federal reserve monetary policy report - mar 2011

8/7/2019 Federal Reserve Monetary Policy Report - Mar 2011

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For use at 10:00 a.m., ESTMarch 1, 2011

Monetary Policy Reportto the CongressMarch 1, 2011

Board of Governors of the Federal Reserve System


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Monetary Policy Reportto the CongressSubmitted pursuant to section 2Bof the Federal Reserve ActMarch 1, 2011

Board of Governors of the Federal Reserve System


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Letter of Transmittal

BOARD OF G OVERNORS OF THEF EDERAL R ESERVE SYSTEM

Washington, D.C., March 1, 2011

THE PRESIDENT OF THE SENATETHE SPEAKER OF THE H OUSE OF R EPRESENTATIVES

The Board of Governors is pleased to submit its Monetary Policy Report to the Congresspursuant to section 2B of the Federal Reserve Act.

Sincerely,

Ben Bernanke, Chairman


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Contents

1Part 1Overview: Monetary Policy and the Economic Outlook

5Part 2Recent Economic and Financial Developments

6 D OMESTIC D EVELOPMENTS

6 The Household Sector6 Consumer Spending and Household Finance8 Residential Investment and Housing Finance

10 The Business Sector10 Fixed Investment11 Inventory Investment11 Corporate Profits and Business Finance

14 The Government Sector14 Federal Government15 Federal Borrowing 15 State and Local Government16 State and Local Government Borrowing

16 The External Sector

17 National Saving

18 The Labor Market18 Employment and Unemployment19 Productivity and Labor Compensation

20 Prices

21 F INANCIAL D EVELOPMENTS

21 Monetary Policy Expectations and T reasury Rates23 Corporate Debt and Equity Markets25 Market Functioning and Dealer-Intermediated Credit26 Banking Institutions28 Monetary Aggregates and the Federal Reserves Balance Sheet

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30 INTERNATIONAL D EVELOPMENTS

30 International Financial Markets32 The Financial Account

33 Advanced Foreign Economies35 Emerging Market Economies

37Part 3Monetary Policy: Recent Developments and Outlook

37 Monetary Policy over the Second Half of 2010 and Early 201140 Tools for the Withdrawal of Monetary Policy Accommodation41 Recent Steps to Increase Transparency

43Part 4Summary of Economic Projections

45 The Outlook46 Uncertainty and R isks47 Diversity of Views

53 Abbreviations

Boxes

22 The Effects of Federal Reserve Asset Purchases34 An Update on the European Fiscal Crisis and Policy Responses52 Forecast Uncertainty

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Part 1Overview:Monetary Policy and the Economic Outlook

Economic activity in the United States expanded at amoderate pace, on average, in the second half of 2010and early 2011. In the spring and early summer, a num-ber of key indicators of economic activity softenedrelative to the readings posted in late 2009 and the firstpart of 2010, raising concerns about the durability of the recovery. In light of these developmentsand inorder to put the economic recovery on a firmer foot-

ingthe Federal Open Market Committee (FOMC)provided additional monetary policy stimulus duringthe second half of 2010 by reinvesting principal repay-ments from its holdings of agency debt and agencymortgage-backed securities in longer-term Treasurysecurities and by announcing its intention to purchasean additional $600 billion of Treasury securities by theend of the second quarter of 2011.

Financial market conditions improved notably in thefall of 2010, partly in response to actual and expectedincreases in monetary policy accommodation. In addi-tion, later in the year, the tenor of incoming economic

news strengthened somewhat, and the downside risksto economic growth appeared to recede. Nonetheless,the job market has improved only slowly. Employmentgains have been modest, and although the unemploy-ment rate fell noticeably in December and January, themargin of slack in the labor market remains wide.Meanwhile, despite rapid increases in commodityprices, longer-term inflation expectations remainedstable, and measures of underlying consumer priceinflation continued to trend downward on net.

Real gross domestic product (GDP) rose at a moder-ate rate in the third quarter. Inventories provided theprincipal impetus to growth while final sales showedlittle vigorthe same pattern that prevailed in the firsthalf of the year. Less favorable readings that began toemerge during the second quarter for a range of indi-catorsnew claims for unemployment insurance,industrial production, and numerous surveys of busi-ness activity, among otherspointed to a slowing inthe pace of the recovery and suggested that the transi-tion from a recovery boosted importantly by the inven-tory cycle to one propelled mainly by private finaldemand was proceeding only very gradually. Later inthe year, however, this process appeared to gain trac-

tion. Indeed, real GDP is estimated to have risen alittle faster in the fourth quarter than in the third quar-ter despite a substantial slowdown in the pace of inventory investment in the fourth quarter; final salesincreased much more rapidly in the fourth quarterthan earlier.

Over the second half of 2010, consumer spendingposted a solid gain, boosted in part by continued,

albeit modest, increases in real wage and salaryincome; some waning of the drag on outlays from ear-lier declines in household net worth; and a modestimprovement in the availability of consumer credit.Businesses continued to step up their spending onequipment and software in response to a brighter out-look for sales as well as more favorable conditions incredit markets. In the external sector, the continuedrebound in exports was supported by firming foreigndemand. Meanwhile, the construction sector remainedexceptionally weak.

The continued recovery in economic activity has

been accompanied by only a slow improvement inlabor market conditions. Private payroll employmenthas moved up at a relatively tepid rateabout 115,000per month, on average, since the February 2010 troughin employmentrecouping only a small portion of the8 million jobs lost during 2008 and 2009. Over mostof this period, the pace of hiring was insufficient tosubstantially reduce the unemployment rate. InDecember and January, however, the jobless rate wasreported to have declined noticeably. In addition to therecent drop in the unemployment rate, some otherindicators of labor market conditionsfor example,measures of firms hiring planshave brightened a bit,raising the prospect that a pickup in the pace of hiringmay be in the offing. That said, the level of the unem-ployment rate remains very elevated, and the long-termunemployed continue to account for a historically largefraction of overall joblessness.

Consumer price inflation trended down during 2010as slack in resource utilization restrained cost pressureswhile longer-term inflation expectations remainedstable. Although the prices of crude oil and manyindustrial and agricultural commodities rose rapidly inthe latter half of 2010 and the early part of 2011, over-

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all personal consumption expenditures (PCE) pricesincreased at an annual rate of just 1 percent over the12 months ending in January, which compares with a2 percent rise during the preceding 12 months. CorePCE priceswhich exclude prices for food andenergyrose percent in the 12 months ending inJanuary.

Financial market conditions continued to be sup-portive of economic growth in the second half of 2010and into 2011. Equity prices rose solidly, reflecting themore accommodative stance of monetary and fiscalpolicy, an improved economic outlook, and better-than-expected corporate earnings reports. Yields onlonger-term Treasury securities declined in the summerand early autumn, reflecting in part anticipation of additional monetary policy stimulus, but subsequentlyrose as economic prospects improved and as marketexpectations of the ultimate size of FOMC Treasurypurchases were revised down. Despite some volatility,yields on Treasury securities remained relatively low onbalance. Medium- and longer-term inflation compen-sation derived from inflation-indexed Treasury securi-ties increased since the summer as concerns aboutdeflation eased, though these measures remainedwithin historical ranges. Interest rates on fixed-rateresidential mortgages moved broadly in line with yieldson Treasury securities while the spreads between yieldson corporate bonds and those on Treasury securitiesdeclined; overall, both mortgage rates and corporate

yields continued to be at low levels. Although banklending policies generally stayed tight, banks reportedsome easing in those conditions on net. After postingsubstantial declines since the third quarter of 2008, total loans held on the books of banks showedsigns of stabilizing in recent months.

Larger nonfinancial corporations with access tocapital markets took advantage of favorable financialconditions to issue debt at a robust pace. Bond andsyndicated loan issuance was strong, particularlyamong lower-rated corporate borrowers. Commercialand industrial loans on banks books started to expandaround the end of 2010. Nevertheless, small, bank-dependent businesses remained constrained in theiraccess to credit, although some indicators suggestedthat credit availability for these firms was beginning toimprove.

Household debt appears to have contracted in thesecond half of 2010, but at a somewhat slower pacethan earlier in the year. Household mortgage debtlikely continued to decline, as housing demandremained weak and lending standards were reportedlystill stringent. Revolving consumer credit also con-tracted. By contrast, nonrevolving consumer credit

primarily auto and student loansincreased solidly inthe final quarter of 2010.

After first emerging during the spring, concernsabout fiscal and banking developments in Europeresurfaced later in the year. Although some Europeansovereigns and financial institutions faced renewedfunding pressures in the fourth quarter, the repercus-sions in broader global financial markets were muted.To help minimize the risk that strains abroad couldspread to the United States, as well as to continue tosupport liquidity conditions in global money markets,the FOMC in December approved an extension of thetemporary U.S. dollar liquidity swap arrangementswith a number of foreign central banks.

