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Monetary Policy and

Economic Developments



Monetary Policy and the Economic Outlook

The U.S. economy turned in anothersolid performance in 2006, although thepattern of growth was uneven. Afterrebounding in the early part of the yearfrom hurricane-related disruptions in theautumn of 2005, the pace of expansionduring the remaining three quartersaveraged somewhat below that of the

preceding two years, responding in partto the removal of monetary policy ac-commodation since 2004. The housingmarket cooled substantially, and, in thelatter part of 2006, the production of light motor vehicles also stepped down.Elsewhere in the economy, activityremained strong. Consumer spendingincreased vigorously in 2006 as house-holds’ real income made strong gains.

Business investment rose at a solid ratefor the year as a whole, although itdecelerated late in the year in part be-cause of some softening in purchases of equipment related to construction andmotor vehicle manufacturing. Demandfor U.S. exports rose at a robust pace in2006, supported by strong economic ac-tivity abroad. Against this backdrop,businesses continued to add jobs at asteady rate, and the unemployment ratedecreased further.

Total consumer price inflation de-clined in 2006 from its elevated pace in2005, as energy prices fell, on net, afterrising rapidly over the preceding coupleof years. Crude oil prices rose duringthe first half of 2006 but turned downsharply later in the year. As a result,consumer price inflation climbed in the

first half of the year before slowing inthe second half. The sharp movementsin prices of crude oil appear to haveaffected not only prices of gasoline andother petroleum-based types of energybut also prices of a broader range of goods and services that use petroleum-based inputs. Partly as a result, con-sumer price inflation excluding food andenergy—so-called core consumer price

inflation—moved up during the first half of the year but eased subsequently. Onbalance, core inflation was a bit higherover the four quarters of 2006 than in2005. Measures of long-term inflationexpectations, however, remained wellanchored.

The monetary policy decisions of theFederal Open Market Committee(FOMC) in 2006 were intended to fostersustainable economic expansion and topromote a return to low and stable infla-tion. In that regard, the economic out-look for this year and next appearsfavorable. Although the contraction inhomebuilding has been a drag ongrowth, that restraint seems likely todiminish over 2007. Further gains inreal wages as well as ongoing increases

in employment should support a solidrise in consumer spending. In addition,at the beginning of 2007, households’balance sheets appeared to be in goodshape. Whereas gains in home pricesslowed last year, household net worth

Note: The discussion here and in the nextchapter consists of the text, tables, and selectedcharts from the Monetary Policy Report submittedto the Congress on February 14, 2007, pursuant tosection 2B of the Federal Reserve Act; the com-plete set of charts is available on the Board’s web

site, at www.federalreserve.gov/boarddocs/hh.Other materials in this annual report related tothe conduct of monetary policy include the min-utes of the 2006 meetings of the Federal OpenMarket Committee (see the ‘‘Records’’ section)and statistical tables 1–4 (at the back of thisreport).

3



increased moderately as stock marketwealth grew and households lessenedtheir accumulation of debt. Delinquency

rates on consumer loans and on mosttypes of mortgages remained low,although they increased markedly forsubprime mortgages with variable inter-est rates. As for businesses, balancesheets are quite liquid, credit quality isgood, and most firms enjoy ready accessto funds. These favorable financial con-ditions, along with further expansion inbusiness output, user costs of capital

equipment that remain attractive, andthe potential for further gains in effi-ciency, should continue to spur businessinvestment. In addition, sustainedexpansion in foreign economies oughtto maintain demand for U.S. exports. Onbalance, growth of real gross domesticproduct in the United States appearslikely to run slightly below that of theeconomy’s potential over the next few

quarters and then to rise to a pacearound that of the economy’s long-runtrend.

Regarding inflation, increases in coreconsumer prices are expected to moder-ate, on balance, over the next two years.Along with inflation expectations thatare well anchored, some of the factorsthat boosted inflation in recent yearsseem likely to lessen. In particular, thepaths for prices of energy and othercommodities embedded in futures mar-kets suggest that the impetus to coreinflation from these influences will di-minish further. In addition, the outsizedincreases in shelter costs that boostedcore inflation last year are not expectedto persist. Although unit labor costs inthe nonfarm business sector have been

rising, the average markup of pricesover such costs is high by historicalstandards. The relatively high markupsuggests that further increases in costscould be absorbed, at least to someextent, by a narrowing of firms’ profit

margins rather than by passing on thecosts in the form of higher consumerprices, especially if pressures on re-

sources ease modestly as anticipated.The outlook for real economic activ-

ity is uncertain. An upside risk is thatconsumer spending, which has beenespecially buoyant in recent months,may continue to expand at a pace thatwould ultimately lead to an escalationof pressures on resources and prices.Alternatively, prospects for residentialconstruction, which are difficult to

assess, may pose some downside risks.Although residential real estate marketshave shown some recent signs of stabilizing, homebuilders’ inventories of unsold homes remain elevated. Furthercutbacks in construction to reduceinventories toward more-comfortablelevels could become steeper and morepersistent than currently anticipated.Moreover, if home values were to

depreciate sharply, the resulting erosionof household wealth could imposeappreciable restraint on consumerspending.

Whether inflation will moderategradually as expected is also uncertain.On the one hand, the nation’s potentialto produce could increase more rapidlythan anticipated, or product and inputmarkets could work efficiently at higherrates of utilization, either of which couldlead to a lower trajectory for inflationthan currently forecast. On the otherhand, expanding global demand andthreats to supply from actual and poten-tial disruptions pose upside risks forenergy prices. In addition, brisk worlddemand for non-energy materials andcommodities could lead to further

upward pressures on business costs.Also, if inflation were to persist aroundthe elevated average level of the pastthree years, longer-run inflation expecta-tions could deteriorate, particularly if pressures on resources were to intensify.

4 93rd Annual Report, 2006



At recent meetings, the FOMC indicatedthat the risk that inflation will fail tomoderate as expected is its predominant

policy concern.

Monetary Policy, FinancialMarkets, and the Economyin 2006 and Early 2007

The FOMC firmed the stance of mone-tary policy 25 basis points at each of itsfour meetings over the first half of 2006. The Committee raised its targetfor the federal funds rate at its Januaryand March meetings as available infor-mation pointed to accumulating pres-sures on inflation and solid economicgrowth. Although readings on coreinflation had remained favorable,increases in energy prices and the rela-tively high level of resource utilizationthreatened to add to existing inflation

pressures. Meanwhile, underlying ag-gregate demand, supported by robustconsumer spending and accelerating

business investment, appeared to begrowing at a solid rate. By the time of the May and June meetings, data

pointed to a moderation in the growth of consumer spending and a further cool-ing in the housing market. However,core consumer prices had risen morerapidly. Although the Committee judgedinflation expectations still to be con-tained, it was mindful that the risingprices of energy and other commoditiescould impart greater inflationarymomentum. Against this backdrop, theFOMC voted to increase the policy ratea further 25 basis points at both the Mayand June meetings, bringing the federalfunds rate to 51 ⁄ 4 percent. In the state-ment accompanying its June decision,the FOMC indicated that it believed thatthe moderation in economic activitywould help to limit inflationary pres-sures over time but also noted that some

upside inflation risks remained. As ithad in its May statement, the FOMCmade clear in June that the extent and

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2007200620052004

Selected Interest Rates, 2004–07

Target federal funds rate

Ten-year Treasury

NOTE: The data are daily and extend through February 7, 2007. The ten-year Treasury rate is the constant-maturity yield based on the most actively traded securities. The dates on the horizontal axis are those of FOMCmeetings.

SOURCE: Department of the Treasury and the Federal Reserve.

Monetary Policy and the Economic Outlook 5



timing of additional firming woulddepend on the evolution of the outlook for both inflation and economic growth

as implied by incoming information.In the second half of the year, a fur-

ther slowdown in residential construc-tion activity and a contraction in motorvehicle production created a significantdrag on economic activity. However,consumer spending held up, and em-ployment rose at a solid pace. Mean-while, energy prices reversed much of their increases of the first half of the

year, sending headline inflation lower.Core inflation also eased somewhat, al-beit to a rate above its year-earlier level.Against this backdrop, the FOMC leftthe stance of policy unchanged at itsfinal four meetings of 2006. Committeediscussions in those meetings focused inpart on developments in the housingmarket and their implications for thebroader economy. Although the housing

market was weakening throughout thisperiod, the Committee judged that thedownturn had not spilled over signifi-cantly to consumer spending. The econ-omy was expected to expand over com-ing quarters at a rate close to or a littlebelow its long-run sustainable pace. Atthe same time, FOMC members notedthat, even though core inflation hadslowed from the very rapid rates of thespring and summer, current rates re-mained undesirably high. Most mem-bers expected core inflation to moderategradually, but they were uncertain aboutthe likely pace and extent of that mod-eration. Thus, in statements accompany-ing each rate announcement over thisperiod, the FOMC reiterated that infla-tion risks remained and that the extent

and timing of any additional policy firm-ing would depend on the outlook forboth inflation and economic growth im-plied by incoming information.

Over the period between the Decem-ber 2006 and January 2007 FOMC

meetings, incoming data on inflation andeconomic activity were generally morefavorable. Core inflation receded further

from the elevated levels reached in early2006, and some indicators suggestedthat the demand for housing might bestabilizing. Business investment hadsoftened in the fourth quarter, and indus-trial production decelerated sharply inthe fall, but consumer spending postedrobust gains in the final months of 2006.At its January 2007 meeting, the Com-mittee again decided to leave its target

for the federal funds rate unchanged,reiterated concern about inflation risks,and again cited the role of incomingdata in determining the extent and tim-ing of any additional firming.

In recent years, the FOMC hasworked to improve the transparency of its decisionmaking process, and theCommittee continues to examinewhether further changes would improve

its communications with the public. Inspring 2006, the Chairman appointed asubcommittee to help the FOMCorganize the discussion of a broad rangeof communication issues. The FOMCbegan its consideration of these issuesat its August meeting and has discussedthem at several meetings since then.

Economic Projectionsfor 2007 and 2008

In conjunction with the FOMC meetingin January, the members of the Board of Governors and the Federal ReserveBank presidents, all of whom participatein the deliberations of the FOMC, pro-vided economic projections for 2007and 2008. The projections indicate that

the participants expect sustainableexpansion of real economic activity dur-ing the next two years, assuming anappropriate course for monetary policy.The central tendency of the FOMC par-ticipants’ forecasts for the increase in




real GDP is 21 ⁄ 2 percent to 3 percentover the four quarters of 2007 and23 ⁄ 4 percent to 3 percent over the four

quarters of 2008. The central tendencyof their forecasts for the civilian unem-ployment rate is 41 ⁄ 2 percent to 43 ⁄ 4 per-cent in the fourth quarter both of thisyear and of 2008. For inflation, the cen-tral tendency of the forecasts anticipatesan increase in the price index for per-sonal consumption expenditures exclud-ing food and energy—the so-called corePCE price index—of 2 percent to

21 ⁄ 4 percent over the four quarters of 2007 and 13 ⁄ 4 percent to 2 percent overthe four quarters of 2008.

The economy is projected to expandat a moderate rate. Although the coolingof the housing market continues to dampeconomic activity, the drag on economicgrowth from declining construction ac-tivity is expected to diminish later thisyear. Household spending for goods and

services should rise at a solid pace, inpart as a result of ongoing gains in realwages and employment and of generally

strong household balance sheets. Busi-ness outlays for new equipment andsoftware are expected to increase at arate consistent with a moderate expan-sion in business output and to be sup-ported by continuing declines in the usercost of high-technology capital equip-ment and by favorable financial condi-tions. In addition, the solid expansion of economic activity abroad should main-

tain the rising demand for U.S. exportsof goods and services.

Decreased pressures from the costs of energy and other commodities, in anenvironment of moderate economicexpansion and well-anchored longer-runinflation expectations, are expected tocontribute to further easing in inflation.In addition, increases in productivityshould help to limit cost pressures. Á

Economic Projections of Federal Reserve Governors and Reserve Bank Presidentsfor 2007 and 2008

Percent

IndicatorMemo:

2006 actual

2007 2008

RangeCentral

tendencyRange

Centraltendency

Change, fourth quarter to fourth quarter 1

Nominal GDP . . . . . . . . . . . . . . . . . 5.9 43 ⁄ 4–51 ⁄ 2 5–51 ⁄ 2 43 ⁄ 4–51 ⁄ 2 43 ⁄ 4–51 ⁄ 4Real GDP . . . . . . . . . . . . . . . . . . . . . 3.4 21 ⁄ 4–31 ⁄ 4 21 ⁄ 2–3 21 ⁄ 2–31 ⁄ 4 23 ⁄ 4–3PCE price index excluding

food and energy . . . . . . . . . . . 2.3 2–21 ⁄ 4 2–21 ⁄ 4 11 ⁄ 2–21 ⁄ 4 13 ⁄ 4–2

Average level, fourth quarter Civilian unemployment rate . . . . 4.5 41 ⁄ 2–43 ⁄ 4 41 ⁄ 2–43 ⁄ 4 41 ⁄ 2–5 41 ⁄ 2–43 ⁄ 4

1. Change from average for fourth quarter of previousyear to average for fourth quarter of year indicated.

Monetary Policy and the Economic Outlook 7



Economic and Financial Developments

in 2006 and Early 2007

The especially brisk pace of economicactivity in early 2006 primarily reflecteda rebound after hurricane-related disrup-tions in the autumn of 2005. During therest of the year, however, economic ac-tivity slowed to a pace somewhat below

the average rate of recent years. RealGDP is reported to have increased at anaverage annual rate of 23 ⁄ 4 percent overthe final three quarters of 2006, downfrom the average 31 ⁄ 4 percent pace in2004 and 2005. The slowdown princi-pally was the result of the contraction inresidential construction, which intensi-fied later in the year, and the markeddecline in production of light motor

vehicles in the second half of the year asmanufacturers took steps to trim deal-ers’ inventories. In other sectors of theeconomy, consumer spending remainedstrong as employment and income madefurther solid gains, and business outlaysfor new structures and equipment rose

considerably over much of the year.Financial market conditions were gener-ally supportive of economic expansionin 2006. Equity markets recorded siz-able gains, and long-term interest ratesrose only modestly from historically low

levels. Risk spreads on corporate bondsremained narrow or declined further.Overall economic conditions were suchthat businesses maintained a steady paceof hiring, and the unemployment ratemoved down further.

Consumer price inflation, as mea-sured by the rise in the PCE price index,moved down in the second half of 2006after having stepped up in the first half.

Energy prices, which rose during thefirst half and turned sharply downwardlater in the year, played an importantrole in shaping the contour of totalconsumer price inflation. In addition,core PCE price inflation eased modestlyover the second half of 2006. Appar-

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5

Percent, annual rate

2006200420022000

Change in Real GDP, 2000–06

NOTE: Here and in subsequent figures, except asnoted, change for a given period is measured to its finalquarter from the final quarter of the preceding period.

SOURCE: Department of Commerce, Bureau of Eco-nomic Analysis.

1

2

3

4

Percent

2006200420022000

Change in PCE Chain-Type Price Index,

2000–06

NOTE: The data are for personal consumptionexpenditures (PCE).


Total

Excluding food and energy

9



ently influenced by incoming data oninflation and economic activity, mea-sures of long-term inflation expecta-

tions rose early in the year but endedthe year slightly lower than at the begin-ning. Nonetheless, core PCE price infla-tion for the year as a whole—at21 ⁄ 4 percent—was a bit higher than inthe preceding year, which perhaps re-flected in part the high level of resourceutilization.

The Household Sector

Consumer Spending

The rapid increase in consumer spend-ing in 2006 was supported by risingemployment, gains in real income,increases in household wealth, andfavorable financial conditions. Over thefour quarters of 2006, real PCE rose33 ⁄ 4 percent—faster than in 2005 and atroughly the same rate as in 2004. Therise in consumer outlays was particu-larly robust in the first quarter of 2006but then moderated in the middle of theyear, when households’ gains in realincome slowed and consumer sentimentsoftened. Consumer spending rosebriskly again in the fourth quarter of theyear as gains in real income picked upand consumer confidence improved.

Household spending for new motorvehicles slowed in 2006; sales of 16.5 million new light vehicles (cars,

sport-utility vehicles, and pickup trucks)were below the average of nearly17 million sold in the preceding twoyears. Moreover, households’ apparentconcerns about elevated gasoline prices,particularly early in the year, shifted thecomposition of light vehicle salestoward more fuel-efficient autos andaway from light trucks and SUVs. Theshift helped boost the share of total

sales captured by foreign producersbecause they tend to offer more fuel-efficient vehicles.

Real PCE for goods other than motorvehicles rose 43 ⁄ 4 percent over the fourquarters of 2006, about in line with thebrisk average pace in the preceding twoyears. Households increased theirspending for a broad range of consumergoods, though the rise was particularly

strong for electronic equipment andother durables. Real spending on gaso-line remained about constant in the firsthalf of the year but increased in the sec-ond half as prices fell. Consumer spend-ing for services maintained a moderatepace of growth; expenditures in thiscategory rose 23 ⁄ 4 percent in 2006, aboutthe same average pace as in 2004 and2005.

In 2006, real household income wasboosted by gains in wage and salaryincome and the increased purchasingpower resulting from the deceleration inoverall consumer prices. Labor incomereceived by households rose both be-cause of gains in real hourly wages andbecause of sustained increases in em-ployment. However, the pickup in real

after-tax income was damped becausetax payments made by householdsincreased at a rate greater than that forincome. The acceleration in tax pay-ments likely reflected, at least in part,several factors: tax payments on larger

2

4

6


2006200420022000

Change in Real Income and Consumption,2000–06


Disposable personal income

Personal consumption

expenditures




capital gains realizations, which areexcluded from income in the nationalincome and product accounts (NIPA);

gains in real income that moved somehouseholds into higher tax brackets; andpossibly a further shift in the distribu-tion of income toward high-incomehouseholds that typically face higher taxrates. All told, real after-tax income rose3 percent over the four quarters of 2006,up from the negligible gain posted in2005 but a little below the average rateof increase in 2003 and 2004.

The rise in after-tax income in 2006was outpaced by increases in householdspending. As a result, the personal sav-ing rate declined further in 2006 andaveraged negative 1 percent for the yearas a whole. Households apparently wereinclined to increase their spending fur-ther above their disposable income, atleast in part, because their wealth con-

tinued to rise. The ratio of household networth to income, which has been trend-ing higher since 2003, inched up furtherin 2006. Although increases in the valueof homes slowed significantly, the valueof corporate equities held by householdsboth indirectly—such as in mutual fundsand retirement accounts—and directlyappreciated considerably.

Consumer sentiment deteriorated in

the first half of 2006, according to theReuters/University of Michigan Surveysof Consumers (Reuters/Michigan). Inthe spring, consumer confidence hadmoved to its lowest level for the year,probably in part because energy priceshad surged. The subsequent decline inenergy prices, along with the rise in thestock market and reductions in the un-employment rate, boosted consumerconfidence in the second half of theyear. On net, the Reuters/Michigan in-dex of consumer sentiment was a shadehigher at the end of 2006 than at thebeginning of the year; sentiment moved

up further in early 2007 to near theupper end of its range since 2003.

