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Annual Report, 2004
2004 Annual Report
Message from the President

With a mandate to promote maximum sustainable economic growth as well as stable prices, Fed policymakers must be constantly vigilant. When the economy gathers strength and overcomes a 'soft patch' or recession, inflation concerns typically become more pressing. Such was the case in 2004.

The economy entered the year with significant momentum, thanks in part to a highly accommodative monetary policy put in place to help foster a recovery from the 2001 recession. With this momentum, the economy's vitality spread into areas that had struggled in the previous two years — specifically the manufacturing sector and labor markets.

With that in mind, the Federal Open Market Committee (FOMC) during 2004 sharpened its focus on inflation. Prices for many commodities increased during most of the year, but none drew as widespread attention as oil prices. The price for a barrel of West Texas Intermediate crude (the bellwether of energy prices) topped $55 in October — well above the $30 average that persisted between 2000 and 2002. As 2004 progressed, core inflation measures moved up from the extremely low rates in late 2003.

Even though the uptick in inflation was widely viewed as temporary and inflation expectations remained contained, it became clear that the highly accommodative monetary policy that had been needed earlier in the recovery was no longer necessary. As a result, the FOMC began to remove its policy accommodation. Beginning in June 2004, we increased our target for the federal funds rate from 1 percent and eventually pushed the rate to 2.75 percent in March 2005.

Even with tighter monetary policy, the economy continued to expand in 2004. Manufacturing production grew at the fastest rate in five years, and payroll employment increased in all 12 months of the year for the first time since 1999. By early 2005, both production and employment surpassed the level of their previous peaks, a sure sign that the economy had shifted from recovery mode to expansion.

Community Banks Play Important Role in Regional Economy

In this year's annual report, we are taking a close look at community banking. Because of the services they provide small businesses, farms and households, community banks play an important role in the economy of the Seventh Federal Reserve District (Iowa and most of Illinois, Indiana, Wisconsin and Michigan). We're home to more community banks than any of the other 11 Fed districts.

The essay, Community Banks At Their Best: Serving Local Financial Needs, offers a comprehensive look at the current state of community banks in the U.S. It explains why community banks are unique, documents the reasons for their declining numbers in recent years, and offers a perspective on what they must do to be competitive moving forward. The conclusion is that in a constantly changing environment, with fierce competition from a wide variety of other financial services providers, those community banks that are well-run and efficiently managed will not only survive, but thrive.

Electronic Payment Growth Forces Check-Processing Consolidations

Another issue we're watching closely is the continued growth of electronic payments. Consumers continue to move away from paper checks (See chart at right). A recent Federal Reserve payment study confirms that U.S. electronic payment transactions in 2003 exceeded check payments for the first time. Between 2000 and 2003, check payments declined an average of 4.3 percent, while electronic payment transactions jumped an average of 13.2 percent.

While the shift is beneficial to the payment system, it has had a profound impact on our check-processing operations. We are consolidating Federal Reserve check-processing facilities across the country. By early next year, the number of check-processing sites will have decreased from 45 to 23. Of all the restructuring throughout the Federal Reserve System, the most took place in the Seventh District. For example:

  • The Omaha check-processing office closed in April of 2004, with the Chicago Fed's Des Moines office picking up the volume.
  • In July of 2004, the Chicago Fed's Milwaukee office closed. Those checks transferred to the Chicago Midway office, where we expanded our capacity to handle additional volume.
  • The Chicago Fed in October of 2004 closed its Peoria office in central Illinois, with that volume shifting to the Chicago Midway office.
  • The Chicago Fed's Indianapolis office also closed in October of 2004, with that volume shifting to the Cincinnati office.
  • In addition, checks being processed at our Detroit branch are slated to transfer in mid-April of 2005 to the Cleveland office.

Despite this much restructuring, our staff continued to provide high-quality check services to our customers. I'm pleased to say the consolidations have gone very well. Our check- processing operations are now more efficient, with costs more in line with revenue. Our Chicago Midway office is processing roughly 3 million checks a day. Overall, more than 2 billion checks were processed in the Seventh District in 2004, with the Check Department achieving local net revenue financial targets.

We will monitor trends in the payments industry, and we're confident we are structured to provide efficient, high-quality service for years to come.

Other 2004 Accomplishments

Other notable accomplishments in 2004 include the work of our Customer Relations and Support Office (CRSO), which serves the entire Federal Reserve System. Despite a tight deadline and technology challenges, the CRSO rolled out Fedline Advantage, which allows customers to conduct high-value, high-risk transactions securely via the Web.

In Supervision & Regulation (S&R), Senior Vice President Cathy Lemieux was promoted in November to lead the department. Throughout the year, S&R continued to improve its risk assessment process by focusing on risk identification, analysis and resolution. We carried out roughly 1,100 examinations, inspections and off-site reviews and also offered training to almost 600 directors of community banks.

Economic Research also had an outstanding year in its effort to produce innovative research that leads to the development of informed public policy. The Research Department had more articles (21) selected to be included in scholarly publications than in any of the 10 years I have been at the Bank.

Work was also completed at our downtown Chicago headquarters on a comprehensive set of building improvements to enhance security and ensure employee safety. In addition, progress continued on construction of our new Detroit Branch building (See photo at right), slated to open in January 2006 with improved security and an expanded, state-of-the-art cash vault.

Looking at operations across the board, support and overhead costs in the Seventh District were 10% below budget in 2004 without impacting service levels or incurring any undue risk. We also made significant progress in enhancing internal controls.

These are just a few of our 2004 highlights. I invite you to look over a more comprehensive listing in the section of this annual report titled, Chicago Fed Highlights of 2004. These would not have been possible without the dedicated commitment of our staff members who remained productive and focused through a challenging year.

Thanks to our Directors

Commitment is also a good word to use when discussing the two teams of directors who provide us with perspective, guidance and counsel. I'd specifically like to thank the directors who retired at the end of 2004: James H. Keyes and Alan R. Tubbs from the Chicago board and Robert E. Churchill from the Detroit board. Their contributions are very much appreciated.

In 2005, we welcomed three new members to our boards. Joining our Chicago board are Mindy C. Meads, CEO of Lands' End, Inc. and executive vice president at Sears, Roebuck and Co., and Jeff Plagge, president and CEO of The First National Bank of Waverly in Waverly, Iowa; president of the First of Waverly Corporation; and CEO of the First National Bank of Cedar Falls and First Insurance Services. Joining the Detroit board is Michael M. Magee, Jr., president and CEO of Independent Bank Corp- oration in Ionia, Michigan.

I am personally very thankful for the contributions of our directors. With their hard work and that of our staff, we are well positioned to continue our efforts in 2005 to foster a strong economy and a stable payment system.

Michael H. Moskow
President and Chief Executive Officer
April 1, 2005

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