Apparently seeking to boost returns in an environ-ment of low interest rates, investors displayed anincreased appetite for higher-yielding fixed-incomeinstruments in the second half of 2010 and into 2011,which likely supported strong issuance of these prod-ucts and contributed to a narrowing of risk spreads,such as those on corporate debt instruments. Informa-tion from a variety of sources, including the FederalReserve Boards Senior Credit Officer Opinion Surveyon Dealer Financing Terms, suggests that use of dealer-intermediated leverage by financial market par-ticipants rose a bit in recent quarters but remained wellbelow its pre-crisis levels. 1 The condition of financialinstitutions generally appeared to improve further, andthe regulatory capital ratios of commercial banks, par-

ticularly the largest banks, moved higher.With the pace of recovery in output and employ-ment seen as disappointingly slow and measures of inflation viewed as somewhat low relative to levelsjudged consistent with the Committees mandate, theFOMC took several actions to provide additional sup-port to the economic recovery during the second half of last year. In August, the FOMC decided to reinvestprincipal payments from agency debt and agencymortgage-backed securities held in the System OpenMarket Account (SOMA) in longer-term Treasurysecurities to keep constant the size of the SOMA port-folio and so avoid an implicit tightening of monetarypolicy. In November, to provide further policy accom-modation to help support the economic recovery, theFOMC announced its intention to purchase an addi-tional $600 billion in longer-term Treasury securitiesby the end of the second quarter of 2011. Throughoutthe second half of 2010 and early 2011, the FOMCmaintained a target range for the federal funds rate of between 0 and percent and reiterated its expectation

1. The survey is conducted quarterly and is available atwww.federalreserve.gov/econresdata/releases/scoos.htm.

2 Monetary Policy Report to the Congress March 2011
http://www.federalreserve.gov/econresdata/releases/scoos.htmhttp://www.federalreserve.gov/econresdata/releases/scoos.htm


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that economic conditions, including low rates of resource utilization, subdued inflation trends, andstable inflation expectations, were likely to warrantexceptionally low levels for the federal funds rate foran extended period.

The Federal Reserve continued to develop and testtools to drain or immobilize large volumes of bankingsystem reserves in order to ensure that it will be able tosmoothly and effectively exit from the current extraor-dinarily accommodative policy stance at the appropri-ate time. The Committee continues to monitor the eco-nomic outlook and financial developments, and it willemploy its policy tools as necessary to support the eco-nomic recovery and to help ensure that inflation, overtime, returns to levels consistent with its mandate.

The economic projections prepared in conjunctionwith the January FOMC meeting are presented in Part 4of this report. In broad terms, FOMC participantsanticipated a sustained but modest recovery in realeconomic activity this year that would pick up some-what in 2012 and 2013. The expansion was expected tobe led by gains in consumer and business spending thatare supported by improvements in household and busi-ness confidence. Nevertheless, economic growth wasexpected to be damped by a number of headwinds,including the gradual pace of improvements in thelabor market, still-stringent borrowing conditions forhouseholds and bank-dependent small businesses, lin-gering household and business uncertainty, and ongo-

ing weakness in real estate markets. On balance,

FOMC participants anticipated that real GDP wouldincrease at above-trend rates over the next three years,but not as rapidly as in previous recoveries. Meanwhile,the unemployment rate was projected to fall gradually.Inflation was expected to drift up slowly toward thelevels that Committee participants believe to be mostconsistent with the Committees mandate. Reflectingtheir assessment that the recovery appeared to be on afirmer footing, the participants upgraded slightly theirprojections for near-term economic growth relative tothe ones they prepared in conjunction with the Novem-ber FOMC meeting; otherwise, their projections foreconomic growth and inflation were little changed.

Participants generally judged that the uncertaintyattached to their projections for both economic activityand inflation was greater than historical norms. A sub-stantial majority of participants viewed the risks toboth economic growth and inflation as balanced; onlya few saw them as tilted either to the upside or to thedownside. In November, a noticeable share of partici-pants had seen the risksparticularly those to eco-nomic growthas tilted to the downside. Participantsalso reported their assessments of the rates to whichkey macroeconomic variables would be expected toconverge over the longer term under appropriate mon-etary policy and in the absence of further shocks to theeconomy. The central tendencies of these longer-runprojections were 2.5 to 2.8 percent for real GDPgrowth, 5.0 to 6.0 percent for the unemployment rate,

and 1.6 to 2.0 percent for the inflation rate.

Board of Governors of the Federal Reserve System 3


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Part 2Recent Economic and Financial Developments

Economic activity expanded at a moderate pace, onbalance, in the second half of 2010. According to thecurrently available estimates from the Bureau of Eco-nomic Analysis, real gross domestic product (GDP)increased at an annual rate of about 2 percent, onaverage, over that period (figure 1). In the third quar-ter, as had been the case in the first half of the year,much of the increase was the result of inventory accu-mulation; in contrast, final sales continued to rise at asubdued rate. Meanwhile, several indicators of eco-

nomic activity had softened from the readingsobserved earlier in the year, raising concerns about thedurability of the recovery. Later in the year, however,the tone of the incoming data on economic activitybrightened somewhat, final sales strengthened, and therecovery appeared to be on a firmer footing.

Since the middle of 2010, consumer spending hasrisen solidly on average, businesses have continued toincrease their outlays for equipment and software, andexports have moved up further. In contrast, construc-tion of new homes and nonresidential buildingsremains exceptionally weak. Conditions in the labor

market have improved only slowly, with payrollsincreasing at a modest pace. Throughout nearly all of 2010, that pace of employment expansion was insuffi-cient to bring the unemployment rate down meaning-

fully from its recent peak. In December 2010 and Janu-ary of this year, however, the unemployment rate isestimated to have dropped more noticeably, eventhough payroll employment gains remained lackluster.Meanwhile, long-duration joblessness persisted atnear-record levels. With regard to inflation develop-ments, despite rapid increases in commodity prices,longer-term inflation expectations have remainedstable and consumer price inflation has continued totrend downward on net (figure 2).

Conditions in financial markets generally improvedover the course of the second half of 2010 and early2011 and continued to be supportive of economicactivity. This improvement reflected, in part, additionalmonetary policy stimulus provided by the FederalReserve, as well as growing investor confidence in thesustainability of the economic recovery. Althoughyields on Treasury securities rose somewhat, on net,since mid-2010, yields on investment-grade corporatebonds were little changed at low levels, and yields onspeculative-grade bonds declined. In equity markets,price indexes generally rose, buoyed by solid corporate

earnings and a more positive economic outlook. Com-mercial banks reported that they had eased some of their lending standards and terms, though lendingstandards remained generally tight and some busi-

4

2

+_0

2

4

Percent, annual rate

2010200920082007200620052004

1. Change in real gross domestic product, 200410

H1 Q3

H1

H2 Q4

NOTE: Here and in subsequent figures, except as noted, change for a givenperiod is measured to its final quarter from the final quarter of the precedingperiod.

SOURCE : Department of Commerce, Bureau of Economic Analysis.

Excluding foodand energy

1

+_0

1

2

3

4

5

Percent

20112010200920082007200620052004

2. Change in the chain-type price index for personalconsumption expenditures, 200411

Total

NOTE: The data are monthly and extend through January 2011; changes arefrom one year earlier.


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nesses and households continued to face difficultiesobtaining credit. Changes in interest rates faced byhouseholds were mixed. The improvement in financialconditions was accompanied by some signs of apickup in the demand for credit. Borrower credit qual-ity generally improved, although problems persisted insome sectors of the economy. Concerns about Euro-pean banking and fiscal strains increased again in late2010 after having eased for a time; however, in contrastto what was observed in the spring, these concerns leftlittle imprint on U.S. financial markets.

D OMESTIC D EVELOPMENTS

The Household SectorConsumer Spending and Household Finance

Real personal consumption expenditures (PCE)increased at an annual rate of about 3 percent in thesecond half of 2010, with a particularly brisk rise inthe fourth quarter (figure 3). The spending gains weresupported by the continued, though modest, pickup inreal household incomes, by some fading of therestraining effects of the earlier sharp declines inhouseholds net worth, and by a modest improvementin the availability of consumer credit. Outlays fordurable goods also may have been boosted to someextent by purchases that had been deferred during the

recession. The increases in spending exceeded the risein income, and the saving rate edged down during thesecond half of the year, though it remains well abovelevels that prevailed prior to the recession (figure 4).

