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Federal Reserve Bank of Richmond I 2006 Annual Report

Inflation and Unemployment:
A Layperson’s Guide to the Phillips Curve

Mission
As a regional Reserve Bank, we work within the Federal
Reserve System to foster the stability, integrity, and efficiency of
the nation’s monetary, financial, and payments systems. In doing
so, we inspire trust and confidence in the U.S. financial system.

Vision
We will excel at everything we do, and make unique and
important contributions to the Federal Reserve System’s mission.

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Contents
Message from the President . . . . . . . . . . . . . . . 1
Inflation and Unemployment:
A Layperson’s Guide to the Phillips Curve . . . 4
By Jeffrey M. Lacker and John A. Weinberg

Fifth District Economic Report . . . . . . . . . . . . 27
Message from Management. . . . . . . . . . . . . . . 30
The Bank in the Community . . . . . . . . . . . . . . 32
Boards of Directors, Advisory Groups,
and Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Financial Statements . . . . . . . . . . . . . . . . . . . . 45

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JEFFREY M. LACKER

Message from the President
Over the three years leading up to 2006, real growth
in the U.S. economy was relatively rapid, and inflation
remained relatively low and stable. Over the course of
2006, though, both those numbers deteriorated a bit.
Growth dropped below 3 percent, and in fact was
closer to 2 percent in the last half of the year. Meanwhile, inflation moved above 2.5 percent. While still
relatively low by historical standards, I view that
number—and, more importantly, the upward trend
in inflation—with some caution. Inflation is, in my
opinion, too high.

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The pairing of softness in real economic growth

The history of the Phillips curve has three distinct

with rising inflation creates a potential dilemma for

phases: the Phillips curve as a stable menu of policy

policymakers, since these two phenomena are

options; the Phillips curve as a short-run relationship

typically understood as requiring opposite policy

that depends crucially on people’s expectations; and

responses—lowering the short-term interest rate

the Phillips curve as one piece of a larger model that

in response to slower real growth while raising rates

describes the complicated interactions of the deci-

when inflation is too high. This dilemma points to the

sions made by diverse participants in the economy.

fundamental question facing the Federal Reserve—

While this last phase may sound impractically com-

what is the relationship between growth and infla-

plex, we believe it offers a clear understanding of

tion? This question has been at the core of macro-

macroeconomic behavior and a useful way to frame

economics for the past 50 years. Can you “buy”

current policy debates.

greater growth by tolerating a little more inflation,

In the first phase, Paul Samuelson and Robert

and do you have to depress growth to lower

Solow showed that Phillips’ empirical finding held

inflation? Or is that one-to-one trade-off too simple?

also for U.S. data on unemployment and price infla-

Instead, for instance, can we have both healthy

tion. And they argued that this statistical relationship

growth and low, stable inflation? Prevailing think-

implied a set of choices for society. If you wanted

ing—both within the Federal Reserve and the

faster economic growth, then you should put more

economics profession in general—has changed

money into the economy. This could be done either

much during that time. This year’s Annual Report

through fiscal policy (say, by cutting taxes or increas-

essay outlines the evolution of that thinking, discusses

ing government spending) or through monetary policy

where we stand now, and considers the implications

(say, by cutting interest rates). This would produce

for policymakers.

higher inflation, but that was a trade-off sometimes
worth making. Conversely, if you felt inflation was

“ This dilemma points to the fundamental ques-

getting too high, then you should take money out of

tion facing the Federal Reserve—what is the

the economy. This version of the Phillips curve was

relationship between growth and inflation? ”

appealing to many policymakers because it implied
a simple, almost mechanistic, approach to the

In 1957, A. W. Phillips looked at data on unemployment and wage inflation in the United Kingdom, and
found that as unemployment went down, wage inflation

macroeconomy, one where desired results could
be achieved through straightforward measures.
Beginning in the late 1960s, and led initially by

tended to go up. This statistical relationship became

Milton Friedman and Edmund Phelps, economists

known as the “Phillips curve.” In the decades since

came to recognize the importance of people’s expecta-

Phillips published his findings, economists’ understand-

tions for the relationship between inflation and such

ing of this relationship has developed along two

real economic indicators as unemployment. Inflation

fronts—refinement of the statistical facts concerning

that was anticipated would not stimulate real economic

the relationship, and the application of theory to explain

growth, nor would disinflation that was anticipated slow

that relationship and draw out its policy implications.

it. Over the long run, they argued, economic growth

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was determined by fundamentals, such as productivity

can influence expectations, they will have only limited

and population growth. The appearance of a correla-

ability to fine-tune the economy, even temporarily,

tion between inflation and unemployment in the data

and that maintaining economic stability hinges largely

was the result of episodes in which unanticipated

on people’s confidence in future policy actions.

changes in inflation had temporary real effects.
This theory gained credence in the 1970s, as the

“ If people are forward looking, their expectations

U.S. economy experienced both slow economic

about the future conduct of policy will play the

growth and rising inflation. The original Phillips curve

dominant role in how inflation and unemployment

seemed to be breaking down and the menu of

interact. ”

options that policymakers supposedly had at their
disposal no longer seemed useful. At the same time,

In the late 1970s and early 1980s, the Federal

Robert Lucas, Edward C. Prescott, and Finn Kydland

Reserve under Paul Volcker began a long and often

extended the work of Friedman and Phelps and

difficult campaign to regain the credibility it had lost

focused on the forward-looking nature of people’s

during the previous decade. Alan Greenspan contin-

expectations. This “rational expectations” approach

ued that fight, and by the 1990s, the Fed arguably had

to the Phillips curve suggested that the public under-

established such credibility. Happily, the economy

stands when policymakers might be tempted to try to

responded well: we witnessed strong economic growth

exploit the seeming relationship between inflation

without a concomitant rise in inflation.

and unemployment, and change their expectations

In light of the modern understanding of the Phillips

even before a policy action has been taken. As a

curve, the real lesson of the Volcker-Greenspan disin-

result, an attempt to bring down unemployment by

flation is that the best contribution the Fed can make

letting inflation increase will not work—prices will rise

to economic growth is to keep inflation low and stable.

but growth will not.

And the key to low inflation is the stability of people’s

Modern work builds on this approach by studying

expectations about the future conduct of monetary

economies in which realistic imperfections in markets

policy. Monetary policy works best when it allows the

create a short-run relationship between inflation and

real economy to respond appropriately to economic

real variables similar to what we observe in the data.

fundamentals, rather than attempts to insulate the

These models have the important implication that the

economy from shocks by tolerating swings in inflation.

relationship between inflation and real activity is not

This is the lesson of the modern Phillips curve and of

causal. Both inflation and unemployment are the out-

our macroeconomic history over the last half century.

comes of the behavior of markets for goods and for
labor. In turn, the behavior of markets is the product
of decisions made by an array of households, firms,
and policymakers. If people are forward looking, their

Jeffrey M. Lacker

expectations about the future conduct of policy will

President

play the dominant role in how inflation and unemployment interact. This means that unless policymakers

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Inflation and Unemployment:
A Layperson’s Guide to the Phillips Curve

by Jeffrey M. Lacker and John A. Weinberg

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What do you remember from the economics class you took in college? Even if you didn’t
take economics, what basic ideas do you think are important for understanding the way
markets work? In either case, one thing you might come up with is that when the demand
for a good rises—when more and more people want more and more of that good—its price
will tend to increase. This basic piece of economic logic helps us understand the phenomena we observe in many specific markets—from the tendency of gasoline prices to rise
as the summer sets in and people hit the road on their family vacations, to the tendency
for last year’s styles to fall in price as consumers turn to the new fashions.
This notion paints a picture of the price of a good moving together in the same direction
with its quantity—when people are buying more, its price is rising. Of course supply
matters, too, and thinking about variations in supply—goods becoming more or less
plentiful or more or less costly to produce—complicates the picture. But in many cases
such as the examples above, we might expect movements up and down in demand to
happen more frequently than movements in supply. Certainly for goods produced by a
stable industry in an environment of little technological change, we would expect that
many movements in price and quantity are driven by movements in demand, which
would cause price and quantity to move up and down together. Common sense suggests
that this logic would carry over to how one thinks about not only the price of one
good but also the prices of all goods. Should an average measure of all prices in the
economy—the consumer price index, for example—be expected to move up when our
total measures of goods produced and consumed rise? And should faster growth in
these quantities—as measured, say, by gross domestic product—be accompanied
by faster increases in prices? That is, should inflation move up and down with real
economic growth?

The authors are respectively President and Senior Vice President and Director of Research.
The views expressed are the authors’ and not necessarily those of the Federal Reserve System.

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The simple intuition behind this series of questions

all goods—that is, rising aggregate demand—would

is seriously incomplete as a description of the behav-

not make all prices rise. Rather, the important impli-

ior of prices and quantities at the macroeconomic

cation of this distinction is that it focuses attention on

level. But it does form the basis for an idea at the

what, besides people’s underlying desire for more

heart of much macroeconomic policy analysis for at

goods and services, might drive a general increase in

least a half century. This idea is called the “Phillips

all prices. The other key factor is the supply of money

curve,” and it embodies a hypothesis about the rela-

in the economy.

tionship between inflation and real economic vari-

Economic decisions of producers and consumers

ables. It is usually stated not in terms of the positive

are driven by relative prices: a rising price of bagels

relationship between inflation and growth but in terms

relative to doughnuts might prompt a baker to shift

of a negative relationship between inflation and

production away from doughnuts and toward bagels.
If we could imagine a situation in which all prices of

“ This idea is called the ‘Phillips curve,’ and it

all outputs and inputs in the economy, including

embodies a hypothesis about the relationship

wages, rise at exactly the same rate, what effect on

between inflation and real economic variables. It

economic decisions would we expect? A reasonable

is usually stated. . . in terms of a negative relation-

answer is “none.” Nothing will have become more

ship between inflation and unemployment. ”

expensive relative to other goods, and labor income
will have risen as much as prices, leaving people no

unemployment. Since faster growth often means
more intensive utilization of an economy’s resources,

poorer or richer.
The thought experiment involving all prices and

faster growth will be expected to come with falling

wages rising in equal proportions demonstrates the

unemployment. Hence, faster inflation is associated

principle of monetary neutrality. The term refers to the

with lower unemployment. In this form, the Phillips

fact that the hypothetical increase in prices and wages

curve looks like the expression of a trade-off between

could be expected to result from a corresponding

two bad economic outcomes—reducing inflation

increase in the supply of money. Monetary neutrality

requires accepting higher unemployment.

is a natural starting point for thinking about the

The first important observation about this relation-

relationship between inflation and real economic

ship is that the simple intuition described at the begin-

variables. If money is neutral, then an increase in the

ning of this essay is not immediately applicable at the

supply of money translates directly into inflation and

level of the economy-wide price level. That intuition is

has no necessary relationship with changes in real

built on the workings of supply and demand in setting

output, output growth, or unemployment. That is,

the quantity and price of a specific good. The price

when money is neutral, the simple supply-and-

of that specific good is best understood as a relative

demand intuition about output growth and inflation

price—the price of that good compared to the prices

does not apply to inflation associated with the growth

of other goods. By contrast, inflation is the rate of

of the money supply.

change of the general level of all prices. Recognizing
this distinction does not mean that rising demand for

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The logic of monetary neutrality is indisputable, but
is it relevant? The logic arises from thinking about

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hypothetical “frictionless” economies in which all mar-

is by no means exhaustive. Important parts of econ-

ket participants at all times have all the information

omists’ understanding of this relationship that we neg-

they need to price the goods they sell and to choose

lect include discussions of how the observed Phillips

among the available goods, and in which sellers can

curve’s statistical relationship could emerge even

easily change the price they charge. Against this

under monetary neutrality.1 We also neglect the liter-

hypothetical benchmark, actual economies are likely

ature on the possibility of real economic costs of

to appear imperfect to the naked eye. And under the

inflation that arise even when money is neutral.2

microscope of econometric evidence, a positive corre-

Instead, we seek to provide the broad outlines of the

lation between inflation and real growth does tend to

intellectual development that has led to the role of

show up. The task of modern macroeconomics has

the Phillips curve in modern macroeconomics,

been to understand these empirical relationships.

emphasizing the interplay of economic theory and

What are the “frictions” that impede monetary neu-

empirical evidence.

trality? Since monetary policy is a key determinant of

After reviewing the history, we will turn to the cur-

inflation, another important question is how the con-

rent debate about the Phillips curve and how it trans-

duct of policy affects the observed relationships. And

lates into differing views about monetary policy.

finally, what does our understanding of these relation-

People commonly talk about a central bank seeking

ships imply about the proper conduct of policy?

to engineer a slowing of the economy to bring about

The Phillips curve, viewed as a way of capturing

lower inflation. They think of the Phillips curve as

how money might not be neutral, has always been a

describing how much slowing is required to achieve a

central part of the way economists have thought

given reduction in inflation. We believe that this read-

about macroeconomics and monetary policy. It also

ing of the Phillips curve as a lever that a policymaker

forms the basis, perhaps implicitly, of popular under-

might manipulate mechanically can be misleading. By

standing of the basic problem of economic policy:

itself, the Phillips curve is a statistical relationship that

namely, we want the economy to grow and unem-

has arisen from the complex interaction of policy deci-

ployment to be low, but if growth is too robust,

sions and the actions of private participants in the

inflation becomes a risk. Over time, many debates

economy. Importantly, choices made by policymakers

about economic policy have boiled down to alterna-

play a large role in determining the nature of the sta-

tive understandings of what the Phillips curve is and

tistical Phillips curve. Understanding that relation-

what it means. Even today, views that economists

ship—between policymaking and the Phillips curve—

express on the effects of macroeconomic policy in

is a key ingredient to sound policy decisions. We

general and monetary policy in particular often derive

return to this theme after our historical overview.

from what they think about the nature, the shape, and
the stability of the Phillips curve.

Some History

This essay seeks to trace the evolution of our

The Phillips curve is named for New Zealand-born

understanding of the Phillips curve, from before its

economist A. W. Phillips, who published a paper in

inception to contemporary debates about economic

1958 showing an inverse relationship between (wage)

policy. The history presented in the pages that follow

inflation and unemployment in nearly 100 years of

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data from the United Kingdom.3 Since this is the work

ultimately, this would merely amount to a change in

from which the curve acquired its name, one might

units of measurement. Given enough time for the

assume that the economics profession’s prior consen-

extra money to spread itself throughout the economy,

sus on the matter embodied the presumption that

all prices would rise proportionately. So while the

money is neutral. But this in fact is not the case.

number of units of money needed to compensate a

The idea of monetary neutrality has long coexisted

day’s labor might be higher, the amount of food,

with the notion that periods of rising money growth

shelter, and clothing that a day’s pay could purchase

and inflation might be accompanied by increases in

would be exactly the same as before the increase in

output and declines in unemployment. Robert Lucas

money and prices.

(1996), in his Nobel lecture on the subject of mone-

Against this logic stood the classical economists’

tary neutrality, finds both ideas expressed in the work

observations of the world around them in which

of David Hume in 1752! Thomas Humphrey (1991)

increases in money and prices appeared to bring

traces the notion of a Phillips curve trade-off through-

increases in industrial and commercial activity. This

out the writings of the classical economists in the

empirical observation did not employ the kind of

eighteenth and nineteenth centuries. Even Irving

formal statistics as that used by modern economists

Fisher, whose statement of the quantity theory of

but simply the practice of keen observation. They

money embodied a full articulation of the conse-

would typically explain the difference between their

quences of neutrality, recognized the possible real

theory’s predictions (neutrality) and their observations

effects of money and inflation over the course of a

by appealing to what economists today would call

business cycle.

