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 Monetary Policy and the Economic Outlook
      Economic and Financial Developments in 2006
 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 pressures have been elevated. Higher
      prices for crude oil contributed to a further run-up in domestic energy
      costs; this year's increases, combined with the steep increases in
      2004 and 2005, not only boosted the prices of gasoline and heating fuel
      but also put upward pressure on the costs of production for a broad
      range of goods and services. Partly as a result of these cost
      pressures, the rate of core consumer price inflation picked up.
      Nevertheless, measures of inflation expectations
      remained
      contained, and the rate of increase in labor costs was subdued, having
      been held down by strong gains in productivity and moderate increases
      in labor compensation. Taking a longer perspective, the U.S. economy appears to be in the
      midst of a transition in which the rate of increase in real gross
      domestic product (GDP) is moving from a pace above that of its
      longer-run capacity to a more moderate and sustainable rate. An
      important element in the transition is the lagged effect of the changes
      in monetary policy since mid-2004, changes that have been intended to
      keep inflation low and to promote sustainable economic expansion by
      aligning real economic activity more closely with the economy's
      productive potential. Moreover, longer-term interest rates have risen,
      contributing to increased borrowing costs for both households and
      businesses. Over time, pressures on inflation should abate as the pace
      of real activity moderates and, as futures markets suggest, the prices
      of energy and other commodities roughly stabilize. The resulting easing
      in inflation should help contain long-run inflation expectations. 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 is that the effect on imported-goods
      prices of earlier declines in the foreign exchange value of the dollar,
      which has been limited to date, could become larger. More broadly, if
      the higher rate of core inflation seen this year persists, it could
      induce a deterioration in longer-run inflation expectations that, in
      turn, might give greater momentum to inflation. However, the risks to
      the inflation outlook are not entirely to the upside. In the current
      environment of elevated profit margins, competitive forces, both in
      domestic markets and from abroad, could impose significant restraint on
      the pricing decisions of businesses. Regarding risks to the outlook for real activity, rates of
      increase in real GDP have been uneven during the past year,
      complicating the assessment of whether the pace of the economic
      expansion is moving into line with its underlying potential rate. One
      possible risk to the upside is that the softer tone of the recent data
      on real activity will prove transitory rather than mark a shift to a
      more sustainable underlying rate of expansion. For example, slower
      spending and hiring in recent months may represent a shorter-lived
      adjustment to a higher level of energy prices or to the unusually
      robust increases in economic activity earlier in the year. In coming
      months, a sharp rebound in consumer spending accompanied by an
      acceleration of capital spending could return real activity to a pace
      that would be unsustainable over the longer run. But downside risks
      also exist. In particular, the slowing in real estate markets since
      last summer has been moderate, and the easing of house-price inflation
      has been gradual. If the softening in the demand for housing and in
      real estate values becomes more pronounced, the resulting drop in
      construction activity and the erosion of household wealth could 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
      4-1/2 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,
      the Committee raised the target federal funds rate another 25 basis
      points, to 4-3/4 percent. The statement released at the end of
      the meeting continued to point to the possible need for further policy
      firming. Data received by the time of the May meeting confirmed that the
      economy had expanded robustly in the first quarter, though both
      consumer spending and housing activity appeared to have moderated in
      late winter. In addition, inflationary pressures had intensified as
      core consumer prices rose more rapidly in March than in earlier months.
      Inflation expectations, as measured by some surveys and by comparisons
      of yields on nominal and inflation-indexed Treasury securities, also
      rose in April. The Committee still judged those expectations to be
      contained, but it was mindful that a further increase could impart
      additional momentum to inflation, as could the surge in energy and
      other commodity prices and the drop in the foreign exchange value of
      the dollar that took place in April and early May. To gain greater
      assurance that inflationary forces would not intensify, the FOMC
      decided to raise the target federal funds rate another 25 basis points,
      bringing it to 5 percent.
      The FOMC also indicated in the
      policy statement that some further policy firming could be required.
      However, the Committee was aware that the cumulative effects of past
      monetary policy actions on economic activity could turn out to be
      larger than expected. Accordingly, the FOMC stressed that the extent
      and timing of any further firming would depend importantly on the
      evolution of the economic outlook as implied by incoming data. By the time of the June meeting, available data appeared to
      confirm that economic growth had moderated from the strong pace evident
      earlier in the year. Consumer spending had softened, 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 5-1/4 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 Economic Projections for 2006 and 2007
        PercentIndicator
          Federal Reserve Governors and
            Reserve Bank presidentsRange
          Central tendency2006Change, fourth quarter to fourth quarter
            1Nominal GDP
          5-1/2-6-1/2
          6--6-1/4Real GDP
          3--3-3/4
          3-1/4--3-1/2PCE price index excluding food and energy
          2-1/4--3
          2-1/4--2-1/2Average level, fourth quarterCivilian unemployment rate
          4-1/2--5
          4-3/4--52006Change, fourth quarter to fourth quarter
            1Nominal GDP
          4-3/4--6
          5--5-1/2Real GDP
          2-1/2--3-1/4
          3--3-1/4PCE price index excluding food and energy
          2--2-1/4
          2--2-1/4Average level, fourth quarterCivilian unemployment rate
          4-1/4--5-1/4
          4-3/4--5 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated.
        Return to table
 In conjunction with the FOMC meeting at the end of June, the
      members of the Board of Governors and the Federal Reserve Bank
      presidents, all of whom participate in the deliberations of the FOMC,
      provided economic projections for 2006 and 2007. In broad terms, the
      participants expect a sustained, moderate expansion of real economic
      activity during the next year and a half. The central tendency of the
      FOMC participants' forecasts for the increase in real GDP is
      3-1/4 percent to 3-1/2 percent over the four quarters of
      2006 and 3 percent to 3-1/4 percent in 2007. The central tendency
      of their forecasts for the civilian unemployment rate is 4-3/4
      percent to 5 percent
      
