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€/fnnual '[Report ^<t_J 2007 Board of Governors of the Federal Reserve System This publication is available from the Board of Governors of the Federal Reserve System, Publications Fulfillment, Washington, DC 20551. It is also available on the Board's website, at www.federalreserve.gov. Letter of Transmittal Board of Governors of the Federal Reserve System Washington, D.C. April 2008 The Speaker of the House of Representatives: Pursuant to the requirements of section 10 of the Federal Reserve Act, I am pleased to submit the ninety-fourth annual report of the Board of Governors of the Federal Reserve System. This report covers operations of the Board during calendar year 2007. Sincerely, Ben Bernanke Chairman Overview of the Federal Reserve ety of System functions, including operating a nationwide payments system; distributing the nation's currency and coin; under authority delegated by the • conducting the nation's monetary pol- Board of Governors, supervising and icy by influencing monetary and credit regulating bank holding companies and conditions in the economy state-chartered banks that are members • supervising and regulating banking in- of the System; serving as fiscal agents stitutions, to ensure the safety and of the U.S. Treasury; and providing a soundness of the nation's banking and variety of financial services for the Treafinancial system and to protect the sury, other government agencies, and credit rights of consumers other fiscal principals. • maintaining the stability of the finanA major component of the Federal cial system and containing systemic Reserve System is the Federal Open risk that may arise in financial markets Market Committee (FOMC), which is • providing financial services to deposi- made up of the members of the Board of tory institutions, the U.S. government, Governors, the president of the Federal and foreign official institutions Reserve Bank of New York, and presiThe Federal Reserve is a federal sys- dents of four other Federal Reserve tem composed of a central, governmen- Banks, who serve on a rotating basis. tal agency—the Board of Governors— The FOMC establishes monetary policy and twelve regional Federal Reserve and oversees open market operations, Banks. The Board of Governors, located the Federal Reserve's main tool for inin Washington, D.C., is made up of fluencing overall monetary and credit seven members appointed by the Presi- conditions. The FOMC sets the federal dent of the United States and supported funds rate, but the Board has sole auby a staff of about 1,860. In addition thority over changes in reserve requireto conducting research, analysis, and ments and must approve any change in policymaking related to domestic and the discount rate initiated by a Reserve international financial and economic Bank. matters, the Board plays a major role Two other groups play roles in the in the supervision and regulation of the functioning of the Federal Reserve: deU.S. banking system and administers pository institutions, through which most of the nation's laws regarding con- monetary policy operates, and advisory sumer credit protection. It also has broad councils, which make recommendations oversight responsibility for the nation's to the Board and the Reserve Banks payments system and the operations and regarding System responsibilities. activities of the Federal Reserve Banks. All federally chartered banks are, by The Federal Reserve Banks, which law, members of the Federal Reserve combine public and private elements, System. State-chartered banks may beare the operating arms of the central come members if they meet Board banking system. They carry out a vari- requirements. • As the nation's central bank, the Federal Reserve System has numerous, varied responsibilities: Contents Monetary Policy and Economic Developments 3 OVERVIEW: MONETARY POLICY AND THE ECONOMIC OUTLOOK 7 8 16 19 22 22 25 27 28 39 RECENT ECONOMIC AND FINANCIAL DEVELOPMENTS The Household Sector The Business Sector The Government Sector National Saving The External Sector The Labor Market Prices Financial Markets International Developments 43 MONETARY POLICY IN 2007 AND EARLY 2008 49 SUMMARY OF ECONOMIC PROJECTIONS 49 The Outlook 52 Risks to the Outlook 53 Diversity of Participants' Views 57 MONETARY POLICY REPORT OF JULY 2007 57 Monetary Policy and the Economic Outlook 62 Economic and Financial Developments in 2007 Federal Reserve Operations 85 BANKING SUPERVISION AND REGULATION 86 Scope of Responsibilities for Supervision and Regulation 86 Supervision for Safety and Soundness 95 Supervisory Policy 105 Supervisory Information Technology 106 Staff Development 107 Regulation of the U.S. Banking Structure 111 Enforcement of Other Laws and Regulations 111 Federal Reserve Membership 113 113 121 123 125 CONSUMER AND COMMUNITY AFFAIRS Mortgage Credit Credit Cards Other Regulatory Actions Other Supervisory Activities Related to Compliance with Consumer Protection and Community Reinvestment Laws 138 Consumer Complaints 140 Responding to Community Economic Development Needs in Historically Underserved Markets 143 Advice from the Consumer Advisory Council 151 FEDERAL RESERVE BANKS 151 155 155 158 159 159 160 161 162 162 162 164 Developments in Federal Reserve Priced Services Developments in Currency and Coin Developments in Fiscal Agency and Government Depository Services Electronic Access to Reserve Bank Services Information Technology Examinations of the Federal Reserve Banks Income and Expenses Holdings of Securities and Loans Volume of Operations Federal Reserve Law Enforcement Federal Reserve Bank Premises Pro Forma Financial Statements for Federal Reserve Priced Services 169 THE BOARD OF GOVERNORS AND THE GOVERNMENT PERFORMANCE AND RESULTS ACT 169 Strategic Plan, Performance Plan, and Performance Report 169 Mission 169 Goals and Objectives Records 175 RECORD OF POLICY ACTIONS OF THE BOARD OF GOVERNORS 175 Regulation A (Extensions of Credit by Federal Reserve Banks) 175 Regulation B (Equal Credit Opportunity), Regulation E (Electronic Fund Transfers), Regulation M (Consumer Leasing), Regulation Z (Truth in Lending), Regulation DD (Truth in Savings) 175 Regulation D (Reserve Requirements of Depository Institutions) 176 Regulation E (Electronic Fund Transfers) 176 Regulation H (Membership of State Banking Institutions in the Federal Reserve System), Regulation K (International Banking Operations) 176 Regulation H (Membership of State Banking Institutions in the Federal Reserve System), Regulation Y (Bank Holding Companies and Change in Bank Control) 177 Regulation L (Management Official Interlocks) 177 Regulation O (Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks) 177 Regulation R (Exceptions for Banks from the Definition of Broker in the Securities Exchange Act of 1934) 178 Regulation V (Fair Credit Reporting) 178 Policy Statements and Other Actions 180 Discount Rates in 2007 183 184 197 205 213 222 230 241 259 MINUTES OF FEDERAL OPEN MARKET COMMITTEE MEETINGS Meeting Held on January 30-31, 2007 Meeting Held on March 20-21, 2007 Meeting Held on May 9, 2007 Meeting Held on June 27-28, 2007 Meeting Held on August 7, 2007 Meeting Held on September 18, 2007 Meeting Held on October 30-31, 2007 Meeting Held on December 11, 2007 271 LITIGATION Federal Reserve System Organization 275 BOARD OF GOVERNORS 278 FEDERAL OPEN MARKET COMMITTEE 279 ADVISORY COUNCILS TO THE BOARD OF GOVERNORS 279 Federal Advisory Council 280 Consumer Advisory Council 281 Thrift Institutions Advisory Council 282 FEDERAL RESERVE BANKS AND BRANCHES 282 Officers of the Banks and Branches 283 Conference of Chairmen 283 Conference of Presidents 284 Conference of First Vice Presidents 284 Directors of the Banks and Branches 301 MEMBERS OF THE BOARD OF GOVERNORS, 1913-2007 Statistical Tables 306 310 311 312 313 314 322 323 324 328 332 338 339 340 1. Federal Reserve Open Market Transactions, 2007 2. Federal Reserve Bank Holdings of U.S. Treasury and Federal Agency Securities, December 31, 2005-2007 3. Federal Reserve Bank Interest Rates on Loans to Depository Institutions, December 31, 2007 4. Reserve Requirements of Depository Institutions, December 31, 2007 5. Banking Offices and Banks Affiliated with Bank Holding Companies in the United States, December 31, 2006 and 2007 6. Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items A. Year-End 1984-2007 and Month-End 2007 B. Year-End 1918-1983 7. Principal Assets and Liabilities of Insured Commercial Banks, by Class of Bank, June 30, 2007 and 2006 8. Initial Margin Requirements under Regulations T, U, and X 9. Statement of Condition of the Federal Reserve Banks, by Bank, December 31, 2007 and 2006 10. Income and Expenses of the Federal Reserve Banks, by Bank, 2007 11. Income and Expenses of the Federal Reserve Banks, 1914-2007 12. Operations in Principal Departments of the Federal Reserve Banks, 2004-2007 13. Number and Annual Salaries of Officers and Employees of the Federal Reserve Banks, December 31, 2007 14. Acquisition Costs and Net Book Value of the Premises of the Federal Reserve Banks and Branches, December 31, 2007 Federal Reserve System Audits 343 345 357 375 376 AUDITS OF THE FEDERAL RESERVE SYSTEM BOARD OF GOVERNORS FINANCIAL STATEMENTS FEDERAL RESERVE BANKS COMBINED FINANCIAL STATEMENTS OFFICE OF INSPECTOR GENERAL ACTIVITIES GOVERNMENT ACCOUNTABILITY OFFICE REVIEWS 378 MAPS OF THE FEDERAL RESERVE SYSTEM 383 INDEX Monetary Policy and Economic Developments Parti Overview: Monetary Policy and the Economic Outlook The U.S. economy has weakened considerably since last July, when the Federal Reserve Board submitted its previous Monetary Policy Report to the Congress. Substantial strains have emerged in financial markets here and abroad, and housing-related activity has continued to contract. Also, further increases in the prices of crude oil and some other commodities have eroded the real incomes of U.S. households and added to business costs. Overall economic activity held up reasonably well into the autumn despite these adverse developments, but it decelerated sharply in the fourth quarter. Moreover, the outlook for 2008 has become less favorable since last summer, and considerable downside risks to economic activity have emerged. Headline consumer price inflation picked up in 2007 as a result of sizable increases in energy and food prices, while core inflation (which excludes the direct effects of movements in energy and food prices) was, on balance, a little lower than in 2006. Nonetheless, with inflation expectations anticipated to remain reasonably well NOTE: The discussion here and in the next three parts consists of the text, tables, and selected charts from the Monetary Policy Report submitted to the Congress on February 27, 2008, pursuant to section 2B of the Federal Reserve Act. The complete set of charts is available on the Board's website, at www.federalreserve.gov/boarddocs/hh. Other materials in this annual report related to the conduct of monetary policy include the minutes of the 2007 meetings of the Federal Open Market Committee (see the "Records" section) and statistical tables 1-4 (at the back of this report). anchored, energy and other commodity prices expected to flatten out, and pressures on resources likely to ease, monetary policy makers generally have expected inflation to moderate somewhat in 2008 and 2009. Under these circumstances, the Federal Reserve has eased the stance of monetary policy substantially since July. The turmoil in financial markets that emerged last summer was triggered by a sharp increase in delinquencies and defaults on subprime mortgages. That increase substantially impaired the functioning of the secondary markets for subprime and nontraditional residential mortgages, which in turn contributed to a reduction in the availability of such mortgages to households. Partly as a result of these developments as well as continuing concerns about prospects for house prices, the demand for housing dropped further. In response to weak demand and high inventories of unsold homes, homebuilders continued to cut the pace of new construction in the second half of 2007, pushing the level of single-family starts in the fourth quarter more than 50 percent below the high reached in the first quarter of 2006. After midyear, as losses on subprime mortgages and related structured investment products continued to mount, investors became increasingly skeptical about the likely credit performance of even highly rated securities backed by such mortgages. The loss of confidence reduced investors' overall willingness to bear risk and caused them to reassess the soundness of the structures of other 94th Annual Report, 2007 financial products. That reassessment was accompanied by high volatility and diminished liquidity in a number of financial markets here and abroad. The pressures in financial markets were reinforced by banks' concerns about actual and potential credit losses. In addition, banks recognized that they might need to take a large volume of assets onto their balance sheets—including leveraged loans, some types of mortgages, and assets relating to asset-backed commercial paper programs—given their existing commitments to customers and the increased resistance of investors to purchasing some securitized products. In response to those unexpected strains, banks became more conservative in deploying their liquidity and balance sheet capacity, leading to tighter credit conditions for some businesses and households. The combination of a more negative economic outlook and a reassessment of risk by investors precipitated a steep fall in Treasury yields, a substantial widening of spreads on both investment-grade and speculative-grade corporate bonds, and a sizable net decline in equity prices. Initially, the spillover from the problems in the housing and financial markets to other sectors of the economy was limited. Indeed, in the third quarter, real gross domestic product (GDP) rose at an annual rate of nearly 5 percent, in part because of solid gains in consumer spending, business investment, and exports. In the fourth quarter, however, real GDP increased only slightly, and the economy seems to have entered 2008 with little momentum. In the labor market, growth in private-sector payrolls slowed markedly in late 2007 and January 2008. The sluggish pace of hiring, along with higher energy prices, lower equity prices, and softening home values, has weighed on consumer sentiment and spending of late. In addition, indicators of business investment have become less favorable recently. However, continued expansion of foreign economic activity and a lower dollar kept U.S. exports on a marked uptrend through the second half of last year, providing some offset to the slowing in domestic demand. Overall consumer price inflation, as measured by the price index for personal consumption expenditures (PCE), stepped up to 3V2 percent over the four quarters of 2007 because of the sharp increase in energy prices and the largest rise in food prices in nearly two decades. Core PCE price inflation picked up somewhat in the second half of last year, but the increase came on the heels of some unusually low readings in the first half; core PCE price inflation over 2007 as a whole averaged slightly more than 2 percent, a little less than in 2006. The Federal Reserve has taken a number of steps since midsummer to address strains in short-term funding markets and to foster its macroeconomic objectives of maximum employment and price stability. With regard to short-term funding markets, the Federal Reserve's initial actions when market turbulence emerged in August included unusually large open market operations as well as adjustments to the discount rate and to procedures for discount window borrowing and securities lending. As pressures intensified near the end of the year, the Federal Reserve established a Term Auction Facility to supply short-term credit to sound banks against a wide variety of collateral; in addition, it entered into currency swap arrangements with two other central banks to increase the availability of term dollar funds in their jurisdictions. With regard to monetary policy, the Federal Open Market Committee (FOMC) cut the target for the federal funds rate 50 basis points at its September meeting to address the poten- Monetary Policy and the Economic Outlook tial downside risks to the broader economy from the ongoing disruptions in financial markets. The Committee reduced the target 25 basis points at its October meeting and did so again at the December meeting. In the weeks following that meeting, the economic outlook deteriorated further, and downside risks to growth intensified; the FOMC cut an additional 125 basis points from the target in January—75 basis points on January 22 and 50 basis points at its regularly scheduled meeting on January 29-30. Since the previous Monetary Policy Report, the FOMC has announced new communications procedures, which include publishing enhanced economic projections on a timelier basis. The most recent projections were released with the minutes of the January FOMC meeting and are reproduced in part 4 of this report. Economic activity was expected to remain soft in the near term but to pick up later this year—supported by monetary and fiscal stimulus—and to be expanding at a pace around or a bit above its long-run trend by 2010. Total inflation was expected to be lower in 2008 than in 2007 and to edge down further in 2009. However, FOMC participants (Board members and Reserve Bank presidents) indicated that considerable uncertainty surrounded the outlook for economic growth and that they saw the risks around that outlook as skewed to the downside. In contrast, most participants saw the risks surrounding the forecasts for inflation as roughly balanced. • Part 2 Recent Economic and Financial Developments Although the U.S. economy had generally performed well in the first half of 2007, the economic landscape was subsequently reshaped by the emergence of substantial strains in financial markets in the United States and abroad, the intensifying downturn in the housing market, and higher prices for crude oil and some other commodities. Rising delinquencies on subprime mortgages led to large losses on related structured credit products, sparking concerns about the structures of other financial products and reducing investors' appetite for risk. The resulting dislocations generated unanticipated pressures on bank balance sheets, and those pressures combined with uncertainty about the size and distribution of credit losses to impair shortterm funding markets. Consequently, the Federal Reserve and other central banks intervened to support liquidity and functioning in those markets. Amid a deteriorating economic outlook, and with downside risks increasing, Treasury yields declined markedly, and the Federal Open Market Committee cut the federal funds rate substantially. Meanwhile, risk spreads in a wide variety of credit markets increased considerably, and equity prices tumbled. The financial turmoil did not appear to leave much of a mark on overall economic activity in the third quarter. Real GDP rose at an annual rate of nearly 5 percent, as solid gains in consumer spending, business investment, and exports more than offset the continuing drag from residential investment. In the fourth quarter, however, economic activity decelerated significantly, and the Change in Real GDP, 2001-07 Percent, annual rate — 5 — 2 — 1 2001 2003 2005 2007 NOTE: Here and in subsequent figures, except as noted, change for a given period is measured to its final quarter from the final quarter of the preceding period. SOURCE: Department of Commerce, Bureau of Economic Analysis. economy seems to have entered 2008 with little forward momentum. In part because of tighter credit conditions for households and businesses, the housing correction has deepened, and capital spending has softened. In addition, a number of factors, including steep increases in energy prices, lower equity prices, and softening home values, have started to weigh on consumer outlays. In the labor market, private hiring slowed sharply in late 2007 and January 2008. The increase in the price index for total personal consumption expenditures (PCE) picked up to 3Vi percent in 2007 as a result of sizable increases in food and energy prices. Core PCE inflation, though uneven over the course of the year, averaged a bit more than 2 percent during 2007 as a whole, a little less than the increase posted in 2006. 8 94th Annual Report, 2007 Change in the Chain-Type Price Index for Personal Consumption Expenditures, Private Housing Starts, 1994-2007 2 0 0 1 —07 Millions of units, annual rate — — — II 2003 1.2 .4 Single-family H Excluding food and energy 2001 1.6 — • Total 4 Multifamily — 2005 1 2007 SOURCE: Department of Commerce, Bureau of Economic Analysis. The Household Sector Residential Investment and Finance Economic activity in the past two years has been restrained by the ongoing contraction in the housing sector, and that restraint intensified in the second half of 2007. Home sales and prices softened significantly further, and homebuilders curtailed new construction in response to weak demand and elevated inventories. In all, the decline in residential investment reduced the annual growth rate of real GDP in the second half of 2007 by more than 1 percentage point, and the further drop in housing starts around the turn of the year suggests that the drag on the growth of real GDP remains substantial in early 2008. The downturn in housing activity followed a multi-year period of soaring home sales and construction and rapidly escalating home prices. The earlier strength in housing reflected a number of factors. One was a low level of global real interest rates. Another was that ] I 1995 I i 1 1999 2003 I I i 2007 NOTE: The data are quarterly and extend through 2007 :Q4. SOURCE: Department of Commerce, Bureau of the Census. many homebuyers apparently expected that home prices would continue to rise briskly into the indefinite future, thereby adding a speculative element to the market. In addition, toward the end of the boom, housing demand was supported by an upsurge in nonprime mortgage lending—in many cases fed by lax lending standards.1 By the middle of the decade, house prices had reached very high levels in many parts of the United States, and housing was becoming progressively less affordable. Declining affordability and waning optimism about future house price appreciation apparently started to weigh on the demand for housing, thereby causing sales to fall and the supply of unsold homes to ratchet up relative to the pace of sales. 1. Nonprime mortgages comprise subprime and near-prime loans and accounted for about onefourth of all home-purchase mortgages in 2006. Near-prime mortgages are generally less risky than subprime mortgages but riskier than prime mortgages; they may require limited or no borrower documentation, have nontraditional amortization structures or high loan-to-value ratios, or be made on investment properties. Recent Economic and Financial Developments for new homes, the constant-quality index of new home prices fell 2lA percent over the four quarters of 2007. Moreover, many large homebuilders reportedly have been using not only price discounts but also nonprice incentives (for S&P/Case-Shilleri ten-city index example, paying closing costs and including optional upgrades at no cost) in an effort to bolster sales of new homes and reduce inventories. In all, the pace of sales of existing homes fell 30 percent between mid-2005 and the fourth quarter of 2007, and sales of new homes dropped by half. Builders cut production in response to the downshift in demand; by the fourth quarter of 1 i I I i 1 II 1 1 M > 1 1 II I li 2007, starts of single-family homes had 1989 1992 1995 1998 2001 2004 2007 fallen to an annual rate of just 826,000 NOTE: The data are quarterly and extend through units—less than half the quarterly high 2007:Q4; changes are from one year earlier. For the years preceding 1991, the repeat-transactions index reached in early 2006. Nonetheless, the includes appraisals associated with mortgage ongoing declines in sales prevented refinancings; beginning in 1991, it includes purchase transactions only. The S&P/Case-Shiller index reflects builders from making much progress in all arm's-length sales transactions in the metropolitan paring their bloated inventories of areas of Boston. Chicago, Denver, Las Vegas, Los homes. In fact, although the number of Angeles. Miami, New York, San Diego, San Francisco, and Washington, D.C. unsold new homes has decreased, on SOURCE: For repeat transactions, Office of Federal net, since the middle of 2006, inventoHousing Enterprise Oversight: for S&P/Case-Shiller, ries have climbed sharply relative to Chicago Mercantile Exchange. sales. Measured relative to the average Against this backdrop, prices began to pace of sales over the three months enddecelerate, further damping expectations ing in December, the months' supply of of future price increases and exacerbat- unsold new homes at the end of December stood at nine months, more than ing the downward pressure on demand. House prices decelerated dramatically twice the upper end of the narrow range in 2006 and softened further in 2007. In that had prevailed from 1997 to midmany areas of the nation, existing home 2005. The contraction in housing demand prices fell noticeably last year. For the nation as a whole, the OFHEO price and construction was exacerbated in the index declined in the second half of the second half of 2007 by the near eliminayear after rising modestly in the first tion of nonprime mortgage originations half; that measure had risen 4 percent in and a tightening of lending standards on 2006 and about 9Vi percent in each of all types of mortgages. Indeed, large the two years before that.2 In the market fractions of banks that responded to the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Prac2. The index is the seasonally adjusted tices reported that they had tightened purchase-only version of the repeat-transactions lending standards over this period. price index for existing single-family homes pubNonetheless, interest rates on prime conlished by the Office of Federal Housing Enterprise Oversight. forming mortgages have declined on Change in Prices of Existing Single-Family Houses, 1988-2007 10 94th Annual Report, 2007 net: Rates on conforming thirty-year fixed-rate loans dropped from about 63/4 percent last summer to just above 6 percent at year-end. This year they dipped as low as 5Vi percent but have recently moved back up to about 6 percent, within the range that prevailed for much of the 2003-05 period.3 Rates on conforming adjustable-rate loans have also fallen significantly over the past several months and now stand at their lowest level since the end of 2005. Offered rates on fixed-rate jumbo loans, which ran up in the second half of 2007, have recently declined somewhat, on net.4 Even so, spreads between rates offered on these loans and conforming loans remain unusually wide. The softness in home prices has played an important role in the ongoing deterioration in the credit quality of subprime mortgages. The deterioration was rooted in poor underwriting standards—and, in some cases, fraudulent and abusive lending practices— which were based in part on the assumption that house prices would continue to rise rapidly for some time to come. Many borrowers with weak credit histories took out adjustable-rate mortgages (subprime ARMs) with low initial rates; of those loans originated in 2005 and 3. Conforming mortgages are those eligible for purchase by Fannie Mae and Freddie Mac; they must be equivalent in risk to a prime mortgage with an 80 percent loan-to-value ratio, and they cannot exceed the conforming loan limit. The Economic Stimulus Act of 2008, signed into law on February 13, retroactively raised the conforming loan limit for a first mortgage on a single-family home in the contiguous United States from $417,000 to 125 percent of the median house price in an area, with an overall cap of $729,750. The new conforming limit will be in effect through the end of 2008. 4. Jumbo mortgages are those that exceed the maximum size of a conforming loan; they are typically extended to borrowers with relatively strong credit histories. 2006, a historically large fraction had high loan-to-value ratios, which were often boosted by the addition of an associated junior lien or "piggyback" mortgage. When house prices decelerated, borrowers with high loan-to-value ratios on their loans were unable to build equity in their homes, making refinancing more difficult, and also faced the prospect of significantly higher mortgage payments after the initial rates on the loans reset. Subprime ARMs account for about 7 percent of all first-lien mortgages outstanding. Delinquency rates on subprime ARMs began to increase in 2006, and by December 2007, more than one-fifth of these loans were seriously delinquent (that is, ninety days or more delinquent or in foreclosure). Moreover, an increasing fraction of subprime ARMs in the past few years have become seriously delinquent soon after they were originated and often well before the initial rate was due to reset.5 For subprime ARMs originated in 2006, about 10 percent had defaulted in the first twelve months, more than double the fraction for mortgages originated in earlier years. Furthermore, the path of the default rate for subprime ARMs originated in 2007 has run even higher. For subprime mortgages with fixed interest rates, delinquency rates have moved up significantly in recent months, to the upper end of their historical range. For mortgages made to higher-quality borrowers (prime and near-prime mortgages), performance weakened somewhat in 2007, but it generally remains 5. The initial low-rate period for most subprime ARMs originated in the period from 2005 to 2007 was twenty-four months. Roughly l!/2 million subprime ARMs are scheduled to undergo their first rate reset in 2008. Even with the recent declines in market interest rates, a notable fraction of those subprime ARMs are scheduled to reset to a higher interest rate. Recent Economic and Financial Developments Mortgage Delinquency Rates, 2001-07 Percent Subprime — 24 — /— 20 — / — Adjustable rate *J / 1 1 1 |2 -c : Fixed rate t i l l 16 — I 1 ! Prime and near prime — 8 4 Adjustable rate Fixed rate J— 2 0 1 1 II 1 1 1 I 1 1 Alt-A pools 8 6 Adjustable rate/ 4 Fixed rate 2 0 1 1 1 2001 1 I 2003 1 2005 I I 2007 I NOTE: The data are monthly. For subprime, prime, and near-prime mortgages, the data extend through December 2007; for mortgages in alt-A pools, which are a mix of prime, near-prime, and subprime mortgages, the data extend through November 2007. For further details on the loans included in alt-A pools, refer to text. Delinquency rate is the percent of loans ninety days or more past due or in foreclosure. SOURCE: First American LoanPerformance. fairly solid. Although the rate of serious delinquency on ARMs has moved up, that on fixed-rate loans has stayed low. Serious delinquencies on jumbo mortgages—which often carry adjustable rates—have crept up slightly from very low levels. The credit quality of loans that were securitized in pools marketed as t4alt-A" 11 has declined considerably. Such loans are typically made to higher-quality borrowers but have nontraditional amortization structures or other nonstandard features. Some of the loans are categorized as prime or near prime and others as subprime. The rate of serious delinquency on loans with adjustable rates in alt-A pools currently stands at almost 6 percent, far above the rates of less than 1 percent seen as recently as early 2006. The rate of serious delinquency on fixed-rate alt-A loans has also increased in recent months. The continued erosion in the quality of mortgage credit has led to a rising number of initial foreclosure filings; indeed, such filings were made at a record pace in the third quarter of 2007. Foreclosures averaged about 360,000 per quarter over the first three quarters of 2007, compared with a rate of about 235,000 in the corresponding quarters of 2006. As was the case in 2006, more than half of the foreclosure filings in 2007 were subprime mortgages despite the relatively smaller share of such loans in total mortgages outstanding. In some cases, falling prices may have tempted more-speculative buyers with little or no equity to walk away from their properties. Foreclosures have risen most in areas where home prices have been falling after a period of rapid increase; foreclosures also have mounted in some regions where economic growth has been below the national average. Avoiding foreclosure—even if it involves granting concessions to the borrower—can be an important lossmitigation strategy for financial institutions. To limit the number of delinquencies and foreclosures, financial institutions can use a variety of approaches, including renegotiating the timing and size of rate resets. A complication in implementing such approaches is that the loans have often been pack- 12 94th Annual Report, 2007 aged and sold in securitized pools that are owned by a dispersed group of investors, which makes the task of coordinating renegotiation among all affected parties difficult. In part to address the challenges in modifying securitized loans, counselors, servicers, investors, and other mortgage market participants joined in a collaborative effort, called the Hope Now Alliance, to facilitate cross-industry solutions to the problem.6 Separately, the Federal Reserve has directly responded in a number of ways to the problems with mortgage credit quality (described in the box entitled "The Federal Reserve's Responses to the Subprime Mortgage Crisis"). Most commercial banks responding to the Federal Reserve's January 2008 Senior Loan Officer Opinion Survey indicated that loan-by-loan modifications based on individual borrowers' circumstances were an important part of their loss-mitigation strategies. Almost twothirds of respondents indicated that they would consider refinancing the loans of their troubled borrowers into other mortgage products at their banks. About onethird of respondents said that streamlined modifications of the sort proposed by the Hope Now Alliance were important to their strategies for limiting losses. All of the factors discussed above— the drop in home sales, softer house prices, and tighter lending standards (especially for subprime and alternative mortgage products)—combined to reduce the growth of household mortgage debt to an annual rate of about 7 V2 percent over the first three quarters of 2007, down from MVA percent in 2006. Growth likely slowed further in the fourth quarter. Consumer Spending and Household Finance Consumer spending held up reasonably well in the second half of 2007, though it moderated some in the fourth quarter. Spending continued to be buoyed by solid gains in aggregate wages and salaries as well as by the lagged effects of the increases in household wealth in 2005 and 2006. However, other influences on spending have become less favorable. Job gains have slowed lately, household wealth has been damped by the softening in home prices as well as by recent declines in equity values, and consumers' purchasing power has been sapped by sharply higher energy prices. Moreover, consumer sentiment has fallen appreciably, and although consumer credit has remained available to Change in Real Income and Consumption, 2001-07 Percent, annual rate • Disposable personal income I I Personal consumption expenditures — 5 — 3 6. The Hope Now Alliance (www.hopenow. com) aims to increase outreach efforts to contact at-risk borrowers and to play an important role in streamlining the process for refinancing and modifying subprime ARMs. The alliance will work to expand the capacity of an existing national network to counsel borrowers and refer them to participating servicers, who have agreed to work toward cross-industry solutions to better serve the homeowner. — 2 — 1 i 2001 1 2003 ,[ 2005 1 1 J_J 2007 SOURCE: Department of Commerce, Bureau of Economic Analysis. Recent Economic and Financial Developments most borrowers, credit standards for many types of loans have been tightened. Real personal consumption expenditures (PCE) increased at an annual rate of 23/4 percent in the third quarter, a little above the average pace during the first half of the year; in the fourth quarter, PCE growth slowed to 2 percent. With the notable exception of outlays for new light motor vehicles (cars, sport-utility vehicles, and pickup trucks)—which were well maintained through yearend—the deceleration in spending in the fourth quarter was widespread. PCE appears to have entered 2008 on a weak trajectory, as sales of light vehicles sagged in January and spending on other goods was soft. Growth in real disposable personal income—that is, after-tax income adjusted for inflation—was sluggish in the second half of 2007. Although aggregate wages and salaries rose fairly briskly in nominal terms over that period, the purchasing power of the nominal gain was eroded by the energydriven upturn in consumer price inflation in the fall. Indeed, for many workers, increases in real wages over 2007 as a whole were modest, once again falling short of the rise in aggregate labor productivity. For example, average hourly earnings, a measure of wages for production or nonsupervisory workers, increased only Vi percent over the four quarters of 2007 after accounting for the rise in the overall PCE price index. Moreover, for some workers, real wages actually declined: Real average hourly earnings in manufacturing edged down about 3A percent last year, while for retail trade—an industry that typically pays relatively low wages—this measure of real wages fell about 2 percent. On the whole, household balance sheets remained in good shape in 2007, 13 although they weakened late in the year. The aggregate net worth of households rose modestly through the third quarter, as increases in equity values more than offset the effect of softening home prices. However, preliminary data suggest that the value of household wealth fell in the fourth quarter, and as a result the ratio of household wealth to disposable income—a key influence on consumer spending—ended the year well below its level at the end of 2006. Nonetheless, because changes in net worth tend to influence consumption with a lag, the increases in wealth during 2005 and 2006 likely helped sustain spending in 2007. In the fourth quarter, the personal saving rate was just a shade above zero, about in line with its average value since 2005. Overall household debt increased at an annual rate of about 1XA percent through the third quarter of 2007, a notable deceleration from the 10V4 percent pace in 2006; household debt likely slowed further in the fourth quarter. Because the growth of household debt about matched the growth in nominal disposable personal income through the third quarter, and net changes in interest rates on mortgage debt to that point were small, the ratio of financial obligations to disposable personal income was about flat. Consumer (nonmortgage) borrowing picked up a bit in 2007 to 5Vi percent, perhaps reflecting some substitution of consumer credit for mortgage debt. The pickup in consumer debt was mostly attributable to faster growth in revolving credit, a pattern consistent with the results of the Federal Reserve's Senior Loan Officer Opinion Survey. Banks, on net, reported easing lending standards on credit cards over the first half of 2007 and reported little change in those standards on net over the second half of the year. In contrast, significant fractions of 14 94th Annual Report 2007 The Federal Reserve's Responses to the Subprime Mortgage Crisis The sharp increases in subprime mortgage loan delinquencies and foreclosures over the past year have created personal, economic, and social distress for many homeowners and communities. The Federal Reserve has taken a number of actions that directly respond to these problems. Some of the efforts are intended to help distressed subprime borrowers and limit preventable foreclosures, and others are aimed at reducing the likelihood of such problems in the future. Home losses through foreclosure can be reduced if financial institutions work with borrowers who are having difficulty meeting their mortgage payment obligations. Foreclosure cannot always be avoided, but in many cases prudent loss-mitigation techniques that preserve homeownership are less costly to lenders than foreclosure. In 2007, the Federal Reserve and other banking agencies encouraged mortgage lenders and mortgage servicers to pursue prudent loan workouts through such measures as modification of loans, deferral of payments, extension of loan maturities, capitalization of delinquent amounts, and conversion of adjustable-rate mortgages (ARMs) into fixed-rate mortgages or fully indexed, fully amortizing ARMs.1 The Federal Reserve has also collaborated with community groups to help 1. Board of Governors of the Federal Reserve System (2007), "Working with Mortgage Borrowers," Division of Banking Supervision and Regulation, Supervision and Regulation Letter SR 07-6 (April 17); and "Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages," Supervision and Regulation Letter SR 07-16 (September 5). respondents in the second half of 2007 reported that they had tightened standards and terms on other consumer loans, a change that may have contributed to a slowing in the growth of nonrevolving loans over the final months of 2007. Average interest rates on credit homeowners avoid foreclosure. Staff members throughout the Federal Reserve System are working to identify localities that are likely to experience the highest rates of foreclosure; the resulting information is helping local groups to better focus their borrower outreach efforts. In addition, the Federal Reserve actively supports NeighborWorks America, a national nonprofit organization that has been helping thousands of mortgage borrowers facing current or potential distress. Federal Reserve staff members have worked closely with this organization and its local affiliates on an array of foreclosure prevention efforts, and a member of the Federal Reserve Board serves on its board of directors. Other contributions include efforts by Reserve Banks to convene workshops for stakeholders to develop community-based solutions to mortgage delinquencies in their areas. The Federal Reserve has taken important steps aimed at avoiding future problems in subprime mortgage markets while still preserving responsible subprime lending and sustainable homeownership. In coordination with other federal supervisory agencies and the Conference of State Bank Supervisors, the Federal Reserve issued principles-based guidance on subprime mortgages last summer.2 The guidance is designed to help ensure that 2. Board of Governors of the Federal Reserve System (2007). "Statement on Subprime Mortgage Lending," Division of Banking Supervision and Regulation, Supervision and Regulation Letter SR 07-12 (July 24). cards generally moved down in the second half of the year, but by less than the short-term market interest rates on which they are often based. Interest rates on new auto loans at banks and at auto finance companies have also declined some in recent months. Recent Economic and Financial Developments 15 borrowers obtain adjustable-rate mortgages that they can afford to repay and can refinance without prepayment penalty for a reasonable period before the first interest rate reset. The Federal Reserve issued similar guidance on nontraditional mortgages in 2006.3 The Federal Reserve is working to help safeguard borrowers in their interactions with mortgage lenders. In support of this effort, in December 2007 the Federal Reserve used its authority under the Home Ownership and Equity Protection Act of 1994 to propose new rules that address unfair or deceptive mortgage lending practices. This proposal addresses abuses related to prepayment penalties, failure to escrow for taxes and insurance, problems related to stated-income and lowdocumentation lending, and failure to give adequate consideration to a borrower's ability to repay. The proposal includes other protections as well, such as rules designed to curtail deceptive mortgage advertising and to ensure that consumers receive mortgage disclosures at a time when the information is likely to be the most useful to them. The Federal Reserve is also currently undertaking a broad and rigorous review of the Truth in Lending Act, including extensive consumer testing of loan disclosure documents. After a similar comprehensive analysis of disclosures related to credit card and other revolving credit arrangements, the Board issued a proposal in May 2007 to require such disclosures to be clearer and easier to understand. Like the credit card review, the review of mortgage disclosures will be lengthy given the critical need for field testing, but the process should ultimately help more consumers make appropriate choices when financing their homes. Finally, strong uniform oversight of all mortgage lenders is critical to avoiding future problems in mortgage markets. Regulatory oversight of the mortgage industry has become more challenging as the breadth and depth of the market has grown over the past decade and as the role of nonbank mortgage lenders, particularly in the subprime market, has increased. In response, the Federal Reserve, together with other federal and state agencies, launched a pilot program last summer focused on selected nondepository lenders with significant subprime mortgage operations.4 The program will review compliance with consumer protection regulations and impose corrective or enforcement actions as warranted. 3. Board of Governors of the Federal Reserve System (2006), "Interagency Guidance on Nontraditional Mortgage Product Risks." Division of Banking Supervision and Regulation, Supervision and Regulation Letter SR 06-15 (October 10). 4. The other agencies collaborating on the effort are the Office of Thrift Supervision, the Federal Trade Commission, the Conference of State Bank Supervisors, and the American Association of Residential Mortgage Regulators. Indicators of the credit quality of consumer loans suggest that it has weakened but generally remains sound. Over the second half of the year, delinquency rates on consumer loans at commercial banks increased, but from relatively moderate recent levels. Meanwhile, de linquency rates at captive auto finance companies increased somewhat but are well below previous highs. Although household bankruptcy filings remained low relative to the levels seen before the changes in bankruptcy law implemented in late 2005, the bankruptcy rate rose 16 94th Annual Report, 2007 modestly over the first nine months of 2007. The issuance of asset-backed securities (ABS) tied to credit card loans and auto loans (consumer loan ABS) has remained robust. Spreads of yields on consumer loan ABS over comparablematurity swap rates have moved up considerably since July; the rise pushed spreads on two-year BBB-rated consumer loan ABS to almost double their previous peaks in late 2002. Spreads on two-year AAA-rated consumer loan ABS jumped to between 60 basis points and 100 basis points after having been near zero for most of the decade, perhaps in part as a result of investors' general reassessment of the risk in structured credit products. Change in Real Business Fixed Investment, 2001-07 Percent, annual rate • Structures • Equipment and software JiH Fixed Investment Real business fixed investment (BFI) rose at an annual rate of 8*/2 percent in the second half of 2007, largely because of a double-digit rise in expenditures on nonresidential construction. Investment in equipment and software (E&S), which had accounted for virtually all of the growth in real BFI from 2003 to 2005, has been erratic since early 2006 but, on balance, has decelerated noticeably. On the whole, the economic and financial conditions that influence capital spending were fairly favorable in mid-2007, but they subsequently worsened as the outlook for sales and profits soured and as credit conditions for some borrowers tightened. A bright spot, however, is that many firms still have ample cash on hand to fund potential projects. On average, real outlays on E&S rose at an annual rate of 5 percent in the second half of 2007; in the first half, these outlays had risen just 2Vi percent, in part because of a sharp downswing in 0 — 10 _L j i U High-tech equipment and software Other equipment excluding transportation — 40 20 FL ra PI n U The Business Sector — 20 J 2001 2003 2005 L L_J 2007 NOTE: High-tech equipment consists of computers and peripheral equipment and communications equipment. SOURCE: Department of Commerce, Bureau of Economic Analysis. outlays on motor vehicles.7 Real investment in high-technology performed well in the second half, with further increases in all major components (computers, communications equipment, and software). Real outlays on equipment other than high-tech and transportation (a broad category that accounts for nearly half of investment in E&S when measured in nominal terms) posted a solid gain in the third quarter. However, those 7. The plunge in business outlays on motor vehicles in the first half was related to new Environmental Protection Agency emissions standards for large trucks, which went into effect at the start of 2007. Many firms had accelerated their purchases of such trucks into 2005 and 2006 so that they could take delivery before the new standards went into effect and thus avoid the higher costs associated with those standards. Outlays on motor vehicles rose modestly, on net, in the second half of the year. Recent Economic and Financial Developments 17 outlays edged down in the fourth quar- sued an aggressive strategy of producter, and the relatively slow pace of or- tion adjustments to keep dealer stocks ders, along with the downbeat tone in reasonably well aligned with sales. In recent surveys of business conditions, December 2007, days' supply of light suggests that the softness in spending vehicles stood at a comfortable sixtyhas extended into early 2008. four days—though it ticked up in JanuMeanwhile, real outlays on nonresi- ary because of the drop in sales noted dential construction remained on a earlier. Apart from motor vehicles, real strong uptrend. Some of the recent nonfarm inventory investment was a strength likely represents a catch-up modest $10 billion (annual rate) in the from the prolonged weakness in this sec- first half of 2007; it stayed around that tor in the first half of the decade. With rate in the third quarter and appears to the notable exception of the non-office have remained modest in the fourth commercial sector—where spending has quarter as manufacturing firms adjusted been about flat since mid-2007—all ma- production promptly in response to jor types of building continued to ex- signs of softening demand. With only a hibit considerable vigor in the second few exceptions—mostly related to the half. In general, the nonfinancial funda- ongoing weakness in construction and mentals affecting nonresidential con- motor vehicle production—book-value struction remain favorable: Vacancy inventory-sales ratios in December rates for office and industrial buildings seemed in line with historical trends. have fallen appreciably over the past Moreover, businesses surveyed in Janufew years despite the addition of a good ary by the Institute for Supply Managedeal of available space; and, although ment reported that their customers were the vacancy rate for retail buildings has generally satisfied with their current moved up somewhat of late, it remains level of stocks. well below its cyclical highs in 1991 and 2003. However, funding has report- Corporate Profits and Business edly become more difficult to obtain in Finance recent months, especially for speculative projects, and the slowing in aggre- Four-quarter growth in economic profits gate output and employment is likely to for all U.S. corporations came in at limit the demand for nonresidential about 2 percent in the third quarter of space in coming quarters. Meanwhile, 2007, with the entire gain attributable to real outlays for drilling and mining a large increase in receipts from foreign structures have continued to rise in re- subsidiaries. The share of profits in the sponse to high prices for petroleum and GDP of the nonfinancial sector peaked in the third quarter of 2006, near its prenatural gas. vious high reached in 1997, and has since receded. For S&P 500 firms, operInventory Investment ating earnings per share in the third Although inventory imbalances had quarter came in about 6 percent below 8 cropped up in a number of industries in year-earlier levels. Data from about late 2006, overhangs were largely eliminated in the first half of 2007, and firms generally continued to keep a tight rein on stocks in the second half. In the motor vehicle sector, manufacturers pur 8. The difference between economic profits and S&P operating earnings in the third quarter is attributable primarily to numerous asset writedowns and capital losses, which are generally ex- 18 94th Annual Report, 2007 80 percent of those firms and analysts' estimates for the rest indicate that operating earnings per share in the fourth quarter fell more than 20 percent from the fourth quarter of 2006. Earnings per share among the group's financial firms are estimated to have been negative, primarily because of asset write-downs; in contrast, earnings per share of the nonfinancial firms appear to have increased about 13 percent. Nonfinancial business debt is estimated to have grown about 11 percent in 2007, buoyed by robust merger and acquisition activity. Net corporate bond issuance was strong throughout the year, although high-yield issuance declined after midyear, as yields on such bonds increased and spreads over yields on Treasury securities of comparable maturity widened to levels not seen since late 2002. The amount of outstanding nonfinancial commercial paper was about flat, on net, over 2007, held down mostly by runoffs of lower-tier paper in the second half of the year as the market for such paper came under pressure. After an unprecedented amount of issuance of leveraged syndicated loans over the first half of 2007, issuance declined considerably in the second half of the year, when demand by nonbank investors for those loans fell off. Commercial and industrial (C&I) loans at banks expanded briskly in 2007 as underlying demand for bank-intermediated business credit seemed to remain solid and banks took onto their balance sheets loans that had been intended for syndication. In the Senior Loan Officer Opinion Surveys taken in October 2007 and January 2008, considerable net fractions of banks reported charging wider spreads on C&I loans—the loan rate less the eluded in the calculation of economic profits but are included as an expense in operating earnings per share of financial firms. Selected Components of Net Financing for Nonfinancial Corporate Businesses, 2003-07 Billions of dollars, annual rate • 2003 Commercial paper Bonds 2004 2005 2006 — 800 2007 NOTE: The data for the components except bonds are seasonally adjusted. The data for 2007:Q4 are estimated. SOURCE: Federal Reserve Board, flow of funds data. bank's cost of funds—the first such tightening in several years. Large fractions of banks also indicated that they had tightened lending standards. Most of the banks that tightened terms and standards indicated that they had done so in response to a less favorable or more uncertain economic outlook and a reduced tolerance for risk. A lesser fraction—about one-fourth—cited concerns about the liquidity or capital position of their own banks as reasons for tightening. Gross equity issuance picked up in 2007 on an increase in the pace of seasoned offerings. Nonetheless, record volumes of share repurchases and cashfinanced mergers and acquisitions pushed net equity retirements even higher in 2007 than in 2006. The credit quality of nonfinancial corporations remained strong. The sixmonth trailing bond default rate stayed near zero through January 2008. The delinquency rate on C&I loans at commercial banks at the end of 2007 remained near the bottom of its historical range, but it trended higher over the year. Charge-offs on C&I loans at banks also increased in 2007, particularly in the Recent Economic and Financial Developments fourth quarter. Rating downgrades of corporate bonds were modest through the fourth quarter, and over the year the fraction of debt that was downgraded roughly equaled the fraction that was upgraded. For public firms, balance sheet liquidity remained at a high level through the third quarter of 2007, and leverage stayed very low despite robust borrowing and surging retirements of equity. Commercial real estate debt continued to expand briskly in 2007, reflecting in part strong investment in nonresidential structures, but the overall pace tapered off some in the second half of the year. As noted above, readings on some market fundamentals for existing structures—for example, vacancy rates and rents—remained solid. Similarly, the latest data for commercial mortgages held by life insurance companies or by issuers of commercial mortgage-backed securities (CMBS)—mortgages that mostly finance existing structures— show little change in delinquency rates in recent quarters. In contrast, the delinquency rate on commercial mortgages held by banks about doubled over the course of 2007, reaching almost 23/4 percent. The loan performance problems were the most striking for construction and land development loans—especially for those that finance residential development—but some increase in delinquency rates was also apparent for loans backed by nonfarm, nonresidential properties and multifamily properties. In the most recent Senior Loan Officer Opinion Survey, large fractions of banks reported having tightened standards and terms on commercial real estate loans. Among the most common reasons cited by those that tightened credit conditions were a less favorable or more uncertain economic outlook, a worsening of commercial real estate market conditions in the 19 areas where the banks operate, and a reduced tolerance for risk. Moreover, despite the generally solid performance of commercial mortgages in securitized pools, spreads of yields on BBB-rated CMBS over comparablematurity swap rates soared, and spreads on AAA-rated tranches of those securities rose to unprecedented levels. The widening of spreads reportedly reflected heightened concerns regarding the underwriting standards for commercial mortgages over the past few years and likely also investors' general wariness of structured finance products. Issuance of CMBS in 2007 topped the pace of 2006. It was fueled by leveraged buyouts of real estate investment trusts in the first half of the year, but issuance slowed to a trickle over the final four months of the year on tighter underwriting standards and the higher required yields. Nonetheless, the still-steady growth of commercial real estate debt indicates that, thus far, borrowers have found alternative funding sources for projects. The Government Sector Federal Government The deficit in the federal unified budget stood at $162 billion in fiscal year 2007, roughly $250 billion below the recent high reached in fiscal 2004 and equal to just 1 VA percent of nominal GDP. However, growth in revenues has slowed since last summer, and growth in outlays has quickened. Given those developments, the deficit during the first four months of fiscal 2008 (October 2007 to January 2008) was larger than it had been during the comparable period of fiscal 2007. Over the remainder of fiscal 2008, a slow pace of economic activity and the revenue loss associated with the 20 94th Annual Report, 2007 Economic Stimulus Act of 2008 are expected to boost the deficit. Nominal federal receipts have decelerated sharply since posting double-digit advances in fiscal years 2005 and 2006: They rose less than 7 percent in fiscal 2007 and have slowed substantially further thus far in fiscal 2008. The deceleration has been most pronounced in corporate receipts, which barely increased in fiscal 2007 after three years of exceptional growth and have fallen well below year-earlier levels so far in fiscal 2008; the downturn has reflected the recent softness in corporate profits. In addition, growth in individual income tax receipts has moderated from the rapid rates seen around the middle of the decade. Nonetheless, total receipts grew faster than nominal GDP for the third year in a row in fiscal 2007 and reached 183/4 percent of GDP, slightly above the average of the past forty years. Nominal federal outlays rose less than 3 percent in fiscal 2007 after having Federal Receipts and Expenditures, 1987-2007 risen about IV2 percent in each of the two preceding years. In large part, the slowing in 2007 reflected a number of transitory factors—most notably, the tapering off of expenditures for flood insurance and disaster relief related to the 2005 Gulf Coast hurricanes, which had produced a noticeable bulge in spending in fiscal 2006. So far in fiscal 2008, sharp increases in outlays for defense and net interest have helped push spending 8 percent above its year-earlier level. As measured in the national income and product accounts (NIPA), real federal expenditures on consumption and gross investment—the part of federal spending that is a direct component of GDP—rose at an annual rate of 3 V2 percent, on average, in the second half of calendar 2007 after having been unchanged in the first half. The step-up was concentrated in real defense spending, which tends to be erratic from quarter to quarter and rose at an annual rate of 4V2 percent in the second half, somewhat above its average pace over the past three years. Federal debt rose at an annual rate of almost 5 percent over the four quarters Percent of nominal GDP Federal Government Debt Held by the Public, 1960-2007 Expenditures Receipts — 22 Percent of nominal GDP — \ \ — 18 — 16 i I I I I I 11 1 1 1 I 1 I I 1987 1991 1995 1999 I 1 2003 2007 45 — 40 /""— 35 — 1967 NOTE: The receipts and expenditures data are on a unified-budget basis and are for fiscal years (October through September); GDP is for the