“frictions” in the marketplace. Of particular importance

In early writings, these two opposing ideas—that

in this instance are frictions that get in the way of

money is neutral and that it is associated with rising

price adjustment or make it hard for buyers and sell-

real growth—were typically reconciled by the distinc-

ers of goods and services to know when the general

tion between periods of time ambiguously referred to

level of all prices is rising. If a craftsman sees that he

as “short-run” and “long-run.” The logic of monetary

can sell his wares for an increased price but doesn’t
realize that all prices are rising proportionately, he

“ In early writings, these two opposing ideas—

might think that his goods are rising in value relative

that money is neutral and that it is associated

to other goods. He might then take action to increase

with rising real growth—were typically recon-

his output so as to benefit from the perceived rise in

ciled by the distinction between periods of

the worth of his labors.

time ambiguously referred to as ‘short-run’ and
‘long-run.’ ”

This example shows how frictions in price adjustment can break the logic of money neutrality. But
such a departure is likely to be only temporary. You

neutrality is essentially long-run logic. The type of

can’t fool everybody forever, and eventually people

thought experiment the classical writers had in mind

learn about the general inflation caused by an increase

was a one-time increase in the quantity of money

in money. The real effects of inflation should then

circulating in an economy. Their logic implied that,

die out. It was in fact in the context of this distinction

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between long-run neutrality and the short-run trade-off
between inflation and real growth that John Maynard
Keynes made his oft-quoted quip that “in the long run
we are all dead.”4
Phillips’ work was among the first formal statistical
analyses of the relationship between inflation and real
economic activity. The data on the rate of wage
increase and the rate of unemployment for Phillips’
baseline period of 1861–1913 are reproduced in
Figure 1. These data show a clear negative relationship—greater inflation tends to coincide with lower

Figure 1: Inflation-Unemployment Relationship in the
United Kingdom, 1861-1913
10
RATE OF CHANGE OF WAGE RATE
(% PER YEAR)

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8
6
4
2
0

-2

-4

0

1

2

3

4
5
6
7
8
UNEMPLOYMENT RATE (%)

9

10

11

Source: Phillips (1958)

unemployment. To highlight that relationship, Phillips fit
the curve in Figure 1 to the data. He then examined a

about 5 1⁄2 percent. To achieve unemployment of about

number of episodes, both within the baseline period

3 percent, which the authors viewed as approximately

and in other periods up through 1957. The general

full employment, the curve suggests that inflation

tendency of a negative relationship persists throughout.

would need to be close to 5 percent.
Samuelson and Solow did not propose that their

Crossing the Atlantic

estimated curve described a permanent relationship

A few years later, Paul Samuelson and Robert Solow,

that would never change. Rather, they presented it as

both eventual Nobel Prize winners, took a look at the

a description of the array of possibilities facing the

U.S. data from the beginning of the twentieth century

economy in “the years just ahead.”6 While recogniz-

through 1958.5 A similar scatter-plot to that in Figure 1

ing that the relationship might change beyond this

was less definitive in showing the negative relation-

near horizon, they remained largely agnostic on how

ship between wage inflation and unemployment.

and why it might change. As a final note, however,

The authors were able to recover a pattern similar to

they suggest institutional reforms that might produce

Phillips’ by taking out the years of the World Wars and

a more favorable trade-off (shifting the curve in

the Great Depression. They also translated their find-

Figure 2 down and to the left). These involve meas-

ings into a relationship between unemployment and

ures to limit the ability of businesses and unions to

price inflation. It is this relationship that economists

exercise monopoly control over prices and wages, or

now most commonly think of as the “Phillips curve.”

even direct wage and price controls. Their closing

Samuelson and Solow’s Phillips curve is repro-

discussion suggests that they, like many economists

duced in Figure 2. (See page 10.) They interpret this

at the time, viewed both inflation and the frictions

curve as showing the combinations of unemployment

that kept money and inflation from being neutral

and inflation available to society. The implication is

as at least partly structural—hard-wired into the

that policymakers must choose from the menu traced

institutions of modern, corporate capitalism. Indeed,

out by the curve. An inflation rate of zero, or price sta-

they concluded their paper with speculation about

bility, appears to require an unemployment rate of

institutional reforms that could move the Phillips curve

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down and to the left. This was an interpretation that

Turning the focus to expectations

was compatible with the idea of a more permanent

This approach to economic policy implicitly either

trade-off that derived from the structure of the

denied the long-run neutrality of money or thought it
irrelevant. A distinct minority view within the profes-

Figure 2: Inflation-Unemployment Relationship in the
United States around 1960

sion, however, continued to emphasize limitations

11
AVERAGE INCREASE IN PRICE (% PER YEAR)

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on the ability of rising inflation to bring down unem-

10

ployment in a sustained way. The leading proponent

9
8

of this view was Milton Friedman, whose Nobel

7

Prize award would cite his Phillips curve work. In

6
5

his presidential address to the American Economics

B

4

Association, Friedman began his discussion of mone-

3

tary policy by stipulating what monetary policy cannot

2
1
-1

do. Chief among these was that it could not “peg

A

0

the rate of unemployment for more than very limited
1

2

3

4

5

6

7

8

9

UNEMPLOYMENT RATE (%)
Source: Samuelson and Solow (1960)

periods.”7 Attempts to use expansionary monetary
policy to keep unemployment persistently below what
he referred to as its “natural rate” would inevitably

economy and that could be exploited by policymakers

come at the cost of successively higher inflation.

seeking to engineer lasting changes in economic

Key to his argument was the distinction between

performance.

anticipated and unanticipated inflation. The short-run

By the 1960s, then, the Phillips curve trade-off had

trade-off between inflation and unemployment

become an essential part of the Keynesian approach

depended on the inflation expectations of the public.

to macroeconomics that dominated the field in the

If people generally expected price stability (zero

decades following the Second World War. Guided by

inflation), then monetary policy that brought about

this relationship, economists argued that the govern-

inflation of 3 percent would stimulate the economy,

ment could use fiscal policy—government spending

raising output growth and reducing unemployment.

or tax cuts—to stimulate the economy toward full

But suppose the economy had been experiencing

employment with a fair amount of certainty about

higher inflation, of say 5 percent, for some time,

what the cost would be in terms of increased inflation.

and that people had come to expect that rate of

Alternatively, such a stimulative effect could be

increase to continue. Then, a policy that brought

achieved by monetary policy. In either case, policy-

about 3 percent inflation would actually slow the

making would be a conceptually simple matter of

economy, making unemployment tend to rise.

cost-benefit analysis, although its implementation

By emphasizing the public’s inflation expectations,

was by no means simple. And since the costs of a

Friedman’s analysis drew a link that was largely

small amount of inflation to society were thought

absent in earlier Phillips curve analyses. Specifically,

to be low, it seemed worthwhile to achieve a lower

his argument was that not only is monetary policy pri-

unemployment rate at the cost of tolerating only a

marily responsible for determining the rate of inflation

little more inflation.

that will prevail, but it also ultimately determines the

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location of the entire Phillips curve. He argued that

the natural rate of unemployment is 5 percent and

the economy would be at the natural rate of unem-

people initially expect inflation of 1 percent. A surprise

ployment in the absence of unanticipated inflation.

inflation of 3 percent drives unemployment down to

That is, the ability of a small increase in inflation to

3 percent. But sustained inflation at the higher rate

stimulate economic output and employment relied on

ultimately changes expectations, and the Phillips curve

the element of surprise. Both the inflation that people

shifts back so that the natural rate of unemployment

had come to expect and the ability to create a surprise

is achieved but now at 3 percent inflation. This analy-

were then consequences of monetary policy decisions.

sis, which takes account of inflation expectations, is

Friedman’s argument involved the idea of a “natural

referred to as the expectations-augmented Phillips

rate” of unemployment. This natural rate was some-

curve. An independent and contemporaneous devel-

thing that was determined by the structure of the

opment of this approach to the Phillips curve was

economy, its rate of growth, and other real factors

given by Edmund Phelps, winner of the 2006 Nobel

independent of monetary policy and the rate of infla-

Prize in economics.8 Phelps developed his version of

tion. While this natural rate might change over time,

the Phillips curve by working through the implications

at any point in time, unemployment below the natural

of frictions in the setting of wages and prices, which

rate could only be achieved by policies that created

anticipated much of the work that followed.

inflation in excess of that anticipated by the public.

The reasoning of Friedman and Phelps implied that

But if inflation remained at the elevated level, people

attempts to exploit systematically the Phillips curve to

would come to expect higher inflation, and its stimula-

bring about lower unemployment would succeed only

tive effect would be lost. Unemployment would move

temporarily at best. To have an effect on real activity,

back toward its natural rate. That is, the Phillips curve

monetary policy needed to bring about inflation in

would shift up and to its right, as shown in Figure 3.

excess of people’s expectations. But eventually,

The figure shows a hypothetical example in which
Figure 3: Expectations-Augmented Phillips Curve

people would come to expect higher inflation, and
the policy would lose its stimulative effect. This insight
comes from an assumption that people base their

8

expectations of inflation on their observation of past

7
INFLATION RATE (%)

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inflation. If, instead, people are more forward looking

6

and understand what the policymaker is trying to do,

5

they might adjust their expectations more quickly,

4

causing the rise in inflation to lose much of even its

3

temporary effect on real activity. In a sense, even the

2

short-run relationship relied on people being fooled.

1

One way people might be fooled is if they are simply
1

2

3

4

5

u*

6

7

8

UNEMPLOYMENT RATE (%)
Note: When expected inflation is 1 percent, an unanticipated increase
in inflation will initially bring unemployment down. But expectations will
eventually adjust, bringing unemployment back to its natural rate (u*)
at the higher rate of inflation.

Page 12 ■ Federal Reserve Bank of Richmond

unable to distinguish general inflation from a change
in relative prices. This confusion, sometimes referred
to as money illusion, could cause people to react to
inflation as if it were a change in relative prices. For

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Figure 4: Inflation-Unemployment Relationship in the
United States,1961-1995

instance, workers, seeing their nominal wages rise
but not recognizing that a general inflation is in

14

process, might react as if their real income were ris-

12

ing. That is, they might increase their expenditures on
goods and services.
Robert Lucas, another Nobel Laureate, demonstrated
how behavior resembling money illusion could result

INFLATION RATE (%)

AR_inside

80

10
8
70

4

even with firms and consumers who fully understood

0

85

2

the difference between relative prices and the general
price level.9 In his analysis, confusion comes not from
people’s misunderstanding, but from their inability to

75

90

6

65
3

4

95
61
5
7
6
UNEMPLOYMENT RATE (%)

8

9

10

Sources: Bureau of Labor Statistics/Haver Analytics
Note: Inflation rate is seasonally-adjusted CPI, Fourth Quarter.

observe all of the economy’s prices at one time. His
was the first formal analysis showing how a Phillips

writers appeared to break down entirely, as shown by

curve relationship could emerge in an economy with

the scatter plot of the data for the 1970s in Figure 4.

forward-looking decisionmakers. Like the work of

Throughout this decade, both inflation and unemploy-

Friedman and Phelps, Lucas’ implications for policy-

ment tended to grow, leading to the emergence of the
term “stagflation” in the popular lexicon.

“ The reasoning of Friedman and Phelps implied

One possible explanation for the experience of the

that attempts to exploit systematically the

1970s is that the decade was simply a case of bad

Phillips curve to bring about lower unemploy-

luck. The Phillips curve shifted about unpredictably as

ment would succeed only temporarily at best. ”

the economy was battered by various external shocks.
The most notable of these shocks were the dramatic

makers were cautionary. The relationship between

increases in energy prices in 1973 and again later in

inflation and real activity in his analysis emerged

the decade. Such supply shocks worsened the avail-

most strongly when policy was conducted in an

able trade-off, making higher unemployment neces-

unpredictable fashion, that is, when policymaking

sary at any given level of inflation.

was more a source of volatility than stability.

By contrast, viewing the decade through the lens of
the expectations-augmented Phillips curve suggests

The Great Inflation

that policy shared the blame for the disappointing

The expectations-augmented Phillips curve had the

results. Policymakers attempted to shield the real

stark implication that any attempt to utilize the rela-

economy from the effects of aggregate shocks. Guided

tionship between inflation and real activity to engineer

by the Phillips curve, this effort often implied a choice

persistently low unemployment at the cost of a little

to tolerate higher inflation rather than allowing unem-

more inflation was doomed to failure. The experience

ployment to rise. This type of policy choice follows

of the 1970s is widely taken to be a confirmation of

from viewing the statistical relationship Phillips first

this hypothesis. The historical relationship identified

found in the data as a menu of policy options, as

by Phillips, Samuelson and Solow, and other earlier

suggested by Samuelson and Solow. But the

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Page 14

arguments made by Friedman and Phelps imply that

played against a public that is trying to anticipate

such a trade-off is short-lived at best. Unemployment

policy. What’s more, this game is repeated over and

would ultimately return to its natural rate at the higher

over, each time a policy choice must be made. This

rate of inflation. So, while the relative importance of

complicated interdependence of policy choices and

luck and policy for the poor macroeconomic perform-

private sector actions and expectations was studied

ance of the 1970s continues to be debated by econo-

by Finn Kydland and Edward C. Prescott.12 In one

mists, we find a powerful lesson in the history of that

of the papers for which they were awarded the 2005

decade.10 The macroeconomic performance of the

Nobel Prize, they distinguish between rules and

1970s is largely what the expectations-augmented

discretion as approaches to policymaking. By discre-

Phillips curve predicts when policymakers try to exploit

tion, they mean period-by-period decisionmaking in

a trade-off that they mistakenly believe to be stable.

which the policymaker takes a fresh look at the costs

The insights of Friedman, Phelps, and Lucas pointed

and benefits of alternative inflation levels at each

to the complicated interaction between policymaking

moment. They contrast this with a setting in which

and statistical analysis. Relationships we observe in

the policymaker makes a one-time decision about the

past data were influenced by past policy. When policy

best rule to guide policy. They show that discretionary

changes, people’s behavior may change and so too

policy would result in higher inflation and no lower

may statistical relationships. Hence, the history of the

unemployment than the once-and-for-all choice of

1970s can be read as an illustration of Lucas’ critique

a policy rule.

of what was at the time the consensus approach to
policy analysis.11
Focusing attention on the role of expectations in the

Recent work by Thomas Sargent and various coauthors shows how discretionary policy, as studied by
Kydland and Prescott, can lead to the type of inflation

Phillips curve creates a challenge for policymakers

outcomes experienced in the 1970s.13 This analysis

seeking to use monetary policy to manage real eco-

assumes that the policymaker is uncertain of the

nomic activity. At any point in time, the current state

position of the Phillips curve. In the face of this un-

of the economy and the private sector’s expectations

certainty, the policymaker estimates a Phillips curve
from historical data. Seeking to exploit a short-run,

“ Focusing attention on the role of expecta-

expectations-augmented Phillips curve—that is, pur-

tions in the Phillips curve creates a challenge

suing discretionary policy—the policymaker chooses

for policymakers seeking to use monetary

among inflation-unemployment combinations described

policy to manage real economic activity. ”

by the estimated Phillips curve. But the policy choices
themselves cause people’s beliefs about policy to

may imply a particular Phillips curve. Assuming that

change, which causes the response to policy choices

Phillips curve describes a stable relationship, a policy-

to change. Consequently, when the policymaker uses

maker might choose a preferred inflation-unemploy-

new data to update the estimated Phillips curve, the

ment combination. That very choice, however, can

curve will have shifted. This process of making policy

alter expectations, causing the trade-off to change.

while also trying to learn about the location of the

The policymaker’s problem is, in effect, a game

Phillips curve can lead a policymaker to choices that

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Page 15

result in persistently high inflation outcomes.
In addition to the joint rise in inflation and unem-

cost, but it is substantially less than many had predicted before the fact. Again, one possible reason

ployment during the 1970s, other empirical evidence

could be that the Fed’s course of action in this

pointed to the importance of expectations. Sargent

episode became well-anticipated once it commenced.

studied the experience of countries that had suffered

While the public might not have known the extent of

from very high

inflation.14

In countries where mone-

the actions the Fed would take, the direction of the

tary reforms brought about sudden and rapid deceler-

change in policy may well have become widely

ations in inflation, he found that the cost in terms of

understood. By the same token, and as argued by

reduced output or increased unemployment tended to

Goodfriend and King, remaining uncertainty about how

be much lower than standard Phillips curve trade-offs

far and how persistently the Fed would bring inflation

would suggest. One interpretation of these findings is

down may have resulted in the costs of disinflation

that the disinflationary policies undertaken tended to

being greater than they might otherwise have been.

be well-anticipated. Policymakers managed to credi-

The experience of the 1970s, together with the

bly convince the public that they would pursue these

insights of economists emphasizing expectations,

policies. Falling inflation that did not come as a sur-

ultimately brought the credibility of monetary policy

prise did not have large real economic costs.

to the forefront in thinking about the relationship

On a smaller scale in terms of peak inflation rates,

between inflation and the real economy. Credibility

another exercise in dramatic disinflation was conduct-

refers to the extent to which the central bank can con-

ed by the Federal Reserve under Chairman Paul

vince the public of its intention with regard to inflation.

Volcker.15 As inflation rose to double-digit levels in the

Kydland and Prescott showed that credibility does not

late 1970s, contemporaneous estimates of the cost in
unemployment and lost output that would be neces-

“ The experience of the 1970s, together with

sary to bring inflation down substantially were quite

the insights of economists emphasizing expec-

large. A common range of estimates was that the

tations, ultimately brought the credibility of

6 percentage-point reduction in inflation that was

monetary policy to the forefront in thinking

ultimately brought about would require output from

about . . . inflation and the real economy. ”

9 to 27 percent below capacity annually for up to
four years.16 Beginning in October 1979, the Fed took

come for free. There is always a short-run gain from

drastic steps, raising the federal funds rate as high

allowing inflation to rise a little so as to stimulate the

as 19 percent in 1980. The result was a steep, but

real economy. To establish credibility for a low rate of

short recession. Overall, the costs of the Volcker

inflation, the central bank must convince the public

disinflation appear to have been smaller than had

that it will not pursue that short-run gain.

been expected. A standard estimate, which appears

The experience of the 1980s and 1990s can be

in a popular economics textbook, is one in which the

read as an exercise in building credibility. In several

reduction in output during the Volcker disinflation

episodes during that period, inflation expectations

amounted to less than a 4 percent annual shortfall

rose as doubts were raised about the Fed’s ability to

relative to

capacity.17

This amount is a significant

maintain its commitment to low inflation. These

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episodes, labeled inflation scares by Marvin
Goodfriend, were marked by rapidly rising spreads

Deriving a Phillips curve from
price-setting behavior

between long-term and short-term interest rates.18

This price-setting friction has become a popular

Goodfriend identifies inflation scares in 1980, 1983,

device for economists seeking to model the behavior

and 1987. These tended to come during or following

of economies with a short-run Phillips curve. To see

episodes in which the Fed responded to real economic

how such a friction leads to a Phillips curve, think

weakness with reductions (or delayed increases) in its

about a business that is setting a price for its product

federal funds rate target. In these instances, Fed policy-

and does not expect to get around to setting the price

makers reacted to signs of rising inflation expectations

again for some time. Typically, the business will

by raising interest rates. These systematic policy re-

choose a price based on its own costs of production

sponses in the 1980s and 1990s were an important part

and the demand that it faces for its goods. But

of the process of building credibility for lower inflation.

because that business expects its price to be fixed
for a while, its price choice will also depend on what

The “Modern” Phillips Curve

it expects to happen to its costs and its demand

The history of the Phillips curve shows that the empir-

between when it sets its price this time and when it

ical relationship shifts over time, and there is evi-

sets its price the next time.

dence that those movements are linked to the public’s

If the price-setting business thinks that inflation will

inflation expectations. But what does the history say

be high in the interim between its price adjustments,

about why this relationship exists? Why is it that there

then it will expect its relative price to fall. As average

is a statistical relationship between inflation and real

prices continue to rise, a good with a temporarily

economic activity, even in the short run? The earliest

fixed price gets cheaper. The firm will naturally be

writers and those that followed them recognized that

interested in its average relative price during the peri-

the short-run trade-off must arise from frictions that

od that its price remains fixed. The higher the inflation

stand in the way of monetary neutrality. There are

expected by the firm up until its next price adjustment,

many possible sources of such frictions. They may

the higher the current price it will set. This reasoning,

arise from the limited nature of the information individ-

applied to all the economy’s sellers of goods and serv-

uals have about the full array of prices for all products

ices, leads directly to a close relationship between

in the economy, as emphasized by Lucas. Frictions

current inflation and expected future inflation.

might also stem from the fact that not all people par-

This description of price-setting behavior implies

ticipate in all markets, so that different markets might

that current inflation depends on the real costs of

be affected differently by changes in monetary policy.

production and expected future inflation. The real

One simple type of friction is a limitation on the flexi-

costs of production for businesses will rise when the

bility sellers have in adjusting the prices of the goods

aggregate use of productive resources rises, for

they sell. If there are no limitations all prices can

instance because rising demand for labor pushes up

adjust seamlessly whenever demand or cost condi-

real wages.19 The result is a Phillips curve relationship

tions change, then a change in monetary policy will,

between inflation and a measure of real economic

again, affect different markets differently.

activity, such as output growth or unemployment.

