

motor vehicles sector appear t

ing relatively prompt adjus

their production, which to dat

be limiting the extent of 

stockbuilding.

Corporate Profits and

Business Finance

Profits of nonfinancial cor

extended their upward move

the ratio of before-tax profits 

in this sector to nearly 14 pe

highest level reached since 19

third quarter, operating earn

share for S&P 500 firms came 

cent above levels of a year earl

two-thirds of firms in the S&P 

reported earnings for the four

Current market estimates of ea

share for S&P 500 firms call fo

10 percent growth in the four

over year-earlier levels. Earnin

was widespread across sectors i

was particularly strong for finan

Firms’ capital expenditures 

internal funds raised in 2006, 

tion that businesses funded in

not only with current cash flow 

with external funds and liqu

Borrowing by nonfinancial fir

up in 2006 in association with 

real investment as well as w

sive retirements of equity

resulted from record share re

and heavy merger and acquisi
ity. 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 industria

by banks was rapid as well. Th

Reserve’s Senior Loan Office

Survey on Bank Lending Pra

vealed that a significant net f

respondents to that survey ea

standards and terms on comm

industrial loans during 2006

indicated that they were resp

more-aggressive competiti

greater liquidity in the seconda

for such loans. Loan officer

ported that a contributing fact

increased tolerance for risk.

The expansion of commer

gage debt in 2006 remained 

historical standards but fell of

swift pace of 2005. The de

likely reflected the rise in 

rates and a net tightening of c

dards for these loans—an ex

consistent with responses to 

officer survey.

Gross public issuance of 

nonfinancial corporations 

roughly maintained the mode

of the past couple of years, a

equity issuance appears to ha

bit to finance buyouts and oth

turings. Still, net equity issuan

more negative as equity re

from cash-financed mergers an

tions and share repurchases 

considerably.

On balance, despite increase

ing and net equity retirem

strength of corporate earning

has left the credit quality of no

firms solid. Balance sheet 

remains high, and corporate l

near historical lows. In add

interest payments relative to 

remained near the low end of 

seen over the past two dec

six-month trailing bond defau

during the first half of the ye

faults by some large firm

troubled airline and automobi

200

+

_

0

200

400

600

Billions of dollars

1991 1994 1997 2000 2003 2006

Financing Gap and Net Equity Retirement 

at Nonfinancial Corporations, 1991–2006 

Net equity retirement

Financing gap

NOTE: The data are annual; the observations for 2006

are based on partially estimated data. The financing gap

is the difference between capital expenditures and

internally generated funds, adjusted for inventory

valuation. Net equity retirement is the difference

between equity retired through share repurchases,

domestic cash-financed mergers, or foreign takeovers of

U.S. firms and equity issued by domestic companies in

public or private markets. Equity issuance includes

funds invested by private equity partnerships and stock

option proceeds. 

SOURCE: Federal Reserve Board, flow of funds data. 

200

+

_

0

200

400

600

800

Billions of dollars, annual rate

2003 2004 2005 2006

Selected Components of Net Financing 

for Nonfinancial Corporate Businesses, 

2003–06 

Sum of selected

components

NOTE: The data for the components excluding bonds

are seasonally adjusted. The data for the sum of selected

components are quarterly. The data for 2006:Q4 are

estimated. 

SOURCE: Federal Reserve Board; Securities Data

Company; and Federal Financial Institutions Examination Council, Consolidated Reports of Condition and

Income (Call Report). 

Commercial paper

Bonds

Bank loans
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.

The Government Sector

Federal Government

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

31⁄2 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 b

as a percentage of nominal GD

was in fiscal 2006. Although t

deficit has improved recently

eral budget will face the moun

sures of providing Social Sec

health benefits to a rapidly 

number of beneficiaries as 

boom generation ages in comi

In fiscal 2006, nominal f

ceipts rose 113⁄4 percent a

equivalent to almost 181⁄2 p

nominal GDP, substantially hi

their recent fiscal year low of 

cent of GDP in 2004. Incom

ceipts from individuals outpac

in taxable personal income (as 

in the NIPA), while surging 

tax payments about matched 

growth in profits. As noted a

increase in individual income t

ties relative to taxable incom

NIPA appears to have reflecte

in part, taxes on larger cap

realizations (which are exclu

NIPA income), the effect of 

payers moving into higher tax 

as their real incomes increased

sibly a further shift in the distr

income toward high-income h

that typically face higher tax 

the first quarter of fiscal 2007

were more than 8 percent grea

the same period a year earlie

individual and corporate tax 

continued to rise briskly.

Nominal federal outlays 

about 71⁄2 percent in fiscal 

were about 201⁄4 percent of 

GDP, well above their most re

year low of less than 181⁄2 p

GDP in 2000. Net interest 

increased 23 percent in fiscal 

interest rates rose and federal 

tinued to grow. Outlays for 

increased 101⁄2 percent, reflect

new benefits payments assoc

the Part D prescription drug 

16

18

20

22

24

Percent of nominal GDP

1986 1990 1994 1998 2002 2006

Federal Receipts and Expenditures, 

1986–2006 

Expenditures

Expenditures

ex. net interest

Receipts

NOTE: The receipts and expenditures data are on a

unified-budget basis and are for fiscal years (October

through September); GDP is for the four quarters ending

in Q3. 

SOURCE: Office of Management and Budget. 
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 21⁄2 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 

years, the improvement has b

by declines in the personal sa

Total national saving, net of 

tion, was 2 percent of nomina

the third quarter of 2006. T

national saving rate is an imp

from the lows of a few years 

has been insufficient to avoid a

ing reliance on borrowing fro

to finance the nation’s capital 

Federal Borrowing

The Treasury responded to the 

in the federal deficit in 2006 

down Treasury bills over the 

the year and by trimming the g

ance of marketable Treasury c

curities. As of the third quarte

the quantity of federal debt h

public as a percentage of nom

had declined about 1⁄2 percent

to about 36 percent.

Early in the first quarter 

federal debt subject to the statu

reached the then-current c

$8.2 trillion. The Treasury 

various methods to avoid brea

Percent o

1966 1976 1986 1996 

Federal Government Debt Held 

by the Public, 1960–2006 

NOTE: The final observation is for 

previous years, the data for debt are as of 

the corresponding values for GDP are 

annual rate. Excludes securities held as i

federal government accounts. 

SOURCE: Federal Reserve Board, flow o
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 

strength in total revenues, alon

efforts of states and localities 

spending for health care, ha

these jurisdictions to step up 

on other programs and still reb

reserve funds. As measured in 

net saving by state and loca

ments excluding social 

funds—a measure that is broad

to the surplus in an operating 

was almost $4 billion during 

three quarters of 2006. States a

ties generally have seen impro

their fiscal positions recentl

coming years most governm

have to face the budget pre

providing pension and health b

an expanding number of retire

ees, and the states’ costs for 

are expected to rise substantia

baby-boom generation ages.

Real expenditures by state 

governments on consumption 

investment, the component of 

ernments’ spending that enter

into the calculation of real G

3 percent over the four quarter

That increase was the largest s

and contributed about 1⁄4 p

point to the change in real GD

the year. Real expenditures f

ment rose 43⁄4 percent, largel

of a strong increase in real co

spending in the first half of 

Spending for current consum

real terms increased 21⁄2 per

the four quarters of 2006. H

state and local governments s

last year. Of the cumulative i

employment of 254,000 in 20

two-thirds of the jobs were in 

State and Local Governmen

Borrowing

Borrowing by state and loca

ments dropped below its ra
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.

The External Sector

The U.S. current account deficit averaged $875 billion at an annual rate, or

about 61⁄2 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 

high in August, and then narr

ticeably through November (

available data). On average, th

trade deficit was wider in 200

the previous year. Nominal i

goods grew more slowly tha

did early last year and, after 

late-summer peaks, dropped b

declines in both the price and 

imported oil. Meanwhile, impo

vices decelerated sharply in t

half of last year. In contrast

exports of goods and service

upward steadily throughout th

grew significantly faster than 

nal imports. Given that the le

ports was smaller than the lev

ports, the faster export grow

2006 was not enough to n

nominal trade deficit. Alth

nominal trade deficit last year 

November, annualized) was 

dollar terms, the trade deficit 

of GDP, at just under 6 per

about the same as in 2005.

Real exports of goods and 

grew a robust 91⁄4 percent las

the first quarter, growth was b

a catch-up of exports affected 

cane damage in late 2005. T

the year, exports were supp

strong foreign economic acti

exports of goods rose 101⁄4 pe

year, a little faster than in the 

year. Export growth was spr

evenly across all major end-u

ries, though exports of comp

semiconductors expanded n

more slowly than in 2005. B

tion, exports to China and oth

ing Asian economies grew ver

as did those to South Americ

to Mexico and western Europe 

more modest pace. Real expo

vices were up a solid 63⁄4 perc

year, double the pace of 2005

7

6

5

4

3

2

1

+

_

0

Percent of nominal GDP

2000 2002 2004 2006

U.S. Trade and Current Account Balances, 

1999–2006 

Trade

Current

account

NOTE: The data are quarterly. For the trade account,

the observation for 2006:Q4 is estimated. The data for

the current account extend through 2006:Q3. 

SOURCE: Department of Commerce. 
Prices of exported goods rose at a

31⁄2 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.

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 inven

some metals, and perhaps 

speculative demand. Prices f

and zinc continued to move up 

out the year. In the second h

year, aluminum prices trended 

and copper prices moved do

their peaks as inventory and su

ditions improved somewhat. F

these metals, those price tre

continued this year. An exc

zinc, the price of which has pl

The spot price of West Texa

diate crude oil averaged $66 

in 2006, nearly $10 per bar

than in 2005; moreover, crude 

were especially volatile last 

spot price climbed from aroun

barrel at the end of 2005 to 

$77 per barrel in August as v

the Middle East, a shutdow

Prudhoe Bay oil field in Al

forecasts of an active hurrica

led to increased demand. In 

oil supply was affected far 

anticipated by these factors

prices declined over the 

months as demand dropped an

D

80

100

120

140

160

180

200

220

2003 2004 2005 2006 

Prices of Oil and of Nonfuel Com

2003–07 

January 2003 = 100

Oil

Nonfuel

commodities

NOTE: The data are monthly and ex

January 2007. The oil price is the spot 

Texas intermediate crude oil. The pric

commodities is an index of forty-f

commodity prices. 

SOURCE: For oil, the Commodity Res

for nonfuel commodities, International M
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 q

have changed little since then

Foreign private purchases o

curities in the second and thir

of 2006 slowed slightly 

extraordinary pace set in the se

of 2005 and early 2006, but pr

fourth-quarter data show recen

to have been strong. More th

private flows last year took th

purchases of corporate bonds, 

of the remainder went towa

ment in GSE bonds and corpo

ties. On net, private foreig

chased few U.S. Treasuries

direct investment flows into t

States remained robust.

Net purchases of foreign sec

U.S. residents, a financial outf

record pace in the first three q

2006. Preliminary data show 

surge in net purchases in the fo

ter. Demand for foreign bond

residents slightly exceeded th

eign equities. After the expirat

partial tax holiday implemen

Homeland Investment Act of 2

direct investment abroad drop

to more normal levels.

The Labor Market

Employment and Unemplo

Labor markets remained stron

Nonfarm payroll employment 

186,000 per month, on averag

the second half of 2006, a r

tially the same as in the first h

year. Employment rose 111,00

ary of 2007. The unemployme

the fourth quarter of las

41⁄2 percent—was at its lowest 

level since 2001, and it w

changed in January 2007.