four quarters ending in Q3. SOURCE: Office of Management and Budget. I 50 — — 20 1977 1987 — 30 — 25 — 20 Hll Mil!! 1997 2007 NOTE: The data for debt are as of year-end; the observation for 2007 is an estimate. The corresponding values for GDP are for Q4 at an annual rate. Excludes securities held as investments of federal government accounts. SOURCE: Federal Reserve Board, flow of funds data. Recent Economic and Financial Developments of calendar year 2007, a bit faster than the roughly 4 percent increase in 2006. The ratio of federal debt held by the public to nominal GDP remained in the narrow range around 361/> percent seen in recent years. The Treasury's decision in May to discontinue auctions of threeyear nominal notes elicited little reaction in financial markets. The Treasury also trimmed some auction sizes for a few other coupon securities over the first three quarters of the year as the narrower deficit reduced borrowing needs. Data suggest that the proportion of nominal coupon securities purchased at Treasury auctions by foreign official institutions edged down over the second half of 2007, but the proportion has changed little, on net, since mid-2005. State and Local Government The fiscal condition of state and local governments appears to have lost some luster in 2007 after improving significantly between the early part of the decade and 2006. Indeed, for the state and local sector as a whole, net saving as measured in the NIPA, which is broadly similar to the surplus in an operating budget, fell from a recent high of $25 billion in 2006 to roughly zero, on average, during the first three quarters of 2007. The downshift occurred as revenue increases tailed off after a period of hefty gains and as nominal expenditures—especially on energy and health care—rose sharply. Recent information from individual states points to a good deal of unevenness in current budget conditions. Some states—especially those in agricultural and energyproducing regions—continue to enjoy strong fiscal positions. Others, however, are reporting sizable shortfalls in revenues, in part because sales tax collections are being hit hard by the weakness in purchases of housing-related items. In 21 these circumstances, some states may have to cut spending or raise taxes to satisfy their balanced-budget requirements. At the local level, property tax receipts apparently were bolstered in 2007 by the earlier run-up in real estate values, but the deceleration in house prices will likely slow the rise in local revenues down the road. Moreover, many state and local governments expect to face significant structural imbalances in their budgets in coming years as a result of the ongoing pressures from Medic aid and the need to provide pensions and health care to their retired employees. According to the NIPA, real expenditures on consumption and gross investment by state and local governments continued to expand briskly in the second half of 2007. Much of the strength was in construction spending, which picked up speed early last year after having been essentially flat between 2002 and 2006. Meanwhile, real outlays for current operations remained on the moderate uptrend that has been evident since 2006. Boosted by spending on education and industrial aid, borrowing for new capital expenditures by state and local governments was very strong in 2007. Refundings in advance of retirements were brisk in the early part of the year as issuers locked in low interest rates, but refundings subsided in the second half as a result of higher volatility and reduced liquidity in the municipal bond market. By contrast, short-term borrowing picked up a bit during the second half of the year, possibly because of some deterioration in state and local budgets. Municipal issuers are benefiting from lower interest rates, as bond yields have declined some since midyear. However, investors reportedly have become increasingly concerned about the weaker 22 94th Annual Report, 2007 fiscal outlooks for many state and local governments and the condition of municipal bond insurers. Partly as a result of those developments, the ratio of an index of municipal bond yields to the yield on comparable-maturity Treasuries has climbed to the top end of its historical range. Some indicators of credit quality in the municipal bond sector have begun pointing to greater weakness in recent months. Rating upgrades have slowed while downgrades have risen. A substantial number of revenue bonds for projects insured by a subsidiary of a major investment bank were downgraded in October. In January another group of bonds was downgraded because of the downgrade of their insurer. rise in the standard of living of U.S. residents over time and hamper the ability of the nation to meet the retirement needs of an aging population. The External Sector International Trade The external sector provided significant support to economic activity in the second half of last year. Net exports added almost 1 percentage point to U.S. GDP growth during that period, according to the latest GDP release from the Bureau of Economic Analysis, but data received since then suggest a somewhat larger positive contribution. The contribution of net exports was supported by a robust expansion—about 11 percent at an annual rate—of real exports of goods and National Saving services that was helped by still-solid Total net national saving—that is, the growth of foreign economies and the efsaving of households, businesses, and fects of the past depreciation of the dolgovernments excluding depreciation lar. The broad-based rise in real exports charges—was equal to about IV2 per- of goods included sizable increases for cent of nominal GDP, on average, dur- automobiles, agricultural goods, and ing the first three quarters of 2007. The capital goods, especially aircraft. Exdrain on national saving from the fed- ports of services rose in 2007 but at a eral budget deficit was smaller than it had been a few years earlier. However, Change in Real Imports and Exports net business saving receded somewhat of Goods and Services, 1999-2007 from the relatively high levels of the Percent preceding few years, and personal sav• Imports ing was very low for the third consecu— • Exports — 15 tive year. Net national saving fell appreciably as a percentage of GDP between the late 1990s and the early part of this decade; — 5 — that ratio has changed little since 2002 + (apart from the third quarter of 2005, which was marked by sizable hurricane— — 5 related property losses). If not boosted over the longer run, persistent low levels — 10 — of national saving will be associated 1 j with either slower capital formation or M i l l 1 1 1 U 2003 1999 2001 2005 2007 continued heavy borrowing from abroad, either of which would retard the SOURCE: Department of Commerce. I 1Mil Recent Economic and Financial Developments slower pace than in the previous year. The value of exports to China, India, Russia, South America, and the members of OPEC rose quite substantially, and gains for exports to Canada and western Europe were also sizable. Exports to Mexico and Japan increased at a somewhat slower pace. A slowdown in real imports was also a factor in the positive contribution of net exports to the growth of real GDP last year. The growth of real imports of goods and services decreased to about \Vi percent in 2007, down from a 33/4 percent rise in 2006, in part because of a slowdown in U.S. domestic demand and the depreciation of the dollar. Although real imports of capital goods were strong, the growth of most other major categories declined. Despite the moderation in the growth of imports overall, the value of goods (excluding oil) imported from western Europe, China, and Mexico still rose at solid rates. Given those movements in exports and imports, along with somewhat higher net investment income, the U.S. current account deficit appears likely to have shrunk in 2007 on an annual basis for the first time since 2001. The current account deficit narrowed from $811 billion in 2006 to an average of $753 billion at an annual rate, or around 5Vi percent of nominal GDP, in the first three quarters of 2007 (the latest available data). However, its largest component, the trade deficit, widened in the fourth quarter because of a steep increase in the price of imported oil. The price of crude oil soared on world markets in 2007. The spot price of West Texas intermediate increased from around $60 per barrel at the end of 2006 to about $100 at present. The strong demand for oil was powered by the continued expansion of the world economy through 2007, especially in the develop 23 Prices of Oil and of Nonfuel Commodities, 2003-08 January 2003 = 100 Dollars per barrel 260 240 220 200 180 — — — — — 160 140 120 100 80 *~/^^ — 50 — J \P* — J y — 40 Nonfuel. . — 30 — W ^ ._ / commodities 20 ——*S —j 10 r1 1 I 1 i II — 100 V — 90 Oil I\P -. J \*ljLs/r_/ — 80 — 60 1 2003 2004 2005 2006 2007 2008 NOTE: The data are monthly. The last observation for the oil price is the average for February 1 through February 21, 2008. The price of nonfuel commodities extends through January 2008. The oil price is the spot price of West Texas intermediate crude oil. The price of nonfuel commodities is an index of forty-five primary-commodity prices. SOURCE: For oil, the Commodity Research Bureau; for nonfuel commodities. International Monetary Fund. ing countries. In addition, a number of actual and potential disruptions to supply have contributed to the surge in oil prices. OPEC members announced cuts to oil production in late 2006. Despite recent agreements that have reversed some of these cuts, OPEC production remains restrained. The growth of production has also been hampered by some governments' moves to take control of oil resources or raise their share of revenues. Geopolitical tensions in the Middle East and instability in Nigeria have contributed to concerns about oil supply as well. The price of the fardated NYMEX oil futures contract (currently for delivery in 2016) now has risen to nearly $95 per barrel and likely reflects a belief by oil market participants that the balance of supply and demand will remain tight for some time to come. Broad indexes of non-oil commodities prices remain elevated. Although they fell back slightly over the second half of last year, prices have again risen since the start of 2008. Prices of a num- 24 94th Annual Report, 2007 ber of metals, which surged in the spring on strong global demand, retreated somewhat during the latter half of 2007 as production increased and as users substituted into other materials. However, more recently the prices of copper and aluminum have moved back up. Prices for food commodities continue to rise steeply. Poor harvests in Australia as well as in parts of Europe and Asia led to higher wheat prices. The price of soybeans also has risen sharply because acreage has been shifted to corn production, in part to produce biofuel; in addition, the soybean harvest in China was down sharply from last year. Import price inflation increased in 2007, with the depreciation of the dollar providing an important impetus; higher oil and food prices also contributed. Prices of imported goods rose about 8V2 percent in 2007, but excluding food, oil, and natural gas, such prices rose 2V* percent; both rates were somewhat higher than in the previous year. The Financial Account Although the current account deficit appears to have narrowed during 2007, it remains sizable and continues to require a significant inflow of financing from abroad. As in the past, the deficit was largely financed by foreign net acquisitions of U.S. securities. The global financial turmoil that began in the summer left an imprint on the components of the U.S. financial account. After acquiring record amounts of U.S. securities in the first half of 2007, foreign private investors sold a sizable net amount of non-Treasury U.S. securities in the third quarter—the first quarterly net sale of such securities in more than fifteen years. In contrast, foreign private demand for U.S. Treasury securities picked up sharply in the third quarter as global investors shifted into less-risky positions. On balance, flows out of non-Treasuries and into U.S. Treasuries nearly offset one another, and total foreign private acquisitions of U.S. securities recorded an unusually small net inflow for the third quarter. Preliminary data for the fourth quarter indicate renewed foreign acquisitions of U.S. corporate securities, although at a notably weaker pace than in the first half of the year. Foreign private demand for U.S. Treasury securities has remained strong. As issuers of asset-backed commercial paper around the globe began to encounter difficulties over the summer, nonbank entities that had issued commercial paper in the United States and lent the proceeds to foreign parents sharply curtailed those activities. As a result, those entities reduced their claims on foreign parents, and net financial inflows from nonbank entities thus were sizable in the third quarter. Foreign inflows through direct investment into the United States surged in the third quarter, as foreign parents injected additional equity capital into their U.S. affiliates. Foreign official inflows slowed in the third quarter, as Asian central banks acquired debt securities issued by government-sponsored enterprises (GSEs) but on net sold U.S. Treasury securities. Official inflows appear to have strengthened again in the fourth quarter, with a return to moderate purchases of U.S. Treasury securities, continued strong purchases of GSE-issued debt securities, and a notable pickup in acquisitions of both corporate equities and corporate debt securities. Net purchases of foreign securities by U.S. residents, which represent a financial outflow, were maintained at a brisk pace for 2007 as a whole. Outflows associated with U.S. direct investment abroad remained strong. Recent Economic and Financial Developments The Labor Market Employment and Unemployment The demand for labor decelerated early last year and has slowed further of late. The average monthly gain in private nonfarm payroll employment, which slid from about 160,000 in 2006 to 80,000 over the first ten months of 2007, was only 50,000 in November and December, and private employment was nearly flat in January 2008. The civilian unemployment rate, which had hovered around 4Vi percent in the early part of 2007, drifted up about lA percentage point from May to November; it rose another lA percentage point, on net, over the following two months and stood at 4.9 percent in January. Employment in residential construction has been falling for about two years and now stands 375,000 below the high reached in early 2006. Jobs in related financial industries have also decreased lately. Payrolls in the manufacturing sector, which have been on a downtrend for Net Change in Private Payroll Employment, 2001-08 Thousands of jobs, 3-month moving average 11 2002 2004 2006 2008 NOTE: Nonfarm business sector. The data are monthly and extend through January 2008. SOURCE: Department of Labor, Bureau of Labor Statistics. 25 more than a quarter-century, have continued to shrink. Meanwhile, some service-producing industries have maintained solid gains. In particular, hiring by health and education institutions and by food services and drinking establishments has remained strong, and job gains at businesses providing professional and technical services have been sizable as well. The increase in joblessness since the spring of 2007 has been widespread across major demographic groups. In January 2008, unemployment rates for men and women aged 25 years and older were both about VA percentage point above the levels of last spring, and—as typically occurs—rates for teenagers and young adults showed larger increases. Among the major racial and ethnic groups, unemployment rates for blacks and Hispanics rose somewhat more than did unemployment rates for whites, a differential also typical of periods when labor market conditions soften. An increase in the number of unemployed who had lost their last jobs (as opposed to those who had voluntarily left their jobs or were new entrants to the labor force) accounted for about half of the rise in the overall jobless rate between the spring of 2007 and January 2008. The labor force participation rate stood slightly above 66 percent in January; it has changed little, on net, over the past couple of years after falling appreciably over the first half of the decade. Most other recent indicators also point to some softening of labor market conditions. Initial claims for unemployment insurance, which had remained relatively low through the fall, moved up somewhat in the closing months of 2007; though erratic from week to week, they appear to have risen further in early 2008. Meanwhile, private surveys suggest that firms have cut back on plans for hiring in the near term. Households 26 94th Annual Report, 2007 have also become less upbeat about the prospects for the labor market in the year ahead. Hourly compensation rose at a relatively moderate rate in 2007 despite a pickup in overall consumer price inflation, a continued advance in labor productivity, and generally tight labor marProductivity and Labor kets. The employment cost index (ECI) Compensation for private industry workers, which measures both wages and the cost of Output per hour in the nonfarm business benefits, increased 3 percent in nominal sector rose 2Vi percent in 2007 after avterms over the twelve months of 2007, eraging just 1 Vi percent per year over about in line with its pace in 2005 and the preceding three years. Although esti2006. Within the ECI, wages and salamates of the underlying pace of producries increased VA percent in 2007, the tivity growth are quite uncertain, the same as in 2006 but 3A percentage point pickup in measured productivity growth above the increases in 2004 and 2005. in 2007 suggests that the fundamental Meanwhile, increases in the cost of proforces supporting a solid underlying viding benefits have slowed markedly in trend remain in place. Those forces in- recent years, in part because employer clude the rapid pace of technological contributions for health insurance have change as well as the ongoing efforts by decelerated. The increase in benefits firms to use information technology to costs in 2007, which amounted to just improve the efficiency of their opera- 2Vi percent, was also held down by a tions. Increases in the amount of capital drop in employer contributions to per worker also appear to be providing defined-benefit retirement plans in the an impetus to productivity growth. first quarter. The lower contributions appear to have been facilitated by several factors, including a high level of emChange in Output per Hour, 1948-2007 ployer contributions over the preceding Percent, annual rate few years and the strong performance of the stock market in 2006. According to preliminary data, nomi— 5 nal compensation per hour in the nonfarm business sector—an alternative measure of hourly compensation derived from the compensation data in the — 3 NIPA—rose 33/4 percent in 2007, somewhat faster than the ECI. In 2006, the nonfarm business measure had risen 5 percent, with an apparent boost from a high level of bonuses and stock option exercises, which do not seem to have been repeated in 2007.y The moderation 1948- 1974- 19962002 2004 2006 73 95 2000 in this measure last year, along with the UlL NOTE: Nonfarm business sector. Change for each multiyear period is measured to the fourth quarter of the final year of the period from the fourth quarter of the year immediately preceding the period. SOURCE: Department of Labor, Bureau of Labor Statistics. 9. Income received from the exercise of stock options is included in the measure of hourly compensation in the nonfarm business sector but not in the ECI. Income received from most types Recent Economic and Financial Developments step-up in measured productivity growth, held the increase in unit labor costs in 2007 to 1 percent. Unit labor costs rose about 2Vi percent per year, on average, from 2004 to 2006 after having been nearly flat over the preceding three years. Prices Headline consumer price inflation slowed dramatically in the third quarter of 2007, when energy prices hit a lull after their first-half surge, but it moved back up in the fourth quarter as energy prices climbed again. Over the year as a whole, the overall PCE chain-type price index rose 3V2 percent, IV2 percentage points more than in 2006. Core price inflation excludes the direct effects of increases in food and energy prices; these increases were sharp last year. Like headline inflation, core PCE inflation was uneven from quarter to quarter in 2007; over the four quarters of the year, it averaged a bit more than 2 percent. In 2006, the core index rose 2l/4 percent. Although data for PCE prices in January 2008 are not yet available, information from the consumer price index (CPI) and other sources suggests that both total and core inflation remained on the high side early this year after having firmed in the fourth quarter of 2007. The PCE price index for energy rose nearly 20 percent over the four quarters of 2007 after having fallen modestly in 2006. The retail price of gasoline was up about 30 percent over the year as a whole, driven higher by the upsurge in the cost of crude oil. In 2008, gasoline prices through mid-February were around the high levels seen late last year. Prices of natural gas rose sharply in of bonuses is included in both measures of compensation. 27 early 2007, but they receded over the second half of the year as inventories reached their highest levels since the early 1990s. So far in 2008, natural gas prices have risen notably as inventories have fallen back into line with seasonal norms. Consumer prices for electricity rose sharply last fall, likely because of last year's higher prices of fossil fuel inputs to electricity generation. Last year's increase in the PCE price index for food and beverages, at 4V2 percent, was the largest in nearly two decades. Food prices accelerated in response to strong world demand and high demand for corn for the production of ethanol. Taken together, prices for meats, poultry, fish, and eggs rose 5V2 percent, and prices of dairy products were up at double-digit rates. Prices for purchased meals and beverages, which typically are influenced more by labor and other business costs than by farm prices, also recorded a sizable increase last year. In commodity markets, grain prices soared to near-record levels in late 2007 as strong global demand outstripped available supply, and they have moved somewhat higher since the turn of the year. Meanwhile, spot prices of livestock have declined of late; the decrease should provide some offset to the upward pressure from grain prices and thus help limit increases in consumer food prices in coming months. The pattern of core PCE inflation was uneven during 2007. In the first half of the year, core inflation was damped significantly by unusually soft prices for apparel, prescription drugs, and nonmarket items (especially financial services provided by banks without explicit charge); all of these developments proved transitory and were reversed later in the year with little net effect on core inflation over the year as a whole. Meanwhile, the rate of increase in the core CPI dropped from 23A percent in 28 94th Annual Report, 2007 2006 to 2!/4 percent in 2007; the main reason for the sharper deceleration in the core CPI than in the core PCE price index is that housing costs, which rose less rapidly in 2007 than they had in 2006, carry much greater weight in the core CPI. More fundamentally, the behavior of core inflation in 2007 was shaped by many of the same forces that were at work in 2006. The December jump in unemployment notwithstanding, resource utilization in labor and product markets remained fairly high last year, and increases in prices for energy and other industrial commodities continued to add to the cost of producing a wide variety of goods and services. Higher prices for non-oil imports also likely put some upward pressure on core inflation. Meanwhile, the news on inflation expectations has been mixed. Probably reflecting the higher rate of actual headline inflation, the median expectation for year-ahead inflation in the Reuters/ University of Michigan Surveys of Consumers moved up from 3 percent in early 2007 to between 3XA percent and 3V2 percent last spring; apart from a downward blip in the autumn, it remained there through January 2008 and spurted to 33A percent in the preliminary estimate for February. In contrast, most indicators suggest that expectations for longer-run inflation have remained reasonably well contained. The preliminary February result for median five- to tenyear inflation expectations in the Reuters/ University of Michigan survey, at 3.0 percent, was around the middle of the narrow range that has prevailed for the past few years. And according to the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, expectations of CPI inflation over the next ten years have remained around 2V2 percent, a level that has been essentially unchanged since Alternative Measures of Price Change, 2005-07 Percent Price measure Chain-type Gross domestic product (GDP) Excluding food and energy Personal consumption expenditures (PCE) Excluding food and energy Market-based PCE excluding food and energy Fixed-weight Consumer price index Excluding food and energy 2005 2006 2007 3.4 3.3 2.7 2.9 2.6 2.3 3.2 2.2 1.9 2.3 3.4 2.1 1.7 2.0 1.9 3.8 2.1 1.9 2.7 4.0 2.3 NOTE: Changes are based on quarterly averages of seasonally adjusted data. SOURCE: For chain-type measures, Department of Commerce, Bureau of Economic Analysis; for fixedweight measures, Department of Labor, Bureau of Labor Statistics. 1998. Meanwhile, ten-year inflation compensation, as measured by the spreads of yields on nominal Treasury securities over those on their inflationprotected counterparts, has changed little, on balance, since mid-2007. Last year's sharp rise in energy prices also left an imprint on the price index for GDP, which rose a little more than 2V2 percent for the second year in a row.10 Excluding food and energy prices, the increase in GDP prices slowed from 3 percent in 2006 to 2lA percent in 2007; significantly smaller increases in construction prices accounted for much of the deceleration. Financial Markets Domestic and international financial markets experienced substantial strains and volatility in 2007 that were sparked by the ongoing deterioration of the 10. The effect of energy prices on GDP prices was much smaller than that on PCE prices. The reason is that much of the energy-price increase was attributable to the higher price of imported oil, which is excluded from GDP because it is not part of domestic production. Recent Economic and Financial Developments subprime mortgage sector and emerging worries about the near-term outlook for U.S. economic growth. Substantial losses on structured products related to subprime mortgages caused market participants to reassess the risks associated with a wide range of other structured financial instruments. The result was a drying up of markets for subprime and nontraditional mortgage products as well as a significant impairment of the markets for asset-backed commercial paper and leveraged syndicated loans. Those dislocations generated unexpected balance sheet pressures at some major financial institutions, and the pressures in turn contributed to severe strains in short-term bank funding markets. The Federal Reserve responded to the financial turmoil and the risks to the broader economy along two tracks: It took a series of actions to support market liquidity and functioning (partly in coordination with foreign central banks), and it eased monetary policy in pursuit of its macroeconomic objectives. As a result of the downward revision to the economic outlook and strained financial conditions, yields on Treasury securities fell, risk spreads widened significantly, equity prices dropped, and volatility in many financial markets increased. Market Functioning and Financial Stability The ongoing erosion in the credit quality of subprime residential mortgages, particularly adjustable-rate mortgages, has exposed weaknesses in other financial markets and posed challenges to financial institutions. Over the first half of 2007, problems were mostly isolated within the subprime mortgage markets. However, around midyear, as credit quality in that sector continued to worsen and losses mounted, investors began to retreat from structured credit 29 products and from risky assets more generally. Strains began to emerge in the leveraged syndicated loan market in late June and then surfaced in the assetbacked commercial paper and term bank funding markets in August. After a respite in late September and October, revelations of larger-than-expected losses at several financial firms and a weaker economic outlook contributed to yearend pressures in short-term funding markets that exacerbated financial strains and heightened market volatility. Financial markets remained volatile through mid-February, in part owing to a further downgrading of the economic outlook and problems at some financial guarantors. Signs of investor nervousness about the mortgage situation first appeared in December 2006 and then intensified in late February 2007, at a time when softer-than-expected U.S. economic data were adding to market uncertainty. Over this period, mortgage companies specializing in subprime products began to experience considerable funding pressures, and many failed, because rising delinquencies on recently originated subprime mortgages required those firms to repurchase the bad loans from securitized pools. Financial markets calmed in April, however, and liquidity in major markets remained ample. In June, rating agencies downgraded or put under review for possible downgrade the credit ratings of a large number of securities backed by subprime mortgages. Shortly thereafter, a few hedge funds experienced serious difficulties as a result of subprime-related investments. Prices of indexes of credit default swaps on residential mortgage-backed securities backed by subprime mortgages—which had already weakened over the first half of 2007 for the lowerrated tranches—dropped steeply in July for both lower-rated and higher-rated 30 94th Annual Report, 2007 Gross Issuance of Securities Backed by Alt-A and Subprime Mortgage Pools, 2002-08 Billions of dollars, annual rate • Alt-A n Subprime " — — 2002 n y ill 2004 75 [1 60 45 30 15 2006 2008 NOTE: Mortgages in alt-A pools are a mix of prime, near-prime, and subprime mortgages; for further details on alt-A pools, refer to text. SOURCE: Inside MBS & ABS. tranches. Subsequently, investor demand for securities backed by subprime and alt-A mortgage pools dwindled, and the securitization market for those products virtually shut down. Those developments amplified credit and funding pressures on mortgage companies specializing in subprime mortgages; with no buyers for the mortgages they originated, more of those firms were forced to close or drastically reduce their operations, and subprime originations slowed to a crawl. Originations of alt-A mortgages—which had held up over the first half of the year—also dropped sharply beginning in July. Interest rates on jumbo loans increased, but institutions that had the capacity to hold such loans on their balance sheets continued to make them available to prime borrowers. In contrast, the market for conforming mortgages for prime borrowers was affected relatively little. Indeed, the issuance of securities carrying guarantees from Fannie Mae or Freddie Mac rose somewhat in the second half of the year. The unprecedented decline in the value of highly rated tranches of mortgage-related securities led investors to doubt their own ability, and that of the rating agencies, to evaluate many other types of structured instruments. The loss of confidence was reflected in significantly higher spreads on the debt of collateralized loan obligations (CLOs), and the issuance of such debt weakened noticeably over the summer. Because CLOs had been the largest purchasers of leveraged syndicated loans, the drop in issuance contributed to the decline in leveraged lending. In the secondary market for such loans, trading volumes were reportedly large, but bidasked spreads widened sharply and prices, which had been high in the first half of 2007, declined markedly. Implied spreads on an index of loan-only credit default swaps (LCDX) spiked in July and remained elevated in August. Unable to distribute many leveraged syndicated loans that they had reportedly underwritten—a problem apparently affecting about $250 billion of such loans in the United States alone— banks faced the prospect of bringing those loans onto their balance sheets as the underlying deals closed. At the end of July, European assetbacked commercial paper (ABCP) and short-term funding markets were roiled by warnings of heavy losses associated with commercial paper programs backed by U.S. subprime mortgages. On August 9, a major European bank announced that it had frozen redemptions for three of its investment funds, citing its inability to value some of the mortgage-related securities held by the funds. After that announcement, liquidity problems and short-term funding pressures intensified in Europe and emerged in U.S. money markets. Partly in response to those developments, the Federal Reserve and other central banks took steps to foster smoother functioning of short-term credit markets (refer to the box entitled "The Federal Recent Economic and Financial Developments Reserve's Responses to Financial Strains"). Spreads on U.S. ABCP widened considerably in mid-August, and the volume of ABCP outstanding began a precipitous decline as investors balked at rolling over paper for more than a few days. Outstanding European ABCP also declined substantially, and the market for Canadian ABCP not sponsored by banks virtually collapsed.11 Structured investment vehicles (SIVs) and singleseller ABCP conduits that were heavily exposed to securities backed by subprime mortgages experienced the greatest difficulties. Unlike traditional ABCP programs, SIVs had very little explicit liquidity support from their sponsors. As a result, investors became particularly concerned about the ability of SIVs— even those with little or no exposure to residential mortgages—to make timely payments, and demand for ABCP issued by SIVs fell sharply. Over the next few weeks, some U.S. issuers invoked their right to extend the maturity of their paper. Others temporarily drew on their bank-provided backup credit lines, and a few issuers defaulted. The general uncertainty and lack of liquidity also led to some decrease in demand for lower-tier unsecured nonfinancial commercial paper—especially at longer maturities— and spreads in that segment of the market widened markedly in August as well. Issuers of high-grade unsecured commercial paper were largely unaffected by the turmoil and experienced little disruption. At the same time, term interbank funding markets in the United States and Europe came under pressure. Banks recognized that the difficulties in the markets for mortgages, syndicated loans, 11. In December, a group of investor representatives agreed in principle to restructure Canadian nonbank ABCP into longer-term notes. 31 and commercial paper could lead to substantially larger-than-anticipated calls on their funding capacity. Moreover, creditors found they could not reliably determine the size of their counterparties' potential exposures to those markets, and concerns about valuation practices added to the overall uncertainty. As a result, banks became much less willing to provide funding to others, including other banks, especially for terms of more than a few days. Spreads of term federal funds rates and term Libor over rates on comparable-maturity overnight index swaps widened appreciably, and the liquidity in these markets diminished (for the definition of overnight index swaps, refer to the accompanying figure). European banks also sought to secure term funding in their domestic currencies, and similar spreads were seen in term euro and sterling Libor markets. Liquidity in the foreign exchange swap market was poor over this period, and European firms found it more difficult and costly to use the foreign exchange swap market to swap term funds denominated in euros or other currencies for funds denominated in dollars. Term funding markets in the Japanese yen and Australian dollar also came under pressure as foreign institutions attempted to borrow in those currencies and swap the funds into dollars or euros. Against that backdrop, investors fled to the relative safety of Treasury securities, particularly Treasury bills, during mid-August. For example, inflows into money market mutual funds investing only in Treasury and agency securities jumped in August. Surges of safe-haven demand caused Treasury bill rates to plunge at times, and the considerable volatility in that market was likely exacerbated in September by a seasonal reduction in bill supply. Bid-asked spreads in the Treasury bill market widened substantially in this period. 32 94th Annual Report, 2007 The Federal Reserve's Responses to Financial Strains In response to the serious financial strains that emerged last August, the Federal Reserve has undertaken a number of measures to foster the normal functioning of financial markets and thereby promote its dual objectives of maximum employment and price stability. In mid-August, the Federal Reserve, as well as several foreign central banks, took actions designed to provide liquidity and help stabilize markets. On August 9, the European Central Bank (ECB) conducted an unscheduled tender operation in response to sharply elevated demands for liquidity by European banks, an action it repeated several more times in subsequent weeks. On August 10, similar stresses emerged in U.S. money markets, and the Federal Reserve added substantial reserves to meet heightened demand for funds from banks. Short-term markets remained under considerable pressure over subsequent days despite the provision of ample liquidity in overnight funding markets by the Federal Reserve, the ECB, and the central banks of other major industrialized countries. On August 17, the Federal Reserve Board announced a narrowing of the spread between the federal funds rate and the discount rate from 100 basis points to 50 basis points and changed discount window lending practices to allow the provision of term financing for as long as thirty days, renewable by the borrower. To ease pressures in the Treasury market, the Federal Reserve Bank of New York announced on August 21 some temporary changes to the terms and conditions of the System Open Market Account (SOMA) securities lending program. The Federal Reserve's efforts achieved some of the desired results. The provision of increased liquidity generally succeeded in keeping the federal funds rate from rising above its intended level. (Indeed, despite heightened demand for liquidity, the effective federal funds rate was somewhat below the target for a time in August and early September, as efforts to keep the rate near the target were hampered by technical factors and financial market volatility.) After the September meeting of the Federal Open Market Committee, conditions in overnight funding markets improved further. The volume of loans to depository institutions made through the discount window increased at times because of term loans to a relatively small number of institutions, but it remained generally moderate. Institutions may have been reluctant to use the discount window, perhaps fearing that their borrowing would become known and would be seen by creditors and counterparties as a sign of financial weakness—the so-called stigma problem. Nonetheless, collateral placed by banks at the discount window in anticipation of possible borrowing rose sharply during August and September, which suggested that some banks viewed the discount window as a potentially valuable option. Pressures in financial markets ebbed for a time in the fall but rose again later in the year. On November 26, the Federal Reserve Bank of New York announced some additional modest, temporary changes to the SOMA securities lending program that were designed to further relax the limitations on borrowing particular Treasury securities and to improve the functioning of the Treasury market. In addition, the New York Reserve Bank stated that the Open Market Trading Desk planned to conduct a series of term repurchase agreements that would extend over year-end and that it would provide Recent Economic and Financial Developments sufficient reserves to resist upward pressures on the federal funds rate around yearend. Then on December 12, the Federal Reserve and several foreign central banks announced a coordinated effort to facilitate a return to more-normal pricing and functioning in term funding markets. As part of that effort, the Federal Reserve announced the creation of a temporary Term Auction Facility (TAF) to provide secured term funding to eligible depository institutions through an auction mechanism beginning in mid-December. The Federal Reserve also established swap lines with the ECB and the Swiss National Bank (SNB), which provided dollar funds that those central banks could lend in their jurisdictions. At the same time, the Bank of England and the Bank of Canada announced plans to conduct similar term funding operations in their own currencies. The Federal Reserve has conducted six TAF auctions thus far, two of $20 billion in December, two of $30 billion in January, and two of $30 billion in February. The auctions attracted a large number of bidders. The ratio of the dollar value of bids to the amount offered (the bid-to-cover ratio) at the two auctions in December was about 3. The auctions in January and February were somewhat less oversubscribed, with bid-to-cover ratios of roughly 2 on January 14, February 11, and February 25 and of 1 lA on January 28. The lower bid-to-cover ratios in those auctions may have reflected improved liquidity in term funding markets, the larger auction size, and, for the January 28 auction, some uncertainty about the monetary policy action that would be taken at the January 29-30 FOMC meeting. The spread of the interest rate for the auctioned funds over the minimum bid rate (the overnight-index-swap rate correspond- 33 ing to the maturity of the credit being auctioned) was about 50 basis points in December but was lower in the January and February auctions. The lower spread apparently reflected some improvement in banks* access to term funding after the turn of the year. Although isolating the impact of the TAF on financial markets is not easy, a decline in spreads in term funding markets since early December provides some evidence that the TAF may have had beneficial effects on financial markets. The initial experience with the TAF suggests that it may well be a useful complement to the discount window in some circumstances, and the Federal Reserve Board will consider making it a permanent addition to the Federal Reserve's available instruments for providing liquidity to the banking system. The swap arrangements with foreign central banks allowed for up to $20 billion in currency swaps with the ECB and up to $4 billion with the SNB. Drawing upon these lines, the ECB auctioned $10 billion in dollar funds on December 17 and another $10 billion on December 20 in coordination with the Federal Reserve's TAF auctions. The SNB auctioned $4 billion in funds on December 17. The bid-to-cover ratios at the ECB and SNB auctions in December ranged between WA and 4lA\ the actions were considered successful in helping to give foreign financial institutions access to additional dollar funding. The December loans were renewed by the ECB and SNB at auctions in January, with bid-to-cover ratios ranging from 1 lA to 2%. The ECB and SNB have not conducted auctions in February; ECB officials have indicated that consideration would be given to reactivating dollar auctions if conditions appear to warrant such actions. 34 94th Annual Report, 2007 Financial conditions appeared to improve somewhat in late September and October after the larger-than-expected reduction of 50 basis points in the federal funds rate at the September FOMC meeting and a few encouraging reports on economic activity. Spreads in many short-term funding markets partially reversed their August run-ups. Bid-asked spreads in the interdealer market for Treasury bills were a bit less elevated than they had been in August. But the Treasury bill market remained thin, and yields were volatile at times. In the syndicated loan market, implied LCDX spreads partly reversed their summer surge, and some multibillion-dollar deals were successfully placed in the market. However, underwriting banks were forced to take sizable discounts from par value to induce investors to purchase the loans, and they retained significantly larger-than-intended portions of deals on their own balance sheets. The improvements in market functioning proved to be short lived, in part because of a further worsening in the outlook for the housing sector and associated concerns about possible effects on financial institutions and the economy. The strains in financial markets intensified during November and December. The syndicated loan market again ground to a halt, and spreads on the LCDX indexes moved up. The heightened uncertainties and ongoing financial turmoil, along with the desire of financial institutions to show safe and liquid assets on their year-end statements, generated significant year-end pressures in short-term funding markets for the first time in several years. Spreads on onemonth Libor and term federal funds shot up in late November when their maturities crossed year-end. Similarly, spreads on ABCP and lower-tier unsecured commercial paper widened further over the period. Strong demand for safe assets over year-end drove yields on shortdated Treasury bills maturing in early 2008 to low levels, and liquidity in that market was impaired at times. In mid-December, the Federal Reserve announced coordinated action with a number of other central banks to help facilitate a return to more-normal pricing and functioning in term funding markets. The efforts of the central banks, combined with the passage of year-end, appeared to help steady short-term financial markets in early 2008. So far this year, commercial paper spreads— both for ABCP and for lower-tier unsecured paper—and term bank funding spreads have dropped, although they remain above the levels that prevailed before last August. In contrast, liquidity in the Treasury bill market has been inconsistent. The subprime and alt-A mortgage markets remain essentially shuttered. Conditions in the market for leveraged syndicated loans have worsened, and the forward calendar of committed deals remains substantial. Risk spreads on corporate bonds widened significantly in January, and equity prices dropped. Most recently, demand has evaporated for auction-rate securities— long-term debt (much of which is municipal bonds) with floating interest rates that are reset at frequent, regular auctions—and thereby imposed higher rates on issuers and reduced liquidity for current holders. In January and February, problems at several financial guarantors intensified as rating agencies and investors became more concerned that guarantors' exposures to collateralized debt obligations that hold asset-backed securities (especially those backed by subprime residential mortgages) had imperiled the guarantors' AAA ratings. Indeed, the rating agencies downgraded a few financial guarantors and put some firms on watch Recent Economic and Financial Developments for possible downgrades; financial guarantors' equity prices declined, and credit default swap spreads increased. A number of guarantors are undertaking efforts to bolster their financial strength. Financial guarantors have played an important role in the markets for municipal bonds and for some structured finance products by providing insurance against default. Those markets have already felt some effects from the stress at the financial guarantors and could be more substantially affected by any future downgrades. The direct exposures of U.S. banks to losses from downgrades of guarantors' ratings—through banks' holdings of municipal bonds and credit protection on structured products— appear to be moderate relative to the banks' capital. But some large banks and broker-dealers could experience significant funding pressures from structured products tied to municipal bonds that might return to their balance sheets if guarantors are downgraded below specified thresholds or if investors choose to unwind their investments in advance of potential downgrades. Although U.S. financial markets and institutions have encountered considerable difficulties over the past several months, the financial system entered that period with some distinct strengths. In particular, most large financial institutions had strong capital positions, and the financial infrastructure was robust. Although some large financial institutions have experienced sizable losses, the sector generally remains healthy. A number of the firms that have reported sizable write-downs of assets have been able to raise additional capital. Market infrastructure for clearing and settlement performed well over the year, even when volatility spiked and trading volumes were very large. Moreover, not all markets experienced significant impairment. For in 35 stance, the investment-grade corporate bond market reportedly functioned well over most of the period, and the unsecured high-grade commercial paper market appeared little affected by the difficulties encountered in other shortterm funding markets. The securitization of consumer loans and conforming residential mortgages was robust. Despite a few notable failures, hedge funds overall seemed to hold up fairly well, and counterparties of failing hedge funds did not sustain material losses. Policy Expectations and Interest Rates The current target for the federal funds rate, 3 percent, is substantially below the level that investors expected at the end of June 2007. Judging from futures quotes at that time, market participants expected the FOMC to shave at most 25 basis points from the federal funds rate by February 2008 rather than the 225 basis points that has been realized. Investors currently expect about 100 basis points of additional easing by the end of 2008. Uncertainty about the path of policy had been very low during the first half of the year, but it increased appreciably over the summer and generally has remained around its long-run historical average since then. Although nominal Treasury yields rose somewhat over the first half of last year, rates subsequently fell sharply as the outlook for the economy dimmed and as market participants revised their expectations for monetary policy accordingly. Treasury bill yields declined to particularly low levels at times because of increased demand for safe and liquid assets. On net, two-year yields fell roughly 180 basis points in the second half of the year, and ten-year yields shed about 100 basis points. Treasury yields fell significantly more in early 36 94th Annual Report, 2007 Spreads of Corporate Bond Yields over Comparable Off-the-Run Treasury Yields, by Securities Rating, 1998-2008 Interest Rates on Selected Treasury Securities, 2003-08 Percent P e r c e n t a l - • .11 its HA. — Ten-year V w Y Two-year J\iyJ Three-month —Kk jWSs/ J II 1 1 2003 2004 2005 — 5 KL — ^ 1 —3 1 2007 1 2008 NOTE: The data are daily and extend through February 21, 2008. SOURCE: Department of the Treasury. 2008, especially for shorter-term securities, as policy expectations shifted down in response to signs of further weakness in the economic outlook. As of February 21, the two-year yield was about 2 percent, and the ten-year yield was about 33/4 percent. Yields on inflation-indexed Treasury securities also declined considerably in the second half of 2007 and into 2008. The difference between the five-year nominal Treasury yield and the fiveyear inflation-indexed Treasury yield— five-year inflation compensation— edged down over that period. Meanwhile, the ten-year inflation compensation measure changed little. As noted earlier, survey-based measures of short-term inflation expectations rose somewhat in 2007 and early 2008, presumably because of the increase in headline inflation. Survey measures of longer-term inflation expectations changed only slightly. Yields on corporate bonds firmed a bit over the first half of 2007, and spreads of those yields over yields on comparable-maturity Treasury securities changed little, on net. Since June, yields on AA-rated corporate bonds have decreased somewhat, on net, while those — 4 — 2 1 1 2006 High-yield _L 1998 1 1 1 2000 11 _L 2002 2004 2006 2008 NOTE: The data are daily and extend through February 21, 2008. The spreads shown are the yields on ten-year bonds less the ten-year Treasury yield. SOURCE: Derived from smoothed corporate yield curves using Merrill Lynch bond data. on BBB-rated bonds increased slightly; spreads on AA-rated and BBB-rated bonds have risen about 90 and 130 basis points respectively. Moreover, yields on speculative-grade securities have increased substantially over the same period, and their spreads have shot up almost 300 basis points. Equity Markets Broad equity indexes logged increases of around 10 percent over the first half of 2007 but then lost ground over the second half; they ended the year with Stock Price Indexes, 2005-08 January 3,2005 * 100 — 130 Wilshire 5OOoM/U /TO — ^T L r HO \ 100 Dow Jones financial index 1 1 1 :>005 120 90 1 2006 2007 2008 NOTE: The data are daily and extend through February21.2OO8. SOURCE: DOW Jones Indexes. Recent Economic and Financial Developments gains of 3 percent to 6 percent. The increase reflected continued strong profitability in many nonfinancial sectors, particularly energy, basic materials, and technology. By contrast, stock indexes for the financial sector fell about 20 percent in 2007 as investors reacted to the fallout from the problems in the subprime mortgage sector. So far in 2008, growing concerns about the economic outlook, along with announcements of additional substantial losses at some large financial firms, have precipitated a widespread drop in equity prices that has pushed broad indexes down about 8 percent. The continued uncertainty surrounding the ultimate size and distribution of losses from subprime-related and other investment products, as well as the potential effects of the financial turmoil on the broader economy, contributed to higher volatility in equity markets and a wider equity premium. The implied volatility of the S&P 500, as calculated from options prices, rose significantly in the second half of 2007 and remains elevated. The ratio of twelve-monthforward expected earnings to equity prices for S&P 500 firms increased over the second half of 2007 and into 2008, while the long-term real Treasury yield decreased. The difference between these two values—a measure of the premium that investors require for holding equity shares—has reached the high end of its range over the past twenty years. Flows into equity mutual funds were heavy early in 2007 but slowed substantially after the first quarter. Indeed, equity funds that focused on domestic holdings experienced consistent net outflows beginning in the spring. By contrast, inflows into foreign equity funds held up through the end of 2007 despite the weakness in many foreign stock markets in the fourth quarter. Both domestic and foreign equity funds experi 37 enced large outflows in January as equity prices tumbled worldwide, but flows appear to have stabilized in February. Debt and Financial Intermediation The total debt of the domestic nonfinancial sectors appears to have expanded about 8 percent in 2007, a slightly slower rate of growth than in 2006. The slowing reflected a deceleration of household debt that was only partially offset by a considerable step-up in borrowing by businesses and governments. Commercial bank credit rose 10% percent last year, a pickup from the 93/4 percent gain in 2006.12 The acceleration of bank credit, as well as the differences in growth rates across bank asset classes, reflect in part the effects of the financial market distress. As already noted, commercial and industrial loans surged in 2007 because of extremely rapid growth in the second half of the year that in part resulted from the inability of banks to syndicate leveraged loans. At various times over the second half of the year, banks' balance sheets were boosted by extensions of credit to nonbank financial institutions, a category that includes loans to ABCP programs that were no longer able to issue commercial paper. Through the third quarter of 2007, the growth of residential mortgages (excluding revolving home equity loans) was fairly robust, but the value of such loans on banks' books contracted in the fourth quarter. The reversal likely stemmed from a 12. The data for commercial bank balance sheets are adjusted for some shifts of assets and liabilities between commercial banks and nonbanks, including those resulting from mergers, acquisitions, changes in charter, and asset purchases and sales. 38 94th Annual Report, 2007 stepped-up pace of securitization of conforming mortgages and a slowing of new originations in response to the weaker demand and the tightening of lending standards reported in the Senior Loan Officer Opinion Surveys covering the second half of 2007. The growth of revolving home equity loans picked up in 2007, particularly late in the year; because rates on such loans are generally tied to short-term market rates, which declined over the second half of 2007, that form of financing may have become relatively more attractive. Bank consumer loans grew somewhat faster in 2007 than in 2006, which is consistent with some substitution of nonmortgage credit for mortgage credit. To fund the rapid expansion of their balance sheets, commercial banks mainly turned to a variety of managed liabilities, including large time deposits and advances from Federal Home Loan Banks. Branches and agencies of foreign banks also tapped their parent institutions for funds. The growth of bank credit slowed in January 2008, as declines in holdings of securities and residential mortgages partly offset continued growth in most other loan categories. Bank profits declined significantly in 2007 as fallout from the subprime mortgage crisis and related financial disruptions caused trading income to plunge and loss provisions to more than double from the previous year. Over the second half of 2007, the return on assets and the return on equity both dropped to levels not seen since the early 1990s. Weak profits or outright losses, along with significant balance sheet growth, also put pressure on capital ratios at some of the largest commercial banks. In response, a number of banking organizations raised significant amounts of new capital in the second half of 2007 and early 2008. Loan delinquency rates rose noticeably for many loan categories, but especially for residential mortgages, construction and land development loans financing residential projects, and other construction and land development loans. Other types of financial institutions also faced substantial challenges in 2007. As a result of exposures to subprime loans, some thrift institutions had significant losses. Several of the major investment banks and their affiliates booked losses on mortgage-related products and other exposures that were large enough to lead some of them to raise additional equity capital. In the third quarter, Fannie Mae and Freddie Mac each experienced sizable losses on their mortgage portfolios and on credit guarantees. In response, both firms raised additional equity. The firms also tightened underwriting standards slightly and increased the fees that they charge to purchase some types of loans. All else equal, these changes would be expected to increase borrower costs for conforming loans. The M2 Monetary Aggregate M2 grew at a solid rate, on balance, in 2007 and the early part of 2008. Growth was supported by declines in the opportunity cost of holding money relative to other financial assets. The considerable growth of money market mutual funds also boosted M2 as investors sought the relative safety of these liquid assets amid the volatility in various financial markets. The currency component of M2 decelerated further in 2007 from its already tepid pace in 2006; it actually contracted from November through January 2008, probably because of reduced demand from foreign sources. Recent Economic and Financial Developments International Developments International Financial Markets Global financial markets were calm over the first half of 2007 except for a brief period in late February when equity markets were roiled in part by worries about U.S. subprime mortgage lenders. After midyear, as the global financial turmoil began in earnest and the possibility of slowing growth weighed on investor sentiment, market volatility rose substantially, and on net most major foreign stock markets fell. Despite the rocky end to the year, most major equity indexes in the advanced foreign economies, with the exception of Japan, finished higher on net in local-currency terms compared with the beginning of 2007. However, indexes of the stock prices of financial firms in those countries declined 10 percent to 30 percent. The financial turbulence had less effect on equity prices in emerging markets, and most major emerging-market stock indexes outperformed their counterparts in the advanced economies. So far in 2008, stock markets in both advanced and emerging-market economies are down further as concerns about global growth have increased. Long-term bond yields in the advanced foreign economies rose over the first half of 2007 but then reversed course as investors reacted to signs in many countries of deteriorating financial conditions, a softening economic outlook, and expectations for a lower future path of monetary policy rates. All told, the net changes were not large; long-term rates in Canada, the United Kingdom, and Japan ended the year 20 to 30 basis points lower, on net, while they were about 10 basis points higher in the euro area than at the start of the year. Yields on inflation-protected longterm securities followed a similar pat 39 tern; inflation compensation (the difference between yields on nominal securities and those on inflationprotected securities) fell modestly in Canada and rose slightly in the euro area. Since the beginning of 2008, yields on nominal securities in most economies have declined; yields on indexed securities have fallen in the euro area but have risen in Canada, the United Kingdom, and Japan. The Federal Reserve's broadest measure of the nominal trade-weighted foreign exchange value of the dollar has declined about 8 percent on net since the beginning of 2007. Over the same period, the major currencies index of the dollar has moved down a bit more than 10 percent. The dollar has depreciated about 9Vi percent against the yen and slightly more than 10 percent versus the euro. The dollar has depreciated roughly U.S. Dollar Nominal Exchange Rate, Broad Index, 2004-08 Week ending January 9,2004 = 100 — 1 I 2(X)4 86 J_ 2005 2006 2007 2008 NOTE: The data, which are in foreign currency units per dollar, are weekly. The last observation for each series is the average for February 18 through February 21, 2008. The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of the most important U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. SOURCE: Federal Reserve Board. 