2006 Annual Report

Message from the President

Michael Moskow THE ECONOMY AND MONETARY POLICY
Real gross domestic product, or real — our broadest measure of economic output — increased at an annual rate of 3.1 percent in 2006. However, over the past few quarters, growth has been averaging close to 2 percent. At the Federal Reserve Bank of Chicago, our estimate of the economy's potential growth rate — that is, the rate of growth it can sustain over time given its labor and capital resources — is just a bit under 3 percent. As such, by this standard, economic growth over the last few quarters has been somewhat below potential. However, even though overall growth has been below our estimate of potential, labor markets have continued to tighten; the unemployment rate fell from 5 percent in late 2005 to an average of about 4 1/2 percent in early 2007.

Such tightening resource pressures, as well as high energy and commodity prices, likely contributed to faster increases in prices. As a result, inflation ran too high. The Fed's preferred measure of inflation is the price index for personal consumption expenditures excluding food and energy, also known as core PCE. Over the four quarters of 2006, core PCE prices increased 2.2 percent, about the same pace as in 2005. By contrast, I prefer that, over time, inflation run between 1 and 2 percent — the range I consider to be most compatible with the Fedâ€™s goal of price stability.

Given the relatively high level of resource utilization in the first half of 2006, the Federal Open Market Committee (FOMC) continued removing policy accommodation at a measured pace. The FOMC raised the target federal funds rate from 4 1/4 percent at the beginning of the year to 5 1/4 percent after its June meeting. With the pace of growth moderating in the second half of the year, but with inflation still running too high, the FOMC left the stance of policy unchanged through the rest of 2006 and the beginning of 2007.

For the balance of 2007, economic growth likely will average modestly below potential, but I expect that growth will return to near potential in 2008. The below-potential growth this year would be consistent with slight increases in the unemployment rate and other measures of resource slack, but the magnitude of the increases would likely be small.

Core inflation should gradually come down, moving closer to the levels I view as being consistent with price stability. Still, there is a risk that inflation could remain stubbornly high for a couple reasons. First, the economy appears to be operating in the neighborhood of its potential level of output. The unemployment rate is low, growth in compensation per hour has moved up some over the past year, and productivity growth has slowed. Together, these have resulted in an acceleration in unit labor costs. Second, inflation has run at or above 2 percent for the past three years. With inflation at such a high level for such a long period of time, we have to recognize the risk that inflation expectations could become stuck in a range that would not be conducive to price stability. To date, inflation expectations appear to be contained, but that is not something we can take for granted. The longer inflation runs above levels consistent with effective price stability, the greater the danger that expectations of future inflation will settle in above those levels as well.

Taking all of these factors into account, my assessment is that the risk of inflation remaining too high in 2007 is greater than the risk of growth falling too low. Of course, whether policy will need to be adjusted and the degree of any adjustment will depend on the incoming data and how that data influences our forecast of the economy.

LOOKING BACK
After 13 years as president of the Federal Reserve Bank of Chicago, I will retire on August 31, 2007. In this year's annual report, I reflect upon my tenure at the Bank, and in particular, on my impressions of the most important developments in the Federal Reserve's core responsibilities of monetary policy, bank supervision and regulation, and the payments system.

In addition, I would be remiss if I did not say how tremendously rewarding my work at the Chicago Fed has been, primarily because of the opportunity over the years to work with such dedicated and talented staff members and directors.

Of special note are the seven individuals who served as chairman of our Board of Directors during my years at the Chicago Fed: Richard Cline; Robert Healey (deceased); Lester McKeever, Jr.; Arthur Martinez; Robert Darnall; James Farrell and Miles White. Each has made significant contributions to the Chicago Fed and the FederaI Reserve System.

I would also like to thank the many directors who served the Chicago Fed and its Detroit Branch during my tenure (listed on page 17) as well as the three individuals who completed their service as directors last year. They are:

James Farrell, former chairman of Glenview, Ill.-based Illinois Tool Works. Jim served as chairman of the board from 2004 to 2005.
William A. Osborn, the chairman and CEO of Northern Trust Corporation and the Northern Trust Company.
Mindy C. Meads, currently the president and chief merchandising officer of Aeropostale, Inc., and formerly the president and CEO of Lands' End Inc.

I am very grateful for their counsel and help in running our operation efficiently and productively. On a related note, I would like to recognize the following people who joined our board this year. They are:

William C. Foote, chairman and CEO of Chicago-based USG Corporation.
Dennis J. Kuester, chairman and CEO, Marshall & Ilsley Corporation, Milwaukee, Wisconsin.
Ann D. Murtlow, president and CEO, Indianapolis Power & Light Company, Indianapolis, Indiana, and vice president, AES Corporation.

In closing, I would like to emphasize how much I have enjoyed serving the Federal Reserve Bank of Chicago and the residents of the Seventh Federal Reserve District. I am proud of our accomplishments and value the relationships that I have been able to form with people throughout Chicago and the Midwest. I also am proud of the tremendous strides we have made in fulfilling our varied responsibilities. With the continued dedication of our staff and directors, I am confident that the Bank will remain in very strong condition in the years ahead.

Michael H. Moskow
President and Chief Executive Officer
May 15, 2007