Residential Investment

The deterioration of conditions in thehousing market played a significant rolein restraining the pace of economicexpansion in 2006. The demand for newand existing homes began to weaken inthe middle of 2005, and the subsequentdecline steepened through the first half of 2006. As a result, the inventory of

unsold new homes relative to sales rosesharply. Apparently prompted by lowerdemand and excessive inventories,homebuilders began to cut back on thepace of new construction near the begin-ning of 2006, and the decline in activitycontinued throughout the year. Later inthe year, however, some indicators werehinting that the demand for housing wasstarting to stabilize.

By the middle of 2006, sales of bothnew and existing homes had fallen dra-matically to a pace that was about15 percent below that of a year earlier.Concurrently, inventories of unsoldhomes relative to sales rose consider-ably above the level that had prevailedduring the period of robust housing de-mand from the late 1990s into 2005. Bythe third quarter of 2006, the backlog of unsold new homes had reached63 ⁄ 4 months’ supply, and the stock of existing homes for sale had risen toabout 7 months’ supply—both wellabove the average of about 41 ⁄ 2 months’supply of new and existing homes in2005. By the end of 2006, however,there were tentative signs that the de-mand for homes was stabilizing. The

decline in sales of new and existinghomes appeared to bottom out in thesummer, and sales were roughly con-stant over the later part of the year. Inthe fourth quarter, builders’ inventoriesof unsold new homes were reported to

Economic and Financial Developments in 2006 and Early 2007 11



have edged down a bit from their third-quarter level, while the stock of existinghomes for sale remained about the same

as in the third quarter. Despite thesedevelopments, the extent of any im-provement in the inventories of unsoldhomes is obscured by the failure of thesefigures to account for recorded sales of new homes that are subsequentlycanceled.

The drag on new residential construc-tion in 2006 imposed by the contractionin home sales and the buildup of inven-

tories was significant. Both the numberof permits issued for new single-familyhomes and the number of home startsdropped sharply. As of the fourth quar-ter of 2006, new single-family homeswere started at an annual rate of 1.23 million units, almost 30 percentbelow the average pace in 2005; permitswere down by a similar amount. In con-trast to the marked slackening in con-

struction of new single-family homes,the rate of starts of new multifamilyhomes in 2006, at 337,000 units, wasabout the same as in the preceding sev-eral years.

Housing activity, as measured by realexpenditures on residential structures inthe NIPA, trimmed 1 ⁄ 4 percentage pointfrom the rate of real GDP growth in the

first half of 2006, but the drag intensi-fied to subtract about 11 ⁄ 4 percentagepoints from the annual rate of increase

in real GDP in the second half. For 2006as a whole, the contraction in real resi-dential investment lowered the annualrate of growth in real GDP 3 ⁄ 4 percent-age point after having added 1 ⁄ 2 percent-age point, on average, to the rate from2003 through 2005.

The rate of house-price appreciationslowed substantially in 2006 after sev-eral years of very rapid gains. The

repeat-transactions index of home pricespublished by the Office of Federal Hous-ing Enterprise Oversight (OFHEO)increased at an annual rate of only11 ⁄ 2 percent in the third quarter of 2006,down substantially from average gainsof about 10 percent in 2004 and 2005.The OFHEO index attempts to controlfor the quality of existing single-familyhomes sold by using prices of homes

involved in repeat transactions. Theincrease in the OFHEO house-price in-dex over the four quarters ending in thethird quarter of 2006 (a calculation thatsmoothes through some of the quarterlyvolatility in the data) was 6 percent, thesmallest four-quarter increase since thelate 1990s. The average price of existingsingle-family homes sold, which is pub-lished by the National Association of Realtors (NAR) and does not control forthe types of homes sold, declined about2 percent over the four quarters of 2006,compared with average gains of roughly9 percent in 2004 and 2005. The out-right decline in the NAR index of homeprices relative to the deceleration in theconstant-quality OFHEO home-price in-dex suggests that the composition of

existing homes sold shifted towardlower-priced homes.The cost of mortgage financing

increased in the first half of 2006, butrates decreased in the second half. Theaverage rate for a thirty-year fixed-rate

.4

.8

1.2

1.6

Millions of units, annual rate

2006200219981994

Private Housing Starts, 1993–2006

Single-family

Multifamily

NOTE: The data are quarterly and extend through2006:Q4.

SOURCE: Department of Commerce, Bureau of theCensus.




mortgage was 61 ⁄ 4 percent at the end of 2006, about the same as at the beginningof the year. The average for a one-year

adjustable-rate mortgage declined alsoin the second half and stood at 51 ⁄ 2 per-cent at the end of 2006, about 1 ⁄ 4 per-centage point above the level at the startof the year. According to respondents tothe Reuters/Michigan survey, relativelylow mortgage rates and the perceptionthat purchase prices were more favor-able improved their assessment of homebuying conditions in the second

half of 2006.

Household Finance

Household sector debt is estimated tohave slowed from the robust 113 ⁄ 4 per-cent increase posted in 2005 to a still-vigorous 81 ⁄ 4 percent in 2006. The decel-eration reflected a drop in the pace of mortgage debt growth from about

14 percent in 2005 to less than 9 percentin 2006. Despite the reduction in mort-gage borrowing, home equity lendingremained active, and the gross volumeof cash-out refinancing exceeded 2005levels. Meanwhile, consumer debtexpanded only moderately in 2006.

Although household indebtednessincreased less rapidly in 2006 than in2005, it still outpaced the growth of disposable personal income. In addition,the rise in interest rates contributed tohigher debt service payments, and thehousehold financial obligations ratiocontinued its upward trend of the pastdecade to reach a record high. Evidenceto date suggests that most householdshave been able to meet their debt serviceobligations, although there are indica-

tions of growing strains among someborrowers. Delinquency rates on sub-prime residential mortgages with vari-able interest rates have increased mark-edly; still, delinquency rates on othermortgages and consumer loans have

remained low. Household bankruptcyfilings during 2006 ran at a pace wellbelow the average of the preceding sev-

eral years. Bankruptcies likely weredamped in 2006 by the decisions of some households to file before theimplementation of more-stringent bank-ruptcy requirements in October 2005.However, even allowing for such aneffect, the recent pace is low relative topre-reform norms.

The Business Sector

Fixed Investment

Total real business fixed investment rose63 ⁄ 4 percent over the four quarters of 2006, up from a 51 ⁄ 2 percent increase in2005 and about the same pace as in2004. In general, the fundamentals sup-porting business capital spending

10

+

_0

10

20


Change in Real Business Fixed Investment,2000–06

Structures

Equipment and software

+

_0

20

40

2006200420022000

NOTE: High-tech equipment consists of computersand peripheral equipment and communications equip-ment.


High-tech equipment

and software

Other equipment excluding

transportation




remained favorable in 2006: The strongrise in profits continued to help firmsmaintain substantial liquid assets, user

costs for equipment declined further, andinterest rates and credit spreads re-mained relatively low. Although thepace of real business outlays for equip-ment and software slowed somewhat in2006, investment in nonresidential struc-tures rose 113 ⁄ 4 percent. Capital spend-ing was quite robust during most of theyear, adding about 1 percentage point tothe annual rate of increase in real GDPover the first three quarters, but it decel-erated sharply in the fourth quarter. Thedeceleration reflected, in part, a slowingin spending for business structures fromits brisk pace earlier in the year, a dropin outlays for transportation equipment,and some weakness in purchases of equipment related to construction andmotor vehicle manufacturing.

Real investment in high-technologyequipment rose 9 percent in 2006, aboutthe same average annual pace as in thepreceding two years. Further decreasesin the prices of high-technology equip-ment continued to reduce the user costof this type of equipment. Real businessspending for computing equipmentincreased 141 ⁄ 2 percent, and softwarespending posted an 8 percent gain, both

roughly comparable to their averagerates of increase in the previous twoyears. Business outlays for communica-tions equipment rose almost 7 percent in2006. Spending for communicationsequipment was particularly robust in theearly part of the year and was likelyboosted in part by spending to replaceequipment damaged by the hurricanes inthe autumn of 2005. Investment in com-munications equipment last year contin-ued to be supported by demand fromtelecommunications service providersthat were expanding their broadbandnetworks.

Real business investment in transpor-tation equipment—typically a volatilecategory of investment—was about un-

changed on net in 2006. For motor vehi-cles, business spending increased lessthan 1 percent over the year. Purchasesof light vehicles weakened, partly be-cause of cutbacks in sales to rental com-panies. In contrast, business outlays formedium and heavy trucks accelerated in2006, reportedly in anticipation of newemissions regulations by the Environ-mental Protection Agency that went into

effect at the beginning of 2007. Neworders for medium and heavy trucksreached new highs early in 2006, andproduction and sales remained strongthrough the end of the year. Outlays fornew aircraft were brisk in early 2006,but they were depressed over the re-mainder of the year; all told, aircraftinvestment declined more than 15 per-cent for the year as a whole.

Real investment in equipment otherthan high-tech and transportationgoods—a broad category that representsabout half of total nominal businessspending for equipment and software—rose at an average annual rate of 51 ⁄ 2 per-cent during the first three quarters of 2006. However, spending for these capi-tal goods softened in the final quarter of the year. Although the declines in thefourth quarter were generally broadbased, they were led by decreases inspending for equipment related to con-struction and motor vehicle manufactur-ing. However, the backlog of orders forcapital goods such as industrial machin-ery and other types of heavy equipmentremained substantial at the end of 2006,and it should sustain production and

shipments of these items in early 2007.Real outlays for nonresidential con-struction increased 113 ⁄ 4 percent in 2006after having been little changed since2003. However, the rise in business con-struction spending slowed near the end




of 2006 from its rapid pace earlier in theyear; outlays increased at an annual rateof only about 3 percent in the fourth

quarter. For 2006 as a whole, sizablegains were posted for office, retail, andindustrial buildings. In addition, outlaysfor drilling and mining structures associ-ated with energy exploration werestrong. At the end of 2006, forward-looking indicators for nonresidentialconstruction activity appeared to befavorable: Vacancy rates for buildingsin both the office and industrial sectors,

which peaked a few years ago, contin-ued to drift down, and the vacancy ratefor retail buildings remained at the lowlevel that has prevailed since 2000.

Inventory Investment

In the first half of 2006, dealer stocks of motor vehicles rose noticeably as salesslowed, particularly for light trucks. The

increase in the prices of gasoline earlierin the year appeared to have reducedconsumers’ demand for light trucks andSUVs, which tend to be less fuel effi-cient. Dealers’ inventories of these vehi-cles reached an elevated 90 days’ supplyat the end of the second quarter. As aresult, motor vehicle manufacturersscaled back the production of lighttrucks over the second half of 2006,which helped to reduce dealers’ inven-tories during that period. Nonetheless, atthe end of 2006, inventories of lightvehicles still appeared to be above de-sired levels. Manufacturers cut produc-tion further in January of this year, help-ing them make additional progress inreducing the stock overhang.

Excluding motor vehicles, inventories

held by businesses in the manufacturingand trade sectors appeared generally tobe well aligned with sales in the firsthalf of 2006. However, later in the year,a variety of indicators suggested thatsome businesses accumulated an unde-

sired level of stocks. The book value of manufacturing and trade inventories(excluding motor vehicles) rose relative

to sales from September throughNovember. The increases were particu-larly noticeable for firms that supply theconstruction and motor vehicle sectors,although increases were apparent in afew other sectors as well. Survey dataalso suggested that inventories for somebusinesses were viewed as too high.However, manufacturers outside of themotor vehicles sector appear to be mak-

ing relatively prompt adjustments totheir production, which to date seem tobe limiting the extent of undesiredstockbuilding.

Corporate Profits andBusiness Finance

Profits of nonfinancial corporationsextended their upward move, pushing

the ratio of before-tax profits to incomein this sector to nearly 14 percent, thehighest level reached since 1969. In thethird quarter, operating earnings pershare for S&P 500 firms came in 20 per-cent above levels of a year earlier. Abouttwo-thirds of firms in the S&P 500 havereported earnings for the fourth quarter.Current market estimates of earnings pershare for S&P 500 firms call for roughly10 percent growth in the fourth quarterover year-earlier levels. Earnings growthwas widespread across sectors in 2006 butwas particularly strong for financial firms.

Firms’ capital expenditures exceededinternal funds raised in 2006, an indica-tion that businesses funded investmentsnot only with current cash flow but alsowith external funds and liquid assets.

Borrowing by nonfinancial firms pickedup in 2006 in association with increasedreal investment as well as with exten-sive retirements of equity, whichresulted from record share repurchasesand heavy merger and acquisition activ-




ity. Net bond issuance proceeded at afaster clip than in the past several years.Similarly, commercial paper issuancewas the strongest it had been since 2000,

and commercial and industrial lendingby banks was rapid as well. The FederalReserve’s Senior Loan Officer Opinion

Survey on Bank Lending Practices re-vealed that a significant net fraction of respondents to that survey eased creditstandards and terms on commercial andindustrial loans during 2006. Bankersindicated that they were responding tomore-aggressive competition andgreater liquidity in the secondary marketfor such loans. Loan officers also re-ported that a contributing factor was an

increased tolerance for risk.The expansion of commercial mort-

gage debt in 2006 remained rapid byhistorical standards but fell off from theswift pace of 2005. The decelerationlikely reflected the rise in mortgagerates and a net tightening of credit stan-dards for these loans—an explanationconsistent with responses to the loanofficer survey.

Gross public issuance of equity bynonfinancial corporations in 2006roughly maintained the moderate paceof the past couple of years, and privateequity issuance appears to have risen abit to finance buyouts and other restruc-turings. Still, net equity issuance turnedmore negative as equity retirementsfrom cash-financed mergers and acquisi-tions and share repurchases increasedconsiderably.

On balance, despite increased borrow-ing and net equity retirements, thestrength of corporate earnings growthhas left the credit quality of nonfinancialfirms solid. Balance sheet liquidityremains high, and corporate leverage isnear historical lows. In addition, netinterest payments relative to cash flow

remained near the low end of the rangeseen over the past two decades. Thesix-month trailing bond default rate fellduring the first half of the year as de-faults by some large firms in thetroubled airline and automobile sectors

200

+

_0

200

400

600

Billions of dollars

200620032000199719941991

Financing Gap and Net Equity Retirementat Nonfinancial Corporations, 1991–2006

Net equity retirement

Financing gap

NOTE: The data are annual; the observations for 2006are based on partially estimated data. The financing gapis the difference between capital expenditures andinternally generated funds, adjusted for inventoryvaluation. Net equity retirement is the differencebetween equity retired through share repurchases,domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued by domestic companies inpublic or private markets. Equity issuance includesfunds invested by private equity partnerships and stock option proceeds.

SOURCE: Federal Reserve Board, flow of funds data.

200

+

_0

200

400

600

800

Billions of dollars, annual rate

2006200520042003

Selected Components of Net Financingfor Nonfinancial Corporate Businesses,2003–06

Sum of selectedcomponents

NOTE: The data for the components excluding bondsare seasonally adjusted. The data for the sum of selectedcomponents are quarterly. The data for 2006:Q4 areestimated.

SOURCE: Federal Reserve Board; Securities DataCompany; and Federal Financial Institutions Exami-nation Council, Consolidated Reports of Condition andIncome (Call Report).

Commercial paper

Bonds

Bank loans




in late 2005 dropped out of the series,and it was near zero throughout thesecond half of 2006. Delinquency rates

on business loans remained quite low.

The Government Sector

Federal Government

The deficit in the federal unified budgetnarrowed further during the past year.The unified budget recorded a deficit of $248 billion in fiscal year 2006—

$70 billion smaller than in the previousfiscal year. The federal deficit in fiscal2006 was a bit less than 2 percent of nominal GDP, significantly lower thanits recent fiscal year peak of more than31 ⁄ 2 percent of GDP in 2004. In fiscal2006, outlays rose about in line withnominal GDP, but receipts increased at afaster pace. From October throughDecember—the first quarter of fiscal

2007—the federal deficit was almost$40 billion less than in the same perioda year earlier, as the rise in receiptscontinued to outpace the growth in out-lays. The latest projections from theCongressional Budget Office and theAdministration anticipate that the uni-

fied deficit in fiscal 2007 will be smalleras a percentage of nominal GDP than itwas in fiscal 2006. Although the unified

deficit has improved recently, the fed-eral budget will face the mounting pres-sures of providing Social Security andhealth benefits to a rapidly growingnumber of beneficiaries as the baby-boom generation ages in coming years.

In fiscal 2006, nominal federal re-ceipts rose 113 ⁄ 4 percent and wereequivalent to almost 181 ⁄ 2 percent of nominal GDP, substantially higher than

their recent fiscal year low of 161 ⁄ 4 per-cent of GDP in 2004. Income tax re-ceipts from individuals outpaced the risein taxable personal income (as measuredin the NIPA), while surging corporatetax payments about matched the robustgrowth in profits. As noted above, theincrease in individual income tax liabili-ties relative to taxable income in theNIPA appears to have reflected, at least

in part, taxes on larger capital gainsrealizations (which are excluded fromNIPA income), the effect of some tax-payers moving into higher tax bracketsas their real incomes increased, and pos-sibly a further shift in the distribution of income toward high-income householdsthat typically face higher tax rates. Inthe first quarter of fiscal 2007, revenueswere more than 8 percent greater than inthe same period a year earlier, as bothindividual and corporate tax paymentscontinued to rise briskly.

Nominal federal outlays increasedabout 71 ⁄ 2 percent in fiscal 2006 andwere about 201 ⁄ 4 percent of nominalGDP, well above their most recent fiscalyear low of less than 181 ⁄ 2 percent of GDP in 2000. Net interest payments

increased 23 percent in fiscal 2006, asinterest rates rose and federal debt con-tinued to grow. Outlays for Medicareincreased 101 ⁄ 2 percent, reflecting in partnew benefits payments associated withthe Part D prescription drug program,

16

18

20

22

24

Percent of nominal GDP

200620021998199419901986

Federal Receipts and Expenditures,1986–2006

Expenditures

Expendituresex. net interest

Receipts

NOTE: The receipts and expenditures data are on aunified-budget basis and are for fiscal years (Octoberthrough September); GDP is for the four quarters endingin Q3.

SOURCE: Office of Management and Budget.




which started in January 2006. At thesame time, outlays for Medicaiddeclined a bit, to some extent because of

a shift of some Medicaid payments toMedicare Part D. Spending for disasterrelief and national flood insurance wasalmost $28 billion greater in fiscal 2006than in the previous fiscal year, prima-rily owing to the federal government’sresponse to the hurricanes in the autumnof 2005. Outlays for defense in fiscal2006 slowed to their lowest rate of increase since fiscal 2001, although the

rise was still about 6 percent. In the firstquarter of fiscal 2007, total federal out-lays were only 1 percent greater thanthose in the same period a year earlier;in this period, defense spending was12 percent above its year-earlier level,but outlays related to disaster relief andflood insurance were markedly lowerthan they were a year earlier.