In response to the contr

homebuilding, hiring in the co

sector slowed considerably in 
ond 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 43⁄4 percent in the first three

quarters of 2006, the unemployment rate

edged down to 41⁄2 percent in the fourth

quarter. The tighter labor market was

associated with a noticeable increase in

employment among individual

not been participating in the la

In line with this cyclical tigh

the labor market, the labor for

pation rate ticked up during 2

66 percent in the first q

661⁄4 percent in the fourth quar

1⁄4 percentage point rise dur

The recent rise in the particip

follows a period of decline be

the late 1990s that in part refle

longer-term secular trends in l

behavior. Those trends include

ing off in the participation 

women and an increase in th

tion of the workforce in o

groups, which have lower ave

ticipation rates.

Other indicators also sug

labor market conditions remain

ally favorable during the seco

2006. Layoffs remained low 

claims for unemployment 

fluctuated around a relatively 

level of 315,000 per week. In 

data reported by the Bureau 

Statistics showed a further inc

ing the later part of the year i

of job openings as a perc

private-sector employment.

Productivity and

Labor Compensation

The growth rate of labor prod

the nonfarm business sector, w

slowed in 2004 and 2005 from 

tionally rapid pace earlier in th

remained relatively subdued 

Over the four quarters of 200

per hour of work in the nonf

ness sector increased 2 perc

pared with about a 3 percen

annual rate of increase during 

half of this decade and the se

of the 1990s. During that earli

productivity gains were spurr

rapid pace of technological ch

100

+

_

0

100

200

Thousands of jobs, monthly average

2001 2003 2005 2007

Net Change in Payroll Employment, 

2001–07 

January

NOTE: Nonfarm business sector. 

SOURCE: Department of Labor, Bureau of Labor

Statistics. 
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 

compensation is the employm

index (ECI) for private nonf

nesses, which is based on a 

firms conducted by the Bureau 

Statistics. According to this 

nominal hourly compensation 

31⁄4 percent in 2006, 1⁄4 percen

faster than in 2005. In real t

ECI for hourly compensa

11⁄4 percent last year after av

1⁄2 percent increase over the 

two years. The nominal wages 

ries component of the ECI ros

cent in 2006, while the benefi

nent advanced 3 percent.

From the perspective of e

the acceleration in hourly com

in the nonfarm business secto

boosted the average labor cos

ated with producing a unit 

23⁄4 percent, up from increase

13⁄4 percent in both 2004 a

Although the rise in unit la

increased, firms’ profit ma

peared to remain elevated in 2

tive to longer-run standards.

Prices

Headline inflation slowed in 2

PCE chain-type price index ro

cent over the four quarters o

step-down from the 3 percen

recorded in 2005. The drop 

prices in the latter part of 

counted for the deceleration in 

line number. Core inflatio

higher in the first part of 200

eased toward the end of the 

balance, core PCE prices ro

21⁄4 percent over the four q

2006, a little faster than the 

increase in 2005. The mar

component of the core P

index—which excludes impu

that are not observed in marke

tions and that often change irre

1

2

3

4

5

Percent, annual rate

Change in Output per Hour, 1948–2006 

1948– 731974– 951996– 20002002 2004 2006

NOTE: Nonfarm business sector. Change for each

multiyear period is measured from the fourth quarter of

the year immediately preceding the period to the fourth

quarter of the final year of the period. 

SOURCE: Department of Labor, Bureau of Labor

Statistics. 
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 21⁄4 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 pric

and soybeans spiked at the e

year in the wake of downward 

to estimates of crop producti

of corn also were boosted d

year by increased demand fo

produce ethanol. But the smal

wheat, corn, and soybeans in 

value of food production lim

effect on retail food prices. 

food consumed away from hom

are influenced importantly by 

of labor, energy, and other 

inputs, increased 31⁄4 percent 

more rapid pace than that for 

food consumed at home.

The core PCE price index a

to an annual rate of about 21⁄2 

the first half of 2006 on the s

pickups in the price indexes 

goods and services. In th

increases in housing rents wer

larly sharp. The rise may have 

in part a shift in demand tow

housing as rising mortgage 

lofty home prices made home 

less affordable. The pass-th

higher energy costs to a broad 

goods and services also prob

tributed to the acceleration in 

sumer price inflation in the fi

2006.

In the second half of 2006, 

price inflation edged down to 

rate of just below 21⁄4 percen

celeration was the result of a d

core goods prices, which likely 

in some measure the waning 

of energy prices. In contrast, 

vices inflation in the second h

year remained at about the sam

in the first half. Although hou

rose more slowly in the secon

the year, their effect on the PC

services was mostly offset 

price increases for medical c

number of other services.

Alternative Measures of Price Change,

2004–06

Percent

Price measure 2004 2005 2006

Chain-type

Gross domestic product (GDP) . 3.2 3.1 2.5

Gross domestic purchases . . . . . . 3.7 3.6 2.2

Personal consumption

expenditures (PCE) . . . . . . . . 3.0 3.1 1.9

Excluding food and energy . . . 2.2 2.1 2.3

Market-based PCE excluding

food and energy . . . . . . . . . . . 1.7 1.8 2.0

Fixed-weight

Consumer price index . . . . . . . . . . 3.3 3.7 1.9

Excluding 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 fixedweight measures, Department of Labor, Bureau of Labor

Statistics.
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 51⁄4 percent in 2006, up from the 43⁄4 percent

increase in 2005. The index increased at

an annual rate of 71⁄4 percent in the first

half of 2006, but it decelerated to an

annual rate of about 31⁄4 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 shortterm 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 33⁄4 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 31⁄4 percent in August. Other

indicators likewise suggest that longerrun 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 21⁄2 percent

in 2006, a level that has been essentially

unchanged since 1998. In addition, inflation compensation implied by the

spread of yields on nominal 

securities over their inflation

counterparts stayed within the 

narrow range of 2 percent to 2

during the year.

U.S. Financial Markets

Financial conditions in the Un

supported economic growth 

Yields on long-term Treasury 

climbed a bit, on balance, b

low by historical standards, wh

corporate profits helped fuel s

gains in equity markets. Liqu

rate balance sheets and low 

leverage helped keep risk sp

corporate bonds narrow. M

business borrowing picked up 

pace, spurred in part by a rise 

and acquisition activity. In th

tial real estate sector, mortgag

ing slowed markedly, as hou

decelerated, especially in the se

of the year. Consumer credit 

at a moderate pace. Nonethele

hold debt growth outpaced th

of disposable personal incom

financial obligations of h

inched higher. Although h

generally appeared able to m

obligations, signs of financ

were apparent in subprime va

mortgages. The M2 monetary 

expanded at a moderate pace i

Interest Rates

Market interest rates rose mo

balance, in 2006—yields on 

ten-year nominal Treasury 

increased about 40 and 30 ba

respectively. Changes in inte

seemed largely tied to chang

outlook for economic growth 

tion. Rates across the maturity 

increased notably over the fir

the year, as incoming data o
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 measur

certainty about monetary polic

from interest rate options rema

the low end of historical range

Yields on inflation-indexed 

securities increased about as 

those on their nominal count

2006. Medium- and long-term 

compensation—measured from 

between yields on nom

inflation-indexed securities—w

unchanged to a little lower, o

during the year these measur

ited only modest swings in re

incoming inflation data and 

movements.

In the corporate bond mark

on investment-grade securiti

about in line with those on co

maturity Treasury securities. In 

yields on speculative-grade 

fell slightly, pulling risk spre

in that segment of the market

rowness of investment- and sp

grade spreads seems to reflect 

sanguine perceptions of corpo

quality over the medium ter

likely reflect in large part the s

1

2

3

4

5

Percent

2003 2004 2005 2006 2007

Interest Rates on Selected Treasury 

Securities, 2003–07 

Ten-year

Three-month

Two-year

NOTE: The data are daily and extend through February 7, 2007. 

SOURCE: Department of the Treasury. 

Pe

1999 2001 2003 2005 

Spreads of Corporate Bond Yield

Comparable Off-the-Run Treasur

1998–2007 

BBB

High-yield

AA

NOTE: The data are daily and ex

February 7, 2007. The ten-year high-y

BBB, and ten-year AA indexes are comp

ten-year Treasury yield. 

SOURCE: Derived from smoothed co

curves using Merrill Lynch bond data. 
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

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 equ

were exceptionally strong.

Market Functioning and

Financial Stability

Overall, financial markets f

smoothly over the year and pro

ient to several shocks. Equit

in the United States and cur

fixed-income markets in 

emerging-market economies 

enced heightened volatility l

second quarter, but the turbu

short lived. The liquidation 

sizable hedge funds attracted 

able attention for a time but 

discernible effect on the broad 

ing of markets. Even the liqu

Amaranth—a hedge fund 

wound down in the fall after r

loss in excess of $6 billion, 

energy trades—left little im

financial markets, although 

some concerns about risk-ma

practices. Implied volatilit

spreads, and various other 

measures of financial stress 

stayed at very low levels throu

year, suggesting that invest

comfortable taking on risk, lik

because they were confident 

economic and financial outloo

Throughout the year, bid-as

on the most actively traded 

securities remained within 

ranges. Some instances of qu

trading activities occurred in th

ary market for Treasury secur

the course of the year. The In

Working Group for Treasur

Surveillance monitored these 

closely.1 In November, the 

Reserve Bank of New York a

1. The group was established in 

includes representatives from the Boa

nors of the Federal Reserve System, t

the Securities and Exchange Comm

90

100

110

120

130

January 3, 2005 = 100

2005 2006 2007

Stock Price Indexes, 2005–07 

Russell 2000

Wilshire 5000

NOTE: The data are daily and extend through February 7, 2007. 

SOURCE: Frank Russell Company; Dow Jones

Indexes. 
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 

Federal Reserve Bank of New 

the fall of 2005, the largest pa

in the fast-growing market 

derivatives agreed to a series o

strengthen that market’s infra

Over the course of 2006, cred

tives dealers phased out the p

transferring positions to a 

counterparty without first obt

consent of the original cou

They also reduced by 85 pe

number of trade confirmations 

ing more than thirty days; the

the share of trades that are 

via an electronic platform, to 8

of total trade volume; and th

upon a new protocol for the 

of such derivatives after a cred

Debt and Financial Interme

by Banks

Total debt of the domestic no

sectors expanded an estimated 

cent in 2006, well below th

2005 but still faster than that o

income. Debt growth slowed 

in the household and govern

tors, but business debt acceler

About 30 percent of the 

nonfinancial sector debt in 

intermediated by the bankin

This share is about even with 

age over the past ten years an

5 percentage points above th

observed in the 1980s and ea

Commercial bank credit 

91⁄2 percent in 2006, supporte

growth in loans to business

credit also was boosted in the a

a consolidation of a substanti

of thrift assets onto a commerc

balance sheet that had resulte

internal reorganization at a l

holding company.

Bank lending to businesse

commercial and industrial 

Commodity Futures Trading Commission, and the

Federal Reserve Bank of New York.
creased 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 wellcontained 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 inte

rise, deposit rates lag some

creasing the opportunity cost o

money. In 2006, this effect a

slowed money growth less th

have been expected on the ba

torical norms, and the veloci

rose only about 3⁄4 percent. Ret

market mutual funds and smal

posits, components of M2 wh

move most closely with mar

grew rapidly. However, liquid 

which constitute the largest c

of M2, and whose yields ad

gradually, were about flat on 

rency expanded a modest 31⁄

an increase similar to that in 

flecting weak, possibly negativ

mand from overseas.

Part of the Financial Service

tory Relief Act of 2006 gave th

Reserve authority, beginning i

2011, to pay interest on reserv

and to further reduce or elim

serve requirements. At the 

FOMC meeting, the Chairman 

staff to prepare for the imple

of this legislation.

