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The President’s Report to the Board of Directors February 2, 2006 CURRENT ECONOMIC DEVELOPMENTS - February 2, 2006 Data since your last Directors' meeting show the economy grew in the fourth quarter at its slowest pace in three years, following strong growth in the third quarter. The increase in real GDP in the fourth quarter was due primarily to private inventory investment, personal consumption expenditures, equipment and software, exports, and residential fixed investment. The contributions of these components were partly offset by a negative contribution from federal government spending and an increase in imports. In January, consumer attitudes rose to recover the losses incurred over the previous year, and initial claims for unemployment insurance dropped to their lowest level in over five years. Both the ISM manufacturing and employment indices increased in the fourth quarter before easing slightly in January. Inflation concerns continue to be mild, as core consumer prices held steady in the fourth quarter and core producer prices slowed slightly. Unit labor costs increased in the fourth quarter, and total compensation costs, as measured by the ECI, were flat. Oil prices approached $70 per barrel again in January, due in part to political issues overseas, after receding a bit in the fourth quarter. Real GDP growth decelerated in the fourth quarter, primarily reflecting a slowdown in PCE, an acceleration in imports, a downturn in government spending and a deceleration in residential investment. These effects were partially offset by an acceleration in inventory investment. Real Gross Domestic Product Annualized Percent Change Annualized Percent Change 8.0 8.0 6.0 6.0 4.0 4.0 2.0 2.0 0.0 0.0 -2.0 -2.0 02:Q4 03:Q2 Source: Bureau of Economic Analysis. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 In the fourth quarter, despite increases in both personal income and real DPI, real consumption grew at its slowest pace in three years. The slowdown in consumption was due mainly to a plunge in auto sales. Personal Income Real Consumption Annualized Percent Change Annualized Percent Change 6.0 14.0 12.0 Personal Income 10.0 4.0 8.0 6.0 4.0 2.0 2.0 0.0 Real Disposable Income -2.0 -4.0 0.0 02:Q4 03:Q4 03:Q2 04:Q4 04:Q2 05:Q4 02:Q4 03:Q4 03:Q2 05:Q2 04:Q4 04:Q2 05:Q4 05:Q2 Source: Bureau of Economic Analysis. In the fourth quarter, auto sales dropped to their lowest level since 1998, as special manufacturer incentives offered in the middle of the year may have prompted many consumers to purchase a vehicle earlier than they would have without the sales; therefore shifting sales from the fourth quarter. Overall, light vehicle sales in 2005 were identical to those seen in 2004. Total Auto and Light Truck Sales Total Sales, Millions of Units Millions of Units, Annualized 20.0 2003 2004 2005 16.64 16.87 16.87 18.0 16.0 14.0 12.0 10.0 02:Q4 03:Q1 03:Q2 03:Q3 Source: Bureau of Economic Analysis 03:Q4 04:Q1 04:Q2 04:Q3 04:Q4 05:Q1 05:Q2 05:Q3 05:Q4 Growth in business investment decreased in the fourth quarter, due in large part to a deceleration in equipment and software investment. Business Investment Annualized Percent Change Annualized Percent Change 20.0 20.0 16.0 16.0 Equipment and Software 12.0 12.0 8.0 8.0 4.0 4.0 0.0 0.0 Business Investment -4.0 -4.0 -8.0 -8.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Source: Bureau of Economic Analysis. In the fourth quarter, new orders for durable goods grew at their fastest pace in over ten years, despite a reduction in vehicle orders. Orders of nondefense capital goods, excluding aircraft, picked up a bit in the fourth quarter. Durable Goods Orders Motor Vehicle Orders Percent Change, year-over-year Percent Change, previous quarter 6.0 16.0 Capital Goods Nondefense, Excluding Aircraft 12.0 4.0 8.0 2.0 4.0 Durable Goods, New Orders 0.0 0.0 -2.0 -4.0 -8.0 -4.0 02:Q4 03:Q2 03:Q4 Source: U.S. Census Bureau. 