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 Monetary Policy, Financial Markets, and the Economy in 2006
          and Early 2007
      Economic Projections for 2007 and 2008
 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 inflation declined in 2006 from its
      elevated pace in 2005, as energy prices fell, on net, after rising
      rapidly over the preceding couple of years. Crude oil prices rose
      during the first half of 2006 but turned down sharply later in the
      year. As a result, consumer price inflation climbed in the first half
      of the year before slowing in the second half. The sharp movements in
      prices of crude oil appear to have affected not only prices of gasoline
      and other petroleum-based types of energy but also prices of a broader
      range of goods and services that use petroleum-based inputs. Partly as
      a result, consumer price inflation excluding food and energy--so-called
      core consumer price inflation--moved up during the first half of the
      year but eased subsequently. On balance, core inflation was a bit
      higher over the four quarters of 2006 than in 2005. Measures of
      long-term inflation expectations, however, remained well anchored. The monetary policy decisions of the Federal Open Market
      Committee (FOMC) in 2006 were intended to foster sustainable economic
      expansion and to promote a return to low and stable inflation. In that
      regard, the economic outlook for this year and next appears favorable.
      Although the contraction in homebuilding has been a drag on growth,
      that restraint seems likely to diminish over 2007. Further gains in
      real wages as well as ongoing increases in employment should support a
      solid rise in consumer spending. In addition, at the beginning of 2007,
      households' balance sheets appeared to be in good shape. Whereas gains
      in home prices slowed last year, household net worth 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 passing on the
      costs in the form of higher consumer prices, especially if pressures on
      resources ease modestly as anticipated. The outlook for real economic activity is uncertain. An upside
      risk is that consumer spending, which has been especially buoyant in
      recent months, may continue to expand at a pace that would
      ultimately lead to an escalation of pressures on resources and prices.
      Alternatively, prospects for residential construction, which are
      difficult to assess, may pose some downside risks. Although residential
      real estate markets have shown some recent signs of stabilizing,
      homebuilders' inventories of unsold homes remain elevated. Further
      cutbacks in construction to reduce inventories toward more-comfortable
      levels could become steeper and more persistent than currently
      anticipated. Moreover, if home values were to depreciate sharply, the
      resulting erosion of household wealth could impose appreciable
      restraint on consumer spending. Whether inflation will moderate gradually as expected is also
      uncertain. On the one hand, the nation's potential to produce could
      increase more rapidly than anticipated, or product and input markets
      could work efficiently at higher rates of utilization, either of which
      could lead to a lower trajectory for inflation than currently forecast.
      On the other hand, expanding global demand and threats to supply from
      actual and potential disruptions pose upside risks for energy prices.
      In addition, brisk world demand for non-energy materials and
      commodities could lead to further upward pressures on business costs.
      Also, if inflation were to persist around the elevated average level of
      the past three years, longer-run inflation expectations could
      deteriorate, particularly if pressures on resources were to intensify.
      At recent meetings, the FOMC indicated that the risk that inflation
      will fail to moderate as expected is its predominant policy concern. Return to menu 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, appeared to be growing at a solid
      rate. By the time of the May and June meetings, data pointed to a
      moderation in the growth of consumer spending and a further cooling in
      the housing market. However, core consumer prices had risen more
      rapidly. Although the Committee judged inflation expectations still to
      be contained, it was mindful that the rising prices of energy and other
      commodities could impart greater inflationary momentum. Against this
      backdrop, the FOMC voted to increase the policy rate a further 25 basis
      points at both the May and June meetings, bringing the federal funds
      rate to 5-1/4 percent. In the statement accompanying its June
      decision, the FOMC indicated that it believed that the moderation in
      economic activity would help to limit inflationary pressures over time
      but also noted that some upside inflation risks remained. As it had in
      its May statement, the FOMC made clear in June that the extent and
      timing of additional firming would depend on the evolution of the
      outlook for both inflation and economic growth as implied by incoming
      information.  *d* Return to text
 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 inflation and economic activity were
      generally more favorable. Core inflation receded further from the
      elevated levels reached in early 2006, and some indicators suggested
      that the demand for housing might be stabilizing. Business investment
      had softened in the fourth quarter, and industrial production
      decelerated sharply in the fall, but consumer spending posted robust
      gains in the final months of 2006. At its January 2007 meeting, the
      Committee again decided to leave its target for the federal funds rate
      unchanged, reiterated concern about inflation risks, and again cited
      the role of incoming data in determining the extent and timing of any
      additional firming. In recent years, the FOMC has worked to improve the
      transparency of its decisionmaking process, and the Committee continues
      to examine whether further changes would improve its communications
      with the public. In spring 2006, the Chairman appointed a subcommittee
      to help the FOMC organize the discussion of a broad range of
      communication issues. The FOMC began its consideration of these issues
      at its August meeting and has discussed them at several meetings since
      then. Return to menu Economic Projections for 2007 and 2008 In conjunction with the FOMC meeting in January, the members of
      the Board of Governors and the Federal Reserve Bank presidents, all of
      whom participate in the deliberations of the FOMC, provided economic
      projections for 2007 and 2008. The projections indicate that the
      participants expect sustainable expansion of real economic activity
      during the next two years, assuming an appropriate course for monetary
      policy. The central tendency of the FOMC participants' forecasts for
      the increase in real GDP is 2-1/2 percent to 3 percent over the
      four quarters of 2007 and 2-3/4 percent to 3 percent over
      the four quarters of 2008. The central tendency of their forecasts for
      the civilian unemployment rate is 4-1/2 percent to 4-3/4
      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 2-1/4 percent over the four quarters of 2007 and
      1-3/4 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 pace, in part as a result of ongoing
      gains in real wages and employment and of generally strong household
      balance sheets. Business outlays for new equipment and software are
      expected to increase at a rate consistent with a moderate expansion in
      business output and to be supported by continuing declines in the user
      cost of high-technology capital equipment and by favorable financial
      conditions. In addition, the solid expansion of economic activity
      abroad should maintain the rising demand for U.S. exports of goods and
      services. Decreased pressures from the costs of energy and other
      commodities, in an environment of moderate economic expansion and
      well-anchored longer-run inflation expectations, are expected to
      contribute to further easing in inflation. In addition, increases in
      productivity should help to limit cost pressures. Economic Projections of Federal Reserve Governors and Reserve Bank Presidents for 2007 and 2008
        PercentIndicator
          Memo:
            2006 actual
          2007
          2008Range
          Central
            tendency
          Range
          Central
            tendencyChange, fourth quarter to fourth quarter
            1Nominal GDP
          5.9
          4-3/4-5-1/2
          5-5-1/2
          4-3/4-5-1/2
          4-3/4-5-1/4Real GDP
          3.4
          2-1/4-3-1/4
          2-1/2-3
          2-1/2-3-1/4
          2-3/4-3PCE price index excluding food and energy
          2.3
          2-2-1/4
          2-2-1/4
          1-1/2-2-1/4
          1-3/4-2Average level, fourth quarterCivilian unemployment rate
          4.5
          4-1/2-4-3/4
          4-1/2-4-3/4
          4-1/2-5
          4-1/2-4-3/4 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated.
        Return to table
 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). Return to menu
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