      in the fourth quarter of this year, and
      the jobless rate is expected to still be in that range at the end of
      2007. For inflation, the central tendency of the forecasts is an
      increase in the price index for personal consumption expenditures
      excluding food and energy (core PCE) of 2-1/4 percent to
      2-1/2 percent over the four quarters of 2006; in 2007, the
      forecast shows a slower rate of 2 percent to 2-1/4 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 high-technology 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 gains in productivity should work to limit
      increases in unit labor costs. Over the next year and a half, FOMC participants expect the
      economy to achieve a sustainable rate of economic expansion. That rate
      will be determined in large part by the rate of increase in
      productivity. Productivity has been rising at a solid rate over the
      past two years, albeit more slowly than the especially rapid pace that
      prevailed during the first three years of the expansion. A strong trend
      in productivity is likely to be maintained as businesses take advantage
      of new investment in facilities and equipment, as diffusion of
      technology continues, and as organizational advancements and business
      process improvements yield further increases in efficiency. Return to menu Economic and Financial Developments in 2006 Although last year's hurricanes caused the pace of aggregate
      economic activity around the turn of the year to be uneven, real GDP
      increased at an average annual rate of 3.6 percent in the final quarter
      of 2005 and first quarter of 2006--about the same pace that prevailed
      during the preceding year and a half. Over this period, payroll
      employment posted additional solid gains, and the unemployment rate
      declined further. In recent months, the incoming information on real
      activity has suggested that the pace of the expansion is moderating,
      with the deceleration in spending most apparent in the household
      sector. Still, as of midyear, resource utilization in labor and in
      product markets remained high. Inflation picked up over the first five months of the year,
      boosted importantly by the effects of rising energy prices. Long-term
      inflation expectations fluctuated over the period but remained
      contained, 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 household goods, such as furniture, electronic
      equipment, food, and clothing, was quite strong in the first quarter of
      2006; real outlays for goods other than motor vehicles increased at an
      annual rate of 8-3/4 percent. Some moderation was to be expected
      after such a surge in spending. Estimates of retail sales, which are
      available through June, suggest that real expenditures for these goods
      rose more slowly in the second quarter. In contrast to the uneven
      pattern of spending for goods, real outlays for consumer services
      remained on a moderate upward trend over the first half of 2006; they
      rose at an annual rate of 2-1/2 percent from the fourth quarter
      of 2005 through May 2006. Boosted by gains in nominal wage and salary income,
      after-tax aggregate personal income rose at an annual rate of 4 percent
      over the first five months of 2006. However, the acceleration in
      consumer prices held real income about constant. As a result, the steep
      decline in the personal saving rate, which began in 2004, extended into
      2006. Since 2003, rising household wealth has provided important
      support for spending, even as gains in real income have been damped by
      increases in energy prices. In 2005 and the first part of 2006, much of
      the increase in wealth was the result of the rapid appreciation in the
      value of homes. According to the survey by the University of Michigan Survey
      Research Center (SRC), the run-up in energy prices contributed
      importantly to the deterioration in consumer confidence this spring.
      Consumers' pessimism peaked in May and then lessened somewhat, on
      average, in June and early July. Nonetheless, at midyear, households
      indicated that they were still concerned about the effect of the high
      cost of energy on their financial situation. In 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 single-family 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 single-family 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
      7-1/4 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 5-1/2 months' supply at that month's
      selling rate, and the backlog of existing homes on the market was
      6-1/2 months' supply; in 2005, the stocks of both unsold new and
      existing homes averaged roughly 4-1/2 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 6-3/4 percent, and the average for a one-year adjustable-rate
      mortgage has risen a bit more, to 5-3/4 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 mid-2005; the rise in home prices has
      apparently also weighed on consumers' attitudes. Although recent increases in house prices have been smaller than
      those that accompanied the robust real estate markets of 2004 and 2005,
      the deceleration thus far appears to have been modest. The
      repeat-transactions index of house prices, which is published by the
      Office of Federal Housing Enterprise Oversight, increased at an annual
      rate of 7-1/4 percent in the first quarter of 2006, the
      smallest quarterly increase since the fourth quarter of 2001; that
      index attempts to control for the quality of existing single-family
      homes sold by using prices of homes involved in repeat transactions
      (excluding refinancings). The first-quarter reading brought the
      year-over-year change in this measure to 10 percent; in the second and
      third quarters of 2005, purchase prices according to this index were up
      11-1/2 percent from the level of a year earlier. An alternative
      measure of house prices is the average price of existing single-family
      homes sold, which is published by the National Association of Realtors.
      This measure, which does not control for the type of homes sold, showed
      that the year-over-year change in prices peaked at 11-1/2
      percent
      in August 2005 and then fell to 4 percent in April and May
      of this year. The greater deceleration in the latter measure suggests
      that, in addition to some softening in prices, the mix of existing
      units sold may have shifted toward lower-priced homes. The effect of the slowdown in demand on new construction became
      apparent during the second half of 2005, when the number of permits
      issued for new single-family homes began to fall. This year, the
      decline in permit issuance was relatively steady from January to May.
      Nonetheless, new single-family homes were started at an exceptionally
      high annual rate of 1.75 million units during the first quarter, when
      builders were able to begin work on scheduled 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
      11-1/2 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 consumer credit borrowing, which, at an annual
      rate of a bit less than 3 percent, continued to expand modestly in the
      first five months of 2006. The ratio of household financial obligations to disposable income
      rose 0.1 percentage point in the first quarter to about
      18-3/4 percent, narrowly exceeding the top of its historical
      range. Nonetheless, the evidence points to only limited pockets of
      financial distress in the household sector. Delinquency rates on
      residential mortgages were low by historical standards in the first
      quarter, though they have edged higher since the middle of last year,
      particularly in the subprime sector. Delinquency rates on consumer debt
      also continued to be low. Meanwhile, household bankruptcy filings
      remained subdued in the first half of 2006, running at a pace well
      below the average of recent years. Bankruptcies have likely been damped
      this year in part by the decision of some households in the fall of
      2005 to accelerate their filings to avoid the implementation of a
      stricter bankruptcy law in October. More recently, they may also have
      been restrained by the greater costs of bankruptcy under the new law. The Business Sector Fixed Investment Real business fixed investment increased at a solid rate,
      on average, during the final quarter of 2005 and the first quarter of
      2006. Over that period, real business spending for new equipment and
      software rose at an annual rate of 9-3/4 percent, a pace similar
      to that over the first three quarters of 2005. In addition, investment
      in nonresidential structures, which had remained weak in 2005, turned
      up noticeably in early 2006. The underlying determinants of 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
      14-3/4 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 this year. Industry
      analysts suggest that firms may be delaying investment in anticipation
      of introductions, later this year and in early 2007, of several
      products that will allow faster and more energy-efficient processing.
      Spending on equipment other than transportation and high-tech goods
      continued to trend up at a solid pace, on average, during the fourth
      and first quarters. Demand was particularly strong for metalworking and
      general industrial machinery as well as for equipment used in
      construction, energy extraction, and services industries. Demand for equipment and software appears to have risen again in
      the second quarter. The information from U.S. manufacturers on their
      orders and shipments of nondefense capital goods and the data on
      imports of capital goods suggest that business spending for equipment
      other than transportation and high-tech items remained on a strong
      upward trajectory in April and May. The elevated backlog of unfilled
      orders at domestic firms likely provided support for factory production
      of capital equipment in the second quarter. The indicators of demand
      for high-tech equipment suggest that spending for communications
      equipment remained at a high level, and real outlays for computing
      equipment were still rising slowly. Sales of medium and heavy trucks
      continued to be robust in the second quarter, although they eased
      slightly from the exceptional rate at the beginning of the year. Real expenditures for nonresidential construction increased at an
      annual rate of 12-1/2 percent in the first quarter after having
      edged up slightly during 2005. Last year, the small net increase in
      this sector reflected a sharp upturn in spending on structures used in
      domestic energy exploration; construction of new office and industrial
      buildings was restrained 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 share of sector GDP rose to
      about 14 percent in the first quarter, above the previous peak reached
      in 1997. The expansion of business debt picked up to an annual rate of
      nearly 10 percent
      