The increase in consumer outlays in the second half of 2010 partly reflected a step-up in sales of new lightmotor vehicles (cars, sport utility vehicles, and pickuptrucks). Sales of light vehicles rose from an annual rateof 11 million units in the second quarter of 2010 tomore than 12 million units in the fourth quarter andmoved up further in the first part of 2011. Sales weresupported, in part, by further improvements in creditconditions for auto buyers as well as by more-generoussales incentives from the automakers. Real spending inother goods categories also rose appreciably, while the

increase in outlays for services was more subdued.The determinants of consumer outlays showed fur-ther, albeit gradual, improvement during the secondhalf of 2010. The level of real disposable personalincome (DPI)after-tax income adjusted for infla-tionwhich rose rapidly in the first half of the year,continued to advance in the second half, as real wagesand salaries moved up at an annual rate of 2 percent(figure 5). The increase in real wage and salary incomereflected the continued, though tepid, recoveries inboth employment and hours worked; in contrast,hourly pay was little changed in real terms.

The ratio of household net worth to DPI moved upa little in the third quarter of 2010 and appears to haverisen further since then, as increases in equity valueslikely more than offset further declines in house prices(figure 6). Although the wealth-to-income ratio hastrended up since the beginning of 2009 and hasreturned to the levels that prevailed prior to the late1990s, it remains well below its highs in 2006 and 2007.Consumer sentiment rose late in the year, boosted bygradual improvements in household assessments of financial and business conditions as well as job pros-pects; nevertheless, these gains only moved sentiment

8,500

8,750

9,000

9,250

9,500

Billions of chained (2005) dollars

20112010200920082007200620052004

3. Real personal consumption expenditures, 200411

NOTE: The data are monthly and extend through January 2011.SOURCE : Department of Commerce, Bureau of Economic Analysis.

+_0

3

6

9

Percent

201020062002199819941990

4. Personal saving rate, 19872010

NOTE: The data are quarterly and extend through 2010:Q4.SOURCE : Department of Commerce, Bureau of Economic Analysis.



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back to or a bit above the low levels that prevailed atthe start of last year (figure 7).

Household debt likely fell at just under a 2 percentannual rate in the second half of 2010, a slightly slowerpace than in the first half. The contraction for 2010 asa whole, which was due primarily to ongoing decreasesin mortgage debt, marked the second consecutiveannual decline. The reduction in overall householddebt levels, combined with increases in personalincome, resulted in a further decline in the ratio of household debt to income and in the debt serviceratiothe required principal and interest payments onexisting mortgage and consumer debt relative toincome (figure 8).

The slowdown in the rate at which household debtcontracted in the latter part of 2010 stemmed in largepart from a modest recovery in consumer credit.Although revolving consumer creditmostly creditcard borrowingcontinued to contract, the declinewas at a slightly slower rate than in the first half of theyear. Nonrevolving consumer credit, which consistslargely of auto and student loans and accounts for

about two-thirds of total consumer credit, rose 2 per-cent in the second half of 2010 after being aboutunchanged in the first half of the year. The pickup innonrevolving consumer credit is consistent with

6

4

2

+_0

2

4

6

8


2010200920082007200620052004

5. Change in real disposable personal income and in realwage and salary disbursements, 200410

H1H2

H1H2


Real disposable personal income

Real wage and salary disbursements

4

5

6

Ratio

201020062002199819941990

6. Wealth-to-income ratio, 19872010

NOTE: The data are quarterly and extend through 2010:Q3. The wealth-to-income ratio is the ratio of household net worth to disposable personalincome.

SOURCE : For net worth, Federal Reserve Board, flow of funds data; forincome, Department of Commerce, Bureau of Economic Analysis.

Conference Board

20

40

60

80

100

120

140

20112008200520021999

7. Consumer sentiment indexes, 19972011

Thomson Reuters/ Michigan

NOTE: The Conference Board data are monthly and extend throughFebruary 2011; the series is indexed to equal 100 in 1985. The ThomsonReuters/University of Michigan data are monthly and extend throughFebruary 2011; the series is indexed to equal 100 in 1966.

SOURCE : The Conference Board and Thomson Reuters/University of Michigan Surveys of Consumers.

11

12

13

14

Percent of disposable income

20102006200219981994199019861982

8. Household debt service, 19802010

NOTE: The data are quarterly and extend through 2010:Q3. Debt servicepayments consist of estimated required payments on outstanding mortgageand consumer debt.

SOURCE : Federal Reserve Board, Household Debt Service and FinancialObligations Ratios, statistical release.



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responses to the Senior Loan Officer Opinion Surveyon Bank Lending Practices (SLOOS) indicating thatbanks have become increasingly willing to make con-sumer installment loans; however, lending standardsfor these loans likely remained fairly tight. 2 In addi-tion, in the most recent survey, a small net fraction of respondents noted increased demand for consumerloans, the first time stronger demand was reportedsince mid-2005.

Some of the increased willingness to make consumerloans may reflect improvements in consumer creditquality. The delinquency rate on auto loans at captivefinance companies moved down in the second half of 2010 to 2.6 percent, close to its longer-run historicalaverage. Delinquency rates on credit cards at commer-cial banks and in securitized pools also moved down toaround longer-run averages. However, charge-off rateson such loans remained well above historical normsdespite having moved lower in the second half of theyear.

Changes in interest rates on consumer loans weremixed. Interest rates on new auto loans were littlechanged, on net, in the second half of 2010 and into2011. By contrast, interest rates on credit cards gener-ally rose over the same period. A portion of theincrease in credit card interest rates may be due to lin-gering adjustments by banks to the imposition of newrules under the Credit Card Accountability Responsi-bility and Disclosure Act (Credit Card Act). 3

Issuance of consumer asset-backed securities (ABS)in the second half of 2010 occurred at about the samepace as in the first half of the year. Auto loan ABSissuance continued to be healthy, and the ability tosecuritize these loans likely held down interest rates onthe underlying loans. Issuance of ABS backed bycredit card loans, however, remained very weak, as thesharp contraction in credit card lending limited theneed for new funding and accounting rule changesimplemented at the beginning of 2010 made securitiza-tion of these loans less attractive. 4 Yields on ABS secu-rities and the spreads of such yields over comparable-maturity interest rate swap rates were not much

changed, on net, over the second half of 2010 andearly 2011 (figure 9).

Residential Investment and Housing Finance

Housing activity remained depressed in the second half of 2010. Homebuilding continues to be restrained by

sluggish demand, the large inventory of foreclosed ordistressed properties on the market, and the tightcredit conditions faced by homebuilders. In the single-family sector, new units were started at an averageannual rate of about 430,000 units from July 2010 toJanuary 2011, just 70,000 units above the quarterly lowreached in the first quarter of 2009 (figure 10). In themultifamily market, demand for apartments appears tobe increasing and occupancy rates have been edgingup, as some potential homebuyers may be choosing torent rather than to purchase a home. Nevertheless, theinventory of unoccupied multifamily units continues tobe elevated, and construction financing remains tight.As a result, starts in the multifamily sector have aver-aged an annual rate of only 135,000 units since themiddle of 2010, well below the 300,000-unit rate thathad prevailed for much of the previous decade.

Home sales surged in the spring ahead of the expira-tion of the homebuyer tax credit, plunged for a fewmonths during a payback period, and then recoveredsomewhat as the payback effect waned. 5 By late 2010

2. The SLOOS is available on the Federal Reserve Boards websiteat www.federalreserve.gov/boarddocs/SnLoanSurvey.

3. The Credit Card Act includes some provisions that placerestrictions on issuers ability to impose certain fees and to engage inrisk-based pricing.

4. In June 2009, the Financial Accounting Standards Board(FASB) published Statements of Financial Accounting StandardsNos. 166 ( Accounting for Transfers of Financial Assets , an Amend-ment of FASB Statement No. 140 ) and 167 ( Amendments to FASB Interpretation No. 46(R) ). The statements became effective at thestart of a companys first fiscal year beginning after November 15,2009, or, for companies reporting earnings on a calendar-year basis,after January 1, 2010.

5. In order to receive the homebuyer tax credit, a purchaser had tosign a sales agreement by the end of April 2010 and close on the

Credit card

+_0

100

200

300

400

500

Basis points

20112010200920082007

9. Spreads of asset-backed securities yields over rates oncomparable-maturity interest rate swaps, 200711

Auto

Jan. July Jan. July Jan. July Jan. July Jan.

NOTE: The data are weekly and extend through February 16, 2011. Thespreads shown are the yields on two-year fixed-rate asset-backed securitiesless rates on two-year interest rate swaps.

SOURCE : JPMorgan Chase & Co.

http://www.federalreserve.gov/boarddocs/SnLoanSurveyhttp://www.federalreserve.gov/boarddocs/SnLoanSurvey


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and early 2011, sales of existing single-family homeswere a bit above levels that prevailed in mid-2009,before the enactment of the first homebuyer tax credit,while sales of new single-family homes remained belowtheir mid-2009 levels. Housing demand has been heldback by tight mortgage credit availability, uncertaintyabout future real estate values, and continued house-hold concerns about the outlook for employment andincome. Nonetheless, other determinants of housingdemand are favorable and hold the potential to providesupport to home sales as the economic recovery pro-

ceeds. In particular, the low level of mortgage rates andthe earlier declines in house prices have made housingmore affordable for those able to obtain mortgages.