International Developmen

Foreign economic growth was 

strong in 2006, as expansion 

in all major regions of the w

Japanese economy decelerat

what but maintained positiv

and the pace of activity in the 

picked up. Labor market con

both areas improved. Emergi

economies also recorded sol

last year and experienced no 

lasting ill effects from the brief 

financial market volatility tha

of them particularly hard in 

spring. Although there are 

steps taken to slow growth 

ment in China have been effe

Chinese economy continued 
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 ener

and indications that global 

growth remained robust.

From their midyear highs

government benchmark bond 

noticeably until about the beg

December in most major 

economies, as investors re

moves in U.S. rates and eva

implications for the global ec

the economic slowdown that 

be under way in the United St

this period, yields on ten-yea

bonds declined by amounts th

from about 25 basis points in t

Kingdom to about 70 basis 

Canada. Yields on inflation-in

curities declined less; modes

in inflation breakeven rates w

uted in part to lower energy pr

second half of the year.

Since the beginning of D

however, nominal and indexe

ment bond yields have risen o

in most advanced economi

because new data releases ap

alleviate investors’ concerns t

economic growth might slow 

bly. Yields on both ten-year 

and indexed securities ha

15 basis points in Japan a

50 basis points in the euro 

United Kingdom, and Cana

their December lows. As a res

tion breakeven rates have b

changed.

The Federal Reserve’s broa

sure of the nominal trade

exchange value of the dollar 

33⁄4 percent from the beginni

year through early February of 

Over that period, the dollar ap

21⁄4 percent against the yen an

cent against the Canadian dol

depreciated about 9 percent

against the euro, almost 1

against sterling, and 4 perce

the Chinese renminbi. The r
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 risktaking. Broad-based gains 

prices since midsummer app

associated with a scaling back 

tations for future tightening of 

policy in several countries 

declines in energy prices. S

June, broad stock market ind

gained 10 percent to 20 p

Europe, Japan, and Canada.

Industrial Economies

After increasing at an annu

roughly 2 percent in the fir

2006, Japanese real GDP g

3⁄4 percent in the third quarte

because of slower growth of 

tion. Capital spending was an 

contributor to growth o

throughout the year, supported 

corporate profitability. Labo

conditions continued to improv

employment rate was about 4 

December, its lowest level si

and the ratio of job offers to 

remained close to a thirteen-y

However, wage growth w

subdued, as firms contro

increases, and unit labor costs 

to fall. In 2006, consumer pric

to rise again, posting smal

month increases after June, 

prices in Japan’s six largest c

for the first time since 1991. 

the GDP deflator continued 

slowly.

Real GDP in the euro area a

somewhat in 2006, posting 

growth of 31⁄4 percent at an a

over the first three quarter

growth was supported in part 

consumer spending, which g

stantially faster than in 2

stronger performance of the 

was reflected in improving lab

conditions: The unemployme

the euro area fell 0.8 percent

during the year to reach 7.5 

90

100

110

Week ending January 2, 2004 = 100

2004 2005 2006 2007

U.S. Dollar Exchange Rate against 

Selected Major Currencies, 2004–07 

U.K. pound

Euro

Japanese yen

Canadian

dollar

NOTE: The data are weekly and are in foreign

currency units per dollar. The last observation for each

series is the average for February 5 through February 7,

2007. 

SOURCE: Bloomberg L.P. 
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 21⁄4 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 21⁄2 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 11⁄2 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 11⁄2 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 A

nomic performance was gener

in 2006. In Korea, GDP grow

from the strong pace registere

partly because of monetary t

and consumer price inflation 

modest. The pace of growth 

countries stayed strong throug

as a result of robust export

some cases, strengthening dom

mand. Four-quarter inflation m

across the region. That m

resulted from the waning effe

lier reductions or removals of 

fuel subsidies, but the previou

ing of monetary policy in the r

an appreciation of exchange 

made a contribution. Capita

into several Asian emergin

economies—particularly Tha

late 2006 and early this year p

pressure on local currencies. 

taken by Thai authorities seem

ceed in limiting upward mov

the baht, but share prices in 

stock market fell sharply. Fina

kets in other countries in t

were less affected and showed 

able spillovers from events in 

Output growth in Mexico w

tionally strong in the first ha

year, especially in the manu

construction, and services 

Growth stepped down in th

half; construction activity rem

bust but was offset by a slow

exports of manufactured goo

United States. Mexican consu

inflation was elevated during t

half by higher food prices an

rates above the 4 percent upp

the central bank’s inflation tar

at year-end, inflation was still 

end of the range.

Brazilian output growth wa

the first quarter but slowed n

later in the year, partly becaus

manufacturing performance. 
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 continu

tempt to bring down inflatio

voluntary price agreements wi

ers in several sectors; although 

had edged down to the single-d

by year-end, it was still high. 
Monetary Policy Report of July 2006

Monetary Policy and the

Economic Outlook

The U.S. economy continued to expand

at a brisk rate, on balance, over the first

half of 2006. Spending in the first quarter, which was especially robust, was

temporarily buoyed by several factors,

including federal spending for hurricane

relief and the effects of favorable

weather on homebuilding. The pace of

the expansion moderated in the spring,

to some degree because the influence of

these special factors dissipated. More

fundamentally, consumer spending

slowed as further increases in energy

prices restrained the real incomes of

households. In addition, home sales and

new homebuilding dropped back noticeably from the elevated levels of last

summer, partly in response to higher

mortgage interest rates. Outside of the

household sector, increases in demand

and production appear to have been well

maintained in the second quarter. Demand for U.S. exports was supported by

strong economic activity abroad, and

business fixed investment remained on a

solid upward trend. Early in the year, as

aggregate output increased rapidly, businesses added jobs at a relatively robust

pace, and the unemployment rate moved

down further. Since April, monthly

gains in payroll employment have been

smaller but still sufficient to keep the

jobless rate steady.

Thus far in 2006, inflation 

have been elevated. Higher 

crude oil contributed to a furth

in domestic energy costs; th

increases, combined with 

increases in 2004 and 2005, 

boosted the prices of gasoline 

ing fuel but also put upward p

the costs of production for a br

of goods and services. Partly 

of these cost pressures, the ra

consumer price inflation pi

Nevertheless, measures of 

expectations remained conta

the rate of increase in labor 

subdued, having been held 

strong gains in productivity an

ate increases in labor compens

Taking a longer perspective

economy appears to be in the 

transition in which the rate o

in real gross domestic product 

moving from a pace above t

longer-run capacity to a more 

and sustainable rate. An impo

ment in the transition is the lag

of the changes in monetary po

mid-2004, changes that have 

tended to keep inflation low a

mote sustainable economic 

by aligning real economic acti

closely with the economy’s p

potential. Moreover, longer-te

est rates have risen, contri

increased borrowing costs 

households and businesses. O

pressures on inflation should 

the pace of real activity mode

as futures markets suggest, the 

energy and other commoditie

stabilize. The resulting easing 

tion should help contain long-

tion expectations.

Note: The discussion in this chapter consists of

the text and tables from the Monetary Policy

Report submitted to the Congress on July 19,

2006; the charts from that report (as well as earlier

reports) are available on the Board’s web site, at

www.federalreserve.gov/boarddocs/hh.
Even as the rate of increase in real

economic activity moderates, the prospects for sustained expansion of household and business spending appear

favorable. Higher energy prices have put

strains on household budgets, but once

that effect fades, households should experience gains in real income consistent

with the ongoing expansion of jobs.

Household balance sheets remain generally sound; although some pockets of

distress have surfaced, average delinquency rates on mortgages and other

consumer debt are still low. Similarly, in

the business sector, balance sheets are

strong, credit quality is high, and most

firms have ready access to funds. Sustained expansion of the global economy,

along with the effects of the earlier

depreciation of the foreign exchange

value of the dollar, should support demand for U.S. exports. The potential for

efficiency gains, as well as further

declines in the relative cost of capital,

are likely to continue to spur capital

spending. Indeed, the ongoing advances

in efficiency should sustain solid growth

of labor productivity, providing support

for gains in real wages and income.

As always, considerable uncertainties

attend the outlook. Regarding inflation,

the margin between production and consumption of crude oil worldwide is quite

narrow, and oil markets are especially

sensitive to news about the balance of

supply and demand and to geopolitical

events with the potential to affect that

balance; adverse developments could

result in yet another surge in energy

costs. Indeed, futures markets provide

only imperfect readings on the prospects

for energy markets, as witnessed by the

fact that the surprises in crude oil prices

during the past few years have been

predominantly to the upside. In addition, a further rise in prices of other,

non-energy materials and commodities,

if it materializes, could also intensify

cost pressures. Another risk i

effect on imported-goods pric

lier declines in the foreign 

value of the dollar, which has 

ited to date, could become lar

broadly, if the higher rate of c

tion seen this year persists, it 

duce a deterioration in longer

tion expectations that, in tu

give greater momentum to 

However, the risks to the infl

look are not entirely to the ups

current environment of eleva

margins, competitive forces

domestic markets and from 

could impose significant restra

pricing decisions of businesse

Regarding risks to the outlo

activity, rates of increase in 

have been uneven during the 

complicating the assessment o

the pace of the economic exp

moving into line with its unde

tential rate. One possible ri

upside is that the softer ton

recent data on real activity w

transitory rather than mark a 

more sustainable underlying 

expansion. For example, slow

ing and hiring in recent mo

represent a shorter-lived adjus

higher level of energy prices 

unusually robust increases in 

activity earlier in the year. I

months, a sharp rebound in 

spending accompanied by an 

tion of capital spending could r

activity to a pace that would 

tainable over the longer run. B

side risks also exist. In parti

slowing in real estate markets 

summer has been moderate, an

ing of house-price inflation 

gradual. If the softening in th

for housing and in real esta

becomes more pronounced, the 

drop in construction activity 

erosion of household wea
weaken aggregate demand noticeably.

Consumer spending might be depressed

by the loss of income and wealth, and

that effect could be amplified if the

downturn is abrupt enough to shake

households’ confidence about their ability to finance spending or manage their

current financial obligations.

The Conduct of Monetary Policy

over the First Half of 2006

The Federal Open Market Committee

(FOMC) continued to firm the stance of

monetary policy over the first half of

2006. At the time of the January meeting, available information suggested that

underlying growth in aggregate demand

was solid at the turn of the year. The

expansion of real GDP in the fourth

quarter of 2005 was estimated to have

slowed temporarily, in part because of

the disruptions associated with last autumn’s hurricanes. Core inflation had

stayed relatively low, and inflation expectations had remained contained. With

rising energy prices and increases in

resource utilization having the potential

to add to inflationary pressures, the

FOMC decided to extend the firming of

policy that it had implemented over the

previous eighteen months by tightening

the policy rate 25 basis points, to

41⁄2 percent. The Committee indicated

that some further policy firming might

be needed to keep the risks to price

stability and to sustainable economic

growth roughly in balance.