As measured in the NIPA, real federal

expenditures on consumption and grossinvestment—the part of federal spend-ing that is a direct component of realGDP—increased 21 ⁄ 2 percent over thefour quarters of calendar year 2006 andcontributed about 1 ⁄ 4 percentage point tothe growth rate of real GDP in that year.The increase was the result of a pickupin real defense purchases, which rosemore than 4 percent during calendar2006 after two years of smallerincreases. At the same time, real nonde-fense purchases declined more than1 percent after having risen, on average,about 2 percent per year over the preced-ing two years.

The reduction in the unified deficit inthe past two years implies that the fed-eral government required less national

saving to finance its operations. How-ever, nonfederal saving, which excludesborrowing by the federal governmentfrom total net national saving, remainedrelatively low. Although the saving ratefor private business and state and local

governments has increased in recentyears, the improvement has been offsetby declines in the personal saving rate.

Total national saving, net of deprecia-tion, was 2 percent of nominal GDP inthe third quarter of 2006. The recentnational saving rate is an improvementfrom the lows of a few years ago, but ithas been insufficient to avoid an increas-ing reliance on borrowing from abroadto finance the nation’s capital spending.

Federal BorrowingThe Treasury responded to the reductionin the federal deficit in 2006 by payingdown Treasury bills over the course of the year and by trimming the gross issu-ance of marketable Treasury coupon se-curities. As of the third quarter of 2006,the quantity of federal debt held by thepublic as a percentage of nominal GDPhad declined about 1 ⁄ 2 percentage point,to about 36 percent.

Early in the first quarter of 2006,federal debt subject to the statutory limitreached the then-current ceiling of $8.2 trillion. The Treasury employedvarious methods to avoid breaching the

25

35

45

55


20061996198619761966

Federal Government Debt Heldby the Public, 1960–2006

NOTE: The final observation is for 2006:Q3. Forprevious years, the data for debt are as of year-end, andthe corresponding values for GDP are for Q4 at anannual rate. Excludes securities held as investments of federal government accounts.

SOURCE: Federal Reserve Board, flow of funds data.




limit until the Congress increased it tonearly $9 trillion in March. As of theend of December, the total amount of

federal debt subject to the limit was$8.6 trillion.

In February, the Treasury auctionedthirty-year bonds for the first time since2001. The offering was apparently wellreceived, as was the reopening of theissue in August. The Treasury an-nounced in August that it would issuethirty-year bonds on a quarterly basisbeginning in 2007.

The acquisition of Treasury debt byforeigners slowed further in 2006 fromits peak in 2004. However, outstandingTreasury debt also grew more slowly,leaving the share of outstanding debtheld by foreign investors little changed,on balance, from its average level overthe preceding two years. According toTreasury data on international capitalflows, foreigners (official and other)

purchased considerably fewer U.S. Trea-sury coupon securities in 2006 than in2005. The average proportion of nomi-nal coupon securities purchased by for-eign and international investors at auc-tions in 2006 about matched the averagefrom the previous year at 16 percent, butit was down noticeably from an averagelevel of 25 percent in 2004.

State and Local Government

The fiscal positions of state and localgovernments improved further in 2006.Apart from federal grants-in-aid, rev-enues rose at an annual rate of 7 percentover the first three quarters of 2006 afterposting relatively strong gains in thepreceding two years. Receipts from

taxes on retail sales and on individualand corporate incomes continued to riseat a brisk pace; however, decreasinggains in house prices slowed the rise inproperty tax revenues in the third quar-ter of 2006 from the rapid pace in the

previous two years. The sustainedstrength in total revenues, along with theefforts of states and localities to restrain

spending for health care, has enabledthese jurisdictions to step up spendingon other programs and still rebuild theirreserve funds. As measured in the NIPA,net saving by state and local govern-ments excluding social insurancefunds—a measure that is broadly similarto the surplus in an operating budget—was almost $4 billion during the firstthree quarters of 2006. States and locali-

ties generally have seen improvement intheir fiscal positions recently, but incoming years most governments willhave to face the budget pressures of providing pension and health benefits toan expanding number of retired employ-ees, and the states’ costs for Medicaidare expected to rise substantially as thebaby-boom generation ages.

Real expenditures by state and local

governments on consumption and grossinvestment, the component of these gov-ernments’ spending that enters directlyinto the calculation of real GDP, rose3 percent over the four quarters of 2006.That increase was the largest since 2001and contributed about 1 ⁄ 4 percentagepoint to the change in real GDP duringthe year. Real expenditures for invest-ment rose 43 ⁄ 4 percent, largely becauseof a strong increase in real constructionspending in the first half of the year.Spending for current consumption inreal terms increased 21 ⁄ 2 percent overthe four quarters of 2006. Hiring bystate and local governments stepped uplast year. Of the cumulative increase inemployment of 254,000 in 2006, abouttwo-thirds of the jobs were in education.

State and Local GovernmentBorrowing

Borrowing by state and local govern-ments dropped below its rapid 2005




pace amid improved fiscal positions andfewer advance refunding issues. None-theless, bond issuance for new capital

expenditures, particularly for educationand transportation, boosted long-termborrowing. Credit quality in the stateand local sector rose substantially in2006, as the number of credit-rating up-grades far exceeded the small number of downgrades.

The External Sector

The U.S. current account deficit aver-aged $875 billion at an annual rate, orabout 61 ⁄ 2 percent of nominal GDP, inthe first three quarters of 2006 (the latestavailable data). The deficit was widerthan in 2005, partly because of a largerdeficit on trade of goods and services. Inaddition, net investment income, whichturned negative in the fourth quarter of 2005, remained negative in the firstthree quarters of last year, further ex-panding the current account deficit.

International Trade

After widening through most of 2005,the nominal trade deficit leveled out in

the first half of 2006, rose to a recordhigh in August, and then narrowed no-ticeably through November (the latest

available data). On average, the nominaltrade deficit was wider in 2006 than inthe previous year. Nominal imports of goods grew more slowly than exportsdid early last year and, after reachinglate-summer peaks, dropped because of declines in both the price and volume of imported oil. Meanwhile, imports of ser-vices decelerated sharply in the secondhalf of last year. In contrast, nominalexports of goods and services pushedupward steadily throughout the year andgrew significantly faster than did nomi-nal imports. Given that the level of ex-ports was smaller than the level of im-ports, the faster export growth during2006 was not enough to narrow thenominal trade deficit. Although thenominal trade deficit last year (through

November, annualized) was wider indollar terms, the trade deficit as a shareof GDP, at just under 6 percent, wasabout the same as in 2005.

Real exports of goods and servicesgrew a robust 91 ⁄ 4 percent last year. Inthe first quarter, growth was boosted bya catch-up of exports affected by hurri-cane damage in late 2005. Throughoutthe year, exports were supported by

strong foreign economic activity. Realexports of goods rose 101 ⁄ 4 percent lastyear, a little faster than in the previousyear. Export growth was spread fairlyevenly across all major end-use catego-ries, though exports of computers andsemiconductors expanded noticeablymore slowly than in 2005. By destina-tion, exports to China and other emerg-ing Asian economies grew very rapidly,as did those to South America. Exportsto Mexico and western Europe rose at amore modest pace. Real exports of ser-vices were up a solid 63 ⁄ 4 percent for theyear, double the pace of 2005.

7

6

5

4

3

2

1

+

_0


2006200420022000

U.S. Trade and Current Account Balances,1999–2006

Trade

Currentaccount

NOTE: The data are quarterly. For the trade account,the observation for 2006:Q4 is estimated. The data forthe current account extend through 2006:Q3.

SOURCE: Department of Commerce.




Prices of exported goods rose at a31 ⁄ 2 percent rate last year, a little fasterthan their pace in 2005. Reflecting the

effects of very large jumps in prices of industrial supplies, particularly fuels andmetals, export prices moved up sharplyin the second and third quarters; theydecelerated toward the end of the yearas prices of exported fuels retreatedfrom their high levels and as prices of exported metals moved up more slowly.

Real imports of goods and servicesrose 3 percent last year, more slowly

than in the previous year. As with thegrowth in real exports, real importgrowth got off to a quick start last yearamid robust domestic growth. But im-port growth slowed, on average, in themiddle quarters of the year, along withU.S. real GDP growth, and real importsfell in the fourth quarter as a result of asharp drop in oil and natural gas im-ports. Despite some fourth-quarter

declines, for the year imports increasedin every major end-use category exceptpetroleum and natural gas. Imports of services rose more than 5 percent lastyear, a step-up from the previous year’ssluggish pace.

Prices of imported non-oil goodsincreased less than 1 percent, on bal-ance, in 2006 despite some wide gyra-tions. After falling in the first quarter,prices reversed course, surged upward,and then cooled in the fourth quarter.The quarterly pattern was driven bymovements in nonfuel commodityprices, which soared in the second andthird quarters before leveling off in thefourth quarter.

Metals figured prominently amongthe nonfuel commodities that boosted

trade prices last year. Prices for a varietyof metals—including copper, aluminum,nickel, and zinc—skyrocketed in thesecond quarter. Factors contributing tothe surge in prices included growingdemand, particularly from developing

countries, low levels of inventories forsome metals, and perhaps increasedspeculative demand. Prices for nickel

and zinc continued to move up through-out the year. In the second half of theyear, aluminum prices trended sideways,and copper prices moved down fromtheir peaks as inventory and supply con-ditions improved somewhat. For most of these metals, those price trends havecontinued this year. An exception iszinc, the price of which has plummeted.

The spot price of West Texas interme-

diate crude oil averaged $66 per barrelin 2006, nearly $10 per barrel higherthan in 2005; moreover, crude oil priceswere especially volatile last year. Thespot price climbed from around $61 perbarrel at the end of 2005 to a peak of $77 per barrel in August as violence inthe Middle East, a shutdown of thePrudhoe Bay oil field in Alaska, andforecasts of an active hurricane season

led to increased demand. In the event,oil supply was affected far less thananticipated by these factors, and oilprices declined over the next fewmonths as demand dropped and elevated

10

20

30

40

50

60

70

80

Dollars per barrel

80

100

120

140

160

180

200

220

20072006200520042003

Prices of Oil and of Nonfuel Commodities,2003–07

January 2003 = 100

Oil

Nonfuelcommodities

NOTE: The data are monthly and extend throughJanuary 2007. The oil price is the spot price of WestTexas intermediate crude oil. The price of nonfuelcommodities is an index of forty-five primary-commodity prices.

SOURCE: For oil, the Commodity Research Bureau;for nonfuel commodities, International Monetary Fund.




petroleum inventories were drawndown. Oil demand for heating was de-pressed by above-average temperatures

in the Northern Hemisphere in thefourth quarter and in the early weeks of 2007, and the spot price fell further, toaround $50 per barrel in mid-January,before moving back up to $58 per barrelat the end of the month. Far-dated fu-tures prices began last year at about$60 per barrel, moved in a pattern simi-lar to spot prices throughout most of theyear, and averaged just over $61 per

barrel in January 2007.Notwithstanding the decrease of glo-

bal oil prices since August, several fac-tors continue to support these prices athistorically elevated levels. Ongoingviolence has diminished oil productionin Iraq and Nigeria. The continuing dis-pute with Iran over its nuclear programthreatens a possible curtailment of Ira-nian exports. Energy investment by in-

ternational oil companies has been ham-pered in some countries, such as Russiaand Venezuela, by increased govern-ment control of domestic energy indus-tries. Moreover, in response to the recentdecline in oil prices, OPEC has reducedits crude oil production to the lowestlevel since 2004. Oil demand over thepast year has also increased modestly indeveloping countries despite high prices.

The Financial Account

Foreign official inflows in the first threequarters of 2006 were above their 2005pace but remained below the record lev-els of 2004. Most of these official in-flows were attributable to Asian centralbanks and took the form of purchases of

U.S. government securities, primarilybonds and mortgage-backed securitiesissued by government-sponsored enter-prises (GSEs). Preliminary data indicatea slight easing of official purchases inthe fourth quarter of 2006. Net private

inflows slowed in the first quarter buthave changed little since then.

Foreign private purchases of U.S. se-

curities in the second and third quartersof 2006 slowed slightly from theextraordinary pace set in the second half of 2005 and early 2006, but preliminaryfourth-quarter data show recent demandto have been strong. More than half of private flows last year took the form of purchases of corporate bonds, and mostof the remainder went toward invest-ment in GSE bonds and corporate equi-

ties. On net, private foreigners pur-chased few U.S. Treasuries. Foreigndirect investment flows into the UnitedStates remained robust.

Net purchases of foreign securities byU.S. residents, a financial outflow, set arecord pace in the first three quarters of 2006. Preliminary data show a furthersurge in net purchases in the fourth quar-ter. Demand for foreign bonds by U.S.

residents slightly exceeded that for for-eign equities. After the expiration of thepartial tax holiday implemented in theHomeland Investment Act of 2004, U.S.direct investment abroad dropped back to more normal levels.

The Labor Market

Employment and UnemploymentLabor markets remained strong in 2006.Nonfarm payroll employment increased186,000 per month, on average, duringthe second half of 2006, a rate essen-tially the same as in the first half of theyear. Employment rose 111,000 in Janu-ary of 2007. The unemployment rate inthe fourth quarter of last year—

41

⁄ 2

percent—was at its lowest quarterlylevel since 2001, and it was littlechanged in January 2007.

In response to the contraction inhomebuilding, hiring in the constructionsector slowed considerably in the sec-




ond and third quarters of 2006, and thissector shed workers in the fourth quar-ter. Although hiring for nonresidentialbuilding construction remained brisk formost of the year, the steep decline inhousing starts curtailed the overall de-

mand for construction workers. Employ-ment in the manufacturing sector, whichrose in the first half of 2006, declined inthe second half as factory output slowed.From July to December, many of thefactory layoffs were at makers of motorvehicles and parts and at producersclosely tied to the construction industry.Outside of the construction and manu-facturing sectors, employment generallyincreased at a solid pace in the secondhalf of 2006, and hiring was particularlyrapid in a number of service industries—especially those providing education andhealth services, professional and tech-nical business services, and financialservices.

As a result of the continued expan-sion of labor demand in 2006, the unem-

ployment rate fell further. After remain-ing around 43 ⁄ 4 percent in the first threequarters of 2006, the unemployment rateedged down to 41 ⁄ 2 percent in the fourthquarter. The tighter labor market wasassociated with a noticeable increase in

employment among individuals who hadnot been participating in the labor force.In line with this cyclical tightening of

the labor market, the labor force partici-pation rate ticked up during 2006, from66 percent in the first quarter to661 ⁄ 4 percent in the fourth quarter, after a1 ⁄ 4 percentage point rise during 2005.The recent rise in the participation ratefollows a period of decline beginning inthe late 1990s that in part reflected somelonger-term secular trends in labor forcebehavior. Those trends included a level-

ing off in the participation rate of women and an increase in the propor-tion of the workforce in older agegroups, which have lower average par-ticipation rates.

Other indicators also suggest thatlabor market conditions remained gener-ally favorable during the second half of 2006. Layoffs remained low as newclaims for unemployment insurance

fluctuated around a relatively subduedlevel of 315,000 per week. In addition,data reported by the Bureau of LaborStatistics showed a further increase dur-ing the later part of the year in the rateof job openings as a percentage of private-sector employment.

Productivity and

Labor CompensationThe growth rate of labor productivity inthe nonfarm business sector, which hadslowed in 2004 and 2005 from an excep-tionally rapid pace earlier in the decade,remained relatively subdued in 2006.Over the four quarters of 2006, outputper hour of work in the nonfarm busi-ness sector increased 2 percent, com-

pared with about a 3 percent averageannual rate of increase during the firsthalf of this decade and the second half of the 1990s. During that earlier period,productivity gains were spurred by therapid pace of technological change, the

100

+

_0

100

200

Thousands of jobs, monthly average

2007200520032001

Net Change in Payroll Employment,2001–07

January

NOTE: Nonfarm business sector.SOURCE: Department of Labor, Bureau of LaborStatistics.




growing ability of firms to use informa-tion and other technology to improvethe efficiency of their operations, and

increases in the amount of capital perworker. Despite the recent slowing inproductivity growth, these underlyingfactors do not appear to have waned.Accordingly, the recent slowdown inlabor productivity may be at least in parta temporary cyclical response to themoderation in the pace of economic ac-tivity in 2006 rather than a meaningfuldownshift in the longer-run trend.

As the labor market tightened in2006, the rise in hourly labor compensa-tion, which includes both wages andemployer payments for employee bene-fits, stepped up for workers in the non-farm business sector. In nominal terms,compensation per hour increased almost5 percent over the four quarters of 2006,compared with an average 4 percent rise

in the preceding two years. After adjust-ing compensation for increases in thePCE price index, real compensation perhour rose 3 percent in 2006, up from anaverage gain of about 1 percent in 2004and 2005.

An alternative measure of employeecompensation is the employment costindex (ECI) for private nonfarm busi-

nesses, which is based on a survey of firms conducted by the Bureau of LaborStatistics. According to this measure,nominal hourly compensation increased31 ⁄ 4 percent in 2006, 1 ⁄ 4 percentage pointfaster than in 2005. In real terms, theECI for hourly compensation rose11 ⁄ 4 percent last year after averaging a1 ⁄ 2 percent increase over the precedingtwo years. The nominal wages and sala-

ries component of the ECI rose 31 ⁄ 4 per-cent in 2006, while the benefits compo-nent advanced 3 percent.

From the perspective of employers,the acceleration in hourly compensationin the nonfarm business sector last yearboosted the average labor costs associ-ated with producing a unit of output23 ⁄ 4 percent, up from increases of about13 ⁄ 4 percent in both 2004 and 2005.

Although the rise in unit labor costsincreased, firms’ profit margins ap-peared to remain elevated in 2006 rela-tive to longer-run standards.

Prices

Headline inflation slowed in 2006. ThePCE chain-type price index rose 2 per-cent over the four quarters of 2006, astep-down from the 3 percent increaserecorded in 2005. The drop in energyprices in the latter part of 2006 ac-counted for the deceleration in the head-line number. Core inflation movedhigher in the first part of 2006 but theneased toward the end of the year. Onbalance, core PCE prices rose about21 ⁄ 4 percent over the four quarters of

2006, a little faster than the 2 percentincrease in 2005. The market-basedcomponent of the core PCE priceindex—which excludes imputed pricesthat are not observed in market transac-tions and that often change irregularly—

1

2

3

4

5


Change in Output per Hour, 1948–2006

1948–73

1974–95

1996–2000

2002 2004 2006

NOTE: Nonfarm business sector. Change for eachmultiyear period is measured from the fourth quarter of the year immediately preceding the period to the fourthquarter of the final year of the period.