House prices, as measured by several nationalindexes, decreased in the latter half of 2010 after hav-ing shown tentative signs of leveling off earlier in theyear (figure 11). According to one measure with widegeographic coveragethe CoreLogic repeat-salesindexhouse prices fell 6 percent between June andDecember and moved below their mid-2009 trough.House prices continued to be weighed down by thelarge inventory of unsold homesespecially distressedpropertiesand by the sluggish demand for housing.

Indicators of credit quality in this sector pointed tocontinued difficulties amid depressed home values andelevated unemployment. Serious delinquency rates on

prime and near-prime mortgages edged down toaround 15 percent for adjustable-rate loans and toabout 5 percent for fixed-rate loanslevels that remainhigh by historical standards (figure 12). Delinquencyrates for subprime mortgages moved up slightly towardthe end of the year and remained extremely elevated.One sign of improvement, however, was that the rate atwhich mortgages transitioned from being current to

property by the end of September. The first-time homebuyer taxcredit, which was enacted in February 2009 as part of the AmericanRecovery and Reinvestment Act, was originally scheduled to expireon November 30, 2009. Shortly before it expired, the Congressextended the credit to sales occurring through April 30, 2010, andexpanded it to include repeat homebuyers who had owned and occu-pied a house for at least five of the past eight years. Sales of existinghomes are measured at closing, while sales of new homes are meas-ured at the time the contract is signed.

Multifamily.4

.8

1.2

1.6

Millions of units, annual rate

20112009200720052003200119991997

10. Private housing starts, 19972011

Single-family

NOTE: The data are monthly and extend through January 2011.SOURCE : Department of Commerce, Bureau of the Census.

S&P/Case-Shiller20-city index

CoreLogicprice index

50

60

70

80

90

100

Index value

2010200720042001

11. Prices of existing single-family houses, 200110

FHFAindex

NOTE: The data are monthly and extend into 2010:Q4. Each index has beennormalized so that its peak is 100. Both the CoreLogic price index and theFHFA index (formerly calculated by the Office of Federal HousingEnterprise Oversight) include purchase transactions only. TheS&P/Case-Shiller index reflects all arms-length sales transactions in selectedmetropolitan areas.

SOURCE : For CoreLogic, CoreLogic; for FHFA, Federal Housing FinanceAgency; for S&P/Case-Shiller, Standard & Poors.

Fixedrate

Fixedrate

+_0

3

6

9

12

15

Percent

201020082006200420022000

12. Mortgage delinquency rates, 200010

Prime and near prime

Adjustable rate

10

20

30

4050

Percent

201020082006200420022000

Subprime

Adjustable rate

NOTE: The data are month ly and extend through December 2010 .Delinquency rate is the percent of loans 90 days or more past due or inforeclosure.

SOURCE : For prime and near prime, LPS Applied Analytics; for subprime,CoreLogic.



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being newly delinquent trended lower toward the endof 2010.

Reflecting the ongoing credit quality issues, thenumber of homes that entered foreclosure in the thirdquarter of 2010 jumped to more than 700,000, wellabove the pace seen earlier in the year. Late in the thirdquarter, concerns about the mishandling of documen-tation led some institutions to temporarily suspendsome or all of their foreclosure proceedings. 6 Despitethese announced moratoriums, the pace of new fore-closures dipped only slightly in the fourth quarter.Moreover, these moratoriums will likely only extend,and not put an end to, the foreclosure process in mostcases.

Interest rates on fixed-rate mortgages remainedquite low, on net, by historical standards during thesecond half of 2010 and reached record lows in thefourth quarter (figure 13). The very low levels of mort-gage rates prompted a sizable pickup in refinancingactivity for a time, although some households wereunable to refinance because of depressed home values,

weak credit scores, and tight lending standards for

mortgages. Mortgage applications for home purchaseswere generally subdued in the second half of the year.Overall, mortgage debt outstanding likely declined inthe second half of 2010 at a pace only slightly slowerthan that of the first half.

Net issuance of mortgage-backed securities (MBS)guaranteed by Fannie Mae, Freddie Mac, and GinnieMae was fairly low in the second half of 2010, consis-tent with the subdued originations of mortgages usedto finance home purchases. The securitization marketfor mortgage loans not guaranteed by a housing-related government-sponsored enterprise (GSE) or theFederal Housing Administration remained essentiallyclosed.

The Business SectorFixed Investment

Real business spending on equipment and software,which surged in the first half of 2010, rose further inthe second half (figure 14). Firms were likely motivatedpartly by a desire to replace aging equipment and toundertake capital spending that had been deferred dur-ing the recession. Improving business prospects alsoappear to have been a factor boosting capital expendi-tures. As a group, large firms continue to have ampleinternal funds, and those with access to capital markets

generally have been able to obtain bond financing atfavorable terms. Although credit availability for smallerfirms and other bank-dependent businesses remainsconstricted, some tentative signs of easing lendingstandards have emerged.

Overall spending on equipment and software rose atan annual rate of about 10 percent in the second half of 2010. Although business outlays in the volatiletransportation equipment category plunged in thefourth quarter, that decline came in the wake of severalquarters of sharp increases when vehicle rental firmswere rebuilding their fleets of cars and light trucks.Meanwhile, spending on information technology (IT)capitalcomputers, software, and communicationsequipmentincreased appreciably throughout the sec-ond half. Gains were apparently spurred by outlays toreplace older, less-efficient IT capital as well as contin-ued investments by wireless service providers toupgrade their networks. In addition, spendingincreases for equipment other than transportation andITnearly one-half of total equipment outlayswerewell maintained and broad based. More recently, neworders for nondefense capital goods other than trans-portation and IT items were little changed, on net, in

6. The Federal Reserve, the Office of the Comptroller of theCurrency, the Office of Thrift Supervision, and the Federal DepositInsurance Corporation are conducting an in-depth interagencyreview of practices at the largest mortgage servicing operations toexamine foreclosure practices generally, but with an emphasis on thebreakdowns that led to inaccurate affidavits and other questionablelegal documents being used in the foreclosure process. See ElizabethA. Duke (2010), Foreclosure Documentation Issues, statementbefore the Financial Services Subcommittee on Housing andCommunity Opportunity, U.S. House of Representatives, November18, www.federalreserve.gov/newsevents/testimony/duke20101118a.htm .

Fixed rate

3

4

5

6

7

8

9

Percent

201120082005200219991996

13. Mortgage interest rates, 19952011

Adjustable rate

NOTE: The data, which are weekly and extend through February 23, 2011,are contract rates on 30-year mortgages.

SOURCE : Federal Home Loan Mortgage Corporation.

http://www.federalreserve.gov/newsevents/testimony/duke20101118a.htmhttp://www.federalreserve.gov/newsevents/testimony/duke20101118a.htmhttp://www.federalreserve.gov/newsevents/testimony/duke20101118a.htmhttp://www.federalreserve.gov/newsevents/testimony/duke20101118a.htm


19/61

December and January; however, the level of ordersremains above shipments, and business surveys sug-gest that respondents are upbeat about business con-ditions as well as their equipment spending plans.

Real spending on nonresidential structures otherthan those used for drilling and mining remaineddepressed, with the level of investment at the end of 2010 down almost 40 percent from its peak in early2008. However, the rate of decline appears to be abat-ing: Spending fell at an annual rate of nearly 10 per-cent in the second half of 2010 after plunging at a25 percent rate in the first half. Although outlays fornew power facilities jumped in the second half of theyear, construction of office buildings, commercialstructures, and manufacturing plants all moved downfurther. A large overhang of vacant space, depressedproperty prices, and an unwillingness of banks to addto their already high construction loan exposure stillweighed heavily on the sector. In contrast, spendingon drilling and mining structures continued to risesharply in response to elevated energy prices.

Inventory Investment

Stockbuilding continued in the second half of 2010 atan average pace about in line with the growth of finalsales (figure 15). Inventory investment surged in thethird quarter, but the pace of accumulation slowedsharply in the fourth quarter, with the swing magnifiedby developments in the motor vehicle sector. Vehiclestocks rose appreciably in the third quarter as dealersattempted to rebuild inventories that had becomedepleted earlier in year, but inventories fell in the

fourth quarter as auto sales moved up more rapidlythan expected near the end of the year. As for otheritems aside from motor vehicles, inventory investmentrose during the second half of the year, albeit morerapidly in the third quarter than in the fourth. Theinventory-to-sales ratios for most industries covered bythe Census Bureaus book-value data, which had risensignificantly in 2009, have moved back to levels thatprevailed before the recession, and surveys suggest thatinventory positions for most businesses generally are ina comfortable range.