40 94th Annual Report, 2007 13V2 percent against the Canadian dollar and in November briefly touched its lowest level in decades against that currency. The dollar has declined %Vi percent against the Chinese renminbi since the beginning of 2007, and the pace of depreciation accelerated late last year. Advanced Foreign Economies Economic activity in the major advanced foreign economies posted relatively strong growth over the first three quarters of 2007, and labor markets tightened. However, evidence of a slowdown has accumulated since the summer. Financial market strains appear to be weighing on growth in the major economies. Surveys of banks have revealed a tightening of credit standards for both households and businesses. Both consumer and business confidence have slid since August, and readings from surveys of economic activity have declined. Retail sales have slowed, and housing markets in a number of countries that until recently had been robust—including Ireland, Spain, and the United Kingdom—have softened. According to initial releases, real GDP growth for the fourth quarter slowed in a number of countries. Although growth in Japan rebounded in the fourth quarter—pushed up by strong exports and capital spending—household spending has been relatively weak, and the construction sector has been depressed by changes to regulations that have resulted in bottlenecks in reviewing building plans. Headline rates of inflation have continued to rise in some economies, mainly because of increasing food and energy prices. The twelve-month change in consumer prices in the euro area exceeded 3 percent in January, up from less than 2 percent just a few months earlier; core inflation (which excludes the changes in the prices of energy and unprocessed food) has moved up as well. Canadian inflation climbed from less than 1 percent late in 2006 to about 2Vi percent in the second half of 2007; however, core inflation has slowed in recent months, partly because of the continued strength of the Canadian dollar. Although inflation in Japan was close to zero for most of 2007, the rate picked up to roughly 3A percent at the end of the year, again mainly a result of the rise in energy prices. Faced with a weaker outlook for growth but somewhat higher inflation, major foreign central banks either have cut official policy rates or have remained on hold since late 2007—a change from earlier market expectations of further rate increases. The Bank of Canada and the Bank of England lowered their targets for their respective overnight rates. The European Central Bank and the Bank of Japan have kept their policy rates at 4 percent and 0.5 percent respectively. (Further discussion of actions by foreign central banks is in the box entitled "The Federal Reserve's Responses to Financial Strains.") Emerging-Market Economies The growth of output in the emergingmarket economies also slowed in the second half of 2007 but was still strong. In China, government policy measures helped moderate the growth rate of real GDP in the second half. To damp loan growth, the government in 2007 repeatedly raised the reserve requirement ratio and the benchmark rate at which banks can lend to their customers. In addition, the government directed banks to freeze their level of lending over the final two months of 2007 at the October level. Chinese authorities also allowed the renminbi's rate of appreciation to step up in Recent Economic and Financial Developments late 2007, and the People's Bank of China noted in its monetary policy report in November that it would be using the exchange rate as a tool to fight inflation. Elsewhere in emerging Asia, growth appears to have stepped down to a more tempered pace in several countries in the second half of the year, though generally from very strong levels in the first half. One factor suppressing growth in these export-dependent economies appears to be a softening of the rate of activity in the rest of the world. In Mexico, output growth was moderate in 2007 and followed roughly the same pattern as in the United States. The growth of economic activity exceeded 5 percent during the third quarter but slowed to 3 percent in the fourth quarter. In Brazil and other Latin American countries, growth was robust. 41 Increases in the prices of food and fuel contributed to a rise in consumer price inflation in many emerging-market economies. Prices of edible oils and grains were boosted by increased demand, higher energy prices, and unfavorable weather in several producing regions. Meat and dairy prices have also increased as consumption of these products in developing countries has grown rapidly and as the price of animal feed— mostly grain—has risen. Inflation rose during 2007 in many emerging Asian economies, including China, where the inflation rate for the twelve months ending in January reached just over 7 percent. Also, the pace of consumer price inflation rose in the second half of the year in Argentina, Chile, Mexico, and Venezuela. The rise in inflation in Venezuela was compounded by stimulative monetary and fiscal policies. • 43 Part 3 Monetary Policy in 2007 and Early 2008 Throughout the first half of 2007, the available information pointed to a generally favorable economic outlook despite the ongoing correction in the housing market. Indicators of consumer and business spending were somewhat uneven, but their generally positive trajectories suggested that the housing market developments were, as yet, having little effect on the broader economy. Net exports, spurred in part by a falling dollar, were providing support to economic growth. Outside of the subprime mortgage sector, financial conditions in general were fairly accommodative. The Federal Open Market Committee expected core inflation to moderate from the somewhat elevated level that had prevailed at the start of the year, but high resource utilization had the potential to sustain upward pressure on inflation. As a result, during the first half of the year, the Committee consistently noted in its statement that its predominant policy concern was that inflation would fail to moderate as expected. However, in part owing to indications of increasing weakness in the housing sector, the Committee emphasized in the statements issued at the conclusion of its March, May, and June meetings that its future policy actions would depend on the evolution of the outlook for both inflation and economic growth. When the Committee met on August 7, financial markets had been unusually volatile for a few weeks, and credit conditions had become somewhat Selected Interest Rates, 2005-08 Percent Ten-year Treasury rate — 1 2/2 5/3 3/22 8/9 6/30 11/1 9/20 2005 1/31 12/13 8/8 5/10 3/28 6/29 2006 5/9 8/7 10/25 1/31 10/31 1/30 9/20 12/12 3/21 6/28 9/18 12/11 2007 2008 NOTE: The data are daily and extend through February 21, 2008. The ten-year Treasury rate is the constantmaturity yield based on the most actively traded securities. The dates on the horizontal axis are those of regularly scheduled FOMC meetings. SOURCE: Department of the Treasury and the Federal Reserve. 44 94th Annual Report 2007 tighter for some households and businesses. Participants in FOMC meetings (Board members and Reserve Bank presidents) noted that adjustments in the housing sector had the potential to prove deeper and more prolonged than had seemed likely earlier in the year, and a further underperformance in the housing area represented a significant downside risk to the economic outlook. Nonetheless, incoming data indicated that economic growth had strengthened in the second quarter, as a quicker pace of business spending offset a slowdown in consumer outlays. Participants believed that the economy remained likely to expand at a moderate pace in coming quarters, supported in part by continued growth in business investment and a robust global economy. Although core inflation had moved lower since the start of the year, participants were still concerned about several factors—including a continued high level of resource utilization—that could augment inflation pressures. They believed that a sustained moderation in those pressures had yet to be convincingly demonstrated. As a result, the FOMC decided to leave the target for the federal funds rate unchanged at 5VA percent and, despite somewhat greater downside risks to growth, reiterated that the predominant policy concern remained the risk that inflation would fail to moderate as expected. In the days following the August 7 FOMC meeting, financial conditions deteriorated rapidly as market participants became concerned about counterparty credit risk and their access to liquidity. After an FOMC conference call on August 10 to review worsening strains in money and credit markets, the Committee issued a statement indicating that the Federal Reserve would provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the FOMC's target rate of 5lA percent. As conditions deteriorated further, the Committee met again on August 16 by conference call to discuss the potential usefulness of various policy responses. The following day, the Federal Reserve announced changes in discount window policies to facilitate the orderly functioning of short-term credit markets. Furthermore, the FOMC released a statement indicating that the downside risks to growth had increased appreciably and that the Committee was prepared to act as needed to mitigate adverse effects on the economy. (The box entitled "The Federal Reserve's Responses to Financial Strains" provides additional detail on the outcomes of these conference calls and other measures taken by the Federal Reserve to facilitate the orderly functioning of financial markets over the second half of the year, including coordinated actions with other central banks.) At the time of the September FOMC meeting, financial markets remained volatile. Liquidity in short-term funding markets was significantly impaired amid heightened investor unease about exposures to subprime mortgages and to structured credit products more broadly. Credit generally remained available for most businesses and households, but the Committee noted that the tighter credit conditions for other borrowers had the potential to restrain economic growth. Incoming economic data were mixed: Consumer spending appeared to have strengthened from its subdued secondquarter pace, but a further intensification of the housing contraction and slowing employment growth suggested a weaker economic outlook. Participants noted that incoming data on core inflation continued to be favorable and that the downwardly revised economic outlook implied some lessening of pressures on resources, but they remained Monetary Policy in 2007 and Early 2008 concerned about possible upside risks to inflation. To forestall some of the adverse macroeconomic effects that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time, the FOMC lowered the target for the federal funds rate 50 basis points, to 43A percent. The Committee also noted that recent developments had increased the uncertainty surrounding the economic outlook and stated that it would act as needed to foster price stability and sustainable economic growth. At the time of the October FOMC meeting, the data indicated that economic growth had been solid in the third quarter. A pickup in consumer spending and continued expansion of business investment suggested that spillovers from the turmoil in the housing and financial markets had been limited to that point. Although strains in financial markets had eased somewhat on balance, tighter credit conditions were thought likely to slow the pace of economic expansion over coming quarters. Furthermore, the downturn in residential construction had deepened, and available indicators pointed to a further slowing in housing activity in the near term. FOMC meeting participants noted that readings on core inflation had improved somewhat over the year and anticipated that some of the moderation likely would be sustained. Nonetheless, participants expressed concern about the upside risks to the outlook for inflation, stemming in part from the effects of recent increases in commodity prices and the significant decline in the foreign exchange value of the dollar. Against that backdrop, the Committee decided to lower the target for the federal funds rate 25 basis points, to 4J/2 percent, and judged that the upside risks to inflation roughly balanced the downside risks to growth. 45 Also at the October meeting, the Committee continued its discussions regarding communication with the public. Participants reached a consensus on increasing the frequency and expanding the content of their periodic economic projections. Under the new procedure, which was announced on November 14, the FOMC compiles and releases the projections made by the Federal Reserve Governors and Reserve Bank presidents four times each year, at approximately quarterly intervals, rather than twice each year, as had been the practice since 1979. In addition, the projection horizon has been extended from two years to three years. FOMC meeting participants provide projections for the increase in the price index for total personal consumption expenditures (PCE) as well as projections for real GDP growth, the unemployment rate, and core PCE price inflation. Summaries of the projections and an accompanying narrative are published along with the minutes of the FOMC meeting at which they were discussed. Beginning with the present report, the projections made in January are included in the February Monetary Policy Report to the Congress, and the projections made in June are included in the July report. In a conference call on December 6, Board members and Reserve Bank presidents reviewed conditions in domestic and foreign financial markets and discussed two proposals aimed at improving market functioning. The first proposal was for the establishment of a temporary Term Auction Facility (TAF), which would provide term funding through an auction mechanism to eligible depository institutions against a broader range of collateral than that used for open market operations. The second proposal was to set up a foreign exchange swap arrangement with the European Central Bank to address elevated 46 94th Annual Report, 2007 pressures in short-term dollar funding markets. At the conclusion of the discussion, the Committee voted to direct the Federal Reserve Bank of New York to establish and maintain a reciprocal currency (swap) arrangement for the System Open Market Account with the European Central Bank.1 The Board of Governors approved the TAF via notation vote on December 10. At the Committee's meeting on December 11, participants noted that incoming information suggested economic activity had decelerated significantly in the fourth quarter. The housing contraction had steepened further, and participants agreed that the sector was weaker than had been expected at the time of the Committee's previous meeting. Moreover, spillovers from housing to other parts of the economy had begun to emerge: Consumption spending appeared to be softening more than had been anticipated, and employment gains appeared to be slowing. Participants noted that evidence of further deterioration in the credit quality of mortgages and other loans to households appeared to be spurring lenders to further tighten the terms on new extensions of credit for a widening range of credit products. Financial market conditions had worsened significantly. The financial strains were exacerbated by concerns related to year-end pressures in short-term funding markets, and similar stresses were evident in the financial markets of major foreign economies. Although a surge in energy prices pushed up headline consumer price inflation during September and October, Committee members agreed that the inflation situation had changed little from the time of the previous meeting. In these circumstances, the 1. A swap arrangement with the Swiss National Bank was approved by the Committee on December 11. FOMC lowered the target for the federal funds rate a further 25 basis points, to 4V4 percent, and, given the heightened uncertainty, the Committee decided to refrain from providing an explicit assessment of the balance of risks. The Committee also indicated that it would continue to assess the effects of financial and other developments on economic prospects and act as needed to foster price stability and sustainable economic growth. In addition to that policy move, the Federal Reserve and several other central banks announced on December 12 the measures they were taking to address elevated pressures in short-term funding markets. The Federal Reserve announced the creation of the TAF and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank. In a conference call on January 9, the Committee reviewed recent economic data and financial market developments. The information, which included weaker-than-expected data on home sales and employment for December, as well as a sharp decline in equity prices since the beginning of the year, suggested that the downside risks to growth had increased significantly since the time of the December FOMC meeting. Moreover, participants cited concerns that the slowing of economic growth could lead to a further tightening of financial conditions, which in turn could reinforce the economic slowdown. However, participants noted that core inflation had edged up in recent months and believed that considerable uncertainty surrounded the inflation outlook. Participants were generally of the view that substantial additional policy easing might well be necessary to support economic activity and reduce the downside risks to growth, and they discussed the possible timing of such actions. Monetary Policy in 2007 and Early 2008 On January 21, the Committee held another conference call. Participants in the call noted that strains in some financial markets had intensified and that incoming evidence had reinforced their view that the outlook for economic activity was weak. Participants observed that investors apparently were becoming increasingly concerned about the economic outlook and that these developments could lead to an excessive pullback in credit availability. Against that background, members judged that a substantial easing in policy was appropriate to foster moderate economic growth and reduce the downside risks to economic activity. The Committee decided to lower the target for the federal funds rate 75 basis points, to 3V2 percent, and stated that appreciable downside risks to growth remained. Although inflation was expected to edge lower over the course of 2008, participants underscored that this assessment was conditioned upon inflation expectations remaining well anchored and stressed that the inflation situation should continue to be monitored carefully. The data reviewed at the regularly scheduled FOMC meeting on January 29 and 30 confirmed a sharp deceleration in economic growth during the fourth quarter of 2007 and continued tightening of financial conditions. With the contraction in the housing sector in- 47 tensifying and a range of financial markets remaining under pressure, participants generally expected economic growth to remain weak in the first half of 2008 before picking up strength in the second half. However, the continuing weakness in home sales and house prices, as well as the tightening of credit conditions for households and businesses, were seen as posing downside risks to the near-term outlook for economic growth. Moreover, many participants cited risks regarding the potential for adverse feedback between the financial markets and the economy. Participants expressed some concern about the disappointing inflation data received over the latter part of 2007. Although many expected that a leveling out of prices for energy and other commodities, such as that embedded in futures markets, and a period of below-trend growth would contribute to some moderation in inflation pressures over time, the Committee believed that it remained necessary to monitor inflation developments carefully. Against that backdrop, the FOMC decided to lower the target for the federal funds rate 50 basis points, to 3 percent. The Committee believed that the policy action, combined with those taken earlier, would help promote moderate growth over time and mitigate the risks to economic activity. However, members judged that downside risks to growth remained. • 49 Part 4 Summary of Economic Projections The following material appeared as an addendum to the minutes of the January 29-30, 2008, meeting of the Federal Open Market Committee. In conjunction with the January 2008 FOMC meeting, the members of the Board of Governors and the presidents of the Federal Reserve Banks, all of whom participate in the deliberations of the FOMC, provided projections for economic growth, unemployment, and inflation in 2008, 2009, and 2010. Projections were based on information available through the conclusion of the January meeting, on each participant's assumptions regarding a range of factors likely to affect economic outcomes, and on his or her assessment of appropriate monetary policy. "Appropriate monetary policy" is defined as the future policy that, based on current information, is deemed most likely to foster outcomes for economic activity and inflation that best satisfy the participant's interpretation of the Federal Reserve's dual objectives of maximum employment and price stability. The projections, which are summarized in table 1 and chart 1, suggest that FOMC participants expected that output would grow at a pace appreciably below its trend rate in 2008, owing primarily to a deepening of the housing contraction and a tightening in the availability of household and business credit, and that the unemployment rate would increase somewhat. Given the substantial reductions in the target federal funds rate through the January FOMC meeting as well as the assumption of appropriate policy going forward, output growth fur ther ahead was projected to pick up to a pace around or a bit above its long-run trend by 2010. Inflation was expected to decline in 2008 and 2009 from its recent elevated levels as energy prices leveled out and economic slack contained cost and price increases. Most participants judged that considerable uncertainty surrounded their projections for output growth and viewed the risks to their forecasts as weighted to the downside. A majority of participants viewed the risks to the inflation outlook as broadly balanced, but a number of participants saw the risks to inflation as skewed to the upside. The Outlook The central tendency of participants' projections for real GDP growth in 2008, at 1.3 to 2.0 percent, was considerably lower than the central tendency of the projections provided in conjunction with the October FOMC meeting, which was 1.8 to 2.5 percent. These downward revisions to the 2008 outlook stemmed from a number of factors, including a further intensification of the housing market correction, tighter credit conditions amid increased concerns about credit quality and ongoing turmoil in financial markets, and higher oil prices. However, some participants noted that a fiscal stimulus package would likely provide a temporary boost to domestic demand in the second half of this year. Beyond 2008, a number of factors were projected to buoy economic growth, including a gradual turnaround in housing markets, lower interest rates associated with the substantial easing of 50 94th Annual Report, 2007 1. Economic Projections of Federal Reserve Governors and Reserve Bank Presidents (Percent) 2008 2009 2010 Central Tendency1 Growth of real GDP October projections Unemployment rate October projections PCE inflation October projections Core PCE inflation October projections 1.3 to 2.0 1.8 to 2.5 5.2 to 5.3 4.8 to 4.9 2.1 to 2.4 1.8 to 2.1 2.0 to 2.2 1.7 to 1.9 2.1 to 2.7 2.3 to 2.7 5.0 to 5.3 4.8 to 4.9 1.7 to 2.0 1.7 to 2.0 1.7 to 2.0 1.7 to 1.9 2.5 to 3.0 2.5 to 2.6 4.9 to 5.1 4.7 to 4.9 1.7 to 2.0 1.6 to 1.9 1.7 to 1.9 1.6 to 1.9 Range2 Growth of real GDP October projections Unemployment rate October projections PCE inflation October projections Core PCE inflation October projections 1.0 to 1.6 to 5.0 to 4.6 to 2.0 to 1.7 to 1.9 to 1.7 to 1.8 to 3.2 2.0 to 2.8 4.9 to 5.7 4.6 to 5.0 1.7 to 2.3 1.5 to 2.2 1.7 to 2.2 1.5 to 2.0 2.2 to 3.2 2.2 to 2.7 4.7 to 5.4 4.6 to 5.0 1.5 to 2.0 1.5 to 2.0 1.4 to 2.0 1.5 to 2.0 2.2 2.6 5.5 5.0 2.8 2.3 2.3 2.0 NOTE: Projections of the growth of real GDP, of PCE inflation, and of core PCE inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures and the price index for personal consumption expenditures excluding food and energy. Projections for the unemployment rate are for the average civilian unem- ployment rate in the fourth quarter of the year indicated. Each participant's projections are based on his or her assessment of appropriate monetary policy. 1. The central tendency excludes the three highest and three lowest projections for each variable in each year. 2. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. monetary policy to date and appropriate adjustments to policy going forward, and an anticipated reduction in financial market strains. Real GDP was expected to accelerate somewhat in 2009 and by 2010 to expand at or a little above participants' estimates of the rate of trend growth. With output growth running below trend over the next year or so, most participants expected that the unemployment rate would edge higher. The central tendency of participants' projections for the average rate of unemployment in the fourth quarter of 2008 was 5.2 to 5.3 percent, above the 4.8 to 4.9 percent unemployment rate forecasted in October and broadly suggestive of some slack in labor markets. The unemployment rate was generally expected to change relatively little in 2009 and then to edge lower in 2010 as output growth picks up, although in both years the unemployment rate was projected to be a little higher than had been anticipated in October. The higher-than-expected rates of overall and core inflation since October, which were driven in part by the steep run-up in oil prices, had caused participants to revise up somewhat their projections for inflation in the near term. The central tendency of participants' projections for core PCE inflation in 2008 was 2.0 to 2.2 percent, up from the 1.7 to 1.9 percent central tendency in October. However, core inflation was expected to moderate over the next two years, reflecting muted pressures on resources and fairly well-anchored inflation expectations. Overall PCE inflation was projected to decline from its current Summary of Economic Projections 51 Chart 1: Central Tendencies and Ranges of Economic Projections Real GDP growth — 6 — 5 — 4 Central tendency of projections — Range of projections I — — 2 — 1 _| * Unemployment rate — 7 — 6 t — 5 — 4 2003 2004 2005 2006 PCE inflation — 4 — 3 ! — 2 — 1 2003 2004 2005 2006 Core PCE inflation — 3 — 2 — 1 _l 2003 2004 2005 Note: See notes to table 1 for variable definitions. 2006 52 94th Annual Report, 2007 elevated rate over the coming year, largely reflecting the assumption that energy and food prices would flatten out. Thereafter, overall PCE inflation was projected to move largely in step with core PCE inflation. Participants' projections for 2010 were importantly influenced by their judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate to promote maximum employment and price stability and about the time frame over which policy should aim to attain those rates given current economic conditions. Many participants judged that, given the recent adverse shocks to both aggregate demand and inflation, policy would be able to foster only a gradual return of key macroeconomic variables to their longer-run sustainable or optimal levels. Consequently, the rate of unemployment was projected by some participants to remain slightly above its longer-run sustainable level even in 2010, and inflation was judged likely still to be a bit above levels that some participants judged would be consistent with the Federal Reserve's dual mandate. Risks to the Outlook Most participants viewed the risks to their GDP projections as weighted to the downside and the associated risks to their projections of unemployment as tilted to the upside. The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment. In addition, despite some recovery in money markets after the turn of the year, financial market conditions continued to be strained—stock prices had declined sharply since the December meeting, concerns about further po tential losses at major financial institutions had mounted amid worries about the condition of financial guarantors, and credit conditions had tightened in general for both households and firms. The potential for adverse interactions, in which weaker economic activity could lead to a worsening of financial conditions and a reduced availability of credit, which in turn could further damp economic growth, was viewed as an especially worrisome possibility. Regarding risks to the inflation outlook, several participants pointed to the possibility that real activity could rebound less vigorously than projected, leading to more downward pressure on costs and prices than anticipated. However, participants also saw a number of upside risks to inflation. In particular, the pass-through of recent increases in energy and commodity prices as well as of past dollar depreciation to consumer prices could be greater than expected. In addition, participants recognized a risk that inflation expectations could become less firmly anchored if the current elevated rates of inflation persisted for longer than anticipated or if the recent substantial easing in monetary policy was misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation. On balance, a larger number of participants than in October viewed the risks to their inflation forecasts as broadly balanced, although several participants continued to indicate that their inflation projections were skewed to the upside. The ongoing financial market turbulence and tightening of credit conditions had increased participants' uncertainty about the outlook for economic activity. Most participants judged that the uncertainty attending their January projections for real GDP growth and for the unemployment rate was above typical levels seen in the past. (Table 2 provides Summary of Economic Projections 2. Average Historical Projection Error Ranges (Percentage Points) 53 The dispersion of participants' projections for real GDP growth was markedly wider than in the forecasts submitted in 2008 2009 2010 October, which in turn were consider±1.2 ±1.4 ±1.4 Real GDP1 ably more diverse than those submitted ±0.5 ±0.8 ±1.0 Unemployment rate2 . Total consumer prices3 ±1.0 ±1.0 ±0.9 in conjunction with the June FOMC meeting and included in the Board's NOTE: Error ranges shown are measured as plus or Monetary Policy Report to the Congress minus the root mean squared error of projections that were released in the winter from 1986 through 2006 for in July. Mirroring the increase in diverthe current and following two years by various private sity of views on real GDP growth, the and government forecasters. As described in the box dispersion of participants' projections "Forecast Uncertainty," under certain assumptions, there is about a 70 percent probability that actual outcomes for for the rate of unemployment also widreal GDP, unemployment, and consumer prices will be in ened notably, particularly for 2009 and ranges implied by the average size of projection errors 2010. The dispersion of projections for made in the past. Further information is in David Reifschneider and Peter Tulip (2007), "Gauging the Unceroutput and employment seemed largely tainty of the Economic Outlook from Historical Forecastto reflect differing assessments of the ing Errors," Finance and Economics Discussion Series #2007-60 (November). effect of financial market conditions on 1. Projection is percent change, fourth quarter of the real activity, the speed with which credit previous year to fourth quarter of the year indicated. conditions might improve, and the depth 2. Projection is the fourth quarter average of the civilian unemployment rate (percent). and duration of the housing market con3. Measure is the overall consumer price index, the traction. The dispersion of participants' price measure that has been most widely used in governlonger-term projections was also afment and private economic forecasts. Projection is percent change, fourth quarter of the previous year to the fected to some degree by differences in fourth quarter of the year indicated. The slightly narrower their judgments about the economy's estimated width of the confidence interval for inflation in trend growth rate and the unemployment the third year compared with those for the second and first years is likely the result of using a limited sample rate that would be consistent over time period for computing these statistics. with maximum employment. Views also differed about the pace at which output an estimate of average ranges of forecast uncertainty for GDP growth, unem- and employment would recover toward ployment, and inflation over the past those levels over the forecast horizon twenty years.1) In contrast, the uncer- and beyond, given appropriate monetary tainty attached to participants' inflation policy. The dispersion of the projections projections was generally viewed as be- for PCE inflation in the near term partly ing broadly in line with past experience, reflected different views on the extent to although several participants judged that which recent increases in energy and the degree of uncertainty about inflation other commodity prices would pass through into higher consumer prices and was higher than normal. on the influence that inflation expectations would exert on inflation over the Diversity of Participants' Views short and medium run. Participants' inCharts 2(a) and 2(b) provide more detail flation projections further out were inon the diversity of participants' views. fluenced by their views of the rate of inflation consistent with the Federal Reserve's dual objectives and the time it 1. The box "Forecast Uncertainty" at the end of this summary discusses the sources and interpretawould take to achieve these goals given tion of uncertainty in economic forecasts and excurrent economic conditions and approplains the approach used to assess the uncertainty priate policy. and risks attending participants' projections. 54 94th Annual Report, 2007 Chart 2(a): Distribution of Participants' Projections (Percent) Unemployment rate Real GDP Number of participants Number of participants 2008 2008 January projections October projections — 14 — - - 12 - - 10 - - - 8 — 6 - 4 January projections — October projections - - — — !~~l 1r L i I I I I I I L, I - 1 I 1 1 10 8 1 - 1 - 6 1 -' I 1 1 12 - i | 1 14 - 1 2 1 - 1 "1 1 1 1 - 4 - 2 1 4.84.9 4.64.7 1 1 5.05.1 1 5.25.3 2009 1 5.6 5.7 Number of participants Number of participai ts _ 1 5.4 5.5 _ - - - 12 - - 10 6 I I I I I I I i i i 1 i 1 4 1 -i h r 2 1 r- 10 1 1 8 6 4 2 liilisl i Ilillll-; 1 1 1 1 1 1 1 4.8 5.0 5.2 - 5.4 4.65.6 4.9 5.1 5.3 4.7 5.5 5.7 1 3.3 itlti! Ninnber of participants 2010 12 - • 14 - 1 1 1 1 1 16 - 8 - 1 1 14 1 - 2009 1 16 - 1 1 _ Number of participants _ 16 _ 2010 - 16 - - 14 - - 14 - - 12 12 10 _ - — - 10 n - i 8 - L 6 - | - I - 4 1 I I I I I I ri i ill i i|l; | 1 1 1 1 1 1 2 i - — T- - ' i ^ 1 | 1 4.8 4.9 5.05.1 1 5.25.3 1 5.45.5 4 — : 1 6 — Sit. 1 4.6 4.7 8 - I 2 1 5.65.7 Summary of Economic Projections 55 Chart 2(b): Distribution of Participants' Projections (Percent) Core PCE inflation PCE inflation Number of participants Nun her of participants 2008 2008 ;:: January projections October projections 14 - 12 - _ January projections October projections — 8 — 10 1 1 1 - 2 - ,.:„: •,:,:, 1 1 1 1.71.8 1.92.0 2.12.2 2.32.4 2.5 2.6 2.7 2.8 1 1.31.4 1 1.51.6 1.71.8 2009 - - 4 _ 2 1 2.12.2 1 2.32.4 Number of participants Number of participants _ 6 0 1 1.92.0 8 — .: m 111 1 10 - | | 0 1 1.51.6 4 - - 1 — 12 - 6 " 1 14 - - 1 - _ 2009 - 16 14 - - 14 - 12 - - 12 - 10 - - 10 - 8 — 4 - - 8 1I 1 |l | iili 1 1 1 16 6 4 1 - r 2 1 ^ 1 0 1 1 1.51.6 1 1.71.8 1 1.92.0 1 1 2.12.2 2.32.4 2.5 2.6 1 1 2.7 2.8 i 1.31.4 Number of participants 2010 - 14 - 12 - 10 - 8 - 6 - 4 -I » 1.71.8 1.92.0 2.1 2.2 2.3- 2.5- 2.4 2.6 2.72.8 - 2 i 1.51.6 1.71.8 1.92.0 2.12.2 2.32.4 Number of participants 16 - 1.51.6 I|9H| 2010 56 94th Annual Report, 2007 Forecast Uncertainty The economic projections provided by the members of the Board of Governors and the presidents of the Federal Reserve Banks help shape monetary policy and can aid public understanding of the basis for policy actions. Considerable uncertainty attends these projections, however. The economic and statistical models and relationships used to help produce economic forecasts are necessarily imperfect descriptions of the real world. And the future path of the economy can be affected by myriad unforeseen developments and events. Thus, in setting the stance of monetary policy, participants consider not only what appears to be the most likely economic outcome as embodied in their projections, but also the range of alternative possibilities, the likelihood of their occurring, and the potential costs to the economy should they occur. Table 2 summarizes the average historical accuracy of a range of forecasts, including those reported in past Monetary Policy Reports and those prepared by Federal Reserve Board staff in advance of meetings of the Federal Open Market Committee. The projection error ranges shown in the table illustrate the considerable uncertainty associated with economic forecasts. For example, suppose a participant projects that real GDP and total consumer prices will rise steadily at annual rates of, respectively, 3 percent and 2 percent. If the uncertainty attending those projections is similar to that experienced in the past and the risks around the projections are broadly balanced, the numbers reported in table 2 might imply a probability of about 70 percent that actual GDP would expand between 1.8 percent to 4.2 percent in the current year, and 1.6 percent to 4.4 percent in the second and third years. The corresponding 70 percent confidence intervals for overall inflation would be 1 percent to 3 percent in the current and second years, and 1.1 percent to 2.9 percent in the third year. Because current conditions may differ from those that prevailed on average over history, participants provide judgments as to whether the uncertainty attached to their projections of each variable is greater than, smaller than, or broadly similar to typical levels of forecast uncertainty in the past as shown in table 2. Participants also provide judgments as to whether the risks to their projections are weighted to the upside, downside, or are broadly balanced. That is, participants judge whether each variable is more likely to be above or below their projections of the most likely outcome. These judgments about the uncertainty and the risks attending each participant's projections are distinct from the diversity of participants' views about the most likely outcomes. Forecast uncertainty is concerned with the risks associated with a particular projection, rather than with divergences across a number of different projections. 57 Monetary Policy Report of July 2007 homes; personal consumption expenditures (PCE) also slowed. Even so, the available data point to solid gains overThe U.S. economy generally performed all in other components of final sales, well in the first half of 2007. Activity and with manufacturing inventory imcontinued to increase moderately, on av- balances significantly reduced, growth erage, over the period; businesses added in real GDP apparently sped up. jobs at a steady pace; and the unemployJob growth in the first half of 2007 ment rate remained at 4Vi percent. Overwas driven by sizable increases in all inflation, however, picked up as a service-producing industries. In the result of sizable increases in energy and goods-producing sector, manufacturing food prices. At the same time, core inemployment contracted, especially at flation (which excludes the direct effects firms closely tied to the construction inof movements in energy and food dustry and at producers of motor veprices) held at about the same rate as in hicles and parts. Employment in resi2006; this measure smoothes through dential construction, which had turned some of the volatility in the highdown in mid-2006, decreased only modfrequency data and thus is generally a estly further over the first half of 2007 better gauge of underlying inflation despite the substantial decline in hometrends. building. Although real gross domestic product Real hourly compensation increased appears to have expanded at about the over the year ending in the first quarter, same average rate thus far this year as it the most recent period for which comdid in the second half of 2006, the pace plete data are available. In the second of expansion has been uneven. In the quarter, however, gains in real compenfirst quarter, consumer expenditures and sation were probably curtailed by a business fixed investment, taken to- steep, energy-driven rise in consumer gether, posted a solid gain. However, prices. Employment continued to rise homebuilding continued to contract, and apace in the first half of 2007 in the manufacturing firms adjusted produc- face of moderate growth in output. As a tion to address stock imbalances in that consequence, growth in labor prosector that had emerged over the course ductivity—which had slowed in 2006 of 2006. In the second quarter, housing from the rapid rate observed earlier in activity declined further in response to the decade—appears to have remained the continued softness in home sales and modest. The cooling of productivity still-elevated inventories of unsold new growth in recent quarters likely reflects cyclical or other temporary factors, but the underlying pace of productivity NOTE: The discussion in this chapter consists of gains may also have slowed somewhat. the text and tables from the Monetary Policy ReFinancial market conditions have conport submitted to the Congress on July 18, 2007; tinued to be generally supportive of ecothe charts from that report (as well as earlier renomic expansion thus far in 2007, ports) are available on the Board's web site, at www.federalreserve.gov/boarddocs/hh. though there was a notable repricing in Monetary Policy and the Economic Outlook 58 94th Annual Report, 2007 the subprime-mortgage sector. In recent weeks, the deterioration in that sector has been particularly marked, and markets for lower-quality corporate credits have also experienced some strains. Nonetheless, spreads on such corporate credits have remained narrow on the whole, and business borrowing has continued to be fairly brisk. On balance, equity markets posted sizable gains through mid-July, in part because of continued robust corporate profits and an upward revision to investors' outlook for the economy. The improved outlook led market participants to mark up their anticipated path for the federal funds rate, and intermediate- and long-term interest rates rose significantly. The foreign exchange value of the dollar has declined moderately this year as the pace of economic activity abroad has strengthened. Overall consumer price inflation, as measured by the PCE price index, picked up noticeably in the first half of 2007, largely because of a sharp increase in energy prices. After moving down over the second half of 2006, the prices households pay for energy subsequently turned up and by May were 14 percent (not at an annual rate) above their level at the end of last year. Food prices also contributed to the step-up in overall inflation this year. The faster rate of increase in overall prices has had only a modest effect on inflation expectations: Surveys suggest that near-term inflation expectations have risen somewhat in recent months, but measures of long-term inflation expectations have remained within the range of recent years. The rate of increase in the core PCE price index ticked down from 2.1 percent over the twelve months of 2006 to an annual rate of 2.0 percent over the first five months of 2007, primarily accounted for by more-favorable readings between March and May. Although higher energy prices this year added to the cost of producing a wide variety of goods and services that are included in the core index, these effects were offset by other factors—most notably, a slowdown in the rate of increase in shelter costs from the very high rates seen in 2006. The U.S. economy seems likely to continue to expand at a moderate pace in the second half of 2007 and in 2008. The current contraction in residential construction will likely restrain overall activity for a while longer, but as stocks of unsold new homes are brought down to more comfortable levels, that restraint should begin to abate. In addition, the inventory correction that damped activity in the manufacturing sector around the turn of the year appears largely to have run its course. Thus, stock adjustment is unlikely to be a drag on production in coming quarters. Consumer spending should also keep moving up. Employment and real wages are on track to rise further, and, although the difficulties in the subprime-mortgage market have created severe financial problems for some individuals and families, the household sector is in good financial shape overall. Businesses are also continuing to enjoy favorable financial conditions, which, along with a further expansion in business output, should support moderate increases in business investment. The positive outlook for economic activity abroad bodes well for U.S. exports. Core inflation is expected to moderate a bit further over the next year and a half. Longer-run inflation expectations are contained, pressures on resource utilization should ease slightly in an environment of economic expansion at or just below the rate of increase in the nation's potential to produce, and some of the other factors that boosted inflation in recent years have already receded Monetary Policy Report of July 2007 or seem likely to do so. As noted, increases in shelter costs, which helped push up core inflation in 2006, have slowed appreciably this year. In addition, the paths for the prices of energy and other commodities embedded in futures markets suggest that the impetus to core inflation from these influences should diminish. And although unit labor costs in the nonfarm business sector have been rising, the average markup of prices over unit labor costs is still high by historical standards, an indication that firms could potentially absorb higher costs, at least for a time, through a narrowing of profit margins. Nonetheless, the possibility that the expected moderation in inflation will fail to materialize remains the predominant risk to the economic outlook. The more-favorable readings on core inflation in recent months partly reflect some factors that seem likely to prove transitory. Moreover, the economy appears to be operating at a high level of resource utilization, which has the potential to sustain inflation pressures. In addition, an upward impetus to costs could emanate from other sources, including higher prices for energy and other commodities or a slower rate of increase in structural productivity. Another concern is that high rates of headline inflation, if prolonged, could cause longer-run inflation expectations to rise and could thus become another factor sustaining inflation pressures. Significant risks also attend the outlook for real economic activity. On the downside, the fall in housing construction could intensify or last longer than expected. In addition, persistent weakness in the housing sector could spill over to other sectors, especially consumption. But upside risks also exist. For example, consumer spending appears to be rising less rapidly of late after a period of large increases that 59 pushed the personal saving rate into negative territory; increases in consumption could return to their earlier pace. Exports could also boost aggregate demand more than anticipated, especially if economic conditions abroad continue to exceed expectations. The Conduct of Monetary Policy over the First Half of 2007 The Federal Open Market Committee (FOMC) left the stance of monetary policy unchanged over the first half of 2007. At the time of the January meeting, available economic information pointed to a relatively favorable outlook for both economic growth and inflation. While manufacturing activity had softened, the housing sector had shown tentative signs of stabilizing, and consumer spending remained strong. Readings on core inflation had improved some from the elevated levels reached in 2006, and inflation expectations continued to be stable. Nevertheless, the prevailing level of inflation was uncomfortably high, and elevated resource utilization had the potential to sustain inflation pressures. Against this backdrop, the Committee decided to leave its target for the federal funds rate unchanged at 5lA percent and reiterated in its policy statement that some inflation risks remained. The Committee also explained that the extent and timing of any additional firming would depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information. When the Committee met in March, data suggested that the ongoing weakness in the housing market had not spilled over to consumption spending, and the strains in the subprime-mortgage market did not appear to be affecting the availability of other types of household or business credit. Although investment 60 94th Annual Report, 2007 spending had been soft, it was expected to pick up, primarily because of strong corporate balance sheets, continued high profitability, and generally favorable financial conditions. Nevertheless, sluggish business spending and the deterioration in the subprime-mortgage market suggested that downside risks to growth had increased. At the same time, readings on core inflation had stayed somewhat elevated, and increases in the prices of energy and non-energy commodities had boosted the risk that the expected deceleration in inflation would fail to occur. The FOMC decided to leave its target for the federal funds rate unchanged at 5lA percent and noted in the accompanying statement that its predominant policy concern remained the risk that inflation would fail to moderate as expected. In light of the increased uncertainty about the outlook for both inflation and growth, the statement indicated that future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information—a characterization that has been repeated in the two postmeeting FOMC statements since then. In May, the data in hand indicated that the adjustment in the housing sector was continuing and appeared likely to persist for longer than previously anticipated. Moreover, growth in consumer spending seemed to have slowed in the early spring. Nonetheless, because the problems in the subprime-mortgage market apparently were contained and business spending indicators suggested improving prospects for investment, the economy seemed likely to expand at a moderate pace over coming quarters. Despite more-favorable readings for March, core inflation remained somewhat elevated from a longer perspective. Inflation pressures were expected to moderate over time, but the high level of resource utilization had the potential to sustain those pressures. As a result, the FOMC decided to leave its target for the federal funds rate unchanged at 5lA percent and repeated in the statement that its predominant policy concern remained the risk that inflation would fail to moderate as expected. At the June meeting, data appeared to confirm that economic growth had strengthened in the second quarter of 2007 despite the ongoing adjustment in the housing sector. Business spending on capital equipment, which had faltered around the turn of the year, firmed somewhat in the spring, and nonresidential construction advanced briskly. In addition, the inventory correction that had held down economic activity late last year and early this year seemed to have mostly run its course. Moreover, defense spending and net exports appeared poised to rebound after sagging in the first quarter. These factors more than offset a slowdown in the growth of consumer spending. Readings on core inflation remained favorable in April and May. Nonetheless, a sustained moderation of inflation pressures had yet to be convincingly demonstrated, and the high level of resource utilization had the potential to sustain those pressures. Under these circumstances, the Committee decided to leave its target for the federal funds rate unchanged at 5lA percent. In its policy statement, the Committee repeated that its predominant policy concern remained the risk that inflation would fail to moderate as expected. At their meetings over the first half of 2007, FOMC meeting participants continued the discussions they had formally initiated last year regarding their communications with the public. The discussions included a review of the role of the economic projections that are made twice a year by the members of the Board of Governors and the Reserve Monetary Policy Report of July 2007 Bank presidents and which are included in the Board's Monetary Policy Report to the Congress. In addition, participants exchanged views on the possible advantages and disadvantages of specifying a numerical price objective for monetary policy. They also discussed the appropriate role of meeting minutes and policy statements. These discussions remain ongoing, as participants continue to evaluate the best available means for improving communication with the public in furtherance of the Committee's dual mandate for both maximum employment and stable prices. Economic Projections for 2007 and 2008 In conjunction with the FOMC meeting at the end of June, the members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, provided economic projections for 2007 and 2008 for this report. The central tendency of the FOMC participants' forecasts for the increase in real GDP is 2VA percent to 2Vz percent over the four quarters of 2007 and 2T/2 percent to 23/4 percent in 2008. The civilian unemployment rate is expected to lie between 4Vi percent and 43A percent in the fourth quarter of 2007 and to be at about the top of that range in 2008. As for inflation, FOMC participants expect that the increase in the price index for personal consumption expenditures excluding food and energy (core PCE inflation) will total 2 percent to 2V4 percent over the four quarters of 2007 and will drift down to l3/4 percent to 2 percent in 2008. Economic activity appears poised to expand at a moderate rate in the second half of 2007, and it should strengthen gradually into 2008. The ongoing correction in the housing market seems 61 Economic Projections for 2007 and 2008 Percent Indicator Federal Reserve Governors and Reserve Bank presidents Central tendency Range 2007 Change, fourth quarter to fourth quarter1 Nominal GDP Real GDP PCE price index excluding food and energy Average level, fourth quarter Civilian unemployment rate 41/2-51/2 2-2VA 4V2-5 21/4-21/2 2-21/4 2-2»/ 4 41/2-43/4 4i/2-43/4 2008 Change, fourth quarter to fourth quarter1 Nominal GDP Real GDP PCE price index excluding food and energy Average level, fourth quarter Civilian unemployment rate 41/2-51/2 2V2-3 4 3 /4-5 2V2-23/4 VA-2 P/4-2 4Vi-5 About 43A 1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated. likely to continue to weigh on the rate of economic expansion over the near term. But as that process runs its course, the rate of growth of economic activity should move up somewhat. The pace of consumer spending may be restrained in the near term as households continue to adjust to the latest run-up in energy prices and to softer house prices; still, household balance sheets are generally in good shape, and increases in employment and real wages over the next year and a half should be sufficient to sustain further gains in spending. Regarding business investment, solid gains in real outlays on equipment and software seem likely in light of the anticipated expansion in business output, continuing 62 94th Annual Report, 2007 strong profits, and generally favorable financial conditions. Opportunities to realize significant gains in efficiency by investing in high-tech equipment should provide ongoing support to equipment spending as well. Investment in nonresidential buildings also seems to be expanding briskly. In addition, prospects are favorable for continued increases in demand for exports of U.S. goods and services. FOMC participants generally expect core inflation to edge down a bit further over the next year and a half. In assessing the apparent slowing of core inflation this spring, participants recognized that the monthly price data are volatile and that some of the recent improvement may prove to have been transitory. Nonetheless, they believe that the current environment will be conducive to some further moderation in underlying price pressures. The participants' forecasts for real activity imply a slight easing over the next several quarters of the tightness in labor and product markets. And although core inflation is expected to remain under some upward pressure in the near term from the pass-through of the increases to date in the prices of energy and other commodities, those cost pressures should subsequently wane. Accordingly, with long-run inflation expectations contained, diminished cost pressures should result in some moderation in core inflation. construction exerted significant restraint on economic activity. The rise in real GDP in the first quarter was also damped by a downswing in inventory investment, a dip in defense spending, and an unusually sharp drop in net exports. The available information suggests that GDP growth rebounded in the second quarter as the drag from inventory investment waned and as defense expenditures and net exports snapped back after their first-quarter declines. In the labor market, hiring continued at a steady pace throughout the first half, although job gains fell short of those recorded in 2006, and the unemployment rate remained at 4Vi percent. Headline consumer price inflation was boosted by a reversal of the downturn in energy prices in late 2006 and a step-up in retail food prices, while core inflation was little changed. Real hourly labor compensation increased over the year ending in the first quarter, although gains in the second quarter were probably eroded by the energy-driven pickup in overall inflation. Conditions in financial markets have remained generally supportive of economic expansion thus far this year despite deteriorating conditions in the subprime-mortgage sector. Investors seemed to become more optimistic about the outlook for the economy: Interest rates rose, credit spreads on corporate bonds stayed narrow on the whole, and equity markets recorded sizable gains. Economic and Financial Developments in 2007 The Household Sector Real GDP increased at an annual rate of 2V4 percent in the second half of 2006, and it appears to have risen at roughly that pace, on average, over the first half of 2007. Although consumer spending and business fixed investment posted moderate gains, on balance, during the first half, the contraction in residential Consumer Spending After exhibiting considerable vigor in late 2006, consumer spending slowed somewhat over the first half of 2007. Spending continued to be bolstered by the strong labor market and the lagged effects of earlier increases in household Monetary Policy Report of July 2007 wealth. However, these positive influences were partly offset by the rise in energy prices this year, which drained consumers' purchasing power, and by reduced home-price appreciation, which limited recent gains in wealth for many households. Surveys of consumer sentiment have remained in a favorable range this year. Real PCE rose at an annual rate of 4V4 percent in the first quarter. Spending on light motor vehicles (cars, sportutility vehicles, and pickup trucks) got off to a fast start this year, expenditures on energy services were boosted by unusually cold weather in February, and outlays for other goods and services posted sizable gains after a steep run-up in the fourth quarter. The available data imply a much slower pace of spending growth in the second quarter, as sales of light motor vehicles softened and real spending on goods other than motor vehicles turned lackluster. Real disposable personal income (DPI)—that is, after-tax income adjusted for inflation—also started the year on a strong note after a large increase in the fourth quarter.1 Wages and salaries and some other major categories of personal income continued to rise appreciably in nominal terms throughout the first half. However, these gains were eroded in real terms by the energy-related jump in inflation in the spring, and, as a result, real DPI rose at an annual rate of just IV2 percent between the fourth quarter 1. According to the published data, real DPI rose at an annual rate of 43A percent in the first quarter. However, a substantial part of the increase occurred because the Bureau of Economic Analysis (BEA) added $50 billion (annual rate) to its estimate of first-quarter wages and salaries in response to information that bonus payments and stock option exercises around the turn of the year were unusually large. Because the BEA did not assume that these payments carried forward into April, real DPI fell sharply in that month. 