2007 Annual Report

THE ECONOMY AND MONETARY POLICY ¹

Overall, economic growth in 2007 was somewhat below what the Federal Reserve Bank of Chicago estimates as the economy's potential growth rate - that is, the rate of growth it can sustain over time given its labor and capital resources. The shortfall from potential in large part reflected a severe decline in residential construction, which reduced real GDP growth by an average of 0.9 percent point per quarter over the year. Solid rates of growth in business fixed investment and household consumption along with rising net exports offset some of the weakness due to the residential sector.

With growth just below potential, labor markets also began to ease in 2007. The unemployment rate rose from 4.4 percent in late 2006 to 4.8 percent in late 2007, and changed little, on balance, in early 2008. Still, the level of resource utilization remained elevated through much of the year, and increases in prices for food and energy and other commodities also put pressure on inflation. As a result, inflation was elevated last year. The price index for personal consumption expenditures (PCE) rose 3.4 percent over the four quarters of 2007. Core PCE, which excludes food and energy prices, increased 2.1 percent. Although this pace was down slightly from 2006, the improvement reflected developments early in the year, and core inflation rates were higher at the end of 2007 than they were at mid-year.

SECOND HALF OF 2007

The second half of 2007 was dominated by financial turmoil. As the residential housing market deteriorated, delinquencies and defaults on subprime mortgages increased substantially, jeopardizing the income flows supporting the many layers of securities that had been built upon them. As a result, market participants substantially reduced the perceived value of these instruments, as well as the value of other similar complex securities even if they contained no subprime-related debt. Uncertainty over collateral valuation and counterparty risk boosted the demand for liquidity. In addition, financial intermediaries had to take troubled assets back onto their balance sheets, reducing their willingness to issue new loans. These factors, along with increased concerns about the macroeconomic environment, resulted in a tightening of terms and costs of credit to some borrowers, thereby reducing their spending capacity. They also induced a sense of caution, which caused some households and firms to pull back on spending plans as they waited to see how events would transpire.

Given the relatively high level of resource utilization in the first half of 2007, the Federal Open Market Committee (FOMC) maintained the slightly restrictive stance it had established in late 2006, holding the target federal funds rate at 5-1/4 percent through August. In light of the developing financial turmoil, the FOMC began lowering the target federal funds rate in early September, bringing the rate to 4-1/4 percent by the end of 2007. As 2008 began, the financial turmoil intensified and the pace of economic growth slowed. With inflation expectations remaining contained, the FOMC then further lowered the target to 2.25 percent by mid-March.

MOVING FORWARD

For 2008 as a whole, it is expected that the economy will grow, but at a quite sluggish rate. Importantly, the adjustments in housing and financial markets likely will weigh on activity, particularly in the first half of the year. However, the current fed funds rate is accommodative; and, because monetary policy operates with a lag, the effects of recent rate cuts should promote growth as the year continues. Fiscal policy will also act as a stimulus. In addition, while not as robust as in the late 1990's and early this decade, the underlying trend in productivity remains solid, providing a sound base for production and income generation over the long term. Accordingly, growth is expected to improve later in 2008 and return to near potential in 2009.

Core inflation should gradually come down in 2008, as the economy operates below its potential level of output. Still, there is a risk that inflation could remain stubbornly high. A particular concern is that increases in food and energy and other commodity prices will be passed on to downstream customers. Persistent food and energy price increases could eventually find their way into inflation expectations. To date, inflation expectations appear to be contained; however, the longer total inflation runs above levels consistent with effective price stability, the greater the danger that inflation expectations will rise. Thus, these inflation developments will be carefully monitored.

Notes:
¹This essay reflects information available as of March 21, 2008.