Corporate Profits and Business Finance

Operating earnings per share for S&P 500 firms con-tinued to increase at a solid pace in the third andfourth quarters of 2010. Most industry groupsreported gains. In aggregate, earnings per shareclimbed to near the levels posted in mid-2007, justprior to the financial crisis.

The already sturdy credit quality of nonfinancialcorporations improved further in the second half of 2010. The aggregate debt-to-asset ratio, which provides

30

20

10

+_0

10

20

30


2010200920082007200620052004

14. Change in real business fixed investment, 200410

H1

H2

H1

H2

StructuresEquipment and software

20

10

+_0

10

20

30

2010200920082007200620052004


H1

H2

H1

H2

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


High-tech equipment and softwareOther equipment excluding transportation

100

50

+_0

50

100

150

Billions of chained (2005) dollars, annual rate

2010200920082007200620052004

15. Change in real business inventories, 200410

H1

Q3

Q4




20/61

an indication of corporate leverage, moved down in thethird quarter, as nonfinancial corporations increasedtheir assets by more than they increased their debt.Credit rating upgrades again outpaced downgradesand corporate bond defaults remained sparse. Thedelinquency rate on commercial and industrial (C&I)loans at commercial banks moved down in the secondhalf of 2010 to 3 percent. By contrast, with fundamen-tals remaining weak, delinquency and charge-off rateson commercial real estate (CRE) loans at commercialbanks decreased only modestly from quite elevatedlevels (figure 16). Moreover, the delinquency rate onCRE loans in securitized pools continued to risesharply.

Borrowing by nonfinancial corporations continuedat a robust pace in the second half of 2010, driven bygood corporate credit quality, attractive financing con-ditions, and an improving economic outlook (fig-ure 17). Issuance of corporate bonds was heavy forboth investment-grade and high-yield issues. Borrow-ing in the syndicated loan market was also sizable, par-ticularly by speculative-grade borrowers, with the dol-lar volume of such loans rebounding sharply from thelow levels seen in 2008 and 2009 (not shown in figure).

Demand for such loans from institutional investorswas strong. Some of the strength in debt originationwas reportedly due to corporations taking advantageof low interest rates to reduce debt service costs andextend maturities by refinancing; issuance to financemergers and acquisitions also reportedly picked up inthe second half of the year. Meanwhile, commercialpaper outstanding remained about flat. C&I loans onbanks books decreased during the third quarter butstarted expanding toward the end of the year, consis-

tent with responses to the January 2011 SLOOS thatreported some easing of standards and terms andsome firming of demand for C&I loans from largefirms over the previous three months. Relatively largefractions of respondents to the most recent surveyindicated that they narrowed the spread of C&I loanrates over their cost of funds somewhat further duringthe second half of 2010 (figure 18). Nevertheless, lend-ing standards reportedly remained tight; about one-half of the respondents to special questions included inthe October 2010 survey indicated that their lendingstandards on C&I loans were tighter than longer-runaverages and were likely to remain so until at least2012.

Borrowing conditions for small businesses continuedto be tighter than for larger firms, although some signsof easing began to emerge. In particular, surveys con-ducted by the National Federation of IndependentBusiness (NFIB) showed a gradual decline in the shareof respondents reporting that credit was more difficultto obtain than three months previously (figure 19).Similarly, in the past several surveys, moderate netfractions of SLOOS respondents have indicated thatbanks have eased some loan terms for smaller borrow-

Nonfarmnonresidential

Life insurancecompanies

+_0

5

10

1520

Percent

2011200820052002199919961993

16. Delinquency rates on commercial real estate loans,19912011

Commercial banks

Construction andland development

+_02

4

6

8

10

Percent

2011200820052002199919961993

CMBS

NOTE: The data for commercial banks and life insurance companies arequarterly and extend through 2010:Q4 and 2010:Q3, respectively. The datafor commercial mortgage-backed securities (CMBS) are monthly and extendthrough January 2011. The delinquency rates for commercial banks andCMBS are the percent of loans 30 days or more past due or not accruinginterest. The delinquency rate for life insurance companies is the percent of loans 60 days or more past due or not accruing interest.

SOURCE : For commercial banks, Federal Financial InstitutionsExamination Council, Consolidated Reports of Condition and Income (CallReport); for life insurance companies, American Council of Life Insurers; forCMBS, Citigroup.

40

20

+_0

20

40

60

80

Billions of dollars, monthly rate

201020092008200720062005

17. Selected components of net financing for nonfinancialbusinesses, 200510

SumH1

H2

Q1

Q2

Q3Q4

NOTE: The data for the components except bonds are seasonally adjusted.SOURCE : Federal Reserve Board, flow of funds data.

Commercial paper

BondsBank loans



21/61

ers. Judging from responses to both the NFIB surveyand the SLOOS, loan demand by small businessesremained subdued.

Banks holdings of CRE loans continued to contractfairly sharply throughout the second half of 2010.Overall commercial mortgage debt declined at an

annual rate of 6 percent in the third quarter, about thesame pace as in the previous quarter. Responses to theJanuary SLOOS suggest that banks have not yetstarted reversing their tight lending standards in thissector and that demand, while starting to pick up,likely remained weak. Despite the strains in CRE mar-kets, the commercial mortgage-backed securities(CMBS) market showed tentative signs of improve-ment in the second half of 2010 and early 2011. Pricesfor some of the more highly rated tranches of existingCMBS rose. Although issuance of new securitiesremained tepid, the pace has been picking up.Responses to special questions on the SeptemberSenior Credit Officer Opinion Survey on DealerFinancing Terms (SCOOS) indicated that demand forwarehousing of CRE loans for securitization hadincreased since the beginning of 2010, and that thewillingness to fund CRE loans on an interim basis hadincreased somewhat.

A substantial number of initial and secondary equityofferings for nonfinancial firms were brought to mar-ket in the second half of 2010. Deals included an initialpublic offering by General Motors that was used torepay a portion of the governments capital infusion.Nevertheless, equity retirements in the third quarterthrough cash-financed mergers and acquisitions andshare repurchases once again outpaced issuance; pre-liminary data for the fourth quarter (not shown) sug-gest a similar pattern (figure 20).

Standards

60

40

20

+_0

20

40

60

80

100

Percent

20112008200520021999

18. Net percentage of domestic banks tightening standardsand widening spreads over the banks cost of funds forlarge and medium-sized business borrowers, 19982011

Spreads

NOTE: The data are drawn from a survey generally conducted four timesper year; the last observation is from the January 2011 survey, which covers2010:Q4. Net percentage is the percentage of banks reporting a tightening of standards or a widening of spreads less the percentage reporting an easing ora narrowing. The definition for firm size suggested for, and generally usedby, survey respondents is that large and medium-sized firms have annualsales of $50 million or more.

SOURCE : Federal Reserve Board, Senior Loan Officer Opinion Survey onBank Lending Practices.

+_0

3

6

9

12

15

Percent

201120072003199919951991

19. Net percentage of small businesses that reported moredifficulty in obtaining credit, 19902011

NOTE: The data are drawn from a survey conducted monthly and areseasonally adjusted; the last observation is from the January 2011 survey,which covers December 2010. The data reflect the proportion of borrowerswho sought credit in the past three months that reported more difficulty inobtaining credit less the proportion that reported more ease in obtainingcredit.

SOURCE : National Federation of Independent Business.

120

90

60

30

+_0

30

Billions of dollars, monthly rate

201020092008200720062005

20. Components of net equity issuance, 200510

Total

H1 H2 H1 Q3

NOTE: The data for 2010:Q3 are estimates. Net equity issuance is thedifference between equity issued by domestic companies in public or privatemarkets and equity retired through share repurchases, domestic cash-financedmergers, or foreign takeovers of U.S. firms. Equity issuance includes fundsinvested by private equity partnerships and stock option proceeds.

SOURCE : Thomson Financial, Investment Benchmark Report; Money TreeReport by PricewaterhouseCoopers, National Venture Capital Association,and Venture Economics.