63 of 2006 and May 2007, compared with an increase of more than 3 percent over the four quarters of 2006. Even given the sharp deceleration in residential real estate values, household wealth has remained supportive of spending growth. One reason is that the surge in equity values in recent quarters has allowed overall household wealth to keep pace with nominal income despite the softness in home prices. In addition, because changes in net worth tend to influence consumption with a lag of several quarters, the increases in wealth during 2005 and 2006 are likely still providing a good deal of impetus to spending. These increases in wealth, which have provided many households with the resources and inclination to raise their spending at a rate that exceeds income growth, have been a factor pushing down the personal saving rate over the past couple of years even as interest rates have moved up. After fluctuating in the vicinity of 2 percent from 1999 to 2004, the saving rate subsequently dropped sharply, and it stood at negative 1 lA percent, on average, in April and May of 2007. Residential Investment Residential construction activity remained soft in the first half of 2007, as builders continued to confront weak demand and an elevated inventory of unsold new homes. In the single-family sector, new units were started at an average annual rate of 1.18 million between January and May—more than 30 percent below the quarterly high reached in the first quarter of 2006. Starts in the multifamily sector averaged a little less than 300,000 units during the first five months of 2007, an amount at the lower end of the range of the past nine years. All told, the contraction in housing activity subtracted nearly 1 percentage 64 94th Annual Report, 2007 point from the change in real GDP in the first quarter of 2007—almost as much as in the second half of 2006—and the drag likely remained substantial in the second quarter. The monthly data on home sales have been erratic this year. But after smoothing through the ups and downs, the data suggest that demand has softened further after falling at a double-digit rate between mid-2005 and mid-2006 and then holding reasonably steady in the second half of last year. On average, sales of existing homes over the three months ending in May 2007 were AVi percent below their average level in the second half of last year, while sales of new homes were down 10 percent over that period. The further weakening of housing demand this year likely reflects, in part, tighter lending standards for mortgages, and it occurred despite mortgage rates that were relatively low by longer-run standards. The ongoing slippage in sales has made it more difficult for homebuilders to make much of a dent in their inventories of new homes for sale. When evaluated relative to the three-month average pace of sales, the months' supply of unsold new homes in May was more than 60 percent above the high end of the relatively narrow range it occupied from 1997 to 2005. Moreover, these published figures probably understate the true inventory overhang in this sector to the extent that they do not account for the surge in canceled sales in the past year; such cancellations return homes to unsold inventory but are not incorporated in the official statistics. The rate of house-price appreciation slowed dramatically in 2006 after nearly a decade of rapid increases, and prices appear to have moved roughly sideways in the first half of 2007. The purchaseonly version of the repeat-transactions price index for existing single-family homes published by the Office of Fed eral Housing Enterprise Oversight, which tracks sales prices of the same houses over time, rose at an annual rate of just 2 percent in the first quarter of 2007 (the latest available data) and was up just 3 percent over the year ending in the first quarter, compared with an increase of 10 percent over the preceding year. For April and May combined, the average price of existing single-family homes sold—which does not control for changes in the mix of houses sold but is available on a more timely basis—was about 1 percent below that of a year earlier. Household Finance Household debt expanded at an annual rate of 6 percent in the first quarter of 2007, somewhat below the pace of 83/4 percent posted in 2006. The deceleration was primarily the result of a significant step-down in the rise of mortgage debt, which reflected the sharp slowing of house-price appreciation and the slower pace of home sales. Consumer (nonmortgage) debt has remained on a moderate uptrend this year. Debt rose a little more slowly than personal income in the first quarter, so the financial obligations ratio for the household sector inched down, though it remained only a bit below its historical high. Most households were able to meet their debt service obligations, and measures of household credit quality were generally little changed. For example, delinquency rates on consumer loans and prime mortgages—the two main components of total household debt—stayed low through the spring of 2007, as did those on subprime fixedrate mortgages. In addition, household bankruptcy filings continued to be subdued in the first half of the year: They ran near the average pace seen since early 2006, after the bulge that accom- Monetary Policy Report of July 2007 panied the implementation of the new bankruptcy law in October 2005. Some households, however, have experienced growing financial strains. Delinquency rates on subprime mortgages with variable interest rates, which account for about 9 percent of all first-lien mortgages outstanding, continued to climb in the first five months of 2007 and reached a level more than double the recent low for this series, which was recorded in mid-2005. The rise in delinquencies has begun to show through to new foreclosures. In the first quarter of 2007, an estimated 325,000 foreclosure proceedings were initiated, up from an average quarterly rate of 230,000 over the preceding two years; about half of the foreclosures this year were on subprime mortgages. The decline in credit quality in the subprime sector has likely stemmed from a combination of several factors, including the moderation in overall economic growth and some regional economic weakness. In addition, a substantial number of subprime borrowers with variable-rate mortgages have faced an upward adjustment of the rates from their initial levels. When house prices were rising rapidly and rates on new loans were lower, many of these borrowers qualified to refinance into another loan with morefavorable terms. With house prices having decelerated and rates having moved higher, however, the scope for refinancing has been reduced. Moreover, investor owners may have been tempted to walk away from properties with little or no equity. Subprime mortgages originated in late 2005 and 2006 have shown unusually high rates of early delinquency, suggesting that some lenders unduly loosened underwriting standards during that period. In recent months, credit has become less easily available in the subprimemortgage market, as investors in sub 65 prime-mortgage-backed securities reportedly have scrutinized the underlying subprime loans more carefully and lenders have tightened underwriting standards. For example, more than half of the respondents to the questions on subprime residential mortgages in the Federal Reserve's April 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices indicated that they had tightened credit standards on such loans over the previous three months. In June, the federal financial regulatory agencies issued a final Statement on Subprime Mortgage Lending to address issues relating to certain adjustable-rate mortgage products. Credit spreads on the lower-rated tranches of new subprime securitizations have increased sharply, on balance, this year, and issuance of subprime-mortgage-backed securities has moderated from its vigorous pace of the past couple of years. However, despite the ongoing problems, the subprime market has continued to function, and new loans are being made. The Business Sector Fixed Investment After having risen sharply over much of 2006, real business fixed investment (BFI) lost some steam in the fourth quarter and posted a relatively meager gain in the first quarter of 2007. The slower rise in business output in recent quarters has likely been a moderating influence on business investment expenditures. But on the whole, economic and financial conditions still appear to be favorable for capital spending: Corporate profits remain robust, businesses have ample liquid assets at their disposal, and conditions in financial markets remain supportive. Much of the recent softness in BFI was in spending on equipment and soft- 66 94th Annual Report, 2007 ware (E&S), which rose at an annual rate of less than 2 percent in real terms in the first quarter after having fallen nearly 5 percent in the fourth quarter of 2006. Within the major components of E&S, real spending on high-tech equipment expanded at an annual rate of more than 20 percent in the first quarter of 2007 because of both a surge in outlays on computers after the release of a major new operating system and a spurt in investment in communications gear. Aircraft purchases also posted a sizable increase. However, spending on motor vehicles tumbled, as many firms had accelerated their purchases of medium and heavy trucks into 2005 and 2006 so that they could take delivery before the Environmental Protection Agency's new emissions standards for engines went into effect this year. Elsewhere, real investment in equipment other than hightech and transportation goods dropped at an annual rate of 10 percent in the first quarter after a fall of nearly 5 percent in the previous quarter. The weakness in this category, which accounts for roughly 40 percent of investment in E&S when measured in nominal terms, appears to have reflected, in part, appreciable declines in spending on equipment disproportionately used by the construction and motor vehicle industries and was most pronounced around the turn of the year. Although the weakness in truck sales apparently extended through midyear, real E&S outlays apart from transportation equipment appear to have posted a solid increase in the second quarter. Incoming information suggests that hightech spending continued to move up in real terms—albeit not as fast as it did in the first quarter. Moreover, shipments and orders for equipment other than high-tech and transportation items regained some lost ground. Nonresidential construction activity turned up steeply in 2006 after having been stagnant for several years, and it continued to exhibit considerable strength in early 2007. Outlays for office, retail, and industrial buildings are all running well above year-earlier levels, and—given that vacancy rates have moved down over the past couple of years—prospects for further gains in coming quarters are good. One exception to the recent strength in this sector is the drilling and mining category, in which real outlays fell in the first quarter after three years of sizable gains. The recent softening in this category of investment may reflect, in part, reported shortages of specialty equipment and skilled labor. Inventory Investment Inventory investment slowed markedly in the fourth quarter of 2006 as firms acted to stem rising inventory imbalances, and it turned negative in the first quarter of 2007. The downswing in inventory investment shaved about 1 pcicentage point from the change in real GDP in both the fourth and first quarters, and it appears to have brought stocks into better alignment with sales. Some of the inventory correction was in the motor vehicle sector, in which high gasoline prices have been causing demand to shift to more-fuel-efficient models—a trend that, by the middle of 2006, had left dealers with bloated inventories of light trucks and sport-utility vehicles. Facing little prospect of significantly stronger sales of those vehicles in the near term, the manufacturers instituted sharp cuts in production starting in the second half of last year. The production cuts, which in the first quarter of 2007 brought assemblies of light vehicles to their lowest level in more than a decade, helped clear out Monetary Policy Report of July 2007 67 dealers' lots and thus set the stage for a double-digit gains in 2006; nonetheless, step-up in assemblies in the second before-tax profits measured as a share of quarter. The automakers have scheduled sector GDP were nearly 13 percent, a further rise in assemblies in the third close to the high levels posted last year. Fueled in part by continued heavy quarter, in part to get a good start on producing the new, more-fuel-efficient merger and acquisition activity, nonfimodels that will be introduced to the nancial business debt expanded at an annual rate of 9 percent in the first quarter public in coming months. Excluding motor vehicles, inventories of this year, only a bit slower than in appeared to be well aligned with sales 2006, and data in hand suggest a robust through much of 2006, but they too pace of expansion again in the second started to look excessive as the growth quarter. Net bond issuance has been of aggregate demand slowed in the latter solid so far in 2007, and commercial part of the year. The emerging imbal- and industrial lending by banks has reances, some—though not all—of which mained strong. Although lower-quality appear to have been at firms that supply corporate credit markets experienced the construction and motor vehicle in- some strains, generally narrow credit dustries, prompted production adjust- spreads have encouraged corporate bond ments that reduced non-auto inventory issuance, and the growth of business investment to a very modest rate in the loans has been spurred by banks' acfirst quarter. According to the limited commodative lending posture. Consideravailable information, the pace of real able net fractions of respondents to the stockbuilding appears to have remained April 2007 Senior Loan Officer Opinion low in April and May, and, for the most Survey indicated that they had eased part, inventories seem to have moved some terms—especially spreads of loan back into rough alignment with sales. In rates over their costs of funds, costs of fact, businesses surveyed in June by the credit lines, and loan covenants—on Institute for Supply Management re- commercial and industrial loans over the ported that their customers were mostly previous three months. Banks pointed to comfortable with their current stock lev- more-aggressive competition from other els, whereas earlier in the year an el- banks or nonbank lenders and to inevated number of respondents had char- creased liquidity in the secondary maracterized these inventory positions as ket for these loans as the most important reasons for having eased business lendtoo high. ing terms. Commercial paper outstanding was flat in the first quarter but inCorporate Profits and Business creased somewhat in the second quarter. Finance Gross public issuance of equity by In the first quarter of 2007, growth in nonfinancial corporations has continued corporate profitability slowed from last to be moderate so far this year, but priyear's pace, but the level of profitability vate equity issuance has apparently reremained high. Earnings per share for mained strong, as leveraged buyout acS&P 500 firms decelerated but still tivity has continued to climb. However, came in nearly 10 percent above their given the elevated levels of share repuryear-earlier level. In the national income chases and equity retirements from cashaccounts, profits of nonfinancial corpo- financed mergers and acquisitions in the rations in the first quarter were little first quarter, net equity issuance continchanged from year-earlier levels after ued to be deeply negative. 68 94th Annual Report, 2007 Despite some deceleration in profits, the credit quality of nonfinancial firms has generally continued to be robust. The six-month trailing bond default rate has stayed near zero this year, and the delinquency rate on commercial and industrial loans at banks remained extremely low in the first quarter. For public firms, balance sheet liquidity was still high in the first quarter, whereas corporate leverage stayed near historical lows despite the large net retirement of equity. In addition, net interest payments relative to cash flow continued to be near the low end of the range seen over the past two decades. Commercial real estate debt expanded briskly in the first quarter of 2007, albeit not quite so rapidly as in 2006, a pattern consistent with the net tightening of credit standards on commercial real estate loans reported in the Senior Loan Officer Opinion Survey. Spreads on BBB-rated commercial-mortgagebacked securities (CMBS) soared in late February and have varied within an elevated range since then. The increase reportedly came in response to a reduction in investor interest in collateralized debt obligations, sponsors of which traditionally have purchased many of these securities, and to plans by the rating agencies to increase the level of credit support required for such securities. However, because rents on commercial properties have been increasing and vacancy rates have remained moderate, credit quality has generally continued to be good. Delinquency rates on commercial mortgages held by life insurance companies and on those backing CMBS have stayed near the bottom of their recent ranges this year. The delinquency rate on commercial mortgages held by banks edged up further in the first quarter in response to a deterioration in the performance of loans for multifamily properties and for construction and land development; nevertheless, this delinquency rate remained low by historical standards. The Government Sector Federal Government The deficit in the federal unified budget narrowed further during the past year: Receipts continued to rise at a fairly rapid rate, while growth in outlays was relatively subdued. Over the twelve months ending in June, the unified budget recorded a deficit of $163 billion, $113 billion less than during the comparable period ending in June 2006. When measured relative to nominal GDP, the deficit has decreased steadily from a recent fiscal year high of 3.6 percent in 2004 to a little more than 1 percent during the past twelve months. Nominal federal receipts during the twelve months ending in June were 8 percent higher than during the same period a year earlier. This increase was considerably smaller than the doubledigit advances recorded in fiscal 2005 and fiscal 2006. Nonetheless, it was faster than the increase in income and pushed up the ratio of receipts to GDP to nearly 19 percent. Individual income tax receipts continued to outpace the rise in taxable personal income as measured in the national income and product accounts (NIPA), likely a result, at least in part, of larger capital gains realizations (which are excluded from NIPA income), the effect of some taxpayers moving into higher tax brackets as their real incomes increased, and perhaps a further shift in the distribution of income toward high-income households, which typically face higher tax rates. Corporate receipts, after rising at an annual rate of nearly 40 percent, on average, over the three years ending in fiscal 2006, rose 15 percent during the year Monetary Policy Report of July 2007 ending in June, a rate more in line with the increase in corporate profits. Nominal federal outlays increased less than 3 percent during the twelve months ending in June and edged down to 20 percent of nominal GDP, around the lower end of the narrow range that has prevailed since 2003. In large part, the deceleration in outlays reflected the tapering off of the temporary bulge in expenditures for flood insurance and disaster relief associated with the 2005 hurricanes. Meanwhile, spending on health programs continued to rise briskly, only in part because of the net increment to spending from the Medicare Part D prescription drug program, which started in January 2006. Defense spending was up 5 percent over the period, an increase somewhat below those recorded in fiscal years 2005 and 2006. Total federal outlays were also boosted by a sizable rise in net interest payments as interest rates moved higher, although the increase in debt service costs was significantly smaller than that of a year earlier. As measured in the NIPA, real federal expenditures on consumption and gross investment—the part of federal spending that is a direct component of GDP— fell at an annual rate of nearly 4 percent in the first quarter, as a drop in defense spending more than offset a moderate increase in nondefense purchases. Defense expenditures tend to be erratic from quarter to quarter, and the firstquarter dip followed a large increase in the fourth quarter. Defense spending appears to have turned back up in the second quarter, and, given currently enacted appropriations, it is likely to increase further in coming quarters. All else being equal, the significant narrowing of the unified budget deficit over the past few years raises national saving. However, the positive effect on national saving of the smaller federal 69 deficit has been largely offset by a downward drift in nonfederal saving. Although business saving has increased substantially over this period, personal saving has dropped sharply. Accordingly, total national saving (that is, federal plus nonfederal) has recovered only a little from the exceptionally low levels reached between 2003 and 2005; measured net of estimated depreciation, it has fluctuated between Wi percent and 2Vi percent of GDP since the start of 2006. If not boosted over the longer run, persistent low levels of saving will be associated with either slower capital formation or continued heavy borrowing from abroad, either of which would retard the rise in the standard of living of U.S. residents over time and hamper the ability of the nation to meet the retirement needs of an aging population. Federal Borrowing Federal debt rose at an annual rate of 63/4 percent in the first quarter of 2007, a bit slower than in the corresponding quarter of last year. As of the end of the first quarter, the ratio of federal debt held by the public to nominal GDP was about 36 percent, a level little changed from that in recent quarters. The improvement in the budget position of the federal government has led the Treasury to scale back issuance of marketable coupon securities. As part of its reduction in issuance, the Treasury announced in May that it was discontinuing auctions of three-year nominal notes. This move had been widely anticipated and elicited little reaction in financial markets. Overall, foreign purchases of Treasury securities appear to have increased further this year, thereby bringing the share of these securities held by foreign investors to a new high of almost 45 percent at the end of the first quarter. The 70 94th Annual Report, 2007 proportion of nominal coupon securities purchased at auctions by foreign investors moved up in late 2006 and has stayed elevated thus far this year, albeit well off the peak reached in 2004. Balance of payments data point to sizable net purchases by foreign private investors between January and March, whereas such investors sold Treasury securities, on net, in 2006. In contrast, net purchases by foreign official investors have declined somewhat this year. Custody holdings at the Federal Reserve Bank of New York on behalf of foreign official and international accounts have only edged up since the end of 2006. State and Local Government On the whole, state and local governments continue to enjoy strong fiscal positions as a consequence of several years of robust revenue inflows and a period of appreciable restraint on spending after these governments' fiscal difficulties earlier in the decade. Accordingly, over the past year or so, states and localities in the aggregate have been able both to raise expenditures and to maintain healthy balances in their reserve funds. However, revenue flows in many states appear to have slowed a bit of late, a pattern similar to the one that has emerged at the federal level. For local governments, property tax receipts are still being bolstered by the earlier run-up in real estate values, but the deceleration in house prices over the past year will likely slow the rise in local revenues down the road. Moreover, many state and local governments expect to face significant structural imbalances in their budgets in coming years as a result of the ongoing pressures from Medicaid and the need to provide pensions and health care to an increasing number of retired state and local government employees. According to the NIPA, real expenditures on consumption and gross investment by state and local governments rose at an annual rate of nearly 4 percent in the first quarter, and they apparently posted a further increase in the second quarter. Much of the strength in the first half of 2007 was in construction spending, which has been climbing since the start of 2006, in part because of very rapid increases in outlays on highways. Hiring by states and localities also exhibited considerable vigor during the first half of 2007, both in the education sector and elsewhere; on average, state and local government employment rose 30,000 per month over the six months ending in June, compared with an average monthly increase of 22,000 over the preceding ten years. State and Local Government Borrowing Borrowing by state and local governments has been strong thus far in 2007, largely because refundings in advance of retirements have been elevated as interest rates have remained relatively low. In contrast, issuance of short-term debt has been moderate—a development consistent with the strong budgets of state and local governments. The credit quality of municipal bonds has remained solid on the whole, as the number of bond-rating upgrades has outpaced the number of downgrades thus far this year. The ratio of yields on municipal bonds to those on comparable-maturity Treasury securities has stayed at the low end of its range of the past decade. The External Sector In 2006, U.S. real net exports made a positive contribution to the full year's economic growth for the first time since 1995. The contribution of net exports moved into negative territory again, Monetary? Policy Report of July 2007 however, in the first quarter of this year, as imports rebounded and exports slowed from their exceptional pace late last year. Data for April and May point to a resurgence of exports and a moderation of imports in the second quarter. The U.S. nominal current account deficit widened a bit in the first quarter of 2007 to $770 billion at an annual rate, or about 53A percent of nominal GDP, from $752 billion in the fourth quarter of 2006. The larger deficit was due to an increase in net unilateral transfers abroad. Although the first-quarter trade balance deteriorated in real terms, increases in export prices outpaced those in import prices, thereby leaving the nominal trade balance unchanged. Despite the large negative U.S. net international investment position, the U.S. balance on investment income remained positive and also was about unchanged in the first quarter. International Trade Despite continued solid foreign economic expansion and persisting stimulus from earlier declines in the dollar, the growth of real exports of goods and services slowed to an annual rate of less than 1 percent in the first quarter from its exceptionally strong pace of more than 10 percent in the fourth quarter. The slowdown was particularly evident in sales of capital goods—especially aircraft and computers—and industrial supplies, which fell in the first quarter after rising robustly in late 2006. Also contributing to the slowdown, real exports of services rose only 2 percent in the first quarter after increasing more than 16 percent in the fourth quarter. Available data for nominal exports in April and May suggest that real export growth moved up in the second quarter, as increases in exports of services, automobiles, industrial supplies, and con 71 sumer goods more than offset a further contraction in exports of capital goods. Prices of exported goods rose at an annual rate of 4 percent in the first quarter of 2007, up from the pace of about 2Vi percent seen in the second half of 2006. Prices of non-agricultural industrial supplies, which had been reduced in the fourth quarter by lower oil prices, were pushed up in the first quarter by higher prices for metals and renewed increases in oil prices. In addition, agricultural prices—especially those of corn, soybeans, and wheat—have risen briskly over the past several quarters, in part because of the direct and indirect effects of the increased demand for ethanol. Monthly data on trade prices in the second quarter point to further increases in export prices on the strength of additional run-ups in the prices of nonagricultural industrial supplies, most notably metals. After falling at an annual rate of 2Vi percent in the fourth quarter, real imports of goods and services rose at a 5Vi percent rate in the first quarter. A sharp increase in oil imports, after a fourth-quarter decline, was the most important contributor to the swing, but imports of computers, semiconductors, and natural gas also accelerated. Imports of other goods continued to be weak, likely a result, in part, of slower U.S. growth; imports of autos and industrial supplies, in particular, contracted sharply. The growth of real imports of services dropped from 6VA percent in the fourth quarter to 23A percent in the first quarter. Data for April and May imply some slowing of overall real imports in the second quarter. In particular, imports of oil and computers displayed noteworthy decelerations. Prices of imported goods excluding oil and natural gas rose at an annual rate of about 1 Vi percent in the first quarter of 2007, as prices of both finished and 72 94th Annual Report, 2007 material-intensive goods recorded higher rates of increase. Monthly trade price data suggest that import prices accelerated in the second quarter, partly because of higher metals prices, which have fluctuated widely in recent months but are up substantially, on balance, so far in 2007. More generally, prices of industrial supplies have been rising briskly, a movement that may reflect, in part, a response to the depreciation of the dollar in recent months. No such effect of the dollar's decline is readily apparent in the prices of finished goods. Oil prices fell at the beginning of 2007, as unusually mild temperatures reduced oil demand and OPEC members appeared less likely to implement fully production cuts agreed to at the end of 2006. The spot price of West Texas intermediate (WTI) crude oil, the U.S. benchmark, fell from an average of $62 per barrel in December to $54 per barrel in January. Oil prices then rose gradually as it became apparent that OPEC, led by Saudi Arabia, indeed would restrain oil production further. Oil prices also have been supported by solid growth in demand, particularly in developing countries, and by long-running concerns about supply disruptions. Ongoing violence has depressed oil production in Iraq and Nigeria; the Nigerian outage recently worsened to about onefourth of the country's estimated capacity. Since the start of the year, concerns have also intensified about a possible future disruption of oil exports from Iran. The spot price of WTI averaged $72 per barrel in the first half of July. Despite its elevated level by historical standards, the spot price of WTI has not increased as much in recent months as have the prices of other grades of crude oil because of high inventories of WTI in the central United States arising from interruptions for maintenance and unplanned outages at refineries. Since early March, the spot price of Brent crude oil, the European benchmark, has risen about $5 per barrel more than has the spot price of WTI; the price of Brent averaged $76 per barrel in the first half of July. The Financial Account The U.S. nominal current account deficit continued to be financed primarily by foreign purchases of U.S. debt securities. Driven by purchases of U.S. government securities by Asian central banks, foreign official inflows moved up noticeably in the first quarter. Although demand for U.S. Treasury securities by foreign official investors eased, it was more than offset by increased official purchases of bonds and mortgagebacked securities issued by governmentsponsored enterprises (GSEs). Preliminary data indicate that official inflows remained strong through April. Foreign private purchases of U.S. securities maintained the extraordinary pace set in 2006. Demand for U.S. Treasury bonds extended its fourth-quarter strength, while demand for equities picked up from an already robust level; purchases of corporate bonds moderated slightly, and, on net, private foreigners sold debt issued by GSEs. Foreign direct investment flows into the United States weakened significantly; the rate of inflows in the first quarter was roughly half that in 2006. Net purchases of foreign securities by U.S. residents, which represent a financial outflow, remained strong in the first quarter of this year. Net acquisitions of bonds continued at the brisk pace recorded in the second half of 2006, while purchases of foreign stocks, although slowing slightly, remained elevated. Outflows associated with U.S. direct investment abroad strengthened to a nearrecord rate. Monetary Policy Report of July 2007 The Labor Market Employment and Unemployment The demand for labor has been increasing at a moderate rate this year, somewhat less quickly than in 2006. After having averaged 190,000 per month in 2006, gains in payroll employment averaged 145,000 per month in the first half of 2007. The civilian unemployment rate has changed little since last fall and stood at 4.5 percent in June. As was the case in 2006, job growth in the first half of 2007 was driven by solid gains in service-producing industries. In particular, hiring at health, education, and eating and drinking establishments remained on strong uptrends, and job gains at businesses providing professional and technical services were sizable. However, employment in the financial activities and administrative support sectors softened after two years of strong advances. In the goodsproducing sector, manufacturing employment, which has been on a secular downtrend for more than a quartercentury, declined again over the first half of 2007. The decline this year reflected cutbacks at firms closely tied to the construction industry and at producers of motor vehicles and parts, as well as the ongoing downtrend in payrolls at manufacturers of apparel and textiles. Employment in residential construction, which had fallen in 2006 after two years of substantial increases, declined just modestly, on net, over the first half of 2007 despite the substantial contraction in housing activity. Other labor market indicators have mostly remained positive. Initial claims for unemployment insurance have stayed relatively low in recent months. In addition, readings from private surveys of hiring plans have remained in a favorable range despite recent declines, 73 and the job openings rate has held at a high level. According to the Conference Board, households' assessments of job availability cooled a bit in the spring after having improved somewhat earlier in the year; even so, the June value for this indicator was still relatively positive. After hovering around 43A percent during the first three quarters of 2006, the unemployment rate fell to 4V2 percent in the fourth quarter, and it remained in that neighborhood through June. The labor force participation rate has continued to be buoyed by the favorable job market, and it stood at 66.1 percent in June, within the narrow range that has prevailed since 2005. Despite the recent flatness, the participation rate has fallen appreciably since the start of the decade; the downtrend has largely reflected longer-run demographic forces that include a leveling off in the participation rate of women and an increase in the proportion of the workforce in older age groups, which have lower average participation rates than do younger age groups. Productivity and Labor Compensation Gains in labor productivity have slowed lately. According to currently published data, output per hour in the nonfarm business sector rose just 1 percent over the year ending in the first quarter of 2007, down from the pace of 2 percent per year recorded over the preceding two years (and down from much larger increases in the first half of the decade). The slowing in productivity was associated with the deceleration in output and thus was probably, at least in part, a temporary cyclical phenomenon. Indeed, the fundamental forces that in recent years have supported a solid uptrend in underlying productivity—the driver of real wage gains over time— 74 94th Annual Report, 2007 remain in place. They include the rapid pace of technological change and firms' ongoing efforts to use information technology to improve the efficiency of their operations. Increases in the amount of capital, especially high-tech capital, available to each worker also appear to be providing considerable impetus to productivity growth. Broad measures of hourly compensation have been bounced around in recent years by the lumpiness of bonus payments, stock option exercises, and sharp swings in employer benefit costs. However, on balance, the evidence points to some pickup recently in the underlying pace of compensation gains, a development consistent with the tight labor market. The employment cost index (ECI) for private industry workers, which measures both wages and the cost of benefits, increased 3V4 percent in nominal terms between March 2006 and March 2007, compared with an increase of 2Vi percent over the preceding twelve months. Adjusted for inflation, as measured by the increase in the overall PCE price index, the ECI rose nearly 1 percent over the year ending in March after having fallen nearly Vi percent over the preceding year. Data on hourly compensation in the second quarter are not yet available, but a sharp rise in overall consumer prices during that period probably offset much—if not all—of the nominal gains that were realized. The step-up in the rate of increase in the ECI over the past year was concentrated in its wage and salary component, which rose V/i percent over the year ending in March, 1 lA percentage points more than the increase over the yearearlier period. Meanwhile, increases in the cost of providing benefits have slowed dramatically of late, in part because premiums for health insurance have stopped rising at double-digit rates. The increase in benefit costs over the year ending in March, which amounted to just 2lA percent, was also held down by a sharp drop in employer contributions to retirement plans. The lower contributions appear to have reflected several factors, including the strong performance of the stock market in 2006 and a high level of employer contributions over the past several years; taken together, these factors significantly boosted the funding levels of definedbenefit plans. According to preliminary data, compensation per hour in the nonfarm business (NFB) sector—an alternative measure of hourly compensation derived from the data in the NIPA—rose 3!/4 percent over the year ending in the first quarter of 2007, the same rise as in the ECI. Over the year ending in the first quarter of 2006, NFB hourly compensation had risen 53/4 percent, in part because of an apparent surge in the value of stock option exercises (which are excluded from the ECI) early last year. Largely reflecting the slower growth in NFB hourly compensation, unit labor costs rose 2lA percent over the year ending in the first quarter of 2007 after increasing ?>Vi percent over the preceding four quarters. Prices Headline inflation picked up again in the first half of 2007, as energy prices surged after having eased late last year and increases in food prices quickened. The PCE chain-type price index increased at an annual rate of 4.4 percent between December 2006 and May 2007 after rising 2.2 percent over the twelve months of 2006. Core PCE prices— which exclude the direct effects of movements in food and energy prices— rose at an annual rate of 2.0 percent over the first five months of the year, 0.1 per- Monetary Policy Report of July 2007 Alternative Measures of Price Change, 2006-07 Percent Price measure Chain-type (Ql to Ql) Gross domestic product (GDP) .. Excluding food and energy ... Gross domestic purchases Personal consumption expenditures (PCE) Excluding food and energy ... Market-based PCE excluding food and energy Fixed-weight (Q2 to Q2) Consumer price index Excluding food and energy ... 2006 2007 3.1 2.9 3.5 2.8 2.7 2.5 3.0 2.0 2.2 2.3 1.6 2.1 4.0 2.4 2.6 2.3 NOTE: Changes are based on quarterly averages of seasonally adjusted data. For the consumer price index, the 2007:Q2 value is calculated as the average for April and May compared with the average for the second quarter of 2006 and is expressed at an annual rate. SOURCE: For chain-type measures, Department of Commerce, Bureau of Economic Analysis; for fixedweight measures. Department of Labor, Bureau of Labor Statistics. centage point less than the increase over the twelve months of 2006. Energy prices, which had fallen substantially in the fourth quarter of 2006, decreased further in January in response to declines in the price of crude oil, unseasonably mild temperatures in North America and Europe, and historically high inventories of petroleum products and natural gas. However, energy prices shot up from February to May, and the rise brought the net increase in the PCE price index for energy over the first five months of the year to 14 percent (not at an annual rate). The increase was especially large for gasoline, the price of which was boosted not only by higher prices for crude oil beginning in late winter but also by numerous refinery shutdowns, reflecting both planned maintenance and unplanned disruptions. Retail gasoline prices have fallen some since May as refiners have made some progress in bringing output closer to seasonal norms, but they are still about $0.70 per gallon above the levels of late December. 75 Food prices have also picked up this year, in part because of the jump in the price of corn, which is now in demand not only as a feedstuff and food but also as an input to the production of ethanol. Between December 2006 and May 2007, the PCE price index for food and beverages increased at an annual rate of nearly 6 percent. The higher cost of corn was partly responsible for a IOV2 percent rise over the period in prices for meats, poultry, fish, and eggs. The index for fruits and vegetables also posted a double-digit increase, mainly because a severe freeze in California in January destroyed a substantial portion of the citrus crop and set back the harvest of many other fruits and vegetables. Prices for food consumed away from home, which typically are influenced more by labor and other business costs than by farm prices, rose at an annual rate of 4 percent over the first five months of the year. The edging down of core PCE inflation this year largely reflected some waning of the sizable increases in shelter costs that were recorded in 2006. Core PCE inflation in the most recent few months was also held down significantly by transitory factors—most notably, a sharp drop in the price of apparel. In addition, the retail price of tobacco, which, like apparel, tends to be volatile from month to month, flattened out after a steep increase earlier in the year. Meanwhile, the rate of increase in the core consumer price index (CPI) has dropped from 2.6 percent in 2006 to an annual rate of 2.1 percent so far this year; the main reason for the sharper deceleration in the core CPI than in core PCE prices is that housing costs receive a much greater weight in this index than they do in the core PCE measure. More fundamentally, the behavior of core inflation so far this year has been shaped by many of the same forces that 76 94th Annual Report, 2007 were at work in 2006. Resource utilization in labor and product markets remains fairly high. And although last autumn's drop in energy prices may have offered some temporary relief, the resurgence in prices for energy and other commodities is likely putting some upward pressure on core inflation. Regarding inflation expectations, the Reuters/ University of Michigan Surveys of Consumers (Reuters/Michigan) suggest that the median expectation for yearahead inflation has moved up in response to the energy-driven pickup in headline inflation: It rose from 3.0 percent in the first three months of the year to 3.3 percent in April and remained at about this level through early July. However, longer-run inflation expectations appear to have remained contained. In fact, according to the Reuters/Michigan surveys, the median five- to ten-year expectation, at 3.1 percent in early July, has stayed within the narrow range that has prevailed for the past two years. According to the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, expectations of inflation over the next ten years remained around 2j/2 percent in the first half of 2007, a level that has been essentially unchanged since 1998. Inflation compensation as measured by the spreads of yields on nominal Treasury securities over those on their inflationprotected counterparts has also stayed within its range of recent years. Broader, NIPA-based measures of inflation, which are available only through the first quarter of this year, slowed relative to the pace of the past couple of years. The latest data show a rise in the price index for GDP less food and energy of 23/4 percent over the year ending in the first quarter, down lA percentage point from the year-earlier figure. Although core PCE inflation picked up slightly during the past four quarters, prices for some other components of final demand, especially construction, decelerated. U.S. Financial Markets U.S. financial markets have functioned well thus far in 2007 despite episodes of heightened volatility. As the year opened, financial market quotes put considerable weight on the expectation of an easing of monetary policy sometime soon. By the spring, however, investors apparently had become more optimistic about the economic outlook and, as a result, had concluded that less Federal Reserve easing would be forthcoming than they had anticipated earlier. In line with the upward shift in policy expectations, two-year Treasury yields rose about 10 basis points, on balance, through mid-July; ten-year yields increased 40 basis points. Supported by solid corporate profits and the more upbeat economic outlook, equity prices advanced roughly 10 percent on net. Despite some widening in recent weeks, risk spreads on corporate credits generally remained narrow, reflecting strong and liquid corporate balance sheets. Measures of investors' uncertainty about prospects for a number of financial asset prices widened somewhat, on balance, from low levels. Market Functioning and Financial Stability In late February and early March, financial market volatility increased sharply amid a pullback from riskier assets that was reportedly spurred by a variety of factors, including a sharp dip in the Chinese equity market, mounting concerns about conditions in the subprimemortgage sector, and some softer-thanexpected U.S. economic data. During the period, spreads on indexes of subprimemortgage credit default swaps (CDS) Monetary Policy Report of July 2007 spiked; equity markets in the United States and abroad declined; Treasury yields dropped across maturities; spreads of riskier fixed-income instruments over comparable Treasuries widened somewhat; and measures of market uncertainty, including implied volatilities derived from options prices, moved up sharply. Despite some capacityrelated technical difficulties in equity markets on February 27, financial markets generally handled the volatility well. Liquidity in the Treasury market continued to be good, as record-high trading volumes were accompanied by bid-ask spreads within ranges of the past few years. Market sentiment subsequently improved—apparently a result, in part, of reduced anxiety about spillovers to broader markets of the problems in the subprime-mortgage sector— and financial markets gradually stabilized. Many asset prices reversed their earlier declines, and measures of uncertainty moved lower. Strains in financial markets increased again late in the spring, prompted largely by renewed concerns about the subprime-mortgage sector. A considerable widening in spreads on indexes of subprime-mortgage CDS contributed to, and was likely reinforced by, troubles at a few small and medium-si zed hedge funds that had taken positions designed to profit from an improvement in subprime credit quality. These pressures intensified as a result of actual and anticipated downgrades of some securities backed by subprime mortgages. Investors' uncertainty about a range of asset prices increased, and lower-quality corporate credit spreads widened, reportedly reflecting, in part, heightened uncertainty about the valuation of structured credit products, which are an important source of funding in the subprime-mortgage market and in other financing markets. These pressures have 11 been contained, though: In spite of the recent rise, spreads on lower-quality corporate credits remain near the low end of their historical ranges, and, although investors recently have balked at some aggressively structured deals, financing activity in bond and other credit markets continues at a fairly brisk pace. Market participants do not appear to have pulled back from risk-taking more generally, in that equity prices have moved higher in recent weeks, and Treasury bid-ask spreads have stayed within normal ranges despite elevated trading volumes. The effects on financial institutions of this year's difficulties in the subprimemortgage sector have depended on the institutions' exposure to the sector. Several mortgage lenders—particularly monoline subprime lenders—experienced substantial losses, as they had to repurchase larger-than-expected volumes of previously securitized loans because of so-called early payment defaults. Consequently, a number of these lenders have gone out of business since the beginning of the year. Large investment banks active in the securitization of subprime mortgages suffered modest hits to their earnings, and their CDS spreads are considerably higher than at the beginning of the year. To date, most large depository institutions appear to have been less affected by the subprime difficulties, in part because of their greater diversification and generally limited subprime lending activity. CDS spreads for these institutions have moved up only a little, on the whole, thus far in 2007. Interest Rates Since the beginning of the year, investors appear to have become more optimistic, on balance, about the outlook for economic activity and consequently 78 94th Annual Report, 2007 have raised their expected path for the federal funds rate. Judging from futures markets, market participants currently anticipate that the rate will decline about 25 basis points through the end of 2008; at the end of last year, market participants had expected about 75 basis points of easing over the same period. Investors also have apparently become more certain about the path for the federal funds rate: Implied volatilities derived from options on Eurodollar futures over the next year have moved down, on net, this year and remain near historical lows. Estimated probability distributions for the target federal funds rate between six and twelve months ahead were somewhat skewed toward lower rates through mid-July. Reflecting the reduced odds placed on policy easing, yields on two-year nominal Treasury securities increased about 10 basis points over the year through mid-July. Ten-year Treasury yields rose 40 basis points over the same period. A portion of the increase in longer-term yields appears to be attributable to a widening of term premiums, although estimated term premiums remain relatively low by historical standards. Yields on inflation-indexed Treasury securities moved nearly in line with those on their nominal counterparts, thereby leaving inflation compensation only a little higher. In the corporate bond market, yields on investment- and speculative-grade securities rose about as much, on balance, as those on comparable-maturity Treasury securities through mid-July, and so risk spreads on such instruments are little changed on the year. The narrow spreads on corporate bonds appear to reflect investors' positive outlook for business credit quality over the medium term. The term structure of forward risk spreads for corporate bonds supports this view, as forward spreads for the next few years are low while spreads further out the curve are more in line with historical norms. Equity Markets Broad equity indexes increased between %Vi percent and 12 percent, on net, through mid-July. Stock prices were boosted by solid first-quarter earnings that generally met or exceeded investors' expectations and by the more upbeat economic outlook. Share prices rose for a wide range of industries, although basic materials and energy firms outperformed the broader market because of strong global demand for commodities. The spread between the twelve-month forward earnings-price ratio for the S&P 500 and a real longrun Treasury yield—a rough gauge of the equity risk premium—narrowed a bit and now stands close to the middle of its range of the past few years. After a spike in connection with the period of unsettled conditions in financial markets in late February and early March, the implied volatility of the S&P 500 calculated from options prices fell back, but it picked up again recently in response to renewed concerns about the subprimemortgage market. Debt and Financial Intermediation by Banks The total debt of the domestic nonfinancial sectors expanded at an annual rate of 11A percent in the first quarter of 2007, a somewhat slower pace than in 2006. The deceleration in borrowing was mainly accounted for by a slowdown in household debt, particularly mortgage debt. In contrast, borrowing by nonfinancial businesses remained robust in the first quarter. Preliminary data for the second quarter suggest slightly slower growth in total domestic nonfinancial sector debt. The step-down in Monetary Policy Report of July 2007 growth is particularly noticeable in the federal government sector, in which strong receipts this tax season held down borrowing. However, the recent data suggest somewhat faster growth in nonfinancial business debt in the second quarter, a pickup fueled by heavy merger and acquisition activity. Commercial bank credit increased at an annual rate of about 6V2 percent in the first half of 2007. However, adjusted to remove the effects of a conversion of a bank to a thrift institution, bank credit expanded at an annual rate of about 8l/4 percent over the same period, somewhat slower than in 2006. Excluding this bank-to-thrift conversion, total loans grew briskly in the first half of the year, with most bank loan types expanding vigorously. Rapid growth in commercial and industrial loans was supported by the continued robust merger and acquisition activity. Growth in commercial real estate loans was also strong even though construction and land development loans, a portion of which is used to fund residential development, decelerated sharply. Despite the ongoing adjustment in the housing market, residential real estate loans on banks' books (adjusted for the bank-to-thrift conversion noted earlier) expanded at a strong pace. But home equity loans grew only modestly. Because rates on these loans are generally tied to short-term market interest rates, the flattening of the yield curve last year made them a relatively more expensive source of credit. Consumer loans held by banks picked up in the first quarter, but they slowed in the second quarter. Commercial bank profitability declined somewhat in the first quarter of 2007 but remained solid. The net interest margin of the industry continued to narrow, a likely result of ongoing competitive pressures and the flat yield curve. Bank profitability was also re 79 strained by growth in non-interest expenses and a modest increase in provisions for loan losses. Credit quality stayed strong overall: Delinquency and charge-off rates remained generally low, although delinquency rates on residential and commercial real estate loans moved up further from last year's levels. The M2 Monetary Aggregate M2 expanded at an annual rate of about IV2 percent over the first half of 2007. The increase evidently outstripped growth in nominal GDP by a substantial margin and exceeded the rate that would have been expected on the basis of the aggregate's previous relationship with income and interest rates. M2 rose at an annual rate of 8 percent in the first quarter before slowing to a pace of 63A percent in the second quarter. Liquid deposits, by far the largest component of M2, have followed a similar pattern this year. Small time deposits and retail money market funds both grew rapidly last year, as the rates paid on them moved up with short-term market interest rates. However, these components have decelerated this year because market rates have changed relatively little. Currency growth has remained modest in 2007, apparently a result of weak demand for U.S. dollars overseas. International Developments Foreign economic growth remained strong in the first quarter of 2007, supported by increased domestic demand in many key countries. Most recent indicators point to continued strength in foreign economies in the second quarter as well. Canada, the euro area, Japan, and the United Kingdom all posted abovetrend growth rates in the first quarter. Although the expansion of the Japanese economy moderated somewhat in the first quarter, growth remained brisk rela- 80 94th Annual Report, 2007 tive to the average pace seen in recent years. Output accelerated in emerging Asia, led by China, and growth in Mexico appears to be picking up again after a lull in the first quarter. Rising energy prices boosted consumer prices in many regions of the world last year, and, in some cases, substantial increases in food prices also contributed to inflation pressures. Broad measures of price inflation have continued to rise in many foreign economies this year, as economic growth has remained strong, and core inflation has moved up noticeably in a number of these economies. In response, monetary policy has been tightened in many major industrial countries as well as in some emerging-market economies. Longerterm foreign interest rates have also risen. Global financial markets were calm at the beginning of 2007, and volatilities for many asset prices were at, or close to, record lows. Toward the end of February, conditions changed, as international investors scaled back their exposure to risky positions—particularly those funded in yen—in response to a sharp drop in Chinese stock prices and concerns about the U.S. economy. As a result, equity prices in most industrial and emerging economies fell over the course of several days, while the yen appreciated sharply against most other currencies. More-placid conditions returned in early March, and by early June share prices around the world had posted solid gains, reaching multiyear highs or even record highs in many countries. In particular, Chinese stock prices resumed their steep climb, although the rise was interrupted by occasional additional periods of heightened volatility. These episodes had no apparent disruptive effects on other global financial markets. Most major global equity indexes experienced another increase in volatility during June and July amid concerns about the U.S. subprime-mortgage market, but they were little changed, on net, over this period. On balance, equity indexes in the major foreign industrial countries have increased between 5 percent and 12 percent in local-currency terms since the beginning of 2007. The Shanghai composite index is up more than 45 percent this year after a remarkable increase of about 130 percent last year. Leading equity indexes in other emerging Asian economies and in Latin America have also posted sizable gains in the range of 10 percent to 35 percent so far this year. As in the United States, long-term bond yields in Canada, the euro area, and Japan rose significantly, on balance, in the first half of 2007; increases on ten-year nominal sovereign debt ranged from 25 to 70 basis points. Starting in early February, yields declined in global markets for several weeks amid growing concerns about the outlook for the U.S. economy. Since then, market participants seem to have become more optimistic about prospects for both U.S. and foreign economic growth, and yields have more than reversed the declines. Yields on inflation-protected long-term securities also rose during the first half of 2007 in the major industrial countries, but, with the exception of those in the euro area, they did not rise quite as much as nominal yields did, implying some modest increases in inflation compensation. Our broadest measure of the nominal trade-weighted foreign exchange value of the dollar has declined about 3Vi percent, on net, since the beginning of 2007. Over the same period, the major currencies index of the dollar has moved down more, about 4x/2 percent. On a bilateral basis, the dollar has depreciated Monetary Policy Report of July 2007 10 percent against the Canadian dollar and roughly 3Vi percent against the euro and sterling; in contrast, it has appreciated about 2l/z percent against the yen. The bulk of the change against the Canadian dollar occurred in the second quarter after better-than-expected news about economic activity and expectations of monetary policy tightening in Canada. The U.S. dollar has depreciated 3 percent, on net, against the Chinese renminbi since the beginning of 2007; the pace of change in the renminbidollar rate has accelerated somewhat over the past two and a half months. Industrial Economies The major foreign industrial economies experienced above-trend growth in the first quarter of this year. In Canada, real GDP grew at an annual rate of 33A percent after rising nearly 2 percent during 2006; inventory accumulation figured prominently in the faster growth. In the United Kingdom, real GDP increased at an annual rate of 23/4 percent in the first quarter. Robust expansions in both countries have been accompanied by increases in inflation rates, which in recent months have hovered at or above those countries' inflation targets of 2 percent. Although the pickup in headline inflation partly reflected higher energy prices, core inflation has also trended up in recent months in both Canada and the United Kingdom. In the midst of elevated inflation and increasing rates of resource utilization, monetary policy was tightened three times this year in the United Kingdom (by 25 basis points each time) after two increases in the policy rate last year. The Bank of Canada also recently raised its policy rate 25 basis points. Market participants expect that both countries' central banks will raise their policy rates further. 