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Current inflation rises with expected future inflation

holds’ and business’ decisions about consumption

and falls as current unemployment rises relative to its

and investment. These decisions involve people’s

“natural” rate (or as current output falls relative to the

demand for resources now, as compared to their

trend rate of output growth).

expected demand in the future. Their willingness to
trade off between the present and the future depends

A Phillips curve in a “complete” modern model

on the price of that trade-off—the real rate of interest.

The price-setting frictions that are part of many mod-

One source of interdependence between different

ern macroeconomic models are really not that differ-

parts of the model—different equations—is in the real

ent from arguments that economists have always

rate of interest. A real rate is a nominal rate—the

made about reasons for the short-run non-neutrality

interest rates we actually observe in financial mar-

of money. What distinguishes the modern approach is

kets—adjusted for expected inflation. Real rates

not just the more formal, mathematical derivation of a

are what really matter for households’ and firms’

Phillips curve relationship, but more importantly, the

decisions. So on the demand side of the economy,

incorporation of this relationship into a complete

people’s choices about consumption and investment

model of the macroeconomy. The word “complete”

depend on what they expect for inflation, which comes,

here has a very specific meaning, referring to what

in part, from the pricing behavior described by the

economists call “general equilibrium.” The general

Phillips curve. Another source of interdependence

equilibrium approach to studying economic activity

comes in the way the central bank influences nominal

recognizes the interdependence of disparate parts of

interest rates by setting the rate charged on overnight,

the economy and emphasizes that all macroeconomic

interbank loans (the federal funds rate in the United

variables such as GDP, the level of prices, and

States). A complete model also requires a description

unemployment are all determined by fundamental

of how the central bank changes its nominal interest

economic forces acting at the level of individual

rate target in response to changing economic con-

households and businesses. The completeness of a

ditions (such as inflation, growth, or unemployment).

general equilibrium model also allows for an analysis

In a complete general equilibrium analysis of an

of the effects of alternative approaches to macroeco-

economy’s performance, all three parts—the Phillips

nomic policy, as well as an evaluation of the relative

curve, the demand side, and central bank behavior—

merits of alternative policies in terms of their effects on

work together to determine the evolution of economic

the economic well-being of the people in the economy.

variables. But many of the economic choices people

The Phillips curve is only one part of a complete

make on a day-to-day basis depend not only on con-

macroeconomic model—one equation in a system

ditions today, but also on how conditions are expected

of equations. Another key component describes

to change in the future. Such expectations in modern

how real economic activity depends on real interest

macroeconomic models are commonly described

rates. Just as the Phillips curve is derived from a

through the assumption of rational expectations. This

description of the price-setting decisions of business-

assumption simply means that the public—households

es, this other relationship, which describes the

and firms whose decisions drive real economic

demand side of the economy, is based on house-

activity—fully understands how the economy evolves

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Page 19

over time and how monetary policy shapes that

current inflation is equal to expected inflation. Then,

evolution. It also means that people’s decisions will

whatever that constant rate of inflation, unemploy-

depend on well-informed expectations not only of the

ment must return to the rate implied by the underlying

evolution of future fundamental conditions, but of

structure of the economy, that is, to a rate that might

future policy as well. While discussions of a central

be considered the “natural” unemployment. Money is

bank’s credibility typically assume that there are

not truly neutral in these models, however. Rather,

things related to policymaking about which the public

the pricing frictions underlying the models imply that

is not fully certain, these discussions retain the pre-

there are real economic costs to inflation. Because

sumption that people are forward looking in trying to

sellers of goods adjust their prices at different times,

understand policy and its impact on their decisions.

inflation makes the relative prices of different goods
vary, and this distorts sellers’ and buyers’ decisions.

Implications and uses of the modern approach
A Phillips curve that is derived as part of a model that

This distortion is greater, the greater the rate of inflation.
The expectational nature of the Phillips curve also

includes price-setting frictions is often referred to as

means that policies that have a short-run effect on

the New Keynesian Phillips curve (NKPC).20 A com-

inflation will induce real movements in output or

plete general equilibrium model that incorporates this

unemployment mainly if the short-run movement in

version of the Phillips curve has been referred to as

inflation is not expected to persist. In this sense, the

the New Neoclassical Synthesis

model.21

These

modern Phillips curve also embodies the importance

models, like any economic model, are parsimonious

of monetary policy credibility, since it is credibility that

descriptions of reality. We do not take them as exact

would allow expected inflation to remain stable, even

descriptions of how a modern economy functions.

as inflation fluctuated in the near term.

Rather, we look to them to capture the most important
forces at work in determining macroeconomic out-

“ The modern Phillips curve also embodies the

comes. The key equations in new neoclassical or new

importance of monetary policy credibility, since

Keynesian models all involve assumptions or approxi-

it is credibility that would allow expected

mations that simplify the analysis without altering the

inflation to remain stable, even as inflation

fundamental economic forces at work. Such simplifica-

fluctuated in the near term. ”

tions allow the models to be a useful guide to our
thinking about the economy and the effects of policy.
The modern Phillips curve is similar to the expecta-

A more general way of emphasizing the importance
of credibility is to say that the modern Phillips curve

tions-augmented Phillips curve in that inflation expec-

implies that the behavior of inflation will depend

tations are important to the relationship between

crucially on people’s understanding of how the central

current inflation and unemployment. But its derivation

bank is conducting monetary policy. What people

from forward-looking price-setting behavior shifts the

think about the central bank’s objectives and strategy

emphasis to expectations of future inflation. It has

will determine expectations of inflation, especially

implications similar to the long-run neutrality of

over the long run. Uncertainty about these aspects of

money, because if inflation is constant over time, then

policy will cause people to try to make inferences

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Page 20

about future policy from the actual policy they observe.

in terms of the long-run levels of inflation and unem-

Even if the central bank makes statements about its

ployment they produce, or more generally in terms of

long-run objectives and strategy, people will still try to

the economic well-being generated for people in the

make inferences from the policy actions they see. But

economy. A typical result is that rules that deliver lower

in this case, the inference that people will try to make

and less variable inflation are better both because low

is slightly simpler: people must determine if actual

and stable inflation is a good thing and because such

policy is consistent with the stated objectives.

rules can also deliver less variability in real economic

Does this newest incarnation of the Phillips curve

activity. Further, lower inflation has the benefit of

present a central bank with the opportunity to actively

reducing the costs from distorted relative prices.

manage real economic activity through choosing more

While low inflation is a preferred outcome, it is typi-

or less inflationary policies? The assumption that peo-

cally not possible, in models or in reality, to engineer

ple are forward looking in forming expectations about

a policy that delivers the same low target rate of infla-

future policy and inflation limits the scope for manag-

tion every month or quarter. The economy is hit by

ing real growth or unemployment through Phillips

any number of shocks that can move both real output

curve trade-offs. An attempt to manage such growth

and inflation around from month to month—large

or unemployment persistently would translate into the

energy price movements, for example. In the pres-

public’s expectations of inflation causing the Phillips

ence of such shocks, a good policy might be one that,

curve to shift. This is another characteristic that the

while not hitting its inflation target each month, always

modern approach shares with the older expectations-

tends to move back toward its target and never stray

augmented Phillips curve.

too far.

What this modern framework does allow is the

Complete models incorporating a modern Phillips

analysis of alternative monetary policy rules—that is,

curve also allow economists to formalize the notion

how the central bank sets its nominal interest rate in

of monetary policy credibility. Remember that

response to such economic variables as inflation,

credibility refers to what people believe about the

relative to the central bank’s target, and the unem-

way the central bank intends to conduct policy.

ployment rate or the rate of output growth relative to

If people are uncertain about what rule best

the central bank’s understanding of trend growth.22

describes the behavior of the central bank, then

A typical rule that roughly captures the actual behavior

they will try to learn from what they see the central

of most central banks would state, for instance, that

bank doing. This learning can make people’s

the central bank raises the interest rate when inflation

expectations about future policy evolve in a compli-

is higher than its target and lowers the interest rate

cated way. In general, uncertainty about the central

when unemployment rises. Alternative rules might

bank’s policy, or doubts about its commitment to low

make different assumptions, for instance, about how

inflation, can raise the cost (in terms of output or

much the central bank moves the interest rate in

employment) of reducing inflation. That is, the short-

response to changes in the macroeconomic variables

run relationship between inflation and unemployment

that it is concerned about. The complete model can

depends on the public’s long-run expectations about

then be used to evaluate how different rules perform

monetary policy and inflation.

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The modern approach embodies many features
of the earlier thinking about the Phillips curve. The

How Well Does the Modern
Phillips Curve Fit the Data?

characterization of policy as a systematic pattern of

The Phillips curve began as a relationship drawn to fit

behavior employed by the central bank, providing

the data. Over time, it has evolved as economists’

the framework within which people form systematic

understanding of the forces driving those data has

expectations about future policy, follows the work of

developed. The interplay between theory—the appli-

Kydland and Prescott. And the focus on expectations

cation of economic logic—and empirical facts has

itself, of course, originated with Friedman. Within

been an important part of this process of discovery.

this modern framework, however, some important

The recognition of the importance of expectations
developed together with the evidence of the apparent

“ The short-run relationship between inflation

instability of the short-run trade-off. The modern

and unemployment depends on the public’s

Phillips curve represents an attempt to study the

long-run expectations about monetary policy

behavior of both inflation and real variables using

and inflation. ”

models that incorporate the lessons of Friedman,
Phelps, and Lucas and that are rich enough to pro-

debates remain unsettled. While our characterization
of the framework has emphasized the forward-looking

duce results that can be compared to real world data.
Attempts to fit the modern, or New Keynesian,

nature of people’s expectations, some economists

Phillips curve to the data have come up against a

believe that deviations from this benchmark are

challenging finding. The theory behind the short-run

important for understanding the dynamic behavior of

relationship implies that current inflation should

inflation. We turn to this question in the next section.

depend on current real activity, as measured by

We have described here an approach that has

unemployment or some other real variable, and

been adopted by many contemporary economists

expected future inflation. When estimating such an

for applied central bank policy analysis. But we

equation, economists have often found that an addi-

should note that this approach is not without its

tional variable is necessary to explain the behavior of

critics. Many economists view the price-setting

inflation over time. In particular, these studies find

frictions that are at the core of this approach as

that past inflation is also important.23

ad hoc and unpersuasive. This critique points to the
value of a deeper theory of firms’ price-setting

Inflation persistence

behavior. Moreover, there are alternative frictions

The finding that past inflation is important for the

that can also rationalize monetary non-neutrality.

behavior of current and future inflation—that is, the

Alternatives include frictions that limit the information

finding of inflation persistence—implies that move-

available to decisionmakers or that limit some

ments in inflation have persistent effects on future

people’s participation in some markets. So while

inflation, apart from any effects on unemployment or

the approach we’ve described does not represent

expected inflation. Such persistence, if it were an

the only possible modern model, it has become a

inherent part of the structure and dynamics of the

popular workhorse in policy research.

economy, would create a challenge for policymakers

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to reduce inflation by reducing people’s expectations.

result of the nature of the shocks hitting the economy.

Remember that we stated earlier the possibility that if

If these shocks are themselves persistent—that is,

the central bank could convince the public that it was

bad shocks tend to be followed by more bad

going to bring inflation down, then the desired reduc-

shocks—then that persistence can lead to persist-

tion might be achieved with little cost in unemploy-

ence in inflation. The way to assess the relative

ment or output. Inherent inflation persistence would

importance of alternative possible sources of persist-

make such a strategy problematic. Inherent persist-

ence is to estimate the multiple equations that make

ence makes the set of choices faced by the policy-

up a more complete model of the economy. This

maker closer to that originally envisioned by

approach, in contrast with the estimation of a single

Samuelson and Solow. The faster one tries to bring

Phillips curve equation, allows for explicitly consider-

down inflation, the greater the real economic costs.

ing the roles of changing monetary policy, backward-

Inherent persistence in inflation might be thought to

looking pricing behavior, and shocks in generating

arise if not all price-setters in the economy were as

inflation persistence. A typical finding is that the back-

forward looking as in the description given earlier. If,

ward-looking terms in the hybrid Phillips curve appear

instead of basing their price decisions on their best

considerably less important for explaining the dynam-

forecast of future inflation behavior, some firms simply

ics of inflation than in single equation estimation.26

based current price choices on the past behavior of

The scientific debate on the short-run relationship

inflation, this backward-looking pricing would impart

between inflation and real economic activity has not

persistence to inflation. Jordi Galí and Mark Gertler,

yet been fully resolved. On the central question of the

who took into account the possibility that the economy

importance of backward-looking behavior, common

is populated by a combination of forward-looking and

sense suggests that there are certainly people in the

backward-looking participants, introduced a hybrid

real-world economy who behave that way. Not every-

Phillips curve in which current inflation depends on

one stays up-to-date enough on economic conditions

both expected future inflation and past inflation.24

to make sophisticated, forward-looking decisions.

An alternative explanation for inflation persistence

People who do not may well resort to rules of thumb

is that it is a result primarily of the conduct of mone-

that resemble the backward-looking behavior in some

tary policy. The evolution of people’s inflation ex-

economic models. On the other hand, people’s

pectations depends on the evolution of the conduct of

behavior is bound to be affected by what they believe

policy. If there are significant and persistent shifts in

to be the prevailing rate of inflation. Market partici-

policy conduct, expectations will evolve as people

pants have ample incentive and ability to anticipate

learn about the changes. In this explanation, inflation

the likely direction of change in the economy. So both

persistence is not the result of backward-looking

backward- and forward-looking behavior are ground-

decisionmakers in the economy but is instead the

ed in common sense. However the more important

result of the interaction of changing policy behavior

scientific questions involve the extent to which either

and forward-looking private decisions by households

type of behavior drives the dynamics of inflation and

and businesses.25

is therefore important for thinking about the conse-

Another possibility is that inflation persistence is the

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2006 Annual Report ■ Page 23

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The importance of inflation
persistence for policymakers

back down after a number of FOMC members made

Related to the question of whether forward- or back-

inflation. This episode illustrates both the potential

ward-looking behavior drives inflation dynamics is the

for the Fed to influence inflation expectations and

question of how stable people’s inflation expectations

the extent to which market participants are at times

are. The backward-looking characterization suggests

uncertain as to how the Fed will respond to

a stickiness in beliefs, implying that it would be hard

new developments.

speeches emphasizing their focus on preserving low

to induce people to change their expectations. If relatively high inflation expectations become ingrained,

Making Policy

then it would be difficult to get people to expect a

While the scientific dialogue continues, policymakers

decline in inflation. This describes a situation in which

must make judgments based on their understanding

disinflation could be very costly, since only persistent

of the state of the debate. At the Federal Reserve

evidence of changes in actual inflation would move

Bank of Richmond, policy opinions and recommenda-

future expectations. Evidence discussed earlier from

tions have long been guided by a view that the short-

episodes of dramatic changes in the conduct of policy,

term costs of reducing inflation depend on expecta-

however, suggests that people can be convinced that

tions. This view implies that central bank credibility—

policy has changed. In a sense, the trade-offs faced

that is, the public’s level of confidence about the central

by a policymaker could depend on the extent to which

bank’s future patterns of behavior—is an important

people’s expectations are subject to change. If people

aspect of policymaking. Central bank credibility

are uncertain and actively seeking to learn about the

makes it less costly to return inflation to a desirable

central bank’s approach to policy, then expectations

level after it has been pushed up (or down) by energy

might move around in a way that departs from the

prices or other shocks to the economy. This view of

very persistent, backward-looking characterization.

policy is consistent with a view of the Phillips curve in

But this movement in expectations would depend on

which inflation persistence is primarily a consequence

the central bank’s actions and statements about its

of the conduct of policy.

conduct of policy.