SOURCE: Department of Labor, Bureau of LaborStatistics.




increased 2 percent in 2006, about1 ⁄ 4 percentage point more than in theprevious year.

Energy prices recorded dramaticswings during 2006. PCE energy pricesincreased at an annual rate of about15 percent in the first half of the yearand declined at an annual rate of almost17 percent in the second half. The sharpmovements in consumer energy pricesin 2006 were associated primarily withfluctuations in prices for crude oil. Thechanges in energy prices also were am-plified by a widening in the margin of the retail price of gasoline over the asso-ciated cost of crude oil in the first half of the year and by some narrowing of thatmargin in the second half. On balance,the PCE energy price index decreased4 percent over the four quarters of 2006.

Food price inflation remained fairlymoderate in 2006. The PCE index for

food and beverages increased 21

⁄ 4

per-cent, roughly the same pace as in thepreceding year. Retail prices of meatand poultry rose modestly for 2006, asrobust demand was met by ample sup-plies of meat. Prices of wheat rose over

the course of the year, and prices of cornand soybeans spiked at the end of theyear in the wake of downward revisions

to estimates of crop production. Pricesof corn also were boosted during theyear by increased demand for corn toproduce ethanol. But the small share of wheat, corn, and soybeans in the totalvalue of food production limited theireffect on retail food prices. Prices forfood consumed away from home, whichare influenced importantly by the costsof labor, energy, and other businessinputs, increased 31 ⁄ 4 percent in 2006, amore rapid pace than that for prices of food consumed at home.

The core PCE price index acceleratedto an annual rate of about 21 ⁄ 2 percent inthe first half of 2006 on the strength of pickups in the price indexes for bothgoods and services. In the spring,increases in housing rents were particu-

larly sharp. The rise may have reflectedin part a shift in demand toward rentalhousing as rising mortgage rates andlofty home prices made home purchasesless affordable. The pass-through of higher energy costs to a broad range of goods and services also probably con-tributed to the acceleration in core con-sumer price inflation in the first half of 2006.

In the second half of 2006, core PCEprice inflation edged down to an annualrate of just below 21 ⁄ 4 percent. The de-celeration was the result of a decrease incore goods prices, which likely reflectedin some measure the waning influenceof energy prices. In contrast, core ser-vices inflation in the second half of theyear remained at about the same pace asin the first half. Although housing rentsrose more slowly in the second half of the year, their effect on the PCE for coreservices was mostly offset by fasterprice increases for medical care and anumber of other services.

Alternative Measures of Price Change,2004–06

Percent

Price measure 2004 2005 2006

Chain-typeGross domestic product (GDP) . 3.2 3.1 2.5Gross domestic purchases . . . . . . 3.7 3.6 2.2Personal consumption

expenditures (PCE) . . . . . . . . 3.0 3.1 1.9Excluding food and energy . . . 2.2 2.1 2.3

Market-based PCE excludingfood and energy . . . . . . . . . . . 1.7 1.8 2.0

Fixed-weight Consumer price index . . . . . . . . . . 3.3 3.7 1.9

Excluding food and energy . . . 2.1 2.1 2.6

Note: Changes are based on quarterly averages of seasonally adjusted data.Source: For chain-type measures, Department of

Commerce, Bureau of Economic Analysis; for fixed-weight measures, Department of Labor, Bureau of LaborStatistics.




The swings in energy costs in 2006were apparent in the prices of inputsused in the production and sale of final

goods and services, especially of itemsfor which energy costs represent a rela-tively large share of total productioncosts, including industrial chemicals,plastics, fertilizer, and stone and clayproducts. In addition, the prices of somecommodities, such as a variety of met-als, rose significantly in 2006 inresponse to strong worldwide demand.As a result, the core producer price in-

dex for intermediate goods, whichexcludes food and energy, rose 51 ⁄ 4 per-cent in 2006, up from the 43 ⁄ 4 percentincrease in 2005. The index increased atan annual rate of 71 ⁄ 4 percent in the firsthalf of 2006, but it decelerated to anannual rate of about 31 ⁄ 4 percent in thesecond half as energy costs declined.

For the year as a whole, measures of long-term inflation expectations re-

mained well anchored, although short-term expectations were heavily influ-enced by fluctuations in energy prices.The Reuters/Michigan survey measureof the median expectation of householdsfor inflation over the next twelve monthswas about 3 percent in December, downfrom its peak of 33 ⁄ 4 percent in August.Longer-term inflation expectations re-corded in the Reuters/Michigan surveyshowed less variability. The median sur-vey respondent in December expectedthe rate of inflation during the next fiveto ten years to be 3 percent, down fromits peak of 31 ⁄ 4 percent in August. Otherindicators likewise suggest that longer-run inflation expectations have remainedcontained. According to the Survey of Professional Forecasters, conducted by

the Federal Reserve Bank of Philadel-phia, expectations of inflation over thenext ten years remained at 21 ⁄ 2 percentin 2006, a level that has been essentiallyunchanged since 1998. In addition, in-flation compensation implied by the

spread of yields on nominal Treasurysecurities over their inflation-protectedcounterparts stayed within the relatively

narrow range of 2 percent to 23

⁄ 4 percentduring the year.

U.S. Financial Markets

Financial conditions in the United Statessupported economic growth in 2006.Yields on long-term Treasury securitiesclimbed a bit, on balance, but stayedlow by historical standards, while strong

corporate profits helped fuel substantialgains in equity markets. Liquid corpo-rate balance sheets and low corporateleverage helped keep risk spreads oncorporate bonds narrow. Meanwhile,business borrowing picked up to a rapidpace, spurred in part by a rise in mergerand acquisition activity. In the residen-tial real estate sector, mortgage borrow-ing slowed markedly, as house prices

decelerated, especially in the second half of the year. Consumer credit expandedat a moderate pace. Nonetheless, house-hold debt growth outpaced the growthof disposable personal income, and thefinancial obligations of householdsinched higher. Although householdsgenerally appeared able to meet theirobligations, signs of financial strainwere apparent in subprime variable-ratemortgages. The M2 monetary aggregateexpanded at a moderate pace in 2006.

Interest Rates

Market interest rates rose modestly, onbalance, in 2006—yields on two- andten-year nominal Treasury securitiesincreased about 40 and 30 basis points

respectively. Changes in interest ratesseemed largely tied to changes in theoutlook for economic growth and infla-tion. Rates across the maturity spectrumincreased notably over the first half of the year, as incoming data on activity




and inflation came in higher than mar-kets had expected and as the FOMCraised the target federal funds rate25 basis points at each of its first fourmeetings. At the time of the June FOMCmeeting, interest rate futures market

quotes indicated that market participantsperceived considerable odds of an addi-tional rate tightening by year-end. How-ever, market interest rates declined, onnet, over subsequent months in responseto incoming data suggesting that infla-tion pressures were moderating and thateconomic growth was slowing. Marketexpectations for the trajectory of thefederal funds rate over the next severalyears shifted down considerably duringthe second half of the year. Morerecently, market participants havebacked away from expectations of a sub-stantial easing of monetary policy asincoming data on economic activityhave been stronger than expected. Inves-tors now expect the FOMC to ease pol-icy only slightly over the next two years.

Although investors modestly revisedtheir medium-term policy expectationsover the course of the year, the Commit-tee’s interest rate decisions were largelyanticipated in financial markets by thetime of each meeting. Throughout the

year, forward-looking measures of un-certainty about monetary policy inferredfrom interest rate options remained near

the low end of historical ranges.Yields on inflation-indexed Treasury

securities increased about as much asthose on their nominal counterparts in2006. Medium- and long-term inflationcompensation—measured from spreadsbetween yields on nominal andinflation-indexed securities—were aboutunchanged to a little lower, on net, andduring the year these measures exhib-

ited only modest swings in response toincoming inflation data and oil pricemovements.

In the corporate bond market, yieldson investment-grade securities movedabout in line with those on comparable-maturity Treasury securities. In contrast,yields on speculative-grade securitiesfell slightly, pulling risk spreads lowerin that segment of the market. The nar-

rowness of investment- and speculative-grade spreads seems to reflect investors’sanguine perceptions of corporate creditquality over the medium term, whichlikely reflect in large part the strength of

1

2

3

4

5

Percent

20072006200520042003

Interest Rates on Selected TreasurySecurities, 2003–07

Ten-year

Three-month

Two-year

NOTE: The data are daily and extend through Feb-ruary 7, 2007.

SOURCE: Department of the Treasury.

+

_0

2

4

6

8

10

Percentage points

20072005200320011999

Spreads of Corporate Bond Yields overComparable Off-the-Run Treasury Yields,1998–2007

BBB

High-yield

AA

NOTE: The data are daily and extend throughFebruary 7, 2007. The ten-year high-yield, ten-yearBBB, and ten-year AA indexes are compared with theten-year Treasury yield.

SOURCE: Derived from smoothed corporate yieldcurves using Merrill Lynch bond data.




business balance sheets and a benigneconomic outlook. The term structure of forward risk spreads for corporate bonds

supports this view, as forward spreadsone and two years ahead are low, whilethe spreads further out the curve aremore in line with historical norms.

Equity Markets

Broad equity indexes soared 10 percentto 20 percent in 2006, boosted by stronggrowth in corporate earnings. Share

prices rose across a wide range of sec-tors, but increases in telecommunica-tions and security brokerage stocks wereespecially noteworthy. The differencebetween the twelve-month forwardearnings-price ratio for the S&P 500 andthe long-term real Treasury yield—acrude measure of the premium that in-vestors require for holding equityshares—was little changed on balance.The implied volatility of the S&P 500calculated from options prices spikedtemporarily in the late spring in connec-tion with a period of strain in severalmarkets but remained near historicallows for the remainder of the year. Netinflows into domestic equity mutualfunds were quite modest in 2006, while

inflows into international equity fundswere exceptionally strong.

Market Functioning andFinancial Stability

Overall, financial markets functionedsmoothly over the year and proved resil-ient to several shocks. Equity marketsin the United States and currency andfixed-income markets in severalemerging-market economies experi-enced heightened volatility late in the

second quarter, but the turbulence wasshort lived. The liquidation of a fewsizable hedge funds attracted consider-able attention for a time but had littlediscernible effect on the broad function-ing of markets. Even the liquidation of Amaranth—a hedge fund that waswound down in the fall after reporting aloss in excess of $6 billion, mostly inenergy trades—left little imprint on

financial markets, although it raisedsome concerns about risk-managementpractices. Implied volatilities, risk spreads, and various other potentialmeasures of financial stress generallystayed at very low levels throughout theyear, suggesting that investors werecomfortable taking on risk, likely in partbecause they were confident about theeconomic and financial outlook.

Throughout the year, bid-ask spreadson the most actively traded Treasurysecurities remained within narrowranges. Some instances of questionabletrading activities occurred in the second-ary market for Treasury securities overthe course of the year. The InteragencyWorking Group for Treasury MarketSurveillance monitored these situations

closely.1

In November, the FederalReserve Bank of New York arranged a

1. The group was established in 1992 andincludes representatives from the Board of Gover-nors of the Federal Reserve System, the Treasury,the Securities and Exchange Commission, the

90

100

110

120

130

January 3, 2005 = 100

200720062005

Stock Price Indexes, 2005–07

Russell 2000

Wilshire 5000

NOTE: The data are daily and extend through Feb-ruary 7, 2007.

SOURCE: Frank Russell Company; Dow JonesIndexes.




meeting with all primary dealers to dis-cuss developments in Treasury marketsand to encourage the firms to review

their internal oversight of trading opera-tions. Subsequently, a private-sectorgroup sponsored by the Federal ReserveBank of New York released a draft re-port laying out a set of best practices forfirms active in the Treasury market ontopics such as appropriate trading strat-egies and internal controls.

In July, the Federal Reserve Boardimplemented a revision to the treatment

of GSEs and certain international orga-nizations under its Policy on PaymentsSystem Risk. Under the change, interestand redemption payments on securitiesissued by these institutions are now re-leased only when the issuer’s FederalReserve account contains sufficientfunds to cover the payments; that is,these institutions no longer may employdaylight credit to fund such payments.The Board of Governors determined thatthe change represents an appropriaterisk-management policy for the centralbank and is consistent with the generalpractices of private issuing and payingagents. In addition, GSEs and interna-tional organizations are now subject to apenalty fee for daylight overdrafts re-sulting from general corporate paymentactivity (activity other than interest andredemption payments). This changealigns the policy for GSEs and interna-tional organizations with that for otherFederal Reserve account holders that donot have regular access to the FederalReserve’s discount window and thus arenot eligible for intraday credit. The tran-sition to the new policy occurredsmoothly with minimal effects on the

functioning of the payments system andno notable adverse effects on short-termfunding markets.

Following up on a meeting with theFederal Reserve Bank of New York inthe fall of 2005, the largest participants

in the fast-growing market for creditderivatives agreed to a series of steps tostrengthen that market’s infrastructure.Over the course of 2006, credit deriva-tives dealers phased out the practice of transferring positions to a differentcounterparty without first obtaining theconsent of the original counterparty.They also reduced by 85 percent thenumber of trade confirmations outstand-

ing more than thirty days; they doubledthe share of trades that are confirmedvia an electronic platform, to 80 percentof total trade volume; and they agreedupon a new protocol for the settlementof such derivatives after a credit event.

Debt and Financial Intermediationby Banks

Total debt of the domestic nonfinancialsectors expanded an estimated 73 ⁄ 4 per-cent in 2006, well below the pace in2005 but still faster than that of nominalincome. Debt growth slowed markedlyin the household and government sec-tors, but business debt accelerated.

About 30 percent of the growth innonfinancial sector debt in 2006 wasintermediated by the banking sector.This share is about even with the aver-age over the past ten years and is about5 percentage points above the averageobserved in the 1980s and early 1990s.Commercial bank credit expanded91 ⁄ 2 percent in 2006, supported by brisk growth in loans to businesses. Bank credit also was boosted in the autumn bya consolidation of a substantial volume

of thrift assets onto a commercial bank ’sbalance sheet that had resulted from aninternal reorganization at a large bank holding company.

Bank lending to businesses throughcommercial and industrial loans in-

Commodity Futures Trading Commission, and theFederal Reserve Bank of New York.




creased at a rapid pace last year. Thegrowth was fueled by vigorous mergerand acquisition activity, rising outlays

for investment goods, ongoing inven-tory accumulation, and an accommoda-tive lending environment. Bank loanssecured by commercial real estate,though strong, decelerated over thecourse of the year. The moderation incommercial real estate lending was con-sistent with responses by large andmedium-sized banks to the Senior LoanOfficer Opinion Survey on Bank Lend-

ing Practices, which pointed to slowingdemand and a net tightening of creditstandards for such loans in the secondhalf of the year. Consumer loans andresidential mortgages held by banksgrew at a moderate rate for the year as awhole. However, excluding the effectsof the thrift consolidation, residentialreal estate lending slowed considerablyin the fourth quarter, no doubt reflecting

in part the downturn in the housingmarket.

Commercial bank profits as a percent-age of average assets were strong in2006 and rose slightly above 2005 lev-els. Net interest margins declined a bitfurther, likely in response to continuedcompetitive pressures and a modest in-version of the yield curve, but bank profitability was supported by growth innon-interest income and by well-contained costs. Continued strong assetquality also helped to support profitabil-ity in 2006 by allowing banks to reducetheir loan-loss provisioning. Robust as-set quality was reflected in loan delin-quency and charge-off rates that re-mained at low levels through the end of 2006.

The M2 Monetary Aggregateand Reserves

M2 expanded at a 5 percent rate lastyear, somewhat faster than in 2005.

Typically, as short-term interest ratesrise, deposit rates lag somewhat, in-creasing the opportunity cost of holding

money. In 2006, this effect apparentlyslowed money growth less than wouldhave been expected on the basis of his-torical norms, and the velocity of M2rose only about 3 ⁄ 4 percent. Retail moneymarket mutual funds and small time de-posits, components of M2 whose yieldsmove most closely with market rates,grew rapidly. However, liquid deposits,which constitute the largest component

of M2, and whose yields adjust moregradually, were about flat on net. Cur-rency expanded a modest 31 ⁄ 2 percent,an increase similar to that in 2005, re-flecting weak, possibly negative, net de-mand from overseas.

Part of the Financial Services Regula-tory Relief Act of 2006 gave the FederalReserve authority, beginning in October2011, to pay interest on reserve balances

and to further reduce or eliminate re-serve requirements. At the OctoberFOMC meeting, the Chairman asked thestaff to prepare for the implementationof this legislation.

International Developments

Foreign economic growth was generallystrong in 2006, as expansion continuedin all major regions of the world. TheJapanese economy decelerated some-what but maintained positive growth,and the pace of activity in the euro areapicked up. Labor market conditions inboth areas improved. Emerging-marketeconomies also recorded solid growthlast year and experienced no apparentlasting ill effects from the brief period of

financial market volatility that hit someof them particularly hard in the latespring. Although there are signs thatsteps taken to slow growth of invest-ment in China have been effective, theChinese economy continued to grow




rapidly. Rising energy prices boostedconsumer price inflation in many areasof the world early last year, but mone-

tary tightening appears to have pre-vented inflation from moving signifi-cantly higher, and the effects of higherenergy prices on core prices weremodest.

Industrial countries tightened mone-tary policy in 2006. Some countriespaused around the same time as theFederal Reserve, and others continuedto tighten throughout the year. After

ending its policy of quantitative easingin the spring, the Bank of Japan (BOJ)raised its policy rate 25 basis points inJuly. Weak consumer spending and lowinflation have apparently deterred theBOJ from tightening since then. Withgrowth in the European economies firm-ing, concerns over inflationary pressuresprompted the European Central Bank toraise its policy rate five times last year,

to 3.5 percent. The Bank of Canadatightened 75 basis points in several stepsover the first half of the year but has leftthe overnight rate unchanged since then.After keeping its policy rate constant inthe first half of the year, the Bank of England tightened policy 25 basis pointsin August and November 2006 and inJanuary 2007. The statements accompa-nying each tightening cited the upsiderisks to inflation posed by low levels of spare capacity.

During the first half of 2006, ten-yearsovereign yields in the euro area, Can-ada, and Japan rose sharply on balance:Increases ranged from 45 basis points inJapan to 75 basis points in Germany.Yields on inflation-protected long-termsecurities in these economies also rose

during the first half of 2006 but not asmuch as nominal yields and thus im-plied a noteworthy rise in inflation com-pensation. These developments occurredlargely in reaction to continuing upwardpressures on inflation, which stemmed

from a further run-up in energy pricesand indications that global economicgrowth remained robust.

From their midyear highs, nominalgovernment benchmark bond yields fellnoticeably until about the beginning of December in most major advancedeconomies, as investors reacted tomoves in U.S. rates and evaluated theimplications for the global economy of the economic slowdown that seemed tobe under way in the United States. Overthis period, yields on ten-year nominal

bonds declined by amounts that rangedfrom about 25 basis points in the UnitedKingdom to about 70 basis points inCanada. Yields on inflation-indexed se-curities declined less; modest declinesin inflation breakeven rates were attrib-uted in part to lower energy prices in thesecond half of the year.