Public issuancePrivate issuanceRepurchasesMergers and acquisitions



22/61

The Government Sector

Federal Government

The deficit in the federal unified budget has remainedvery wide. The budget deficit for fiscal year 2010,although down somewhat from fiscal 2009, was$1.3 trillion. The fiscal 2010 figure was equal to8 percent of nominal GDP, substantially above theaverage value of 2 percent recorded during the three-year period prior to the onset of the recession. Thebudget deficit continued to be boosted by spendingcommitments from the American Recovery and Rein-vestment Act (ARRA) and other stimulus policyactions and by the weakness of the economy, whichhas reduced tax revenues and boosted payments forincome support. By contrast, the budget effects of sev-eral financial transactions reduced the deficit in 2010:Outlays related to the Troubled Asset Relief Program(TARP), which added significantly to the deficit in2009, helped to shrink the deficit in 2010 as estimatedlosses were revised down when many of the largerTARP recipients repaid their obligations to the Treas-ury; in addition, new assistance for the mortgage-related GSEs was extended at a slower pace, anddepository institutions prepaid three years worth of federal deposit insurance premiums. Moreover, thenascent recovery in the economy led to a small increasein revenues. The deficit is projected by the Congres-

sional Budget Office to widen in fiscal 2011 to a levelsimilar to the shortfall recorded in fiscal 2009.Despite increasing 3 percent in fiscal 2010, tax

receipts remained at very low levels; indeed, at lessthan 15 percent of GDP, the ratio of receipts tonational income was at its lowest level in 60 years (fig-ure 21). Corporate income taxes surged nearly 40 per-cent in fiscal 2010 as profits increased briskly, and Fed-eral Reserve remittances to the Treasury rose markedlyowing to the expansion of its balance sheet. By con-trast, despite rising household incomes, individualincome and payroll taxes moved down in fiscal 2010,reflecting the tax cuts put in place by the ARRA. Totaltax receipts increased nearly 10 percent over the firstfour months of fiscal 2011 relative to the comparableyear-earlier period; individual income and payrolltaxes turned up, a consequence of the further recoveryin household incomes, and corporate income taxescontinued to rise.

Outlays decreased 2 percent in fiscal 2010, a devel-opment attributable to financial transactions. Exclud-ing financial transactions, spending rose 9 percentcompared with fiscal 2009, mainly because of theeffects of the weak labor market on outlays for income

support programs (such as unemployment insuranceand food stamps) as well as increases in Medicaidexpenditures and spending associated with the ARRAand other stimulus-related policies. Net interest pay-ments rose 5 percent in fiscal 2010, and Social Securityspending increased 3 percentits smallest rise in11 yearsas the low rate of consumer price inflationin the previous year resulted in no cost of living adjust-ment. In the first four months of fiscal 2011, total fed-eral outlays rose nearly 5 percent relative to the compa-rable year-earlier period. Excluding financialtransactions, outlays were up about 1 percent. Therelatively small increase so far this fiscal year for out-lays excluding financial transactions reflects a flatten-ing out of ARRA spending and income support pay-

Expenditures

14

16

18

20

22

24

Percent of nominal GDP

201020062002199819941990

21. Federal receipts and expenditures, 19902010

Receipts

NOTE: The receipts and expenditures data are on a unified-budget basis andare for fiscal years (October through September); gross domestic product(GDP) is for the four quarters ending in Q3.

SOURCE : Office of Management and Budget.

3

+_0

3

6

9


2010200920082007200620052004

22. Change in real government expenditureson consumption and investment, 200410

H1H2


FederalState and local



23/61

ments; by contrast, other spending has been increasingat rates comparable to those recorded during fiscal2010.

As measured in the national income and productaccounts (NIPA), real federal expenditures on con-sumption and gross investmentthe part of federalspending that is a direct component of GDProse atan annual rate of about 4 percent in the second half of 2010, a bit less than in the first half of the year (fig-ure 22). Nondefense outlays increased more slowlythan in the first half of the yearwhen spending forthe decennial census ramped upwhile defense spend-ing rose at roughly the same pace as in the first half.

Federal Borrowing

Federal debt expanded appreciably in the second half of last year, though at a slightly slower pace than in thefirst half. The ratio of Federal debt held by the publicto nominal GDP rose to more than 60 percent at theend of 2010 and is projected to reach nearly 70 percentby the end of 2011 (figure 23). Demand for Treasurysecurities has been well maintained. Bid-to-cover ratiosat auctions, although somewhat mixed, were generallywithin historical ranges during the second half of 2010and early 2011. Indicators of foreign participation atauctions as well as a rise in foreign custody holdings of Treasury securities by the Federal Reserve Bank of

New York pointed to steady demand from abroad.Demand for these securities may have been supportedby a heightened desire for relatively safe and liquid

assets in light of fiscal troubles in some Europeancountries.

State and Local Government Despite the substantial federal aid provided by theARRA, state and local governments remained undersignificant fiscal pressure in the second half of 2010.The strains reflect several factors, including a sharpdrop in tax revenues in late 2008 and 2009 andincreased commitments for Medicaid outlaysa cycli-cally sensitive transfer programall in the context of balanced budget requirements. To address their budgetshortfalls, these governments have been paring backoperating expenditures. Indeed, real consumptionexpenditures of state and local governments, as meas-ured in the NIPA, fell about 1 percent in 2010 afterdecreasing a similar amount in 2009. The weakness inspending was reflected in the continued reductions inpayrolls. Total employment of state and local govern-ments fell 250,000 during 2010, with nearly all of thecutbacks at the local level. Construction spendingundertaken by these governments was volatile during2010 but, on net, was down a bit for the year andremained below the level that prevailed before therecession despite the infrastructure grants provided bythe federal government as part of the ARRA. Whilemost capital expenditures are not subject to balanced

budget requirements, some of these expenditures arefunded out of operating budgets subject to theserequirements. In addition, a substantial share of debtservice payments on the bonds used to finance capitalprojects is made out of operating budgetsa factorthat may be limiting the willingness of governments toundertake some new infrastructure projects.

With overall economic activity recovering, state gov-ernment revenues from income, business, and salestaxes rose in the second half of 2010. Nevertheless,state tax collections remain well below their pre-recession levels, and available balances in reserve fundsare low. Tax collections at the local level have faredrelatively better. In particular, some localities appear tohave adjusted statutory tax rates so that declining realestate assessments, which typically significantly lagmarket prices, are holding down property tax revenuesby less than they otherwise would. However, manylocalities have seen sharp cutbacks in their grants-in-aid from state governments, and thus have experiencedsignificant fiscal pressures. State and local governmentswill continue to face considerable budget strains, inpart because federal stimulus grants will be windingdown. Moreover, many state and local governments

20

30

40

50

60

70


201020001990198019701960

23. Federal government debt held by the public, 19602010

NOTE: The data for debt are as of year-end; the observation for 2010 is anestimate. The corresponding values for gross domestic product (GDP) are forQ4 at an annual rate. Excludes securities held as investments of federalgovernment accounts.

SOURCE : Federal Reserve Board, flow of funds data.



24/61

will need to set aside additional resources in comingyears both to meet their pension obligations and to payfor health benefits provided to their retired employees.

State and Local Government Borrowing

Issuance of securities by state and local governmentswas robust during the latter half of 2010; it surgednear the end of the year as state governments soughtto take advantage of the Build America Bond programbefore the program expired. 7 Issuance of short-termmunicipal securities was also strong.

Yields on state and local government bonds rosenoticeably more than those on comparable-maturityTreasury securities in the second half of 2010 and early2011. The rise in yields on municipal securities mayhave reflected increased concerns about the fiscal posi-tion and financial health of state and local govern-ments, although the heavy supply of these securitiescoming to market likely also played a role. Spreads oncredit default swaps for some states remained volatilebut narrowed, on net, from their peak levels last sum-mer. Downgrades of the credit ratings of state andlocal governments continued to outpace upgrades dur-ing the second half of 2010. Nonetheless, the pace of actual defaults on municipal issues continued to comedown from its peak in 2008. In recent months, therewere substantial outflows from long-term mutual funds

that invest in municipal bonds.

The External Sector

Supported by the expansion of foreign economic activ-ity, real exports of goods and services continued toincrease at a solid pace in the second half of 2010, ris-ing at an annual rate of 8 percent (figure 24). Nearlyall major categories of exports rose, with exports of machinery, agricultural goods, and services registeringthe largest gains. Moreover, the increase in export

demand was broad based across trading partners.Real imports of goods and services decelerated con-

siderably in the second half of 2010, increasing at anannual rate of only 1 percent after surging more than20 percent during the first half of last year. The sharpstep-down partly reflected an unusually large decline inreal oil imports, but more important, the growth innon-oil imports moderated to a pace more in line with

the expansion in U.S. economic activity. During thesecond half of 2010, imports of consumer goods,machinery, and services posted the largest increases. Aswith exports, the increase in imports occurred across awide range of trading partners.

All told, net exports shaved percentage point off real GDP growth last year as the rebound in importsoutpaced the recovery in exports for the year as awhole. The current account deficit widened from$378 billion in 2009 to an average of $479 billion at anannual rate, or about 3 percent of nominal GDP, inthe first three quarters of 2010 (figure 25).