      in the first quarter of this year, and data
      in hand suggest a robust pace in the second quarter. A substantial
      fraction of borrowing proceeds reportedly went to finance mergers and
      acquisitions in the first half of the year. Net bond issuance has been
      strong so far in 2006. Short-term borrowing by nonfinancial
      corporations stepped up in the first quarter of 2006 after slowing
      somewhat in the fourth quarter of last year; it appears to have
      remained strong in the second quarter as well. Commercial paper
      outstanding started rising again, on balance, after edging lower in
      2005. Bank business loans outstanding expanded at an annual rate of
      15-1/2 percent in the first quarter. Businesses benefited from a
      more accommodative lending environment: For example, a significant net
      fraction of respondents to the Federal Reserve's Senior Loan Officer
      Opinion Survey on Bank Lending Practices in April 2006 noted that their
      institutions had eased both standards and terms on commercial and
      industrial loans in the first three months of the year. The most
      commonly cited reasons for the easing of lending policies were
      more-aggressive competition from other banks and nonbank lenders,
      increased liquidity in the secondary market for business loans, and
      increased tolerance for risk. Gross equity issuance has remained moderate so far this year,
      while an elevated level of cash-financed mergers along with record
      share repurchases has produced further sizable net equity retirements.
      Taken together, net funds raised by nonfinancial corporations in the
      credit and equity markets have been 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-mortgage-backed 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
      comparable-quality 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-Session Review
      