81 Growth of real GDP in the euro area moved down to 23A percent in the first quarter after posting growth of 3lA percent over the four quarters of 2006. Although export growth moderated from its strong performance of 2006, recovery of domestic demand appears to have taken firmer hold, as investment accelerated in the first quarter. Private consumption in Germany had been muted earlier this year, partly because of a hike in the value-added tax at the start of the year, but lately retail sales in Germany and the euro area more broadly have picked up, on balance, from their January lows. Survey indicators of consumer and business sentiment also point to relatively strong growth in the euro area during the second quarter. Overall consumer price inflation has remained just below the European Central Bank's 2 percent ceiling since the fall of last year, while core inflation has risen to about 2 percent from around 1 Vi percent last year. To combat potential inflation pressures, the Bank continued to tighten monetary policy during the first half of this year, implementing two more increases of 25 basis points in its policy rates. Japanese economic growth moderated in the first quarter of this year to a stillbrisk annual rate of 3lA percent. Household consumption rose at a robust rate of about 3 percent, and real exports increased almost 14 percent. Investment growth slowed, although recent surveys report that businesses are optimistic about the outlook. The labor market in Japan improved further in the first five months of the year: The unemployment rate fell below 4 percent, and the ratio of job offers to applicants remained elevated. Despite the strong growth of output and improved labor markets, consumer prices were about unchanged on a twelve-month basis in May; the GDP deflator has continued to fall, though, 82 94th Annual Report, 2007 during the period. Core consumer prices have shown small twelve-month declines over the past several months, and wages have declined relative to their year-earlier levels. Emerging-Market Economies Economic activity in China accelerated in the first quarter of 2007 and appears to have remained robust in the second quarter. Growth was supported by a surge in exports and a pickup in fixed investment, which had slowed somewhat in the second half of 2006. The strength of exports has resulted in a ballooning of the Chinese trade surplus. Since late 2006, inflation in China has increased—reaching a rate of V/i percent over the twelve months ending in May—largely because of higher food prices. Continuing rapid growth of aggregate demand and liquidity pressures from the accumulation of foreign exchange reserves have raised concerns about broader, more-sustained upward pressures on inflation. Chinese authorities have tightened monetary policy through several increases in banks' reserve requirements and two increases in interest rates so far this year; they have also continued to use sterilization operations to partially offset the effect of the reserve accumulation on the money supply. Elsewhere in emerging Asia, real GDP surged in India and the Philippines in the first quarter and remained strong in Malaysia and Singapore. Growth was generally supported by domestic demand in all four economies. Growth held steady in South Korea, as stronger domestic demand was partially offset by a drag from net exports. Incoming data point to strength in the region in the second quarter. Outside of China, infla tionary pressures in several emerging Asian economies have eased somewhat this year because of the unwinding of previous increases in food prices and, in some cases, the effect of currency appreciations. During the past year, political tensions in Thailand and uncertainty about the government's policy on capital controls have periodically disrupted markets and economic activity. In a continuation of the deceleration that started about the middle of last year, Mexican output rose a scant Vz percent in the first quarter; manufacturing (particularly in the automobile sector) was restrained by the moderation in the U.S. economic expansion, and construction slowed sharply. Recent data on industrial production, however, suggest that growth may have rebounded in the second quarter. Mexican headline consumer price inflation continues to hover at the upper limit of the Bank of Mexico's target range of 2 percent to 4 percent. Monetary policy was tightened in Mexico in April for the first time since March 2005. In Brazil, the growth of real GDP moderated to about 3 percent in the first quarter, as the appreciation of the Brazilian real weighed on the external sector. The strong real has also helped keep inflation in check despite fairly strong economic growth and a lowering of the policy interest rate. Economic growth in Argentina moved down in the first quarter, in part because of a contraction in exports, and reported data suggest that inflation has continued to decline. Growth in Venezuela appears to have slowed sharply so far in 2007 after three years of double-digit performances, driven by expansionary fiscal policy funded by high petroleum revenues. Venezuelan twelve-month inflation picked up to nearly 20 percent in June. • Federal Reserve Operations 85 Banking Supervision and Regulation The Federal Reserve has supervisory and regulatory authority over a variety of financial institutions and activities. It plays an important role as umbrella supervisor of bank holding companies, including financial holding companies. And it is the primary federal supervisor of state banks that are members of the Federal Reserve System. Two thousand seven was a challenging year for bank holding companies (BHCs) and state member banks. BHC asset quality and earnings deteriorated over the second half of the year, mainly because of the effects of developments in the residential housing market. Nonperforming assets increased notably as the quality of mortgages, home equity lines of credit, and loans to real estate developers weakened. Nevertheless, BHCs reported net income exceeding $90 billion for the full year. A sharp increase in subprime mortgage delinquencies adversely affected the securitization market. Liquidity and capital were strained as some BHCs brought certain off-balance-sheet exposures onto their books. Several institutions also recognized significant valuation writedowns on assets affected by market conditions. Despite these pressures, BHCs continued to maintain regulatory capital ratios in excess of minimum regulatory requirements. Most state member banks entered 2007 after a sustained period of strong earnings performance, partly mitigating developments in the market. Although net income and return on assets fell late in the year, reflecting asset write-downs and higher loan-loss provisions, these measures of profitability have been at historically high levels since the mid1990s, helping to provide banks with a substantial base of capital. Risk-based capital ratios declined modestly over the year, but at year-end more than 99 percent of all commercial banks continued to report capital ratios consistent with a "well capitalized" designation under prompt corrective action standards. Although credit quality indicators also worsened during the year, overall loan quality measures remained relatively sound by historical standards. In 2007 the banking industry saw bank failures for the first time in three years as three insured institutions—two state nonmember banks and one thrift institution with assets totaling approximately $2.6 billion—were closed. Banking supervisors focused in 2007 on credit risk issues related to subprime lending activities. During the course of the year the federal financial regulatory agencies—the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS)—issued guidance encouraging supervised institutions to work constructively with homeowners unable to continue meeting their mortgage payments. The agencies also released a statement emphasizing the need to maintain prudent underwriting standards and to provide clear and balanced information to consumers so that institutions and consumers can assess the risks arising from certain adjustablerate mortgage (ARM) products that offer discounted or low introductory rates. The Federal Reserve also joined with 86 94th Annual Report, 2007 the FDIC, NCUA, OCC, OTS, and the Conference of State Bank Supervisors to issue a statement encouraging federally regulated financial institutions and state-supervised entities that service securitized residential mortgages to review their authority under pooling and servicing agreements so as to identify borrowers at risk of default and pursue appropriate loss-mitigation strategies designed to preserve sustainable home ownership. Federal Reserve staff continued to work with the other federal banking agencies in 2007 to prepare for U.S. implementation of the Basel II capital accord.1 In November the Board of Governors approved final rules implementing new risk-based capital requirements for large, internationally active banking organizations (the Basel II advanced approaches framework) and joined the OCC, FDIC, and OTS in publishing those rules in December. Scope of Responsibilities for Supervision and Regulation The Federal Reserve is the federal supervisor and regulator of all U.S. bank holding companies, including financial holding companies formed under the authority of the 1999 Gramm-Leach-Bliley Act, and state-chartered commercial banks that are members of the Federal Reserve System. In overseeing these or1. The Basel II capital accord, an international agreement formally titled "International Convergence of Capital Measurement and Capital Standards: A Revised Framework," was developed by the Basel Committee on Banking Supervision, which is made up of representatives of the central banks or other supervisory authorities of thirteen countries. The original document was issued in 2004; the original version and an updated version issued in November 2005 are available on the website of the Bank for International Settlements (www.bis.org). ganizations, the Federal Reserve seeks primarily to promote their safe and sound operation, including their compliance with laws and regulations. The Federal Reserve also has responsibility for supervising the operations of all Edge Act and agreement corporations, the international operations of state member banks and U.S. bank holding companies, and the U.S. operations of foreign banking organizations. The Federal Reserve exercises important regulatory influence over entry into the U.S. banking system, and the structure of the system, through its administration of the Bank Holding Company Act, the Bank Merger Act (with regard to state member banks), the Change in Bank Control Act (with regard to bank holding companies and state member banks), and the International Banking Act. The Federal Reserve is also responsible for imposing margin requirements on securities transactions. In carrying out these responsibilities, the Federal Reserve coordinates its supervisory activities with the other federal banking agencies, state agencies, functional regulators, and the bank regulatory agencies of other nations. Supervision for Safety and Soundness To promote the safety and soundness of banking organizations, the Federal Reserve conducts on-site examinations and inspections and off-site surveillance and monitoring. It also takes enforcement and other supervisory actions as necessary. Examinations and Inspections The Federal Reserve conducts examinations of state member banks, the U.S. branches and agencies of foreign banks, Banking Supervision and Regulation 87 State Member Banks and Bank Holding Companies, 2003-2007 Entity/Item State member banks Total number Total assets (billions of dollars) Number of examinations By Federal Reserve System By state banking agency Top-tier bank holding companies Large (assets of more than $1 billion) Total number Total assets (billions of dollars) ... Number of inspections By Federal Reserve System1 . . . On site Off site By state banking agency Small (assets of $1 billion or less) Total number Total assets (billions of dollars) ... Number of inspections By Federal Reserve System On site Off site By state banking agency Financial holding companies Domestic Foreign 2007 2006 2005 2004 2003 878 1,519 694 479 215 901 1,405 761 500 261 907 1,318 783 563 220 919 1,275 809 581 228 935 1,912 822 581 241 459 13,281 492 476 438 38 16 448 12,179 566 557 500 57 9 394 10,261 501 496 457 39 5 355 8,429 500 491 440 51 9 365 8,295 454 446 399 47 8 4,611 974 3,186 3,007 120 2,887 179 4,654 947 3,449 3,257 112 3,145 192 4,760 890 3,420 3,233 170 3,063 187 4,796 852 3,703 3,526 186 3,340 177 4,787 847 3,453 3,324 183 3,141 129 597 43 599 44 591 38 600 36 612 32 1. For large bank holding companies subject to continuous, risk-focused supervision, includes multiple targeted reviews. and Edge Act and agreement corporations. In a process distinct from examinations, it conducts inspections of bank holding companies and their nonbank subsidiaries. Whether an examination or an inspection is being conducted, the review of operations entails (1) an assessment of the quality of the processes in place to identify, measure, monitor, and control risks; (2) an assessment of the quality of the organization's assets; (3) an evaluation of management, including an assessment of internal policies, procedures, controls, and operations; (4) an assessment of the key financial factors of capital, asset quality, earnings, and liquidity; and (5) a review for compliance with applicable laws and regulations. The table provides information on examinations and inspections conducted by the Federal Reserve during the past five years. Inspections of bank holding companies, including financial holding companies, are built around a rating system introduced in 2005 that reflects the recent shift in supervisory practices for these organizations away from a historical analysis of financial condition toward a more dynamic, forward looking assessment of risk-management practices and financial factors. Under the system, known as RFI but more fully termed RFI/C(D), holding companies are assigned a composite rating (C) that is based on assessments of three components: Risk Management (R), Financial Condition (F), and the potential Impact (I) of the parent company and its nondepository subsidiaries on the subsidiary 88 94th Annual Report, 2007 depository institution.2 The fourth component, Depository Institution (D), is intended to mirror the primary regulator's rating of the subsidiary depository institution. In managing the supervisory process, the Federal Reserve takes a risk-focused approach that directs resources to (1) those business activities posing the greatest risk to banking organizations and (2) the organizations' management processes for identifying, measuring, monitoring, and controlling risks. The key features of the supervision program for large complex banking organizations (LCBOs) are (1) identifying those LCBOs that are judged, on the basis of their shared risk characteristics, to present the highest level of supervisory risk to the Federal Reserve; (2) maintaining continual supervision of these organizations so that the Federal Reserve's assessment of each organization's condition is current; (3) assigning to each LCBO a supervisory team composed of Reserve Bank staff members who have skills appropriate for the organization's risk profile (the team leader is the Federal Reserve System's central point of contact for the organization, has responsibility for only one LCBO, and is supported by specialists capable of evaluating the risks of LCBO business activities and functions); and (4) promoting Systemwide and interagency information-sharing through automated systems. For other banking organizations, the risk-focused supervision program provides that examination procedures are 2. Each of the first two components has four subcomponents: Risk Management—Board and Senior Management Oversight; Policies, Procedures, and Limits; Risk Monitoring and Management Information Systems; and Internal Controls. Financial Condition—Capital; Asset Quality; Earnings; and Liquidity. tailored to each banking organization's size, complexity, and risk profile. As with the LCBOs, examinations entail both off-site and on-site work, including planning, pre-examination visits, detailed documentation, and examination reports tailored to the scope and findings of the examination. State Member Banks At the end of 2007, 878 state-chartered banks (excluding nondepository trust companies and private banks) were members of the Federal Reserve System. These banks represented approximately 12 percent of all insured U.S. commercial banks and held approximately 14 percent of all insured commercial bank assets in the United States. The guidelines for Federal Reserve examinations of state member banks are fully consistent with section 10 of the Federal Deposit Insurance Act, as amended by section 111 of the Federal Deposit Insurance Corporation Improvement Act of 1991 and by the Riegle Community Development and Regulatory Improvement Act of 1994. A fullscope, on-site examination of these banks is required at least once a year, although certain well-capitalized, wellmanaged organizations having total assets of less than $500 million may be examined once every eighteen months.3 The Federal Reserve conducted 479 exams of state member banks in 2007. 3. The total assets threshold for this group of well-capitalized, well-managed organizations was increased during the year. The Financial Services Regulatory Relief Act of 2006, which became effective in October 2006, authorized the federal banking agencies to raise the threshold from $250 million to $500 million, and final rules incorporating the change into existing regulations were issued on September 21, 2007. Banking Supervision and Regulation Bank Holding Companies At year-end 2007, a total of 5,793 U.S. bank holding companies were in operation, of which 5,070 were top-tier bank holding companies. These organizations controlled 6,038 insured commercial banks and held approximately 96 percent of all insured commercial bank assets in the United States. Federal Reserve guidelines call for annual inspections of large bank holding companies and complex smaller companies. In judging the financial condition of the subsidiary banks owned by holding companies, Federal Reserve examiners consult examination reports prepared by the federal and state banking authorities that have primary responsibility for the supervision of those banks, thereby minimizing duplication of effort and reducing the supervisory burden on banking organizations. Noncomplex bank holding companies with consolidated assets of $1 billion or less are subject to a special supervisory program that permits a more flexible approach.4 In 2007, the Federal Reserve conducted 476 inspections of large bank holding companies and 3,007 inspections of small, noncomplex bank holding companies. Financial Holding Companies Under the Gramm-Leach-Bliley Act, bank holding companies that meet certain capital, managerial, and other requirements may elect to become financial holding companies and thereby engage in a wider range of financial activities, including full-scope securities underwriting, merchant banking, and insurance underwriting and sales. The 4. The special supervisory program was implemented in 1997 and modified in 2002. See SR letter 02-01 for a discussion of the factors considered in determining whether a bank holding company is complex or noncomplex (www. federalreserve.gov/boarddocs/srletters/). 89 statute streamlines the Federal Reserve's supervision of all bank holding companies, including financial holding companies, and sets forth parameters for the supervisory relationship between the Federal Reserve and other regulators. The statute also differentiates between the Federal Reserve's relations with regulators of depository institutions and its relations with functional regulators (that is, regulators for insurance, securities, and commodities firms). As of year-end 2007, 597 domestic bank holding companies and 43 foreign banking organizations had financial holding company status. Of the domestic financial holding companies, 33 had consolidated assets of $15 billion or more; 136, between $1 billion and $15 billion; 93, between $500 million and $1 billion; and 335, less than $500 million. International Activities The Federal Reserve supervises the foreign branches and overseas investments of member banks, Edge Act and agreement corporations, and bank holding companies and also the investments by bank holding companies in export trading companies. In addition, it supervises the activities that foreign banking organizations conduct through entities in the United States, including branches, agencies, representative offices, and subsidiaries. Foreign Operations of U.S. Banking Organizations In supervising the international operations of state member banks, Edge Act and agreement corporations, and bank holding companies, the Federal Reserve generally conducts its examinations or inspections at the U.S. head offices of these organizations where the ultimate responsibility for the foreign offices lies. 90 94th Annual Report, 2007 Examiners also visit the overseas offices of U.S. banks to obtain financial and operating information and, in some instances, to evaluate the organizations' efforts to implement corrective measures or to test their adherence to safe and sound banking practices. Examinations abroad are conducted with the cooperation of the supervisory authorities of the countries in which they take place; for national banks, the examinations are coordinated with the OCC. At the end of 2007, 55 member banks were operating 619 branches in foreign countries and overseas areas of the United States; 33 national banks were operating 567 of these branches, and 22 state member banks were operating the remaining 52. In addition, 17 nonmember banks were operating 23 branches in foreign countries and overseas areas of the United States. Edge Act and Agreement Corporations Edge Act corporations are international banking organizations chartered by the Board to provide all segments of the U.S. economy with a means of financing international business, especially exports. Agreement corporations are similar organizations, state chartered or federally chartered, that enter into an agreement with the Board to refrain from exercising any power that is not permissible for an Edge Act corporation. Sections 25 and 25A of the Federal Reserve Act grant Edge Act and agreement corporations permission to engage in international banking and foreign financial transactions. These corporations, most of which are subsidiaries of member banks, may (1) conduct a deposit and loan business in states other than that of the parent, provided that the business is strictly related to international transactions, and (2) make foreign in vestments that are broader than those permissible for member banks. At year-end 2007, 67 banking organizations, operating 12 branches, were chartered as Edge Act or agreement corporations. These corporations are examined annually. U.S. Activities of Foreign Banks The Federal Reserve has broad authority to supervise and regulate the U.S. activities of foreign banks that engage in banking and related activities in the United States through branches, agencies, representative offices, commercial lending companies, Edge Act corporations, commercial banks, bank holding companies, and certain nonbanking companies. Foreign banks continue to be significant participants in the U.S. banking system. As of year-end 2007, 172 foreign banks from 53 countries were operating 211 state-licensed branches and agencies, of which 8 were insured by the FDIC, and 47 OCC-licensed branches and agencies, of which 4 were insured by the FDIC. These foreign banks also owned 9 Edge Act and agreement corporations and 2 commercial lending companies; in addition, they held a controlling interest in 62 U.S. commercial banks. Altogether, the U.S. offices of these foreign banks at the end of 2007 controlled approximately 18 percent of U.S. commercial banking assets. These 172 foreign banks also operated 91 representative offices; an additional 49 foreign banks operated in the United States through a representative office. State-licensed and federally licensed branches and agencies of foreign banks are examined on-site at least once every eighteen months, either by the Federal Reserve or by a state or other federal regulator. In most cases, on-site examinations are conducted at least once ev- Banking Supervision and Regulation ery twelve months, but the period may be extended to eighteen months if the branch or agency meets certain criteria. In cooperation with the other federal and state banking agencies, the Federal Reserve conducts a joint program for supervising the U.S. operations of foreign banking organizations. The program has two main parts. One part involves examination of those foreign banking organizations that have multiple U.S. operations and is intended to ensure coordination among the various U.S. supervisory agencies. The other part is a review of the financial and operational profile of each organization to assess its general ability to support its U.S. operations and to determine what risks, if any, the organization poses through its U.S. operations. Together, these two processes provide critical information to U.S. supervisors in a logical, uniform, and timely manner. The Federal Reserve conducted or participated with state and federal regulatory authorities in 357 examinations in 2007. Compliance with Regulatory Requirements The Federal Reserve examines supervised institutions for compliance with a broad range of legal requirements, including anti-money-laundering and consumer protection laws and regulations, and other laws pertaining to certain banking and financial activities. Most compliance supervision is conducted under the oversight of the Division of Banking Supervision and Regulation, but consumer compliance supervision is conducted under the oversight of the Division of Community and Consumer Affairs. The two divisions coordinate their efforts with each other and also with the Board's Legal Division to ensure consistent and comprehensive Federal Reserve 91 supervision for compliance with legal requirements. Anti-Money-Laundering Examinations With regard to anti-money-laundering requirements, U.S. Department of the Treasury regulations (31 CFR 103) implementing the Bank Secrecy Act (BSA) generally require banks and other types of financial institutions to file certain reports and maintain certain records that are useful in criminal or regulatory proceedings. The BSA and separate Board regulations require banking organizations supervised by the Board to file reports on suspicious activity related to possible violations of federal law, including money laundering, terrorism financing, and other financial crimes. In addition, BSA and Board regulations require that banks develop written programs on BSA/anti-money-laundering compliance and that the programs be formally approved by bank boards of directors. An institution's compliance program must (1) establish a system of internal controls to ensure compliance with the BSA, (2) provide for independent compliance testing, (3) identify individuals responsible for coordinating and monitoring day-to-day compliance, and (4) provide training for personnel as appropriate. The Federal Reserve is responsible for examining its supervised institutions for compliance with various antimoney-laundering laws and regulations. During examinations of state member banks and U.S. branches and agencies of foreign banks and, when appropriate, inspections of bank holding companies, examiners review the institution's compliance with the BSA and determine whether adequate procedures and controls to guard against money laundering and terrorism financing are in place. 92 94th Annual Report, 2007 Specialized Examinations The Federal Reserve conducts specialized examinations of banking organizations in the areas of information technology, fiduciary activities, transfer agent activities, and government and municipal securities dealing and brokering. The Federal Reserve also conducts specialized examinations of certain entities, other than banks, brokers, or dealers, that extend credit subject to the Board's margin regulations. Information Technology Activities In recognition of the importance of information technology to safe and sound operations in the financial industry, the Federal Reserve reviews the information technology activities of supervised banking organizations as well as certain independent data centers that provide information technology services to these organizations. All safety and soundness examinations include a risk-focused review of information technology risk management activities. During 2007, the Federal Reserve was the lead agency in 2 cooperative, interagency examinations of large, multiregional data processing servicers. Fiduciary Activities The Federal Reserve has supervisory responsibility for state member commercial banks and depository trust companies that together reported, at the end of 2007, $39 trillion of assets in various fiduciary or custodial capacities. Additionally, state member nondepository trust companies supervised by the Federal Reserve reported $40 trillion of assets held in a fiduciary or custodial capacity. During on-site examinations of fiduciary activities, an organization's compliance with laws, regulations, and general fiduciary principles and its po tential conflicts of interest are reviewed; its management and operations, including its asset- and account-management, risk-management, and audit and control procedures, are also evaluated. In 2007, Federal Reserve examiners conducted 98 on-site fiduciary examinations. Transfer Agents and Securities Clearing Agencies As directed by the Securities Exchange Act of 1934, the Federal Reserve conducts specialized examinations of those state member banks and bank holding companies that are registered with the Board as transfer agents. Among other things, transfer agents countersign and monitor the issuance of securities, register the transfer of securities, and exchange or convert securities. On-site examinations focus on the effectiveness of an organization's operations and its compliance with relevant securities regulations. During 2007, the Federal Reserve conducted on-site examinations at 18 of the 68 state member banks and bank holding companies that were registered as transfer agents and examined 1 state member limited-purpose trust company acting as a national securities depository. Government and Municipal Securities Dealers and Brokers The Federal Reserve is responsible for examining state member banks and foreign banks for compliance with the Government Securities Act of 1986 and with Treasury regulations governing dealing and brokering in government securities. Thirty state member banks and 6 state branches of foreign banks have notified the Board that they are government securities dealers or brokers not exempt from Treasury's regulations. During 2007, the Federal Reserve conducted 7 examinations of broker-dealer activi- Banking Supervision and Regulation ties in government securities at these organizations. These examinations are generally conducted concurrently with the Federal Reserve's examination of the state member bank or branch. The Federal Reserve is also responsible for ensuring that state member banks and bank holding companies that act as municipal securities dealers comply with the Securities Act Amendments of 1975. Municipal securities dealers are examined pursuant to the Municipal Securities Rulemaking Board's rule G-16 at least once every two calendar years. Of the 22 entities that dealt in municipal securities during 2007, 7 were examined during the year. Securities Credit Lenders Under the Securities Exchange Act of 1934, the Board is responsible for regulating credit in certain transactions involving the purchase or carrying of securities. As part of its general examination program, the Federal Reserve examines the banks under its jurisdiction for compliance with the Board's Regulation U (Credit by Banks and Persons other than Brokers or Dealers for the Purpose of Purchasing or Carrying Margin Stock). In addition, the Federal Reserve maintains a registry of persons other than banks, brokers, and dealers who extend credit subject to Regulation U. The Federal Reserve may conduct specialized examinations of these lenders if they are not already subject to supervision by the Farm Credit Administration (FCA), the NCUA, or the OTS. At the end of 2007, 621 lenders other than banks, brokers, or dealers were registered with the Federal Reserve. Other federal regulators supervised 200 of these lenders, and the remaining 421 were subject to limited Federal Reserve supervision. On the basis of regulatory requirements and annual reports, the 93 Federal Reserve exempted 246 lenders from its on-site inspection program. Nonexempt lenders are subject to either biennial or triennial inspection. Sixtyeight inspections were conducted during the year. Business Continuity In 2007, the Federal Reserve continued its efforts to strengthen the resilience of the U.S. financial system in the event of unexpected disruptions. The Federal Reserve, the OCC, and the Securities and Exchange Commission (SEC) continued joint supervisory assessments of the activities of core clearing and settlement firms and significant market participants in implementing and maintaining sound business resiliency and continuity practices as outlined in "Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System." The Federal Reserve and the other Federal Financial Institutions Examination Council (FFIEC) agencies continued to coordinate their efforts to ensure a consistent supervisory approach for business continuity practices.5 Enforcement Actions The Federal Reserve has enforcement authority over the banking organizations it supervises and their affiliated parties. Enforcement actions may be taken to address unsafe and unsound practices or violations of any law or regulation. Formal enforcement actions include ceaseand-desist orders, written agreements, removal and prohibition orders, and civil money penalties. In 2007, the Federal Reserve completed 34 formal enforcement actions. Civil money penalties totaling $20,255,290 were assessed. 5. The FFIEC member agencies are the Federal Reserve Board, the FDIC, the NCUA, the OCC, and the OTS. 94 94th Annual Report, 2007 As directed by statute, all civil money penalties are remitted to either the Treasury or the Federal Emergency Management Agency. Enforcement orders, which are issued by the Board, and written agreements, which are executed by the Reserve Banks, are made public and are posted on the Board's website (www.federalreserve.gov/boarddocs/ enforcement). In addition to taking these formal enforcement actions, the Reserve Banks completed 67 informal enforcement actions in 2007. Informal enforcement actions include memoranda of understanding and board of directors resolutions. Information about these actions is not available to the public. Surveillance and Off-Site Monitoring The Federal Reserve uses automated screening systems to monitor the financial condition and performance of state member banks and bank holding companies between on-site examinations. Such monitoring and analysis helps direct examination resources to institutions that have higher risk profiles. Screening systems also assist in the planning of examinations by identifying companies that are engaging in new or complex activities. The primary off-site monitoring tool used by the Federal Reserve is the Supervision and Regulation Statistical Assessment of Bank Risk model (SRSABR). Drawing primarily on the financial data that banks report on their Reports of Condition and Income (Call Reports), SR-SABR uses econometric techniques to identify banks that report financial characteristics weaker than those of other banks assigned similar supervisory ratings. To supplement the SR-SABR screening, the Federal Reserve also monitors various market data, including equity prices, debt spreads, agency ratings, and measures of expected default frequency, to gauge market perceptions of the risk in banking organizations. In addition, the Federal Reserve prepares quarterly Bank Holding Company Performance Reports (BHCPRs) for use in monitoring and inspecting supervised banking organizations. The BHCPRs, which are compiled from data provided by large bank holding companies in quarterly regulatory reports (FR Y-9C and FR Y-9LP), contain, for individual companies, financial statistics and comparisons with peer companies. BHCPRs are made available to the public on the National Information Center (NIC) website, which can be accessed at www.ffiec.gov. During 2007, three major upgrades to the web-based Performance Report Information and Surveillance Monitoring (PRISM) application were completed. PRISM is a querying tool used by Federal Reserve analysts to access and display financial, surveillance, and examination data. In the analytical module, users can customize the presentation of institutional financial information drawn from Call Reports, Uniform Bank Performance Reports, FR Y-9 statements, BHCPRs, and other regulatory reports. In the surveillance module, users can generate reports summarizing the results of surveillance screening for banks and bank holding companies. The upgrades made more regulatory data available for querying, gave users the ability to display commercial real estate guidance data, and provided a way to access structure information for all institutions in NIC. The Federal Reserve works through the FFIEC Task Force on Surveillance Systems to coordinate surveillance activities with the other federal banking agencies. Banking Supervision and Regulation International Training and Technical Assistance In 2007, the Federal Reserve continued to provide technical assistance on bank supervisory matters to foreign central banks and supervisory authorities. Technical assistance involves visits by Federal Reserve staff members to foreign authorities as well as consultations with foreign supervisors who visit the Board or the Reserve Banks. Technical assistance in 2007 was concentrated in Latin America, Asia, and former Soviet bloc countries. The Federal Reserve, along with the OCC, the FDIC, and the Treasury, was also an active participant in the Middle East and North Africa Financial Regulators' Training Initiative, which is part of the U.S. government's Middle East Partnership Initiative. During the year the Federal Reserve offered training courses exclusively for foreign supervisory authorities, both in the United States and in a number of foreign jurisdictions. System staff also took part in technical assistance and training missions led by the International Monetary Fund, the World Bank, the Inter-American Development Bank, the Asian Development Bank, the Basel Committee on Banking Supervision (Basel Committee), and the Financial Stability Institute. The Federal Reserve is also an associate member of the Association of Supervisors of Banks of the Americas (ASBA), an umbrella group of bank supervisors from countries in the Western Hemisphere. The group, headquartered in Mexico, promotes communication and cooperation among bank supervisors in the region; coordinates training programs throughout the region, with the help of national banking supervisors and international agencies; and aims to help members develop banking laws, regulations, and supervisory practices 95 that conform to international best practices. The Federal Reserve contributes significantly to ASBA's organizational management and to its training and technical assistance activities. Supervisory Policy The Federal Reserve's supervisory policy function is responsible for developing guidance for examiners and banking organizations as well as regulations for banking organizations under the Federal Reserve's supervision. Staff members participate in supervisory and regulatory forums, provide support for the work of the FFIEC, and participate in international forums such as the Basel Committee, the Joint Forum, and the International Accounting Standards Board. Capital Adequacy Standards Risk-Based Capital Standards for Certain Internationally Active Banking Organizations On December 7, 2007, the Federal Reserve, OCC, FDIC, and OTS published final rules implementing new risk-based capital requirements for large, internationally active banking organizations (the Basel II advanced approaches framework). The advanced approaches framework is broadly consistent with international approaches to implementation of Basel II and includes a number of prudential safeguards, such as the requirement that banking organizations satisfactorily complete a four-quarter parallel run period before operating under the Basel II framework, and the use of transitional capital floors. It retains the long-standing minimum risk-based capital requirement of 4 percent tier 1 capital and 8 percent total qualifying capital and the tier 1 leverage ratio. 96 94th Annual Report 2007 New Capital Adequacy Framework for UJS, Banking Organizations Aligning regulatory capital requirements with risk and fostering good risk measurement and management practices for our largest and most complex banking organizations will, I believe, contribute to safer and sounder banks and a more resilient financial system. Randall S. Kroszner, Member, Board of Governors November 2007 On December 7, 2007, the US. banking agencies published a new risk-based capital adequacy framework.1 The new framework—known as the advanced approaches framework—is designed to align more closely the amount of capital U.S. banking organizations are required to hold as a cushion against potential losses with the risks to which they are exposed. Effective April 2008, large, internationally active U.S. banking organizations will be required to transition to the advanced approaches framework to calculate the amount of capital they must hold relative to their risk profile; other banking organizations may choose to use the new framework.2 The advanced approaches framework for U.S. banking organizations is based on the revised international capital accord known as Basel II, which was 1. The U.S. banking agencies are the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. 2. Banking organizations with at least $250 billion of consolidated total assets or at least $10 billion of foreign exposure are required to use the advanced approaches and to meet the rule's rigorous qualification requirements; other banking organizations may opt into the advanced approaches framework, provided they also meet its requirements. Banking organizations subject to the framework are expected to meet certain public disclosure requirements designed to foster transparency and market discipline. In addition, the prompt corrective adopted in 2006 by international banking authorities working through the Basel Committee on Banking Supervision. The need for a new capital adequacy framework arose from continuing rapid and extensive evolution and innovation in the financial marketplace, which has substantially reduced the effectiveness of the existing risk-based capital rules (the Basel I-based rules) for large, internationally active banking organizations. The Basel II-based rules are more sensitive to risk and are tailored to the different kinds of risk to which banking organizations are exposed. Basel II regulatory capital requirements will vary from organization to organization in line with the organization's actual risk profile, so that a banking organization exposed to greater risk will have higher requirements than one exposed to less risk. Both the international and the U.S. frameworks encompass three elements, or pillars: minimum risk-based capital requirements (pillar 1); supervisory review of capital adequacy (pillar 2); and market discipline through enhanced public disclosure (pillar 3). Pillar 1 addresses calculation of regulatory capital requirements in relation to certain risk exposures. To calculate their minimum requirements in relation to the credit risk arising from wholesale and retail action rules for banks that are not adequately capitalized remain in effect. (For more information, see the box "New Capital Adequacy Framework for U.S. Banking Organizations.") Banking Supervision and Regulation exposures, U.S. banking organizations will use an internal ratings-based approach, inserting their own internal estimates of key credit risk parameters into formulas provided by supervisors. They will calculate their minimum requirements in relation to operational risk using advanced measurement approaches, which rely on the institutions* internal risk-measurement and capital calculation processes. The advanced approaches framework also specifies separate methodologies for calculating capital requirements in relation to securitization and equity exposures. Compared with the Basel I-based rules, banking organizations under Basel II-based rules will be required to take greater account of their off-balance-sheet activities in calculating their capital requirements. The new framework also provides a more-risksensitive regulatory capital approach to capital markets activities and transactions, such as repurchase agreements, securities borrowing and lending, margin loans, and over-the-counter derivatives. The enhanced risk sensitivity of the advanced approaches framework should provide incentives for lending to creditworthy counterparties and using effective credit-risk mitigation techniques, such as requiring collateral. The advanced approaches build on the risk-measurement and risk-management approaches already being used by sophisticated banking organizations and are designed to evolve over time as these organizations refine and enhance their internal practices. As a result, these approaches are better able than the Basel 1-based rules to be adapted to innovations in banking and financial markets and to capture the risks arising from new products and activities. This increased adaptability and flexibility suggests that the relationship between Revisions to the Market Risk Capital Rule During 2007, the Federal Reserve, OCC, FDIC, and OTS considered public com 97 the risk-based regulatory measure of capital adequacy and a banking organization's actual risk exposures and its day-to-day risk management will be stronger and more consistent. Pillars 2 and 3 are also essential elements of the advanced approaches framework. Under pillar 2, banking organizations are required to have an internal process for ensuring that they are holding enough capital to support their overall risk profile (including those risks not captured or not fully addressed under pillar 1), particularly during economic downturns and periods of financial stress. These internal processes will be subject to rigorous supervisory review. Pillar 3 addresses banking organizations' communication with market participants about their risks, the associated levels of capital, and the manner in which they are meeting the requirements of the advanced approaches framework. The public disclosures called for under pillar 3 are expected to increase the transparency of banking organizations' activities and exposures, giving market participants useful information about banking organizations' risk profiles and their ability to manage risk. Adoption of the advanced approaches framework is an important milestone for the U.S. banking agencies, but effective implementation in the coming years will be just as important. Implementation of the Basel II-based rules, and the associated improvements in risk management, will not be a one-time event, but rather an ongoing process. The agencies will observe carefully how the advanced approaches work in practice, assessing their advantages and limitations, to ensure that they are operating as intended. ments on a September 2006 notice of proposed rulemaking that presented revisions to the market risk capital rule used by the Federal Reserve, OCC, and 98 94th Annual Report, 2007 FDIC since 1997 for banking organizations having significant exposure to market risk. Under the existing market risk capital rule, certain banking organizations are required to calculate a capital requirement for the general market risk of their covered positions and the specific risk of their covered debt and equity positions. The proposed revisions would enhance the rule's risk sensitivity, require banking organizations that model specific risk to reflect any incremental default risk of traded positions, and require public disclosure of certain qualitative and quantitative market risk information. The agencies expect to finalize this rule in the first half of 2008. In July 2007, the Federal Reserve issued a letter reminding supervised banking organizations that the application of the fair value option to securities may subject the organization to the market risk capital rule. The letter directed those organizations to contact their Reserve Bank to discuss their plans to address the rule's requirements. Risk-Based Capital Standards for Banking Organizations Not Subject to Basel II During 2007, the Federal Reserve, OCC, FDIC, and OTS considered public comments on a notice of proposed rulemaking (NPR) issued in December 2006 proposing modifications to the current Basel I-based capital rules. The proposed rules would provide an option to those banking organizations that are not required to adopt Basel II and do not wish to voluntarily follow the advanced approaches. This option is known as the Basel I-A proposal. In response to comments calling for an option to adopt the standardized approach under Basel II, the agencies revised the Basel I-A proposal and intend to issue a new NPR setting forth a pro posed standardized Basel II capital rule in the first half of 2008. Other Capital Issues Board staff conduct supervisory analyses of innovative capital instruments and novel transactions to determine whether such instruments qualify for inclusion in tier 1 capital.6 Much of this work in 2007 involved evaluating enhanced forms of trust preferred securities and mandatory convertible securities. Staff members also identify and address supervisory concerns related to supervised banking organizations' capital issuances and work with the Reserve Banks to evaluate the overall composition of banking organizations' capital. In this work, the staff often must review the funding strategies proposed in applications for acquisitions and other transactions submitted to the Federal Reserve by banking organizations. Accounting Policy The supervisory policy function is also responsible for monitoring major domestic and international proposals, standards, and other developments affecting the banking industry in the areas of accounting, auditing, internal controls over financial reporting, financial disclosure, and supervisory financial reporting. Federal Reserve staff members interact with key constituents in the accounting and auditing professions, including regulators, standardsetters, accounting firms, accounting and banking industry trade groups, and the banking industry, and issue supervisory guidance as appropriate. 6. Tier 1 capital comprises common stockholders' equity and qualifying forms of preferred stock, less required deductions such as goodwill and certain intangible assets. Banking Supervision and Regulation Domestic Accounting The Federal Reserve continues to closely monitor domestic and international accounting standard-setting related to the use of fair value accounting. In previous comment letters to the Financial Accounting Standards Board (FASB), the Federal Reserve has raised concerns about the reliability of reported financial results based on fair value measurements, especially when financial instruments are illiquid. In May 2007, Federal Reserve staff issued a comment letter to the FASB regarding its "Invitation to Comment on Valuation Guidance for Financial Reporting" that strongly supported efforts to consider the need for additional valuation guidance. The FASB's Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, issued in February 2007, allows most financial assets and financial liabilities to be reported at fair value. As part of its continued focus on the use of fair value accounting at banking organizations, and in light of the potential increased use of fair value accounting for loans, the Federal Reserve staff conducted a study of fair value measurements of commercial loan values. The study was intended to provide additional insight into valuation methodologies used and related control frameworks for loans at a number of large, internationally active banking organizations. The study report, issued in June 2007, summarizes commercial loan fair value measurement practices at these organizations. Federal Reserve staff participated in a number of SEC and FASB efforts to address current accounting issues. A senior Federal Reserve representative is an official observer on the SEC Advisory Committee on Improvements to Fi- 99 nancial Reporting, which was established to examine the U.S. financial reporting system with the goals of reducing unnecessary complexity and making information more useful and understandable for investors. Federal Reserve staff also participated in FASB efforts to improve financial reporting, including roundtable discussions on modifications of securitized subprime mortgage loans and the joint FASBInternational Accounting Standards Board (IASB) project on Financial Statement Presentation. Bank Secrecy Act and Anti-Money Laundering In 2007, the FFIEC again updated the Bank Secrecy Act/Anti-Money Laundering Examination Manual (originally issued in 2005) to further clarify supervisory expectations, incorporate new regulatory issuances, and respond to industry requests for additional guidance. Significant revisions included updates to the chapters on customer due diligence, suspicious activity reporting, foreign correspondent accounts, electronic banking, and trade finance. The manual provides current and consistent riskbased guidance to help banking organizations comply with the BSA and safeguard operations from money laundering and terrorism financing. Also during the year, the FFIEC agencies issued "Interagency Statement on Enforcement of Bank Secrecy Act/AntiMoney Laundering Requirements" setting forth their interpretation of the requirement in the Federal Deposit Insurance Act relating to supervisory actions to address certain BSA compliance issues. The statement provides greater consistency among the agencies on certain BSA enforcement decisions and describes considerations that affect those decisions. 