The evidence is perhaps not yet definitive. As out-

The periods that Goodfriend (1993) described as

lined in our argument, however, we do find support

inflation scares can be seen as periods when people’s

for our view in the broad contours of the history of

assessment of likely future policy was changing

U.S. inflation over the last several decades. At a time

rather fluidly. Even very recently, we have seen

when a consensus developed in the economics

episodes that could be described as “mini scares.”

profession that the Phillips curve trade-off could be

For instance, in the wake of Hurricane Katrina in late

exploited by policymakers, apparent attempts to do

2005, markets’ immediate response to rising energy

so led to or contributed to the decidedly unsatisfactory

prices suggested expectations of persistently rising

economic performance of the 1970s. And the

inflation. Market participants, it seems, were uncer-

improved performance that followed coincided with

tain as to how much of a run-up in general inflation

the solidification of the profession’s understanding of

the Fed would allow. Inflation expectations moved

the role of expectations. We also see the initial costs

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of bringing down inflation in the early 1980s as

There are also, we think, important lessons in the

consistent with our emphasis on expectations and

observation that overall economic performance, in

credibility. After the experience of the 1970s, credibili-

terms of both real economic activity and inflation, was

ty was low, and expectations responded slowly to the

much improved beginning in the 1980s as compared

Fed’s disinflationary policy actions. Still, the response

to that in the preceding decade. While this improve-

of expectations was faster than might be implied by a

ment could have some external sources related to the

backward-looking Phillips curve.

kinds of shocks that affect the economy, it is also

We also view policymaking on the basis of a

likely that improved conduct of monetary policy

forward-looking understanding of the Phillips curve

played a role. In particular, monetary policy was able

as a prudent approach. A hybrid Phillips curve with

to persistently lower inflation by responding more to

a backward-looking component presents greater

signs of rising inflation or inflation expectations than

opportunities for exploiting the short-run trade-off.

had been the case in the past. At the same time, the

In a sense, it assumes that the monetary policymaker

variability of inflation fell, while fluctuations in output

has more influence over real economic activity than

and unemployment were also moderating.

is assumed by the purely forward-looking specification. Basing policy on a backward-looking formulation

“ An approach to policy that is able to stabilize

would also risk underestimating the extent to which

expectations will be most able to maintain low

movements in inflation can generate shifts in inflation

and stable inflation with minimal effects on real

expectations, which could work against the policy-

activity. ”

maker’s intentions. Again, the experience of past
decades suggests the risks associated with policy-

We think the observed behavior of policy and

making under the assumption that policy can

economic performance is directly linked to the

persistently influence real activity more than it really

lessons from the history of the Phillips curve. Both

can. In our view, these risks point to the importance

point to the importance of the expectational con-

of a policy that makes expectational stability

sequences of monetary policy choices. An approach

its centerpiece.

to policy that is able to stabilize expectations will be
most able to maintain low and stable inflation with

Conclusion

minimal effects on real activity. It is the credible main-

One key lesson from the history of the relationship

tenance of price stability that will in turn allow real

between inflation and real activity is that any short-run

economic performance to achieve its potential over

trade-off depends on people’s expectations for infla-

the long run. This will not eliminate the business cycle

tion. Ultimately, monetary policy has its greatest

since the economy will still be subject to shocks that

impact on real activity when it deviates from people’s

quicken or slow growth. We believe the history of the

expectations. But if a central bank tries to deviate

Phillips curve shows that monetary policy’s ability to

from people’s expectations repeatedly, so as to sys-

add to economic variability by overreacting to shocks

tematically increase real output growth, people’s

is greater than its ability to reduce real variability,

expectations will adjust.

once it has achieved credibility for low inflation.

2006 Annual Report ■ Page 25

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Endnotes
1. King and Plosser (1984).

14. Sargent (1986).

2. Cooley and Hansen (1989), for instance.

15. Goodfriend and King (2005).

3. Phillips (1958).

16. Ibid.

4. Keynes (1923).

17. Mankiw (2007).

5. Samuelson and Solow (1960).

18. Goodfriend (1993).

6. Ibid., p. 193.
7. Friedman (1968), p. 5.

19. There are a number of technical assumptions needed to make
this intuitive connection precisely correct.

8. Phelps (1967).

20. Clarida, Galí, and Gertler (1999).

9. Lucas (1972).

21. Goodfriend and King (1997).

10. Velde (2004) provides an excellent overview of this debate.
A nontechnical description of the major arguments can be found
in Sumo (2007).

22. We use the term “monetary policy rule” in the very general sense of
any systematic pattern of choice for the policy instrument—the funds
rate—based on the state of the economy.

11. Lucas (1976).

23. Fuhrer (1997).

12. Kydland and Prescott (1977).

24. Galí and Gertler (1999).

13. Sargent (1999), Cogley and Sargent (2005), and Sargent, Williams,
and Zha (2006).

25. Dotsey (2002) and Sbordone (2006).
26. Lubik and Schorfheide (2004).

References
Clarida, Richard, Jordi Galí, and Mark Gertler. 1999. “The Science of
Monetary Policy: A New Keynesian Perspective.” Journal of Economic
Literature 37 (4): 1661-1707.

Lubik, Thomas A., and Frank Schorfheide. 2004. “Testing for
Indeterminacy: An Application to U.S. Monetary Policy.” American
Economic Review 94 (1): 190-217.

Cogley, Timothy, and Thomas J. Sargent. 2005. “The Conquest of U.S.
Inflation: Learning and Robustness to Model Uncertainty.” Review of
Economic Dynamics 8 (2): 528-63.

Lucas, Robert E., Jr. 1972. “Expectations and the Neutrality of Money.”
Journal of Economic Theory 4 (2): 103-24.

Cooley, Thomas F., and Gary D. Hansen. 1989. “The Inflation Tax in a
Real Business Cycle Model.” American Economic Review 79 (4): 733-48.
Dotsey, Michael. 2002. “Structure from Shocks.” Federal Reserve Bank of
Richmond Economic Quarterly 88 (4): 37-47.
Friedman, Milton. 1968. “The Role of Monetary Policy.” American
Economic Review 58 (1): 1-17.
Fuhrer, Jeffrey C. 1997. “The (Un)Importance of Forward-Looking
Behavior in Price Specifications.” Journal of Money, Credit, and Banking
29 (3): 338-50.
Galí, Jordi, and Mark Gertler. 1999. “Inflation Dynamics: A Structural
Econometric Analysis.” Journal of Monetary Economics 44 (2): 195-222.
Goodfriend, Marvin. 1993. “Interest Rate Policy and the Inflation Scare
Problem: 1979-1992.” Federal Reserve Bank of Richmond Economic
Quarterly 79 (1): 1-24.
Goodfriend, Marvin, and Robert G. King. 1997. “The New Neoclassical
Synthesis and the Role of Monetary Policy.” In NBER Macroeconomics
Annual 1997, eds. Ben S. Bernanke and Julio J. Rotemberg. Cambridge,
MA: The MIT Press.
Goodfriend, Marvin, and Robert G. King. 2005. “The Incredible Volcker
Disinflation.” Journal of Monetary Economics 52 (5): 981-1015.
Humphrey, Thomas M. 1991. “Nonneutrality of Money in Classical
Monetary Thought.” Federal Reserve Bank of Richmond Economic
Review 77 (2): 3-15.
Keynes, John Maynard. 1923. A Tract on Monetary Reform. London:
Macmillan and Company.
King, Robert G., and Charles I. Plosser. 1984. “Money, Credit, and Prices
in a Real Business Cycle.” American Economic Review 74 (3): 363-80.
Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than
Discretion: The Inconsistency of Optimal Plans.” Journal of Political
Economy 85 (3): 473-91.

Page 26 ■ Federal Reserve Bank of Richmond

Lucas, Robert E., Jr. 1976. “Econometric Policy Evaluation: A Critique.” In
the Carnegie-Rochester Conference Series on Public Policy 1, The
Phillips Curve and Labor Markets, eds. Karl Brunner and Allan H.
Meltzer. Amsterdam: North-Holland.
Lucas, Robert E., Jr. 1996. “Nobel Lecture: Monetary Neutrality.” Journal
of Political Economy 104 (4): 661-82.
Mankiw, N. Gregory. 2007. Principles of Microeconomics (4th ed.).
United States: Thomson South-Western.
Phelps, Edmund S. 1967. “Phillips Curves, Expectations of Inflation and
Optimal Unemployment over Time.” Economica 34 (135): 254-81.
Phillips, A. W. 1958. “The Relation Between Unemployment and the Rate
of Change of Money Wage Rates in the United Kingdom, 1861-1957.”
Economica 25 (100): 283-99.
Samuelson, Paul A., and Robert M. Solow. 1960. “Analytical Aspects of
Anti-Inflation Policy.” American Economic Review 50 (2): 177-94.
Sargent, Thomas J. 1986. “The Ends of Four Big Inflations.” In Rational
Expectations and Inflation, ed. Thomas J. Sargent. New York, NY: Harper
and Row.
Sargent, Thomas J. 1999. The Conquest of American Inflation. Princeton,
NJ: Princeton University Press.
Sargent, Thomas, Noah Williams, and Tao Zha. 2006. “Shocks and
Government Beliefs: The Rise and Fall of American Inflation.” American
Economic Review 96 (4): 1193-1224.
Sbordone, Argia M. 2006. “Inflation Persistence: Alternative
Interpretations and Policy Implications.” Federal Reserve Bank of New
York, manuscript (October).
Sumo, Vanessa. 2007. “Bad Luck or Bad Policy? Why Inflation Rose and
Fell, and What This Means for Monetary Policy.” Federal Reserve Bank of
Richmond Region Focus 11 (1): 40-43.
Velde, François R. 2004. “Poor Hand or Poor Play? The Rise and Fall of
Inflation in the U.S.” Federal Reserve Bank of Chicago Economic
Perspectives 28 (1): 34-51.

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Fifth District Economic Report
After three years of robust growth, the Fifth District

Total Payroll Employment
December 2006
(thousands of jobs)

economy moderated in 2006, much like the national
economy that it closely tracks. The well-documented
slowdown in housing contributed to this deceleration.
But the housing market’s retreat was not enough to
significantly dampen regional activity. Moreover, residential investment accounts for only a small portion
of total U.S. output—just 6 percent. It would take a
much larger contraction than we saw in 2006 to

Fifth District
United States
District of Columbia
Maryland
North Carolina
South Carolina
Virginia
West Virginia

% Change from
December 2005

13,729
137,147

1.5
1.7

695
2,612
4,000
1,907
3,755
760

1.2
1.7
1.4
1.7
1.5
1.0

Sources: Bureau of Economic Analysis/Haver Analytics
Note: All data are seasonally adjusted.

weaken consumer spending.
Most economic measures during 2006 pointed

West Virginia and Washington, D.C., were alone

upward in the District, just not as sharply as in

among District jurisdictions in seeing their jobless

recent years. Persistent growth in services-related

rates worsen compared with the previous year.

businesses—such as health care and financial

Across the District, the healthiest advances were

services—and solid employment gains across most

seen in services-oriented urban areas, with rural

of the District indicate underlying strength that so far

parts weaker.

has counterbalanced softer portions of the economy,
including the long-struggling manufacturing sectors.

The overall expansion of employment in the
District masked considerable variation among specific industries. Manufacturing employment declined

Employment

by 1.8 percent over the course of the year, as the

It was an up-and-down year in the Fifth District

sector shed 23,300 jobs. This hit was felt strongest

labor market. The region added about 203,000 jobs

in North Carolina, which accounted for more than

during 2006, a 1.5 percent increase. Unemployment

half that loss with 13,600 jobs eliminated. Yet North

dropped 0.3 percentage points compared with the

Carolina ended up gaining more than 56,000 jobs

close of 2005 to 4.4 percent, beating the national

on the year, with a large share of those in its thriving

average of 4.5 percent. Though the overall story

health and professional services sectors. Likewise,

was of a strong performance, it really was one of a

Maryland’s addition of roughly 44,000 jobs came

fast start followed by a loss of steam. January 2006

despite losses in manufacturing and a sluggish

began with joblessness at 4.1 percent, and the

financial sector. The state’s gains were powered

rate crept up over the course of the year as

mostly by the education and health care, leisure

the market cooled.

and hospitality, and professional and business

Job prospects differed across the region, with

services sectors. Competition for skilled workers

manufacturing-heavy South Carolina posting the

was strong, especially in large metropolitan areas

highest unemployment rate at 6.6 percent, and

like Washington, D.C., and Charlotte, and there

Virginia, abundant in stable government and growing

were some reports of employers having difficulty

services jobs, reporting the lowest at 2.9 percent.

with recruiting.

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Households

Business

The District’s fair performance in the labor market

The financial health of Fifth District businesses was

can be seen in household financial conditions. While

mixed in 2006. Our monthly surveys of business con-

national real personal income climbed 3.6 percent in

ditions pointed to contraction in retail establishments.

2006, our region’s rate of income growth trailed

Sales were brisk at the start but as the year drew to

slightly at 3.5 percent. Three of the Fifth District’s

a close, retailers generally reported weakening

jurisdictions topped the national average: North

revenues as well as declines in employment.

Carolina at 4 percent; West Virginia at 3.8 percent;

Managers with non-retail service establishments,

and Washington, D.C., at 3.7 percent. In 2005, all of

however, indicated decent growth in both revenue

the District’s jurisdictions except North Carolina beat

and employment throughout the year.

the national pace.

As reflected in labor market measures, manufacturers in the District saw continued pullback, with

Real Personal Income

new orders trending downward over the course of the

Fourth Quarter 2006
(billions of chained
2000 dollars)
Fifth District
United States
District of Columbia
Maryland
North Carolina
South Carolina
Virginia
West Virginia

% Change from
Fourth Quarter 2005

922
9,604

3.5
3.6

29
219
253
113
264
45

3.7
3.1
4.0
3.6
3.4
3.8

Sources: Bureau of Economic Analysis/Haver Analytics
Note: All data are seasonally adjusted.

year. Our composite index of manufacturing activity
says it all: 2006 began with gains, followed by pointed
retreats. This pattern repeated itself throughout the
year, but with each gain smaller than the last.
This trend of moderation as 2006 progressed was
also reflected in business bankruptcy filings. Though,
as with personal filings, business bankruptcies
dropped off significantly from the year before because
of stricter new filing rules, they inched up steadily

The number of personal bankruptcies plunged

through the seasons. The number of firms seeking

across the District and nation in 2006 with sweeping

protection from creditors rose 7.7 percent from the first

reforms to federal bankruptcy laws. But after the initial

quarter to the second; 13.3 percent from the second

dip, filings began to grow, with each jurisdiction in the

to the third; and 7.8 percent from the third quarter to

District reporting personal bankruptcies at least 25 per-

the last. From the first quarter to the last, Fifth District

cent higher in the fourth quarter than in the first. The

business filings grew a sizable 31.6 percent. Still, this

ability of households to keep up with mortgage pay-

was lower than the national pace of 36.7 percent.

ments worsened nationwide and in the District. At the

Venture capital—money typically provided to new

end of the year, 3.3 percent of U.S. mortgages were

businesses with strong growth prospects—flowed

past due 30 days or more, with 49 out of 51 states

into the District. The 2006 total was $1.6 billion,

seeing overall rates increase. By comparison, 3.4 per-

a 10 percent increase over 2005. As would be

cent of mortgages were late in the Fifth District, up

expected, more than 90 percent of those funds

0.3 percentage points from 2005. West Virginia report-

were invested into firms in three states: Maryland,

ed the toughest conditions on this front, with a 0.6 per-

North Carolina, and Virginia, in that order.

centage point increase in delinquencies to 4.8 percent.

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Housing and Commercial Real Estate

and manufacturing activity have been softer. Not

No report on annual economic activity in 2006 would

surprisingly, manufacturing-dependent states like

be complete without mention of the housing market.

West Virginia and South Carolina continue to

What’s important to note is that, at least for our region,

experience weaker employment than Maryland

the run-up in housing prices over the past five years

and Virginia. Metro areas are seeing the strongest

appears to have been based by and large on funda-

job markets, but their housing markets are also

mentals, not speculation. But the slowdown is affect-

seeing some of the biggest retreats. The weakness

ing District conditions. Existing home sales in our

in housing has been generally persistent throughout

region fell 14.6 percent over the year. The biggest

the first half of 2007, but many analysts expect the

drop was the 26.2 percent decline registered in

market to strengthen toward the end of the year.

Virginia, followed by the District of Columbia, and

How the rest of the story of the Fifth District econ-

Maryland. North Carolina’s decrease of 1.5 percent

omy unfolds remains to be seen.

was by far the smallest.

Note: The data presented and discussed above are accurate as
of April 25, 2007, but subject to later revision.

Yet home prices were resilient: Fifth District
home prices were actually 7.8 percent higher than
the year before, though the increase was well off the

Richmond Fed Economic Resources

17 percent annual increases that were the norm in

however, were mostly confined to large metro areas.

5E Indicators
Published monthly by the regional economics section of
the Federal Reserve Bank of Richmond, after the
release of the monthly state employment and unemployment data.