By March, economic activity appeared to be expanding rapidly, propelled by robust consumer spending and

accelerating business investment. Although readings on core inflation for

January and February were generally

favorable, higher prices for energy and

other commodities, together with relatively tight labor and product markets,

threatened to add to existing inflation

strains. Against this backdrop, 

mittee raised the target fede

rate another 25 basis points, t

cent. The statement released 

of the meeting continued to po

possible need for further polic

Data received by the time o

meeting confirmed that the 

had expanded robustly in the 

ter, though both consumer spe

housing activity appeared to h

erated in late winter. In addit

tionary pressures had intensifi

consumer prices rose more r

March than in earlier months

expectations, as measured by 

veys and by comparisons of 

nominal and inflation-indexed 

securities, also rose in April. T

mittee still judged those expec

be contained, but it was mind

further increase could impart 

momentum to inflation, as 

surge in energy and other c

prices and the drop in th

exchange value of the dollar 

place in April and early May

greater assurance that inflation

would not intensify, the FOM

to raise the target federal f

another 25 basis points, brin

5 percent. The FOMC also in

the policy statement that som

policy firming could be requir

ever, the Committee was awar

cumulative effects of past mon

icy actions on economic activ

turn out to be larger than expe

cordingly, the FOMC stresse

extent and timing of any furth

would depend importantly on 

tion of the economic outlook a

by incoming data.

By the time of the June 

available data appeared to co

economic growth had moder

the strong pace evident earl

year. Consumer spending had 
and activity in housing markets had continued to cool gradually. Evidence of

inflationary pressures was accumulating, however, and core price inflation

had increased. In addition, the high levels of resource utilization and of the

prices for energy and other commodities

had the potential to spur further inflation. Consequently, the FOMC decided

to increase the target federal funds rate

an additional 25 basis points, to

51⁄4 percent. The Committee recognized

that the moderation in the growth of

aggregate demand that appeared to be

under way would help to limit inflationary pressures over time, but it judged

that, even after its policy action, some

upside inflation risks remained. Yet the

FOMC made clear that the extent and

timing of any additional firming needed

to address those risks will depend on the

evolution of the outlook for both inflation and economic growth as implied by

incoming information.

In recent years, the FOMC has

worked to improve the transparency of

its decisionmaking process, and it continues to seek further improvements.

Between the March and May meetings,

the Chairman appointed a subcommittee

to help the FOMC frame and organize

the discussion of a broad range of communication issues. At the June meeting,

the Committee discussed the subcommittee’s plans for work in coming

months and decided to begin its consideration of communication issues at its

August meeting and to lengthen meetings later this year to allow a fuller

discussion of these issues.

Economic Projections

for 2006 and 2007

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 deliberatio

FOMC, provided economic p

for 2006 and 2007. In broad 

participants expect a sustaine

ate expansion of real econom

during the next year and a 

central tendency of the FOM

pants’ forecasts for the increa

GDP is 31⁄4 percent to 31⁄2 pe

the four quarters of 2006 and 

to 31⁄4 percent in 2007. The ce

dency of their forecasts for th

unemployment rate is 43⁄4 p

5 percent in the fourth quart

year, and the jobless rate is ex

still be in that range at the end 

For inflation, the central tende

forecasts is an increase in the 

Economic Projections for 2006 an

Percent

Indicator

Federal Reser

an

Reserve Ban

Range 

20

Change, fourth quarter

to fourth quarter1

Nominal GDP ............ 51⁄2–61⁄2 

Real GDP ................ 3–33⁄4 

PCE price index excluding

food and energy ...... 21⁄4–3 

Average level,

fourth quarter

Civilian unemployment

rate . . . . . . . . . . . . . . . . . 41⁄2–5 

20

Change, fourth quarter

to fourth quarter1

Nominal GDP ............ 43⁄4–6 

Real GDP ................ 21⁄2–31⁄4 

PCE price index excluding

food and energy ...... 2–21⁄4 

Average level,

fourth quarter

Civilian unemployment

rate . . . . . . . . . . . . . . . . . 41⁄4–51⁄4 

1. Change from average for fourth quart

year to average for fourth quarter of year i
dex for personal consumption expenditures excluding food and energy (core

PCE) of 21⁄4 percent to 21⁄2 percent over

the four quarters of 2006; in 2007, the

forecast shows a slower rate of 2 percent

to 21⁄4 percent, which is similar to the

rate of core PCE price inflation in 2004

and 2005.

A slowing in activity now appears to

be under way in the housing sector,

where home sales and residential construction have receded from the elevated

levels of last summer. The associated

easing in house-price appreciation will

likely temper gains in household wealth,

which, over time, may be a factor in

damping consumer spending. However,

households’ financial positions should

receive a boost from an acceleration of

real income if energy prices stabilize as

suggested by futures markets. In the

business sector, participants view the

outlook for fixed investment over the

forecast period as positive. Although

outlays for new equipment and software

may increase a little more slowly with

the deceleration in real output, investment opportunities appear to remain attractive: The relative user cost of capital

for equipment, particularly hightechnology items, is expected to remain

favorable, and competitive pressures

should maintain strong incentives to exploit opportunities for efficiency gains

and cost reduction. At the same time,

nonresidential construction seems likely

to continue to move up. Finally, the

strong performance of the economies of

the United States’ major trading partners should continue to stimulate U.S.

exports of goods and services.

The more moderate pace of expansion and the stability in resource utilization, when coupled with less pressure

from the prices of energy and other commodities, should contribute to an environment in which inflation expectations

are contained and inflation edges lower.

Moreover, ongoing solid gain

ductivity should work to limit 

in unit labor costs.

Over the next year and a ha

participants expect the eco

achieve a sustainable rate of 

expansion. That rate will be d

in large part by the rate of in

productivity. Productivity has 

ing at a solid rate over the 

years, albeit more slowly than 

cially rapid pace that prevail

the first three years of the exp

strong trend in productivity is 

be maintained as businesses ta

tage of new investment in fac

equipment, as diffusion of te

continues, and as organizat

vancements and business pr

provements yield further inc

efficiency.

Economic and Financial

Developments in 2006

Although last year’s hurrican

the pace of aggregate econom

around the turn of the year to b

real GDP increased at an avera

rate of 3.6 percent in the final 

2005 and first quarter of 200

the same pace that prevailed d

preceding year and a half. 

period, payroll employment po

tional solid gains, and the u

ment rate declined further. 

months, the incoming inform

real activity has suggested tha

of the expansion is moderating

deceleration in spending mos

in the household sector. Still, 

year, resource utilization in lab

product markets remained hig

Inflation picked up over the 

months of the year, boosted im

by the effects of rising ener

Long-term inflation expectatio

ated over the period but rema
tained, and increases in unit labor costs

were subdued. Although short-term market interest rates rose in line with the

FOMC’s firming of monetary policy,

financial market conditions were still

generally supportive of economic

expansion in the first half of 2006.

Long-term interest rates rose but were

still moderate by historical standards,

and credit spreads and risk premiums

stayed narrow.

The Household Sector

Consumer Spending

After increasing at a robust rate around

the turn of the year, consumer spending

has been rising at a more moderate pace

in recent months. Over the first half of

2006, rising employment and the lagged

effect of increases in wealth continued

to provide support for spending by

households. However, consumers’ purchasing power was restrained by a further run-up in energy costs in the spring.

Sales of new cars and light trucks

bounced back sharply at the turn of the

year; those sales had slackened in late

2005 after manufacturers ended the special “employee discount” programs that

had boosted sales last summer. New

light vehicles sold at an annual rate of

16.8 million units between January and

April, about the same as the average rate

in 2004 and 2005. However, elevated

gasoline prices affected the composition

of demand, and consumers shifted their

purchases away from light trucks and

sport-utility vehicles (SUVs) and toward autos. That shift led to an increase

in the market share captured by foreign

producers. As households’ concerns

about the higher price of gasoline

weighed on their attitudes toward buying vehicles, sales dipped to an annual

rate of 16.2 million units in May and

June.

Spending for other househo

such as furniture, electronic e

food, and clothing, was quite 

the first quarter of 2006; real o

goods other than motor 

increased at an annual rate o

cent. Some moderation wa

expected after such a surge in 

Estimates of retail sales, w

available through June, sugges

expenditures for these goods 

slowly in the second quarter. I

to the uneven pattern of spe

goods, real outlays for cons

vices remained on a moderat

trend over the first half of 2

rose at an annual rate of 21⁄

from the fourth quarter of 200

May 2006.

Boosted by gains in nomi

and salary income, after-tax 

personal income rose at an a

of 4 percent over the first fiv

of 2006. However, the accel

consumer prices held real inco

constant. As a result, the stee

in the personal saving rate, wh

in 2004, extended into 200

2003, rising household we

provided important support f

ing, even as gains in real inc

been damped by increases 

prices. In 2005 and the firs

2006, much of the increase 

was the result of the rapid ap

in the value of homes.

According to the survey by 

versity of Michigan Survey 

Center (SRC), the run-up i

prices contributed importantly 

terioration in consumer confid

spring. Consumers’ pessimis

in May and then lessened som

average, in June and early Ju

theless, at midyear, househo

cated that they were still c

about the effect of the high 

energy on their financial sit
addition, households’ assessments of

current and expected business conditions remained considerably less optimistic than they were at the beginning

of the year.

Residential Investment

The demand for homes had begun to

soften in the summer of 2005, and, by

the spring of 2006, starts of new singlefamily homes were well below the very

rapid pace that had prevailed in the preceding two years. The reduced level of

activity in real estate markets also led to

some easing in house-price appreciation

early this year.

Sales of new and existing singlefamily homes, which had been climbing

steadily since 2003, stopped rising during the third quarter of 2005. By May,

sales of new and existing homes together were 71⁄4 percent below their

peak in June 2005. The cooling in sales

caused inventories of unsold homes to

rise. In May, the backlog of unsold new

homes equaled 51⁄2 months’ supply at

that month’s selling rate, and the backlog of existing homes on the market was

61⁄2 months’ supply; in 2005, the stocks

of both unsold new and existing homes

averaged roughly 41⁄2 months of supply.

An increase in mortgage rates contributed to the slackening in the demand for

housing. Since the middle of 2005, the

average rate for a thirty-year fixed-rate

mortgage has increased about 1 percentage point, to 63⁄4 percent, and the average for a one-year adjustable-rate mortgage has risen a bit more, to 53⁄4 percent.

According to respondents to the Michigan SRC survey, the rise in borrowing

costs has been an important consideration damping their assessment of buying conditions for homes since mid2005; the rise in home prices has

apparently also weighed on consumers’

attitudes.

Although recent increases 

prices have been smaller than 

accompanied the robust real e

kets of 2004 and 2005, the de

thus far appears to have bee

The repeat-transactions index 

prices, which is published by 

of Federal Housing Enterpr

sight, increased at an annua

71⁄4 percent in the first quarte

the smallest quarterly increase 

fourth quarter of 2001; that 

tempts to control for the qualit

ing single-family homes sold 

prices of homes involved in rep

actions (excluding refinancin

first-quarter reading brought 

over-year change in this meas

percent; in the second and thir

of 2005, purchase prices acc

this index were up 111⁄2 per

the level of a year earlier. An a

measure of house prices is th

price of existing single-fami

sold, which is published by the 

Association of Realtors. This 

which does not control for th

homes sold, showed that the y

year change in prices p

111⁄2 percent in August 2005 

fell to 4 percent in April and M

year. The greater deceleration 

ter measure suggests that, in a

some softening in prices, th

existing units sold may have 

ward lower-priced homes.

The effect of the slowdow

mand on new construction be

parent during the second half 

when the number of permits 

new single-family homes beg

This year, the decline in permi

was relatively steady from J

May. Nonetheless, new sing

homes were started at an exc

high annual rate of 1.75 mil

during the first quarter, when 

were able to begin work on 
projects earlier than normal because of

favorable weather conditions. With

some starts having been advanced into

the first quarter, single-family starts

dropped to an average rate of 1.57 million units in April and May. In contrast

to the recent trend in the single-family

sector, construction of new multifamily

homes averaged an annual rate of

360,000 units from January to May,

about where it has been for more than

four years.

