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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. AR_inside 6/5/07 8:04 AM Page 1 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 AR_inside 6/5/07 8:04 AM Page 2 AR_inside 6/5/07 8:04 AM Page 1 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. 2006 Annual Report ■ Page 1 AR_inside 6/5/07 8:04 AM Page 2 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 Page 2 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:04 AM Page 3 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 2006 Annual Report ■ Page 3 AR_inside 6/5/07 8:04 AM Page 4 Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve by Jeffrey M. Lacker and John A. Weinberg AR_inside 6/5/07 8:04 AM Page 5 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. 2006 Annual Report ■ Page 5 AR_inside 6/5/07 8:04 AM Page 6 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 Page 6 ■ Federal Reserve Bank of Richmond The logic of monetary neutrality is indisputable, but is it relevant? The logic arises from thinking about AR_inside 6/5/07 8:04 AM Page 7 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 2006 Annual Report ■ Page 7 AR_inside 6/5/07 8:04 AM Page 8 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 Page 8 ■ Federal Reserve Bank of Richmond 6/5/07 8:04 AM Page 9 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) AR_inside 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 2006 Annual Report ■ Page 9 6/5/07 8:04 AM Page 10 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) AR_inside 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 Page 10 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 11 2006 Annual Report ■ Page 11 6/5/07 8:05 AM Page 12 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 (%) AR_inside 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 6/5/07 8:05 AM Page 13 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 2006 Annual Report ■ Page 13 AR_inside 6/5/07 8:05 AM 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 Page 14 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM 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 2006 Annual Report ■ Page 15 AR_inside 6/5/07 8:05 AM Page 16 Page 16 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 17 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. 2006 Annual Report ■ Page 17 AR_inside 6/5/07 8:05 AM Page 18 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 Page 18 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM 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 2006 Annual Report ■ Page 19 AR_inside 6/5/07 8:05 AM 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. Page 20 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 21 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 2006 Annual Report ■ Page 21 AR_inside 6/5/07 8:05 AM Page 22 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 Page 22 ■ Federal Reserve Bank of Richmond quences of alternative policy choices. AR_inside 6/5/07 8:05 AM Page 23 2006 Annual Report ■ Page 23 AR_inside 6/5/07 8:05 AM Page 24 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 Page 24 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 25 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 AR_inside 6/5/07 8:05 AM Page 26 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. AR_inside 6/5/07 8:05 AM Page 27 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. 2006 Annual Report ■ Page 27 AR_inside 6/5/07 8:05 AM Page 28 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. Page 28 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 29 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 AR_inside 6/5/07 8:05 AM 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 Page 30 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM 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 2006 Annual Report ■ Page 31 AR_inside 6/5/07 8:05 AM 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. Page 32 ■ Federal Reserve Bank of Richmond AR_inside 6/5/07 8:05 AM Page 33 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 AR_inside 6/5/07 8:05 AM Page 34 AR_inside 6/5/07 8:06 AM Page 35 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 AR_inside 6/5/07 8:06 AM 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 AR_inside 6/5/07 8:06 AM Page 37 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 AR_inside 6/5/07 8:06 AM 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 AR_inside 6/5/07 8:06 AM Page 39 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 AR_inside 6/5/07 8:07 AM 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 AR_inside 6/5/07 8:07 AM 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 AR_inside 6/5/07 8:07 AM 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 AR_inside 6/5/07 8:07 AM 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 AR_inside 6/5/07 8:07 AM 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 AR_article_final-5-23 5/23/07 12:19 PM Page 46 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM 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 AR_article_final 5/21/07 10:29 AM Page 53 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 AR_article_final 5/21/07 10:29 AM Page 54 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 AR_article_final 5/21/07 10:29 AM Page 55 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. 2006 Annual Report ■ Page 55 AR_article_final 5/21/07 10:29 AM Page 56 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. AR_article_final 5/21/07 10:29 AM Page 57 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. 2006 Annual Report ■ Page 57 AR_article_final 5/21/07 10:29 AM Page 58 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- AR_article_final 5/21/07 10:29 AM Page 59 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 2006 Annual Report ■ Page 59 AR_article_final 5/22/07 10:24 AM Page 60 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 AR_article_final 5/21/07 10:29 AM Page 61 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 AR_article_final 5/21/07 10:29 AM Page 62 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. AR_article_final 5/21/07 10:30 AM Page 63 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 AR_article_final 5/21/07 10:30 AM 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