Since the beginning of December,however, nominal and indexed govern-

ment bond yields have risen once againin most advanced economies, partlybecause new data releases appeared toalleviate investors’ concerns that globaleconomic growth might slow apprecia-bly. Yields on both ten-year nominaland indexed securities have risen15 basis points in Japan and 25 to50 basis points in the euro area, theUnited Kingdom, and Canada sincetheir December lows. As a result, infla-tion breakeven rates have been littlechanged.

The Federal Reserve’s broadest mea-sure of the nominal trade-weightedexchange value of the dollar declined33 ⁄ 4 percent from the beginning of lastyear through early February of this year.Over that period, the dollar appreciated

21

⁄ 4

percent against the yen and 11

⁄ 2

per-cent against the Canadian dollar, but itdepreciated about 9 percent, on net,against the euro, almost 13 percentagainst sterling, and 4 percent againstthe Chinese renminbi. The renminbi’s




rate of appreciation stepped up in late2006 and early 2007, but daily fluctua-tions in the dollar-renminbi exchangerate were very small.

Most of the dollar’s overall decline in

2006 occurred between mid-April andearly May. During this period, marketparticipants reportedly sensed that theFOMC was approaching the end of itsseries of policy tightenings, and interestrate differentials moved against the dol-lar. Traders also refocused on the largeand persistent U.S. current account defi-cit, which was further boosted by crudeoil prices that had moved above $70 perbarrel. To date in 2007, the dollar’sbroad nominal exchange value has risen1 percent on balance.

In the wake of strong advances in2005, major global equity indexesposted solid gains, on balance, in 2006and in early 2007. After rising 5 percentto 10 percent in the first quarter of 2006,most global indexes fell sharply begin-

ning in early May to reach intra-yearlows in mid-June. Market participantsattributed the drops in share prices toincreased uncertainty about prospectiveinflation, caused in part by the run-up inenergy prices, and to a retreat from risk-

taking. Broad-based gains in stock prices since midsummer appear to beassociated with a scaling back of expec-

tations for future tightening of monetarypolicy in several countries and withdeclines in energy prices. Since mid-June, broad stock market indexes havegained 10 percent to 20 percent inEurope, Japan, and Canada.

Industrial Economies

After increasing at an annual rate of

roughly 2 percent in the first half of 2006, Japanese real GDP grew only3 ⁄ 4 percent in the third quarter, largelybecause of slower growth of consump-tion. Capital spending was an importantcontributor to growth of outputthroughout the year, supported by strongcorporate profitability. Labor marketconditions continued to improve; the un-employment rate was about 4 percent in

December, its lowest level since 1998,and the ratio of job offers to applicantsremained close to a thirteen-year high.However, wage growth was verysubdued, as firms controlled costincreases, and unit labor costs continuedto fall. In 2006, consumer prices startedto rise again, posting small twelve-month increases after June, and landprices in Japan’s six largest cities rosefor the first time since 1991. However,the GDP deflator continued to declineslowly.

Real GDP in the euro area acceleratedsomewhat in 2006, posting averagegrowth of 31 ⁄ 4 percent at an annual rateover the first three quarters. Outputgrowth was supported in part by strongconsumer spending, which grew sub-

stantially faster than in 2005. Thestronger performance of the economywas reflected in improving labor marketconditions: The unemployment rate inthe euro area fell 0.8 percentage pointduring the year to reach 7.5 percent in

90

100

110

Week ending January 2, 2004 = 100

2007200620052004

U.S. Dollar Exchange Rate againstSelected Major Currencies, 2004–07

U.K. pound

Euro

Japanese yen

Canadiandollar

NOTE: The data are weekly and are in foreigncurrency units per dollar. The last observation for eachseries is the average for February 5 through February 7,2007.

SOURCE: Bloomberg L.P.




December, continuing a downwardmovement that began in 2004. Wagesand salaries in the manufacturing and

services sector grew at an averageannual rate of 21 ⁄ 4 percent in the firstthree quarters of the year—a bit lowerthan their rate of growth in 2005. Higherenergy prices boosted euro-area con-sumer price inflation, which rose toabout 21 ⁄ 2 percent in the first half of 2006; late in the year, it dropped belowthe European Central Bank ’s target ceil-ing of 2 percent. Core inflation remained

near 11 ⁄ 2 percent.Real GDP in the United Kingdom

grew 3 percent last year, and real GDPin Canada grew 3 percent, on average,through the first three quarters. Despitedeclining consumer confidence in theUnited Kingdom, the pace of consump-tion growth over the year was slightlyhigher than in 2005, and consumerspending in Canada, supported by mod-erate employment growth, also remainedrobust. Declines in energy pricesbrought Canadian consumer price infla-tion down after the middle of the year toa twelve-month change of about 11 ⁄ 2 per-cent in December, below the Bank of Canada’s 2 percent inflation target. In-flation in the United Kingdom edged upthroughout the year, partly because of

increases in electricity and natural gasprices that were implemented in the fall.

Emerging-Market Economies

Real GDP growth in China remainedstrong but moderated a bit in the secondhalf. The mild slowdown suggests thatthe administrative measures put in place

by the Chinese authorities to cool invest-ment have had an effect. The trade sur-plus recorded a substantial increase in2006. Four-quarter inflation picked upnear the end of last year to over 2 per-cent, reflecting higher food prices.

Elsewhere in emerging Asia, eco-nomic performance was generally solidin 2006. In Korea, GDP growth slowed

from the strong pace registered in 2005,partly because of monetary tightening,and consumer price inflation remainedmodest. The pace of growth in othercountries stayed strong throughout 2006as a result of robust exports and, insome cases, strengthening domestic de-mand. Four-quarter inflation moderatedacross the region. That moderationresulted from the waning effects of ear-

lier reductions or removals of domesticfuel subsidies, but the previous tighten-ing of monetary policy in the region andan appreciation of exchange rates alsomade a contribution. Capital inflowsinto several Asian emerging-marketeconomies—particularly Thailand—inlate 2006 and early this year put upwardpressure on local currencies. Measurestaken by Thai authorities seemed to suc-

ceed in limiting upward movement of the baht, but share prices in the Thaistock market fell sharply. Financial mar-kets in other countries in the regionwere less affected and showed no notice-able spillovers from events in Thailand.

Output growth in Mexico was excep-tionally strong in the first half of lastyear, especially in the manufacturing,construction, and services sectors.Growth stepped down in the secondhalf; construction activity remained ro-bust but was offset by a slowdown inexports of manufactured goods to theUnited States. Mexican consumer priceinflation was elevated during the secondhalf by higher food prices and reachedrates above the 4 percent upper limit of the central bank ’s inflation target range;

at year-end, inflation was still at the topend of the range.Brazilian output growth was solid in

the first quarter but slowed noticeablylater in the year, partly because of weak manufacturing performance. Brazilian




four-quarter inflation fell markedly,from almost 6 percent at the end of 2005to just over 3 percent in December. In

Argentina, steady growth in investmentand consumption kept real GDP on asolid uptrend throughout 2006. The Ar-

gentine government continued to at-tempt to bring down inflation throughvoluntary price agreements with produc-

ers in several sectors; although inflationhad edged down to the single-digit rangeby year-end, it was still high. Á




Monetary Policy Report of July 2006

Monetary Policy and theEconomic Outlook

The U.S. economy continued to expandat a brisk rate, on balance, over the firsthalf of 2006. Spending in the first quar-ter, which was especially robust, wastemporarily buoyed by several factors,

including federal spending for hurricanerelief and the effects of favorableweather on homebuilding. The pace of the expansion moderated in the spring,to some degree because the influence of these special factors dissipated. Morefundamentally, consumer spendingslowed as further increases in energyprices restrained the real incomes of households. In addition, home sales and

new homebuilding dropped back notice-ably from the elevated levels of lastsummer, partly in response to highermortgage interest rates. Outside of thehousehold sector, increases in demandand production appear to have been wellmaintained in the second quarter. De-mand for U.S. exports was supported bystrong economic activity abroad, andbusiness fixed investment remained on a

solid upward trend. Early in the year, asaggregate output increased rapidly, busi-nesses added jobs at a relatively robustpace, and the unemployment rate moveddown further. Since April, monthlygains in payroll employment have beensmaller but still sufficient to keep the

jobless rate steady.

Thus far in 2006, inflation pressureshave been elevated. Higher prices forcrude oil contributed to a further run-upin domestic energy costs; this year’sincreases, combined with the steepincreases in 2004 and 2005, not onlyboosted the prices of gasoline and heat-ing fuel but also put upward pressure on

the costs of production for a broad rangeof goods and services. Partly as a resultof these cost pressures, the rate of coreconsumer price inflation picked up.Nevertheless, measures of inflationexpectations remained contained, andthe rate of increase in labor costs wassubdued, having been held down bystrong gains in productivity and moder-ate increases in labor compensation.

Taking a longer perspective, the U.S.economy appears to be in the midst of atransition in which the rate of increasein real gross domestic product (GDP) ismoving from a pace above that of itslonger-run capacity to a more moderateand sustainable rate. An important ele-ment in the transition is the lagged effectof the changes in monetary policy sincemid-2004, changes that have been in-tended to keep inflation low and to pro-mote sustainable economic expansionby aligning real economic activity moreclosely with the economy’s productivepotential. Moreover, longer-term inter-est rates have risen, contributing toincreased borrowing costs for bothhouseholds 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 roughlystabilize. The resulting easing in infla-tion should help contain long-run infla-tion expectations.

Note: The discussion in this chapter consists of the text and tables from the Monetary PolicyReport submitted to the Congress on July 19,2006; the charts from that report (as well as earlierreports) are available on the Board’s web site, atwww.federalreserve.gov/boarddocs/hh.

35



Even as the rate of increase in realeconomic activity moderates, the pros-pects for sustained expansion of house-

hold and business spending appearfavorable. Higher energy prices have putstrains on household budgets, but oncethat effect fades, households should ex-perience gains in real income consistentwith the ongoing expansion of jobs.Household balance sheets remain gener-ally sound; although some pockets of distress have surfaced, average delin-quency rates on mortgages and other

consumer debt are still low. Similarly, inthe business sector, balance sheets arestrong, credit quality is high, and mostfirms have ready access to funds. Sus-tained expansion of the global economy,along with the effects of the earlierdepreciation of the foreign exchangevalue of the dollar, should support de-mand for U.S. exports. The potential forefficiency gains, as well as further

declines in the relative cost of capital,are likely to continue to spur capitalspending. Indeed, the ongoing advancesin efficiency should sustain solid growthof labor productivity, providing supportfor gains in real wages and income.

As always, considerable uncertaintiesattend the outlook. Regarding inflation,the margin between production and con-sumption of crude oil worldwide is quitenarrow, and oil markets are especiallysensitive to news about the balance of supply and demand and to geopoliticalevents with the potential to affect thatbalance; adverse developments couldresult in yet another surge in energycosts. Indeed, futures markets provideonly imperfect readings on the prospectsfor energy markets, as witnessed by the

fact that the surprises in crude oil pricesduring the past few years have beenpredominantly to the upside. In addi-tion, a further rise in prices of other,non-energy materials and commodities,if it materializes, could also intensify

cost pressures. Another risk is that theeffect on imported-goods prices of ear-lier declines in the foreign exchange

value of the dollar, which has been lim-ited to date, could become larger. Morebroadly, if the higher rate of core infla-tion seen this year persists, it could in-duce a deterioration in longer-run infla-tion expectations that, in turn, mightgive greater momentum to inflation.However, the risks to the inflation out-look are not entirely to the upside. In thecurrent environment of elevated profit

margins, competitive forces, both indomestic markets and from abroad,could impose significant restraint on thepricing decisions of businesses.

Regarding risks to the outlook for realactivity, rates of increase in real GDPhave been uneven during the past year,complicating the assessment of whetherthe pace of the economic expansion ismoving into line with its underlying po-

tential rate. One possible risk to theupside is that the softer tone of therecent data on real activity will provetransitory rather than mark a shift to amore sustainable underlying rate of expansion. For example, slower spend-ing and hiring in recent months mayrepresent a shorter-lived adjustment to ahigher level of energy prices or to theunusually robust increases in economicactivity earlier in the year. In comingmonths, a sharp rebound in consumerspending accompanied by an accelera-tion of capital spending could return realactivity to a pace that would be unsus-tainable over the longer run. But down-side risks also exist. In particular, theslowing in real estate markets since lastsummer has been moderate, and the eas-

ing of house-price inflation has beengradual. If the softening in the demandfor housing and in real estate valuesbecomes more pronounced, the resultingdrop in construction activity and theerosion of household wealth could




weaken aggregate demand noticeably.Consumer spending might be depressedby the loss of income and wealth, and

that effect could be amplified if thedownturn is abrupt enough to shakehouseholds’ confidence about their abil-ity to finance spending or manage theircurrent financial obligations.

The Conduct of Monetary Policyover 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 meet-ing, available information suggested thatunderlying growth in aggregate demandwas solid at the turn of the year. Theexpansion of real GDP in the fourthquarter of 2005 was estimated to haveslowed temporarily, in part because of the disruptions associated with last au-

tumn’s hurricanes. Core inflation hadstayed relatively low, and inflation ex-pectations had remained contained. Withrising energy prices and increases inresource utilization having the potentialto add to inflationary pressures, theFOMC decided to extend the firming of policy that it had implemented over theprevious eighteen months by tighteningthe policy rate 25 basis points, to41 ⁄ 2 percent. The Committee indicatedthat some further policy firming mightbe needed to keep the risks to pricestability and to sustainable economicgrowth roughly in balance.

By March, economic activity ap-peared to be expanding rapidly, pro-pelled by robust consumer spending andaccelerating business investment. Al-

though readings on core inflation forJanuary and February were generallyfavorable, higher prices for energy andother commodities, together with rela-tively tight labor and product markets,threatened to add to existing inflation

strains. Against this backdrop, the Com-mittee raised the target federal fundsrate another 25 basis points, to 43 ⁄ 4 per-

cent. The statement released at the endof the meeting continued to point to thepossible need for further policy firming.

Data received by the time of the Maymeeting confirmed that the economyhad expanded robustly in the first quar-ter, though both consumer spending andhousing activity appeared to have mod-erated in late winter. In addition, infla-tionary pressures had intensified as core

consumer prices rose more rapidly inMarch than in earlier months. Inflationexpectations, as measured by some sur-veys and by comparisons of yields onnominal and inflation-indexed Treasurysecurities, also rose in April. The Com-mittee still judged those expectations tobe contained, but it was mindful that afurther increase could impart additionalmomentum to inflation, as could the

surge in energy and other commodityprices and the drop in the foreignexchange value of the dollar that took place in April and early May. To gaingreater assurance that inflationary forceswould not intensify, the FOMC decidedto raise the target federal funds rateanother 25 basis points, bringing it to5 percent. The FOMC also indicated inthe policy statement that some furtherpolicy firming could be required. How-ever, the Committee was aware that thecumulative effects of past monetary pol-icy actions on economic activity couldturn out to be larger than expected. Ac-cordingly, the FOMC stressed that theextent and timing of any further firmingwould depend importantly on the evolu-tion of the economic outlook as implied

by incoming data.By the time of the June meeting,available data appeared to confirm thateconomic growth had moderated fromthe strong pace evident earlier in theyear. Consumer spending had softened,

Monetary Policy Report of July 2006 37



and activity in housing markets had con-tinued to cool gradually. Evidence of inflationary pressures was accumulat-

ing, however, and core price inflationhad increased. In addition, the high lev-els of resource utilization and of theprices for energy and other commoditieshad the potential to spur further infla-tion. Consequently, the FOMC decidedto increase the target federal funds ratean additional 25 basis points, to51 ⁄ 4 percent. The Committee recognizedthat the moderation in the growth of

aggregate demand that appeared to beunder way would help to limit inflation-ary pressures over time, but it judgedthat, even after its policy action, someupside inflation risks remained. Yet theFOMC made clear that the extent andtiming of any additional firming neededto address those risks will depend on theevolution of the outlook for both infla-tion 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 con-tinues to seek further improvements.Between the March and May meetings,the Chairman appointed a subcommitteeto help the FOMC frame and organizethe discussion of a broad range of com-munication issues. At the June meeting,the Committee discussed the subcom-mittee’s plans for work in comingmonths and decided to begin its consid-eration of communication issues at itsAugust meeting and to lengthen meet-ings later this year to allow a fullerdiscussion of these issues.

Economic Projections

for 2006 and 2007In conjunction with the FOMC meetingat the end of June, the members of theBoard of Governors and the FederalReserve Bank presidents, all of whom

participate in the deliberations of theFOMC, provided economic projectionsfor 2006 and 2007. In broad terms, theparticipants expect a sustained, moder-ate expansion of real economic activityduring the next year and a half. Thecentral tendency of the FOMC partici-pants’ forecasts for the increase in realGDP is 31 ⁄ 4 percent to 31 ⁄ 2 percent overthe four quarters of 2006 and 3 percentto 31 ⁄ 4 percent in 2007. The central ten-dency of their forecasts for the civilian

unemployment rate is 43

⁄ 4

percent to5 percent in the fourth quarter of thisyear, and the jobless rate is expected tostill be in that range at the end of 2007.For inflation, the central tendency of theforecasts is an increase in the price in-

Economic Projections for 2006 and 2007

Percent

Indicator

Federal Reserve Governorsand

Reserve Bank presidents

RangeCentral

tendency

2006


Nominal GDP . . . . . . . . . . . . 51 ⁄ 2–61 ⁄ 2 6–61 ⁄ 4Real GDP . . . . . . . . . . . . . . . . 3–33 ⁄ 4 31 ⁄ 4–31 ⁄ 2PCE price index excluding

food and energy . . . . . . 21

⁄ 4–3 21

⁄ 4–21

⁄ 2

Average level, fourth quarter Civilian unemployment

rate . . . . . . . . . . . . . . . . . 41 ⁄ 2–5 43 ⁄ 4–5

2007


Nominal GDP . . . . . . . . . . . . 43 ⁄ 4–6 5–51 ⁄ 2Real GDP . . . . . . . . . . . . . . . . 21 ⁄ 2–31 ⁄ 4 3–31 ⁄ 4PCE price index excluding

food and energy . . . . . . 2–21

⁄ 4 2–21

⁄ 4

Average level, fourth quarter Civilian unemployment

rate . . . . . . . . . . . . . . . . . 41 ⁄ 4–51 ⁄ 4 43 ⁄ 4–5

1. Change from average for fourth quarter of previousyear to average for fourth quarter of year indicated.




dex for personal consumption expendi-tures excluding food and energy (corePCE) of 21 ⁄ 4 percent to 21 ⁄ 2 percent over

the four quarters of 2006; in 2007, theforecast shows a slower rate of 2 percentto 21 ⁄ 4 percent, which is similar to therate of core PCE price inflation in 2004and 2005.