And the decline in housing permits was still less pro-

www.richmondfed.org/research/regional_conditions/5e_indicators

nounced than the national trend. In the world of com-

Manufacturing Survey
Monthly survey of manufacturing managers in the
Fifth District on economic conditions.

the early part of 2005. Housing starts were down
toward the end of the year. The biggest declines,

mercial real estate, office vacancy rates fell across
the largest metro areas in the District. The most significant tightening occurred in Baltimore, where office
vacancies dropped from 15 percent to 11.4 percent.
Outlook
2007 is shaping up much like the latter months

www.richmondfed.org/research/regional_conditions/manufacturing_conditions

Services Sector Survey
Monthly survey of managers at retail and services firms
in the Fifth District on economic conditions.
www.richmondfed.org/research/regional_conditions/service_sector

tied to location and industry. Growth is centered in

Beige Book
Summary of commentary on current economic
conditions by Federal Reserve District.

the services sector, particularly health care, tourism,

www.federalreserve.gov/FOMC/BeigeBook/2007

and professional services. Demand for skilled work-

Region Focus
Quarterly magazine of the Richmond Fed providing
information and analysis about the economy of the
Fifth Federal Reserve District.

of 2006. Economic performance more than ever is

ers in those industries is fierce and some labor shortages have been reported. Still, through the first few
months of 2007, the District is adding jobs at a

www.richmondfed.org/publications/economic_research/region_focus

slower pace than the national economy. Both retail

2006 Annual Report ■ Page 29

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Page 30

SARAH G. GREEN

Message from Management
In 2006, the Federal Reserve Bank of Richmond took

We pursued a number of initiatives during the year

significant steps toward achieving the organization’s

to broaden our influence on policy issues. We aug-

vision of excelling in all we do and making important

mented our monetary policy preparations with

contributions to our key constituents: financial institu-

research on emerging findings related to inflation

tions, the U.S. Treasury, the public, and our employ-

dynamics. Our Research Department is also finding

ees. Our attention and energy are concentrated in

new ways to share insights with audiences outside

several areas—strengthening our voice on policy

the Bank on specialized economic subjects, starting

issues, sustaining strong overall performance in our

with consumer finance. In supervision and regulation,

financial services and fiscal agency responsibilities,

we made contributions to key System efforts, assum-

strengthening our connection to the region, and fully

ing leadership positions in quality management, credit

engaging our people.

risk management, and asset securitization, as well as

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Page 31

in capital markets training. Our examination staff con-

cash policy changes. Our economic and financial

tinues to provide effective and efficient supervision of

education initiatives grew out of a District-wide effort

our community, regional, and large banking organiza-

to find ways to strengthen contributions to our com-

tions and through various forums is expanding its

munities. We completed research on the unbanked

efforts to share information with the industry about

population and are working with organizations

emerging risks and best risk-management practices.

throughout the District to build awareness about

This policy work is among the Bank’s more public

financial education issues. Bank management and

roles. Our leadership also has been evident in our

staff have increased outside speaking events and

payments system role. The Currency Technology

service on organization boards, and have built new

Office, which is responsible for the System’s auto-

partnerships.

mated currency-handling processes, developed

As we define what we as a Bank mean to our

important enhancements that will drive productivity

region, we also recognize that our people define who

gains and also contributed to counterfeit detection

we are as a Bank. To attract and retain the best peo-

and currency recirculation initiatives. We worked

ple, we created a talent management framework in

closely with our financial institution customers to

2006 that addresses recruitment, development, per-

accelerate the adoption of Check 21 and electronic

formance, compensation, and Bank culture. We have

payments services. And in our role as fiscal agent,

implemented a more comprehensive recruiting

we enhanced a number of the U.S. Treasury’s critical

process and a new approach to performance man-

electronic payments and collection systems.

agement for all employees. Development opportuni-

The Richmond Reserve Bank performs a number
of important administrative functions on behalf of the
entire Federal Reserve System. The Bank now

ties now focus on both leadership skills and helping
all members of our staff grow in their jobs.
Over the past year, the Richmond Fed has expand-

processes the paychecks for all 19,000 employees

ed the influence we have on financial matters and in

of the 12 Federal Reserve Banks. The National

monetary policy, increased the contributions we make

Procurement Office, also located in Richmond,

to important Federal Reserve services, deepened the

achieved significant System-wide procurement cost

connections we have throughout our region with

savings and expanded its use of e-business tools.

financial institutions and community organizations,

In the region, we worked to build teaching and

and implemented new practices that will strengthen

learning relationships that expand the Bank’s contri-

the people whose work is critical to our mission. We

butions to and the public’s understanding of the finan-

are proud of our policy contributions, of our leader-

cial system and the economy. Our outreach in 2006

ship of critical Federal Reserve System initiatives, of

focused both on improving relationships with depos-

the services we provide to our customers and the

itory institutions and on improving economic and

U.S. Treasury, and of our people.

financial education in the Fifth District. We developed
new strategies to meet more frequently with depository
institutions throughout the region. As an example, we

Sarah G. Green

held forums with bankers to talk about impending

First Vice President

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Page 32

The Bank in the Community
The Federal Reserve Bank of Richmond values its

In 2006, for instance, the Bank’s President, senior

connections with Fifth District communities and works

officers, and economists gave more than 100 talks

to strengthen those relationships through our contact

throughout the District on a wide range of topics

with constituents across all of our functions and

related to the economy, banking, and policy. Our

through the charitable activities of our employees.

economic education division conducted programs for

The Bank conducts annual United Way campaigns

teachers and students from the elementary school

at its Richmond, Baltimore, and Charlotte Offices,

level through college. A number of departments within

and our employees participate in numerous

the Bank partnered with local organizations to hold a

community service projects through our FedCorps

forum addressing regional economic issues in south-

volunteer program.

west Virginia and southern West Virginia. And the

In addition, by reaching out to and talking with

Community Affairs Office organized housing and

people in the Fifth District, the Bank’s staff learns

economic development seminars in Maryland and

a great deal about economic conditions in the region

South Carolina. Moving forward, providing resources

and uses that information to help in the formulation

to increase public understanding of the financial

of monetary policy. This interaction is also invaluable

system and the broader economy will remain a high

in learning about, and sharing insights regarding,

priority for the Bank, as will our efforts to deepen our

community development issues facing our

own understanding of the economic successes and

many constituents.

challenges facing communities in our region.

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Boards of Directors, Advisory Groups,
and Officers
Federal Reserve Bank of Richmond
Board of Directors . . . . . . . . . . . . . . . . . . . . . . 35

Small Business and Agriculture
Advisory Council . . . . . . . . . . . . . . . . . . . . . . . 38

Our Richmond Board oversees the management of the

Established in 1985, the Small Business and

Bank and its Fifth District offices, provides timely busi-

Agriculture Advisory Council advises the Bank presi-

ness and economic information, participates in the for-

dent and other senior officers on the impact that mon-

mulation of national monetary and credit policies, and

etary, banking, and fiscal policies have on the District’s

serves as a link between the Federal Reserve System

small business and agricultural sectors. The Council’s

and the private sector. The Board also has the respon-

12 members are appointed by the Bank president.

sibility of appointing the Bank’s president and first vice
president, with approval from the Federal Reserve
Board of Governors. Six directors are elected by banks

Community Development
Advisory Council . . . . . . . . . . . . . . . . . . . . . . . 39

in the Fifth District that are members of the Federal

Created in 1998 to enhance communication between

Reserve System, and three are appointed by the

the Bank and the public concerning community devel-

Board of Governors.

opment issues, our Community Development Advisory
Council advises the Bank president and other senior

The Bank’s board of directors annually appoints

officers on community development concerns and

our District representative to the Federal Advisory

related policy matters. The Council’s eight members

Council, which consists of one member from each of

are appointed by the Bank president.

the 12 Federal Reserve Districts. The Council meets
four times a year with the Board of Governors to

Operations Advisory Committee . . . . . . . . . . 40

consult on business conditions and issues related to

The Operations Advisory Committee was established

the banking industry.

by the Bank in 1978 to serve as a forum for communication with financial institutions about the Federal

Baltimore and Charlotte Office
Boards of Directors. . . . . . . . . . . . . . . . . . . . . . 36

Reserve’s financial services and to help the Bank

Our Baltimore and Charlotte Offices have separate

stituency. Committee members are appointed by the

boards that oversee operations at their respective loca-

Bank’s first vice president.

respond to the changing needs of our banking con-

tions and, like our Richmond Board, contribute to policymaking and provide timely business and economic

Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

information about the District. Four directors on each of
these boards are appointed by the Richmond directors,
and three are appointed by the Board of Governors.

2006 Annual Report ■ Page 33

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Federal Reserve Bank of Richmond Board of Directors

DEPUTY CHAIRMAN

Theresa M. Stone
President, Retired
Lincoln Financial Media
Greensboro, North Carolina

CHAIRMAN

Thomas J. Mackell, Jr.
Warrenton, Virginia

Dana S. Boole
President and
Chief Executive Officer
Community Affordable
Housing Equity Corp.
Raleigh, North Carolina

Kathleen Walsh Carr
President
Cardinal Bank Washington
Washington, D.C.

Hunter R. Hollar
President and
Chief Executive Officer
Sandy Spring Bancorp
Sandy Spring Bank
Olney, Maryland

Harry M. Lightsey, III
State President,
South Carolina
BellSouth
Columbia, South Carolina

Lemuel E. Lewis
Director
Landmark
Communications, Inc.
Norfolk, Virginia

Kenneth R. Sparks
President and
Chief Executive Officer
Ken Sparks Associates LLC
White Stone, Virginia

Ernest J. Sewell
Senior Advisor
FNB Southeast
Greensboro, North Carolina

FEDERAL ADVISORY
COUNCIL REPRESENTATIVE

G. Kennedy Thompson
President and
Chief Executive Officer
Wachovia Corporation
Charlotte, North Carolina

2006 Annual Report ■ Page 35

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Page 36

Baltimore Office Board of Directors

CHAIRMAN

William C. Handorf
Professor of Finance
School of Business
and Public Management
George Washington University
Washington, D.C.

Cynthia Collins Allner
Principal
Miles & Stockbridge P.C.
Baltimore, Maryland

Biana J. Arentz
President and
Chief Executive Officer
Hemingway’s Inc.
Stevensville, Maryland

Kenneth C. Lundeen
President
Environmental
Reclamation Company
Baltimore, Maryland

Donald P. Hutchinson
President and
Chief Executive Officer
SunTrust Bank, Maryland
Baltimore, Maryland

NOT PICTURED

Michael L. Middleton
Chairman and President
Community Bank
of Tri-County
Waldorf, Maryland

Page 36 ■ Federal Reserve Bank of Richmond

William R. Roberts
President
Verizon Maryland Inc.
Baltimore, Maryland

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Charlotte Office Board of Directors

CHAIRMAN

Jim Lowry
Automotive Consultant
High Point, North Carolina

Anthony J. DiGiorgio
President
Winthrop University
Rock Hill, South Carolina

Linda L. Dolny
President
PML Associates, Inc.
Greenwood, South Carolina

Michael C. Miller
Chairman and President
FNB United Corp. and
First National Bank
and Trust Company
Asheboro, North Carolina

Barry L. Slider
President and
Chief Executive Officer
First South Bancorp, Inc.
First South Bank
Spartanburg, South Carolina

James H. Speed, Jr.
President and
Chief Executive Officer
North Carolina Mutual Life
Insurance Company
Durham, North Carolina

Donald K. Truslow
Chief Risk Officer
Wachovia Corporation
Charlotte, North Carolina

2006 Annual Report ■ Page 37

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Page 38

Small Business and Agriculture Advisory Council

Barbara B. Lang
President and
Chief Executive Officer
DC Chamber of Commerce
Washington, D.C.

R. Gerald Warren
President
Warren Farming Co., Inc.
Warren Swine Farms
Newton Grove, North Carolina

David A. Leonard
President
Leonard Companies, Ltd.
Lebanon, Virginia

William F. Willard, Sr.
President
Willard Agri-Service
of Frederick, Inc.
Frederick, Maryland

Jane Tabb
Secretary
Lyle C. Tabb & Sons, Inc.
Kearneysville, West Virginia

LEFT TO RIGHT: M. CRUM, G. WARREN, S. BOWLING, B. LANG, D. LEONARD

CHAIRMAN

S. M. Bowling
President
Dougherty Company, Inc.
Charleston, West Virginia

William W. Ditman
Chairman Emeritus
Willow Construction, LLC
Easton, Maryland

Ronnie L. Bryant
President and
Chief Executive Officer
Charlotte Regional
Partnership
Charlotte, North Carolina

James B. Gates, Jr.
Senior Partner
The Ridge Animal Hospital
Farmville, Virginia

Melvin L. Crum
Owner/Operator
Crum Farms
Rowesville, South Carolina

Page 38 ■ Federal Reserve Bank of Richmond

Dawn Gifford
Executive Director
D.C. Greenworks
Washington, D.C.

LEFT TO RIGHT: W. WILLARD, J. TABB, J. GATES, R. BRYANT, W. DITMAN

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Community Development Advisory Council

LEFT TO RIGHT: E. STEIN, S. WALDEN, M. STEGMAN, P. CALDWELL, T. SOMANATH

T. K. Somanath
Executive Director
Better Housing Coalition
Richmond, Virginia
Michael A. Stegman
Director of Policy
The John D. and Catherine T.
MacArthur Foundation
Chicago, Illinois

LEFT TO RIGHT: G. HARRIS, D. SWINTON, J. HENDERSON, P. PONNE, B. MAZYCK

CHAIR

Greta J. Harris
Program Vice President,
Southeast Region
Local Initiatives Support
Corporation (LISC)
Richmond, Virginia
Phyllis R. Caldwell
President, Community
Development Banking
Bank of America
Washington, D.C.
Jane N. Henderson
President
Virginia Community Capital
Christiansburg, Virginia

Bernie Mazyck
President and
Chief Executive Officer
South Carolina Association of
Community Development
Corporations (SCACDC)
Charleston, South Carolina

MacRae Professor of
Public Policy, Planning,
and Business
University of North Carolina
at Chapel Hill
Chapel Hill, North Carolina

Eric Stein
President
Center for Community
Self-Help
Durham, North Carolina
David H. Swinton
President
Benedict College
Columbia, South Carolina
Sharon Walden
Executive Director
Stop Abusive Family
Environments (S.A.F.E.)
Welch, West Virginia

Peter J. Ponne
Senior Vice President
and Manager
SunTrust CDC,
Mid-Atlantic Region
SunTrust Bank
Baltimore, Maryland

2006 Annual Report ■ Page 39

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Page 40

Operations Advisory Committee

LEFT TO RIGHT: M. PATTERSON, R. REARDON, J. GRAHAM, J. HARPER, J. THOMPSON, D.WILLIS, J. RIFFE

CHAIRMAN

Martin W. Patterson
Senior Vice President
Enterprise Check Services
SunTrust Banks, Inc.
Richmond, Virginia

Tim Dillow
Senior Vice President
Branch Banking & Trust
Company
Wilson, North Carolina

Jay G. Fitzhugh
Senior Vice President
Strategic Directions
Provident Bank
Baltimore, Maryland

Cynthia B. Cervenka
President and
Chief Executive Officer
Damascus Community Bank
Damascus, Maryland

Debra E. Droppleman
Chief Financial Officer
Fairmont Federal Credit Union
Fairmont, West Virginia

Jack H. Goldstein
President and
Chief Executive Officer
NBRS Financial
Rising Sun, Maryland

Terry Childress
Senior Vice President
Virginia Credit Union League
Lynchburg, Virginia
Daniel O. Cook, Jr.
Executive Vice President and
Chief Operating Officer
Arthur State Bank
Union, South Carolina

John DuBose
Executive Vice President,
Chief Operating Officer, and
Chief Technology Officer
Carolina First Bank
Lexington, South Carolina

Jimmy Graham
Executive Vice President
Coastal Federal Bank
Myrtle Beach, South Carolina
Kenneth L. Greear
Executive Vice President
United Bank
Charleston, West Virginia

LEFT TO RIGHT: S. LILLY, D. COOK, D. DROPPLEMAN, K. GREEAR, S. WINSTON, W. JOHNSON

Page 40 ■ Federal Reserve Bank of Richmond

John A. Harper
Vice President
Summit Financial Group
Moorefield, West Virginia
Jay F. Hinkle
Senior Vice President
Mid-Atlantic Regional Manager
Item Processing Day 1
Wachovia Corporation
Glen Allen, Virginia
William T. Johnson, Jr.
President and
Chief Executive Officer
Citizens National Bank
Elkins, West Virginia

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Page 41

LEFT TO RIGHT: P. SLABY, T. DILLOW, J. HINKLE, C. CERVENKA, G. SINK, N. ROBINSON, K. RICHEY

E. Stephen Lilly
Senior Vice President and
Chief Operating Officer
First Community
Bancshares, Inc.
Bluefield, Virginia
Gerald McQuaid
Senior Vice President
Division Executive,
Bank Operations
Chevy Chase Bank, FSB
Laurel, Maryland
Kent B. Miller
Vice President
Operations and Service Delivery
RBC Centura Bank
Rocky Mount, North Carolina

Melissa Quirk
Executive Vice President
The Columbia Bank
Columbia, Maryland

Norman K. Robinson
President
EastPay
Richmond, Virginia

Ralph Reardon
Senior Vice President and
Chief Financial Officer
Coastal Federal Credit Union
Raleigh, North Carolina

D. Gerald Sink
Senior Vice President
Lexington State Bank
Lexington, North Carolina

Kenneth L. Richey
Director
Corporate Cash Management
Synovus Financial Corporation
Columbia, South Carolina

Paul A. Slaby
Senior Vice President
Finance
Aberdeen Proving Ground
Federal Credit Union
Edgewood, Maryland

James T. Riffe
Executive Vice President and
Chief Operating Officer
Highlands Union Bank
Abingdon, Virginia

James H. Thompson, III
Vice President and Cashier
The National Capital Bank
of Washington
Washington, D.C.
B. Martin Walker
Senior Vice President
Bank of America
Richmond, Virginia
David Willis
Vice President
Debit Card and
Funds Services
Navy Federal Credit Union
Merrifield, Virginia
Stephen R. Winston
Vice President
Treasury Cash Operations
Capital One Services, Inc.
Glen Allen, Virginia

LEFT TO RIGHT: J. GOLDSTEIN, M. WALKER, G. MCQUAID, J. DUBOSE, J. FITZHUGH, M. QUIRK, K. MILLER

2006 Annual Report ■ Page 41

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Page 42

We express our sincere appreciation to all of our directors
for their guidance and support in 2006 and to members of
our advisory groups for their service throughout the year.
The insights of all of these individuals help us to better
serve the communities and institutions within the
Fifth District and to make greater contributions to the
Federal Reserve System.
We especially thank those members of our boards of
directors whose terms ended in 2006:
Ernest J. Sewell from our Richmond Board
William C. Handorf and Kenneth C. Lundeen from our
Baltimore Board

Page 42 ■ Federal Reserve Bank of Richmond

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Page 43

SEATED, LEFT TO RIGHT: M. ALFRIEND, J. CLATTERBUCK, J. MCAFEE, V. BRUGH
STANDING, LEFT TO RIGHT: R. WETZEL, C. MACSWAIN, J. WEINBERG, J. LACKER,
S. GREEN, J. KANE, M. SHULER, D. BECK

Management Committee
Jeffrey M. Lacker
President
Sarah G. Green
First Vice President
Malcolm C. Alfriend
Senior Vice President
David E. Beck
Senior Vice President
Baltimore Office
Victor M. Brugh, II
Medical Director

Claudia N. MacSwain
Senior Vice President
and Chief Financial Officer
James McAfee
Senior Vice President
and General Counsel
Marsha S. Shuler
Senior Vice President
John A. Weinberg
Senior Vice President
and Director of Research