04:Q2 04:Q4 05:Q2 05:Q4 04:Q4 05:Q2 05:Q4 Residential investment cooled further in the fourth quarter, resulting in its slowest growth of the year. Residential Investment Annualized Percent Change Annualized Percent Change 25.0 25.0 20.0 20.0 15.0 15.0 10.0 10.0 5.0 5.0 0.0 0.0 -5.0 -5.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Source: U.S. Census Bureau. In the fourth quarter, sales of existing homes dropped from the previous quarter's record high, while the pace of new home sales held relatively steady. New and Existing Home Sales Thousands of Units, Annualized Thousands of Units, Annualized 1400 7500 Existing Home Sales New Home Sales 1300 7000 1200 6500 1100 6000 1000 5500 900 5000 02:Q4 03:Q2 Source: U.S. Census Bureau. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Government spending decreased in the fourth quarter, following three quarters of increasing growth. Government spending was a drag on real GDP for the first time in nearly three years. Government Spending Annualized Percent Change Annualized Percent Change 8.0 8.0 Government spending and investment 6.0 6.0 4.0 4.0 2.0 2.0 0.0 0.0 Contribution to Real GDP -2.0 -2.0 -4.0 -4.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Source: Bureau of Economic Analysis. Import growth accelerated in the fourth quarter, and exports were essentially unchanged. Exports and Imports Annualized Percent Change Annualized Percent Change 25.0 25.0 20.0 20.0 Exports Imports 15.0 15.0 10.0 10.0 5.0 5.0 0.0 0.0 -5.0 -5.0 -10.0 -10.0 02:Q4 03:Q2 Source: Bureau of Economic Analysis. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 After falling further in the fourth quarter, consumer attitudes surged in January due in large part to more positive job market opinions. Consumer Confidence and Expectations Index, 1985 = 100 Index, 1985 = 100 120 120 Confidence 110 110 100 100 90 90 80 80 Expectations 70 70 60 60 02:Q4 03:Q1 03:Q2 03:Q3 03:Q4 04:Q1 04:Q2 04:Q3 04:Q4 05:Q1 05:Q2 05:Q3 05:Q4 Jan-06 Consumer Sentiment and Expectations Index, 1966:Q1=100 Index, 1966:Q1=100 110 110 Sentiment 100 100 90 90 80 80 70 70 Expectations 60 60 02:Q4 03:Q1 03:Q2 03:Q3 03:Q4 04:Q1 04:Q2 04:Q3 04:Q4 05:Q1 05:Q2 05:Q3 05:Q4 Jan-06 Source: The Conference Board (confidence) and University of Michigan (sentiment). Initial claims for unemployment insurance fell sharply in January, reaching their lowest level in nearly six years. Initial Claims Thousands of Units at Annual Rates Thousands of Units at Annual Rates 450 450 425 425 400 400 375 375 350 350 325 325 300 300 275 275 02:Q4 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Source: Department of Labor, Employment and Training Administration. 05:Q2 05:Q1 05:Q4 05:Q3 Jan-06 In January, both the ISM and employment indices decreased following fourth quarter gains. Both measures remain above 50. ISM Index Index (50+ = Economic Expansion) Index (50+ = Economic Expansion) 70.0 70.0 65.0 65.0 60.0 60.0 ISM Index 55.0 55.0 50.0 50.0 45.0 45.0 40.0 40.0 Employment Index 35.0 35.0 30.0 30.0 02:Q4 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 05:Q2 05:Q1 05:Q4 05:Q3 Jan-06 Source: Institute for Supply Management. Inflation exhibited little change in the fourth quarter. Total consumer prices slowed slightly, while core inflation was flat. Producer prices, both total and core, slowed a bit. Consumer Price Index Percent Change, Year-Over-Year Percent Change, Year-Over-Year 5.0 5.0 Consumer Price Index Consumer Price Index, excluding food and energy 4.0 4.0 3.0 3.0 2.0 2.0 1.0 1.0 0.0 0.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Producer Price Index Percent Change, Year-Over-Year Percent Change, Year-Over-Year 8.0 6.0 8.0 Producer Price Index Producer Price Index, excluding food and energy 6.0 4.0 4.0 2.0 2.0 0.0 0.0 -2.0 -2.0 02:Q4 03:Q2 Source: Bureau of Labor Statistics. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Productivity decreased in the fourth quarter for the first time since 2001. Unit labor costs rose during the quarter, and total compensation slowed. Productivity and Costs Percent Change, Previous Quarter Percent Change, Previous Quarter 12.0 12.0 Compensation Per Hour Output Per Hour 9.0 9.0 6.0 6.0 3.0 3.0 0.0 0.0 -3.0 -3.0 Unit Labor Costs -6.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 05:Q2 -6.0 05:Q4 Source: Bureau of Labor Statistics. In the fourth quarter, total employment costs were flat as wages and salaries increased and benefit costs decreased. Employment Cost Index Annualized Percent Change Annualized Percent Change 8.0 8.0 Benefit Costs 7.0 7.0 6.0 6.0 5.0 5.0 Total Compensation 4.0 4.0 3.0 3.0 2.0 2.0 Wages and Salaries 1.0 1.0 0.0 0.0 02:Q4 03:Q2 Source: Bureau of Labor Statistics. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 Oil prices eased a bit in the fourth quarter, but rose sharply in January due in part to political issues overseas. Past Five Months Domestic Spot Oil Price Dollars per Barrel Dollars per Barrel 70.0 70.0 60.0 65.0 50.0 40.0 60.0 30.0 20.0 02:Q4 03:Q3 04:Q2 05:Q1 05:Q4 Sep-05 Nov-05 55.0 Jan-06 Source: Wall Street Journal (oil prices). . Overall, the economy grew in the fourth quarter at its slowest pace in three years. But the economy remains resilient in the face of recent shocks, and hurricance reconstrucion should help support growth in early 2006. Positive employment data has helped boost consumer attitudes, but high energy prices could restict spending and a cooling housing market will likely temper economic growth during the year. Percent Short-Term Interest Rates 5.0 Discount Window Primary Credit 4.0 6.00 3.0 5.00 4.00 3.00 2.0 2.94 3.44 3.91 4.43 4.97 5.26 Federal Funds Rate (effective rate) 2.00 04:Q4 05:Q1 05:Q2 05:Q3 05:Q4 Jan-06 1.0 0.0 02:Q4 03:Q1 03:Q2 03:Q3 03:Q4 04:Q1 04:Q2 04:Q3 04:Q4 05:Q1 05:Q2 05:Q3 Source: Federal Reserve Board of Governors. 05:Q4 Jan-06 PRESIDENT'S REPORT TO THE BOARD OF DIRECTORS, FEDERAL RESERVE BANK OF BOSTON February 9, 2006 Current Economic Developments - Addendum: Data released in the past week In January, nonfarm payrolls added 193,000 jobs and the unemployment rate decreased to 4.7%. December payrolls were revised to show an increase of 140,000 jobs, 32,000 more than the original estimate of a 108,000 job increase, and November payrolls were revised to show an increase of 354,000 jobs, 49,000 more than the previously reported increase of 305,000. Auto sales increased in January, to an annualized rate of 17.6 million units. It was the second consecutive monthly increase, and was the result of a new round of manufacturer incentives designed to boost sales following the slower fourth quarter sales. Consumer sentiment, after imporving in early January, fell back to its December level by the end of the month. Sentiment closed the month at 91.2, nearly identical to the 91.5 recorded in December. Expectations decreased slightly to 78.9 in January, from 80.2 in December. Redbook sales increased 0.4% in the first week of February, compared to January. Sales were 3.3% higherer than during the same period last year. Oil prices decreased during the past week, averaging 65.0 dollars per barrel compared to last week's average of 67.1. Payroll employment posted a strong gain in January, and revisions to the prior two months' estimates resulted in a net gain of 81,000 additional jobs. The unemployment rate fell two-tenths of a percentage point in January to 4.7%. Nonfarm Payroll Employment Change from Previous Quarter, Monthly Average Unemployment Rate Rate 6 400 Change from Previous Month 350 5.8 Nov-05 Dec-05 Jan-06 354,000 140,000 193,000 300 5.6 250 5.4 200 5.2 150 5 100 4.8 50 4.6 0 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 04:Q1 04:Q3 05:Q1 05:Q3 Jan-06 Source: Bureau of Labor Statistics. 03:Q4 04:Q2 04:Q4 05:Q2 05:Q4 04:Q1 04:Q3 05:Q1 05:Q3 Jan-06