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PRESIDENT'S REPORT TO THE BOARD OF DIRECTORS, FEDERAL RESERVE BANK OF BOSTON Current Economic Developments - February 10, 2005 Data since your previous Directors' meeting show the economy grew at a slower pace in the fourth quarter than seen in the third quarter. Core inflation has become a greater concern and continued employment increases remain key in sustaining a vibrant economy. During the fourth quarter, real GDP posted a moderate gain, led by growth in consumption, equipment and software and inventory investment. The gains in these areas were partly offset by a negative contribution from exports and an increase in imports. Despite the sustained increases in core inflation for consumers and wholesalers, consumption remains strong. Total compensation costs, as measured by the ECI, declined slightly even as benefit costs edged up. Wage and salary inflation held steady. Productivity growth slowed in the fourth quarter, while unit labor costs edged up and compensation costs fell slightly. The limited data available for 2005 suggest continued economic strength. In January, payroll employment increased and the unemployment rate fell. Initial claims continued to edge down further. Also in January, the ISM index declined despite an increase in the employment component. Consumer confidence and sentiment rose while expectations remained relatively flat. Auto and light truck sales fell in January after two successive quarters of growth. During the fourth quarter, real GDP decelerated due primarily to a downturn in exports and an acceleration in imports. Still, the GDP figures portray an expanding economy, as consumers continue to spend and businesses continue to invest. Real Gross Domestic Product Annualized Percent Change Annualized Percent Change 10.0 10.0 8.0 8.0 6.0 6.0 4.0 4.0 2.0 2.0 0.0 0.0 -2.0 -2.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 Source: Bureau of Economic Analysis. 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Real consumption remained robust in the fourth quarter, aided by increases in both personal and real disposable income. Personal Income Real Consumption Annualized Percent Change Annualized Percent Change 9.0 6.0 Real Disposable Income 4.0 6.0 Personal Income 3.0 2.0 0.0 0.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 Source: Bureau of Economic Analysis. Still, consumer spending was somewhat lower in the fourth quarter as consumption of durable goods decreased. Spending on nondurable goods rose for the second consecutive quarter. Annualized Percent Change Durable and Nondurable Goods AnnualizedPercent Change 40.0 40.0 Durable Goods 30.0 30.0 20.0 20.0 Nondurable goods 10.0 10.0 0.0 0.0 -10.0 -10.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 Source: Bureau of Economic Analysis. 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 During the fourth quarter, businesses continued to invest in equipment and software, although at a slower pace than seen in the third quarter. Residential investment posted its smallest gain in three years. Residential Investment Business Investment Annualized Percent Change Annualized Percent Change 25.0 25.0 Equipment and Software 20.0 20.0 15.0 15.0 10.0 10.0 5.0 0.0 5.0 -5.0 0.0 Business Investment -10.0 -5.0 -15.0 01:Q4 02:Q4 02:Q2 03:Q4 03:Q2 01:Q4 04:Q4 02:Q4 02:Q2 04:Q2 03:Q4 03:Q2 04:Q4 04:Q2 Source: Bureau of Economic Analysis. Government spending increased slightly in the fourth quarter, yet continues to contribute less than two-tenths of a percentage point to real GDP. Government Spending Annualized Percent Change Annualized Percent Change 10.0 10.0 8.0 8.0 Government spending and investment Contribution to Real GDP 6.0 6.0 4.0 4.0 2.0 2.0 0.0 0.0 -2.0 -2.0 01:Q4 02:Q2 Source: Bureau of Economic Analysis. 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 Following a year of diminishing growth, exports fell in the fourth quarter. Imports also increased to further subtract from real growth. Exports and Imports Annualized Percent Change Annualized Percent Change 20.0 20.0 Imports 15.0 15.0 10.0 10.0 5.0 5.0 0.0 0.0 Exports -5.0 -5.0 -10.0 -10.0 -15.0 -15.0 01:Q4 02:Q2 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 Source: Bureau of Economic Analysis. Both consumer and producer prices rose in the fourth quarter, due in large part to record high energy prices. Inflation in the core indices, which exclude food and energy, has eased after the rapid increases seen earlier in the year. Consumer Price Index Past Six Months Annualized Percent Change Percent Change, Year-Over-Year 5.0 5.0 4.0 Consumer Price Index Consumer Price Index, excluding food and energy 3.0 4.0 2.0 3.0 1.0 2.0 0.