Janice E. Clatterbuck
Senior Vice President

Robert E. Wetzel, Jr.
Senior Vice President
and General Auditor

Jeffrey S. Kane
Senior Vice President
Charlotte Office

Officer listing continued on
next page

2006 Annual Report ■ Page 43

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Page 44

Officers, continued
James M. Barnes
Vice President

Granville Burruss
Assistant Vice President

Barbara J. Moss
Assistant Vice President

Amy L. Eschman
Assistant Vice President

Roland Costa
Vice President

John B. Carter, Jr.
Assistant Vice President

Edward B. Norfleet
Assistant Vice President

John I. Turnbull, II
Assistant Vice President

Alan H. Crooker
Vice President

Constance B. Frudden
Assistant Vice President

Lisa T. Oliva
Assistant Vice President

Tammy H. Cummings
Vice President

Joan T. Garton
Assistant Vice President

Arlene S. Saunders
Assistant Vice President

A. Linwood Gill, III
Vice President

Anne C. Gossweiler
Assistant Vice President

Rebecca J. Snider
Assistant Vice President

Howard S. Goldfine
Vice President

Cathy I. Howdyshell
Assistant Vice President

Daniel D. Tatar
Assistant Vice President

Mattison W. Harris
Vice President

Gregory A. Johnson
Assistant Vice President

Jeffrey K. Thomas
Assistant Vice President

Andreas L. Hornstein
Vice President

Jeannette M. Johnson
Assistant Vice President

Sandra L. Tormoen
Assistant Vice President

Eugene W. Johnson, Jr.
Vice President

Steve V. Malone
Assistant Vice President

Mark D. Vaughan
Assistant Vice President

Malissa M. Ladd
Vice President

Page W. Marchetti
Assistant Vice President
and Secretary

Lauren E. Ware
Assistant Vice President

Edgar A. Martindale, III
Vice President
and Controller
P. A. L. Nunley
Deputy General Counsel
Raymond E. Owens, III
Vice President

Jonathan P. Martin
Assistant Vice President
Andrew S. McAllister
Assistant Vice President
William R. McCorvey, Jr.
Assistant General Counsel

Howard S. Whitehead
Vice President

Diane H. McDorman
Assistant Vice President

Anthony Bardascino
Assistant Vice President

Robert J. Minteer
Assistant Vice President

Hattie R. C. Barley
Assistant Vice President

Susan Q. Moore
Assistant Vice President

Page 44 ■ Federal Reserve Bank of Richmond

William F. White
Assistant Vice President
Michael L. Wilder
Assistant Vice President
Karen J. Williams
Assistant Vice President
H. Julie Yoo
Assistant Vice President
Baltimore Office
Steven T. Bareford
Assistant Vice President
Karen L. Brooks
Assistant Vice President

Charlotte Office
R. William Ahern
Vice President
Jennifer J. Burns
Vice President
Terry J. Wright
Vice President
Jennifer R. Zara
Vice President
T. Stuart Desch
Assistant Vice President
Ronald B. Holton
Assistant Vice President
Richard J. Kuhn
Assistant Vice President
Adam S. Pilsbury
Assistant Vice President
Gregory E. Sierra
Assistant Vice President
Richard F. Westerkamp, Jr.
Assistant Vice President
Lisa A. White
Assistant Vice President
Listing as of December 31,
2006

Financial Statements
Management Assertion . . . . . . . . . . . . . . . . . . 47
Report of Independent Auditors . . . . . . . . . . . 48
Comparative Financial Statements . . . . . . . . . 50
Notes to Financial Statements . . . . . . . . . . . . 53

The firm engaged by the Board of Governors for
the audits of the individual and combined financial
statements of the Reserve Banks for 2006 was
PricewaterhouseCoopers LLP (PwC). Fees for these
services totaled $4.2 million. To ensure auditor
independence, the Board of Governors requires that
PwC be independent in all matters relating to the
audit. Specifically, PwC may not perform services for
the Reserve Banks or others that would place it in a
position of auditing its own work, making management
decisions on behalf of the Reserve Banks, or in any
other way impairing its audit independence. In 2006,
the Bank did not engage PwC for any material
advisory services.

2006 Annual Report n Page 45

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Page 47

Management Assertion
March 5, 2007
To the Board of Directors:
The management of the Federal Reserve Bank of Richmond (“FRB Richmond”) is responsible for the preparation
and fair presentation of the Statement of Financial Condition, Statement of Income, and Statement of Changes in
Capital as of December 31, 2006 (the “Financial Statements”). The Financial Statements have been prepared in
conformity with the accounting principles, policies, and practices established by the Board of Governors of the
Federal Reserve System and as set forth in the Financial Accounting Manual for the Federal Reserve Banks
(“Manual”), and as such, include amounts, some of which are based on management judgments and estimates.
To our knowledge, the Financial Statements are, in all material respects, fairly presented in conformity with the
accounting principles, policies, and practices documented in the Manual and include all disclosures necessary for
such fair presentation.
The management of the FRB Richmond is responsible for establishing and maintaining effective internal control
over financial reporting as it relates to the Financial Statements. Such internal control is designed to provide reasonable assurance to management and to the Board of Directors regarding the preparation of the Financial Statements
in accordance with the Manual. Internal control contains self-monitoring mechanisms, including, but not limited to,
divisions of responsibility and a code of conduct. Once identified, any material deficiencies in internal control are
reported to management and appropriate corrective measures are implemented.
Even effective internal control, no matter how well designed, has inherent limitations, including the possibility of
human error, and therefore can provide only reasonable assurance with respect to the preparation of reliable financial statements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies
or procedures may deteriorate.
The management of the FRB Richmond assessed its internal control over financial reporting reflected in the
Financial Statements, based upon the criteria established in the “Internal Control—Integrated Framework” issued
by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, we
believe that the FRB Richmond maintained effective internal control over financial reporting as it relates to the
Financial Statements.
Management’s assessment of the effectiveness of the FRB Richmond’s internal control over financial reporting
as of December 31, 2006, is being audited by PricewaterhouseCoopers LLP, the independent registered public
accounting firm which also is auditing the FRB Richmond’s Financial Statements.
Federal Reserve Bank of Richmond

Jeffrey M. Lacker
President

Sarah G. Green
First Vice President

Claudia N. MacSwain
Senior Vice President and
Chief Financial Officer

2006 Annual Report ■ Page 47

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Page 48

Report of Independent Auditors

To the Board of Governors of the Federal Reserve System and the
Board of Directors of the Federal Reserve Bank of Richmond:
We have completed an integrated audit of the Federal Reserve Bank of Richmond’s 2006 financial statements, and
of its internal control over financial reporting as of December 31, 2006 and an audit of its 2005 financial statements
in accordance with the generally accepted auditing standards as established by the Auditing Standards Board
(United States) and in accordance with the auditing standards of the Public Company Accounting Oversight Board
(United States). Our opinions, based on our audits, are presented below.
Financial statements
We have audited the accompanying statements of condition of the Federal Reserve Bank of Richmond (the “Bank”)
as of December 31, 2006 and 2005, and the related statements of income and changes in capital for the years then
ended, which have been prepared in conformity with the accounting principles, policies, and practices established by
the Board of Governors of the Federal Reserve System. These financial statements are the responsibility of the
Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards as established by the
Auditing Standards Board (United States) and in accordance with the auditing standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As described in Note 3, these financial statements were prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve System. These
principles, policies, and practices, which were designed to meet the specialized accounting and reporting needs
of the Federal Reserve System, are set forth in the Financial Accounting Manual for Federal Reserve Banks
which is a comprehensive basis of accounting other than accounting principles generally accepted in the United
States of America.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial
position of the Bank as of December 31, 2006 and 2005, and results of its operations for the years then ended,
on the basis of accounting described in Note 3.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal
Control Over Financial Reporting, that the Bank maintained effective internal control over financial reporting as of
December 31, 2006 based on criteria established in Internal Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material

Page 48 ■ Federal Reserve Bank of Richmond

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Page 49

respects, based on those criteria. Furthermore, in our opinion, the Bank maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2006, based on criteria established in
Internal Control—Integrated Framework issued by the COSO. The Bank’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the
effectiveness of the Bank’s internal control over financial reporting based on our audit. We conducted our audit of
internal control over financial reporting in accordance with generally accepted auditing standards as established
by the Auditing Standards Board (United States) and in accordance with the auditing standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such other procedures as we consider
necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal control over financial reporting
includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLP
March 12, 2007

2006 Annual Report ■ Page 49

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Page 50

Statements of Condition (in millions)
As of December 31,

2006

2005

Assets
Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
U.S. government securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Interdistrict settlement account
Bank premises and equipment, net
Interest on Federal Reserve notes due from U.S. Treasury
Other assets

$

853
147
78
237
—
65,095
5,625
558
4,858
272
—
102

$

836
147
66
225
1
57,253
3,454
445
8,521
252
35
90

Total assets

$ 77,825

$ 71,325

$ 63,695
2,460

$ 57,760
2,328

2,748
76
384
39
192
45

3,182
153
509
—
107
36

69,639

64,075

Liabilities and Capital
Liabilities:
Federal Reserve notes outstanding, net
Securities sold under agreements to repurchase
Deposits:
Depository institutions
Other deposits
Deferred credit items
Interest on Federal Reserve notes due U.S. Treasury
Accrued benefit costs
Other liabilities
Total liabilities
Capital:
Capital paid-in
Surplus (including accumulated other comprehensive loss of
$73 million at December 31, 2006)

4,093

3,942

4,093

3,308

Total capital

8,186

7,250

$ 77,825

$ 71,325

Total liabilities and capital

The accompanying notes are an integral part of these financial statements.

Page 50 ■ Federal Reserve Bank of Richmond

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Page 51

Statements of Income (in millions)
For the year ended December 31,

2006

2005

$ 2,862
98

$ 2,143
53

2,960

2,196

109

62

2,851

2,134

Compensation received for services provided
Reimbursable services to government agencies
Foreign currency gains (losses), net
Other income

44
28
322
11

40
28
(519)
8

Total other operating income (loss)

405

(443)

Salaries and other benefits
Occupancy expense
Equipment expense
Assessments by the Board of Governors
Other credits

253
32
62
121
(75)

241
33
59
99
(99)

Total operating expenses

393

333

$ 2,863

$ 1,358

Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on Federal Reserve notes

$

$

Total distribution

$ 2,863

Interest Income
Interest on U.S. government securities
Interest on investments denominated in foreign currencies
Total interest income
Interest Expense
Interest expense on securities sold under agreements
to repurchase
Net interest income
Other Operating Income (Loss)

Operating Expenses

Net income prior to distribution
Distribution of Net Income

241
858
1,764

198
1,160
—

$ 1,358

The accompanying notes are an integral part of these financial statements.

2006 Annual Report ■ Page 51

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Page 52

Statements of Changes in Capital (in millions)
Surplus

For the years ended December 31, 2006
and December 31, 2005
Balance at January 1, 2005
(43.0 million shares)
Net change in capital stock issued
(35.8 million shares)
Transferred to surplus
Balance at December 31, 2005
(78.8 million shares)
Net change in capital stock issued
(3.0 million shares)
Transferred to surplus
Adjustment to initially apply
FASB Statement No. 158
Balance at December 31, 2006
(81.8 million shares)

Capital
Paid-In

Net Income
Retained

$ 2,148

$ 2,148

1,794
—

—
1,160

$ 3,942

$ 3,308

151
—

Accumulated Other
Comprehensive Total
Loss
Surplus

—

$ 2,148

$ 4,296

—
—

—
1,160

1,794
1,160

—

$ 3,308

$ 7,250

—
858

—
—

—
858

151
858

—

—

(73)

(73)

(73)

$ 4,093

$ 4,166

The accompanying notes are an integral part of these financial statements.

Page 52 ■ Federal Reserve Bank of Richmond

$

Total
Capital

$

$

(73)

$ 4,093

$ 8,186

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Notes to Financial Statements
1. Structure

2. Operations and Services

The Federal Reserve Bank of Richmond (“Bank”) is part
of the Federal Reserve System (“System”) and one of
the twelve Reserve Banks (“Reserve Banks”) created by
Congress under the Federal Reserve Act of 1913
(“Federal Reserve Act”), which established the central
bank of the United States. The Reserve Banks are
chartered by the federal government and possess a
unique set of governmental, corporate, and central bank
characteristics. The Bank and its branches in Baltimore,
Maryland, and Charlotte, North Carolina serve the Fifth
Federal Reserve District, which includes Maryland,
North Carolina, South Carolina, Virginia, District of
Columbia, and portions of West Virginia.
In accordance with the Federal Reserve Act, supervision and control of the Bank is exercised by a board of
directors. The Federal Reserve Act specifies the
composition of the board of directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including
those designated as chairman and deputy chairman, are
appointed by the Board of Governors of the Federal
Reserve System (“Board of Governors”) to represent the
public, and six directors are elected by member banks.
Banks that are members of the System include all
national banks and any state-chartered banks that apply
and are approved for membership in the System.
Member banks are divided into three classes according
to size. Member banks in each class elect one director
representing member banks and one representing the
public. In any election of directors, each member bank
receives one vote, regardless of the number of shares
of Reserve Bank stock it holds.
The System also consists, in part, of the Board of
Governors and the Federal Open Market Committee
(“FOMC”). The Board of Governors, an independent federal agency, is charged by the Federal Reserve Act with
a number of specific duties, including general supervision over the Reserve Banks. The FOMC is composed
of members of the Board of Governors, the president of
the Federal Reserve Bank of New York (“FRBNY”), and
on a rotating basis four other Reserve Bank presidents.

The Reserve Banks perform a variety of services and
operations. Functions include participation in formulating
and conducting monetary policy; participation in the payments system, including large-dollar transfers of funds,
automated clearinghouse (“ACH”) operations, and check
collection; distribution of coin and currency; performance
of fiscal agency functions for the U.S. Treasury, certain
federal agencies, and other entities; serving as the
federal government’s bank; provision of short-term loans
to depository institutions; service to the consumer and
the community by providing educational materials and
information regarding consumer laws; and supervision of
bank holding companies, state member banks, and U.S.
offices of foreign banking organizations. The Reserve
Banks also provide certain services to foreign central
banks, governments, and international official institutions.
The FOMC, in the conduct of monetary policy,
establishes policy regarding domestic open market
operations, oversees these operations, and annually
issues authorizations and directives to the FRBNY for
its execution of transactions. The FRBNY is authorized
and directed by the FOMC to conduct operations in
domestic markets, including the direct purchase and
sale of U.S. government securities, the purchase of
securities under agreements to resell, the sale of
securities under agreements to repurchase, and the
lending of U.S. government securities. The FRBNY
executes these open market transactions at the direction of the FOMC and holds the resulting securities,
with the exception of securities purchased under
agreements to resell, in the portfolio known as the
System Open Market Account (“SOMA”).
In addition to authorizing and directing operations in
the domestic securities market, the FOMC authorizes
and directs the FRBNY to execute operations in foreign
markets for major currencies in order to counter disorderly conditions in exchange markets or to meet other
needs specified by the FOMC in carrying out the
System’s central bank responsibilities. The FRBNY is
authorized by the FOMC to hold balances of, and to
execute spot and forward foreign exchange (“FX”) and
securities contracts for, nine foreign currencies and to
invest such foreign currency holdings ensuring adequate

2006 Annual Report ■ Page 53

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liquidity is maintained. The FRBNY is authorized and
directed by the FOMC to maintain reciprocal currency
arrangements (“FX swaps”) with two central banks and
“warehouse” foreign currencies for the U.S. Treasury
and Exchange Stabilization Fund (“ESF”) through the
Reserve Banks. In connection with its foreign currency
activities, the FRBNY may enter into transactions that
contain varying degrees of off-balance-sheet market risk
that results from their future settlement and counterparty credit risk. The FRBNY controls credit risk by
obtaining credit approvals, establishing transaction
limits, and performing daily monitoring procedures.
Although the Reserve Banks are separate legal
entities, in the interests of greater efficiency and effectiveness they collaborate in the delivery of certain
operations and services. The collaboration takes the
form of centralized operations and product or service
offices that have responsibility for the delivery of certain
services on behalf of the Reserve Banks. Various
operational and management models are used and are
supported by service agreements between the Reserve
Bank providing the service and the other eleven
Reserve Banks. In some cases, costs incurred by a
Reserve Bank for services provided to other Reserve
Banks are not shared; in other cases, the Reserve
Banks are billed for services provided to them by
another Reserve Bank.
Major services provided on behalf of the System by
the Bank, for which the costs were not redistributed to
the other Reserve Banks, include: Standard Cash
Automation, Currency Technology Office, National
Procurement Office, Daylight Overdraft Reporting and
Pricing, and the Payroll Central Business Administration
Function. Costs are, however, redistributed to the other
Reserve Banks for computing and support services the
Bank provides for the System. The Bank’s total reimbursement for these services was $269 million and $263
million for the years ended December 31, 2006 and
2005, respectively, and is included in “Other credits” on
the Statements of Income.
During 2005, the Federal Reserve Bank of Atlanta
(“FRBA”) was assigned the overall responsibility for
managing the Reserve Banks’ provision of check services to depository institutions, and, as a result, recognizes total System check revenue on its Statements of
Income. Because the other eleven Reserve Banks incur
costs to provide check services, a policy was adopted
by the Reserve Banks in 2005 that required that the

Page 54 ■ Federal Reserve Bank of Richmond

FRBA compensate the other Reserve Banks for costs
incurred to provide check services. In 2006 this policy
was extended to the ACH services, which are managed
by the FRBA, as well as to Fedwire funds transfer and
securities transfer services, which are managed by the
FRBNY. The FRBA and the FRBNY compensate the
other Reserve Banks for the costs incurred to provide
these services. This compensation is reported as a
component of “Compensation received for services
provided”, and the Bank would have reported $42 million as compensation received for services provided had
this policy been in place in 2005 for ACH, Fedwire funds
transfer, and securities transfer services.