Housing activity, as measured by real

expenditures on residential structures,

contributed almost 1⁄2 percentage point

per year to the annual rate of increase in

real GDP in 2004 and 2005. In the first

quarter of 2006, that contribution

dropped to 0.2 percentage point; with

the reduced pace of sales and construction since the winter, a decline in residential investment is likely to have held

down the rise in real GDP in the second

quarter.

Household Finance

Household debt expanded at an annual

rate of about 111⁄2 percent in the first

quarter of 2006, about the same pace as

in 2005. Despite the rise in mortgage

rates and the slowing in housing activity, home mortgage debt expanded rapidly again early in the year as homeowners apparently continued to extract some

of the substantial gains in equity that

they have accumulated on their homes

in the past several years. Indeed, according to industry estimates, although the

number of homeowners refinancing

their mortgages has remained well below that seen during the refinancing

boom of several years ago, a large fraction of homeowners who have refinanced so far this year have chosen to

withdraw equity from their homes. As

has been the case in recent years, this

mortgage-related borrowing likely replaced, in part, some consum

borrowing, which, at an annua

bit less than 3 percent, con

expand modestly in the first fiv

of 2006.

The ratio of household fina

gations to disposable inco

0.1 percentage point in the fir

to about 183⁄4 percent, narrowl

ing the top of its historical ran

theless, the evidence points to 

ited pockets of financial distr

household sector. Delinquency 

residential mortgages were lo

torical standards in the firs

though they have edged higher 

middle of last year, particula

subprime sector. Delinquency 

consumer debt also continued 

Meanwhile, household bankr

ings remained subdued in the 

of 2006, running at a pace w

the average of recent years. 

cies have likely been damped 

in part by the decision of som

holds in the fall of 2005 to 

their filings to avoid the imple

of a stricter bankruptcy law in 

More recently, they may also 

restrained by the greater costs 

ruptcy under the new law.

The Business Sector

Fixed Investment

Real business fixed invest

creased at a solid rate, on ave

ing the final quarter of 2005 an

quarter of 2006. Over that pe

business spending for new e

and software rose at an annu

93⁄4 percent, a pace similar to 

the first three quarters of 2005

tion, investment in nonresiden

tures, which had remained 

2005, turned up noticeably 

2006. The underlying determ
capital spending have stayed quite positive: Businesses have seen steady

increases in sales, robust profits, and

declining user costs for equipment; they

have ample liquid assets; and, despite

the rise in interest rates, credit quality is

strong.

Real outlays for equipment and software rose at an annual rate of

143⁄4 percent in the first quarter after

having risen at a 5 percent rate in the

fourth quarter of 2005. As can often be

the case, the timing of spending for a

number of types of equipment was uneven between these two quarters. Business purchases of cars and trucks slowed

in late 2005, after manufacturers reduced their special discounts on light

vehicles, and then recovered in the first

quarter. The first-quarter rebound was

strengthened by a further acceleration of

outlays for medium and heavy trucks.

According to industry analysts, businesses have been pulling forward these

purchases because the engines in the

2007 models will be required to meet

new emission regulations by the Environmental Protection Agency that will

make the new vehicles more costly to

operate. Deliveries of commercial aircraft to domestic customers also rebounded in the first quarter from a very

low level in the fourth quarter.

Demand for high-technology equipment stepped up noticeably in the first

quarter because of a sharp jump in outlays for communications equipment.

Providers of telecommunications services appear to be investing heavily in

fiber-optic networks, which will allow

them to offer a wider range of Internet

services; the recent spurt likely also

includes some replacement demand for

equipment damaged by last year’s hurricanes. In contrast, business demand for

computing equipment, while still increasing at a double-digit pace in real

terms, has been relatively modest by

historical standards so far 

Industry analysts suggest that 

be delaying investment in an

of introductions, later this ye

early 2007, of several product

allow faster and more energ

processing. Spending on e

other than transportation and 

goods continued to trend up 

pace, on average, during the f

first quarters. Demand was p

strong for metalworking an

industrial machinery as we

equipment used in constructio

extraction, and services indust

Demand for equipment and 

appears to have risen again i

ond quarter. The information 

manufacturers on their orders 

ments of nondefense capital g

the data on imports of capi

suggest that business spen

equipment other than transpor

high-tech items remained on 

upward trajectory in April and 

elevated backlog of unfilled 

domestic firms likely provide

for factory production of capi

ment in the second quarter. T

tors of demand for high-tech e

suggest that spending for co

tions equipment remained a

level, and real outlays for c

equipment were still rising slo

of medium and heavy trucks 

to be robust in the second 

although they eased slightly 

exceptional rate at the beginn

year.

Real expenditures for nonr

construction increased at an a

of 121⁄2 percent in the first qu

having edged up slightly dur

Last year, the small net increa

sector reflected a sharp upturn 

ing on structures used in 

energy exploration; constructi

office and industrial building
strained by elevated vacancy rates.

However, vacancy rates for office and

industrial properties gradually declined

over the course of 2005, and, by the

turn of the year, nonresidential construction began to firm. As a result, the

increase in nonresidential investment in

the first quarter of 2006 was broadly

based; it included pickups in outlays in

the office, retail, and industrial sectors

in addition to another steep rise in

spending on structures associated with

energy exploration.

Inventory Investment

Business inventories appear generally to

be well aligned with sales. In surveys

taken during the first six months of

2006, about two-thirds of purchasing

managers at manufacturing firms who

responded characterized the level of

their customers’ inventories as about

right. A similar proportion of respondents at nonmanufacturing firms reported that they were comfortable with

their own levels of inventories. However, dealer stocks of new light motor

vehicles, particularly trucks (including

SUVs), have risen noticeably as sales

have slowed; inventories of light trucks

reached an uncomfortable 89 days’ supply in May. In late June, a number of

manufacturers introduced a new round

of incentives aimed at reducing dealer

stocks in advance of the introduction of

their new models this fall.

Corporate Profits

and Business Finance

Corporate profits were again strong in

the first quarter of 2006, and earnings

per share for S&P 500 firms rose about

15 percent from the same time last year.

Gains were widespread but were especially large for firms in the energy sector. Before-tax profits of nonfinancial

corporations measured as a sha

tor GDP rose to about 14 perc

first quarter, above the prev

reached in 1997.

The expansion of busin

picked up to an annual rate 

10 percent in the first quart

year, and data in hand sugges

pace in the second quarter. A s

fraction of borrowing procee

edly went to finance mergers a

sitions in the first half of the 

bond issuance has been strong 

2006. Short-term borrowing 

nancial corporations stepped 

first quarter of 2006 after slow

what in the fourth quarter of la

appears to have remained stro

second quarter as well. Co

paper outstanding started risi

on balance, after edging lowe

Bank business loans ou

expanded at an annual rate of 

cent in the first quarter. Busin

efited from a more accommoda

ing environment: For exa

significant net fraction of resp

the Federal Reserve’s Senior L

cer Opinion Survey on Bank 

Practices in April 2006 noted 

institutions had eased both stan

terms on commercial and 

loans in the first three mont

year. The most commonly cite

for the easing of lending poli

more-aggressive competition f

banks and nonbank lenders, 

liquidity in the secondary m

business loans, and increased 

for risk.

Gross equity issuance has 

moderate so far this year, wh

evated level of cash-financed 

along with record share repurc

produced further sizable net 

tirements. Taken together, n

raised by nonfinancial corpo

the credit and equity markets 
slightly negative in 2006, an indication

that nonfinancial corporations have financed their increased investment

spending with internal funds.

With profitability strong and balance

sheets flush with liquid assets, credit

quality in the nonfinancial business sector generally has remained quite high.

The six-month trailing default rate on

corporate bonds dropped after some

large firms in the troubled airline and

automobile sectors defaulted during the

past fall and winter. Delinquency rates

on business loans have stayed near the

bottom of their historical range.

Commercial real estate debt expanded

briskly in the first half of 2006, albeit

not as quickly as during 2005. Spreads

on BBB-rated commercial-mortgagebacked securities have fallen this year.

The decline reversed an increase that

took place at the end of last year, when

issuance surged; these spreads are now

back in line with those of comparablequality corporate bonds. With rents

climbing and vacancy rates falling, delinquency rates on commercial real estate loans have been low, and credit

quality has remained generally good.

The Government Sector

Federal Government

The deficit in the federal unified budget

narrowed further during the past year.

Over the twelve months ending in June,

the unified budget recorded a deficit of

$276 billion, about $60 billion less than

during the comparable period last year.

The federal deficit over the twelve

months ending in June was approximately 2 percent of nominal GDP and

was significantly lower than its recent

fiscal year peak of 3.6 percent of GDP

in 2004. Although outlays increased

faster than nominal GDP over the past

year, the rise in receipts was even larger.

Thus, in its recent Mid-Sessio

of the budget, the Administr

mated that the federal govern

finish fiscal 2006 with a defic

billion; that figure marks a dec

the fiscal 2005 deficit of $3

and is much lower than mos

had projected at the beginnin

year.

During the twelve months 

June, federal receipts were 13

higher than over the same per

earlier and equivalent to 

181⁄4 percent of nominal GD

tax receipts from individuals 

paced the rise in nominal inco

tax payments on income from 

especially strong in April and 

porate tax payments continued 

a robust rate, even faster than 

profits.

Nominal federal outlays ro

cent between June 2005 and J

and were about 201⁄2 percent o

GDP. The rise in outlays was 

by increases in several comp

federal spending. Net interest 

increased 20 percent over the 

ing in June as federal debt co

rise and interest rates increas

care outlays were up 141⁄2 perc

the inception of the new Part D 

tion drug program in Januar

for benefits have added more 

billion to spending in this categ

islative actions related to the h

in the Gulf Coast region las

have added significantly to spe

disaster relief over the past te

Although defense spending h

from the annual double-digi

increase from 2002 to 2004, 

increased about 8 percent per y

past two years.

As measured in the nation

and product accounts (NIPA)

eral expenditures on consum

gross investment—the part o
spending that is a direct component of

real GDP—increased at an annual rate

of 33⁄4 percent, on average, during the

final calendar quarter of 2005 and the

first calendar quarter of 2006 and contributed roughly 0.3 percentage point to

the annualized change in real GDP over

the period. Over these two quarters, real

defense purchases were about constant,

on average, while spending related to

disaster relief from the hurricanes contributed importantly to a rise in real

nondefense purchases.

The narrowing of the federal deficit

recently has reduced its drain on national saving. However, net national saving excluding the federal government

has remained low relative to historical

norms. Although the saving rate for private business has moved up during the

past two years, the improvement has

been offset by the further decline in

personal saving. Overall, national saving, net of depreciation, stood at

21⁄2 percent of nominal GDP in the first

quarter of 2006. Although the recent

rate is a noticeable improvement from

the lows of the preceding few years, it

has been insufficient to avoid an increasing reliance on borrowing from abroad

to finance the nation’s capital spending.

Federal Borrowing

Federal debt rose at an annual rate of

13 percent in the first quarter, a bit less

than in the corresponding quarter of

2005. In February, federal debt subject

to the statutory limit reached the ceiling

of $8.184 trillion, and the Treasury resorted to accounting devices to avoid

breaching the limit. The Congress subsequently increased the debt ceiling to

$8.965 trillion in March. In the second

quarter, federal debt likely declined temporarily because of a surge in tax receipts. On net, the Treasury has raised

substantially less cash in the market so

far this year than in the co

period of 2005.