The spot price of West Texas Intermediate (WTI)crude oil moved higher over the second half of the

7. The Build America Bond program allowed state and localgovernments to issue taxable bonds for capital projects and receive asubsidy payment from the Treasury for 35 percent of interest costs.

10

+_0

10

20


2010200820062004

24. Change in real imports and exports of goodsand services, 200410

H1Q3

Q4


Imports

Exports

Currentaccount

7

6

5

4

3

2

1

+_0


20102008200620042002

25. U.S. trade and current account balances, 200210

Trade

NOTE: The data are quarterly. For the trade account, the data extendthrough 2010:Q4; for the current account, they extend through 2010:Q3. GDPis gross domestic product.




25/61

year, rising to an average of $89 per barrel in Decem-ber, about $11 above the average price that prevailedover the first six months of the year (figure 26). Theupward movement in oil prices during the second half of the year largely reflected a widespread strengtheningin global oil demand, particularly in emerging marketeconomies (EMEs), against a backdrop of constrainedsupply. The depreciation of the dollar over this periodalso contributed somewhat to the rise in the price of oil. Spot WTI continued to fluctuate around itsDecember average for much of the first two months of this year but moved up sharply in late February. 8

Unrest in several Middle Eastern and North Africancountries, and uncertainty about its potential implica-tions for global oil supply, has put considerableupward pressure on oil prices in recent weeks.

The price of the long-term futures contract for crudeoil (expiring in December 2019) has generally fluctu-ated in the neighborhood of $95 per barrel over thepast six months, not much different from the averageover the first half of 2010, although it has moved up

some recently. Accordingly, the sharply upward slopingfutures curve that characterized the oil market sincethe onset of the financial crisis has flattened consider-ably. Concurrent with this flattening of the futurescurve, measured global inventories of crude oil havedeclined in recent months, although they remain highby historical standards.

Nonfuel commodity prices also rose markedly overthe second half of the year and into early 2011, withincreases broad based across a variety of commodities.As with oil, these prices have been supported bystrengthening global economic activity, primarily inChina as well as in other EMEs, and, to a lesser extent,by the lower dollar. In addition, adverse weather con-ditions have reduced harvests and curtailed supplies of important agricultural products in a number of keyexporting countries, including Russia, Ukraine, andthe United States.

Prices of non-oil imported goods rose 1 percent atan annual rate over the second half of 2010 and haveincreased at an accelerated pace in January, boosted byhigher commodity prices, the depreciation of the U.S.dollar, and foreign inflation. On net, non-oil importprices rose a bit more slowly over the second half of 2010 than in the first half and finished the year 2 per-cent higher than at the end of 2009.

National Saving

Total net national savingthat is, the saving of house-holds, businesses, and governments excluding deprecia-tion chargesremains low by historical standards (fig-ure 27). After having reached 3 percent of nominalGDP in 2006, net national saving dropped steadilyover the subsequent three years, reaching roughlynegative 3 percent in the third quarter of 2009. Thewidening of the federal budget deficit during thecourse of the recession more than accounted for thedownswing in net saving. Since late 2009, net national

8. The prices of other grades of crude oil have risen by more overthe first two months of this year as the high level of inventories accu-mulated at Cushing, Oklahoma, the delivery point for WTI, hasdepressed WTI prices.

Total

Federal saving

9

6

3

+_0

3

6

9


201020062002199819941990

27. Net saving, 19902010

Nonfederal saving

NOTE: The data are quarterly and extend through 2010:Q3. Nonfederalsaving is the sum of personal and net business saving and the net saving of state and local governments. GDP is gross domestic product.


Oil

40

60

80

100

120

140

Dollars per barrel

80

100

120

140

160

180

200

201120102009200820072006

26. Prices of oil and nonfuel commodities, 200611

December 2005 = 100

Nonfuelcommodities

NOTE: The data are monthly. The oil price is the spot price of West Texas Intermediate crude oil, and the last observation is the average forFebruary 122, 2011. The price of nonfuel commodities is an index of 45primary-commodity prices and extends through January 2011.

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



26/61

saving has moved up, reflecting a sharp rise in privatesaving. Nonetheless, the total averaged about negative1 percent in the third quarter of 2010 (the latest avail-able data), and the large federal deficit will likely keepit at low levels in the near term. Currently, real interestrates are still low despite the depressed rate of nationalsaving. If national saving were to remain low as theeconomy recovers, interest rates would likely experi-ence upward pressure, capital formation rates wouldlikely be low, and borrowing from abroad would likelybe heavy. In combination, such developments wouldlimit the rise in the standard of living of U.S. residentsand hamper the ability of the nation to meet the retire-ment needs of an aging population.

The Labor MarketEmployment and Unemployment

Conditions in the labor market have continued toimprove only slowly since the middle of 2010. Privatepayroll employment rose just 120,000 per month, onaverage, over the second half of last year, and payrollemployment gains remained lackluster in January of 2011 (figure 28). 9 All told, only about one-seventh of the 8 million jobs lost from the beginning of 2008 tothe trough in private payrolls in February 2010 havebeen recovered. Rather than adding jobs briskly, busi-

nesses have been achieving much of their desiredincreases in labor input over the past year by lengthen-

ing the hours worked by their employees; indeed, byJanuary, the average workweek had recouped morethan one-half of its decrease during the recession.

For most of last year, the overall net increase in hir-ing was barely sufficient to accommodate the increasein the size of the labor force, and the unemploymentrate remained at or above 9 percent through Novem-ber (figure 29). However, the unemployment rate isestimated to have moved down noticeably in Decemberand January, reaching 9.0 percentabout 1 percentagepoint below the highest reading during this episode.

The recent decline in the jobless rate is encouraging,but the extent of the improvement in underlying labor-market conditions is, as yet, difficult to judge. The levelof unemployment remains very elevated, and long-duration joblessness continues to account for an espe-9. Total employmentprivate plus governmentexhibited sharp

swings from March 2010 to September 2010 as a result of the hiringof temporary workers for the decennial census.

800

600

400

200

+

_0

200

Thousands of jobs, 3-month moving average

20112010200920082007200620052004

28. Net change in private payroll employment, 200411

NOTE: The data are monthly and extend through January 2011.SOURCE : Department of Labor, Bureau of Labor Statistics.

4

6

8

10

Percent

20112003199519871979

29. Civilian unemployment rate, 19772011


10

20

30

40

Percent

20112003199519871979

30. Long-term unemployed, 19772011

NOTE: The data are monthly and extend through January 2011. The seriesshown is the percentage of total unemployed persons who have beenunemployed for more than 26 weeks.

SOURCE : Department of Labor, Bureau of Labor Statistics.



27/61

cially large share of the total. Indeed, in January,nearly 6 million persons among those counted asunemployedabout 44 percent of the totalhad beenout of work for more than six months, figures thatwere only a little below record levels observed in themiddle of 2010 (figure 30). 10 Moreover, the number of individuals who are working part time for economicreasonsanother indicator of the underutilization of laborremained roughly twice its pre-recession value.Meanwhile, the labor force participation rate moveddown further in the second half of the year (figure 31).

The decline in participation was mainly concentratedamong men aged 25 and over without a college degree.Several other indicators of labor market conditions,

however, have brightened a bit recently. After showinglittle progress over the first half of the year, initialclaims for unemployment insurance (an indicator of the pace of layoffs) generally have trended down inrecent months. Moreover, survey measures of labormarket expectationssuch as business plans for futurehiring and consumer attitudes about future labor mar-ket conditionsimproved, on net, over the second half of 2010 and early this year after having softenedaround the middle of last year.

Productivity and Labor Compensation

Labor productivity rose further in the second half of 2010. According to the most recent published data,output per hour in the nonfarm business sectorincreased at an annual rate of about 2 percent overthat period (figure 32). Productivity had surged in 2009

as firms aggressively eliminated many operational inef-ficiencies and reduced their labor input in an environ-ment of severe economic stress. Although the recentgains in productivity have been less rapid, firms none-theless continue to make efforts to improve the effi-ciency of their operations, and they appear to remainreluctant to increase staffing levels in a climate of lin-gering economic uncertainty.

Increases in hourly compensation remained subduedin 2010, restrained by the wide margin of labor marketslack (figure 33). The employment cost index (ECI) for

10. The data on the duration of unemployment begin in 1948.

61

64

67

Percent

20112003199519871979

31. Labor force participation rate, 19772011


+_0

1

2

3

4

5

6


32. Change in output per hour, 19482010

194873

197495

19962000

200104

2006 2008 2010

NOTE: Nonfarm business sector. Change for each multiyear period ismeasured to the fourth quarter of the final year of the period from the fourth

quarter of the year immediately preceding the period.SOURCE : Department of Labor, Bureau of Labor Statistics.