3. Significant Accounting Policies
Accounting principles for entities with the unique powers
and responsibilities of the nation’s central bank have not
been formulated by accounting standard-setting bodies.
The Board of Governors has developed specialized
accounting principles and practices that it considers to
be appropriate for the nature and function of a central
bank, which differ significantly from those of the private
sector. These accounting principles and practices are
documented in the Financial Accounting Manual for
Federal Reserve Banks (“Financial Accounting
Manual”), which is issued by the Board of Governors.
All of the Reserve Banks are required to adopt and
apply accounting policies and practices that are consistent with the Financial Accounting Manual and the
financial statements have been prepared in accordance
with the Financial Accounting Manual.
Differences exist between the accounting principles
and practices in the Financial Accounting Manual and
generally accepted accounting principles in the United
States (“GAAP”), primarily due to the unique nature of
the Bank’s powers and responsibilities as part of the
nation’s central bank. The primary difference is the
presentation of all securities holdings at amortized cost,
rather than using the fair value presentation required by
GAAP. Amortized cost more appropriately reflects the
Bank’s securities holdings given its unique responsibility
to conduct monetary policy. While the application of current market prices to the securities holdings may result
in values substantially above or below their carrying values, these unrealized changes in value would have no
direct effect on the quantity of reserves available to the
banking system or on the prospects for future Bank
earnings or capital. Both the domestic and foreign

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components of the SOMA portfolio may involve transactions that result in gains or losses when holdings are
sold prior to maturity. Decisions regarding securities and
foreign currency transactions, including their purchase
and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, market values, earnings,
and any gains or losses resulting from the sale of such
securities and currencies are incidental to the open
market operations and do not motivate decisions related
to policy or open market activities.
In addition, the Bank has elected not to present a
Statement of Cash Flows because the liquidity and
cash position of the Bank are not a primary concern
given the Bank’s unique powers and responsibilities. A
Statement of Cash Flows, therefore, would not provide
any additional meaningful information. Other information
regarding the Bank’s activities is provided in, or may be
derived from, the Statements of Condition, Income, and
Changes in Capital. There are no other significant
differences between the policies outlined in the Financial
Accounting Manual and GAAP.
The preparation of the financial statements in
conformity with the Financial Accounting Manual
requires management to make certain estimates and
assumptions that affect the reported amounts of assets
and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements, and the
reported amounts of income and expenses during the
reporting period. Actual results could differ from those
estimates. Unique accounts and significant accounting
policies are explained below.

a. Gold and Special Drawing Rights Certificates
The Secretary of the U.S. Treasury is authorized to
issue gold and special drawing rights (“SDR”) certificates to the Reserve Banks.
Payment for the gold certificates by the Reserve
Banks is made by crediting equivalent amounts in dollars into the account established for the U.S. Treasury.
The gold certificates held by the Reserve Banks are
required to be backed by the gold of the U.S. Treasury.
The U.S. Treasury may reacquire the gold certificates at
any time and the Reserve Banks must deliver them to
the U.S. Treasury. At such time, the U.S. Treasury’s
account is charged, and the Reserve Banks’ gold certificate accounts are reduced. The value of gold for purposes of backing the gold certificates is set by law at
$42 2/9 a fine troy ounce. The Board of Governors allo-

cates the gold certificates among Reserve Banks once a
year based on the average Federal Reserve notes outstanding in each Reserve Bank.
SDR certificates are issued by the International Monetary Fund (“Fund”) to its members in proportion to each
member’s quota in the Fund at the time of issuance.
SDR certificates serve as a supplement to international
monetary reserves and may be transferred from one
national monetary authority to another. Under the law
providing for United States participation in the SDR
system, the Secretary of the U.S. Treasury is authorized
to issue SDR certificates somewhat like gold certificates,
to the Reserve Banks. When SDR certificates are
issued to the Reserve Banks, equivalent amounts in
dollars are credited to the account established for the
U.S. Treasury, and the Reserve Banks’ SDR certificate
accounts are increased. The Reserve Banks are
required to purchase SDR certificates, at the direction
of the U.S. Treasury, for the purpose of financing SDR
acquisitions or for financing exchange stabilization
operations. At the time SDR transactions occur, the
Board of Governors allocates SDR certificate transactions among Reserve Banks based upon each Reserve
Bank’s Federal Reserve notes outstanding at the end
of the preceding year. There were no SDR transactions
in 2006 or 2005.

b. Loans to Depository Institutions
Depository institutions that maintain reservable transaction accounts or nonpersonal time deposits, as defined
in regulations issued by the Board of Governors, have
borrowing privileges at the discretion of the Reserve
Bank. Borrowers execute certain lending agreements
and deposit sufficient collateral before credit is extended.
Outstanding loans are evaluated for collectibility, and
currently all are considered collectible and fully
collateralized. If loans were ever deemed to be uncollectible, an appropriate reserve would be established.
Interest is accrued using the applicable discount rate
established at least every fourteen days by the Board of
Directors of the Reserve Bank, subject to review and
determination by the Board of Governors.

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c. U.S. Government Securities and Investments
Denominated in Foreign Currencies
U.S. government securities and investments denominated
in foreign currencies comprising the SOMA are recorded
at cost, on a settlement-date basis, and adjusted for
amortization of premiums or accretion of discounts on
a straight-line basis. Interest income is accrued on a
straight-line basis. Gains and losses resulting from sales
of securities are determined by specific issues based on
average cost. Foreign-currency-denominated assets
are revalued daily at current foreign currency market
exchange rates in order to report these assets in U.S.
dollars. Realized and unrealized gains and losses on
investments denominated in foreign currencies are reported as “Foreign currency gains (losses), net” in the
Statements of Income.
Activity related to U.S. government securities, including the premiums, discounts, and realized and unrealized
gains and losses, is allocated to each Reserve Bank on a
percentage basis derived from an annual settlement of
interdistrict clearings that occurs in April of each year.
The settlement also equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding in
each District. Activity related to investments denominated
in foreign currencies is allocated to each Reserve Bank
based on the ratio of each Reserve Bank’s capital and
surplus to aggregate capital and surplus at the preceding
December 31.

d. Securities Sold Under Agreements to
Repurchase and Securities Lending
Securities sold under agreements to repurchase are
accounted for as financing transactions and the associated interest expense is recognized over the life of the
transaction. These transactions are reported in the
Statements of Condition at their contractual amounts
and the related accrued interest payable is reported as
a component of “Other liabilities.”
U.S. government securities held in the SOMA are
lent to U.S. government securities dealers in order to
facilitate the effective functioning of the domestic securities market. Securities-lending transactions are fully
collateralized by other U.S. government securities and
the collateral taken is in excess of the market value of
the securities loaned. The FRBNY charges the dealer a
fee for borrowing securities and the fees are reported as
a component of “Other income.”

Page 56 ■ Federal Reserve Bank of Richmond

Activity related to securities sold under agreements
to repurchase and securities lending is allocated to each
of the Reserve Banks on a percentage basis derived
from the annual settlement of interdistrict clearings.
Securities purchased under agreements to resell are
allocated to FRBNY and not allocated to the other
Reserve Banks.

e. FX Swap Arrangements and Warehousing
Agreements
FX swap arrangements are contractual agreements
between two parties, the FRBNY and an authorized foreign central bank, to exchange specified currencies, at a
specified price, on a specified date. The parties agree to
exchange their currencies up to a prearranged maximum amount and for an agreed-upon period of time (up
to twelve months), at an agreed-upon interest rate.
These arrangements give the FOMC temporary access
to the foreign currencies it may need to intervene to
support the dollar and give the authorized foreign central bank temporary access to dollars it may need to
support its own currency. Drawings under the FX swap
arrangements can be initiated by either party acting as
drawer, and must be agreed to by the drawee party.
The FX swap arrangements are structured so that the
party initiating the transaction bears the exchange rate
risk upon maturity. The FRBNY will generally invest the
foreign currency received under an FX swap arrangement in interest-bearing instruments.
Warehousing is an arrangement under which the
FOMC agrees to exchange, at the request of the U.S.
Treasury, U.S. dollars for foreign currencies held by the
U.S. Treasury or ESF over a limited period of time. The
purpose of the warehousing facility is to supplement the
U.S. dollar resources of the U.S. Treasury and ESF for
financing purchases of foreign currencies and related
international operations.
FX swap arrangements and warehousing agreements are revalued daily at current market exchange
rates. Activity related to these agreements, with the
exception of the unrealized gains and losses resulting
from the daily revaluation, is allocated to each Reserve
Bank based on the ratio of each Reserve Bank’s capital
and surplus to aggregate capital and surplus at the preceding December 31. Unrealized gains and losses
resulting from the daily revaluation are allocated to
FRBNY and not allocated to the other Reserve Banks.

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f. Bank Premises, Equipment, and Software
Bank premises and equipment are stated at cost less
accumulated depreciation. Depreciation is calculated on
a straight-line basis over the estimated useful lives of
the assets, which range from two to fifty years. Major
alterations, renovations, and improvements are capitalized at cost as additions to the asset accounts and are
depreciated over the remaining useful life of the asset
or, if appropriate, over the unique useful life of the alteration, renovation, or improvement. Maintenance, repairs,
and minor replacements are charged to operating
expense in the year incurred.
Costs incurred for software during the application
development stage, either developed internally or acquired for internal use, are capitalized based on the cost
of direct services and materials associated with designing, coding, installing, or testing software. Capitalized
software costs are amortized on a straight-line basis
over the estimated useful lives of the software applications, which range from two to five years. Maintenance
costs related to software are charged to expense in the
year incurred.
Capitalized assets including software, buildings,
leasehold improvements, furniture, and equipment are
impaired when events or changes in circumstances indicate that the carrying amount of assets or asset groups is
not recoverable and significantly exceeds their fair value.

g. Interdistrict Settlement Account
At the close of business each day, each Reserve Bank
assembles the payments due to or from other Reserve
Banks. These payments result from transactions between Reserve Banks and transactions that involve
depository institution accounts held by other Reserve
Banks, such as Fedwire funds transfer, check collection,
security transfer, and ACH operations. The cumulative
net amount due to or from the other Reserve Banks is
reflected in the “Interdistrict settlement account” in the
Statements of Condition.

h. Federal Reserve Notes
Federal Reserve notes are the circulating currency of
the United States. These notes are issued through the
various Federal Reserve agents (the chairman of the
board of directors of each Reserve Bank and their
designees) to the Reserve Banks upon deposit with
such agents of specified classes of collateral security,

typically U.S. government securities. These notes are
identified as issued to a specific Reserve Bank. The
Federal Reserve Act provides that the collateral security
tendered by the Reserve Bank to the Federal Reserve
agent must be at least equal to the sum of the notes
applied for by such Reserve Bank.
Assets eligible to be pledged as collateral security
include all of the Bank’s assets. The collateral value is
equal to the book value of the collateral tendered, with
the exception of securities, for which the collateral value
is equal to the par value of the securities tendered. The
par value of securities pledged for securities sold under
agreements to repurchase is deducted.
The Board of Governors may, at any time, call upon
a Reserve Bank for additional security to adequately
collateralize the Federal Reserve notes. To satisfy the
obligation to provide sufficient collateral for outstanding
Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets
of the Reserve Banks to be jointly pledged as collateral
for the Federal Reserve notes issued to all Reserve
Banks. In the event that this collateral is insufficient,
the Federal Reserve Act provides that Federal Reserve
notes become a first and paramount lien on all the
assets of the Reserve Banks. Finally, Federal Reserve
notes are obligations of the United States and are
backed by the full faith and credit of the United
States government.
“Federal Reserve notes outstanding, net” in the
Statements of Condition represents the Bank’s Federal
Reserve notes outstanding, reduced by the currency
issued to the Bank but not in circulation, of $11,394 million and $11,887 million at December 31, 2006 and
2005, respectively.

i. Items in Process of Collection and Deferred
Credit Items
“Items in process of collection” in the Statements of
Condition primarily represents amounts attributable to
checks that have been deposited for collection and that,
as of the balance sheet date, have not yet been presented to the paying bank. “Deferred credit items” are
the counterpart liability to items in process of collection,
and the amounts in this account arise from deferring
credit for deposited items until the amounts are collected.
The balances in both accounts can vary significantly.

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j. Capital Paid-in
The Federal Reserve Act requires that each member
bank subscribe to the capital stock of the Reserve Bank
in an amount equal to 6 percent of the capital and surplus of the member bank. These shares are nonvoting
with a par value of $100 and may not be transferred or
hypothecated. As a member bank’s capital and surplus
changes, its holdings of Reserve Bank stock must be
adjusted. Currently, only one-half of the subscription is
paid-in and the remainder is subject to call. By law,
each Reserve Bank is required to pay each member
bank an annual dividend of 6 percent on the paid-in
capital stock. This cumulative dividend is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.

k. Surplus
The Board of Governors requires the Reserve Banks to
maintain a surplus equal to the amount of capital paid-in
as of December 31 of each year. This amount is intended to provide additional capital and reduce the possibility that the Reserve Banks would be required to call on
member banks for additional capital.
Accumulated other comprehensive income is reported as a component of surplus in the Statements of
Condition and the Statements of Changes in Capital.
The balance of accumulated other comprehensive
income is comprised of expenses, gains, and losses
related to defined benefit pension plans and other
postretirement benefit plans that, under accounting
principles, are included in comprehensive income but
excluded from net income. Additional information
regarding the classifications of accumulated other
comprehensive income is provided in Notes 9 and 10.

are suspended and earnings are retained until the surplus is equal to the capital paid-in.
In the event of a decrease in capital paid-in, the
excess surplus, after equating capital paid-in and surplus at December 31, is distributed to the U.S. Treasury
in the following year.
Due to the substantial increase in capital paid-in,
surplus was not equated to capital at December 31,
2005. The amount of additional surplus required due to
these events exceeded the Bank’s earnings in 2005.

m. Income and Costs Related to U.S. Treasury
Services
The Bank is required by the Federal Reserve Act to
serve as fiscal agent and depository of the United
States. By statute, the Department of the Treasury is
permitted, but not required, to pay for these services.

n. Assessments by the Board of Governors
The Board of Governors assesses the Reserve Banks
to fund its operations based on each Reserve Bank’s
capital and surplus balances as of December 31 of the
previous year. The Board of Governors also assesses
each Reserve Bank for the expenses incurred for the
U.S. Treasury to issue and retire Federal Reserve notes
based on each Reserve Bank’s share of the number of
notes comprising the System’s net liability for Federal
Reserve notes on December 31 of the previous year.

o. Taxes
The Reserve Banks are exempt from federal, state, and
local taxes, except for taxes on real property. The Bank’s
real property taxes were $2 million for each of the years
ended December 31, 2006 and 2005, respectively, and
are reported as a component of “Occupancy expense.”

l. Interest on Federal Reserve Notes
The Board of Governors requires the Reserve Banks to
transfer excess earnings to the U.S. Treasury as interest
on Federal Reserve notes, after providing for the costs of
operations, payment of dividends, and reservation of an
amount necessary to equate surplus with capital paid-in.
This amount is reported as a component of “Payments to
U.S. Treasury as interest on Federal Reserve notes” in
the Statements of Income and is reported as a liability in
the Statements of Condition. Weekly payments to the
U.S. Treasury may vary significantly.
In the event of losses or an increase in capital paidin at a Reserve Bank, payments to the U.S. Treasury

Page 58 ■ Federal Reserve Bank of Richmond

p. Restructuring Charges
In 2003, the Reserve Banks began the restructuring of
several operations, primarily check, cash, and U.S.
Treasury services. The restructuring included streamlining the management and support structures, reducing
staff, decreasing the number of processing locations,
and increasing processing capacity in some locations.
These restructuring activities continued in 2004
through 2006.
Note 11 describes the restructuring and provides
information about the Bank’s costs and liabilities associated with employee separations and contract termina-

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tions. The costs associated with the impairment of
certain of the Bank’s assets are discussed in Note 6.
Costs and liabilities associated with enhanced pension
benefits in connection with the restructuring activities for
all of the Reserve Banks are recorded on the books of
the FRBNY. Costs and liabilities associated with
enhanced postretirement benefits are discussed in
Note 9.

q. Implementation of FASB Statement No. 158,
Employers’ Accounting for Defined Benefit
Pension and Other Postretirement Plans
The Bank initially applied the provisions of FASB
Statement No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans, at
December 31, 2006. This accounting standard requires
recognition of the overfunded or underfunded status of a
defined benefit postretirement plan in the Statements of
Condition, and recognition of changes in the funded status in the years in which the changes occur through
comprehensive income. The transition rules for implementing the standard require applying the provisions as
of the end of the year of initial implementation with no
retrospective application. The incremental effects on the
line items in the Statement of Condition at December
31, 2006, were as follows (in millions):
Before
After
Applicaton of
Application of
Statement 158 Adjustments Statement 158

Accrued
benefit costs

119

73

192

73

$ 69,639

4,166

(73)

4,093

$ 8,259

$ (73)

$ 8,186

Total liabilities $ 69,566
Surplus
Total capital

$

4. U.S. Government Securities, Securities Sold
Under Agreements to Repurchase, and
Securities Lending
The FRBNY, on behalf of the Reserve Banks, holds
securities bought outright in the SOMA. The Bank’s
allocated share of SOMA balances was approximately
8.307 percent and 7.632 percent at December 31, 2006
and 2005, respectively.

The Bank’s allocated share of U.S. government
securities, net, held in the SOMA at December 31, was
as follows (in millions):
2006
Par value:
U.S. government:
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to the Bank

2005

$ 23,012
33,425
8,268

$ 20,703
29,009
7,084

64,705
723
(333)
$ 65,095

56,796
673
(216)
$ 57,253

At December 31, 2006 and 2005, the fair value of the
U.S. government securities allocated to the Bank,
excluding accrued interest, was $66,116 million and
$58,571 million, respectively, as determined by reference to quoted prices for identical securities.
The total of the U.S. government securities, net,
held in the SOMA was $783,619 million and $750,202
million at December 31, 2006 and 2005, respectively.
At December 31, 2006 and 2005, the fair value of the
U.S. government securities held in the SOMA, excluding accrued interest, was $795,900 million and
$767,472 million, respectively, as determined by reference to quoted prices for identical securities.
Although the fair value of security holdings can be
substantially greater or less than the carrying value at
any point in time, these unrealized gains or losses have
no effect on the ability of a Reserve Bank, as a central
bank, to meet its financial obligations and responsibilities, and should not be misunderstood as representing a
risk to the Reserve Banks, their shareholders, or the
public. The fair value is presented solely for informational purposes.
At December 31, 2006 and 2005, the total contract
amount of securities sold under agreements to repurchase was $29,615 million and $30,505 million, respectively, of which $2,460 million and $2,328 million were
allocated to the Bank. The total par value of the SOMA
securities that were pledged for securities sold under
agreements to repurchase at December 31, 2006 and
2005 was $29,676 million and $30,559 million, respectively, of which $2,465 million and $2,332 million
was allocated to the Bank. The contract amount for

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securities sold under agreements to repurchase approximates fair value.
The maturity distribution of U.S. government
securities bought outright, and securities sold under
agreements to repurchase, that were allocated to the
Bank at December 31, 2006, was as follows (in millions):

Maturities of
Securities Held

Securities
Sold Under
U.S. Government Agreements to
Securities
Repurchase
(Par value)
(Contract amount)

Within 15 days
$ 3,372
16 days to 90 days
15,027
91 days to 1 year
15,379
Over 1 year to 5 years
18,623
Over 5 years to 10 years
5,619
Over 10 years
6,685
Total allocated to
the Bank
$ 64,705

$ 2,460
—
—
—
—
—
$ 2,460

At December 31, 2006 and 2005, U.S. government
securities with par values of $6,855 million and $3,776
million, respectively, were loaned from the SOMA, of
which $569 million and $288 million, respectively, were
allocated to the Bank.