100 94th Annual Report, 2007 The Federal Reserve and other federal banking agencies continued during 2007 to share information with the Financial Crimes Enforcement Network (FinCEN) under the interagency memorandum of understanding (MOU) that was finalized in 2004, and with the Treasury's Office of Foreign Assets Control (OFAC) under the interagency MOU that was finalized in 2006. The Federal Reserve continues to participate in efforts to promote transparency and address risks faced by financial institutions that act as intermediaries in international funds transfers. The Federal Reserve, other U.S. banking agencies, and the Treasury have supported private-sector efforts to address the anti-money-laundering and sanctions concerns of banks that have international operations. In addition, the Federal Reserve participates in the AntiMoney Laundering and Countering the Financing of Terrorism Expert Group, a subcommittee of the Basel Committee's International Liaison Group. International Guidance on Supervisory Policies As a member of the Basel Committee, the Federal Reserve participates in efforts to advance sound supervisory policies for internationally active banking organizations and to improve the stability of the international banking system. In 2007, the Federal Reserve participated in ongoing cooperative work on implementation of Basel II and on development of international supervisory guidance, particularly in the area of funding liquidity risk management. The Federal Reserve also continued to participate in Basel Committee working groups addressing issues not fully resolved in the Basel II framework. One effort is a look at eligible capital instruments across jurisdictions with the goal of developing a definition of capital. The Federal Reserve also participated in a workshop addressing supervisory and industry expectations with regard to implementation of pillar 2 of Basel II (supervisory review). Risk Management The Federal Reserve contributed to supervisory policy papers, reports, and recommendations issued by the Basel Committee during 2007 that were generally aimed at improving the supervision of banking organizations' risk-management practices.7 Two of these were • "Principles for Home-Host Supervisory Cooperation and Allocation Mechanisms in the Context of Advanced Measurement Approaches," consultative document published in February and final document published in November • "Guidelines for Computing Capital for Incremental Default Risk in the Trading Book," consultative document published in October The Federal Reserve contributed to efforts begun in January 2007 to look at liquidity regulation across jurisdictions and to review the 2000 Basel Committee paper "Sound Practices for Managing Liquidity in Banking Organisations" with a view toward updating the paper. Joint Forum In 2007, the Federal Reserve continued to participate in the Joint Forum—a group established under the aegis of the Basel Committee to address issues related to the banking, securities, and insurance sectors, including the regulation 7. Papers issued by the Basel Committee can be accessed via the Bank for International Settlements website at www.bis.org. Banking Supervision and Regulation of financial conglomerates. The Joint Forum is made up of representatives of the Basel Committee, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors. The Federal Reserve contributed to the development of supervisory policy papers, reports, and recommendations issued by the Joint Forum during 2007, including work on risk concentrations, credit risk transfer, customer suitability, and implementation of principles for the supervision of financial conglomerates.8 The Federal Reserve also participated in Joint Forum-sponsored informationsharing on pandemic planning and other business continuity initiatives. International Accounting The Federal Reserve participates in the Basel Committee's Accounting Task Force (ATF), which represents the Basel Committee at international meetings on accounting, auditing, and disclosure issues affecting global banking organizations. During 2007, Federal Reserve staff contributed to the development of numerous Basel Committee comment letters related to accounting and auditing matters that were submitted to the IASB and the International Auditing and Assurance Standards Board (IAASB). The Basel Committee in May 2007 issued a comment letter to the IASB on its discussion paper "Fair Value Measurements." The paper was prepared by the IASB as part of its efforts to develop a standard for fair value measurements similar to the FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued in September 2006. In its letter, the Basel Committee emphasized the importance of sound 101 guidance on fair value measurement, particularly as part of the joint FASBIASB program on convergence between International Financial Reporting Standards and U.S. generally accepted accounting principles (GAAP). In 2007 the Basel Committee also issued a series of comment letters to the IAASB related to the international standards on auditing (ISAs) that are being revised as part of the IAASB's Clarity Project. The Clarity Project is part of an effort by the IAASB to increase consistency in the application of auditing standards around the world and to improve the clarity of the ISAs. The revised ISAs cover such audit areas as planning the audit, auditing different types of financial statements, audit evidence, related parties, going concern, fair value measurements, internal audit, and the auditor's report. Credit Risk Management The Federal Reserve works with the other federal banking agencies to develop guidance on the management of credit risk. Working with Mortgage Borrowers In April 2007 the Federal Reserve, FDIC, NCUA, OCC, and OTS issued staff guidance to encourage supervised institutions to work constructively with homeowners who are financially unable to continue meeting their mortgage payments. The agencies reminded institutions that prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower. Subprime Mortgage Lending 8. Papers issued by the Joint Forum can be accessed via the Bank for International Settlements website at www.bis.org. In June the Federal Reserve, FDIC, NCUA, OCC, and OTS issued "State- 102 94th Annual Report, 2007 ment on Subprime Mortgage Lending" to address issues and questions related to certain adjustable-rate mortgage (ARM) products marketed to subprime borrowers. The statement emphasizes the need for prudent underwriting standards and clear and balanced consumer information, so that institutions and consumers can assess the risks arising from certain ARM products that have discounted or low introductory rates. It describes the prudent safety and soundness and consumer protection standards that institutions should follow to ensure that borrowers obtain loans they can afford to repay. These standards include qualifying borrowers on a fully indexed, fully amortized basis and guidelines on the use of risk-layering features, including an expectation that stated income and reduced documentation would be accepted only if there are documented factors that clearly minimize the need for verification of the borrower's repayment capacity. Consumer protection standards include clear and balanced product disclosures for customers and limits on prepayment penalties so that customers have a reasonable period to refinance without penalty, typically at least sixty days before expiration of the initial fixed interest rate period. Statement on Loss-Mitigation Strategies In September the Federal Reserve, FDIC, NCUA, OCC, OTS, and Conference of State Bank Supervisors issued a statement encouraging federally regulated financial institutions and statesupervised entities that service securitized residential mortgages to review their authority under pooling and servicing agreements to identify borrowers at risk of default and to pursue appropriate loss-mitigation strategies designed to preserve sustainable home ownership. The statement outlines the steps a servicer may take when there is an increased risk of default, including identifying borrowers at heightened risk of delinquency or default, contacting borrowers to assess their ability to repay, and determining whether default is reasonably foreseeable. The statement goes on to explain possible loss-mitigation techniques that a servicer may pursue with a borrower, recognizing that the servicer must consider the documents governing the securitization trust to determine its authority to restructure loans that are delinquent or are at risk of imminent default. Pandemic Planning In December, the FFIEC agencies published guidance on planning for the purpose of minimizing the potential adverse effects of an influenza pandemic. The guidance emphasizes the importance of (1) a preventive program to reduce the likelihood that the institution's operations will be significantly affected by a pandemic, (2) a documented strategy that scales the response to the particular stages of an outbreak, (3) a comprehensive framework of facilities, systems, or procedures needed to continue critical operations, (4) a testing program, and (5) an oversight program. In September and October, the Federal Reserve participated with the other FFIEC agencies in a Treasury-sponsored, industrywide business continuity exercise to test the financial sector's ability to respond to a pandemic crisis. The Federal Reserve helped develop the after-exercise report, which was published in January 2008. Banks' Securities Activities In September, the Federal Reserve and the SEC adopted joint final rules defining the scope of securities activities a Banking Supervision and Regulation bank may conduct without registering with the SEC as a securities broker. The Gramm-Leach-Bliley Act eliminated the blanket "broker" exception for banks that had been contained in section 3(a)(4) of the Securities Exchange Act of 1934, but it granted exceptions designed to allow banks to continue to engage in securities transactions for customers in connection with their normal trust, fiduciary, custodial, and other banking operations. The rules implement the most important "broker" exceptions for trust and fiduciary activities, custodial and deposit "sweep" functions, and third-party networking arrangements. Economic Growth and Regulatory Paperwork Reduction Act of 1996 The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA) requires that the federal banking agencies review their regulations every ten years to identify and eliminate any unnecessary requirements imposed on insured depository institutions. (In addition, the Board periodically reviews each of its regulations.) During 2007, the Federal Reserve, OCC, FDIC, and OTS completed the required review and issued a joint report to Congress, which is available on the EGRPRA website at www.egrpra.gov. Regulatory Reports The supervisory policy function is responsible for developing, coordinating, and implementing regulatory reporting requirements for various financial reporting forms filed by domestic and foreign financial institutions subject to Federal Reserve supervision. Federal Reserve staff' members interact with appropriate federal and state supervisors, including foreign bank supervisors as 103 needed, to recommend and implement appropriate and timely revisions to the reporting forms and the attendant instructions. Bank Holding Company Regulatory Reports The Federal Reserve requires that U.S. bank holding companies periodically submit reports providing financial and structure information. The information is essential in supervising the companies and in formulating regulations and supervisory policies. It is also used in responding to requests from Congress and the public for information about bank holding companies and their nonbank subsidiaries. Foreign banking organizations also are required to periodically submit reports to the Federal Reserve. Reports in the FR Y-9 series— FR Y-9C, FR Y-9LP, and FR Y-9SP— provide standardized financial statements for bank holding companies on both a consolidated and a parent-only basis. The reports are used to detect emerging financial problems, to review performance and conduct pre-inspection analysis, to monitor and evaluate risk profiles and capital adequacy, to evaluate proposals for bank holding company mergers and acquisitions, and to analyze the holding company's overall financial condition. Nonbank subsidiary reports— FR Y-l 1, FR 2314, and FR Y-7N—help the Federal Reserve determine the condition of bank holding companies that are engaged in nonbank activities and also aid in monitoring the number, nature, and condition of the companies' nonbank subsidiaries. In March, several revisions to the FR Y-9C report were approved for implementation during 2007: (1) collection of certain data on the sources of fair value measurements from all institutions that choose, under GAAP, to apply a fair 104 94th Annual Report, 2007 value option to one or more financial instruments and one or more classes of servicing assets and liabilities, and from certain institutions that report trading assets and liabilities; (2) collection of information on the cumulative change in the fair value of liabilities accounted for under the fair value option that is attributable to changes in the bank holding company's own creditworthiness, for purposes of determining regulatory capital; (3) collection of certain data on oneto four-family residential mortgage loans that have terms allowing for negative amortization; and (4) revision of instructions for reporting time deposits and brokered deposits. Effective March 2007, four new items were added to the quarterly FR Y-11 and FR2314 reporting forms to facilitate monitoring of the extension of negatively amortizing residential mortgage loans. Also, a new section concerning notes to the financial statements was added to the FR 2314. Effective June 2007, reporting forms used to collect information on changes in organizational structure and the status of a foreign branch (FR Y-10, FRY-10F, FR Y-10S, and FR 2058) were combined into one event-generated form called the FR Y-10. Also, a supplemental form was created (FR Y-10E) to collect additional structure information that the Federal Reserve deems to be critical and is needed in an expedited manner in order to meet new legislative requirements, answer congressional inquiries, or respond to market events. Effective December 2007, a requirement that an institution verify its list of domestic branches was added to the FR Y-6. In November, the Federal Reserve proposed a number of revisions to the FR Y-9 for the 2008 reporting period comparable to those proposed for the bank Consolidated Reports of Condition and Income (Call Report) as described in the next section. In addition, the Federal Reserve proposed to collect certain data on the FR Y-9LP, FR Y-9SP, FRY-11, FR 2314, FR Y-7, and FR 2886b forms from all institutions that choose to apply a fair value option to financial instruments and servicing assets and liabilities, and also proposed to collect other information on sources of income for supervisory purposes. Commercial Bank Regulatory Financial Reports As the federal supervisor of state member banks, the Federal Reserve, along with the other banking agencies through the FFIEC, requires banks to submit quarterly Call Reports. Call Reports are the primary source of data for the supervision and regulation of banks and the ongoing assessment of the overall soundness of the nation's banking system. Call Report data, which also serve as benchmarks for the financial information required by many other Federal Reserve regulatory financial reports, are widely used by state and local governments, state banking supervisors, the banking industry, securities analysts, and the academic community. For the 2007 reporting period, the FFIEC implemented various revisions to the Call Report to address new safety and soundness considerations and to facilitate supervision. Among these revisions were changes related to the reporting of data for deposit insurance assessments; changes to provide for the reporting of data on nontraditional mortgage products; and changes to provide for the reporting of data related to certain financial instruments measured at fair value. In September, the FFIEC proposed a number of revisions to the Call Report for the 2008 reporting period. The pro- Banking Supervision and Regulation posed revisions include collecting additional information related to one- to four-family residential mortgage loans; modifying the definition of trading account in response to the creation of a fair value option in generally accepted accounting principles; revising certain schedules to enhance the reporting of information available under the fair value option; revising the instructions for reporting daily average deposit data by newly insured institutions to conform with the FDIC's assessment regulations; and clarifying the instructions for reporting credit derivatives data in the riskbased capital schedule. In 2007, Federal Reserve staff led a review of the Call Report by the federal banking agencies to determine which data requirements are no longer necessary or appropriate. The review, required by the Financial Regulatory Relief Act of 2006 to be conducted every five years, documented the safety and soundness and other public policy uses of each Call Report item and will serve as a reference for future changes to the Call Report. Supervisory Information Technology Information technology supporting Federal Reserve supervisory activities is managed within the System supervisory information technology (SSIT) function in the Board's Division of Banking Supervision and Regulation. SSIT works through assigned staff at the Board and the Reserve Banks, as well as through System committees, to ensure that key staff members throughout the System participate in identifying requirements and setting priorities for information technology initiatives. In 2007, the SSIT function worked on several strategic projects and initiatives: (1) alignment of technology investments 105 with business needs; (2) identification and implementation of improvements to make technology more accessible to staff working in the field; (3) strengthening of compliance with data-privacy regulations; (4) identification of opportunities to converge and streamline IT applications, including key administrative systems, to provide consistent and seamless information; (5) evaluation and implementation of collaboration and analysis technologies (such as communities of practice and business intelligence tools) to integrate supervisory and management information systems that support both office-based and field staff; (6) with the other federal regulatory agencies, modernization of the Shared National Credit system; and (7) enhancement of the information security framework for the supervisory function, improving both overall security and compliance with best-practices and regulatory requirements (security enhancements included the encryption of data on all laptop computers and distribution of encrypted portable drives). In addition, new, advanced security measures were pilot-tested prior to expected implementation in 2008. National Information Center The National Information Center (NIC) is the Federal Reserve's comprehensive repository for supervisory, financial, and banking structure data and supervisory documents. NIC includes data on banking structure throughout the United States; the National Examination Database (NED), which enables supervisory personnel as well as federal and state banking authorities to access NIC data; the Banking Organization National Desktop (BOND), an application that facilitates secure, real-time electronic information-sharing and collaboration among federal and state banking regula- 106 94th Annual Report, 2007 tors for the supervision of banking organizations; and the Central Document and Text Repository (CDTR), which contains documents supporting the supervisory processes. Within the NIC, the supporting systems have been modified over time to extend their useful lives and improve business workflow efficiency. During 2007 work continued on upgrading the entire NIC infrastructure in order to provide easier access to information, a consistent Federal Reserve enterprise information layer, a comprehensive metadata repository, and uniform security across the Federal Reserve. Implementation is expected to be phased in beginning midyear 2008, with a completion target of 2010. Also in 2007, the NED system was modified to enhance the collection and reporting of Bank Secrecy Act information. In addition, the BOND and CDTR systems were enhanced to provide the document storage facility for the new national Federal Reserve Consumer Help call center. Key summary documentation regarding consumer complaints and inquiries is posted into the CDTR and made available to System staff and staff at the other federal banking agencies via the BOND system. The BOND and CDTR systems were also enhanced to provide an automated, electronic means for passing examination and inspection reports to the records management system of the Board's Office of the Secretary. This new electronic process has allowed the Reserve Banks to discontinue the long-standing practice of sending hard-copy reports to the Board for records management purposes. Finally, during 2007 the Federal Reserve continued to work closely with other federal and state banking agencies—including federal agency chief information officers, FFIEC task forces and subgroups, and the Confer ence of State Bank Supervisors—on a variety of technology-related initiatives and projects supporting the supervision business function. Staff Development The System Staff Development Program trains staff members at the Board, the Reserve Banks, and state banking departments. Training is offered at the basic, intermediate, and advanced levels in several disciplines within bank supervision: safety and soundness, information technology, foreign banking organizations, and consumer affairs. Classes are conducted in Washington, D.C., as well as at Reserve Banks and other locations. The Federal Reserve also participates in training offered by the FFIEC and by certain other regulatory agencies. The System's involvement includes developing and implementing basic and advanced training in relation to various emerging issues as well as in specialized areas such as international banking, information technology, anti-money laundering, capital markets, payment systems risk, and real estate appraisal (see table). In 2007, the Federal Reserve trained 2,588 students in Federal Reserve System schools, 894 in schools sponsored by the FFIEC, and 26 in other schools, for a total of 3,508. The number of training days in 2007 totaled 16,791. The System provides scholarship assistance to the states for training their examiners in Federal Reserve and FFIEC schools. Through this program, 659 state examiners were trained—347 in Federal Reserve courses, 309 in FFIEC programs, and 3 in other courses. A staff member seeking an examiner's commission is required to take a first proficiency examination as well as a second proficiency examination in one of two specialty areas, safety and sound- Banking Supervision and Regulation 107 Training Programs for Banking Supervision and Regulation, 2007 Number of sessions conducted Program Total Regional 9 9 3 17 9 15 8 8 1 17 9 15 Other schools Credit risk analysis Examination management Real estate lending seminar Senior forum for current banking and regulatory issues Basel II corporate activities Basel II operational risk Basel II retail activities 7 6 2 1 1 2 2 7 5 1 1 1 1 2 Principles of fiduciary supervision Commercial lending essentials for consumer affairs Consumer compliance examinations I Consumer compliance examinations II CRA examination techniques CA risk-focused examination techniques Fair lending examination techniques 1 2 2 2 2 2 1 1 0 2 2 2 2 1 8 2 6 4 2 4 7 21 1 8 2 6 4 2 4 7 21 0 0 0 0 0 71 1 1 1 Schools or seminars conducted by the Federal Reserve Core schools Banking and supervision elements Financial analysis and risk management Bank management Report writing Team dynamics and negotiation Conducting meetings with management Foreign banking organizations seminar Information systems continuing education Asset liability management (ALMl) Fundamentals of interest rate risk management . Technology risk integration Trading risk management Leadership and influence Fundamentals of fraud Information technology seminars1 Self-study or online learning2 Orientation (core and specialty) Self-study programs 1, 2, and 3 Self-study modules Other agencies conducting courses3 Federal Financial Institutions Examination Council The Options Institute 1. Held at the IT Lab at the Chicago Federal Reserve Bank. ness or consumer affairs. In 2007, 161 examiners passed the first proficiency examination and 73 passed the second proficiency examination, 53 examiners in safety and soundness and 20 in consumer affairs. An information technology specialty is also offered; it requires passing a proficiency examination and an examination administered by an information technology industry association. 2. Self-study programs do not involve group sessions. 3. Open to Federal Reserve employees. Regulation of the U.S. Banking Structure The Federal Reserve administers several federal statutes that apply to bank holding companies, financial holding companies, member banks, and foreign banking organizations—the Bank Holding Company Act, the Bank Merger Act, the Change in Bank Control Act, the Federal Reserve Act, and the Interna- 108 94th Annual Report, 2007 tional Banking Act. In administering these statutes, the Federal Reserve acts on a variety of proposals that directly or indirectly affect the structure of the U.S. banking system at the local, regional, and national levels; the international operations of domestic banking organizations; or the U.S. banking operations of foreign banks. The proposals concern bank holding company formations and acquisitions, bank mergers, and other transactions involving bank or nonbank firms. In 2007, the Federal Reserve acted on 1,365 proposals, which represented 2,661 individual applications filed under the five administered statutes. Bank Holding Company Act Under the Bank Holding Company Act, a corporation or similar legal entity must obtain the Federal Reserve's approval before forming a bank holding company through the acquisition of one or more banks in the United States. Once formed, a bank holding company must receive Federal Reserve approval before acquiring or establishing additional banks. The act also identifies the nonbanking activities permissible for bank holding companies. Depending on the circumstances, these activities may or may not require Federal Reserve approval in advance of their commencement. When reviewing a bank holding company application or notice that requires prior approval, the Federal Reserve may consider the financial and managerial resources of the applicant, the future prospects of both the applicant and the firm to be acquired, the convenience and needs of the community to be served, the potential public benefits, the competitive effects of the proposal, and the applicant's ability to make available to the Federal Reserve information deemed necessary to ensure compliance with ap plicable law. In the case of a foreign banking organization seeking to acquire control of a U.S. bank, the Federal Reserve also considers whether the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home-country supervisor. In 2007, the Federal Reserve acted on 603 applications and notices filed by bank holding companies to acquire a bank or a nonbank firm, or to otherwise expand their activities. Bank holding companies generally may engage in only those nonbanking activities that the Board has previously determined to be closely related to banking under section 4(c)(8) of the Bank Holding Company Act. Since 1996, the act has provided an expedited prior notice procedure for certain permissible nonbank activities and for acquisitions of small banks and nonbank entities. Since that time the act has also permitted well-run bank holding companies that satisfy certain criteria to commence certain other nonbank activities on a de novo basis without first obtaining Federal Reserve approval. A bank holding company may repurchase its own shares from its shareholders. When the company borrows money to buy the shares, the transaction increases the company's debt and decreases its equity. The Federal Reserve may object to stock repurchases by holding companies that fail to meet certain standards, including the Board's capital adequacy guidelines. In 2007, the Federal Reserve reviewed 11 stock repurchase proposals by bank holding companies. The Federal Reserve also reviews elections from bank holding companies seeking financial holding company status under the authority granted by the Gramm-Leach-Bliley Act. Bank holding companies seeking financial holding company status must file a written dec- Banking Supervision and Regulation laration with the Federal Reserve. In 2007, 37 domestic financial holding company declarations and 2 foreign bank declarations were approved. Bank Merger Act The Bank Merger Act requires that all proposals involving the merger of insured depository institutions be acted on by the appropriate federal banking agency. The Federal Reserve has primary jurisdiction if the institution surviving the merger is a state member bank. Before acting on a merger proposal, the Federal Reserve considers the financial and managerial resources of the applicant, the future prospects of the existing and combined organizations, the convenience and needs of the community(ies) to be served, and the competitive effects of the proposed merger. The Federal Reserve also must consider the views of the U.S. Department of Justice regarding the competitive aspects of any proposed bank merger involving unaffiliated insured depository institutions. In 2007, the Federal Reserve approved 68 merger applications under the act. Change in Bank Control Act The Change in Bank Control Act requires individuals and certain other parties that seek control of a U.S. bank or bank holding company to obtain approval from the appropriate federal banking agency before completing the transaction. The Federal Reserve is responsible for reviewing changes in the control of state member banks and bank holding companies. In its review, the Federal Reserve considers the financial position, competence, experience, and integrity of the acquiring person; the effect of the proposed change on the financial condition of the bank or bank holding company being acquired; the fu 109 ture prospects of the institution to be acquired; the effect of the proposed change on competition in any relevant market; the completeness of the information submitted by the acquiring person; and whether the proposed change would have an adverse effect on the federal deposit insurance fund. A proposed transaction should not jeopardize the stability of the institution or the interests of depositors. During its review of a proposed transaction, the Federal Reserve may contact other regulatory or law enforcement agencies for information about relevant individuals. In 2007, the Federal Reserve approved 106 changes in control of state member banks and bank holding companies. Federal Reserve Act Under the Federal Reserve Act, a member bank may be required to seek Federal Reserve approval before expanding its operations domestically or internationally. State member banks must obtain Federal Reserve approval to establish domestic branches, and all member banks (including national banks) must obtain Federal Reserve approval to establish foreign branches. When reviewing proposals to establish domestic branches, the Federal Reserve considers, among other things, the scope and nature of the banking activities to be conducted. When reviewing proposals for foreign branches, the Federal Reserve considers, among other things, the condition of the bank and the bank's experience in international banking. In 2007, the Federal Reserve acted on new and merger-related branch proposals for 1,520 domestic branches and granted prior approval for the establishment of 20 new foreign branches. State member banks must also obtain Federal Reserve approval to establish fi- 110 94th Annual Report, 2007 nancial subsidiaries. These subsidiaries may engage in activities that are financial in nature or incidental to financial activities, including securities and insurance agency-related activities. In 2007, no financial subsidiary applications were filed. Overseas Investments by U.S. Banking Organizations U.S. banking organizations may engage in a broad range of activities overseas. Many of the activities are conducted indirectly through Edge Act and agreement corporation subsidiaries. Although most foreign investments are made under general consent procedures that involve only after-the-fact notification to the Federal Reserve, large and other significant investments require prior approval. In 2007, the Federal Reserve approved 69 proposals for overseas investments by U.S. banking organizations, many of which represented investments through an Edge Act or agreement corporation. International Banking Act The International Banking Act, as amended by the Foreign Bank Supervision Enhancement Act of 1991, requires foreign banks to obtain Federal Reserve approval before establishing branches, agencies, commercial lending company subsidiaries, or representative offices in the United States. In reviewing proposals, the Federal Reserve generally considers whether the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home-country supervisor. It also considers whether the home-country supervisor has consented to the establishment of the U.S. office; the financial condition and resources of the foreign bank and its existing U.S. operations; the managerial resources of the foreign bank; whether the homecountry supervisor shares information regarding the operations of the foreign bank with other supervisory authorities; whether the foreign bank has provided adequate assurances that information concerning its operations and activities will be made available to the Federal Reserve, if deemed necessary to determine and enforce compliance with applicable law; whether the foreign bank has adopted and implemented procedures to combat money laundering and whether the home country of the foreign bank is developing a legal regime to address money laundering or is participating in multilateral efforts to combat money laundering; and the record of the foreign bank with respect to compliance with U.S. law. In 2007, the Federal Reserve approved 18 applications by foreign banks to establish branches, agencies, or representative offices in the United States. Public Notice of Federal Reserve Decisions Certain decisions by the Federal Reserve that involve an acquisition by a bank holding company, a bank merger, a change in control, or the establishment of a new U.S. banking presence by a foreign bank are made known to the public by an order or an announcement. Orders state the decision, the essential facts of the application or notice, and the basis for the decision; announcements state only the decision. All orders and announcements are made public immediately; they are subsequently reported in the Board's weekly H.2 statistical release. The H.2 release also contains announcements of applications and notices received by the Federal Reserve upon which action has not yet been taken. For each pending applica- Banking Supervision and Regulation tion and notice, the related H.2 contains the deadline for comments. The Board's website (www.federalreserve.gov) provides information on orders and announcements as well as a guide for U.S. and foreign banking organizations that wish to submit applications or notices to the Federal Reserve. Enforcement of Other Laws and Regulations The Federal Reserve's enforcement responsibilities also extend to the disclosure of financial information by state member banks and the use of credit to purchase and carry securities. Financial Disclosures by State Member Banks State member banks that issue securities registered under the Securities Exchange Act of 1934 must disclose certain information of interest to investors, including annual and quarterly financial reports and proxy statements. By statute, the Board's financial disclosure rules must be substantially similar to those of the SEC. At the end of 2007, 12 state member banks were registered with the Board under the Securities Exchange Act of 1934. 111 the credit is used to purchase debt and equity securities. The Board's Regulation U limits the amount of credit that may be provided by lenders other than brokers and dealers when the credit is used to purchase or carry publicly held equity securities if the loan is secured by those or other publicly held equity securities. The Board's Regulation X applies these credit limitations, or margin requirements, to certain borrowers and to certain credit extensions, such as credit obtained from foreign lenders by U.S. citizens. Several regulatory agencies enforce the Board's securities credit regulations. The SEC, the Financial Industry Regulatory Authority (formed through the combination of the National Association of Securities Dealers and the regulation, enforcement, and arbitration functions of the New York Stock Exchange), and the Chicago Board Options Exchange examine brokers and dealers for compliance with Regulation T. With respect to compliance with Regulation U, the federal banking agencies examine banks under their respective jurisdictions; the FCA, the NCUA, and the OTS examine lenders under their respective jurisdictions; and the Federal Reserve examines other Regulation U lenders. Securities Credit Federal Reserve Membership Under the Securities Exchange Act, the Board is responsible for regulating credit in certain transactions involving the purchase or carrying of securities. The Board's Regulation T limits the amount of credit that may be provided by securities brokers and dealers when At the end of 2007, 2,489 banks were members of the Federal Reserve System and were operating 55,603 branches. These banks accounted for 36 percent of all commercial banks in the United States and for 71 percent of all commercial banking offices. • 113 Consumer and Community Affairs Among the Federal Reserve's responsibilities in the areas of consumer and community affairs are • writing and interpreting regulations to implement federal laws that protect and inform consumers; • supervising state member banks to ensure compliance with the regulations; • investigating complaints from the public about state member banks' compliance with regulations; • promoting community development in historically underserved markets; and • conducting research and promoting consumer education. These responsibilities are carried out by the members of the Board of Governors, the Board's Division of Consumer and Community Affairs, and the consumer and community affairs staff of the Federal Reserve Banks. The Federal Reserve System's various consumer protection and community development roles were the subject of great interest in 2007. Consumer protection concerns moved to the forefront of public dialogue as lawmakers, regulators, the media, and consumers scrutinized various practices being used in the financial services marketplace, particularly in the markets for subprime mortgages and credit cards. Intense examination of the policies and practices at issue has revealed the complexity of the current financial services marketplace. Deregulation and technological and financial innovation over the last two decades fueled the growth of this market, in creasing competition and consumer choice. However, the number and types of consumer financing products and providers now available means consumers have to become more vigilant and wellinformed as they shop for financial products and manage their personal finances. The Federal Reserve has strategically used its regulatory and supervisory authorities to address consumer protection issues in today's complex consumer financial services marketplace and to promote consumer education and community development. Mortgage Credit Homeownership has long been a highly valued goal of both policymakers and consumers. In response to the demand for home loans, the mortgage industry has introduced innovative and creative loan products into the consumer financial services market. As a result, consumers' access to home mortgage credit has expanded considerably over the last decade. Market opportunities and technological advancements have contributed to the growth of the mortgage industry. As the mortgage market grew, some lenders employed nontraditional underwriting and risk-layering strategies in order to capture new market segments, particularly consumers who may not have been able to qualify for credit under more-traditional mortgageunderwriting criteria. Although innovation in the mortgage market has made access to mortgage credit possible for increasing numbers of households, loan products have become increasingly complex—and underwriting standards 114 94th Annual Report, 2007 An Overview of the Subprime Mortgage Market At $ 11 trillion, the depth and breadth of the U.S. home mortgage market is unique. Its sheer capacity has enabled many families to become homeowners, facilitating a long-standing goal of consumers and policymakers. Over the past two decades, the mortgage industry has expanded as a result of financial innovation, technological advancements, and deregulation. Lenders have been able to provide more consumers with access to mortgage credit. In particular, advances in credit scoring technology and risk-based pricing strategies opened up the mortgage market to consumers considered to be higher-risk because of their limited or negative credit histories, income limitations, or other financial issues. Lenders charged these borrowers, known as subprime borrowers, higher rates to reflect the higher level of risk they presented. The subprime mortgage market began to expand markedly in the mid-1990s and peaked in 2006. The growth of the subprime mortgage market was fueled by expansive developments across the financial industry that significantly changed every aspect of the mortgage industry, from how mortgages were marketed and underwritten to how they were funded. The use of credit scoring models to price for risk enabled lenders to more efficiently evaluate a consumer's creditworthiness, reducing transaction costs for lenders. In addition, changes to and the ongoing growth of the secondary mortgage market increased the have loosened in recent years, particularly in the subprime market. (See related box "An Overview of the Subprime Mortgage Market.") Aware of the changing conditions in the mortgage market, the Federal Reserve Board has responded to the consumer protection and supervisory concerns of nontraditional and subprime ability of lenders to sell many mortgages to "securitizers" that pooled large numbers of mortgages and sold the rights to the resulting cash flows to investors. Previously, lenders tended to hold mortgages on their books until the loans were repaid. The increasingly popular "originate-todistribute" lending model gave lenders (and mortgage borrowers) greater access to capital markets and allowed risk to be shared more widely. Increased access to mortgage credit was further fueled by the rise of both mortgage brokers who expanded the sales and distribution channels of mortgage lending and independent mortgage originators not directly affiliated with a federally supervised depository institution. The expanding field of nonbank mortgage lenders was particularly notable in the subprime mortgage market. Data from 2006 reported under the Home Mortgage Disclosure Act indicate that 45 percent of high-cost first mortgages were originated by independent mortgage companies, institutions that are not regulated by the federal banking agencies and that typically sell nearly all of the mortgages they originate. These nondepository institutions fund mortgage lending through the capital markets rather than customer deposits, the traditional source of loan funding for banks. All of these mortgage market developments increased the supply of mortgage credit, which in turn likely contributed to mortgage loans. 1 In recent years and throughout 2007, Federal Reserve staff have undertaken various initiatives to (1) scrutinize potentially risky practices within the mortgage industry and (2) ad1. See the testimony of Chairman Ben S. Bernanke, September 20.2007 (www.federalreserve.gov/ newsevents/testimony/bernanke20070920a.htm). Consumer and Community Affairs the rise in the national homeownership rate from 64 percent in 1994 to about 68 percent in 2007. But the broadening of access to mortgage credit also had negative aspects. Given their weaker credit histories and financial conditions, subprime borrowers tend to default on their loans more frequently than prime borrowers. A higher incidence of weaker underwriting standards and risk-layering practices, such as failing to document income and lending nearly to the full value of the home, further increased a subprime borrower's vulnerability for default. In 2007, the problems in the subprime market, deceleration of the housing market, decreased house-price appreciation, and the weakening of the overall economy contributed to a significant number of subprime mortgage defaults. As a result, the subprime mortgage market experienced significant setbacks: several independent mortgage lenders declared bankruptcy, and some large financial organizations experienced multimillion dollar losses in their portfolios. For consumers, the consequences of defaulting on a mortgage can be severe, such as the loss of accumulated home equity, reduced access to credit, and foreclosure. And the negative effects can spread beyond subprime customers. Clusters of foreclosures in one community can cause the value of nearby properties to decline and lead to an increase in vacant and abandoned properties, thereby inflicting economic harm on entire neighborhoods. dress issues through regulatory, supervisory, or community engagement activities. 115 As the subprime mortgage crisis expanded throughout the last quarter of 2007, the Federal Reserve actively used its policy, supervisory, and regulatory tools to respond to the needs of markets, lenders, consumers, and communities. These activities were discussed in detail by Federal Reserve Board governors and other officials who testified before Congress throughout the year, offering lawmakers and the public an in-depth discussion about the issues and actions undertaken by the Federal Reserve in response to concerns about the subprime market.1 In addition, staff at Federal Reserve Banks across the country worked with regulators, government officials, lenders, servicers, consumer advocates, and community leaders to improve their understanding of the complex issues that contribute to, as well as the effects of, widespread mortgage delinquencies and foreclosures. (For a detailed discussion of the Federal Reserve's efforts, see the "Mortgage Credit" section of this chapter.) The Federal Reserve has a strong interest in supporting consumers and communities. Its activities during 2007 have laid the foundation for continued efforts to help stabilize the mortgage industry and assist consumers to make sound financial decisions. 1. See www.federalreserve.gov/newsevents/ testimony/2007testimony.htm) Regulatory Actions of the hearing was to gather information on how the Board might use its rulemaking authority to curb abusive lending practices in the home mortgage market, particularly the subprime sector.2 The In June, the Board held a public hearing under the Home Ownership and Equity Protection Act (HOEPA). The purpose 2. In 1994, HOEPA was enacted in response to reports of predatory home equity lending practices in underserved markets. HOEPA amended the 116 94th Annual Report, 2007 meeting, moderated by Governor Randall Kroszner, was the last in a series of five hearings held under HOEPA; the other four hearings were held throughout the nation during the summer of 2006.3 Representatives from the financial services industry, consumer and community groups, and state agencies participated in the June hearing and shared their perspectives on certain lending practices, such as prepayment penalties, the underwriting of "stated income" loans, and the failure to provide escrow accounts for taxes and insurance.4 Representatives from the financial services industry acknowledged that some recent lending practices merited concern, but these participants urged the Board to address most of the concerns by issuing supervisory guidance rather than regulations under HOEPA. They suggested that recent supervisory guidance on nontraditional mortgages and subprime lending, as well as corrective measures initiated within the mortgage market, had reduced the need for new regulations. Industry participants said that if the Board issues regulations, they must be clear enough to eliminate uncertainty and avoid unduly restricting credit. To help consumers avoid abusive lending practices, industry representaTruth in Lending Act by imposing additional disclosure requirements and other limits on certain high-cost, home-secured loans. Under HOEPA, the Board is authorized to issue rules that prohibit certain acts or practices in connection with home mortgage loans. HOEPA also directs the Board to periodically hold public hearings to examine the home equity lending market and the adequacy of existing regulatory and legislative provisions for protecting the interests of consumers, particularly low-income consumers. 3. For Governor Kroszner's opening comments, see www.federalreserve.gov/newsevents/ speech/kroszner20070614a.htm. 4. For a list of panelists and the agenda, see www.federalreserve.gov/newsevents/press/bcreg/ 20070612a.htm. tives supported improving the disclosures provided to consumers during the mortgage process. Conversely, consumer advocates and state and local officials urged the Board to adopt robust regulations under HOEPA. They acknowledged a useful role for supervisory guidance but contended that recent problems in the mortgage market indicated a need for stronger requirements that can be enforced through civil actions—actions that would only be possible under regulations, not supervisory guidance. Consumer advocates and others welcomed efforts to improve mortgage disclosures but insisted that disclosures alone would not prevent abusive loans. They argued that independent mortgage lenders are not subject to the federal regulators' guidance, and enforcement of the existing laws governing these entities is limited. In addition to the series of hearings, the Board received information and advice from its Consumer Advisory Council (see "Advice from the Consumer Advisory Council") and from outreach meetings to gain insight into industry practices. These efforts informed the Board's release of proposed amendments to Regulation Z (Truth in Lending) at a public meeting in December.5 The goals of these proposed amendments are to • protect consumers in the mortgage market from unfair, abusive, or deceptive lending and servicing practices, while preserving responsible lending and sustainable homeownership; • ensure that advertisements for mortgage loans provide accurate and balanced information and do not contain misleading or deceptive representations; and 5. See www.federalreserve.gov/newsevents/ press/bcreg/20071218a.htm. Consumer and Community Affairs • provide additional consumer protections on "higher-priced mortgages," mortgages whose annual percentage rate (APR) exceeds the yield on comparable Treasury securities by at least three percentage points for first-lien loans, or five percentage points for subordinate-lien loans. The proposed rules are comprehensive both in their reach and aim: they would apply to all mortgage lenders, not just depository institutions, and they seek to improve transparency and enhance consumer protection in mortgage lending. The proposal directly addresses those practices raising the most significant concerns. For higher-priced loans, the proposed rule would prohibit lenders from engaging in a pattern or practice of making mortgage loans on the basis of collateral alone, without considering a borrower's ability to repay the loan; require lenders to verify the income or assets they rely upon in making the loan; and require lenders to establish escrow accounts for taxes and insurance. Prepayment penalties would be permitted on higher-cost loans only under certain conditions. For higher-cost loans and most other mortgage loans secured by a principal dwelling, the proposed rules would prohibit lenders from paying yield-spread premiums to brokers, unless a written agreement between the consumer and broker disclosed the broker's total compensation and other important information; prohibit lenders and brokers from coercing appraisers to misstate a home's value; and require that servicers credit loan payments on the date of receipt and refrain from charging consumers multiple late fees. With respect to the marketing of home loans, the proposed rules would require lenders to disclose applicable rates or payments in advertisements as prominently as advertised teaser rates. 117 For closed-end loans, the proposed rules would prohibit seven misleading or deceptive advertising practices, for example, using the term "fixed" to describe a rate that is not fixed. The public comment period ends in early April 2008. Supervisory Activities Throughout 2007, concerns about the mortgage industry continued to grow. The Board undertook various supervisory activities in collaboration with other agencies to provide guidance to lenders and support to consumers. A comprehensive overview of the Federal Reserve Board's ongoing efforts to address supervisory concerns in the subprime mortgage market was outlined in congressional testimony delivered in March by the director of the Division of Consumer and Community Affairs.6 In April, the federal financial regulatory agencies jointly issued the "Statement on Working with Mortgage Borrowers" that encouraged institutions to work constructively with residential borrowers who are, or who are reasonably expected to be, unable to make payments on their home loans.7 The statement emphasizes that loan-workout arrangements are generally in the long-term best interest of both financial institutions and borrowers, provided the arrangement is consistent with safe and sound lending practices. The statement cites examples of constructive workout arrangements; for instance, an institution might modify a borrower's loan terms or move a borrower from a variable-rate to a fixed6. See the testimony of Sandra F. Braunstein, March 27, 2007 (www.federalreserve.gov/ newsevents/testimony/braunstein20070327a.htm). 7. See www.federalreserve.gov/newsevents/ press/bcreg/20070417a.htm (press release) and www .federalreserve .gov/boarddocs/srletters/2007/ sr0706.htm (Consumer Affairs letter). 118 94th Annual Report, 2007 rate loan. In addition, bank and thrift programs that transition low- or moderate-income homeowners from higher-cost loans to lower-cost loans in a safe and sound manner may receive favorable consideration under the Community Reinvestment Act.8 In May, the federal bank, thrift, and credit union regulatory agencies issued final illustrations of the information on nontraditional mortgage products that lenders should provide to consumers. The sample illustrations are intended to help institutions implement consumer protections in the "Interagency Guidance on Nontraditional Mortgage Product Risks" that the agencies adopted in October 2006.9 The consumer protections described in the guidance aim to ensure that consumers receive clear and balanced information about nontraditional mortgages—before they choose a mortgage product or select a payment option for an existing mortgage. Accordingly, the illustrations consist of a narrative explanation of nontraditional mortgage products, a chart comparing interest-only and payment-option adjustable-rate mortgages (ARMs) with a traditional fixed-rate loan, and a table showing the impact of various payment options on the loan balance of a payment-option ARM (such a table could be included in monthly loan statements). Institutions are not required to use the sample illustrations, but the guidance sets forth information that lenders should provide to consumers to allow them to evaluate a nontraditional mortgage loan. The federal financial regulatory agencies jointly issued additional guidance 8. For more information, see Q&A § .22(a)-l (Interagency Questions and Answers Regarding Community Reinvestment, July 11, 2001). 9. See www.federalreserve.gov/newsevents/ press/bcreg/20070531b.htm. titled the "Statement on Subprime Mortgage Lending" in June.10 This guidance describes prudent safety-and-soundness and consumer protection standards that institutions should follow when originating certain ARMs that are typically offered to subprime borrowers. These ARMs offer low initial payments that are based on a short-term fixed introductory rate that is significantly discounted from the fully indexed rate (the sum of the current index and the margin). The statement emphasizes the importance of evaluating a borrower's repayment capacity and ability to make payments under the fully indexed rate, assuming a fully amortizing repayment schedule. The guidance also stresses the need for institutions to consider a borrower's total monthly housing-related payments (that is, principal, interest, taxes, and insurance) when assessing the borrower's repayment capacity, using the borrower's debt-to-income ratio. Finally, the guidance instructs lenders to provide consumers with clear and balanced information on the benefits and risks of this type of ARM. In September, the federal financial regulatory agencies and the Conference of State Banking Supervisors issued the "Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages."11 The guidance encourages servicers of residential mortgages to pursue strategies to mitigate their losses and seek to preserve homeownership among their borrowers. The statement outlines steps that servicers may pursue to determine if a borrower is at an increased risk 10. See www.federalreserve.gov/newsevents/ press/bcreg/20070629a.htm (press release) and ww w .federalreserve .gov/boarddocs/srletters/2007/ srO712.htm (Consumer Affairs letter). 11. See www.federalreserve.gov/newsevents/ press/bcreg/20070904a.htm (press release) and www.federalreserve.gov/boarddocs/srletters/2007/ srO716.htm (Consumer Affairs letter). Consumer and Community Affairs of mortgage default. Steps include identifying borrowers who have a heightened risk of delinquency, contacting those borrowers to assess their ability to repay, and determining whether default is reasonably foreseeable. The guidance also presents many possible lossmitigation techniques that a servicer may initiate with a troubled borrower. In addition to issuing industry guidance, the Board entered a multiagency partnership to conduct targeted consumer compliance reviews of selected nondepository lenders that have significant subprime mortgage operations.12 The joint effort, announced in July, is the first time multiple agencies have collaborated to plan and conduct consumer compliance reviews of independent mortgage lenders and nondepository subsidiaries of bank and thrift holding companies, as well as mortgage brokers doing business with, or working for, these entities. The agencies involved—the Federal Reserve, the Office of Thrift Supervision (OTS), the Federal Trade Commission (FTC), state agencies represented by the Conference of State Bank Supervisors, and the American Association of Residential Mortgage Regulators—have begun developing plans for the targeted consumer compliance reviews. Federal Reserve System examiners, assisted by representatives from the FTC and the states, will lead reviews of entities supervised by the Federal Reserve System. At the same time, state regulators will conduct a coordinated review of an independent state-licensed subprime lender and associated mortgage brokers, and the OTS will conduct a review of a selected mortgage subsidiary of a thrift holding company. These reviews will evaluate the companies' underwriting 12. See www.federalreserve.gov/newsevents/ press/bcreg/20070717a.htm. 119 standards, as well as senior management's oversight of the risk-management practices the companies used to ensure compliance with state and federal consumer protection regulations and laws, including the Home Mortgage Disclosure Act, the Equal Credit Opportunity Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act, the Federal Trade Commission Act, and the Home Ownership and Equity Protection Act. The agencies will share information about the reviews and investigations; take supervisory action, as appropriate; collaborate on lessons learned; and seek ways to better cooperate in ensuring effective and consistent reviews of these institutions. By jointly developing and applying a coordinated review program, the regulatory agencies will be better positioned to evaluate and more consistently assess subprime mortgage practices across a broad range of mortgage lenders and other participants within the industry. On-site reviews are scheduled to begin in February 2008. Community Outreach Efforts To augment the Board's regulatory and supervisory activities, System community affairs staff engaged in numerous efforts to address the personal, economic, and social distress of homeowners and communities that have been negatively affected by the sharp increases in subprime mortgage loan delinquencies and foreclosures. Community affairs analysts and outreach specialists used their long-standing networks of industry and community relationships to convene local community and business leaders, investors, lenders, servicers, rating agency representatives, government officials, consumer and community groups, and others across the country. To complement these discussions, System research staff collected 120 94th Annual Report, 2007 and analyzed data on real estate and subprime mortgage conditions and on the impact of homeowner counseling programs. The Federal Reserve Bank of Philadelphia began collecting data for a longitudinal study of the effectiveness of homeownership counseling. In a similar but smaller-scale study, the Dallas Reserve Bank began measuring the impact of a local mortgage assistance program. The New York Reserve Bank collected zip code-level data on the incidence of Alt-A and subprime mortgage products in its District. Several other researchers focused on loan workouts and modifications throughout the country. Other key initiatives for the research functions included providing regional foreclosure projections and indepth analyses of the incidence of defaults within a particular region. The Board and the Reserve Banks hosted a number of events, conferences, and meetings on foreclosure-related matters in 2007. Many events focused on encouraging lenders and servicers to develop systematic loss-mitigation techniques and to promote coordinated outreach to distressed borrowers. In the twelfth District, the San Francisco Reserve Bank and its partners conducted a series of six forums to explore foreclosure issues and identify strategies for preserving homeownership among minorities and low-income borrowers.13 The Federal Reserve Bank of Chicago sponsored symposiums in Chicago, Indianapolis, and Detroit that featured discussions on the regional impact of foreclosures. The Cleveland Reserve Bank cosponsored a conference on vacant and abandoned properties, and the Federal Reserve Bank of Minneapolis hosted several events in the Twin Cities area focused on mortgage broker licensing, 13. See www.sf.frb.org/community/issues/assets/ preservation/index.html. the need to modernize the foreclosure system, and the differences in state foreclosure laws. The Reserve Banks also organized several public workshops and participated in outreach events to highlight innovative intervention programs. For example, the San Francisco and Dallas Reserve Banks cosponsored a series of mortgage-streamlining workshops to leverage participants' broader knowledge of community development subjects and apply this knowledge to homeownership initiatives for Native Americans. During the past year, Board and System staff strengthened partnerships with two prominent national homeownership preservation organizations, NeighborWorks America and the Hope Now Alliance. Both groups have mobilized their national networks of affiliates and partners in order to advance efforts to streamline the mortgage-refinancing process and modify subprime mortgages. In 2007, Governor Kroszner continued to serve on the NeighborWorks America board of directors. Members of the Board's staff remain involved with that organization's Center for Homeownership Education and Counseling, which establishes education standards for counseling intermediaries. System community affairs staff collaborated with NeighborWorks America by participating in several foreclosureprevention training workshops for homeownership counselors; staff also helped promote the 1-888-995-HOPE hotline that links borrowers in financial distress with mortgage counseling. The Atlanta Reserve Bank produced an educational DVD in partnership with NeighborWorks America that addressed the growing foreclosure challenges in its region. Several Reserve Banks also supported the Hope Now Alliance, a collaboration of counselors, servicers, investors, and other mortgage market participants. Sys- Consumer and Community Affairs tern community affairs staff worked with local Hope Now partners and community stakeholders to identify crossindustry technology solutions that would enable servicers and counselors to contact at-risk borrowers and better serve homeowners. Substantial consumer protection and community development concerns continue to be raised about mortgage lending practices. The Federal Reserve will continue its regulatory, supervisory, and community development efforts to seek ways to protect and support consumers' interests in mortgage credit. The Federal Reserve will also work collaboratively with a broad spectrum of partners to develop strategies and programs that will help troubled homeowners address their mortgage credit difficulties.14 Credit Cards The credit card market is another area of consumer finance that has grown rapidly, spurred by technological advances, new products, and other innovations. Increasingly, electronic payments are accepted for a wide range of transactions, and consumers now use credit cards to facilitate everyday purchases, such as groceries, gasoline, and even a cup of coffee. In 2007, the total level of revolving debt held by consumers increased by nearly 8 percent from 2006, to nearly $944 billion. Competition in the credit card market has intensified over the last decade. As a result, lenders have undertaken aggressive marketing and product development campaigns and also pursued strategies to rely more on fee-based income. (Pre14. See the testimony of Governor Randall S. Kroszner, December 6, 2007 (www.federalreserve. gov/newsevents/testimony/kroszner20071206a.htm), and October 24, 2007 (www.federalreserve.gov/ newsevents/testimony/kroszner20071024a.htm). 