In February, the Treasury 

an auction of thirty-year bon

first time since 2001. The iss

ated strong interest, especia

investment funds; foreign inve

awarded only a small fracti

total. In general, foreign de

Treasury securities appears 

eased somewhat in 2006. Th

tion of nominal coupon 

bought at auction by foreign 

has continued to fall from it

24 percent in 2004; it avera

14 percent in the first six m

2006. Data from the Treasur

tional Capital system gener

gested subdued demand from 

eign private investors and 

official institutions over this p

amount of Treasury securitie

custody at the Federal Reserv

New York on behalf of foreig

and international accounts ha

little since the end of 2005.

State and Local Governments

The fiscal positions of states a

ties continued to improve thro

2006. In particular, revenues ar

to post a relatively strong g

third consecutive year. Tax rec

sales, property, and personal a

rate income were up 81⁄4 perce

the year ending in the first 

2006, a rate similar to the incre

preceding year. The sustained 

in revenues has enabled these 

tions to increase their nominal 

somewhat while rebuilding the

funds. On a NIPA basis, net 

state and local governments—

that is broadly similar to the 

an operating budget—rose to 

rate of $211⁄2 billion in the fir

of 2006 after having been clo
in 2005. Although most states have seen

improvement, a number of states are

still struggling with structural imbalances in their budgets, and those in the

Gulf Coast region are coping with demands related to damage from last

year’s hurricanes. In addition, local governments may face pressure to hold the

line on property taxes after the sharp

increases in the past several years, and

governments at all levels will have to

contend with the need to provide pensions and health benefits to a rising

number of retirees in coming years.

Real expenditures by state and local

governments on consumption and gross

investment, as estimated in the NIPA,

rose at an annual rate of 11⁄2 percent in

the first quarter of 2006 after having

increased roughly 1 percent per year in

2004 and 2005. Real expenditures for

investment turned up in the first quarter

after having fallen during the second

half of 2005. Real outlays for current

consumption posted a moderate increase

in the first quarter, and that trend

appears to have continued into midyear.

Hiring by state and local governments

was slow early in the year but appears to

have firmed in the spring. Of the cumulative increase in employment of

100,000 between December and June,

40 percent of the jobs were in education.

State and Local Government

Borrowing

Borrowing by state and local governments has slowed thus far in 2006. The

deceleration likely reflects the general

improvement in budget conditions and a

decline in advance refundings, which

have dropped below their 2005 pace

amid rising interest rates and a dwindling pool of eligible securities. Credit

quality in the state and local sector has

continued to improve, and upgrades of

credit ratings have far outnumbered

downgrades. Consistent with 

provement in credit quality, 

long-dated municipal bonds 

creased substantially less than 

comparable-maturity Treasur

ties, and the yield ratio has ac

fallen sharply.

The External Sector

The U.S. current account de

rowed in the first quarter of 

$835 billion at an annual rate

61⁄2 percent of nominal G

$892 billion in the fourth q

2005. The narrowing resulted f

factors. Unilateral transfer pa

foreigners dropped, largely be

decrease in government gr

trade deficit narrowed, prim

cause the value of imported oil 

ral gas declined. In additio

direct investment receipts a

direct investment payments 

an increase in the investmen

balance.

International Trade

Real exports of goods and 

increased 143⁄4 percent at an a

in the first quarter of 2006, 

than the 61⁄2 percent rate re

2005. The surge in export gro

first quarter resulted in par

recovery in exports of many 

industrial supplies following a 

hurricane-related disruptions 

year. Exports of capital go

increased rapidly in the firs

with deliveries of aircraft to fo

riers exhibiting particular stre

first-quarter increase in exp

widespread across destinations

robust economic activity in m

of the world, and exports to M

Canada showed especially 

creases. Real exports of serv
at an annual rate of about 61⁄2 percent in

the first quarter after increasing just

23⁄4 percent in 2005. Available data for

nominal exports in April and May suggest that the increase in real exports was

smaller in the second quarter, held down

in part by a drop in aircraft exports after

a strong first quarter.

Prices of exported goods increased at

an annual rate of 23⁄4 percent in the first

quarter of 2006, a pace somewhat faster

than in the second half of 2005. Prices

of non-agricultural industrial supplies

continued to increase steadily in the first

quarter, driven importantly by higher

prices for oil and metals. An acceleration in prices for finished goods, especially for capital and consumer goods,

contributed to the faster pace of export

price inflation in the first quarter. The

available data for the second quarter

point to further increases in export

prices on the strength of additional runups in the prices of non-agricultural

industrial supplies, especially metals.

Real imports of goods and services

rose at an annual rate of 103⁄4 percent in

the first quarter, slightly slower than in

the fourth quarter but still considerably

faster than the 51⁄4 percent rate observed

for 2005 as a whole. Robust growth of

real GDP in the United States supported

the first-quarter increase in imports.

Among categories of goods, large

increases in imports of consumer goods,

automotive products, and capital goods,

particularly computers, more than offset

declines in imports of oil and some other

industrial supplies. The rise in imports

in the first quarter was widely distributed across countries, and the increases

for China and Mexico were especially

large. Real imports of services jumped

at an annual rate of 81⁄2 percent in the

first quarter. Nominal imports in April

and May point to an abrupt slowing of

real imports in the second quarter from

the first quarter’s rapid pace.

Prices of imported goods 

oil and natural gas rose at an a

of about 1 percent in the first 

2006, 3⁄4 percentage point faste

pace in the second half of 20

of material-intensive goods, 

nonfuel industrial supplies a

increased steadily in the last 

2005 and in the first quarter 

Also in the first quarter, pric

ished goods, such as consum

and many kinds of capital goo

up slightly. Available data fo

ond quarter indicate that pric

ished goods kept rising at a 

pace. However, prices of 

intensive goods continued to 

sharply, a development reflect

prices for metals. The Int

Monetary Fund’s index of glo

prices rose 46 percent betwee

ber 2005 and May 2006, largel

of robust global demand. In Ju

prices retreated about 8 

although they remained well 

levels of earlier this year.

The spot price of West Texa

diate crude oil increased fro

$60 per barrel at the end of la

more than $75 per barrel in Ju

than the peak that followed l

hurricanes. Oil prices have be

sensitive to news about both s

demand, particularly in light o

row margin of worldwide spar

tion capacity. Global oil de

continued to grow as the for

nomic expansion has spread, a

oping countries have posted t

increases in oil consumption

events in the Middle East—

concerns over Iran’s nuclear 

violence in Iraq, and the recen

in Lebanon—have put 

upward pressure on oil prices

ria, attacks against oil infr

have reduced oil production fo

this year. Government interv
energy markets also raised concerns

about supply from some countries: In

recent months, Bolivia nationalized its

natural gas reserves, and Venezuela and

Russia continued to tighten governmental control of their energy industries.

The rise in the price of the far-dated

NYMEX oil futures contract (currently

for delivery in 2012) to more than $70

per barrel likely reflects a belief by oil

market participants that the balance of

supply and demand will remain tight

over the next several years.

The Financial Account

The U.S. current account deficit continues to be financed primarily by foreign

purchases of U.S. debt securities. Foreign official inflows in the first quarter

maintained the strength exhibited in

2005 but remained below the record

levels of 2004. As in recent years, the

majority of these official inflows were

attributable to Asian central banks and

have taken the form of purchases of U.S.

government securities.

Foreign private purchases of U.S. securities continued in the first quarter at

the extraordinary pace set in the second

half of 2005. Although private flows

into U.S. Treasury bonds were significantly smaller than in recent quarters,

this slowing was more than offset by

larger flows into agency bonds and equities. Preliminary data for April and May

suggest a slowdown in foreign purchases of U.S. securities relative to the

first quarter. Foreign direct investment

flows into the United States continued

in the first quarter near last year’s average levels.

Net purchases of foreign securities by

U.S. residents, which represent a financial outflow, strengthened slightly in the

first quarter and continued at a solid

pace in April and May. In addition, significant outflows were associated with

U.S. direct investment abroad, 

of some unusual inflows in t

half of 2005. These second-ha

were prompted by the partial ta

offered under the 2004 H

Investment Act (HIA), which 

the foreign affiliates of U.S. 

repatriate a portion of earlier 

that had been retained abroa

first quarter, the foreign affil

tially unwound the HIA-indu

by retaining an unusually larg

of their first-quarter earnings. 

merger activity abroad also 

direct investment outflows in 

quarter.

The Labor Market

Employment and Unemployme

Conditions in the labor 

continued to improve in the fi

2006, although the pace of h

slowed in recent months. 

payroll employment increased 

per month during the first qua

roughly in line with the relati

pace that prevailed during 

2005. During the second quar

slowed, and monthly gains in 

averaged 108,000 jobs per mo

the two quarters, the civilian u

ment rate edged down furth

lowest quarterly level of jobl

five years.

In the first quarter, with hom

quite strong, hiring continued 

ticularly robust at construction 

of this strength was the result 

able weather, which allowed m

struction activity than is typic

the winter months. Although 

dential construction activity w

by the spring, the pullback i

starts slowed the demand for r

contractors and workers in th

trades. As a result, monthly ad
construction industry payrolls declined

from more than 25,000 per month in the

first quarter to just 3,000 per month in

the second quarter. Cutbacks at retailers

also were an important factor holding

down the overall gain in employment in

the second quarter. After having been

stable early in 2006, employment at

retail outlets fell almost 30,000 per

month between March and June; most

of the cutbacks occurred at general

merchandisers.

In other sectors, employment remained on a solid upward trend during

the first half of the year. As has been the

case since mid-2004, establishments

providing education and health services,

those offering professional and technical

business services, and those involved in

financial activities, taken together,

added more than 60,000 jobs per month.

Employment in manufacturing, which

had turned up at the end of 2005, rose

further over the first half of 2006.

Expanding industrial production was

also associated with further job gains in

related industries, such as wholesale

trade and transportation. In addition, the

increase in energy production led to a

sustained rise in employment in the

natural resources and mining industry

over the first half of the year.

The increase in job opportunities so

far in 2006 led to a further reduction in

the civilian unemployment rate, from an

average of 5.0 percent in the second half

of 2005 to 4.7 percent in the second

quarter of 2006. Although hiring moderated in the spring, layoffs remained low.

New claims for unemployment insurance (UI) dipped below 300,000 per

week in January and February and then

fluctuated around a still-low level of

about 315,000 per week for most of the

period from March through early July.

Over the first half of 2006, longer-term

unemployment (fifteen weeks or more)

also moved down, and the proportion of

UI claimants who remained o

employment rolls until the exh

their benefits continued to rec

After having edged up dur

the labor force participation 

relatively stable over the fir

2006 despite the ongoing imp

in labor market conditions. 

most broad age groups w

changed from last year’s level

longer perspective, developm

ing the past decade highlight t

tance of structural as well a

influences on participation. T

the attachment of adult wom

workforce, which was a signif

tor in the secular rise in pa

over much of the post-Worl

period, appears to have leveled 

the aging of the population is 

the proportion of the workfor

55 years and older; it rose from 

12 percent in 1996 to 163⁄4 p

recent months. Although olde

have tended in recent years to 

labor force longer, their par

rate, at 38 percent in the secon

was less than half the rate fo

who are age 25 to 54. Thus, 

graphic shift to an older popu

already begun to reduce the o

of labor force participation an

set part of the rise in particip

has been associated with th

upturn in job creation. Th

forces that are slowing the exp

the labor force imply that the i

employment that is consiste

stable unemployment rate w

time, be smaller than it was d

period when labor force pa

was rising steadily.