A slowing in activity now appears tobe under way in the housing sector,where home sales and residential con-struction have receded from the elevatedlevels of last summer. The associated

easing in house-price appreciation willlikely temper gains in household wealth,which, over time, may be a factor indamping consumer spending. However,households’ financial positions shouldreceive a boost from an acceleration of real income if energy prices stabilize assuggested by futures markets. In thebusiness sector, participants view theoutlook for fixed investment over the

forecast period as positive. Althoughoutlays for new equipment and softwaremay increase a little more slowly withthe deceleration in real output, invest-ment opportunities appear to remain at-tractive: The relative user cost of capitalfor equipment, particularly high-technology items, is expected to remainfavorable, and competitive pressuresshould maintain strong incentives to ex-ploit opportunities for efficiency gainsand cost reduction. At the same time,nonresidential construction seems likelyto continue to move up. Finally, thestrong performance of the economies of the United States’ major trading part-ners should continue to stimulate U.S.exports of goods and services.

The more moderate pace of expan-

sion and the stability in resource utiliza-tion, when coupled with less pressurefrom the prices of energy and other com-modities, should contribute to an envi-ronment in which inflation expectationsare contained and inflation edges lower.

Moreover, ongoing solid gains in pro-ductivity should work to limit increasesin unit labor costs.

Over the next year and a half, FOMCparticipants expect the economy toachieve a sustainable rate of economicexpansion. That rate will be determinedin large part by the rate of increase inproductivity. Productivity has been ris-ing at a solid rate over the past twoyears, albeit more slowly than the espe-cially rapid pace that prevailed duringthe first three years of the expansion. A

strong trend in productivity is likely tobe maintained as businesses take advan-tage of new investment in facilities andequipment, as diffusion of technologycontinues, and as organizational ad-vancements and business process im-provements yield further increases inefficiency.

Economic and FinancialDevelopments in 2006

Although last year’s hurricanes causedthe pace of aggregate economic activityaround the turn of the year to be uneven,real GDP increased at an average annualrate of 3.6 percent in the final quarter of 2005 and first quarter of 2006—aboutthe same pace that prevailed during thepreceding year and a half. Over thisperiod, payroll employment posted addi-tional solid gains, and the unemploy-ment rate declined further. In recentmonths, the incoming information onreal activity has suggested that the paceof the expansion is moderating, with thedeceleration in spending most apparentin the household sector. Still, as of mid-year, resource utilization in labor and in

product markets remained high.Inflation picked up over the first fivemonths of the year, boosted importantlyby the effects of rising energy prices.Long-term inflation expectations fluctu-ated over the period but remained con-




tained, and increases in unit labor costswere subdued. Although short-term mar-ket interest rates rose in line with the

FOMC’s firming of monetary policy,financial market conditions were stillgenerally supportive of economicexpansion in the first half of 2006.Long-term interest rates rose but werestill moderate by historical standards,and credit spreads and risk premiumsstayed narrow.

The Household SectorConsumer Spending

After increasing at a robust rate aroundthe turn of the year, consumer spendinghas been rising at a more moderate pacein recent months. Over the first half of 2006, rising employment and the laggedeffect of increases in wealth continuedto provide support for spending by

households. However, consumers’ pur-chasing power was restrained by a fur-ther run-up in energy costs in the spring.

Sales of new cars and light trucksbounced back sharply at the turn of theyear; those sales had slackened in late2005 after manufacturers ended the spe-cial “employee discount” programs thathad boosted sales last summer. Newlight vehicles sold at an annual rate of 16.8 million units between January andApril, about the same as the average ratein 2004 and 2005. However, elevatedgasoline prices affected the compositionof demand, and consumers shifted theirpurchases away from light trucks andsport-utility vehicles (SUVs) and to-ward autos. That shift led to an increasein the market share captured by foreign

producers. As households’ concernsabout the higher price of gasolineweighed on their attitudes toward buy-ing vehicles, sales dipped to an annualrate of 16.2 million units in May andJune.

Spending for other household goods,such as furniture, electronic equipment,food, and clothing, was quite strong in

the first quarter of 2006; real outlays forgoods other than motor vehiclesincreased at an annual rate of 83 ⁄ 4 per-cent. Some moderation was to beexpected after such a surge in spending.Estimates of retail sales, which areavailable through June, suggest that realexpenditures for these goods rose moreslowly in the second quarter. In contrastto the uneven pattern of spending for

goods, real outlays for consumer ser-vices remained on a moderate upwardtrend over the first half of 2006; theyrose at an annual rate of 21 ⁄ 2 percentfrom the fourth quarter of 2005 throughMay 2006.

Boosted by gains in nominal wageand salary income, after-tax aggregatepersonal income rose at an annual rateof 4 percent over the first five months

of 2006. However, the acceleration inconsumer prices held real income aboutconstant. As a result, the steep declinein the personal saving rate, which beganin 2004, extended into 2006. Since2003, rising household wealth hasprovided important support for spend-ing, even as gains in real income havebeen damped by increases in energyprices. In 2005 and the first part of 2006, much of the increase in wealthwas the result of the rapid appreciationin the value of homes.

According to the survey by the Uni-versity of Michigan Survey ResearchCenter (SRC), the run-up in energyprices contributed importantly to the de-terioration in consumer confidence thisspring. Consumers’ pessimism peaked

in May and then lessened somewhat, onaverage, in June and early July. None-theless, at midyear, households indi-cated that they were still concernedabout the effect of the high cost of energy on their financial situation. In




addition, households’ assessments of current and expected business condi-tions remained considerably less opti-

mistic than they were at the beginningof the year.

Residential Investment

The demand for homes had begun tosoften in the summer of 2005, and, bythe spring of 2006, starts of new single-family homes were well below the veryrapid pace that had prevailed in the pre-

ceding two years. The reduced level of activity in real estate markets also led tosome easing in house-price appreciationearly this year.

Sales of new and existing single-family homes, which had been climbingsteadily since 2003, stopped rising dur-ing the third quarter of 2005. By May,sales of new and existing homes to-gether were 71 ⁄ 4 percent below their

peak in June 2005. The cooling in salescaused inventories of unsold homes torise. In May, the backlog of unsold newhomes equaled 51 ⁄ 2 months’ supply atthat month’s selling rate, and the back-log of existing homes on the market was61 ⁄ 2 months’ supply; in 2005, the stocksof both unsold new and existing homesaveraged roughly 41 ⁄ 2 months of supply.

An increase in mortgage rates contrib-uted to the slackening in the demand forhousing. Since the middle of 2005, theaverage rate for a thirty-year fixed-ratemortgage has increased about 1 percent-age point, to 63 ⁄ 4 percent, and the aver-age for a one-year adjustable-rate mort-gage has risen a bit more, to 53 ⁄ 4 percent.According to respondents to the Michi-gan SRC survey, the rise in borrowing

costs has been an important consider-ation damping their assessment of buy-ing conditions for homes since mid-2005; the rise in home prices hasapparently also weighed on consumers’attitudes.

Although recent increases in houseprices have been smaller than those thataccompanied the robust real estate mar-

kets of 2004 and 2005, the decelerationthus far appears to have been modest.The repeat-transactions index of houseprices, which is published by the Officeof Federal Housing Enterprise Over-sight, increased at an annual rate of 71 ⁄ 4 percent in the first quarter of 2006,the smallest quarterly increase since thefourth quarter of 2001; that index at-tempts to control for the quality of exist-

ing single-family homes sold by usingprices of homes involved in repeat trans-actions (excluding refinancings). Thefirst-quarter reading brought the year-over-year change in this measure to 10percent; in the second and third quartersof 2005, purchase prices according tothis index were up 111 ⁄ 2 percent fromthe level of a year earlier. An alternativemeasure of house prices is the average

price of existing single-family homessold, which is published by the NationalAssociation of Realtors. This measure,which does not control for the type of homes sold, showed that the year-over-year change in prices peaked at111 ⁄ 2 percent in August 2005 and thenfell to 4 percent in April and May of thisyear. The greater deceleration in the lat-ter measure suggests that, in addition tosome softening in prices, the mix of existing units sold may have shifted to-ward lower-priced homes.

The effect of the slowdown in de-mand on new construction became ap-parent during the second half of 2005,when the number of permits issued fornew single-family homes began to fall.This year, the decline in permit issuance

was relatively steady from January toMay. Nonetheless, new single-familyhomes were started at an exceptionallyhigh annual rate of 1.75 million unitsduring the first quarter, when builderswere able to begin work on scheduled




projects earlier than normal because of favorable weather conditions. Withsome starts having been advanced into

the first quarter, single-family startsdropped to an average rate of 1.57 mil-lion units in April and May. In contrastto the recent trend in the single-familysector, construction of new multifamilyhomes averaged an annual rate of 360,000 units from January to May,about where it has been for more thanfour years.

Housing activity, as measured by real

expenditures on residential structures,contributed almost 1 ⁄ 2 percentage pointper year to the annual rate of increase inreal GDP in 2004 and 2005. In the firstquarter of 2006, that contributiondropped to 0.2 percentage point; withthe reduced pace of sales and construc-tion since the winter, a decline in resi-dential investment is likely to have helddown the rise in real GDP in the second

quarter.

Household Finance

Household debt expanded at an annualrate of about 111 ⁄ 2 percent in the firstquarter of 2006, about the same pace asin 2005. Despite the rise in mortgagerates and the slowing in housing activ-ity, home mortgage debt expanded rap-idly again early in the year as homeown-ers apparently continued to extract someof the substantial gains in equity thatthey have accumulated on their homesin the past several years. Indeed, accord-ing to industry estimates, although thenumber of homeowners refinancingtheir mortgages has remained well be-low that seen during the refinancing

boom of several years ago, a large frac-tion of homeowners who have refi-nanced so far this year have chosen towithdraw equity from their homes. Ashas been the case in recent years, thismortgage-related borrowing likely re-

placed, in part, some consumer creditborrowing, which, at an annual rate of abit less than 3 percent, continued to

expand modestly in the first five monthsof 2006.

The ratio of household financial obli-gations to disposable income rose0.1 percentage point in the first quarterto about 183 ⁄ 4 percent, narrowly exceed-ing the top of its historical range. None-theless, the evidence points to only lim-ited pockets of financial distress in thehousehold sector. Delinquency rates on

residential mortgages were low by his-torical standards in the first quarter,though they have edged higher since themiddle of last year, particularly in thesubprime sector. Delinquency rates onconsumer debt also continued to be low.Meanwhile, household bankruptcy fil-ings remained subdued in the first half of 2006, running at a pace well belowthe average of recent years. Bankrupt-

cies have likely been damped this yearin part by the decision of some house-holds in the fall of 2005 to acceleratetheir filings to avoid the implementationof a stricter bankruptcy law in October.More recently, they may also have beenrestrained by the greater costs of bank-ruptcy under the new law.

The Business Sector

Fixed Investment

Real business fixed investment in-creased at a solid rate, on average, dur-ing the final quarter of 2005 and the firstquarter of 2006. Over that period, realbusiness spending for new equipmentand software rose at an annual rate of

93

⁄ 4

percent, a pace similar to that overthe first three quarters of 2005. In addi-tion, investment in nonresidential struc-tures, which had remained weak in2005, turned up noticeably in early2006. The underlying determinants of




capital spending have stayed quite posi-tive: Businesses have seen steadyincreases in sales, robust profits, and

declining user costs for equipment; theyhave ample liquid assets; and, despitethe rise in interest rates, credit quality isstrong.

Real outlays for equipment and soft-ware rose at an annual rate of 143 ⁄ 4 percent in the first quarter afterhaving risen at a 5 percent rate in thefourth quarter of 2005. As can often bethe case, the timing of spending for a

number of types of equipment was un-even between these two quarters. Busi-ness purchases of cars and trucks slowedin late 2005, after manufacturers re-duced their special discounts on lightvehicles, and then recovered in the firstquarter. The first-quarter rebound wasstrengthened by a further acceleration of outlays for medium and heavy trucks.According to industry analysts, busi-

nesses have been pulling forward thesepurchases because the engines in the2007 models will be required to meetnew emission regulations by the Envi-ronmental Protection Agency that willmake the new vehicles more costly tooperate. Deliveries of commercial air-craft to domestic customers also re-bounded in the first quarter from a verylow level in the fourth quarter.

Demand for high-technology equip-ment stepped up noticeably in the firstquarter because of a sharp jump in out-lays for communications equipment.Providers of telecommunications ser-vices appear to be investing heavily infiber-optic networks, which will allowthem to offer a wider range of Internetservices; the recent spurt likely also

includes some replacement demand forequipment damaged by last year’s hurri-canes. In contrast, business demand forcomputing equipment, while still in-creasing at a double-digit pace in realterms, has been relatively modest by

historical standards so far this year.Industry analysts suggest that firms maybe delaying investment in anticipation

of introductions, later this year and inearly 2007, of several products that willallow faster and more energy-efficientprocessing. Spending on equipmentother than transportation and high-techgoods continued to trend up at a solidpace, on average, during the fourth andfirst quarters. Demand was particularlystrong for metalworking and generalindustrial machinery as well as for

equipment used in construction, energyextraction, and services industries.

Demand for equipment and softwareappears to have risen again in the sec-ond quarter. The information from U.S.manufacturers on their orders and ship-ments of nondefense capital goods andthe data on imports of capital goodssuggest that business spending forequipment other than transportation and

high-tech items remained on a strongupward trajectory in April and May. Theelevated backlog of unfilled orders atdomestic firms likely provided supportfor factory production of capital equip-ment in the second quarter. The indica-tors of demand for high-tech equipmentsuggest that spending for communica-tions equipment remained at a highlevel, and real outlays for computingequipment were still rising slowly. Salesof medium and heavy trucks continuedto be robust in the second quarter,although they eased slightly from theexceptional rate at the beginning of theyear.

Real expenditures for nonresidentialconstruction increased at an annual rateof 121 ⁄ 2 percent in the first quarter after

having edged up slightly during 2005.Last year, the small net increase in thissector reflected a sharp upturn in spend-ing on structures used in domesticenergy exploration; construction of newoffice and industrial buildings was re-




strained by elevated vacancy rates.However, vacancy rates for office andindustrial properties gradually declined

over the course of 2005, and, by theturn of the year, nonresidential construc-tion began to firm. As a result, theincrease in nonresidential investment inthe first quarter of 2006 was broadlybased; it included pickups in outlays inthe office, retail, and industrial sectorsin addition to another steep rise inspending on structures associated withenergy exploration.

Inventory Investment

Business inventories appear generally tobe well aligned with sales. In surveystaken during the first six months of 2006, about two-thirds of purchasingmanagers at manufacturing firms whoresponded characterized the level of their customers’ inventories as about

right. A similar proportion of respon-dents at nonmanufacturing firms re-ported that they were comfortable withtheir own levels of inventories. How-ever, dealer stocks of new light motorvehicles, particularly trucks (includingSUVs), have risen noticeably as saleshave slowed; inventories of light trucksreached an uncomfortable 89 days’ sup-ply in May. In late June, a number of manufacturers introduced a new roundof incentives aimed at reducing dealerstocks in advance of the introduction of their new models this fall.

Corporate Profitsand Business Finance

Corporate profits were again strong in

the first quarter of 2006, and earningsper share for S&P 500 firms rose about15 percent from the same time last year.Gains were widespread but were espe-cially large for firms in the energy sec-tor. Before-tax profits of nonfinancial

corporations measured as a share of sec-tor GDP rose to about 14 percent in thefirst quarter, above the previous peak

reached in 1997.The expansion of business debt

picked up to an annual rate of nearly10 percent in the first quarter of thisyear, and data in hand suggest a robustpace in the second quarter. A substantialfraction of borrowing proceeds report-edly went to finance mergers and acqui-sitions in the first half of the year. Netbond issuance has been strong so far in

2006. Short-term borrowing by nonfi-nancial corporations stepped up in thefirst quarter of 2006 after slowing some-what in the fourth quarter of last year; itappears to have remained strong in thesecond quarter as well. Commercialpaper outstanding started rising again,on balance, after edging lower in 2005.Bank business loans outstandingexpanded at an annual rate of 151 ⁄ 2 per-

cent in the first quarter. Businesses ben-efited from a more accommodative lend-ing environment: For example, asignificant net fraction of respondents tothe Federal Reserve’s Senior Loan Offi-cer Opinion Survey on Bank LendingPractices in April 2006 noted that theirinstitutions had eased both standards andterms on commercial and industrialloans in the first three months of theyear. The most commonly cited reasonsfor the easing of lending policies weremore-aggressive competition from otherbanks and nonbank lenders, increasedliquidity in the secondary market forbusiness loans, and increased tolerancefor risk.

Gross equity issuance has remainedmoderate so far this year, while an el-

evated level of cash-financed mergersalong with record share repurchases hasproduced further sizable net equity re-tirements. Taken together, net fundsraised by nonfinancial corporations inthe credit and equity markets have been




slightly negative in 2006, an indicationthat nonfinancial corporations have fi-nanced their increased investment

spending with internal funds.With profitability strong and balance

sheets flush with liquid assets, creditquality in the nonfinancial business sec-tor generally has remained quite high.The six-month trailing default rate oncorporate bonds dropped after somelarge firms in the troubled airline andautomobile sectors defaulted during thepast fall and winter. Delinquency rates

on business loans have stayed near thebottom of their historical range.

Commercial real estate debt expandedbriskly in the first half of 2006, albeitnot as quickly as during 2005. Spreadson BBB-rated commercial-mortgage-backed securities have fallen this year.The decline reversed an increase thattook place at the end of last year, whenissuance surged; these spreads are now

back in line with those of comparable-quality corporate bonds. With rentsclimbing and vacancy rates falling, de-linquency rates on commercial real es-tate loans have been low, and creditquality has remained generally good.

The Government Sector

Federal Government

The deficit in the federal unified budgetnarrowed 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 thanduring the comparable period last year.The federal deficit over the twelvemonths ending in June was approxi-

mately 2 percent of nominal GDP andwas significantly lower than its recentfiscal year peak of 3.6 percent of GDPin 2004. Although outlays increasedfaster than nominal GDP over the pastyear, the rise in receipts was even larger.

Thus, in its recent Mid-Session Reviewof the budget, the Administration esti-mated that the federal government will

finish fiscal 2006 with a deficit of $296billion; that figure marks a decline fromthe fiscal 2005 deficit of $318 billionand is much lower than most analystshad projected at the beginning of thisyear.

During the twelve months ending inJune, federal receipts were 131 ⁄ 4 percenthigher than over the same period a yearearlier and equivalent to almost

181 ⁄ 4 percent of nominal GDP. Incometax receipts from individuals have out-paced the rise in nominal income; finaltax payments on income from 2005 wereespecially strong in April and May. Cor-porate tax payments continued to rise ata robust rate, even faster than corporateprofits.

