2005 Annual Report

Message from the President

During the first three quarters of 2005, the U.S. economy grew at a rate about equal to or slightly above its potential growth rate - the rate that can be sustained over the long run without creating inflation pressures. Real GDP growth in the fourth quarter of 2005, however, dropped to an annual rate of below 2 percent. This appears to have been largely due to transitory factors, and various indicators point to a recovery in growth in early 2006.

When the economy has an abundance of slack resources, as it did after the 2001 recession and the slow recovery that followed, inflation pressures can remain relatively muted even when the economy grows faster than its potential. Over the last couple of years, a highly accommodative monetary policy has helped foster such economic growth, which has removed much of this slack. The unemployment rate has fallen from almost 6 percent at the end of 2003 to under 5 percent at the end of 2005, and the capacity utilization rate in manufacturing has risen from under 77 percent at the end of 2003 to over 80 percent at the end of 2005, near its 30-year average.

With the economy growing at a robust, self-sustaining rate, the Federal Open Market Committee (FOMC) began removing policy accommodation at a measured pace in June 2004 to prevent inflation pressures from developing. This continued throughout 2005, with the target federal funds rate (see chart below) rising from 2.25 percent at the beginning of 2005 to 4.75 percent after the FOMC meeting in late March of this year, the first one led by new chairman Ben Bernanke, who replaced Alan Greenspan.

The target Federal Funds rate rose from 2.25 percent at the beginning of 2005 to 4.75 percent after the FOMC meeting in late March of this year. Source: Federal Reserve System

Soaring energy prices are also an inflation threat. Spot crude oil prices jumped over 30 percent in 2004, and strong worldwide demand, continued geopolitical risks, and the terrible devastation caused by Hurricane Katrina contributed to a 40 percent increase in oil prices in 2005. Natural gas and refined oil product prices also rose sharply in 2005. Like other costs related to production, higher energy prices can pass through to the prices of other goods and services.

Finally, there is a concern that if people see a string of higher inflation numbers, they may begin to expect permanently higher inflation. Though inflation expectations are currently contained, one of the goals of monetary policy is to keep these expectations in check.

Some have suggested that explicit numerical inflation guidelines can aid the Fed in keeping inflation expectations well anchored at a low level. In this year's annual report, we examine the issue of inflation targets in more detail and pose some questions that need to be answered before I feel we can make a final determination on this issue.

2005 Results and Recognition of our Employees and Directors

The hard work and dedication of our employees and the leadership and counsel of our directors in 2005 contributed to another successful year at the Chicago Fed. A list of some of our many accomplishments.

Two individuals completed their service as directors last year and merit separate mention: Connie E. Evans from the Chicago board and Edsel B. Ford II from the Detroit board. Both Connie and Edsel served on their respective boards since 2000, and Edsel served as chairman of the Detroit Branch board for the last two years. I am personally grateful to both for their valuable perspective and guidance. On a related note, Valerie B. Jarrett, managing director and executive vice president of the Habitat Company, joined the Chicago board this year, and Timothy M. Manganello, chairman and CEO of BorgWarner, Inc., joined the Detroit board.

I would also like to recognize Alan Greenspan, whom I have known for over 35 years, for his more than 18 years of outstanding service as chairman of the Federal Reserve Board and the FOMC. His contributions will be missed, but I have high regard for his successor, Ben Bernanke. And Chairman Bernanke is taking over a very strong institution. The quality of the people at the Fed and the collegial nature of this organization will continue to contribute to our success in 2006.

Michael H. Moskow
President and Chief Executive Officer
April 1, 2006