      of the
      budget, the Administration estimated that the federal government will
      finish fiscal 2006 with a deficit of $296 billion; that figure marks a
      decline from the fiscal 2005 deficit of $318 billion and is much lower
      than most analysts had projected at the beginning of this year. During the twelve months ending in June, federal receipts were
      13-1/4 percent higher than over the same period a year earlier
      and equivalent to almost 18-1/4 percent
      
      of nominal GDP.
      Income tax receipts from individuals have outpaced the rise in nominal
      income; final tax payments on income from 2005 were especially strong
      in April and May. Corporate tax payments continued to rise at a robust
      rate, even faster than corporate profits. Nominal federal outlays rose 9 percent between June 2005 and June
      2006 and were about 20-1/2 percent of nominal GDP. The rise in
      outlays was bolstered by increases in several components of federal
      spending. Net interest payments increased 20 percent over the year
      ending in June as federal debt continued to rise and interest rates
      increased. Medicare outlays were up 14-1/2 percent; since the
      inception of the new Part D prescription drug program in January,
      outlays for benefits have added more than $20 billion to spending in
      this category. Legislative actions related to the hurricanes in the
      Gulf Coast region last autumn have added significantly to spending for
      disaster relief over the past ten months. Although defense spending has
      slowed from the annual double-digit rates of increase from 2002 to
      2004, it still has increased about 8 percent per year in the past two
      years. As measured in the national income and product accounts (NIPA),
      real federal expenditures on consumption and gross investment--the part
      of federal spending that is a direct component of real GDP--increased
      at an annual rate of 3-3/4 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 2-1/2 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 comparable period of 2005. In February, the Treasury conducted an auction of thirty-year
      bonds for the first time since 2001. The issue generated strong
      interest, especially from investment funds; foreign investors were
      awarded only a small fraction of the total. In general, foreign demand
      for Treasury securities appears to have eased somewhat in 2006. The
      proportion of nominal coupon securities bought at auction by foreign
      investors has continued to fall from its peak of 24 percent
      
      in 2004; it averaged about 14 percent
      
      in the first six months
      of 2006. Data from the Treasury International Capital system generally
      suggested subdued demand from both foreign private investors and
      foreign official institutions over this period. The amount of Treasury
      securities held in custody at the Federal Reserve Bank of New York on
      behalf of foreign official and international accounts has changed
      little since the end of 2005. State and Local Governments The fiscal positions of states and localities continued to
      improve through early 2006. In particular, revenues are on track to
      post a relatively strong gain for a third consecutive year. Tax
      receipts from sales, property, and personal and corporate income were
      up 8-1/4 percent during the year ending in the first quarter of
      2006, a rate similar to the increase in the preceding year. The
      sustained strength in revenues has enabled these jurisdictions to
      increase their nominal spending somewhat while rebuilding their reserve
      funds. On a NIPA basis, net saving by state and local governments--a
      measure that is broadly similar to the surplus in an operating
      budget--rose to an annual rate of $21-1/2 billion in the first
      quarter of 2006 after having been close to zero 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 1-1/2 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 the improvement in
      credit quality, yields on long-dated municipal bonds have increased
      substantially less than those on comparable-maturity Treasury
      securities, and the yield ratio has accordingly fallen sharply. The External Sector The U.S. current account deficit narrowed in the first
      quarter of 2006 to $835 billion at an annual rate, or about 6-1/2
      percent of nominal GDP, from $892 billion
      
      in the fourth
      quarter of 2005. The narrowing resulted from three factors. Unilateral
      transfer payments to foreigners dropped, largely because of a decrease
      in government grants. The trade deficit narrowed, primarily because the
      value of imported oil and natural gas declined. In addition, higher
      