121 viously, lenders had relied almost solely on interest from their customers' account balances for revenue.) These industry developments have significantly elevated concerns about consumer protection; the transparency of credit card pricing; and the adequacy of consumer disclosures in credit card marketing materials, contracts, and periodic statements.15 Credit card disclosures are intended to provide consumers with the information they need to shop for the product that best meets their needs and to enable them to make well-informed decisions regarding usage of their cards. However, as credit products became more complex, the Board recognized the need to evaluate its existing regulations governing the content and presentation of information on credit card disclosures. This undertaking required an in-depth understanding of the credit card industry, consumers' information needs, and the way consumers shop for credit cards. Before engaging in rule-writing, the Board undertook extensive consumer testing. Working with a consultant, the Board developed a testing methodology that involved several stages. First, two sets of focus-group meetings were held with credit card customers. The focus groups offered insight on • what credit terms consumers usually consider when shopping for a credit card, • what information consumers find useful when they receive a new card in the mail, and • what information consumers find useful on periodic statements. 15. See the testimony of Governor Frederic S. Mishkin, June 7, 2007 (www.federalreserve.gov/ newsevents/testimony/mishkin20070607a.htm). 122 94th Annual Report, 2007 The second stage of the consumer testing focused on current credit card disclosures. In one-on-one interviews, credit card customers were presented with mock disclosures. Participants were asked to evaluate the information presented, and an interviewer asked them follow-up questions in order to evaluate the usability of the disclosures and consumers' understanding of them. Feedback from the second stage was used to develop revised sample disclosures for the third phase of testing. These sample disclosures were tested and refined during multiple interviews with consumers. This process allowed staff to learn more about what information consumers read on current credit card disclosures; to observe how easily consumers can find various pieces of information in these disclosures; and to test consumers' understanding of the terminology used in the disclosures. The consumer testing process provided important insights into the way consumers shop for credit cards and the information they need to make informed decisions. In particular, staff found that consumers tend to notice numbers rather than narrative text. Consumers frequently reviewed the summary table of rates and terms that they receive with credit card solicitations but paid little attention to densely worded accountopening disclosures and change-interms notifications. Likewise, on periodic statements, consumers generally focused on numbers, such as fee and interest charge information. The Board took these findings into account as it began drafting proposed amendments to Regulation Z. Proposed Amendments to Regulation Z In May, the Board issued for public comment proposed Regulation Z amend ments. The proposal is intended to improve the effectiveness of the disclosures consumers receive in connection with credit card accounts and other revolving credit plans; specifically, the proposal seeks to ensure that such information is provided in a timely manner and in a form that is readily understandable. The proposed amendments would require changes to the format, timing, and content requirements of the five main types of open-end credit disclosures: (1) credit and charge card application and solicitation disclosures; (2) account-opening disclosures; (3) periodicstatement disclosures; (4) change-interms notices; and (5) advertising provisions. The proposed amendments largely reflect the results of the consumer testing described above. The proposal generated a great deal of interest, yielding more than 2,500 comments during the comment period that ended in October. A large number of these comments were submitted by individual consumers. Additional insights were provided by consumer advocates and industry representatives serving on the Board's Consumer Advisory Council. (See "Advice from the Consumer Advisory Council.") Applications and Solicitations The proposal contains changes to make the disclosures provided with credit and charge card applications and solicitations more meaningful and easier for consumers to use. Proposed changes include adopting new format requirements for the summary table, including rules regarding type size and the use of boldface type for certain key terms; placement of information; and use of crossreferences. The proposed rules address a number of issues regarding the penalties credit and charge card companies may charge customers. For example, applications and solicitations would have to Consumer and Community Affairs state how long penalty rates may be in effect, provide a modified disclosure about variable rates, describe the effect of creditors' payment-allocation practices, and reference consumer education materials on the Board's website. Account-Opening Disclosures The proposal contains revisions to make the cost disclosures provided to consumers at account opening more conspicuous and easier to read. The proposed changes would require that certain key terms be disclosed in a summary table at account opening; this table would summarize the key information consumers need to make informed decisions about how they use credit cards. The proposed changes would also adopt a different approach to disclosing fees, in order to make it easier for consumers to identify the costs associated with using the card. Periodic-Statement Disclosures The proposal contains revisions to make the disclosures on periodic statements more understandable, primarily by changing the format requirements for these disclosures—for example, by grouping fees, interest charges, and transactions together by type. Other format changes include itemizing the interest charges for different types of transactions, such as purchases and cash advances, and providing aggregate totals of fees and interest for the month and year-to-date. In addition, creditors would have to disclose to consumers the effect of making only the minimum required payments on their account balances. Change in Consumer's Interest Rate and Other Account Terms The proposal expands the circumstances under which consumers will receive written notice of changes in the terms 123 (for example, an increase in the interest rate) applicable to their accounts, and it increases the amount of time these notices must be sent before the change becomes effective. Generally, the proposed rules would increase advance notice before a changed term can be imposed from 15 to 45 days, to better allow consumers to obtain alternative financing or change their account usage. The proposed rules would also require a creditor to provide 45 days' prior notice before increasing a rate as a result of a consumer's delinquency or default. Advertising Provisions The proposal revises the rules governing the advertising of open-end credit, to help consumers better understand the credit terms being offered. Under the proposed revisions, advertisements that state a minimum monthly payment on a plan offered to finance the purchase of goods or services would be required to disclose, in equal prominence to the minimum payment, the time period required to pay off the balance and the total of payments if only minimum payments were made. Furthermore, advertisements would be able to refer to a rate as "fixed" only if the advertisement specified the time period for which the rate was fixed and that the rate would not increase for any reason during that time. If a time period is not specified, the term "fixed" may be used only if the rate will not increase for any reason while the plan is open. Other Regulatory Actions In addition to proposed rules related to mortgages and credit cards, the Board issued regulatory amendments in 2007 related to the electronic delivery of consumer disclosures, electronic fund 124 94th Annual Report, 2007 transfers, and the privacy of financial information. Electronic Disclosures In November, the Board published amendments to five consumer financial services and fair lending regulations (Regulations B, E, M, Z, and DD). The amendments clarify the requirements for providing consumer disclosures in electronic form under the Electronic Signatures in Global and National Commerce Act (the E-Sign Act). Enacted in 2000, the E-Sign Act provides that electronic documents and electronic signatures have the same validity as paper documents and handwritten signatures. The E-Sign Act also contains special rules for the use of electronic disclosures in consumer transactions. Under the act, consumer disclosures that are required by other laws or regulations to be provided in writing may be provided in electronic form if the consumer affirmatively consents after receiving the notice specified in the statute and if certain other conditions are met. In March 2001, the Board published interim final rules under Regulations B, E, M, Z, and DD that established uniform standards for the timing and delivery of electronic disclosures, consistent with the requirements of the E-Sign Act. The Board later lifted the mandatory compliance date for these rules. As a result, institutions could provide disclosures electronically pursuant to the E-Sign Act but were not required to comply with the 2001 interim rules. In November, the Board withdrew certain portions of the 2001 interim rules from the Code of Federal Regulations in order to reduce confusion about their status and simplify the regulations. The Board also withdrew other provisions of the 2001 interim rules that might have imposed undue burdens on electronic banking and commerce and that were unnecessary for consumer protection. The November final rules also included guidance on the use of electronic disclosures, including provisions to clarify the circumstances under which consumers conducting transactions online may obtain electronic disclosures without regard to the consent requirements of the E-Sign Act. The mandatory compliance date for the final rules is October 1, 2008.16 Regulation E The Electronic Fund Transfer Act (EFTA) provides a basic framework of rights, liabilities, and responsibilities for participants in electronic fund transfer systems. The EFTA is implemented by the Board's Regulation E (12 CFR 205). In July, the Board published a final rule that exempts transactions of $15 or less from Regulation E's requirement that receipts be made available to consumers for transactions initiated at an electronic terminal. For this purpose, electronic terminals include automated teller machines and point-of-sale terminals. This exception is intended to facilitate the ability of consumers to use debit cards in retail settings where it may not be practical or cost-effective to provide receipts. The rule was effective August 6, 2007.17 Fair Credit Reporting Act In November, the Board published two final rules under Regulation V to implement provisions of the Fair and Accurate Credit Transactions Act of 2003 (the FACT Act), which amended the 16. See www.federalreserve.gov/newsevents/ press/bcreg/20071101 a.htm. 17. See www.federalreserve.gov/newsevents/ press/bcreg/20070628a.htm. Consumer and Community Affairs Fair Credit Reporting Act (FCRA). First, the Board published final rules to implement the affiliate-marketing-notice and opt-out requirements of section 214 of the FACT Act. The final rules give consumers the ability to limit the use of certain information for marketing purposes by affiliates of companies with which consumers have done business. The final rules also incorporate certain statutory exceptions to the notice and opt-out requirement, including exceptions for when an affiliate has a preexisting business relationship with a consumer or when the marketing is in response to a consumer-initiated communication. The mandatory compliance date for the final rule is October 1, 2008. The affiliate-marketing rules were developed on an interagency basis with the other federal banking agencies, the Federal Trade Commission (FTC), and the Securities and Exchange Commission.18 Second, the Board published final rules to implement the identity theft "red flag" provisions of section 114 of the FACT Act and the address-discrepancy provisions of section 315 of the act. The final rules require financial institutions and creditors to develop and implement an identity theft protection program that is designed to detect, prevent, and mitigate identity theft. The final rules also require users of consumer reports to (1) adopt reasonable policies and procedures for verifying the identity of a consumer upon receipt of a notice of address discrepancy from a consumer reporting agency and (2) reconcile the discrepancy when the user opens an account despite the discrepancy and regularly furnishes information to the consumer reporting agency. The mandatory compliance date for the final rule is November 1, 2008. The rules for identity 18. See www.federalreserve.gov/newsevents/ press/bcreg/20071025a.htm. 125 theft red flags and address discrepancies were developed on an interagency basis with the other federal banking agencies and the FTC.19 In December, the Board published proposed rules to implement the provisions of section 312 of the FACT Act, which apply to those who furnish information to consumer reporting agencies (furnishers). That section requires the Board to issue guidelines to ensure the accuracy and integrity of information being furnished to consumer reporting agencies. Section 312 also requires the Board to issue rules identifying the circumstances under which furnishers must investigate disputes about the accuracy of information contained in consumer reports based on a direct request from a consumer. The comment period for the proposal will close in February 2008. The furnisher accuracy-and-integrity guidelines and the direct-dispute rules were developed on an interagency basis with the other federal banking agencies and the FTC.20 Other Supervisory Activities Related to Compliance with Consumer Protection and Community Reinvestment Laws The Division of Consumer and Community Affairs supports and oversees the supervisory efforts of the Reserve Banks to ensure that consumer protection laws and regulations are fully and fairly enforced. (See "Mortgage Credit" earlier in this chapter for a description of the division's supervisory activities related to mortgage lending.) Division staff members provide guidance and expertise to the Reserve Banks on consumer 19. See www.federalreserve.gov/newsevents/ press/bcreg/20071031 a.htm. 20. See www.federalreserve.gov/newsevents/ press/bcreg/20071129a.htm. 126 94th Annual Report, 2007 protection regulations, examination and enforcement techniques, examiner training, and emerging issues. Routinely, staff members develop and update examination policies, procedures, and guidelines; review Reserve Bank supervisory reports and work products; and participate in interagency activities that promote uniformity in examination principles and standards. Examinations are the System's primary means of enforcing compliance with consumer protection laws. During the 2007 reporting period,21 the Reserve Banks conducted 324 consumer compliance examinations—312 of state member banks and 12 of foreign banking organizations.22 are enforced consistently and rigorously throughout the Federal Reserve System.23 The Federal Reserve enforces the ECOA and the provisions of the Fair Housing Act that apply to lending institutions. The ECOA prohibits creditors from discriminating against any applicant, in any aspect of a credit transaction, on the basis of race, color, religion, national origin, sex, marital status, or age. In addition, creditors may not discriminate against an applicant because the applicant receives income from a public assistance program or has exercised, in good faith, any right under the Consumer Credit Protection Act. The Fair Housing Act prohibits discrimination in residential real estate-related transactions, including the making and Fair Lending purchasing of mortgage loans, on the The Federal Reserve is committed to en- basis of race, color, religion, national suring that the institutions it supervises origin, handicap, familial status, or sex. comply fully with the federal fair lendPursuant to the ECOA, if the Board ing laws—the Equal Credit Opportunity has reason to believe that a creditor has Act (ECOA) and the Fair Housing Act. engaged in a pattern or practice of disFair lending reviews are conducted crimination in violation of the ECOA, regularly within the supervisory cycle. the matter will be referred to the DepartAdditionally, examiners may conduct fair lending reviews outside of the usual ment of Justice (DOJ) The DOJ reviews supervisory cycle, if warranted. When the referral and decides if further invesexaminers find evidence of potential dis- tigation is warranted. A DOJ investigacrimination, they work closely with the tion may result in a public civil enforcedivision's Fair Lending Enforcement ment action or settlement. The DOJ may Section, which brings additional legal decide instead to return the matter to the and statistical expertise to the examina- Federal Reserve for administrative ention and ensures that fair lending laws forcement. When a matter is returned to the Federal Reserve, staff ensures that the institution corrects the problems and 21. The 2007 reporting period for examination makes amends to the victims. data was July 1, 2006, through June 30, 2007. During 2007, the Board referred the 22. The foreign banking organizations examfollowing eight matters to the DOJ: ined by the Federal Reserve are organizations op- erating under section 25 or 25A of the Federal Reserve Act (Edge Act and agreement corporations) and state-chartered commercial lending companies owned or controlled by foreign banks. These institutions are not subject to the Community Reinvestment Act and typically engage in relatively few activities that are covered by consumer protection laws. 23. See the testimony of Sandra F. Braunstein, director, Division of Consumer and Community Affairs, July 25, 2007 (www.federalreserve.gov/ newsevents/testimony/braunstein20070725a.htm). Consumer and Community Affairs • Two referrals involved ethnic and racial discrimination in mortgage pricing by nationwide lenders. These referrals are discussed in more detail below. (See "Evaluating PricingDiscrimination Risk by Analyzing HMDA Data and Other Information.") • One referral involved racial discrimination in the pricing of automobile loans. The institution purchased loans in which auto dealers had charged higher interest rates, through the use of markups, that were based on the race of the borrowers. This pricing was permitted by the lender, who received a share of the markups. • One referral involved an institution with two loan policies that were found to be discriminatory. One policy prohibited lending on Native American lands. The other policy restricted lending on row houses, which resulted in discrimination against African Americans. • Four referrals involved discrimination against unmarried people. In one matter, an institution combined incomes for married applicants, but not for coapplicants who were unmarried, when underwriting consumer loans. In another matter, an institution only permitted spousal co-applicants for consumer loans. The institution also improperly required non-applicant spouses to sign mortgage notes. The remaining two referrals involved improper spousal guarantees. If a fair lending violation does not constitute a pattern or practice that is referred to the DOJ, the Federal Reserve acts on its own to ensure that the bank remedies it. Most lenders readily agree to correct fair lending violations. In fact, lenders often take corrective steps as 127 soon as they become aware of a problem. Thus, the Federal Reserve generally uses informal supervisory tools (such as memoranda of understanding between the bank's board of directors and the Reserve Bank) or board resolutions to ensure that violations are corrected. If necessary to protect consumers, however, the Board can and does bring public enforcement actions. Evaluating Pricing-Discrimination Risk by Analyzing HMDA Data and Other Information The two previously mentioned referrals involving mortgage-pricing discrimination resulted from a process of targeted pricing reviews that the Federal Reserve initiated when Home Mortgage Disclosure Act (HMDA) pricing data first became available in 2005. (See "Reporting on Home Mortgage Disclosure Act Data.") Board staff developed, and continue to refine, HMDA screens that identify institutions that may warrant further review on the basis of an analysis of HMDA pricing data. Because HMDA data lack many factors that lenders routinely use to make credit decisions and set loan prices, such as information about a borrower's creditworthiness and loan-to-value ratios, HMDA data alone cannot be used to determine whether a lender discriminates. Thus, the Federal Reserve staff analyzes HMDA data in conjunction with other supervisory information to evaluate a lender's risk for engaging in discrimination. For the 2006 HMDA pricing data— the most recent year for which the data are publicly available—Federal Reserve examiners performed a pricingdiscrimination risk assessment for each institution that was identified through the HMDA screening process. These risk assessments incorporated not just 128 94th Annual Report, 2007 the institution's HMDA data but also the strength of the institution's fair lending compliance program; past supervisory experience with the institution; consumer complaints against the institution; and the presence of fair lending risk factors, such as discretionary pricing. On the basis of these comprehensive assessments, Federal Reserve staff determined which institutions would receive a targeted pricing review. Depending on the examination schedule, the targeted pricing review could occur as part of the institution's next examination or outside the usual supervisory cycle. Even if an institution is not identified through HMDA screening, examiners may still conclude that the institution is at risk for engaging in pricing discrimination and may perform a pricing review. The Federal Reserve supervises many institutions that are not required to report data under HMDA. Also, many of the HMDA-reporting institutions supervised by the Federal Reserve originate few higher-priced loans and, therefore, report very little pricing data. For these institutions, examiners analyze other available information to assess pricing-discrimination risk and, when appropriate, perform a pricing review. During a targeted pricing review, staff analyze additional information, including potential pricing factors that are not available in the HMDA data, to determine whether any pricing disparity by race or ethnicity is fully attributable to legitimate factors, or whether any portion of the pricing disparity may be attributable to illegal discrimination. To perform these reviews, staff use analytical techniques that account for the increasing complexity of the mortgage market. Two industry changes in particular—the proliferation of product offerings and the increased use of riskbased pricing—have increased the complexity of fair lending reviews. It is not uncommon for a lender to offer many different products, each with its own pricing based on the borrower's credit risk. To effectively detect discrimination in the expanding range of products and credit-risk categories, the Federal Reserve increasingly uses statistical techniques. When performing a pricing review, staff typically obtain extensive proprietary loan-level data on all mortgage loans originated by the lender, including prime loans (that is, not just the higher-priced loans reported under HMDA). To determine how to analyze these data, the Federal Reserve studies the lender's specific business model, pricing policies, and product offerings. On the basis of the review of the lender's policies, staff determine which factors from the lender's data should be considered. A statistical model is then developed that takes those factors into account and is then tailored to that specific lender. Typically, a test for discrimination in particular geographic markets, such as metropolitan statistical areas (MSAs), is performed. Looking at specific markets is important, as relatively small unexplained pricing disparities at the national level can mask much larger disparities in individual markets. On the basis of the results of pricing reviews conducted, Federal Reserve staff had reason to believe that two nationwide lenders had engaged in a pattern or practice of discrimination and referred these cases to the DOJ. After accounting for legitimate factors reflected in the lenders' specific pricing policies, staff found that minorities still paid more for their mortgages than nonHispanic white borrowers in multiple MSAs. The first referral involved two of the fair lending risk factors that the agencies have identified and used for some time: (1) broad discretion in pricing by loan officers or brokers and (2) fi- Consumer and Community Affairs nancial incentives for loan officers or brokers to charge borrowers higher prices. The lending institution gave its loan officers discretion to charge overages and underages, that is, to set loan prices higher or lower than its standard rates. The institution also paid loan officers more if they charged overages. The Federal Reserve found evidence that, in multiple MSAs, African American and Hispanic borrowers paid higher overages than comparable non-Hispanic whites. The second referral involved loans originated through mortgage brokers at which the institution also permitted pricing discretion. In multiple MSAs, African Americans and Hispanics paid higher annual percentage rates than comparable non-Hispanic whites. Pricing discretion and financial incentives to charge borrowers more do not always result in fair lending violations; however, these referrals underscore that it is critical for lenders that permit these practices to have clear policies about their use and to monitor their use effectively. Reporting on Home Mortgage Disclosure Act Data The Home Mortgage Disclosure Act (HMDA), enacted by Congress in 1975, requires most mortgage lenders located in metropolitan areas to collect data about their housing-related lending activity, report the data annually to the government, and make the data publicly available. In 1989, Congress expanded the data required by HMDA to include information about loan applications that did not result in a loan origination, as well as information about the race, sex, and income of applicants and borrowers. In response to the growth of the subprime loan market, the Federal Reserve updated Regulation C (HMDA's 129 implementing regulation) in 2002. The revisions, which became effective in 2004, require lenders to collect price information for loans they originated in the higher-priced segment of the homeloan market. When applicable, lenders report the number of percentage points by which a loan's annual percentage rate exceeds the threshold that defines "higher-priced loans." The threshold is 3 percentage points or more above the yield on comparable Treasury securities for first-lien loans, and 5 percentage points or more above that yield for junior-lien loans. The HMDA data collected in 2004 and released to the public in 2005 provided the first publicly available loan-level data about loan prices. The FFIEC released the 2006 HMDA data to the public in September 2007. A December 2007 article published by Federal Reserve staff in the Federal Reserve Bulletin uses the 2006 data to describe the market for higher-priced loans and patterns of lending across loan products, geographic markets, and borrowers and neighborhoods of different races and incomes.24 The article also analyzed several of the items included in the HMDA data in order to determine their usefulness in predicting mortgageloan delinquency across metropolitanarea counties. The analysis resulted in several findings, including that the incidence of higher-priced lending and the share of non-owner-occupied loans in a county were both related to higher levels of default in the future. As in 2004 and 2005, most reporting institutions reported extending few if any higher-priced loans in 2006; 61 percent of the lenders originated less than 24. Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, "The 2006 HMDA Data," Federal Reserve Bulletin, December 2007 (www.federalreserve.gov/pubs/bulletin/2007/pdf/ hmdaO6final.pdf). 130 94th Annual Report, 2007 10 higher-priced loans that year. The data also indicate that relatively few lenders accounted for most of the higher-priced loan originations in 2006. Of the nearly 8,900 home lenders reporting HMDA data, 928 of them made 100 or more higher-priced loans. The 10 home lenders that had the largest volume of higher-priced loans accounted for about 38 percent of all such loans in 2006. Also as in 2004 and 2005, the majority of all loan originations were not higher priced in 2006; however, the incidence of higher-priced lending did increase from 26.2 percent in 2005 to 28.7 percent in 2006. Some of the increase in the incidence of higher-priced lending is attributed to changes in the interest rate environment from 2005 to 2006, as well as to changes in borrower profiles and lender practices. Loan pricing is a complex process that may reflect a wide variety of factors about the level of risk a particular loan or borrower presents to the lender. As a result, the prevalence of higher-priced lending varies widely. First, the incidence of higher-priced lending varies by product type. For example, manufactured-home loans show the greatest incidence of higher-priced lending (more than half of these loans are higher priced), because these loans are considered higher risk. In addition, first-lien mortgages are generally less risky than comparable junior-lien loans, and the pricing for these loans reflects their risk profiles: 25.3 percent of first-lien conventional home purchase loans were reported as higher-priced in 2006, compared with 45.7 percent of comparable junior-lien loans. Second, higher-priced lending varies widely by geography. As in 2004 and 2005, many of the metropolitan areas that reported the greatest incidence of higher-priced lending were in the south ern region of the country. Several metropolitan areas on the West Coast also had an elevated incidence of higher-priced lending in 2006. In many metropolitan areas in the South, Southwest, and West, 30 percent to 40 percent of the homebuyers who obtained conventional loans in 2006 received higher-priced loans. Third, the incidence of higher-priced lending varies greatly among borrowers of different races and ethnicities. In 2006, as in 2004 and 2005, African Americans and Hispanics were much more likely than non-Hispanic whites and Asians to receive higher-priced loans. For example, in 2006, 54 percent of African American borrowers, and 47 percent of Hispanic borrowers, received higher-priced conventional home purchase loans, compared with 18 percent of non-Hispanic white and 17 percent of Asian borrowers. Because HMDA data lack information about credit risk and other legitimate pricing factors, it is not possible to determine from HMDA data alone whether the observed pricing disparities and market segmentation reflect discrimination. When analyzed in conjunction with other fair lending risk factors and supervisory information, however, the HMDA data can facilitate fair lending supervision and enforcement. (See "Fair Lending.") Examinations and Activities Related to the Community Reinvestment Act The Community Reinvestment Act (CRA) requires that the Federal Reserve and other banking agencies encourage financial institutions to help meet the credit needs of the local communities in which they do business, consistent with safe and sound operations. To carry out this mandate, the Federal Reserve Consumer and Community Affairs • examines state member banks to assess their compliance with the CRA,25 • analyzes applications for mergers and acquisitions by state member banks and bank holding companies in relation to CRA performance, and26 • disseminates information on community development techniques to bankers and the public through community affairs offices at the Reserve Banks. The Federal Reserve assesses and rates the performance of state member banks under the CRA in the course of examinations conducted by staff at the twelve Reserve Banks. During the 2007 reporting period, the Reserve Banks conducted 271 CRA examinations of banks: 33 were rated Outstanding, 237 were rated Satisfactory, none was rated Needs to Improve, and one was rated Substantial Noncompliance.27 Consumer Alert on Solicitations for CRA Programs In February, the Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision jointly released a consumer alert about CRArelated solicitations from lenders.28 This alert cautioned the public about loan solicitations or other offers from lenders or mortgage brokers that offer consumers cash as part of a "Community Reinvestment Act (CRA) Program." The agen25. See the testimony of Sandra F. Braunstein, director, Division of Consumer and Community Affairs, October 24, 2007 (www.federalreserve.gov/ newsevents/testimony/braunstein20071024a.htm). 26. See the testimony of Sandra F. Braunstein, director, Division of Consumer and Community Affairs, May 21, 2007 (www.federalreserve.gov/ ne wse vents/testimony/braunstein20070521 a.htm). 27. The 2007 reporting period for examination data was July 1, 2006, through June 30, 2007. 28. See www.federalreserve.gov/newsevents/ press/other/20070216a.htm. 131 cies had received numerous consumer complaints and inquiries about this type of solicitation, and the alert warned that the solicitation appears to be a deceptive effort to encourage consumers to apply for a mortgage loan secured by their home. A statement that the agencies do not sponsor or endorse such programs and that the CRA does not require such programs was also included in the alert, along with a warning for consumers to be suspicious about conducting business with lenders who make deceptive claims. Proposed Interagency Questions and Answers on the CRA In July, the federal bank and thrift regulatory agencies released for comment a series of new and revised interagency questions and answers on CRA. The agencies are proposing new questions and answers, as well as making substantive and technical revisions to the existing material. Some of the proposed revisions are intended to encourage institutions to work with homeowners who are unable to make their mortgage payments; the questions and answers emphasize that institutions can receive CRA consideration for foreclosureprevention programs for low- and moderate-income homeowners, consistent with the April 2007 interagency "Statement on Working with Mortgage Borrowers."29 In addition, several technical changes are being proposed to clarify, update, and improve the readability of existing guidance. A few of the more substantive changes include • allowing CRA consideration for investments made by banks to minorityor women-owned financial institutions when that investment benefits 29. See www.federalreserve.gov/newsevents/ press/bcreg/20070417a.htm. 132 94th Annual Report, 2007 the minority or women-owned financial institution's local community, even if the investment does not benefit the bank's own assessment area; • providing flexibility to certain intermediate small banks in the evaluation of their home mortgage, small business, and small farm loans; and • clarifying that an institution that makes a loan or investment in a national or regional community development fund should be able to demonstrate that the fund will benefit the institution's assessment area(s) or the broader statewide or regional area that includes the bank's assessment area(s) as contemplated by the regulation, provided the fund meets certain definition and geographic requirements. • An application by Huntington Baneshares, Inc., Columbus, Ohio, to acquire Sky Financial Group, Inc., Bowling Green, Ohio, was approved in June. • An application by Wells Fargo & Company, San Francisco, California, to acquire Greater Bay Bancorp, East Palo Alto, California, was approved in August. The public submitted comments on nine applications, including those mentioned above. Many of the commenters referenced pricing information on residential mortgage loans and concerns that minority applicants were more likely than nonminority applicants to receive higher-priced mortgages. These concerns were largely based on observaAnalysis of Applications for tions of lenders' 2005 and 2006 HMDA Mergers and Acquisitions pricing data. Other issues raised by comin Relation to the CRA menters involved minority applicants During 2007, the Board considered ap- being denied mortgage loans more freplications for several significant bank- quently than nonminority applicants; poing mergers. The Board approved two tentially predatory lending practices by applications by Bank of America Corpo- subprime and payday lenders; the potenration, Charlotte, North Carolina, the tial adverse effects of branch closings; second largest depository institution in and lenders' failure to address the the United States. The company's acqui- convenience and needs of low- and sition of U.S. Trust Corporation, New moderate-income communities. In addiYork, New York, was approved by the tion, the Board also received comments Board in March and its application to about the adverse effects of increased acquire ABN AMRO North America foreclosures, especially in low- and Holding Company, Chicago, Illinois, moderate-income communities. The Board considered forty-two was approved in September. The merger applications with outstanding issues inof two historic bank holding companies, The Bank of New York, New York, New volving compliance with consumer proYork, and Mellon Financial Corporation, tection statutes and regulations, includ30 Pittsburgh, Pennsylvania, was approved ing fair lending laws, and the CRA. by the Board in June. Several other sig- Thirty-seven of those applications were approved and five were withdrawn, nificant applications are listed below. including one with an adverse CRA • An application by PNC Financial Ser- rating. vices Group, Inc., Pittsburgh, Pennsylvania, to acquire Mercantile Bankshares Corporation, Baltimore, 30. The forty-two applications do not include Maryland, was approved in February. the nine protested applications. Consumer and Community Affairs Initiatives for Minority-Owned Financial Institutions 133 Bank Examiner Guidance and Training The Federal Reserve is committed to en- Examiner Guidance on Unfair and suring the provision of financial services Deceptive Acts and Practices to all consumers and communities. One of the many ways the Board achieves Periodically, the Board issues guidance this goal is by promoting the safety and on consumer protection laws and regulasoundness of all the institutions subject tions to Reserve Bank examiners. Some to System supervision, including those guidance is developed and updated in that are minority owned. Through its concert with the other federal financial regulatory, supervisory, and community institution regulatory agencies, and development functions, the Board con- some is issued solely by the Board. In sistently addresses the unique challenges 2007, the Board issued examination proand needs of minority-owned banks. At cedures designed to help examiners dethe same time, the Board holds these termine whether specific acts or pracinstitutions to the supervisory standards tices conducted by state-chartered banks that are applied to all state member are unfair or deceptive. These procebanks. The Board views this strategy as dures incorporate general guidance prointegral to its efforts to promote a safe, vided in the March 11, 2004, "Statement sound, and competitive banking system on Unfair or Deceptive Acts or Practices (UDAP) by State-Chartered Banks" isthat also protects consumer interests. To enhance its support of minority- sued jointly by the Board and the Fedowned institutions, the Federal Reserve eral Deposit Insurance Corporation. The has been developing an innovative and Board's guidance helps examiners anacomprehensive training and technical lyze potential UDAP issues during a assistance program for minority-owned consumer compliance examination or a depository institutions. Designed to ad- complaint investigation. dress issues that might inhibit or limit the financial and operating performance Training for Bank Examiners of minority-owned institutions, the program includes outreach and technical as- Ensuring that financial institutions comsistance for institution directors. It also ply with laws that protect consumers and fosters relationship-building between in- encourage community reinvestment is stitutions and supervisory staff, and an important part of the bank examinaraises supervisory awareness of the tion and supervision process. As the unique challenges faced by minority- number and complexity of consumer fiowned institutions. The program is nancial transactions grow, training for scheduled to be fully operational in staff that review and examine the organizations under the Federal Reserve's su2008.31 pervisory responsibility becomes even more important. The consumer compliance examiner training curriculum con31. See the speech by Governor Randall S. Kroszner, August 1, 2007 (www.federalreserve.gov/ sists of six courses focused on various newsevents/speech/kroszner20070801a.htm). See consumer protection laws, regulations, also the testimony of Sandra F. Braunstein, direcand examination concepts. In 2007, tor, Division of Consumer and Community Afthese courses were offered in eleven sesfairs, October 30, 2007 (www.federalreserve.gov/ sions to more than 193 consumer comnewsevents/testimony/braunstein20071030a.htm). 134 94th Annual Report, 2007 pliance examiners and System staff members. Board and Reserve Bank staff regularly review the core curriculum for examiner training, updating subject matter and adding new elements as appropriate. During 2007, staff conducted a curriculum review of the Introduction to Consumer Compliance Examinations I (CA I) course to incorporate technical changes in policy and laws, along with changes in instructional delivery techniques. This course, designed for assistant examiners, focuses on the (1) consumer laws and regulations that govern operations and non-real estate lending and (2) regulations affecting deposit and non-real estate lending operations. The course emphasizes examination techniques and procedures that demonstrate the practical application of these laws and regulations. When appropriate, courses are delivered via alternative methods, such as the Internet or other distance-learning technologies. The CA I course uses a combination of instructional methods: (1) classroom instruction focused on case studies and (2) specially developed computer-based instruction that includes interactive self-check exercises. In addition to providing core training, the examiner curriculum emphasizes the importance of continuing professional development. Opportunities for continuing development include special projects and assignments, self-study programs, rotational assignments, the opportunity to instruct at System schools, mentoring programs, and an annual senior examiner forum. determined to have special flood hazards. Under the Federal Reserve's Regulation H, which implements the act, state member banks are generally prohibited from making, extending, increasing, or renewing any such loan unless the building or mobile home and any personal property securing the loan are covered by flood insurance for the term of the loan. Moreover, the act requires the Board and other federal financial institution regulatory agencies to impose civil money penalties when it finds a pattern or practice of violations of the regulation. The civil money penalties are payable to the Federal Emergency Management Agency for deposit into the National Flood Mitigation Fund. During 2007, the Board imposed civil money penalties against eight state member banks. The penalties, which were assessed via consent orders, totaled $246,050. Agency Reports on Compliance with Consumer Protection Laws The Board reports annually on compliance with consumer protection laws by entities supervised by federal agencies. This section summarizes data collected from the twelve Federal Reserve Banks and the FFIEC member agencies (collectively, the FFIEC agencies), as well as other federal enforcement agencies.32 Regulation B (Equal Credit Opportunity) The FFIEC agencies reported that 85 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation B, com- Flood Insurance The National Flood Insurance Act imposes certain requirements on loans secured by buildings or mobile homes located in, or to be located in, areas 32. Because the agencies use different methods to compile the data, the information presented here supports only general conclusions. The 2007 reporting period was July 1, 2006, through June 30, 2007. Consumer and Community Affairs pared with 87 percent for the 2006 reporting period. The most frequently cited violations involved • the failure to properly collect information for monitoring purposes, including the race, ethnicity, sex, marital status, and age of applicants seeking credit primarily for the purchase or refinancing of a principal residence • the improper collection of information on an applicant's race, color, religion, national origin, or sex when not permitted by regulation • the improper requirement of the signature of an applicant's spouse or other person, other than a joint applicant, when the applicant qualified under the creditor's standards of creditworthiness for the amount and terms of the credit requested • the failure to provide a written notice of denial or other adverse action to a credit applicant that contains the specific reason for the adverse action, along with other required information During this reporting period, the OTS issued two supervisory agreements and one cease-and-desist order to a savings association for alleged violations of the Equal Credit Opportunity Act (ECOA) and Regulation B, as well as other consumer regulations. The other FFIEC agencies did not issue any formal enforcement actions specific to Regulation B during the reporting period. The other agencies that enforce the ECOA—the Farm Credit Administration (FCA), the Department of Transportation, the Securities and Exchange Commission (SEC), the Small Business Administration, and the Grain Inspection, Packers and Stockyards Administration of the Department of Agriculture— reported substantial compliance among 135 the entities they supervise. The FCA's examination activities revealed Regulation B violations involving the improper collection of government monitoring information. Regulation E (Electronic Fund Transfers) The FFIEC agencies reported that approximately 94 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation E, compared with 95 percent in the 2006 reporting period. The most frequently cited violations involved the failure to take one or more of the following actions: • determine whether an error occurred, within ten business days of receiving a notice of error from a consumer • give the consumer provisional credit for the amount of an alleged error when an investigation into the alleged error cannot be completed within ten business days • provide initial disclosures that contain required information, including limitations on the types of transfers permitted and error-resolution procedures, at the time a consumer contracts for an electronic fund transfer service • when a determination is made that no error has occurred, provide a written explanation and note the consumer's right to request documentation supporting the institution's findings The FFIEC agencies did not issue any formal enforcement actions relating to Regulation E during the period. The Federal Trade Commission (FTC) settled charges against one corporation that falsely marketed products and 136 94th Annual Report, 2007 debited consumer accounts without obtaining consumers' authorization for preauthorized electronic fund transfers, in violation of Regulation E. The FTC also continued litigation against a group of defendants for allegedly enrolling consumers in a program and automatically billing them for charges without obtaining authorization for the recurring debits. Regulation M (Consumer Leasing) The FFIEC agencies reported that more than 99 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation M, which equals the level of compliance for the 2006 reporting period. The FFIEC agencies did not issue any formal enforcement actions relating to Regulation M during the period. Regulation P (Privacy of Consumer Financial Information) The FFIEC agencies reported that 97 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation P, compared with 98 percent for the 2006 reporting period. The most frequently cited violations involved the failure to take one or more of the following actions: • provide a clear and conspicuous annual privacy notice to customers • disclose the institution's informationsharing practices in initial, annual, and revised privacy notices • provide customers with a clear and conspicuous initial privacy notice that accurately reflects the institution's privacy policies and practices, not later than when the customer relationship is established The FFIEC agencies did not issue any formal enforcement actions relating to Regulation P during the reporting period. Regulation Z (Truth in Lending) The FFIEC agencies reported that 82 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation Z, compared with 85 percent for the 2006 reporting period. The most frequently cited violations involved the failure to take one or more of the following actions: • accurately disclose the finance charge in closed-end credit transactions • accurately disclose the amount financed, by subtracting any prepaid finance charge from the amount financed • accurately disclose the payment schedule, including the number, amounts, and timing of payments scheduled to repay the obligation • ensure that disclosures reflect the terms of the legal obligation between the parties In addition, 185 banks supervised by the Federal Reserve, FDIC, OCC, and OTS were required, under the Interagency Enforcement Policy on Regulation Z, to reimburse a total of approximately $2.75 million to consumers for understating the annual percentage rate or the finance charge in their consumer loan disclosures. The OTS issued two supervisory agreements and two cease-and-desist orders for violations of a number of consumer regulations, including Regulation Z, during the reporting period. The other FFIEC agencies did not issue any formal enforcement actions specific to Consumer and Community Affairs Regulation Z during the reporting period. The Department of Transportation continued to prosecute one air carrier for its improper handling of credit card refund requests and other Federal Aviation Act violations. The FCA identified creditors that were using incorrect templates, resulting in violations of Regulation Z. While all required disclosures were made, the format of the disclosures was not consistent with regulatory requirements. The FTC continued litigation in federal district court against a mortgage broker for alleged violations of Regulation Z; the alleged violations involved the broker's advertisements and financecharge disclosures. 137 that are not subject to next-day availability • follow procedures when invoking the exception for large-dollar deposits • provide required information when placing an exception hold on an account • make funds from local and certain other checks available for withdrawal within the times prescribed by regulation The OTS issued one supervisory agreement for violations of a number of consumer regulations, which included Regulation CC. The other FFIEC agencies did not issue any formal enforcement actions specific to Regulation CC during the reporting period. Regulation AA (Unfair or Deceptive Acts or Practices) Regulation DD (Truth in Savings) The FFIEC agencies reported that more than 99 percent of the institutions examined during the 2007 reporting period were in compliance with Regulation AA, which equals the level of compliance for the 2006 reporting period. No formal enforcement actions relating to Regulation AA were issued during the reporting period. The FFIEC agencies reported that 88 percent of institutions examined during the 2007 reporting period were in compliance with Regulation DD, compared with 91 percent for the 2006 reporting period. The most frequently cited violations involved the failure to take one or more of the following actions: Regulation CC (Availability of Funds and Collection of Checks) The FFIEC agencies reported that 90 percent of institutions examined during the 2007 reporting period were in compliance with Regulation CC, compared with 92 percent for the 2006 reporting period. The most frequently cited violations involved the failure to take one or more of the following actions: • make available on the next business day the lesser of $100 or the aggregate amount of checks deposited • provide a statement that fees could reduce the earnings on an account, when the term "annual percentage yield" is used in an advertisement • use the term "annual percentage yield" if an advertisement states a rate of return • provide initial account disclosures containing all required information • provide adequate subsequent account disclosures for time accounts that have maturities greater than one year The OTS issued one supervisory agreement and one cease-and-desist order for 138 94th Annual Report, 2007 violations of a number of consumer regulations, including Regulation DD. The other FFIEC agencies did not issue any formal enforcement actions specific to Regulation DD during the reporting period. Consumer Complaints The Federal Reserve investigates complaints against state member banks and forwards those that involve other creditors and businesses to the appropriate enforcement agency. Each Reserve Bank investigates complaints against state member banks in its District. In 2007, the Federal Reserve received 1,540 consumer complaints concerning regulated practices by state member banks. In November, the Federal Reserve System launched Federal Reserve Consumer Help (FRCH), an initiative that consolidates and streamlines the Federal Reserve's process for handling consumer complaints and inquiries. FRCH improves consumers' access to the Federal Reserve by providing a convenient, one-stop website and a toll-free number where consumers can get assistance with their banking problems or questions. (See related box "The Federal Reserve Consumer Help Center.") Under the direction of the Federal Financial Institutions Examination Council (FFIEC), an interagency working group was formed in late 2007 to explore ways to improve consumers' experiences with contacting a banking agency and with submitting a complaint or inquiry to the appropriate regulator. A third-party contractor may be used to examine best practices and recommend improvements to the process consumers use to file a complaint or inquiry with one of the FFIEC agencies.33 33. FFIEC agencies represented on the working group are the Federal Reserve Board, the Office of Complaints Against State Member Banks The majority (61 percent) of complaints about regulated practices involved credit cards. The most common credit card problem fell into the complaint category called "other rates/terms/fees" (35 percent), followed by problems with billing-error resolution (19 percent) and banks' providing inaccurate account information (8 percent).34 Complaints about checking accounts were the next largest category (19 percent) of complaints about regulated practices. The most common checking account concerns were insufficientfunds or overdraft charges and procedures (30 percent), funds availability (14 percent), and disputed withdrawals of funds by banks (13 percent). Real estate-related complaints made up 5 percent of complaints involving regulated practices.35 Of those, only 4 percent (or three complaints) concerned adjustable-rate mortgages. The most common real estate-related loan problems concerned escrow accounts (15 percent); other rates, terms, or fees (11 percent); and errors or delays in crediting loan payments (10 percent). Of all complaints involving regulated practices, 13 (0.8 percent) alleged discrimination on a basis prohibited by law (race, color, religion, national origin, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration. Representatives from the Conference of State Bank Supervisors are also participating. 34. Includes complaints about interest rates, terms, or fees other than late fees, overlimit fees, prepayment fees, fees related to credit insurance, or the calculation of the finance charge. 35. Includes adjustable-rate mortgages; residential construction loans, open-end home equity lines of credit, home improvement loans, home purchase loans, home refinance or closed-end loans; and reverse mortgages. Consumer and Community Affairs 139 Consumer Complaints against State Member Banks That Involve Regulated Practices, by Classification, 2007 sex, marital status, handicap, age, the fact that the applicant's income comes from a public assistance program, or the fact that the applicant has exercised a right under the Consumer Credit Protection Act). Complaint investigations determined that banks had handled customers' accounts in accordance with Federal Reserve regulations in the majority (96 percent) of the complaints reviewed. Investigations for the remaining 4 percent determined that the bank had violated a consumer protection regulation. The most common violations involved credit cards and checking accounts. (See tables.) Number Classification Regulation A A (Unfair or Deceptive Acts or Practices) Regulation B (Equal Credit Opportunity) Regulation C (Home Mortgage Disclosure)... Regulation E (Electronic Fund Transfers) Regulation H (Bank Sales of Insurance) Regulation M (Consumer Leasing) Regulation P (Privacy of Consumer Financial Information) Regulation Q (Payment of Interest) Regulation Z (Truth in Lending) Regulation BB (Community Reinvestment)... Regulation CC (Expedited Funds Availability) Regulation DD (Truth in Savings) Regulations T, U, and X Regulation V (Fair and Accurate Credit Transactions) Fair Credit Reporting Act Fair Debt Collection Practices Act Fair Housing Act Flood Insurance Homeownership Counseling HOPA (Homeowners Protection Act) Real Estate Settlement Procedures Act Right to Financial Privacy Act Unregulated Practices As required by section 18(f) of the Federal Trade Commission Act, the Board continued to monitor complaints about banking practices that are not subject to existing regulations and to focus on those that concern possible unfair or deceptive practices. In 2007, the Board received more than 2,000 complaints against state member banks that involved unregulated practices. The product categories that contained the most complaints were credit cards and checking accounts. In those categories, con- 85 62 1 98 2 3 35 3 761 6 123 124 0 13 138 64 1 2 1 15 2 1,540 Total sumers most frequently complained about fraud, forgery, or theft (216 complaints); problems with opening or closing an account (196 complaints); issues involving insufficient-funds or overdraft charges and procedures (190 complaints); and certain credit card interest rates, terms, and fees (129 complaints). Complaints against State Member Banks That Involve Regulated Practices, 2007 All complaints Complaints involving violations Subject of complaint Number Discrimination alleged Real estate loans Credit cards Other loans . .. .. Nondiscrimination complaints, total1 Credit cards Checking accounts Real estate loans Number 1,540 Total Percent 100 53 3 0 0 0 0 0 0 39 13 0 3 13 1 8 4 1,527' 939 295 80 .1 .5 .3 61 19 5 1. Only the top three product categories of nondiscrimination complaints are listed here. Percent .8 0 140 94th Annual Report, 2007 The Federal Reserve Consumer Help Center: A New Resource for Expert, Immediate Help Credit cards, mortgages, and electronic funds transfers are just a few of the services and products consumers use to conduct their financial business. The use of these products and services has become widespread, and it can be easy to lose sight of their complexity—until a consumer has a question or something goes wrong. Consumers often need help navigating the maze of terminology, regulations, and policies that governs financial products, services, and institutions. For more than 30 years, the Federal Reserve System has provided professional help to consumers who have complaints against a financial institution. In 2007, the Federal Reserve launched the Federal Reserve Consumer Help (FRCH) center, a centralized consumer complaint center that improves consumers' access to information and services. The FRCH website (www. federalreserveconsumerhelp.gov) provides comprehensive information on consumer financial issues, as well as contact information. Consumers can use the site to research their issue, or they may contact the Federal Reserve to ask a question or file a complaint via e-mail, a toll-free number, fax, or mail. Complaint Referrals to HUD In 2007, the Federal Reserve received one housing-related discrimination complaint and forwarded it to HUD in accordance with a memorandum of understanding between HUD and the federal bank regulatory agencies regarding complaints alleging a violation of the Fair Housing Act. The Federal Reserve's investigation of this complaint revealed no evidence of illegal credit discrimination. Consumer complaints are an important source of information for the Federal Reserve Board. Regardless of their outcome, complaints often identify areas of concern that the Board considers when writing regulations or guidance for bank examiners. Complaints can also reveal emerging consumer-protection issues and trends in banking practices. The Federal Reserve established its program for receiving consumer complaints and inquiries in 1976. Drawing on the resources of the Federal Reserve System*s twelve Reserve Bank Districts, the program answers consumers' questions, investigates complaints against state member banks (those institutions under the Federal Reserve's supervisory authority), or refers consumers to the appropriate agency for a response. In addition, the Board responds to issues raised by congressional representatives on behalf of their constituents. Over the last decade, the consumer financial services marketplace has dramatically changed. Technological developments and increased access to technology have also changed both the way institutions operate and how consumers want to communicate with financial Responding to Community Economic Development Needs in Historically Underserved Markets The mission of the community affairs function within the Federal Reserve System is to promote community economic development and fair access to credit for low- and moderate-income communities and populations. As a decentralized function, the Community Affairs Offices (CAOs) at each of the twelve Reserve Consumer and Community Affairs institutions and others. In 2007, the Federal Reserve responded to these forces by launching FRCH, while continuing to tap staff expertise and knowledge of regional banking markets. The Federal Reserve is committed to providing superior service to consumers. The call center is staffed by highly trained professionals; 80 percent of incoming calls or e-mail inquiries are answered by a representative within 60 seconds or less. Complaints against banking institutions supervised by the Federal Reserve continue to be investigated by the Reserve Bank responsible for examining the institution in question. This approach ensures that complaints are investigated by examiners who are knowledgeable about an institution and its regional banking market—and who can leverage the bank-supervisor relationship to resolve an issue. If a consumer has a complaint against an institution not supervised by the Federal Reserve, FRCH can seamlessly connect him or her with the appropriate agency. FRCH tracks ail incoming questions and requests for assistance, by issue and volume. Data will be shared with the other federal banking regulatory agencies. The Federal Reserve and other agencies Banks design activities in response to the needs of communities in the Districts they serve, with oversight from Board staff. The CAOs focus on providing information and promoting awareness of investment opportunities to financial institutions, government agencies, and organizations that serve lowand moderate-income communities and populations. Similarly, the Board's CAO promotes and coordinates Systemwide 141 analyze the data so that they can identify shared issues, develop best practices for customer service and complaint investigation, and develop consumer education materials. Such collaboration is critical to addressing consumer protection issues in the broader financial services marketplace and developing consumer information materials to educate consumers about trends in banking products and their rights. In addition, FRCH is establishing a mechanism for tracking customer satisfaction, that is, whether consumers feel the center helped them with their financial services issues. Early reviews of available data on FRCH call volume and website visits indicate that consumers are contacting the the Federal Reserve in record numbers. The Federal Reserve is dedicated to providing superior access to consumers who need assistance and will continue to monitor the performance of FRCH, with the goal of identifying further opportunities to help consumers exercise their rights and work through their financial services challenges. The Federal Reserve plans to launch a Spanish-language version of the website in the first quarter of 2008. high-priority efforts; in particular, Board community affairs staff focus on issues that have public policy implications. 