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 Producer Price Index Core CPI Percent Change, Year-Over-Year 0.0 6.0 Producer Price Index 4.0 1.0 -1.0 2.0 Core PPI 0.0 Producer Price Index, excluding food and energy -2.0 -4.0 02:Q4 03:Q2 Source: Bureau of Labor Statistics. 03:Q4 04:Q2 04:Q4 -2.0 -3.0 Jul-04 Sep-04 Nov-04 Aug-04 Oct-04 Dec-04 Oil prices peaked in the fourth quarter, reaching an all-time high in October before receding in November and December. Recent data shows prices remain at historically high levels. Past Five Months Domestic Spot Oil Price Dollars per Barrel Dollars per Barrel 54.0 54.0 48.0 51.0 42.0 Week ending February 8th, $46.1 36.0 48.0 30.0 45.0 24.0 42.0 18.0 01:Q1 02:Q3 01:Q4 Oct-04 04:Q1 03:Q2 Dec-05 Nov-04 04:Q4 Feb-05 Jan-05 Source: Wall Street Journal (oil prices). . Employee costs decelerated during the fourth quarter, as wages and salaries were flat and benefit costs increased. Employment Cost Index Annualized Percentage Change Annualized Percentage 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 Wages and Salaries 2.0 2.0 01:Q4 02:Q2 Source: Bureau of Labor Statistics. 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 Productivity growth slowed in the fourth quarter, compared to the third, seeing its smallest increase in nearly four years. Unit labor costs rose slightly while compensation costs fell somewhat. Productivity and Costs Percent Change, Previous Quarter Percent Change, Previous Quarter 10.0 10.0 Output Per Hour Compensation Per Hour 5.0 5.0 0.0 0.0 Unit Labor Costs -5.0 -5.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Source: Bureau of Labor Statistics. The labor market continues to show signs of strength. Payroll employment increased again in January and initial claims edged down further. The unemployment rate fell to its lowest point in over three years. Nonfarm Payroll Employment Unemployment Rate and Initial Claims Change from Previous Quarter, Average Monthly Percent 300 6.2 Thousands of Units at Annual Rates 440 Unemployment Rate Change from Previous Month 200 Nov-04 Dec-04 Jan-05 132,00 0 133,00 0 146,00 0 100 6.0 420 5.8 400 5.6 380 5.4 360 Initial Claims 0 340 5.2 -100 5.0 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 03:Q1 03:Q3 04:Q1 04:Q3 Jan-05 320 02:Q4 03:Q2 03:Q4 04:Q2 04:Q4 03:Q1 03:Q3 04:Q1 04:Q3 Jan-05 Source: Bureau of Labor Statistics (employment) Department of Labor, Employment and Training Administration (claims). The ISM index continued to fall in January, despite a rise in the employment index. ISM Index Index (50+ = Economic Expansion) Index (50+ = Economic Expansion) 70.0 70.0 60.0 60.0 ISM Index Employment Index 50.0 50.0 40.0 40.0 30.0 30.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Jan-05 Source: National Association of Purchasing Management. Consumer confidence increased and sentiment rose slightly in January while expectations were bascially flat. Consumer Confidence and Expectations Index, 1985 = 100 Index, 1985 = 100 125 125 Confidence Expectations 100 100 75 75 50 01:Q4 50 02:Q2 02:Q1 02:Q4 02:Q3 03:Q2 03:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Consumer Senitment and Expectations Index, 1966:Q1=100 Jan-05 Index, 1966:Q1=100 120.0 120.0 100.0 Sentiment 100.0 Expectations 80.0 80.0 60.0 60.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 03:Q2 03:Q1 03:Q4 03:Q3 Source: The Conference Board (confidence) and University of Michigan (sentiment). 04:Q2 04:Q1 04:Q4 04:Q3 Jan-05 Despite the increases in consumer attitudes, auto and light truck sales fell in January but remain at a high level. Total Auto and Light Truck Sales Millions of Units, Annualized Millions of Units, Annualized 18.0 18.0 17.0 17.0 16.0 16.0 15.0 15.0 01:Q4 02:Q2 02:Q1 02:Q4 02:Q3 03:Q2 02:Q1 03:Q4 03:Q3 04:Q2 04:Q1 04:Q4 04:Q3 Jan-05 Source: Federal Reserve, Board of Governors. Overall the economy grew at a slower pace in the fourth quarter than seen in the third quarter. Core inflation has become a greater concern and continued employment increases remain key to sustaining a vibrant economy. Percent Short-Term Interest Rates 3.0 Federal Funds Rate (effective rate) 2.0 Discount Window Primary Credit 3.50 3.25 3.00 2.94 2.50 2.00 1.0 1.50 2.42 2.00 2.00 04:Q1 04:Q2 04:Q3 04:Q4 Jan-05 0.0 01:Q4 02:Q1 02:Q2 02:Q3 02:Q4 03:Q1 03:Q2 03:Q3 03:Q4 04:Q1 04:Q2 04:Q3 Source: Federal Reserve Board of Governors. 04:Q4 Jan-05