      direct investment receipts and lower direct investment payments
      produced
      
      an increase in the investment income balance. International Trade Real exports of goods and services increased
      14-3/4 percent at an annual rate in the first quarter of 2006,
      far faster than the 6-1/2 percent rate recorded in 2005. The
      surge in export growth in the first quarter resulted in part from a
      recovery in exports of many types of industrial supplies following a
      period of hurricane-related disruptions late last year. Exports of
      capital goods also increased rapidly in the first quarter, with
      deliveries of aircraft to foreign carriers exhibiting particular
      strength. The first-quarter increase in exports was widespread
      across destinations, a sign of robust economic activity in many parts
      of the world, and exports to Mexico and Canada showed especially large
      increases. Real exports of services rose at an annual rate of about
      6-1/2 percent in the first quarter after increasing just
      2-3/4 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
      2-3/4 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 run-ups in the prices of non-agricultural industrial
      supplies, especially metals. Real imports of goods and services rose at an annual rate of
      10-3/4 percent in the first quarter, slightly slower than in the
      fourth quarter but still considerably faster than the 5-1/4
      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 8-1/2 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 excluding oil and natural gas rose at an
      annual rate of about 1 percent in the first quarter of 2006, 3/4
      percentage point faster than the pace in the second half of 2005.
      Prices of material-intensive goods, such as nonfuel industrial supplies
      and foods, increased steadily in the last quarter of 2005 and in the
      first quarter of 2006. Also in the first quarter, prices of finished
      goods, such as consumer goods and many kinds of capital goods, turned
      up slightly. Available data for the second quarter indicate that prices
      of finished goods kept rising at a subdued pace. However, prices of
      material-intensive goods continued to increase sharply, a development
      reflecting higher prices for metals. The International Monetary Fund's
      index of global metals prices rose 46 percent between December 2005 and
      May 2006, largely because of robust global demand. In June, metals
      prices retreated about 8 percent, although they remained well above the
      levels of earlier this year. The spot price of West Texas intermediate crude oil increased from
      around $60 per barrel at the end of last year to more than $75 per
      barrel in July, higher than the peak that followed last year's
      hurricanes. Oil prices have been highly sensitive to news about both
      supply and demand, particularly in light of the narrow margin of
      worldwide spare production capacity. Global oil demand has continued to
      grow as the foreign economic expansion has spread, and developing
      countries have posted the largest increases in oil consumption. Recent
      events in the Middle East--including concerns over Iran's nuclear
      program, violence in Iraq, and the recent conflict in Lebanon--have put
      additional upward pressure on oil prices. In Nigeria, attacks against
      oil infrastructure have reduced oil production for most of this year.
      Government intervention in 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, a reversal of some unusual inflows in the second half of 2005.
      These second-half inflows were prompted by the partial tax holiday
      offered under the 2004 Homeland Investment Act (HIA), which induced the
      foreign affiliates of U.S. firms to repatriate a portion of earlier
      earnings that had been retained abroad. In the first quarter, the
      foreign affiliates partially unwound the HIA-induced flows by retaining
      an unusually large portion of their first-quarter earnings. Increased
      merger activity abroad also boosted direct investment outflows in the
      first quarter. The Labor Market Employment and Unemployment Conditions in the labor market continued to improve in
      the first half of 2006, although the pace of hiring has slowed in
      recent months. Nonfarm payroll employment increased 176,000 per month
      during the first quarter, a rate roughly in line with the relatively
      brisk pace that prevailed during 2004 and 2005. During the second
      quarter, hiring slowed, and monthly gains in payrolls averaged 108,000
      jobs per month. Over the two quarters, the civilian unemployment rate
      edged down further, to the lowest quarterly level of joblessness in
      five years. In the first quarter, with homebuilding quite strong, hiring
      continued to be particularly robust at construction sites; part of this
      strength was the result of favorable weather, which allowed more
      construction activity than is typical during the winter months.
      Although nonresidential construction activity was firming by the
      spring, the pullback in housing starts slowed the demand for
      residential contractors and workers in the building trades. As a
      result, monthly additions to 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 on the unemployment rolls until
      the exhaustion of their benefits continued to recede. After having edged up during 2005, the labor force participation
      rate was relatively stable over the first half of 2006 despite the
      ongoing improvement in labor market conditions. Rates for most broad
      age groups were little changed from last year's levels. From a longer
      perspective, developments during the past decade highlight the
      importance of structural as well as cyclical influences on
      participation. The rise in the attachment of adult women to the
      workforce, which was a significant factor in the secular rise in
      participation over much of the post-World War II period, appears to
      have leveled off. And the aging of the population is increasing the
      proportion of the workforce that is 55 years and older; it rose from
      less than 12 percent in 1996 to 16-3/4 percent in recent months.
      Although older workers have tended in recent years to stay in the labor
      force longer, their participation rate, at 38 percent in the second
      quarter, was less than half the rate for workers who are age 25 to 54.
      Thus, the demographic shift to an older population has already begun to
      reduce the overall rate of labor force participation and has offset
      part of the rise in participation that has been associated with the
      cyclical upturn in job creation. The secular forces that are slowing
      the expansion of the labor force imply that the increase in employment
      that is consistent with a stable unemployment rate will, over time, be
      smaller than it was during the period when labor force participation
      was rising steadily. Productivity and Labor Costs After having advanced at an unusually rapid rate from 2001 to
      mid-2004, labor productivity in the nonfarm business sector increased
      at a more moderate annual rate of 2-1/2 percent from mid-2004 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 2-3/4 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 insurance, which
      typically accounts for about one-fourth of overall benefit costs, rose
      just 4-3/4 percent during the year ending in March 2006; between
      2000 and 2005, these costs increased, on average, 8-3/4
      percent
      