5. Investments Denominated in Foreign
Currencies
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and
with the Bank for International Settlements and invests in
foreign government debt instruments. Foreign government debt instruments held include both securities
bought outright and securities purchased under agreements to resell. These investments are guaranteed as to
principal and interest by the issuing foreign governments.
The Bank’s allocated share of investments denominated in foreign currencies was approximately 27.462
percent and 18.248 percent at December 31, 2006 and
2005, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, including accrued interest,
valued at foreign currency market exchange rates at
December 31, was as follows (in millions):

Page 60 ■ Federal Reserve Bank of Richmond

2006
European Union Euro:
Foreign currency deposits
Securities purchased under
agreements to resell
Government debt instruments
Japanese Yen:
Foreign currency deposits
Government debt instruments
Total allocated to the Bank

$ 1,714

2005
$

990

608
1,119

352
650

715
1,469

477
985

$ 5,625

$ 3,454

At December 31, 2006 and 2005, the fair value of
investments denominated in foreign currencies, including accrued interest, allocated to the Bank was $5,612
million and $3,461 million, respectively. The fair value of
government debt instruments was determined by reference to quoted prices for identical securities. The cost
basis of foreign currency deposits and securities purchased under agreements to resell, adjusted for accrued
interest, approximates fair value. Similar to the U.S.
government securities discussed in Note 4, unrealized
gains or losses have no effect on the ability of a
Reserve Bank, as a central bank, to meet its financial
obligations and responsibilities.
Total System investments denominated in foreign
currencies were $20,482 million and $18,928 million
at December 31, 2006 and 2005, respectively. At
December 31, 2006 and 2005, the fair value of the total
System investments denominated in foreign currencies,
including accrued interest, was $20,434 million and
$18,965 million, respectively.
The maturity distribution of investments denominated
in foreign currencies that were allocated to the Bank at
December 31, 2006, was as follows (in millions):
Maturities
of Investments
Denominated in
Foreign Currencies

European
Euro

Within 15 days
$ 1,197
16 days to 90 days
653
91 days to 1 year
671
Over 1 year to 5 years
920
Over 5 years to 10 years
—
Over 10 years
—
Total allocated
to the Bank
$ 3,441

Japanese
Yen

Total

$ 714
332
608
530
—
—

$ 1,911
985
1,279
1,450
—
—

$ 2,184

$ 5,625

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At December 31, 2006 and 2005, there were no
material open foreign exchange contracts.
At December 31, 2006 and 2005, the warehousing
facility was $5,000 million, with no balance outstanding.

Future Minimum Lease Payments

A summary of bank premises and equipment at
December 31 is as follows (in millions):
2006
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment

257
358
394
431
433
78

$

1,951

2005

$ 32
143
51
26
292

$ 32
142
51
4
288

Subtotal

544

517

Accumulated depreciation

(272)

(265)

$ 272

$ 252

$ 45

$

Bank premises and equipment, net
Depreciation expense, for the
year ended December 31

$

Total

6. Bank Premises, Equipment, and Software

2007
2008
2009
2010
2011
Thereafter

The Bank has capitalized software assets, net of amortization, of $36 million and $41 million at December 31,
2006 and 2005, respectively. Amortization expense was
$19 million for each of the years ended December 31,
2006 and 2005, respectively. Capitalized software
assets are reported as a component of “Other assets”
and the related amortization is reported as a component
of “Other expenses.”
Assets impaired as a result of the Bank’s restructuring plan, as discussed in Note 11, include furniture and
equipment. There were no asset impairment losses in
2006 and 2005.

43

7. Commitments and Contingencies
Bank premises and equipment at December 31 included
the following amounts for leases that have been capitalized (in millions):
2006
Leased premises and equipment
under capital leases
Accumulated depreciation
Leased premises and equipment
under capital leases, net

2005

$ 11
(5)

$

9
(5)

$

$

4

6

The Bank leases space to outside tenants with remaining lease terms of five years. Rental income from such
leases was $1.5 million for each of the years ended
December 31, 2006 and 2005, respectively, and is
reported as a component of “Other income.” Future minimum lease payments that the Bank will receive under
noncancelable lease agreements in existence at
December 31, 2006, are as follows (in thousands):

At December 31, 2006, the Bank was obligated under
noncancelable leases for premises and equipment with
remaining terms ranging from one to approximately
seven months. These leases provide for increased
rental payments based upon increases in real estate
taxes, operating costs, or selected price indices.
Rental expense under operating leases for certain
operating facilities, warehouses, and data processing
and office equipment (including taxes, insurance, and
maintenance when included in rent), net of sublease
rentals and rental charges to other entities within the
Federal Reserve System, was approximately $1 million
for each of the years ended December 31, 2006 and
2005, respectively. Certain of the Bank’s leases have
options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net
of sublease rentals, with terms of one year or more,
at December 31, 2006 were not material.
At December 31, 2006, there were no other material
commitments or long-term obligations in excess of
one year.
Under the Insurance Agreement of the Federal
Reserve Banks, each of the Reserve Banks has agreed

2006 Annual Report ■ Page 61

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to bear, on a per incident basis, a pro rata share of
losses in excess of one percent of the capital paid-in of
the claiming Reserve Bank, up to 50 percent of the total
capital paid-in of all Reserve Banks. Losses are borne in
the ratio that a Reserve Bank’s capital paid-in bears to
the total capital paid-in of all Reserve Banks at the
beginning of the calendar year in which the loss is
shared. No claims were outstanding under the agreement at December 31, 2006 or 2005.
The Bank is involved in certain legal actions and
claims arising in the ordinary course of business. Although it is difficult to predict the ultimate outcome of
these actions, in management’s opinion, based on
discussions with counsel, the aforementioned litigation
and claims will be resolved without material adverse
effect on the financial position or results of operations
of the Bank.

8. Retirement and Thrift Plans
Retirement Plans
The Bank currently offers three defined benefit retirement plans to its employees, based on length of service
and level of compensation. Substantially all of the
Bank’s employees participate in the Retirement Plan for
Employees of the Federal Reserve System (“System
Plan”). Employees at certain compensation levels participate in the Benefit Equalization Retirement Plan
(“BEP”) and certain Reserve Bank officers participate in
the Supplemental Employee Retirement Plan (“SERP”).
The System Plan is a multi-employer plan with contributions funded by the participating employers.
Participating employers are the Federal Reserve Banks,
the Board of Governors, and the Office of Employee
Benefits of the Federal Reserve Employee Benefits
System. No separate accounting is maintained of assets
contributed by the participating employers. The FRBNY
acts as a sponsor of the System Plan and the costs
associated with the Plan are not redistributed to other
participating employers.
The Bank’s projected benefit obligation, funded status, and net pension expenses for the BEP and the
SERP at December 31, 2006 and 2005, and for the
years then ended, were not material.

Thrift Plan
Employees of the Bank may also participate in the
defined contribution Thrift Plan for Employees of the

Page 62 ■ Federal Reserve Bank of Richmond

Federal Reserve System (“Thrift Plan”). The Bank’s
Thrift Plan contributions totaled $9 million and $8 million
for the years ended December 31, 2006 and 2005,
respectively, and are reported as a component of
“Salaries and other benefits” in the Statements of
Income. The Bank matches employee contributions
based on a specified formula. For the years ended
December 31, 2006 and 2005, the Bank matched 80
percent on the first 6 percent of employee contributions
for employees with less than five years of service and
100 percent on the first 6 percent of employee contributions for employees with five or more years of service.

9. Postretirement Benefits Other Than Pensions
and Postemployment Benefits
Postretirement Benefits other than Pensions
In addition to the Bank’s retirement plans, employees
who have met certain age and length-of-service requirements are eligible for both medical benefits and life
insurance coverage during retirement.
The Bank funds benefits payable under the medical
and life insurance plans as due and, accordingly, has no
plan assets.
Following is a reconciliation of beginning and ending
balances of the benefit obligation (in millions):
2006
Accumulated postretirement
benefit obligation at January 1 $ 135.3
Service cost-benefits earned
during the period
4.8
Interest cost of accumulated
benefit obligation
8.0
Actuarial loss
33.2
Contributions by plan participants
1.4
Benefits paid
(7.6)
Accumulated postretirement
benefit obligation at
December 31
$ 175.1

2005
$ 93.7
14.0
7.0
27.1
1.1
(7.6)

$135.3

At December 31, 2006 and 2005, the weighted-average
discount rate assumptions used in developing the
postretirement benefit obligation were 5.75 percent and
5.50 percent, respectively.
Discount rates reflect yields available on high-quality
corporate bonds that would generate the cash flows
necessary to pay the plan’s benefits when due.

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Following is a reconciliation of the beginning and
ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions):
2006
Fair value of plan assets
at January 1
Contributions by the employer
Contributions by plan participants
Benefits paid
Fair value of plan assets
at December 31
Unfunded postretirement
benefit obligation
Unrecognized prior service cost
Unrecognized net actuarial loss
Accrued postretirement
benefit cost
Amounts included in accumulated
other comprehensive loss are
shown below (in millions):
Prior service cost
Net actuarial loss
Total accumulated other
comprehensive loss

$

$

2005

—
6.2
1.4
(7.6)

$

—

$

$175.1

—
6.5
1.1
(7.6)
—

$ 135.3
7.7
(50.0)
$ 93.0

$ 6.2
(79.0)
$ (72.8)

Accrued postretirement benefit costs are reported as a
component of “Accrued benefit costs” in the Statements
of Condition.
For measurement purposes, the assumed health
care cost trend rates at December 31 are as follows:
2006
Health care cost trend rate
assumed for next year
Rate to which the cost trend
rate is assumed to decline
(the ultimate trend rate)
Year that the rate reaches
the ultimate trend rate

2005

9.00 %

9.00 %

5.00 %

5.00 %

2012

2011

Assumed health care cost trend rates have a significant
effect on the amounts reported for health care plans. A
one percentage point change in assumed health care
cost trend rates would have the following effects for the
year ended December 31, 2006 (in millions):

1% Point
Increase

Effect on aggregate of
service and interest cost
components of net
periodic postretirement
benefit costs
Effect on accumulated
postretirement benefit
obligation

1% Point
Decrease

$ 2.3

$ (1.8)

23.1

(19.1)

The following is a summary of the components of net
periodic postretirement benefit expense for the years
ended December 31 (in millions):
2006
Service cost-benefits
earned during the period
$ 4.8
Interest cost on accumulated
benefit obligation
8.0
Amortization of prior service cost
(1.4)
Recognized net actuarial loss
4.2
Net periodic postretirement
benefit expense
$ 15.6
Estimated amounts that will be
amortized from accumulated
other comprehensive loss
into net periodic postretirement
benefit expense in 2007
are shown below (in millions):
Prior service cost
$ (1.4)
Actuarial loss
7.8
Total

2005
$ 14.0
7.0
(1.4)
3.0
$ 22.6

$ 6.4

Net postretirement benefit costs are actuarially determined
using a January 1 measurement date. At January 1, 2006
and 2005, the weighted-average discount rate assumptions used to determine net periodic postretirement benefit
costs were 5.50 percent and 5.75 percent, respectively.
Net periodic postretirement benefit expense is reported
as a component of “Salaries and other benefits” in the
Statements of Income.
The Medicare Prescription Drug, Improvement and
Modernization Act of 2003 established a prescription drug
benefit under Medicare (“Medicare Part D”) and a federal
subsidy to sponsors of retiree health care benefit plans
that provide benefits that are at least actuarially equivalent
to Medicare Part D. The benefits provided under the
Bank’s plan to certain participants are at least actuarially

2006 Annual Report ■ Page 63

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Page 64

equivalent to the Medicare Part D prescription drug benefit. The estimated effects of the subsidy, retroactive
to January 1, 2004, are reflected in actuarial loss in the
accumulated postretirement benefit obligation.
There were no receipts of federal Medicare subsidies
in the year ended December 31, 2006. Expected receipts in the year ending December 31, 2007, related to
payments made in the year ended December 31, 2006,
are $.5 million.
Following is a summary of expected postretirement
benefit payments (in millions):
Without
Subsidy

$ 8.3
9.2
10.1
11.1
11.9
68.7

$ 7.8
8.6
9.4
10.4
11.1
63.1

Total

$119.3

$110.4

Postemployment Benefits
The Bank offers benefits to former or inactive employees.
Postemployment benefit costs are actuarially determined
using a December 31 measurement date and include the
cost of medical and dental insurance, survivor income,
and disability benefits. The accrued postemployment benefit costs recognized by the Bank at December 31, 2006
and 2005 were $15 million and $13 million, respectively.
This cost is included as a component of “Accrued benefit
costs” in the Statements of Condition. Net periodic
postemployment benefit expense included in 2006 and
2005 operating expenses were $4 million and $1 million,
respectively, and are recorded as a component of
“Salaries and other benefits” in the Statements of Income.

10. Accumulated Other Comprehensive Income
Following is a reconciliation of beginning and ending
balances of accumulated other comprehensive income
(loss) (in millions):
Amount Related to
Postretirement Benefits
other than Pensions

Page 64 ■ Federal Reserve Bank of Richmond

11. Business Restructuring Charges
In 2003, the Bank announced plans for restructuring to
streamline operations and reduce costs, including consolidation of check operations and staff reductions in
various functions of the Bank. In 2004, additional consolidation and restructuring initiatives were announced in the
savings bonds operations. These actions resulted in the
following business restructuring charges (in millions):

With
Subsidy

2007
2008
2009
2010
2011
2012-2016

Balance at December 31, 2005
Adjustment to initially apply FASB
Statement No. 158
Balance at December 31, 2006

Additional detail regarding the classification of accumulated other comprehensive income is included in Note 9.

$ —
(73)
$ (73)

Year-Ended 12/31/2006
Total
Accrued
Estimated Liability
Costs 12/31/2005

Employee
separation $ 4.0
Contract
termination 0.3
Total
$ 4.3

Total
Charges and
Adjustments

Accrued
Total Liability
Paid 12/31/2006

$ 0.5

$ (0.2)

$ 0.2 $ 0.1

—
$ 0.5

—
$ (0.2)

—
—
$ 0.2 $ 0.1

Employee separation costs are primarily severance
costs related to identified staff reductions of approximately 178 related to restructuring announced in 2003
and 2004. Costs related to staff reductions for the years
ended December 31, 2006 and 2005 are reported as a
component of “Salaries and other benefits” in the
Statements of Income. Contract termination costs
include the charges resulting from terminating existing
lease and other contracts.
Restructuring costs associated with the impairment
of certain Bank assets, including software, buildings,
leasehold improvements, furniture, and equipment, are
discussed in Note 6. Costs associated with enhanced
pension benefits for all Reserve Banks are recorded on
the books of the FRBNY as discussed in Note 8. Costs
associated with enhanced postretirement benefits are
disclosed in Note 9.
The Bank substantially completed its announced
plans in June 2005.

The Federal Reserve Bank of Richmond 2006 Annual
Report was produced by the Research Department,
Publications Division and the Public Affairs Department,
Graphics Division.
Managing Editor: Alice Felmlee
Designer: Cecilia Bingenheimer
Article Editor: Elaine Mandaleris
Andreas Hornstein, Thomas Lubik, John Walter, and
Alex Wolman also contributed valuable comments to
the feature article.
Article Photography:
Cover: Signs – Lester Lefkowitz/Corbis
Computer screen – Gregor Schuster/Corbis
Phillips curve – Geep Schurman
One dollar bill – Image Source/Corbis
Page 4: Produce stand – Owen Franken/Corbis
Hiring sign – Getty Images
Page 11: Federal Reserve building – Lance Nelson/Corbis
Truck – Associated Press
Receipt – Tetra Images/Corbis
Hundred dollar bills – Ross Anania/Getty Images

Page 16: Road – Image Source/Corbis
Store – Richard Hamilton Smith/Corbis
Television – Associated Press
Page 23: Shopping mall – James Leynse/Corbis
Car on road – Momatiuk-Eastcott/Corbis
Sign – Rob Casey/Getty Images
Portrait Photography:
Photographer: Geep Schurman
Photography Assistants: Larry Cain, Ailsa Long
Printer: Federal Reserve Bank of Richmond
Special Thanks to: Kevin Bryan, Doug Campbell,
Julia Forneris, Rebecca Martin, Aaron Steelman,
Jim Strader
This Annual Report is also available on the
Federal Reserve Bank of Richmond’s Web site at
www.richmondfed.org. For additional print copies,
contact the Public Affairs Department at (804) 697-8109.

Fifth Federal Reserve District Offices
Richmond
701 East Byrd Street
Richmond, Virginia 23219
(804) 697-8000
Baltimore
502 South Sharp Street
Baltimore, Maryland 21201
(410) 576-3300
Charlotte
530 East Trade Street
Charlotte, North Carolina 28202
(704) 358-2100

www.richmondfed.org


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102