Productivity and Labor Costs

After having advanced at an 

rapid rate from 2001 to mid-2

productivity in the nonfarm 
sector increased at a more moderate

annual rate of 21⁄2 percent from mid2004 to early 2006. Nonetheless, by historical standards, productivity performance recently has still been solid, with

gains at a rate matching those during the

second half of the 1990s. In an environment of a sustained expansion of aggregate demand, businesses have gradually

adjusted their use of labor, capital, and

services to achieve ongoing gains in

efficiency. Productivity has continued

to benefit importantly from investment

in new technologies, organizational

changes, and improvements in business

processes, although the contribution

from capital deepening has been smaller

in recent years than it was during the

capital investment boom of the late

1990s.

Broad measures of hourly labor compensation, which include both wages

and the costs of benefits, posted moderate gains over the year ending in early

2006 despite the run-up in headline price

inflation and the further tightening of

labor markets. Both the employment

cost index (ECI) and the estimate of

compensation per hour that uses data

from the national income and product

accounts increased 23⁄4 percent between

the first quarter of 2005 and the first

quarter of 2006.1 Both series had reported higher rates of change in hourly

labor compensation a year earlier.

The deceleration in labor compensation appears to have been associated

largely with smaller increases in employers’ benefit costs. The benefits component of the ECI was up just 3 percent

between March 2005 and March 2006,

compared with an increase of 5.5 percent between March 2004 and March

2005. The cost of health i

which typically accounts for a

fourth of overall benefit costs

43⁄4 percent during the year 

March 2006; between 2000 

these costs increased, on 

83⁄4 percent per year. Another l

tributor to the slower rise i

costs over the past year wa

employer contributions to thei

benefit pension plans; tho

dropped back somewhat after e

made sizable payments to bol

pension assets in 2004.

Indicators of the recent tre

wage component of worker c

tion have been providing mixe

As measured in the ECI, w

2.4 percent between March 

March 2006, slightly less th

preceding two years. In con

year-over-year change in avera

earnings of production or no

sory workers—which refers 

rower group of private nonfarm 

ees and has tended to show 

cyclical variation than the 

increased steadily over the p

years. Average hourly earn

3.9 percent over the twelve mo

ing in June 2006, compared 

increase of 2.7 percent over t

months ending in June 2005.

Prices

Inflation pressures were eleva

the first half of 2006. The c

price index for personal con

expenditures (PCE) rose at 

rate of 41⁄4 percent between 

2005 and May 2006. Over 

period, core PCE prices incre

annual rate of 2.6 percen

0.6 percentage point faster tha

twelve months of 2005.

Although energy prices eas

rarily in February, they tu

1. The Bureau of Labor Statistics (BLS) developed a new ECI series and has provided data for

the changes in that series beginning in 2001. The

BLS considers the new ECI to be continuous with

the old series.
sharply again from March to May; as a

result, the PCE price index for energy

increased 13 percent (not at an annual

rate) over the first five months of 2006,

a rise that marked a continuation of the

steep climb in prices that began in 2004.

This year, almost the entire rise in

energy prices has been associated with

higher prices for petroleum-based products. The PCE price index for gasoline

and motor fuel, which increased more

than 161⁄2 percent last year, climbed

another 24 percent (not at an annual

rate) by May. Although recent data from

the Department of Energy indicate that

gasoline prices fell back in June, they

moved up again in early July. Retail

prices of gasoline this year have risen

faster than the cost of crude oil in part

because of the additional cost of producing and distributing reformulated product with ethanol. Also, the demand for

fuel ethanol has been strong relative to

the current capacity to produce it. In

contrast, the consumer price of natural

gas has turned down this year as inventories have remained relatively high; the

price decline between January and May

almost completely reversed the steep

run-up that occurred last autumn.

Food price inflation remain

ate during the first five month

between December 2005 and M

the PCE price index for food a

ages increased at an annua

21⁄4 percent. Retail prices of 

poultry have fallen so far 

Domestic supplies of meat h

ample. Production has been e

at a time when export deman

has been soft largely because o

imports of U.S. beef by J

Korea. Prices of processed f

continued to rise at only a mod

despite higher prices for grai

demand for grains has been st

the price of corn has been b

demand from producers of 

Prices for food consumed a

home, which typically are i

heavily by labor and other 

costs, have continued to 

relatively rapidly, rising at a

rate of 33⁄4 percent over the 

months of the year.

The pickup in core inflati

first half of 2006 was evide

indexes for both goods and 

Prices of consumer goods 

food and energy, which were u

in 2005, edged up at an annu

3⁄4 percent this year. Prices of 

services also accelerated this 

a result, the PCE price index 

energy services increased at 

rate of 31⁄2 percent between 

2005 and May 2006, compar

rise of 23⁄4 percent in 2005. In 

months ending in May, inc

housing rents were especially 

rise may reflect, in part, a sh

mand toward rental units beca

purchases have become less a

Another contributor to the hig

tion rate for consumer service

the acceleration in the index fo

ket services to an annual rate 

cent over the first five mont

Alternative Measures of Price Change

Percent

Price measure

2004

to

2005

2005

to

2006

Chain-type (Q1 to Q1)

Gross domestic product (GDP) . 2.8 3.1

Gross domestic purchases . . . . . . 3.1 3.5

Personal consumption

expenditures (PCE) . . . . . . . . 2.7 3.0

Excluding food and energy . . . 2.2 1.9

Market-based PCE excluding

food and energy . . . . . . . . . . . 1.8 1.5

Fixed-weight (Q2 to Q2)

Consumer price index . . . . . . . . . . 3.0 4.0

Excluding food and energy . . . 2.1 2.4

Note: Changes are based on quarterly averages of

seasonally adjusted data.
year from 3 percent last year.2 More

broadly, the pickup in core consumer

price inflation over the first five months

of 2006 likely is the result of the passthrough of higher energy costs to a wide

range of goods and services.

The cost pressures from the increase

in energy costs during the past three

years have been apparent in rising prices

of inputs used in the production and sale

of final goods and services. The producer price index for intermediate

goods, excluding food and energy, rose

at an annual rate of 71⁄4 percent between

December 2005 and May 2006; this index rose 43⁄4 percent in 2005 and

81⁄4 percent in 2004. In particular, prices

of industrial chemicals, fertilizer, and

stone and clay products, for which

energy represents a relatively high share

of the total costs of production, accelerated over the past several years. The

costs of a number of important business

services, particularly transportation by

air, rail, and truck, have also been

boosted by higher energy costs. The

pass-through of the costs of energy to

consumer prices is clear for a few items,

such as airfares. For other components

of core consumer price indexes, however, the extent of the pass-through is

harder to trace. Quantifying the extent

of the pass-through is difficult, in part

because it is diffused through a wide

range of retail goods and services. In

addition, the cost of energy is a small

share of overall costs—and that share

has been declining over time as businesses adopt more energy-efficient technologies and households reduce their

consumption of energy. Nonetheless, the

cumulative rise in energy costs in recent

years has been large enough to show

through to pricing of final g

services even as businesses h

their labor costs, which 

roughly two-thirds of their cos

restrained.

Near-term inflation expectat

also influenced importantly ov

half of 2006 by movements 

prices, but, as of midyear, t

only slightly higher than the

the turn of the year. The Mich

survey measure of the median 

tion of households for inflatio

next twelve months held 

3 percent during the first thre

of the year but then rose s

4 percent in May as gasoli

climbed. By early July, this m

near-term inflation expectation

back to 3.1 percent. Longer-t

tion expectations remained w

ranges in which they have flu

recent years. On average ove

half of 2006, the median resp

the Michigan SRC survey con

expect the rate of inflation d

next five to ten years to be j

3 percent. In June, the Survey 

sional Forecasters, conducte

Federal Reserve Bank of Phi

reported expected inflation at 

21⁄2 percent over the next ten 

expectation that has been ro

changed for the past eight ye

tion compensation implied by 

of yields on nominal Treasury 

over their inflation-protected 

parts rose slightly, on net, ove

half of the year; in early July 

above 21⁄2 percent.

U.S. Financial Markets

U.S. financial markets f

smoothly in the first half of 20

the backdrop of increased vo

some asset prices. Yields on 

Treasury coupon securities r

2. These are services—such as foreign travel or

the financial services provided by banks—for

which no prices based on market transactions are

available; the Bureau of Economic Analysis must

impute or estimate these indexes.
70 basis points, on net, through early

July as investors came to appreciate that

economic conditions and inflation pressures required more monetary policy

tightening than they had expected at the

end of 2005. Equity prices advanced

until mid-May but then reversed those

gains. Apparently, evidence of increased

inflationary pressures and some softerthan-expected data on economic activity

induced market participants to revise

down their longer-term outlook for business profits and to perceive greater risks

to that outlook. With corporate balance

sheets remaining strong and liquid, risk

spreads on corporate bonds stayed low,

an indication that the revision to the

outlook had not sparked broad concerns

about credit quality. Firms had ample

access to funds, and business-sector debt

expanded rapidly in the first quarter.

The need to finance brisk merger and

acquisition activity was one factor that

reportedly induced nonfinancial businesses to tap the credit markets heavily.

Bond issuance picked up noticeably, and

commercial and industrial loans

increased robustly. Banks continued to

ease terms and standards on such loans.

Household debt expanded further in the

first quarter amid rising house prices

and brisk cash-out refinancing activity.

As was the case in 2005, the M2 monetary aggregate has advanced moderately

so far in 2006.

Interest Rates

The FOMC increased the target federal

funds rate 25 basis points at each of its

four meetings this year. These actions

brought the rate to 51⁄4 percent, about 60

basis points above the rate expected at

the end of last year for early July. In

contrast to the situation earlier in the

tightening cycle, when it was evident to

investors that considerable monetary

policy accommodation was in place and

had to be removed, market pa

more recently have had to f

greater degree on economic 

leases and their implications fo

look for economic growth and 

to form expectations about 

policy. Although the inform

rently available suggests that 

real output slowed appreciab

second quarter, incoming price 

pointed to greater-than-expec

tionary pressures throughout 

half of the year. Investors a

that the FOMC would act t

such pressures, and the expec

path moved upward, on bala

the first half of 2006. Neverthe

ket participants currently a

expect the target federal fun

ease after the end of the yea

investors’ apparent awaren

monetary policy decisions in

depend on the implications of 

information for the economic 

the implied volatility on s

Eurodollar rates calculated fro

prices has remained near the l

its historical range.

Yields on nominal Treasur

securities rose about 70 ba

across the maturity spectrum 

early July, in part because of t

tations for firmer policy. In a

appears that a modest reboun

premiums, including investor c

tion for inflation risk, may hav

uted to the rise in longer-te

still, estimated premiums rema

historical standards. Yields on 

indexed Treasury securities 

than those on their nominal 

parts, leaving inflation compe

medium- and long-term horiz

30 basis points higher than at t

the year.

In the corporate bond mark

on investment-grade securiti

about in line with those on co
maturity Treasury securities through

early July. In contrast, those on

speculative-grade securities rose only

about 40 basis points; as a result, risk

spreads were 30 basis points lower in

that segment of the market. The narrowness of high-yield spreads was likely a

reflection of investors’ sanguine views

about corporate credit quality over the

medium term, given the strength of business balance sheets and the outlook for

continued economic expansion.

Equity Markets

Broad equity indexes changed little, on

net, through early July. Stock prices

were boosted up to the first part of May

by an upbeat economic outlook and by

strong corporate earnings in the first

quarter. However, those gains were subsequently reversed as incoming data

clouded the prospects for economic

growth and continued to point to upward

pressures on inflation; the drop in share

prices was led by stocks that had logged

the largest gains in the previous months,

including those of firms with small capitalizations and of firms in cyclically sensitive sectors. A measure of the equity

risk premium—computed as the difference between the twelve-month forward

earnings–price ratio for the S&P 500

and an estimate of the real long-term

Treasury yield—has increased slightly

so far this year and remains near the

high end of its range of the past two

decades. The implied volatility of the

S&P 500 calculated from option prices

spiked temporarily in late May and early

June and remained somewhat elevated

compared with its levels earlier in the

year.