      per year. Another likely contributor to the slower rise in
      benefit costs over the past year was smaller employer contributions to
      their defined-benefit pension plans; those costs dropped back somewhat
      after employers made sizable payments to bolster those pension assets
      in 2004. Indicators of the recent trend in the wage component of worker
      compensation have been providing mixed signals. As measured in the ECI,
      wages rose 2.4 percent
      
      between March 2005 and March 2006,
      slightly less than in the preceding two years. In contrast, the
      year-over-year change in average hourly earnings of production or
      nonsupervisory workers--which refers to a narrower group of private
      nonfarm employees and has tended to show greater cyclical variation
      than the ECI--has increased steadily over the past three years. Average
      hourly earnings rose 3.9 percent
      
      over the twelve months
      ending in June 2006, compared with an increase of 2.7 percent
      
      over the twelve months ending in June 2005. Prices Inflation pressures were elevated during the first half of
      2006. The chain-type price index for personal consumption expenditures
      (PCE) rose at an annual rate of 4-1/4 percent between December
      2005 and May 2006. Over the same period, core PCE prices increased at
      an annual rate of 2.6 percent, nearly 0.6 percentage point faster
      than over the twelve months of 2005. Alternative Measures of Price Change
        PercentPrice measure
          2004
            to
            2005
          2005
            to
            2006Chain-type (Q1 to Q1)Gross domestic product (GDP)
          2.8
          3.1Gross domestic purchases
          3.1
          3.5Personal consumption expenditures (PCE)
          2.7
          3.0Excluding food and energy
          2.2
          1.9Market-based PCE excluding food and energy
          1.8
          1.5Fixed-weight (Q2 to Q2)Consumer price index
          3.0
          4.0Excluding food and energy
          2.1
          2.4 Note:
        Changes are based on quarterly averages of seasonally adjusted data.
        Return to table
 Although energy prices eased temporarily in February, they turned
      up 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 16-1/2 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 remained moderate during the first five
      months of 2006; between December 2005 and May 2006, the PCE price index
      for food and beverages increased at an annual rate of 2-1/4
      percent.
      
      Retail prices of meat and poultry have fallen so far this
      year. Domestic supplies of meat have been ample. Production has been
      expanding at a time when export demand for beef has been soft largely
      because of bans on imports of U.S. beef by Japan and Korea. Prices of
      processed food have continued to rise at only a moderate rate despite
      higher prices for grains; export demand for grains has been strong, and
      the price of corn has been boosted by demand from producers of ethanol.
      Prices for food consumed away from home, which typically are influenced
      heavily by labor and other business costs, have continued to increase
      relatively rapidly, rising at an annual rate of 3-3/4 percent
      over the first five months of the year. The pickup in core inflation in the first half of 2006 was evident
      in the indexes for both goods and services. Prices of consumer goods
      excluding food and energy, which were unchanged in 2005, edged up at an
      annual rate of 3/4 percent
      
