Monetary Policy Report to the Congress
Report submitted to the Congress on February 11, 2004, pursuant to section 2B of the Federal Reserve Act
MONETARY POLICY AND THE ECONOMIC OUTLOOK
The economic expansion in the United States gathered strength during 2003 while price inflation remained quite low. At the beginning of the year, uncertainties about the economic outlook and about the prospects of war in Iraq apparently weighed on spending decisions and extended the period of subpar economic performance that had begun more than two years earlier. However, with the support of stimulative monetary and fiscal policies, the nation's economy weathered that period of heightened uncertainty to post a marked acceleration in economic activity over the second half of 2003. Still, slack in resource utilization remained substantial, unit labor costs continued to decline as productivity surged, and core inflation moved lower. The performance of the economy last year further bolstered the case that the faster rate of increase in productivity, which began to emerge in the late 1990s, would persist. The combination of that favorable productivity trend and stimulative macroeconomic policies is likely to sustain robust economic expansion and low inflation in 2004.
At the time of our last Monetary Policy Report to the Congress, in July, near-term prospects for U.S. economic activity remained unclear. Although the Federal Open Market Committee (FOMC) believed that policy stimulus and rapid gains in productivity would eventually lead to a pickup in the pace of the expansion, the timing and extent of the improvement were uncertain. During the spring, the rally that occurred in equity markets when the war-related uncertainties lifted suggested that market participants viewed the economic outlook as generally positive. By then, the restraints imparted by the earlier sharp decline in equity prices, the retrenchment in capital spending, and lapses in corporate governance were receding. As the price of crude oil dropped back and consumer confidence rebounded last spring, house-hold spending seemed to be rising once again at a moderate rate. Businesses, however, remained cautious; although the deterioration in the labor market showed signs of abating, private payroll employment was still declining, and capital spending continued to be weak. In addition, economic activity abroad gave few signs of bouncing back, even though long-term interest rates in major foreign economies had declined sharply. At its June meeting, the FOMC provided additional policy accommodation, given that, as yet, it had seen no clear evidence of an acceleration of U.S. economic activity and faced the possibility that inflation might fall further from an already low level.
During the next several months, evidence was accumulating that the economy was strengthening. The improvement was initially most apparent in financial markets, where prospects for stronger economic activity and corporate earnings gave a further lift to equity prices. Interest rates rose as well, but financial conditions appeared to remain, on net, stimulative to spending, and additional impetus from the midyear changes in federal taxes was in train. Over the remainder of the year, in the absence of new shocks to economic activity and with gathering confidence in the durability of the economic expansion, the stimulus from monetary and fiscal policies showed through more readily in an improvement in domestic demand. Consumer spending and residential construction, which had provided solid support for the expansion over the preceding two years, rose more rapidly, and business investment revived. Spurred by the global recovery in the high-tech sector and by a pickup in economic activity abroad, U.S. exports also posted solid increases in the second half of the year. Businesses began to add to their payrolls, but only at a modest pace that implied additional sizable gains in productivity.
The fundamental factors underlying the strengthening of economic activity during the second half of 2003 should continue to promote brisk expansion in 2004. …