Nominal federal outlays rose 9 per-cent between June 2005 and June 2006

and were about 201 ⁄ 2 percent of nominalGDP. The rise in outlays was bolsteredby increases in several components of federal spending. Net interest paymentsincreased 20 percent over the year end-ing in June as federal debt continued torise and interest rates increased. Medi-care outlays were up 141 ⁄ 2 percent; sincethe inception of the new Part D prescrip-tion drug program in January, outlaysfor benefits have added more than $20billion to spending in this category. Leg-islative actions related to the hurricanesin the Gulf Coast region last autumnhave added significantly to spending fordisaster relief over the past ten months.Although defense spending has slowedfrom the annual double-digit rates of increase from 2002 to 2004, it still has

increased about 8 percent per year in thepast two years.As measured in the national income

and product accounts (NIPA), real fed-eral expenditures on consumption andgross investment—the part of federal




spending that is a direct component of real GDP—increased at an annual rateof 33 ⁄ 4 percent, on average, during the

final calendar quarter of 2005 and thefirst calendar quarter of 2006 and con-tributed roughly 0.3 percentage point tothe annualized change in real GDP overthe period. Over these two quarters, realdefense purchases were about constant,on average, while spending related todisaster relief from the hurricanes con-tributed importantly to a rise in realnondefense purchases.

The narrowing of the federal deficitrecently has reduced its drain on na-tional saving. However, net national sav-ing excluding the federal governmenthas remained low relative to historicalnorms. Although the saving rate for pri-vate business has moved up during thepast two years, the improvement hasbeen offset by the further decline inpersonal saving. Overall, national sav-

ing, net of depreciation, stood at21 ⁄ 2 percent of nominal GDP in the firstquarter of 2006. Although the recentrate is a noticeable improvement fromthe lows of the preceding few years, ithas been insufficient to avoid an increas-ing reliance on borrowing from abroadto finance the nation’s capital spending.

Federal Borrowing

Federal debt rose at an annual rate of 13 percent in the first quarter, a bit lessthan in the corresponding quarter of 2005. In February, federal debt subjectto the statutory limit reached the ceilingof $8.184 trillion, and the Treasury re-sorted to accounting devices to avoidbreaching the limit. The Congress sub-

sequently increased the debt ceiling to$8.965 trillion in March. In the secondquarter, federal debt likely declined tem-porarily because of a surge in tax re-ceipts. On net, the Treasury has raisedsubstantially less cash in the market so

far this year than in the comparableperiod of 2005.

In February, the Treasury conducted

an auction of thirty-year bonds for thefirst time since 2001. The issue gener-ated strong interest, especially frominvestment funds; foreign investors wereawarded only a small fraction of thetotal. In general, foreign demand forTreasury securities appears to haveeased somewhat in 2006. The propor-tion of nominal coupon securitiesbought at auction by foreign investors

has continued to fall from its peak of 24 percent in 2004; it averaged about14 percent in the first six months of 2006. Data from the Treasury Interna-tional Capital system generally sug-gested subdued demand from both for-eign private investors and foreignofficial institutions over this period. Theamount of Treasury securities held incustody at the Federal Reserve Bank of

New York on behalf of foreign officialand international accounts has changedlittle since the end of 2005.

State and Local Governments

The fiscal positions of states and locali-ties continued to improve through early2006. In particular, revenues are on track to post a relatively strong gain for athird consecutive year. Tax receipts fromsales, property, and personal and corpo-rate income were up 81 ⁄ 4 percent duringthe year ending in the first quarter of 2006, a rate similar to the increase in thepreceding year. The sustained strengthin revenues has enabled these jurisdic-tions to increase their nominal spendingsomewhat while rebuilding their reserve

funds. On a NIPA basis, net saving bystate and local governments—a measurethat is broadly similar to the surplus inan operating budget—rose to an annualrate of $211 ⁄ 2 billion in the first quarterof 2006 after having been close to zero




in 2005. Although most states have seenimprovement, a number of states arestill struggling with structural imbal-

ances in their budgets, and those in theGulf Coast region are coping with de-mands related to damage from lastyear’s hurricanes. In addition, local gov-ernments may face pressure to hold theline on property taxes after the sharpincreases in the past several years, andgovernments at all levels will have tocontend with the need to provide pen-sions and health benefits to a rising

number of retirees in coming years.Real expenditures by state and local

governments on consumption and grossinvestment, as estimated in the NIPA,rose at an annual rate of 11 ⁄ 2 percent inthe first quarter of 2006 after havingincreased roughly 1 percent per year in2004 and 2005. Real expenditures forinvestment turned up in the first quarterafter having fallen during the second

half of 2005. Real outlays for currentconsumption posted a moderate increasein the first quarter, and that trendappears to have continued into midyear.Hiring by state and local governmentswas slow early in the year but appears tohave firmed in the spring. Of the cumu-lative 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 govern-ments has slowed thus far in 2006. Thedeceleration likely reflects the generalimprovement in budget conditions and adecline in advance refundings, which

have dropped below their 2005 paceamid rising interest rates and a dwin-dling pool of eligible securities. Creditquality in the state and local sector hascontinued to improve, and upgrades of credit ratings have far outnumbered

downgrades. Consistent with the im-provement in credit quality, yields onlong-dated municipal bonds have in-

creased substantially less than those oncomparable-maturity Treasury securi-ties, and the yield ratio has accordinglyfallen sharply.

The External Sector

The U.S. current account deficit nar-rowed in the first quarter of 2006 to$835 billion at an annual rate, or about

61 ⁄ 2 percent of nominal GDP, from$892 billion in the fourth quarter of 2005. The narrowing resulted from threefactors. Unilateral transfer payments toforeigners dropped, largely because of adecrease in government grants. Thetrade deficit narrowed, primarily be-cause the value of imported oil and natu-ral gas declined. In addition, higherdirect investment receipts and lower

direct investment payments producedan increase in the investment incomebalance.

International Trade

Real exports of goods and servicesincreased 143 ⁄ 4 percent at an annual ratein the first quarter of 2006, far fasterthan the 61 ⁄ 2 percent rate recorded in2005. The surge in export growth in thefirst quarter resulted in part from arecovery in exports of many types of industrial supplies following a period of hurricane-related disruptions late lastyear. Exports of capital goods alsoincreased rapidly in the first quarter,with deliveries of aircraft to foreign car-riers exhibiting particular strength. The

first-quarter increase in exports waswidespread across destinations, a sign of robust economic activity in many partsof the world, and exports to Mexico andCanada showed especially large in-creases. Real exports of services rose




at an annual rate of about 61 ⁄ 2 percent inthe first quarter after increasing just23 ⁄ 4 percent in 2005. Available data for

nominal exports in April and May sug-gest that the increase in real exports wassmaller in the second quarter, held downin part by a drop in aircraft exports aftera strong first quarter.

Prices of exported goods increased atan annual rate of 23 ⁄ 4 percent in the firstquarter of 2006, a pace somewhat fasterthan in the second half of 2005. Pricesof non-agricultural industrial supplies

continued to increase steadily in the firstquarter, driven importantly by higherprices for oil and metals. An accelera-tion in prices for finished goods, espe-cially for capital and consumer goods,contributed to the faster pace of exportprice inflation in the first quarter. Theavailable data for the second quarterpoint to further increases in exportprices on the strength of additional run-

ups in the prices of non-agriculturalindustrial supplies, especially metals.

Real imports of goods and servicesrose at an annual rate of 103 ⁄ 4 percent inthe first quarter, slightly slower than inthe fourth quarter but still considerablyfaster than the 51 ⁄ 4 percent rate observedfor 2005 as a whole. Robust growth of real GDP in the United States supportedthe first-quarter increase in imports.Among categories of goods, largeincreases in imports of consumer goods,automotive products, and capital goods,particularly computers, more than offsetdeclines in imports of oil and some otherindustrial supplies. The rise in importsin the first quarter was widely distrib-uted across countries, and the increasesfor China and Mexico were especially

large. Real imports of services jumpedat an annual rate of 81 ⁄ 2 percent in thefirst quarter. Nominal imports in Apriland May point to an abrupt slowing of real imports in the second quarter fromthe first quarter’s rapid pace.

Prices of imported goods excludingoil and natural gas rose at an annual rateof about 1 percent in the first quarter of

2006,3

⁄ 4 percentage point faster than thepace in the second half of 2005. Pricesof material-intensive goods, such asnonfuel 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 fin-ished goods, such as consumer goodsand many kinds of capital goods, turnedup slightly. Available data for the sec-

ond quarter indicate that prices of fin-ished goods kept rising at a subduedpace. However, prices of material-intensive goods continued to increasesharply, a development reflecting higherprices for metals. The InternationalMonetary Fund’s index of global metalsprices rose 46 percent between Decem-ber 2005 and May 2006, largely becauseof robust global demand. In June, metals

prices retreated about 8 percent,although they remained well above thelevels of earlier this year.

The spot price of West Texas interme-diate crude oil increased from around$60 per barrel at the end of last year tomore than $75 per barrel in July, higherthan the peak that followed last year’shurricanes. Oil prices have been highlysensitive to news about both supply anddemand, particularly in light of the nar-row margin of worldwide spare produc-tion capacity. Global oil demand hascontinued to grow as the foreign eco-nomic expansion has spread, and devel-oping countries have posted the largestincreases in oil consumption. Recentevents in the Middle East—includingconcerns over Iran’s nuclear program,

violence in Iraq, and the recent conflictin Lebanon—have put additionalupward pressure on oil prices. In Nige-ria, attacks against oil infrastructurehave reduced oil production for most of this year. Government intervention in




energy markets also raised concernsabout supply from some countries: Inrecent months, Bolivia nationalized its

natural gas reserves, and Venezuela andRussia continued to tighten governmen-tal control of their energy industries.

The rise in the price of the far-datedNYMEX oil futures contract (currentlyfor delivery in 2012) to more than $70per barrel likely reflects a belief by oilmarket participants that the balance of supply and demand will remain tightover the next several years.

The Financial Account

The U.S. current account deficit contin-ues to be financed primarily by foreignpurchases of U.S. debt securities. For-eign official inflows in the first quartermaintained the strength exhibited in2005 but remained below the recordlevels of 2004. As in recent years, the

majority of these official inflows wereattributable to Asian central banks andhave taken the form of purchases of U.S.government securities.

Foreign private purchases of U.S. se-curities continued in the first quarter atthe extraordinary pace set in the secondhalf of 2005. Although private flowsinto U.S. Treasury bonds were signifi-cantly smaller than in recent quarters,this slowing was more than offset bylarger flows into agency bonds and equi-ties. Preliminary data for April and Maysuggest a slowdown in foreign pur-chases of U.S. securities relative to thefirst quarter. Foreign direct investmentflows into the United States continuedin the first quarter near last year’s aver-age levels.

Net purchases of foreign securities byU.S. residents, which represent a finan-cial outflow, strengthened slightly in thefirst quarter and continued at a solidpace in April and May. In addition, sig-nificant outflows were associated with

U.S. direct investment abroad, a reversalof some unusual inflows in the secondhalf of 2005. These second-half inflows

were prompted by the partial tax holidayoffered under the 2004 HomelandInvestment Act (HIA), which inducedthe foreign affiliates of U.S. firms torepatriate a portion of earlier earningsthat had been retained abroad. In thefirst quarter, the foreign affiliates par-tially unwound the HIA-induced flowsby retaining an unusually large portionof their first-quarter earnings. Increased

merger activity abroad also boosteddirect investment outflows in the firstquarter.

The Labor Market

Employment and Unemployment

Conditions in the labor marketcontinued to improve in the first half of

2006, although the pace of hiring hasslowed in recent months. Nonfarmpayroll employment increased 176,000per month during the first quarter, a rateroughly in line with the relatively brisk pace that prevailed during 2004 and2005. During the second quarter, hiringslowed, and monthly gains in payrollsaveraged 108,000 jobs per month. Overthe two quarters, the civilian unemploy-ment rate edged down further, to thelowest quarterly level of joblessness infive years.

In the first quarter, with homebuildingquite strong, hiring continued to be par-ticularly robust at construction sites; partof this strength was the result of favor-able weather, which allowed more con-struction activity than is typical during

the winter months. Although nonresi-dential construction activity was firmingby the spring, the pullback in housingstarts slowed the demand for residentialcontractors and workers in the buildingtrades. As a result, monthly additions to




construction industry payrolls declinedfrom more than 25,000 per month in thefirst quarter to just 3,000 per month in

the second quarter. Cutbacks at retailersalso were an important factor holdingdown the overall gain in employment inthe second quarter. After having beenstable early in 2006, employment atretail outlets fell almost 30,000 permonth between March and June; mostof the cutbacks occurred at generalmerchandisers.

In other sectors, employment re-

mained on a solid upward trend duringthe first half of the year. As has been thecase since mid-2004, establishmentsproviding education and health services,those offering professional and technicalbusiness services, and those involved infinancial activities, taken together,added more than 60,000 jobs per month.Employment in manufacturing, whichhad turned up at the end of 2005, rose

further over the first half of 2006.Expanding industrial production wasalso associated with further job gains inrelated industries, such as wholesaletrade and transportation. In addition, theincrease in energy production led to asustained rise in employment in thenatural resources and mining industryover the first half of the year.

The increase in job opportunities sofar in 2006 led to a further reduction inthe civilian unemployment rate, from anaverage of 5.0 percent in the second half of 2005 to 4.7 percent in the secondquarter of 2006. Although hiring moder-ated in the spring, layoffs remained low.New claims for unemployment insur-ance (UI) dipped below 300,000 perweek in January and February and then

fluctuated around a still-low level of about 315,000 per week for most of theperiod from March through early July.Over the first half of 2006, longer-termunemployment (fifteen weeks or more)also moved down, and the proportion of

UI claimants who remained on the un-employment rolls until the exhaustion of their benefits continued to recede.

After having edged up during 2005,the labor force participation rate wasrelatively stable over the first half of 2006 despite the ongoing improvementin labor market conditions. Rates formost broad age groups were littlechanged from last year’s levels. From alonger perspective, developments dur-ing the past decade highlight the impor-tance of structural as well as cyclical

influences on participation. The rise inthe attachment of adult women to theworkforce, which was a significant fac-tor in the secular rise in participationover much of the post-World War IIperiod, appears to have leveled off. Andthe aging of the population is increasingthe proportion of the workforce that is55 years and older; it rose from less than12 percent in 1996 to 163 ⁄ 4 percent in

recent months. Although older workershave tended in recent years to stay in thelabor force longer, their participationrate, at 38 percent in the second quarter,was less than half the rate for workerswho are age 25 to 54. Thus, the demo-graphic shift to an older population hasalready begun to reduce the overall rateof labor force participation and has off-set part of the rise in participation thathas been associated with the cyclicalupturn in job creation. The secularforces that are slowing the expansion of the labor force imply that the increase inemployment that is consistent with astable unemployment rate will, overtime, be smaller than it was during theperiod when labor force participationwas rising steadily.

Productivity and Labor Costs

After having advanced at an unusuallyrapid rate from 2001 to mid-2004, laborproductivity in the nonfarm business




sector increased at a more moderateannual rate of 21 ⁄ 2 percent from mid-2004 to early 2006. Nonetheless, by his-

torical standards, productivity perfor-mance recently has still been solid, withgains at a rate matching those during thesecond half of the 1990s. In an environ-ment of a sustained expansion of aggre-gate demand, businesses have graduallyadjusted their use of labor, capital, andservices to achieve ongoing gains inefficiency. Productivity has continuedto benefit importantly from investment

in new technologies, organizationalchanges, and improvements in businessprocesses, although the contributionfrom capital deepening has been smallerin recent years than it was during thecapital investment boom of the late1990s.

Broad measures of hourly labor com-pensation, which include both wagesand the costs of benefits, posted moder-

ate gains over the year ending in early2006 despite the run-up in headline priceinflation and the further tightening of labor markets. Both the employmentcost index (ECI) and the estimate of compensation per hour that uses datafrom the national income and productaccounts increased 23 ⁄ 4 percent betweenthe first quarter of 2005 and the firstquarter of 2006.1 Both series had re-ported higher rates of change in hourlylabor compensation a year earlier.

The deceleration in labor compensa-tion appears to have been associatedlargely with smaller increases in em-ployers’ benefit costs. The benefits com-ponent of the ECI was up just 3 percentbetween March 2005 and March 2006,compared with an increase of 5.5 per-

cent between March 2004 and March

2005. The cost of health insurance,which typically accounts for about one-fourth of overall benefit costs, rose just

43

⁄ 4 percent during the year ending inMarch 2006; between 2000 and 2005,these costs increased, on average,83 ⁄ 4 percent per year. Another likely con-tributor to the slower rise in benefitcosts over the past year was smalleremployer contributions to their defined-benefit pension plans; those costsdropped back somewhat after employersmade sizable payments to bolster those

pension assets in 2004.Indicators of the recent trend in the

wage component of worker compensa-tion have been providing mixed signals.As measured in the ECI, wages rose2.4 percent between March 2005 andMarch 2006, slightly less than in thepreceding two years. In contrast, theyear-over-year change in average hourlyearnings of production or nonsupervi-

sory workers—which refers to a nar-rower group of private nonfarm employ-ees and has tended to show greatercyclical variation than the ECI—hasincreased steadily over the past threeyears. Average hourly earnings rose3.9 percent over the twelve months end-ing in June 2006, compared with anincrease of 2.7 percent over the twelvemonths ending in June 2005.

Prices

Inflation pressures were elevated duringthe first half of 2006. The chain-typeprice index for personal consumptionexpenditures (PCE) rose at an annualrate of 41 ⁄ 4 percent between December2005 and May 2006. Over the same

period, core PCE prices increased at anannual rate of 2.6 percent, nearly0.6 percentage point faster than over thetwelve months of 2005.

Although energy prices eased tempo-rarily in February, they turned up

1. The Bureau of Labor Statistics (BLS) devel-oped a new ECI series and has provided data forthe changes in that series beginning in 2001. TheBLS considers the new ECI to be continuous withthe old series.




sharply again from March to May; as aresult, the PCE price index for energyincreased 13 percent (not at an annualrate) 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 inenergy prices has been associated withhigher prices for petroleum-based prod-ucts. The PCE price index for gasolineand motor fuel, which increased morethan 161 ⁄ 2 percent last year, climbedanother 24 percent (not at an annualrate) by May. Although recent data fromthe Department of Energy indicate thatgasoline prices fell back in June, theymoved up again in early July. Retailprices of gasoline this year have risenfaster than the cost of crude oil in partbecause of the additional cost of produc-ing and distributing reformulated prod-uct with ethanol. Also, the demand forfuel ethanol has been strong relative tothe current capacity to produce it. In

contrast, the consumer price of naturalgas has turned down this year as inven-tories have remained relatively high; theprice decline between January and Mayalmost completely reversed the steeprun-up that occurred last autumn.