      this year. Prices of
      consumer services also accelerated this spring; as a result, the PCE
      price index for non-energy services increased at an annual rate of
      3-1/2 percent between December 2005 and May 2006, compared with a
      rise of 2-3/4 percent in 2005. In the three months ending in May,
      increases in housing rents were especially steep; the rise may reflect,
      in part, a shift in demand toward rental units because home purchases
      have become less affordable. Another contributor to the higher
      inflation rate for consumer services has been the acceleration in the
      index for nonmarket services to an annual rate of 4 percent over the
      first five months of the 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 pass-through 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 7-1/4 percent between December 2005 and May 2006;
      this index rose 4-3/4 percent in 2005 and 8-1/4
      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 goods and
      services even as businesses have seen their labor costs, which
      represent roughly two-thirds of their costs, remain restrained. Near-term inflation expectations were also influenced importantly
      over the first half of 2006 by movements in energy prices, but, as of
      midyear, they were only slightly higher than they were at the turn of
      the year. The Michigan SRC survey measure of the median expectation of
      households for inflation over the next twelve months held steady at
      3 percent
      during the first three months of the year but then
      rose sharply to 4 percent in May as gasoline prices climbed. By
      early July, this measure of near-term inflation expectations dropped
      back to 3.1 percent. Longer-term inflation expectations remained within
      the ranges in which they have fluctuated in recent years. On average
      over the first half of 2006, the median respondent to the Michigan SRC
      survey continued to expect the rate of inflation during the next five
      to ten years to be just under 3 percent.
      In June, the Survey
      of Professional Forecasters, conducted by the Federal Reserve Bank of
      Philadelphia, reported expected inflation at a rate of 2-1/2
      percent over the next ten years, an expectation that has been roughly
      unchanged for the past eight years. Inflation compensation implied by
      the spread of yields on nominal Treasury securities over their
      inflation-protected counterparts rose slightly, on net, over the first
      half of the year; in early July it was just above 2-1/2 percent. U.S. Financial Markets U.S. financial markets functioned smoothly in the first half
      of 2006 against the backdrop of increased volatility in some asset
      prices. Yields on nominal Treasury coupon securities rose about 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 softer-than-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 5-1/4 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 participants more recently have had to
      focus to a greater degree on economic data releases and their
      implications for the outlook for economic growth and inflation to form
      expectations about near-term policy. Although the information currently
      available suggests that growth of real output slowed appreciably in the
      second quarter, incoming price data have pointed to
      greater-than-expected inflationary pressures throughout the first half
      of the year. Investors anticipated that the FOMC would act to counter
      such pressures, and the expected policy path moved upward, on balance,
      over the first half of 2006. Nevertheless, market participants
      currently appear to expect the target federal funds rate to ease after
      the end of the year. Despite investors' apparent awareness that
      monetary policy decisions increasingly depend on the implications of
      incoming information for the economic outlook, the implied volatility
      on short-term Eurodollar rates calculated from option prices has
      remained near the low end of its historical range. Yields on nominal Treasury coupon securities rose about 70 basis
      points across the maturity spectrum through early July, in part because
      of the expectations for firmer policy. In addition, it appears that a
      modest rebound in term premiums, including investor compensation for
      inflation risk, may have contributed to the rise in longer-term rates;
      still, estimated premiums remain low by historical standards. Yields on
      inflation-indexed Treasury securities rose less than those on their
      nominal counterparts, leaving inflation compensation at medium- and
      long-term horizons 20 to 30 basis points higher than at the turn of the
      year. In the corporate bond market, yields on investment-grade
      securities moved about in line with those on comparable-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 funds as share prices began to sag. Debt and Financial Intermediation In the first quarter of 2006, the total debt of domestic
      nonfinancial sectors expanded at an annual rate of 11 percent. The
      household, business, and federal government components all
      increased at double-digit rates, while state and local government
      debt advanced at about a 6 percent pace. Preliminary data suggest
      somewhat slower growth of the debt of nonfinancial sectors in the
      second quarter. The slowdown is particularly noticeable in the federal
      and state and local government sectors, where strong tax receipts held
      down borrowing. The available data also point to somewhat reduced
      growth of nonfinancial business debt in the second quarter. Commercial bank credit increased at an annual rate of about 11 percent in the first quarter of 2006, a little faster than in 2005, and
      picked up further to an almost 13 percent pace in the second quarter. A
      continued rapid increase in business loans was likely supported by
      brisk merger and acquisition activity, rising outlays for investment
      goods, ongoing inventory accumulation, and an accommodative lending
      environment. Growth in commercial mortgages was also strong, as
      fundamentals in that sector continued to improve. Despite a slowing of
      housing activity in recent months, residential mortgage holdings
      expanded robustly. However, higher short-term interest rates likely
      contributed to a runoff in loans drawn down under revolving home-equity
      lines of credit. Consumer loans adjusted for securitizations
      decelerated in the second quarter after rising at a solid pace in the
      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 6-1/2 percent,
      but its expansion
      moderated in the second quarter to a 2-3/4 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 rose at an
      annual rate of 2-1/4 percent in the first quarter and appears to
      have continued to rise in the second quarter. International Developments Foreign economic growth was strong in the first quarter of
      2006 as the expansion spread to all major regions of the world.
      Accelerating domestic demand boosted growth in the foreign industrial
      countries, especially Canada and the euro area. Emerging-market
      economies continued to benefit from rapid export growth, and Chinese
      economic activity was also spurred by a surge in investment spending.
      Data for the second quarter suggest continued strong growth abroad but
      with moderation in some countries. Rising energy prices have pushed up
      inflation in many countries this year, but upward pressure on core
      inflation has generally continued to be moderate. Foreign monetary policy tightened in the first half of this year
      in the context of solid growth and some heightened inflation concerns.
      The European Central Bank (ECB) raised its policy rate 1/4
      percentage
      point in March and again in June, citing rapid credit
      growth and the ECB's expectation of above-target inflation. At its
      July policy meeting, the Bank of Canada kept its target for the
      overnight rate unchanged at 4-1/4 percent, but it had increased
      its target for the overnight rate 1/4 percentage point at each
      of its previous seven policy meetings. On July 14, the Bank of Japan
      (BOJ) ended its zero-interest-rate policy by raising its target for the
      call money rate to 1/4 percent for the first time since 2001.
      Earlier, on March 9, the BOJ, announcing an end to its five-year-old
      policy of quantitative easing, said that it would set policy in the
      future to control 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
      4-1/2 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
      flight-
      