H1

H2

Employmentcost index

+_0

1

2

3

4

5

6

7

8

9

Percent

201020082006200420022000

33. Measures of change in hourly compensation,200010

Nonfarm businesscompensation per hour

NOTE: The data are quarterly and extend through 2010:Q4. For nonfarmbusiness compensation, change is over four quarters; for the employment costindex (ECI), change is over the 12 months ending in the last month of eachquarter. The nonfarm business sector excludes farms, government, nonprofitinstitutions, and households. The sector covered by the ECI used here is thenonfarm business sector plus nonprofit institutions.

SOURCE : Department of Labor, Bureau of Labor Statistics.



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private industry workers, which measures both wagesand the cost to employers of providing benefits, rosejust 2 percent in nominal terms in 2010up from anespecially small increase in 2009 but still lower than theroughly 3 percent pace averaged in the several yearspreceding the recession. The rise in the ECI last yearreflected a pickup in the growth of benefits, after asubdued increase in 2009, and a modest acceleration inwages and salaries. Nominal compensation per hour inthe nonfarm business sectorderived from the laborcompensation data in the NIPAincreased only1 percent in 2010, well below the average gain of about 4 percent in the years before the recession. Afteradjusting for the rise in consumer prices, hourly com-pensation was little changed in 2010. Because nominalhourly compensation and labor productivity in thenonfarm business sector rose at roughly the same pacein 2010, unit labor costs were about flat last year. Dur-ing the preceding year, unit labor costs had plunged3 percent as a result of the moderate rise in nominalhourly compensation and the sizable advance in outputper hour.

Prices

Consumer price inflation has been trending downward,on net, and survey measures of longer-term inflationexpectations have remained stable, despite the rapid

increases in a variety of commodity prices during thesecond half of 2010. Overall prices for personal con-sumption expenditures increased 1 percent over the12 months ending in January 2011, compared with arise of 2 percent in the preceding 12-month period(figure 2). The core PCE price indexwhich excludesthe prices of energy items as well as those of food andbeveragesincreased just percent over the12 months ending in January, down from a 1 percentrise over the preceding 12 months.

The index of consumer energy prices, which declinedin the first half of 2010, rose rapidly during the secondhalf of the year and early 2011. The index was boostedby a surge in the prices of gasoline and home heatingoil, which reflected the run-up in the price of crude oilthat began in late summer. In contrast, consumer natu-ral gas prices fell as increases in supply from newdomestic wells helped boost inventories above typicallevels. All told, the overall index of consumer energyprices rose nearly 7 percent during the 12 months end-ing in January 2011.

The index of consumer food prices rose 1 percentover the 12 months ending in January 2011 as theprices of beef and pork posted sizable increases. The

price of fruits and vegetables ran up briskly early in2010 following a couple of damaging freezes, but theseprices turned down in the second half of the year, leav-ing them up only slightly for the year as a whole. How-ever, spot prices in commodity markets for crops andfor livestock moved up sharply toward the end of lastyear, pointing to some upward pressure on consumerfood prices in the first part of 2011.

The slowdown in core PCE price inflation over thepast year was particularly evident in the prices of goods other than food and energy, which fell 0.6 per-cent over the 12 months ending in January 2011. Thedecline in these core goods prices occurred despite siz-able increases in the prices of some industrial com-modities and materials; the modest degree of pass-through from commodity input costs to retail pricesreflects the relatively small weight of materials inputsin total production costs. Prices for services other thanenergy rose about 1 percent over the 12 months end-ing in January, down from an increase of almost 2 per-cent in the preceding 12 months, as the continuedweakness in the housing market put downward pres-sure on the rise in housing costs and as the wide mar-gin of economic slack continued to restrain priceincreases for other services.

The widespread slowing in inflation over the pastyear is also apparent in a variety of alternative indica-tors of the underlying trend in inflation (figure 34).These indicators include trimmed-mean price indexes,

which exclude the most extreme price increases andprice declines in each period, and market-based mea-sures of core prices, which exclude prices that must be

Trimmed mean

Market basedexcluding

food and energy1

2

3

Percent

2011201020092008200720062005

Excludingfood and energy

34. Alternative measures of underlying price changesin personal consumption expenditures, 200511

NOTE: The data are monthly and extend through January 2011. Thetrimmed-mean personal consumption expenditures price index excludes thebottom 24 percent and the top 31 percent of the distribution of monthly pricechanges and is based on 178 components.

SOURCE : For trimmed mean, Federal Reserve Bank of Dallas; for all else,Department of Commerce, Bureau of Economic Analysis.



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imputed. These imputed prices (often referred to asnonmarket prices) tend to be highly erratic.

Survey-based measures of near-term inflation expec-tations have increased in recent months, likely reflect-ing the recent run-up in energy and food prices; in con-trast, survey-based measures of longer-term inflationexpectations have remained relatively stable over thepast year. In the Thomson Reuters/University of Michigan Surveys of Consumers, median year-aheadinflation remained between 2 percent and 3 percentfor most of 2010 but then rose above 3 percent in early2011. Longer-term expectations in the survey, at2.9 percent in February, remained in the narrow rangethat has prevailed over the past few years. In the Sur-vey of Professional Forecasters, conducted by the Fed-eral Reserve Bank of Philadelphia, expectations for theincrease in the consumer price index over the next10 years edged down, on balance, during 2010 afterhaving been essentially unchanged for many years.

F INANCIAL DEVELOPMENTS

In light of the disappointing pace of the progresstoward the Federal Reserves dual objectives of maxi-mum employment and price stability, the Federal OpenMarket Committee (FOMC) took steps in the secondhalf of the year to reduce downside risk to the sustain-ability of the recovery and to provide further support

to economic activity. At its August 2010 meeting, theFOMC decided to keep the Federal Reserves holdingsof longer-term securities constant at their then-currentlevel by reinvesting principal payments from holdingsof agency debt and agency MBS in longer-term Treas-ury securities. In November, the FOMC announced itsintention to purchase a further $600 billion in longer-term Treasury securities by the end of the second quar-ter of 2011 (see box The Effects of Federal ReserveAsset Purchases).

Financial market conditions, which had worsenedearly in the summer as a result of developments inEurope and concerns about the durability of the globalrecovery, subsequently improved as investors increas-ingly priced in further monetary policy accommoda-tion. Accordingly, real Treasury yields declined, assetprices increased, and credit spreads narrowed. Abrightening tone to the economic news starting in thefall bolstered investor sentiment and, together with areassessment on the part of investors of the ultimatesize of Federal Reserve Treasury purchases, contrib-uted to a backup in interest rates and in measures of inflation compensation that continued through year-end. In contrast to the developments earlier in the year,

the reemergence later in the year of concerns about thefinancial situation in Europe left little imprint ondomestic financial markets.

Monetary Policy Expectationsand Treasury Rates

In response to indications of a slowing pace of recov-ery in U.S. output and employment and a continueddownward trend in measures of underlying inflation,expectations regarding the path for the federal fundsrate during 2011 and 2012 were revised down sharplyin the third quarter and investors came to anticipatefurther Federal Reserve asset purchases. The FOMCsdecision to begin additional purchases of longer-termTreasury securities occurred against the backdrop of this downward shift in expectations about monetarypolicy. Subsequently, expectations regarding the ulti-mate size of such purchases were scaled back as therecovery appeared to strengthen, downside risks to theoutlook seemed to recede somewhat, and a tax-cut dealthat was seen as supportive of economic activity waspassed into law.

The current target range for the federal funds rate of 0 to percent is consistent with the level that investorsexpected at the end of June 2010. However, the date atwhich monetary policy tightening is expected to com-mence has moved back somewhat since the time of the

July 2010 Monetary Policy Report to the Congress .Quotes on money market futures contracts indicatethat, as of late February, investors anticipate that thefederal funds rate will rise above its current range inthe first quarter of 2012, about a year later than thedate implied in July 2010. By the end of 2012, investorsexpect that the effective federal funds rate will bearound 1.3 percent, fairly similar to the level antici-pated in mid-2010. 11

Yields on nominal Treasury securities fluctuatedconsiderably in the second half of 2010 and in early2011 due to shifts in investors expectations regarding

11. When interest rates are close to zero, determining the point atwhich financial market quotes indicate that the federal funds rate willmove above its current range can be challenging. The path describedin the text is the mean of a distribution calculated from derivativescontracts on federal funds and Eurodollars. The skewness induced inthis distribution by the zero lower bound causes the mean to be influ-enced strongly by changes in uncertainty regarding the policy path,complicating its interpretation. Alternatively, one can use similarderivatives to calculate the most likelyor modalpath of thefederal funds rate, which tends to be more stable. This path has alsomoved down, on net, since last summer, but it suggests a flatter over-all trajectory for the target federal funds rate, according to which theeffective rate does not rise above its current level until around themiddle of 2012.



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the prospects for econ

federal reserve monetary policy report - mar 2011

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