Food price inflation remained moder-ate during the first five months of 2006;between December 2005 and May 2006,

the PCE price index for food and bever-ages increased at an annual rate of 21 ⁄ 4 percent. Retail prices of meat andpoultry have fallen so far this year.Domestic supplies of meat have beenample. Production has been expandingat a time when export demand for beef has been soft largely because of bans onimports of U.S. beef by Japan andKorea. Prices of processed food have

continued to rise at only a moderate ratedespite higher prices for grains; exportdemand for grains has been strong, andthe price of corn has been boosted bydemand from producers of ethanol.Prices for food consumed away fromhome, which typically are influencedheavily by labor and other businesscosts, have continued to increaserelatively rapidly, rising at an annual

rate of 33 ⁄ 4 percent over the first fivemonths of the year.

The pickup in core inflation in thefirst half of 2006 was evident in theindexes for both goods and services.Prices of consumer goods excludingfood and energy, which were unchangedin 2005, edged up at an annual rate of 3 ⁄ 4 percent this year. Prices of consumerservices also accelerated this spring; asa result, the PCE price index for non-energy services increased at an annualrate of 31 ⁄ 2 percent between December2005 and May 2006, compared with arise of 23 ⁄ 4 percent in 2005. In the threemonths ending in May, increases inhousing rents were especially steep; therise may reflect, in part, a shift in de-mand toward rental units because home

purchases have become less affordable.Another contributor to the higher infla-tion rate for consumer services has beenthe acceleration in the index for nonmar-ket services to an annual rate of 4 per-cent over the first five months of the

Alternative Measures of Price Change

Percent

Price measure2004

to2005

2005to

2006

Chain-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 1.9

Market-based PCE excludingfood and energy . . . . . . . . . . . 1.8 1.5

Fixed-weight (Q2 to Q2)Consumer price index . . . . . . . . . . 3.0 4.0

Excluding food and energy . . . 2.1 2.4

Note: Changes are based on quarterly averages of seasonally adjusted data.




year from 3 percent last year.2 Morebroadly, the pickup in core consumerprice inflation over the first five months

of 2006 likely is the result of the pass-through of higher energy costs to a widerange of goods and services.

The cost pressures from the increasein energy costs during the past threeyears have been apparent in rising pricesof inputs used in the production and saleof final goods and services. The pro-ducer price index for intermediategoods, excluding food and energy, rose

at an annual rate of 71 ⁄ 4 percent betweenDecember 2005 and May 2006; this in-dex rose 43 ⁄ 4 percent in 2005 and81 ⁄ 4 percent in 2004. In particular, pricesof industrial chemicals, fertilizer, andstone and clay products, for whichenergy represents a relatively high shareof the total costs of production, acceler-ated over the past several years. Thecosts of a number of important business

services, particularly transportation byair, rail, and truck, have also beenboosted by higher energy costs. Thepass-through of the costs of energy toconsumer prices is clear for a few items,such as airfares. For other componentsof core consumer price indexes, how-ever, the extent of the pass-through isharder to trace. Quantifying the extentof the pass-through is difficult, in partbecause it is diffused through a widerange of retail goods and services. Inaddition, the cost of energy is a smallshare of overall costs—and that sharehas been declining over time as busi-nesses adopt more energy-efficient tech-nologies and households reduce theirconsumption of energy. Nonetheless, thecumulative rise in energy costs in recent

years has been large enough to show

through to pricing of final goods andservices even as businesses have seentheir labor costs, which represent

roughly two-thirds of their costs, remainrestrained.

Near-term inflation expectations werealso influenced importantly over the firsthalf of 2006 by movements in energyprices, but, as of midyear, they wereonly slightly higher than they were atthe turn of the year. The Michigan SRCsurvey measure of the median expecta-tion of households for inflation over the

next twelve months held steady at3 percent during the first three monthsof the year but then rose sharply to4 percent in May as gasoline pricesclimbed. By early July, this measure of near-term inflation expectations droppedback to 3.1 percent. Longer-term infla-tion expectations remained within theranges in which they have fluctuated inrecent years. On average over the first

half of 2006, the median respondent tothe Michigan SRC survey continued toexpect the rate of inflation during thenext five to ten years to be just under3 percent. In June, the Survey of Profes-sional Forecasters, conducted by theFederal Reserve Bank of Philadelphia,reported expected inflation at a rate of 21 ⁄ 2 percent over the next ten years, anexpectation that has been roughly un-changed for the past eight years. Infla-tion compensation implied by the spreadof yields on nominal Treasury securitiesover their inflation-protected counter-parts rose slightly, on net, over the firsthalf of the year; in early July it was justabove 21 ⁄ 2 percent.

U.S. Financial Markets

U.S. financial markets functionedsmoothly in the first half of 2006 againstthe backdrop of increased volatility insome asset prices. Yields on nominalTreasury coupon securities rose about

2. These are services—such as foreign travel orthe financial services provided by banks—forwhich no prices based on market transactions areavailable; the Bureau of Economic Analysis mustimpute or estimate these indexes.




70 basis points, on net, through earlyJuly as investors came to appreciate thateconomic conditions and inflation pres-

sures required more monetary policytightening than they had expected at theend of 2005. Equity prices advanceduntil mid-May but then reversed thosegains. Apparently, evidence of increasedinflationary pressures and some softer-than-expected data on economic activityinduced market participants to revisedown their longer-term outlook for busi-ness profits and to perceive greater risks

to that outlook. With corporate balancesheets remaining strong and liquid, risk spreads on corporate bonds stayed low,an indication that the revision to theoutlook had not sparked broad concernsabout credit quality. Firms had ampleaccess to funds, and business-sector debtexpanded rapidly in the first quarter.The need to finance brisk merger andacquisition activity was one factor that

reportedly induced nonfinancial busi-nesses to tap the credit markets heavily.Bond issuance picked up noticeably, andcommercial and industrial loansincreased robustly. Banks continued toease terms and standards on such loans.Household debt expanded further in thefirst quarter amid rising house pricesand brisk cash-out refinancing activity.As was the case in 2005, the M2 mone-tary aggregate has advanced moderatelyso far in 2006.

Interest Rates

The FOMC increased the target federalfunds rate 25 basis points at each of itsfour meetings this year. These actionsbrought the rate to 51 ⁄ 4 percent, about 60

basis points above the rate expected atthe end of last year for early July. Incontrast to the situation earlier in thetightening cycle, when it was evident toinvestors that considerable monetarypolicy accommodation was in place and

had to be removed, market participantsmore recently have had to focus to agreater degree on economic data re-

leases and their implications for the out-look for economic growth and inflationto form expectations about near-termpolicy. Although the information cur-rently available suggests that growth of real output slowed appreciably in thesecond quarter, incoming price data havepointed to greater-than-expected infla-tionary pressures throughout the firsthalf of the year. Investors anticipated

that the FOMC would act to countersuch pressures, and the expected policypath moved upward, on balance, overthe first half of 2006. Nevertheless, mar-ket participants currently appear toexpect the target federal funds rate toease after the end of the year. Despiteinvestors’ apparent awareness thatmonetary policy decisions increasinglydepend on the implications of incoming

information for the economic outlook,the implied volatility on short-termEurodollar rates calculated from optionprices has remained near the low end of its historical range.

Yields on nominal Treasury couponsecurities rose about 70 basis pointsacross the maturity spectrum throughearly July, in part because of the expec-tations for firmer policy. In addition, itappears that a modest rebound in termpremiums, including investor compensa-tion for inflation risk, may have contrib-uted to the rise in longer-term rates;still, estimated premiums remain low byhistorical standards. Yields on inflation-indexed Treasury securities rose lessthan those on their nominal counter-parts, leaving inflation compensation at

medium- and long-term horizons 20 to30 basis points higher than at the turn of the year.

In the corporate bond market, yieldson investment-grade securities movedabout in line with those on comparable-




maturity Treasury securities throughearly July. In contrast, those onspeculative-grade securities rose only

about 40 basis points; as a result, risk spreads were 30 basis points lower inthat segment of the market. The narrow-ness of high-yield spreads was likely areflection of investors’ sanguine viewsabout corporate credit quality over themedium term, given the strength of busi-ness balance sheets and the outlook forcontinued economic expansion.

Equity Markets

Broad equity indexes changed little, onnet, through early July. Stock priceswere boosted up to the first part of Mayby an upbeat economic outlook and bystrong corporate earnings in the firstquarter. However, those gains were sub-sequently reversed as incoming dataclouded the prospects for economic

growth and continued to point to upwardpressures on inflation; the drop in shareprices was led by stocks that had loggedthe largest gains in the previous months,including those of firms with small capi-talizations and of firms in cyclically sen-sitive sectors. A measure of the equityrisk premium—computed as the differ-ence between the twelve-month forwardearnings–price ratio for the S&P 500and an estimate of the real long-termTreasury yield—has increased slightlyso far this year and remains near thehigh end of its range of the past twodecades. The implied volatility of theS&P 500 calculated from option pricesspiked temporarily in late May and earlyJune and remained somewhat elevatedcompared with its levels earlier in the

year.Net inflows to equity mutual fundswere very strong through April, as in-vestors were evidently attracted by thesolid performance of the equity marketup to that point. In May and June, how-

ever, investors withdrew funds as shareprices began to sag.

Debt and Financial Intermediation

In the first quarter of 2006, the total debtof domestic nonfinancial sectors ex-panded at an annual rate of 11 percent.The household, business, and federalgovernment components all increasedat double-digit rates, while state andlocal government debt advanced at

about a 6 percent pace. Preliminarydata suggest somewhat slower growthof the debt of nonfinancial sectors inthe second quarter. The slowdown isparticularly noticeable in the federaland state and local government sectors,where strong tax receipts held downborrowing. The available data alsopoint to somewhat reduced growth of nonfinancial business debt in the sec-

ond quarter.Commercial bank credit increased at

an annual rate of about 11 percent in thefirst quarter of 2006, a little faster thanin 2005, and picked up further to analmost 13 percent pace in the secondquarter. A continued rapid increase inbusiness loans was likely supported bybrisk merger and acquisition activity,rising outlays for investment goods, on-going inventory accumulation, and anaccommodative lending environment.Growth in commercial mortgages wasalso strong, as fundamentals in that sec-tor continued to improve. Despite aslowing of housing activity in recentmonths, residential mortgage holdingsexpanded robustly. However, highershort-term interest rates likely contrib-

uted to a runoff in loans drawn downunder revolving home-equity lines of credit. Consumer loans adjusted for se-curitizations decelerated in the secondquarter after rising at a solid pace in thefirst quarter.




Bank profitability remained solid, andasset quality continued to be excellent inthe first quarter. Profits were supported

by gains in non-interest income and re-ductions in loan-loss provisions thatmore than offset a rise in non-interestexpenses. Delinquency and charge-off rates remained low across all loan types.Delinquency rates on residential mort-gages on banks’ books edged lower inthe first quarter after moving up during2005. Charge-off rates on consumerloans declined to the lowest level seen

in recent years after a fourth-quartersurge in charge-offs on credit card loansthat was associated with the implemen-tation of the bankruptcy legislation inOctober of last year.

As the policy debate about the possi-bility of curbing the balance sheetgrowth of both Fannie Mae and FreddieMac continued, the combined size of themortgage investment portfolios at the

two government-sponsored enterprisesincreased about 1 percent over the firstfive months of 2006.

The M2 Monetary Aggregate

In the first quarter of 2006, M2 in-creased at an annual rate of about61 ⁄ 2 percent, but its expansion moder-ated in the second quarter to a 23 ⁄ 4 per-cent pace, likely because of some slow-ing in the growth of nominal GDP.Rising short-term interest rates contin-ued to push up the opportunity cost of holding M2 assets. Growth in liquiddeposits, whose rates tend to adjust slug-gishly to changes in market rates, wasparticularly slack. By contrast, the ex-pansion in retail money market funds

and, especially, small time deposits wasbrisk, as the yields on those instrumentskept better pace with rising market inter-est rates. Despite apparently modest de-mand from abroad, currency growth wasstrong in the first quarter but has slowed

since. The velocity of M2 rose at anannual rate of 21 ⁄ 4 percent in the firstquarter and appears to have continued to

rise in the second quarter.

International Developments

Foreign economic growth was strong inthe first quarter of 2006 as the expan-sion spread to all major regions of theworld. Accelerating domestic demandboosted growth in the foreign industrial

countries, especially Canada and theeuro area. Emerging-market economiescontinued to benefit from rapid exportgrowth, and Chinese economic activitywas also spurred by a surge in invest-ment spending. Data for the secondquarter suggest continued strong growthabroad but with moderation in somecountries. Rising energy prices havepushed up inflation in many countries

this year, but upward pressure on coreinflation has generally continued to bemoderate.

Foreign monetary policy tightened inthe first half of this year in the contextof solid growth and some heightenedinflation concerns. The European Cen-tral Bank (ECB) raised its policy rate1 ⁄ 4 percentage point in March and againin June, citing rapid credit growth andthe ECB’s expectation of above-targetinflation. At its July policy meeting, theBank of Canada kept its target for theovernight rate unchanged at 41 ⁄ 4 percent,but it had increased its target for theovernight rate 1 ⁄ 4 percentage point ateach of its previous seven policy meet-ings. On July 14, the Bank of Japan(BOJ) ended its zero-interest-rate policy

by raising its target for the call moneyrate to 1 ⁄ 4 percent for the first time since2001. Earlier, on March 9, the BOJ,announcing an end to its five-year-oldpolicy of quantitative easing, said that itwould 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 onindications of robust global growth andexpectations of additional tightening of monetary policy. Ten-year sovereignyields have risen roughly 70 basis pointsin the euro area since the end of lastyear, while the increases on similar se-curities in Canada and the United King-dom have been about 50 basis points.Part of the rise in yields abroad has been

increased compensation for possiblefuture inflation as measured by the dif-ference in yield between ten-year nomi-nal and inflation-indexed bonds. Yieldspreads of emerging-market bonds overU.S. Treasuries narrowed somewhatearly in the year, but that narrowing wasmore than reversed in the second quarteras investors apparently demandedgreater compensation for risk amid un-

certainties about economic growth andinflation.

The foreign exchange value of thedollar has declined about 41 ⁄ 2 percent,on net, this year against a basket of thecurrencies of the major industrial coun-tries but is down only about 1 percent,on net, against the currencies of theother important trading partners of theUnited States. Much of the dollar’sdownward move occurred at times whenthe market was focused on concernsabout global current account imbal-ances. The dollar has recovered someground since early May, as investorsreportedly have engaged in flight-to-safety transactions into dollar-denominated assets in conjunction withthe volatility in global commodity and

asset markets. On net, the dollar hasdepreciated since the turn of the yearabout 61 ⁄ 2 percent against the euro andsterling, 3 percent against the Canadiandollar, and 11 ⁄ 2 percent against the Japa-nese yen. In contrast, the dollar has risen

roughly 4 percent, on balance, againstthe Mexican peso this year. During thefirst half of this year, several smaller

countries experienced episodes of sub-stantial financial volatility that in somecases involved sharp depreciations inthe exchange value of their currencies.

Through the first four months of 2006, a favorable economic outlook andlow interest rates supported gains inequity prices in all major foreign coun-tries. During May and early June, how-ever, equity prices registered widespread

declines, as market participants grewmore concerned about inflation, mone-tary policy, and global economicgrowth. More recently, developments inthe Middle East have weighed furtheron stock prices. On net, equity priceindexes are up between 1 percent and4 percent so far in 2006 in Europe andCanada, but they have fallen roughly8 percent since year-end in Japan. Latin

American and Asian emerging-marketequity indexes, which had generallygained more than industrial-country in-dexes early in the year, have fallen moresharply since early May. Equity indexesin Mexico, Brazil, and Argentina havedropped between 12 percent and 15 per-cent—leaving them still between5 percent and 7 percent higher so far thisyear—while stock prices in Korea havefallen about 9 percent, on net, for theyear.

Industrial Economies

The Japanese economy has continued tostrengthen this year, although economicgrowth has stepped down a bit from thecomparatively strong rate recorded in

2005. Household consumption main-tained a solid rate of growth in the firstquarter, and private investment spendingrose 11 percent. However, net exports,which previously had been an additionalsource of strength, did not contribute to




growth in the first quarter; the growth of imports increased while export growthremained firm. The labor market in Ja-

pan improved further in April and May:The unemployment rate fell to 4 per-cent, and the ratio of job offers to appli-cants reached a thirteen-year high.Although the GDP deflator has contin-ued to decline, other signs indicate thatdeflation is ending. In the first quarter of 2006, land prices in Japan’s six largestcities rose 3.8 percent over their year-ago level, the first increase since 1991.

Core consumer prices have shown smalltwelve-month increases over the pastseveral months.

Real GDP in the euro area acceleratedin the first quarter, expanding 21 ⁄ 2 per-cent, a rate of growth somewhat aboveits average in recent years. The accelera-tion was spurred by strength in domesticdemand, especially private consumptionspending, which increased in the first

quarter at double its pace in 2005. Retailsales were also strong at the start of thesecond quarter. The revival in householdspending has been supported by a smallrise in the growth rate of employmentand by an improvement in employer andconsumer perceptions of employmentprospects. Private investment spendinghas remained strong in the euro area,and business sentiment has continued tobrighten in recent months. Energy priceincreases have pushed euro-area con-sumer price inflation to about 21 ⁄ 2 per-cent recently, a level above the ECB’s2 percent ceiling, but core inflation hasremained near 11 ⁄ 2 percent.

In the United Kingdom, real GDPexpanded at an annual rate of 3 percentin the first quarter after rising about

13

⁄ 4

percent in 2005. Consumer spend-ing grew about 11 ⁄ 2 percent, the samemoderate pace seen last year. Houseprices, which remained relatively flatduring late 2004 and most of 2005,picked up in late 2005 and have contin-

ued to rise in the first half of this year.The twelve-month change in consumerprices was 2.2 percent in May. Con-

sumer prices have been boosted impor-tantly by increases in energy prices overthe past several months.

In Canada, real GDP grew at anannual rate of nearly 4 percent in thefirst quarter, an increase led by a jumpin spending on consumer durables andhousing. Investment in residential struc-tures grew at its fastest rate in more thantwo years, and business investment con-

tinued to exhibit the strength observedin the previous two quarters. Indicatorsfor the second quarter point generally toa deceleration of GDP. Housing starts inthe second quarter were significantly be-low their elevated first-quarter levels;the merchandise trade balance declined,on balance, during the first five monthsof this year; and in the manufacturingsector, the volume of new orders and of

shipments both fell in April. In contrast,in the second quarter, the labor marketmaintained its strength of the past year,and the unemployment rate has fallen to6.2 percent, the lowest level in morethan thirty years. Consumer prices rose2.8 percent in the twelve months endingin May.

Emerging-Market Economies

In China, growth of real output wasespecially robust in the first half. Eco-nomic indicators suggest that fixedinvestment surged and that exportgrowth continued to be strong. The rapidgrowth of investment prompted the Chi-nese government to impose a series of new measures to slow capital spending,

including controls on credit and land useand stricter criteria for approving invest-ment projects. In addition, to restraincredit, which has soared more than15 percent over the past year, China’scentral bank raised the one-year bank




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