      to-safety transactions into dollar-denominated 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
      6-1/2 percent against the euro and sterling, 3 percent against
      the Canadian dollar, and 1-1/2 percent against the Japanese yen.
      In contrast, the dollar has risen roughly 4 percent, on balance,
      against the Mexican peso this year. During the first half of this year,
      several smaller countries experienced episodes of substantial financial
      volatility that in some cases involved sharp depreciations in the
      exchange value of their currencies. Through the first four months of 2006, a favorable economic
      outlook and low interest rates supported gains in equity prices in all
      major foreign countries. During May and early June, however, equity
      prices registered widespread declines, as market participants grew more
      concerned about inflation, monetary policy, and global economic growth.
      More recently, developments in the Middle East have weighed further on
      stock prices. On net, equity price indexes are up between 1 percent and
      4 percent
      so far in 2006 in Europe and Canada, but they have
      fallen roughly 8 percent
      since year-end in Japan. Latin
      American and Asian emerging-market equity indexes, which had generally
      gained more than industrial-country indexes early in the year, have
      fallen more sharply since early May. Equity indexes in Mexico, Brazil,
      and Argentina have dropped between 12 percent and 15
      percent--leaving them still between 5 percent
      and 7 percent higher so far this year--while stock prices in Korea have
      fallen about 9 percent, on net, for the year. Industrial Economies The Japanese economy has continued to strengthen this year,
      although economic growth has stepped down a bit from the comparatively
      strong rate recorded in 2005. Household consumption maintained a solid
      rate of growth in the first quarter, and private investment spending
      rose 11 percent. However, net exports, which previously had been an
      additional source of strength, did not contribute to 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 year-ago 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 2-1/2 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 2-1/2 percent
      recently, a level above the ECB's 2 percent
      ceiling, but
      core inflation has remained near 1-1/2 percent. In the United Kingdom, real GDP expanded at an annual rate of 3 percent in the first quarter after rising about 1-3/4
      percent
      in 2005. Consumer spending grew about 1-1/2 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 this year. The
      twelve-month change in consumer prices was 2.2 percent in May. Consumer
      prices have been boosted importantly by increases in energy prices over
      the past several months. In Canada, real GDP grew at an annual rate of nearly 4 percent in
      the first quarter, an increase led by a jump in spending on consumer
      durables and housing. Investment in residential structures grew at its
      fastest rate in more than two years, and business investment continued
      to exhibit the strength observed in the previous two quarters.
      Indicators for the second quarter point generally to a deceleration of
      GDP. Housing starts in the second quarter were significantly below
      their elevated first-quarter levels; the merchandise trade balance
      declined, on balance, during the first five months of this year; and in
      the manufacturing sector, the volume of new orders and of shipments
      both fell in April. In contrast, in the second quarter, the labor
      market maintained its strength of the past year, and the unemployment
      rate has fallen to 6.2 percent, the lowest level in more than thirty
      years. Consumer prices rose 2.8 percent in the twelve months ending in
      May. Emerging-Market Economies In China, growth of real output was especially robust in the
      first half. Economic indicators suggest that fixed investment surged
      and that export growth continued to be strong. The rapid growth of
      investment prompted the Chinese government to impose a series of new
      measures to slow capital spending, including controls on credit and
      land use and stricter criteria for approving investment projects. In
      addition, to restrain credit, which has soared more than 15 percent
      over the past year, China's central bank raised the
      one-year bank 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 1-1/2 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 percent.
      After easing policy nine times between August and April, the Bank of
      Mexico signaled in April that it would leave its policy rate unchanged
      for a time. Real GDP growth in Brazil also increased in the first quarter,
      rising to 5-3/4 percent, and was supported by very strong
      performances in manufacturing, mining, and construction. The rate of
      inflation has been declining from a high of 8 percent reached in April
      2005; in June, the twelve-month change in prices edged down to 4 percent. In late May, the central bank reduced its target for the
      overnight interest rate 50 basis points, to 15-1/4 percent,
      bringing the cumulative decline to 450 basis points since the current
      easing phase began last September. In the minutes of its late-May
      meeting, the policymaking committee said that the onset of market
      volatility over the past month had increased its uncertainty about the
      prospects for inflation and had thus prompted it to ease less than it
      would have otherwise. In Argentina, output growth slowed slightly in the first quarter.
      Amid emerging capacity constraints, inflation rose to about 11 percent,
      up from 6 percent in 2004. The Argentine government has tried to hold
      down inflation, with limited success, through voluntary price
      agreements in several sectors.  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
      . 
      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.
      Return to text
      
      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.
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