Net inflows to equity mutual funds

were very strong through April, as investors were evidently attracted by the

solid performance of the equity market

up to that point. In May and June, however, investors withdrew fund

prices began to sag.

Debt and Financial Intermedi

In the first quarter of 2006, the 

of domestic nonfinancial se

panded at an annual rate of 1

The household, business, an

government components all 

at double-digit rates, while 

local government debt adv

about a 6 percent pace. Pr

data suggest somewhat slow

of the debt of nonfinancial 

the second quarter. The slow

particularly noticeable in th

and state and local governmen

where strong tax receipts h

borrowing. The available 

point to somewhat reduced g

nonfinancial business debt in 

ond quarter.

Commercial bank credit in

an annual rate of about 11 perc

first quarter of 2006, a little f

in 2005, and picked up furt

almost 13 percent pace in th

quarter. A continued rapid in

business loans was likely sup

brisk merger and acquisition 

rising outlays for investment g

going inventory accumulation

accommodative lending env

Growth in commercial mortg

also strong, as fundamentals in 

tor continued to improve. D

slowing of housing activity 

months, residential mortgage 

expanded robustly. Howeve

short-term interest rates likel

uted to a runoff in loans dra

under revolving home-equity 

credit. Consumer loans adjust

curitizations decelerated in th

quarter after rising at a solid p

first quarter.
Bank profitability remained solid, and

asset quality continued to be excellent in

the first quarter. Profits were supported

by gains in non-interest income and reductions in loan-loss provisions that

more than offset a rise in non-interest

expenses. Delinquency and charge-off

rates remained low across all loan types.

Delinquency rates on residential mortgages on banks’ books edged lower in

the first quarter after moving up during

2005. Charge-off rates on consumer

loans declined to the lowest level seen

in recent years after a fourth-quarter

surge in charge-offs on credit card loans

that was associated with the implementation of the bankruptcy legislation in

October of last year.

As the policy debate about the possibility of curbing the balance sheet

growth of both Fannie Mae and Freddie

Mac continued, the combined size of the

mortgage investment portfolios at the

two government-sponsored enterprises

increased about 1 percent over the first

five months of 2006.

The M2 Monetary Aggregate

In the first quarter of 2006, M2 increased at an annual rate of about

61⁄2 percent, but its expansion moderated in the second quarter to a 23⁄4 percent pace, likely because of some slowing in the growth of nominal GDP.

Rising short-term interest rates continued to push up the opportunity cost of

holding M2 assets. Growth in liquid

deposits, whose rates tend to adjust sluggishly to changes in market rates, was

particularly slack. By contrast, the expansion in retail money market funds

and, especially, small time deposits was

brisk, as the yields on those instruments

kept better pace with rising market interest rates. Despite apparently modest demand from abroad, currency growth was

strong in the first quarter but has slowed

since. The velocity of M2 r

annual rate of 21⁄4 percent in 

quarter and appears to have co

rise in the second quarter.

International Developments

Foreign economic growth was 

the first quarter of 2006 as t

sion spread to all major regio

world. Accelerating domestic 

boosted growth in the foreign 

countries, especially Canada 

euro area. Emerging-market e

continued to benefit from rap

growth, and Chinese econom

was also spurred by a surge 

ment spending. Data for th

quarter suggest continued stro

abroad but with moderation 

countries. Rising energy pr

pushed up inflation in many 

this year, but upward pressur

inflation has generally contin

moderate.

Foreign monetary policy tig

the first half of this year in th

of solid growth and some h

inflation concerns. The Europ

tral Bank (ECB) raised its p

1⁄4 percentage point in March 

in June, citing rapid credit gr

the ECB’s expectation of ab

inflation. At its July policy me

Bank of Canada kept its targ

overnight rate unchanged at 41⁄

but it had increased its targ

overnight rate 1⁄4 percentage 

each of its previous seven po

ings. On July 14, the Bank 

(BOJ) ended its zero-interest-r

by raising its target for the c

rate to 1⁄4 percent for the first 

2001. Earlier, on March 9, 

announcing an end to its fiv

policy of quantitative easing, s

would set policy in the future 
inflation over the medium to long run,

defined as one to two years ahead.

Long-term bond yields abroad have

risen along with U.S. bond yields on

indications of robust global growth and

expectations of additional tightening of

monetary policy. Ten-year sovereign

yields have risen roughly 70 basis points

in the euro area since the end of last

year, while the increases on similar securities in Canada and the United Kingdom have been about 50 basis points.

Part of the rise in yields abroad has been

increased compensation for possible

future inflation as measured by the difference in yield between ten-year nominal and inflation-indexed bonds. Yield

spreads of emerging-market bonds over

U.S. Treasuries narrowed somewhat

early in the year, but that narrowing was

more than reversed in the second quarter

as investors apparently demanded

greater compensation for risk amid uncertainties about economic growth and

inflation.

The foreign exchange value of the

dollar has declined about 41⁄2 percent,

on net, this year against a basket of the

currencies of the major industrial countries but is down only about 1 percent,

on net, against the currencies of the

other important trading partners of the

United States. Much of the dollar’s

downward move occurred at times when

the market was focused on concerns

about global current account imbalances. The dollar has recovered some

ground since early May, as investors

reportedly have engaged in flightto-safety transactions into dollardenominated assets in conjunction with

the volatility in global commodity and

asset markets. On net, the dollar has

depreciated since the turn of the year

about 61⁄2 percent against the euro and

sterling, 3 percent against the Canadian

dollar, and 11⁄2 percent against the Japanese yen. In contrast, the dollar has risen

roughly 4 percent, on balanc

the Mexican peso this year. D

first half of this year, severa

countries experienced episode

stantial financial volatility tha

cases involved sharp deprec

the exchange value of their cu

Through the first four m

2006, a favorable economic ou

low interest rates supported 

equity prices in all major fore

tries. During May and early J

ever, equity prices registered w

declines, as market participa

more concerned about inflatio

tary policy, and global 

growth. More recently, develo

the Middle East have weigh

on stock prices. On net, eq

indexes are up between 1 pe

4 percent so far in 2006 in E

Canada, but they have fallen 

8 percent since year-end in Ja

American and Asian emergi

equity indexes, which had 

gained more than industrial-c

dexes early in the year, have fa

sharply since early May. Equi

in Mexico, Brazil, and Argen

dropped between 12 percent an

cent—leaving them still 

5 percent and 7 percent higher 

year—while stock prices in K

fallen about 9 percent, on ne

year.

Industrial Economies

The Japanese economy has co

strengthen this year, although 

growth has stepped down a bi

comparatively strong rate re

2005. Household consumpti

tained a solid rate of growth i

quarter, and private investmen

rose 11 percent. However, ne

which previously had been an 

source of strength, did not con
growth in the first quarter; the growth of

imports increased while export growth

remained firm. The labor market in Japan improved further in April and May:

The unemployment rate fell to 4 percent, and the ratio of job offers to applicants reached a thirteen-year high.

Although the GDP deflator has continued to decline, other signs indicate that

deflation is ending. In the first quarter of

2006, land prices in Japan’s six largest

cities rose 3.8 percent over their yearago level, the first increase since 1991.

Core consumer prices have shown small

twelve-month increases over the past

several months.

Real GDP in the euro area accelerated

in the first quarter, expanding 21⁄2 percent, a rate of growth somewhat above

its average in recent years. The acceleration was spurred by strength in domestic

demand, especially private consumption

spending, which increased in the first

quarter at double its pace in 2005. Retail

sales were also strong at the start of the

second quarter. The revival in household

spending has been supported by a small

rise in the growth rate of employment

and by an improvement in employer and

consumer perceptions of employment

prospects. Private investment spending

has remained strong in the euro area,

and business sentiment has continued to

brighten in recent months. Energy price

increases have pushed euro-area consumer price inflation to about 21⁄2 percent recently, a level above the ECB’s

2 percent ceiling, but core inflation has

remained near 11⁄2 percent.

In the United Kingdom, real GDP

expanded at an annual rate of 3 percent

in the first quarter after rising about

13⁄4 percent in 2005. Consumer spending grew about 11⁄2 percent, the same

moderate pace seen last year. House

prices, which remained relatively flat

during late 2004 and most of 2005,

picked up in late 2005 and have continued to rise in the first half of 

The twelve-month change in 

prices was 2.2 percent in M

sumer prices have been boost

tantly by increases in energy p

the past several months.

In Canada, real GDP gr

annual rate of nearly 4 perce

first quarter, an increase led b

in spending on consumer dur

housing. Investment in residen

tures grew at its fastest rate in 

two years, and business invest

tinued to exhibit the strength 

in the previous two quarters. 

for the second quarter point ge

a deceleration of GDP. Housin

the second quarter were signifi

low their elevated first-quart

the merchandise trade balance 

on balance, during the first fiv

of this year; and in the man

sector, the volume of new ord

shipments both fell in April. In 

in the second quarter, the lab

maintained its strength of the 

and the unemployment rate ha

6.2 percent, the lowest level 

than thirty years. Consumer p

2.8 percent in the twelve mont

in May.

Emerging-Market Economies

In China, growth of real ou

especially robust in the first 

nomic indicators suggest t

investment surged and tha

growth continued to be strong. 

growth of investment prompte

nese government to impose a 

new measures to slow capital 

including controls on credit an

and stricter criteria for approvi

ment projects. In addition, t

credit, which has soared m

15 percent over the past yea

central bank raised the one-y
lending rate in April and raised banks’

reserve requirements 1⁄2 percentage point

in June. The Chinese trade surplus widened in the first half of this year as

exports accelerated. Chinese consumer

price inflation is about 11⁄2 percent,

slightly above its pace in the second half

of last year but well below the more

than 5 percent rate seen in 2004.

Economic growth in India, Malaysia,

and Hong Kong also was quite strong in

the first quarter, although the pace of

activity of some of the other Asian

emerging-market economies has moderated a bit from last year’s rapid rate.

Concerns about inflationary pressures

have increased, largely because of rising energy prices. In response, monetary policy has been tightened in some

countries, including Korea, India, and

Thailand.

In Mexico, strong performance in the

industrial sector, an expansion in services output, and a recovery in agricultural production propelled real GDP

growth to more than 6 percent at an

annual rate in the first quarter. In addition, a surge in manufacturing exports

boosted Mexico’s trade and current

account balances noticeably. Industrial

production continued to increase early

in the second quarter. In June, Mexican

inflation was 3.2 percent, just above the

center of the Bank of Mexico’s target

range of 2 percent to 4 perc

easing policy nine times 

August and April, the Bank o

signaled in April that it would 

policy rate unchanged for a tim

Real GDP growth in Br

increased in the first quarter, 

53⁄4 percent, and was supporte

strong performances in manu

mining, and construction. Th

inflation has been declining fr

of 8 percent reached in April 

June, the twelve-month chang

edged down to 4 percent. In 

the central bank reduced its 

the overnight interest rate 

points, to 151⁄4 percent, bringi

mulative decline to 450 ba

since the current easing phase 

September. In the minutes o

May meeting, the policymak

mittee said that the onset of ma

tility over the past month had 

its uncertainty about the pro

inflation and had thus prom

ease less than it would have o

In Argentina, output grow

slightly in the first quarter. Am

ing capacity constraints, inflati

about 11 percent, up from 6 

2004. The Argentine govern

tried to hold down inflation, 

ited success, through volunt

agreements in several sectors.