36 In 2007, disruptions in the housing market made collaboration among the financial services community, the Board, and the Reserve Banks impera- 36. See www.federalreserve.gov/communitydev/ default.htm. 142 94th Annual Report, 2007 tive. The CAOs worked diligently to identify solutions that would help mitigate the adverse consequences of the increasing numbers of mortgage defaults and foreclosures in many Districts. (See "Mortgage Credit.") System staff also continued work on a number of important topics: improving the sustainability and financial capacity of community development organizations, creating assetbuilding opportunities for low- and moderate-income populations, and developing programs to promote community development and consumer education. Activities included conducting research, sponsoring conferences and seminars, publishing newsletters and articles, and supporting the dissemination of information to both general and targeted audiences. System Collaborative Efforts The Reserve Banks and the Board continued their work on two substantial collaborative efforts over the past year. The first effort, an initiative undertaken by System Community Affairs staff and the Brookings Institution, analyzes and compares communities that have high concentrations of poverty. Using sixteen case studies from selected communities, the project employs both quantitative and qualitative analyses to explore the dynamics of the communities, their residents, their economies, and programs that are helping or hindering a community's integration into the economic mainstream. The data generated by this ongoing initiative help Reserve Banks, local financial institutions, business leaders, service providers, and philanthropic organizations better understand their regional economies and the capital and credit needs of the communities they serve. The second major collaborative effort in 2007 was the Community Affairs System Research Conference, "Financing Community Development: Learning from the Past, Looking to the Future," cosponsored by the Board and the Federal Reserve Bank of Philadelphia. The conference brought together a diverse audience from academia, financial institutions, community organizations, foundations, and the government. Approximately 400 participants learned about and discussed original studies on the opportunities and obstacles to helping lowand moderate-income communities and people build wealth by using home loans, small business loans, or other financial services. System community affairs staff were actively involved in the planning and execution of the conference: staff reviewed papers, developed the agenda, presented research, and served as moderators and participants in formal discussion groups. The Board's Community Affairs officer delivered a keynote address during the conference, and Chairman Ben Bernanke provided remarks on the history, evolution, and new challenges of the Community Reinvestment Act.37 Identifying Strategies to Enhance Access to Community Development Financing and Asset-Building In 2007, Community Affairs staff from around the System continued working on several initiatives to not only enhance access to affordable credit in currently underserved markets but also to provide information and promote awareness of investment opportunities to financial institutions, government agencies, and organizations. The St. Louis Reserve Bank hosted "Exploring Innovation: A Conference on Community 37. See www.federalreserve.gov/newsevents/ speech/bernanke20070330a.htm. Consumer and Community Affairs Development Finance" to explore how organizational creativity, learning, and innovation can improve community development projects, increase their access to capital, and help projects achieve scale and sustainability. The San Francisco Reserve Bank's Center for Community Investments hosted two conferences focused on community development investment. One conference, which was cosponsored with the Board, focused on the availability of rural venture capital; the other, cosponsored with the New York Reserve Bank, discussed issues related to the creation of a secondary market for community development loans. Other Reserve Banks hosted symposiums on this topic as well, such as the Federal Reserve Bank of Richmond's Community Development Financial Institution (CDFI) workshops that gathered community development lenders, local bankers, and representatives from the CDFI Fund to discuss capitalizing and certifying potential CDFIs. The Federal Reserve Bank of Boston and the Aspen Institute, a national research and leadership development organization, cohosted a conference on socially responsible investment and the role of subsidy dollars in public investment. In a related initiative, the Boston Reserve Bank collaborated with the Massachusetts Small Business Assistance Advisory Council on the launch of a loan program for small businesses. Asset-building and financial education remained major areas of focus for the Community Affairs Offices in 2007. System staff continued to collaborate with constituent organizations on efforts to provide advisory services and conduct outreach to low- and moderateincome communities. The Federal Reserve Bank of Atlanta worked with the Federal Deposit Insurance Corporation to create MoneySmart curriculum modules on low-income investment. The 143 Kansas City Reserve Bank cosponsored a major conference on entrepreneurship with the Association for Enterprise Opportunity. Together with the San Francisco and Minneapolis Reserve Banks, the Kansas City Reserve Bank also continued work on several Indian country initiatives focused on improving the financial literacy and housing options of Native Americans. The three Banks continued to promote the adoption of uniform commercial codes to facilitate tribes' efforts to borrow from offreservation partners or other tribes. The Federal Reserve Bank of Dallas engaged in efforts to promote financial education in the workplace, including sponsorship of a highly successful seminar for human resource professionals attended by approximately 80 employers, who in turn represented 380,000 employees. The Richmond Reserve Bank released two issues of its journal MarketWise, one which featured an article on the earned-income tax credit (EITC). The New York Reserve Bank cosponsored a conference with the New York City Office of Financial Empowerment that promoted the EITC. As a result of the conference, a statewide coalition of EITC practitioners was created, and several statewide asset-building strategies for low- and moderate-income communities were adopted. Advice from the Consumer Advisory Council The Board's Consumer Advisory Council—whose members represent consumer and community organizations, the financial services industry, academic institutions, and state agencies—advises the Board of Governors on matters concerning laws and regulations that the Board administers and on other issues related to consumer financial services. Council meetings are held three times a 144 94th Annual Report, 2007 year, in March, June, and October, and are open to the public. (For a list of members of the council, see the section "Federal Reserve System Organization.") Among other issues, council discussions in 2007 focused on two significant topics: • various issues related to mortgage lending, specifically the Board's rulemaking authority under the Home Ownership and Equity Protection Act (HOEPA) to address concerns about abusive lending practices in the home mortgage market, and concerns about foreclosures and the subprime lending market • proposed amendments to Regulation Z that would revise the disclosure requirements for credit card accounts and other open-end (revolving) credit plans that are not secured by a borrower's home Mortgage Lending Issues HOEPA In its June and October meetings, the council addressed several issues related to the Board's rulemaking authority under HOEPA: whether the Board should issue rules or guidance, the possibility of prohibiting or restricting certain loan terms or practices in subprime loans, the definition of "subprime," and the role and timing of the disclosures provided to consumers during the loan-making process. Several consumer representatives strongly supported issuing rules under HOEPA rather than guidance. Consumer representatives expressed the view that guidance puts supervised institutions at a competitive disadvantage to other mortgage lenders that do not have to comply with guidance. Rules, however, would apply to all mortgage lenders, not just federally supervised institutions. Consumer representatives noted that rules would also provide consumers with a private right of action. Several members stated that rulemaking may be appropriate for areas in which the Board can establish clear, bright lines for regulatory supervision but that guidance is the best way to ensure that institutions have appropriate flexibility to meet consumers' needs. In considering whether proposed rules on mortgage lending should apply to the subprime mortgage market, council members generally urged the Board to define "subprime" not by borrower characteristics but according to the type of loan or its terms, such as a loan's annual percentage rate. An industry member endorsed the definition of "subprime" that the Board used in earlier guidance and cautioned against using Home Mortgage Disclosure Act (HMDA) standards as a pricing criterion for subprime loans, because the HMDA standards may not capture all subprime loans. Several members urged the Board to ban prepayment penalties, particularly for subprime loans. They expressed concerns that, for subprime borrowers, prepayment penalties are not balanced by lower interest rates and often prevent borrowers from graduating into prime loans. Other members acknowledged problems with using prepayment penalties in the subprime market but said the penalties can be a useful tool and yield lower interest rates for consumers. These members urged the Board to regulate prepayment penalties to ensure that borrowers receive a choice about whether to have a prepayment penalty, which may result in a lower interest rate for them. A consumer representative suggested that prepayment penalties for adjustable-rate mortgages should expire 60 days before the first interest-rate reset on such a loan. Consumer and Community Affairs Council members generally agreed that it is a sound underwriting practice to require borrowers to make monthly payments to escrow accounts for taxes and insurance, as loans that include escrow payments generally perform better. There was also consensus on the importance of clearly disclosing whether an advertised payment amount includes a borrower's taxes and insurance. Recognizing the financial vulnerability of subprime borrowers, members generally agreed that the Board should mandate that escrow accounts be established for subprime loans. Some members suggested that escrow accounts should not be required for borrowers who take out prime loans. Members had a variety of views about initially mandated escrow accounts that borrowers could later opt out of. Both consumer and industry representatives generally agreed that any opt-out decision should not be made at loan closing and that clear disclosure of any escrow requirement and opt-out provision is paramount. Several council members commented on the need for stated-income loans, especially in immigrant communities and for borrowers who engage in cash transactions or are otherwise not connected with mainstream financial institutions. The members emphasized the importance of sound, responsible underwriting for stated-income loans and urged that lenders be given flexibility to use nontraditional, third-party forms of income documentation. Some members highlighted the importance of providing borrowers with clear disclosures for stated-income loans to ensure that these borrowers are aware they may not be receiving the lowest rate for which they qualify. Council members generally agreed that the Board should require lenders to ensure borrowers' ability to repay a loan for a reasonable term by underwriting 145 the loan to the fully indexed rate. Some members commented that such a standard would also benefit investors by giving them greater assurance about the quality of the loans they are purchasing. Members disagreed about the length of time for which ability to repay should be considered. Some industry representatives cautioned that setting too strict a standard could inappropriately restrict access to credit. Members agreed on the importance of providing consumers with simplified, plain-language disclosures for mortgage products. Several members identified key terms that should be clearly and concisely disclosed. Some members expressed concern, however, that simplified disclosures may not sufficiently inform borrowers about the more complex or exotic mortgage products being offered; they suggested such products may require a different type of disclosure. Some members supported a requirement that Truth in Lending Act (TILA) disclosures be provided earlier in the loanmaking process for nonpurchase mortgage loans. They also emphasized that TILA disclosures should accurately reflect the terms of the transaction. In a discussion of yield-spread premiums (YSPs), several members stated that many consumers do not know about YSPs or understand how they work. Members agreed on the importance of providing borrowers with transparent YSP disclosures. Several consumer representatives expressed concern about abusive practices related to YSPs; for example, a consumer may receive a higher interest rate because his or her mortgage broker has an agreement to receive a YSP from a certain lender, or some lenders may combine YSPs and discount points, resulting in higher fees for borrowers. An industry member expressed the view that banning YSPs would hurt small broker businesses by 146 94th Annual Report, 2007 eliminating a key source of their compensation and would put small loan originators at a competitive disadvantage to large lenders, thereby leaving consumers with fewer choices in the marketplace. adjustable-rate mortgage loans and (2) these products may pose an elevated risk to financial institutions. Most members supported the guidance. Several members voiced approval for the provision recommending that lenders underwrite a loan at its fully indexed rate. They were also supportive of the recommendation Foreclosures and that a loan's underwriting include an esSubprime Lending Issues crow component for taxes and insurAt its March meeting, the council dis- ance. Some members supported extendcussed the recent increase in home fore- ing the principles of the guidance to closures in a number of markets across prime mortgage lending, but others the country. Several members described noted possible difficulties to segmenting the impact of defaults and foreclosures the mortgage market in this way. Sevon their communities: large concentra- eral members shared concerns that aptions of abandoned and vacant proper- plying the guidance to prime loans ties and the associated need to enhance might reduce the variety of loan prodpolicing efforts and other city services, a ucts available to consumers. Members rise in homelessness, decreasing prop- representing the financial services inerty values, and declining tax revenues dustry questioned whether the guidance for local governments. Some members might lead to the creation of a loannoted a disproportionate concentration suitability standard, that is, a requireof foreclosures in communities that are ment that lenders gauge the suitability predominately Latino or African Ameri- of a loan product for certain borrowers. can; members also shared concerns Industry members generally thought about foreclosure "rescue" scams and such a standard could limit the array of the "flipping" of previously foreclosed loan products available to consumers. homes, and they stressed the importance Several members emphasized the need of having community-based organiza- for a new Federal Housing Administrations coordinate and manage rescue tion loan product that could meet the funds for homeowners facing foreclo- needs of subprime borrowers. sure. Members discussed possible ways to assist households facing default or foreclosure. Several consumer represen- Credit Cards tatives described the difficulty credit counselors face when they try to contact In May, the Board issued proposed servicers on behalf of borrowers. Mem- amendments to Regulation Z, which bers also noted the challenges associ- implements the Truth in Lending Act, ated with restructuring mortgages that that would affect the content, format, have been securitized. and timing of credit card disclosures. Members commented on the proposed The council's discussions in June and statement on subprime mortgage lend- October focused on several dimensions ing issued by the federal financial regu- of the proposal: the summary table, or latory agencies in March. The proposal "Schumer box," for application and soaddressed concerns that (1) subprime licitation disclosures; account-opening borrowers may not fully understand the disclosures; periodic statements; and risks and consequences of products like change-in-terms notices. Consumer and Community Affairs Several members commended the Board for proposed revisions to the Schumer box. By highlighting key information on credit card terms, the revisions would facilitate consumers' ability to compare different credit cards, members said. Several consumer representatives urged the Board to include a "typical APR" in the Schumer box. This APR would include the fees that consumers typically pay during a billing cycle and could alert them to the potential costs of using the credit card. A typical APR would also allow consumers to compare the fees different cards charge. Several industry members objected to the idea of a typical APR, however, expressing concerns that such a rate would be misleading and unhelpful, as many fees are not necessarily incurred by every consumer. Industry representatives supported the disclosure of fees in dollar amounts rather than as a percentage of the balance, noting that the Board's consumer testing found that consumers more readily understand dollar amounts than percentages. Several consumer representatives commended the Board for proposing a disclosure to inform consumers about the amount of available credit if the account-opening fees are 25 percent or more of the credit limit, as is sometimes the case with subprime credit cards. For account-opening disclosures, members generally supported the Board's proposal to require a summary table similar to the Schumer box. They noted that a summary would make it easy for consumers to compare the actual account terms with those they were originally offered. Some industry and consumer representatives disagreed about the proposal to allow the verbal disclosure of some fees at the time a consumer incurs a charge, instead of relying on account-opening disclosures to disclose all fees. 147 Members generally approved of the new format for periodic statements, particularly the clear grouping of fees and the year-to-date totals for interest charges and fees. They noted the importance of highlighting the late-payment notice by requiring its placement on the front of the statement and emphasized the importance of clearly disclosing day and time deadlines for payments (that is, the cutoff before late-payment charges apply). Several consumer representatives stated that the effective APR disclosure should be retained because it more accurately accounts for the total cost of credit. Industry representatives, however, expressed their preference for eliminating the effective APR disclosure on the basis that, even with the change in labeling, the figure is confusing to consumers. The industry members stated that the proposed year-to-date totals for interest and fees represent the most meaningful disclosure to consumers of the total cost. Several members commended the Board on its use of consumer testing to develop the credit card disclosures and urged the Board to continue using both qualitative and quantitative testing as it determines how best to communicate complicated financial terms to consumers. For change-in-terms notices, several consumer representatives expressed support for requiring 45 days' advance notice for rate increases triggered by a consumer's default or delinquency. They emphasized that advance notice will give consumers the opportunity to pursue other credit options. Industry representatives disagreed with providing a 45-day advance notice of increased rates when the increase is prompted by consumer default. They noted that default pricing is properly disclosed to consumers at account opening and that the triggering of a default rate by a consumer's action does not 148 94th Annual Report, 2007 constitute a change in terms. Industry representatives expressed support for 45 days' advance notice of charges or changes in terms that have not been previously disclosed. Several industry representatives opposed having an optout when a rate increase is prompted by default or delinquency, but they supported a consumer's right to opt out in other cases. The council also discussed credit card issuers' practice of offering a 0 percent APR for consumers' balance transfers from other credit cards and a higher APR for purchases. Typically, issuers then typically allocate consumers' payments to balances that have the lowest APR—allowing high-APR balances to remain high. Several consumer representatives urged the Board to prohibit policies that apply all payments to the lowest-rate balance first, noting that many consumers do not understand how such low-APR products work. Several industry representatives expressed the view that such payment-allocation methods are appropriate business practices and that consumers benefit from lowAPR cards because they receive an interest-free loan for a certain period of time. Industry representatives did acknowledge the need for better disclosures. There was consensus among council members on what they consider to be best practices for due dates on credit card payments: if creditors do not receive mail or post payments on weekends or holidays, then payments that arrive on those days should be posted on the next business day and should be credited as on time if the due date fell on that weekend or holiday. Similarly, a payment that has a weekend or holiday due date should be credited as on time if it is received on the next business day. Other Issues At their March meeting, council members discussed additional topics, including model privacy notices, proposed amendments to Regulation E, and several aspects of Regulation CC. To comply with their disclosure obligations on the sharing of consumer information under the Gramm-LeachBliley Act, financial institutions may use the model privacy form developed jointly by the federal financial regulatory agencies and the Federal Trade Commission. Members generally commended the agencies for the proposed form, noting that the prototype was a marked improvement over current privacy notices because it is clearer and easier to navigate—and thus makes it easier for consumers to compare different privacy policies. Some industry representatives expressed concerns that the form did not sufficiently address additional notice and opt-out requirements that may exist under state laws; they urged the agencies to preempt state privacy law requirements. Institutions may not use the form if they lack confidence that doing so would satisfy their obligations under state laws, industry representatives said. The council provided feedback on proposed amendments to Regulation E, which implements the Electronic Fund Transfer Act, that would eliminate the receipt requirement at point-of-sale and other electronic terminals for debit card transactions of $15 or less. Members acknowledged that consumers increasingly use credit and debit cards for smalldollar transactions but disagreed about whether receiving a receipt helps consumers manage their finances. Industry members generally expressed the view that consumers receive minimal benefit Consumer and Community' Affairs from receipts for small-dollar transactions. They noted that consumers would continue to receive information about each of their transactions on periodic statements. Several consumer representatives opposed the Board's proposal, stating that receipts are an important tool to help consumers accurately track their transactions, obtain reimbursements, and provide documentation in a dispute. Several industry representatives expressed concern that the costs associated with providing terminal receipts for debit card transactions are burdensome and impede industry efforts to create cashless payment options in certain retail settings. Consumer representatives generally regarded the proposed $15 threshold as too high. Industry representatives, however, suggested that the threshold should be increased to $25, consistent with current credit card rules that waive requirements for authorization by signature or personal identification number for transactions less than this amount. Members discussed several aspects of Regulation CC, which governs the availability of funds deposited in checking 149 accounts and the collection and return of checks. They focused particularly on scams involving fraudulent checks and on the exception-hold practices that financial institutions can use to protect themselves and their customers from these scams. Members expressed concern that the brief hold periods permitted under Regulation CC for certain checks may impede financial institutions' ability to conduct appropriate due diligence. Several industry representatives emphasized the importance of cooperation and information-sharing among financial institutions when an institution has concerns that a check may be fraudulent. Some members suggested that enhanced enforcement to require a paying institution to return a check item promptly could be helpful in this process. Others recommended that the federal financial regulatory agencies standardize and coordinate fraudulent-check alerts rather than issue separate alerts. Members highlighted the importance of education to increase awareness of fraudulent-check issues among both financial institution employees and consumers. • 151 Federal Reserve Banks In addition to contributing to setting national monetary policy and supervising and regulating banks and other financial entities (discussed in preceding chapters), the Federal Reserve Banks provide payment services to depository and certain other institutions, distribute the nation's currency and coin, and serve as fiscal agents and depositories for the United States. Developments in Federal Reserve Priced Services The Federal Reserve Banks provide a range of payment and related services to depository institutions, including collecting checks, operating an automated clearinghouse service, transferring funds and securities, and providing a multilateral settlement service. The Reserve Banks charge fees for providing these "priced services." The Monetary Control Act of 1980 requires that the Federal Reserve establish fees for priced services provided to depository institutions so as to recover, over the long run, all direct and indirect costs actually incurred as well as the imputed costs that would have been incurred, including financing costs, taxes, and certain other expenses, and the return on equity (profit) that would have been earned if a private business firm had provided the services.1 The imputed costs and imputed profit are collectively referred to as the private-sector adjust1. Financial data reported throughout this chapter—revenue, other income, cost, income before taxes, and net income—can be linked to the pro forma financial statements at the end of this chapter. ment factor (PSAF).2 Over the past ten years, the Reserve Banks have recovered 99.1 percent of their priced services costs, including the PSAF (table).3 In 2007, the Reserve Banks recovered 101.9 percent of total costs of $993.7 million, including the PSAF.4 Revenue from priced services amounted to $878.4 million, other income was $133.8 million, and costs were $913.3 million, resulting in net income from priced services of $98.9 million. 2. In addition to income taxes and the return on equity, the PSAF is made up of three imputed costs: interest on debt, sales taxes, and assessments for deposit insurance by the Federal Deposit Insurance Corporation (FDIC). Board of Governors assets and costs that are related to priced services are allocated to priced services; in the pro forma financial statements at the end of this chapter, Board assets are part of long-term assets, and Board expenses are included in operating expenses. 3. Effective December 31, 2006, the Reserve Banks implemented the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 158, Employers1 Accounting for Defined Benefit Pension and Other Postretirement Plans, which has resulted in the recognition of a $237.9 million reduction in equity related to the priced services' benefit plans through 2007. Including this reduction in equity, which represents a decline in economic value, results in cost recovery of 96.7 percent for the tenyear period. For details on how implementing SFAS No. 158 affected the pro forma financial statements, refer to notes 2, 3, and 5 at the end of this chapter. 4. Other income is revenue from investment of clearing balances net of earnings credits, an amount termed net income on clearing balances. Total cost is the sum of operating expenses, imputed costs (interest on debt, interest on float, sales taxes, and the FDIC assessment), imputed income taxes, and the targeted return on equity. 152 94th Annual Report 2007 Priced Services Cost Recovery, 1998-2007 Millions of dollars except as noted Year Revenue from servicesl Operating expenses and imputed costs2 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 839.8 867.6 922.8 960.4 918.3 881.7 914.6 994.7 1,031.2 1,012.3 743.2 775.7 818.2 901.9 891.7 931.3 842.6 834.7 875.5 913.3 1998-2007 9,343.4 8,528.0 Targeted return on equity Total costs Cost recovery (percent) 3 ' 4 66.8 57.2 98.4 109.2 92.5 104.7 112.4 103.0 72.0 80.4 809.9 832.9 916.6 1,011.1 984.3 1,036.1 955.0 937.7 947.5 993.7 103.7 104.2 100.7 95.0 93.3 85.1 95.8 106.1 108.8 101.9 896.6 9,424.8 99.1 NOTE: Here and elsewhere in this chapter, totals and percentages may not reflect components shown because of rounding. 1. For the ten-year period, includes revenue from services of $8,816.8 million and other income and expense (net) of $526.6 million. 2. For the ten-year period, includes operating expenses of $7,938.1 million, imputed costs of $227.2 million, and imputed income taxes of $362.8 million. 3. Revenue from services divided by total costs. 4. For the ten-year period, cost recovery is 96.7 percent, including the net reduction in equity related to FAS 158 reported by the priced services in 2007. Commercial Check-Collection Service 9.8 percent from 2006 (table). The decline in Reserve Bank check volume is consistent with nationwide trends away from the use of checks and toward greater use of electronic payment methods.5 Of all the checks presented by the Reserve Banks to paying banks in 2007, 42.2 percent were deposited and 24.6 percent were presented using Check 21 products, compared with 14.0 percent and 4.3 percent, respectively, in 2006.6 By the end of 2007, this growth resulted in 57.5 percent of the Reserve Bank In 2007, the Reserve Banks recovered 100.7 percent of the total costs of their commercial check-collection service, including the PSAF. The Reserve Banks' operating expenses and imputed costs totaled $743.3 million, of which $26.1 million was attributable to the transportation of commercial checks between Reserve Bank check-processing centers. Revenue amounted to $705.0 million, of which $23.1 million was attributable to estimated revenues derived from the transportation of commercial checks between Reserve Bank check-processing centers, and other income was $106.9 million. The resulting net income was $68.6 million. Check-service revenue in 2007 decreased $40.0 million from 2006, largely because of a drop in paper-check fee revenue; this drop was partially offset by an increase in Check 21 fee revenue. The Reserve Banks handled 10.0 billion checks in 2007, a decrease of 5. The Federal Reserve System's retail payments research suggests that the number of checks written in the United States has been declining since the mid-1990s. For details, see Federal Reserve System, "The 2007 Federal Reserve Payments Study: Noncash Payment Trends in the United States, 2003-2006" (December 2007). (www.frbservices.org/files/communications/pdf/ research/2007_pay ments_study.pdf)6. The Reserve Banks also offer non-Check 21 electronic-presentment products. In 2007, 19.2 percent of the Reserve Banks' deposit volume was presented to paying banks using these products. Federal Reserve Banks 153 Activity in Federal Reserve Priced Services, 2005-2007 Thousands of items Percent change Service 2006 2007 2005 2006 to 2007 Commercial check Commercial ACH Funds transfer Multilateral settlement Securities transfer 10,001,289 9,363.429 137,555 505 10,110 11,083,122 8,230,782 136,399 470 9,053 12,227,718 7,338,950 135,227 440 9,235 2005 to 2006 -9.8 13.8 0.9 7.4 11.7 -9.4 12.2 0.9 6.8 -2.0 NOTE: Activity in commercial check is the total number of commercial checks collected, including processed and fine-sort items; in commercial ACH, the total number of commercial items processed; in funds transfer and securities transfer, the number of transactions originated online and offline; and in multilateral settlement, the number of settlement entries processed. check deposits and 39.0 percent of Reserve Bank check presentments being made through Check 21 products. In 2007, the Reserve Banks continued efforts to reduce check-service operating costs in response to the ongoing decline in check volume. These efforts included the consolidation of some checkprocessing sites. Check processing at Nashville has now been consolidated to Atlanta; San Francisco operations to Los Angeles; and Helena (Montana) operations to Denver. As part of a longerrange strategy, the Reserve Banks have selected Philadelphia, Cleveland, Atlanta, and Dallas as regional checkprocessing sites, which will provide a full range of check-processing services. The transition to this new structure is expected to begin in 2008. The Reserve Banks will continue to review their check infrastructure regularly to respond to further changes within the nation's payments system and to meet statutory requirements for long-term cost recovery. The Reserve Banks' operating expenses and imputed costs totaled $85.9 million. Revenue from ACH operations totaled $88.3 million and other income totaled $13.7 million, resulting in net income of $16.0 million. The Banks processed 9.4 billion commercial ACH transactions, an increase of 13.8 percent from 2006. In 2007, nationwide ACH volumes continued to grow at double-digit rates. This growth is largely attributable to volume increases associated with electronic check conversion applications— including checks converted at lockbox locations or at the point of purchase. ACH rule changes that took effect in early 2007 permitted checks to be converted in processing centers or back offices, spurring further growth in the volume of ACH check conversions. Commercial Automated Clearinghouse Services In 2007, the Reserve Banks recovered 107.6 percent of the total costs of their commercial automated clearinghouse (ACH) services, including the PSAF. Fedwire Funds and National Settlement Services In 2007, the Reserve Banks recovered 107.3 percent of the costs of their Fedwire Funds and National Settlement Services, including the PSAF. The Reserve Banks' operating expenses and imputed costs totaled $63.1 million in 2007. Revenue from these operations totaled $64.4 million and other income 154 94th Annual Report, 2007 amounted to $10.1 million, resulting in net income of $11.4 million. Fedwire Funds Service The Fedwire Funds Service allows participants to use their reserve or clearing balances at the Reserve Banks to transfer funds to other participants. In 2007, the number of Fedwire funds transfers originated by depository institutions increased 0.9 percent from 2006, to approximately 137.6 million. The average daily value of Fedwire funds transfers in 2007 was $2.7 trillion. National Settlement Service The National Settlement Service is a multilateral settlement system that allows participants in private-sector clearing arrangements to exchange and settle transactions on a net basis using reserve or clearing balances. In 2007, the service processed settlement files for approximately fifty-four local and national private arrangements, primarily check clearinghouse associations. The Reserve Banks processed slightly more than 17,000 files that contained almost 505,000 settlement entries for these arrangements in 2007. Fedwire Securities Service In 2007, the Reserve Banks recovered 103.7 percent of the total costs of their Fedwire Securities Service, including the PSAF. The Reserve Banks' operating expenses and imputed costs for providing this service totaled $21.0 million in 2007. Revenue from the service totaled $20.6 million, and other income totaled $3.2 million, resulting in net income of $2.9 million. The Fedwire Securities Service allows participants to electronically transfer securities issued by the U.S. Treasury, federal government agencies, government-sponsored enterprises, and certain international organizations to other participants in the service.7 In 2007, the number of non-Treasury securities transfers processed by the service increased 11.7 percent from 2006, to approximately 10.1 million. In 2007, the Board published an assessment of the compliance of the Fedwire Securities Service with the Recommendations for Securities Settlement Systems that are included in the Federal Reserve Policy on Payments System Risk.8 The Fedwire Securities Service mostly complied with the recommendations' applicable standards.9 Both the Fedwire Funds Service and the Fedwire Securities Service assessments will be reviewed periodically to ensure that they remain accurate. Float The Federal Reserve had daily average credit float of $604.9 million in 2007, 7. The expenses, revenues, volumes, and fees reported here are for transfers of securities issued by federal government agencies, governmentsponsored enterprises, and certain international organizations. The Reserve Banks provide Treasury securities services in their role as the US. Treasury's fiscal agent. These services are not considered priced services. For details, see the section "Debt Services" later in this chapter. 8. The Recommendations are a set of nineteen minimum standards, developed by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO), to address legal, presettlement, settlement, operational, and custody risks, among other issues, in securities settlement systems. See www. federalreserve.gov/paymentsystems/fedwiresecsvs/ fedwiresecsvs.pdf. 9. In 2006, the Board published an assessment of the compliance of the Fedwire Funds Service with the Core Principles for Systemically ImportantPaymentSystems.Seewww.federalreserve.gov/ paymentsystems/coreprinciples/coreprinciples.pdf. Federal Reserve Banks 155 the Reserve Banks' Currency Technology Office to develop more-secure designs for the $5 Federal Reserve note. The Reserve Banks issued the redeDevelopments in signed $5 note in March 2008. Currency and Coin Board staff worked with the Reserve Banks and the United States Mint to The Federal Reserve Banks issue the nation's currency (in the form of Federal implement the distribution strategy for Reserve notes) and distribute coin the Presidential $1 Coin Program. Conthrough depository institutions. The Re- sistent with the requirements of the serve Banks also receive currency and Presidential $1 Coin Act, the Federal coin from circulation through these in- Reserve and the Mint conducted addistitutions. The Reserve Banks received tional outreach to depository institutions 38.0 billion Federal Reserve notes from and coin users to gauge demand for the circulation in 2007, a 0.8 percent de- coins and to anticipate and eliminate obcrease from 2006, and made payments stacles to the efficient circulation of $1 of 38.5 billion notes into circulation in coins. The Reserve Banks began implement2007, a 1.5 percent decrease from 2006. ing a program to extend to 2017 the They received 63.3 billion coins from circulation in 2007, a 5.9 percent in- useful life of the System's BPS 3000 crease from 2006, and made payments high-speed currency-processing maof 75.7 billion coins into circulation, a chines. The program will replace the operating systems of the current equip2.2 percent increase from 2006. ment but retain the machines' frames, In July, the Reserve Banks implenote-transport mechanisms, and large mented the fee component of the Fedmechanical parts. Software problems eral Reserve currency recirculation and development delays have extended policy. The intent of the policy is to the schedule for completion of the proreduce the overuse of Federal Reserve gram to the fourth quarter of 2009. currency-processing services by deposiThe Reserve Banks selected a vendor tory institutions. Under the policy, the to design software to replace the current Reserve Banks assess fees to institutions that, within a one-week period, deposit standard cash application. The multiyear fit $10 or $20 notes and reorder cur- project will begin in 2008; the target rency of the same denomination, above implementation date for the new autoa de minimis amount, within the same mation system is 2010. Reserve Bank office's service area. At the end of the first two billing quarters, the Developments in Reserve Banks had collected $5.5 million Fiscal Agency and in recirculation fees from institutions. Government Depository Services Board staff worked with the Treasury Department, the U.S. Secret Service, and As fiscal agents and depositories for the federal government, the Federal Reserve Banks provide services related to the 10. Credit float occurs when the Reserve Banks federal debt, help the Treasury collect present items for collection to the paying bank funds owed to the federal government, prior to providing credit to the depositing bank, process electronic and check payments and debit float occurs when the Reserve Banks for the Treasury, maintain the Treacredit the depositing bank prior to presenting items sury's bank account, and invest excess for collection to the paying bank. compared with credit float of $85.9 million in 2006.10 156 94th Annual Report 2007 Expenses of the Federal Reserve Banks for Fiscal Agency and Depository Services, 2005-2007 Thousands of dollars Agency and service 2007 2006 2005 74,149.2 8,687.7 41,372.0 3,558.7 724.5 128,492.1 73,931.4 7,535.2 23,594.9 3,853.1 1,578.7 110,493.2 86,503.2 6,055.8 17,553.5 2,575.5 1,806.5 114,494.5 DEPARTMENT OF THE TREASURY Bureau of the Public Debt Treasury retail securities Treasury securities safekeeping and transfer Treasury auction Computer infrastructure development and support Other services Total Financial Management Service Payment services Government check processing Automated clearinghouse Fedwire funds transfers Other payment programs Collection services Tax and other revenue collections Other collection programs Cash-management services Computer infrastructure development and support Other services Total 17,522.7 6,050.3 116.8 81,636.9 20,918.6 5,823.1 123.1 69,696.8 20,988.0 5,709.5 109.4 49,366.0 38,254.5 12,483.6 46,093.6 70,999.9 7,507.2 280,665.7 37,095.5 14,122.6 48,320.2 67,046.4 7,414.8 270,561.2 39,736.0 14,354.2 40,496.7 67,703.3 2,332.2 240,795.4 Other Treasury Total Total, Treasury 17.997.1 427,154.9 16,786.3 397,840.7 15,726.7 371,016.6 2,706.0 2,929.8 2,642.4 8,913.2 9,334.4 7,647.8 OTHER FEDERAL AGENCIES Department of Agriculture Food coupons United States Postal Service Postal money orders Other agencies Other services Total, other agencies 19,412.0 31,031.1 15,977.1 28,241.4 14,870.2 25,160.4 Total reimbursable expenses 458,186.0 426.082.1 396,177.0 Treasury balances. The Reserve Banks also provide limited fiscal agency and depository services to other entities. The total cost of providing fiscal agency and depository services to the Treasury and other entities in 2007 amounted to $458.2 million, compared with $426.1 million in 2006 (table). Treasury-related costs were $427.2 million in 2007, compared with $397.8 million in 2006, an increase of 7.4 percent. The cost of providing services to other entities was $31.0 million, compared with $28.2 million in 2006. In 2007, as in 2006, the Treasury and other entities reimbursed the Reserve Banks for the costs of providing these services. Debt Services The Reserve Banks auction, provide safekeeping for, and transfer Treasury securities. Reserve Bank operating expenses for these activities totaled $50.1 million in 2007, compared with $31.1 million in 2006. The Banks processed 104,000 commercial tenders for Treasury securities in 2007 through the Fedwire Securities Service, compared with 148,000 in 2006. They originated Federal Reserve Banks 13.7 million transfers of Treasury securities in 2007, a 6.4 percent increase from 2006. The Reserve Banks are developing a new Treasury auction application and infrastructure that will provide increased functionality and security. The application will be operational in early 2008. The Reserve Banks also operate computer applications and provide customer service and back-office support for the Treasury's retail securities programs. Reserve Bank operating expenses for these activities were $74.1 million in 2007, compared with $73.9 million in 2006. The Reserve Banks operate Legacy Treasury Direct, a program that allows investors to purchase and hold Treasury securities directly with the Treasury through the Reserve Banks instead of through a broker. The program held $70.3 billion (par value) of Treasury securities as of December 31. Because the program was designed for investors who plan to hold their securities to maturity, it does not provide transfer services. Investors may, however, sell their securities for a fee through Sell Direct, a program operated by one of the Reserve Banks. Approximately 13,000 securities worth $642.4 million were sold through Sell Direct in 2007, compared with 13,000 securities worth $678.9 million in 2006. The Banks printed and mailed more than 25.1 million savings bonds in 2007, a 13.2 percent decrease from 2006. They issued more than 4.2 million Series I (inflationindexed) bonds and 20.6 million Series EE bonds. Payments Services The Reserve Banks process both electronic and check payments for the Treasury. Reserve Bank operating expenses for processing government payments and for payments-related programs to 157 taled $105.3 million in 2007, compared with $96.6 million in 2006. The Banks processed 1,027 million ACH payments for the Treasury, an increase of 3.6 percent from 2007, and more than 618,000 Fed wire funds transfers. They also processed 214 million government checks, a decline of 3.6 percent from 2006. The proportion of government checks being processed as paper checks has been declining as an increasing number of checks are being presented by depository institutions in image form. Of all the government checks processed by the Banks in 2007, 54 percent of the checks were presented as paper and 46 percent were presented as images, compared with 87 percent and 13 percent, respectively, in 2006. In addition, the Banks issued more than 131,000 fiscal agency checks, a decrease of 22.6 percent from 2006. Collection Services The Reserve Banks support several Treasury programs to collect funds owed the federal government. Reserve Bank operating expenses related to these programs totaled $50.7 million in 2007, compared with $51.2 million in 2006. The Banks operate the Federal Reserve Electronic Tax Application (FR-ETA) as an adjunct to the Treasury's Electronic Federal Tax Payment System (EFTPS). EFTPS allows businesses and individual taxpayers to pay their taxes electronically. It uses the automated clearinghouse (ACH) to collect funds, so tax payments must be scheduled at least one day in advance. Some business taxpayers, however, do not know their tax liability until the tax due date. FR-ETA allows these taxpayers to use EFTPS by providing a same-day electronic federal tax payment alternative. FR-ETA collected $519.8 billion for the Treasury in 158 94th Annual Report, 2007 2007, compared with $456.3 billion in 2006. In addition, the Reserve Banks operate Pay.gov, a Treasury program that allows members of the public to use the Internet to pay for goods and services offered by the federal government. They also operate the Treasury's Paper Check Conversion and Electronic Check Processing programs, whereby checks written to government agencies are converted into ACH transactions at the point of sale or at lockbox locations. In 2007, the Reserve Banks originated more than 10.1 million ACH transactions through these programs, a significant increase from 2006 due to growth in the electronic check processing program. Treasury Cash-Management Services The Treasury maintains its bank account at the Reserve Banks and invests the funds it does not need for current payments with qualified depository institutions through the Treasury Tax and Loan (TT&L) program, which the Reserve Banks operate. Reserve Bank operating expenses related to this program and other cash-management initiatives totaled $46.1 million in 2007, compared with $48.3 million in 2006. The investments either are callable on demand or are for a set term. In 2007, the Reserve Banks placed a total of $308.4 billion in immediately callable investments, which includes funds invested through retained tax deposits and direct, special direct, and dynamic investments, and $687 billion in term investments. The rate for term investments is set by auction; the Reserve Banks held 126 such auctions in 2007, roughly the same number of auctions as in 2006. In 2007, the Treasury's income from the TT&L program was $1.15 billion. The Treasury pro vides the Repurchase Agreement Program on a limited basis, which allows the Treasury to place a portion of its excess operating funds directly with TT&L depositaries through a repurchase transaction for a set period at an agreed-on interest rate. In 2007, the Reserve Banks placed a total of $499 billion of investments through repurchase agreements. In 2007, the Treasury announced the Collections and Cash Management Modernization (CCMM) initiative, which is a multiyear effort to streamline, modernize, and improve the process and systems supporting the Treasury's collections and cash-management programs. Several Federal Reserve Banks have been selected to work on the CCMM initiative. Services Provided to Other Entities The Reserve Banks provide fiscal agency and depository services to other domestic and international entities when required to do so by the Secretary of the Treasury or when required or permitted to do so by federal statute. The majority of the work is securities-related. Electronic Access to Reserve Bank Services In 2007, the Federal Reserve Banks continued to migrate their computer interface customers to FedLine Direct and FedLine Command. This migration, typically for high-volume depository institutions, comes after the Reserve Banks completed the FedLine Advantage migration, typically for low- to moderate-volume depository institutions, in 2006. FedLine Direct is an internet-protocol-based computer-tocomputer electronic access channel used to access critical payment services, such as Fedwire Funds, Fedwire Securities, Federal Reserve Banks National Settlement, and FedACH Services. FedLine Command is a lowercost internet-protocol-based computerto-computer electronic access channel for file delivery services, including the FedACH Service. The Reserve Banks began the migration to FedLine Direct and FedLine Command in 2006 and expect to complete the conversion in 2008. Information Technology In 2007, the Federal Reserve Banks enhanced their information technology (IT) governance framework to better align IT management authority and accountability with the business models used in the System. A System chief information officer (CIO) position and two advisory councils were established. The Business Technology Council represents the technology needs of the Federal Reserve's business lines, and the Technology Services Council represents the Federal Reserve's IT providers. The CIO leads System efforts to develop and implement the Federal Reserve's overall IT strategy at the Reserve Banks, manages national information-security risk, and analyzes and coordinates the System's IT investments. The System continued to develop the National Information Security Assurance function as a central point of governance for enterprise-level information security. Associated roles and responsibilities within the function were clarified. Efforts to improve the function will continue as the Federal Reserve's information security environment continues to evolve. To address the business implications of reduced demand for mainframe services, Federal Reserve Information Technology in mid-2007 implemented a multiyear strategic plan for mainframe technologies. These technologies are no longer considered strategic, and the Sys 159 tem has decided not to make any further significant investments in the mainframe platform. System business owners are looking at alternative platforms for webbased access to applications and data, partly because of concerns about the continued availability of technical resources to support mainframe platforms. In 2007, the Federal Reserve continued to implement the Information Security Architecture Framework (ISAF), a large program scheduled to be completed in 2008. ISAF is intended to respond to the continuing and increasingly sophisticated security threats facing information technology systems and to improve information security at all points in the Federal Reserve by raising the level of enterprise-wide assurance. Major accomplishments in 2007 include improving the separation of sensitive infrastructure, limiting access to sensitive desktop functions, and strengthening desktop-access protections. Examinations of the Federal Reserve Banks Section 21 of the Federal Reserve Act requires the Board of Governors to order an examination of each Federal Reserve Bank at least once a year. The Board performs its own reviews and engages a public accounting firm. The public accounting firm performs an annual audit of the combined financial statements of the Reserve Banks (see the section "Federal Reserve Banks Combined Financial Statements") and audits the annual financial statements of each of the twelve Banks. The Reserve Banks use the framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) to assess their internal controls over financial reporting, including the safeguarding of assets. The Reserve Banks have further enhanced their as- 160 94th Annual Report, 2007 sessments under the COSO framework to strengthen the key control assertion process and in 2007 met the requirements of the Sarbanes-Oxley Act of 2002. Within this framework, management of each Reserve Bank provides an assertion letter to its board of directors annually confirming adherence to COSO standards, and a public accounting firm confirms management's assertion and issues an attestation report to each Bank's board of directors and to the Board of Governors. In 2007, the Board engaged Deloitte & Touche LLP (D&T) for the audits of the individual and combined financial statements of the Reserve Banks. Previously, PricewaterhouseCoopers LLP performed the audits. Fees for D&T's services totaled $4.7 million. To ensure auditor independence, the Board requires that D&T be independent in all matters relating to the audit. Specifically, D&T 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 Reserve Banks, or in any other way impairing its audit independence. In 2007, the Reserve Banks did not engage D&T for nonaudit services. The Board's annual examination of the Reserve Banks includes a wide range of off-site and on-site oversight activities conducted primarily by the Division of Reserve Bank Operations and Payment Systems. Division personnel monitor the activities of each Reserve Bank on an ongoing basis and conduct on-site reviews based on the division's riskassessment methodology. The examinations also include assessing the efficiency and effectiveness of the internal audit function. To assess compliance with the policies established by the Federal Reserve's Federal Open Market Committee (FOMC), the division also reviews the accounts and holdings of the System Open Market Account at the Federal Reserve Bank of New York and the foreign currency operations conducted by that Bank. In addition, D&T audits the schedule of participated asset and liability accounts and the related schedule of participated income accounts at year-end. The FOMC receives the external audit reports and the report on the division's examination. Income and Expenses The accompanying table summarizes the income, expenses, and distributions of net earnings of the Federal Reserve Banks for 2006 and 2007. Income in 2007 was $42,576 million, compared with $38,410 million in 2006. Expenses totaled $4,382 million ($3,270 million in operating expenses, $240 million in earnings credits granted to depository institutions, $296 million in assessments for expenditures by the Board of Governors, and $576 million for the cost of new currency). Revenue from priced services was $878.4 million. Net additions to and deductions from current net income showed a net profit of $198 million. The profit was due primarily to unrealized gains on assets denominated in foreign currencies revalued to reflect current market exchange rates offset, in part, by interest expense on reverse repurchase agreements. Statutory dividends paid to member banks totaled $992 million, $121 million more than in 2006; the increase reflects an increase in the capital and surplus of member banks and a consequent increase in the paid-in capital stock of the Reserve Banks. Payments to the U.S. Treasury in the form of interest on Federal Reserve notes totaled $34,598 million in 2007, up from $29,052 million in 2006; the payments equal net income after the de- Federal Reserve Banks 161 Income, Expenses, and Distribution of Net Earnings of the Federal Reserve Banks, 2007 and 2006 Millions of dollars 2007 2006 Current income Current expenses Operating expenses1 Earnings credits granted 42,576 3,510 3,270 240 38,410 3,264 2,987 276 Current net income Net additions to (deductions from, - ) current net income Assessments by the Board of Governors For expenditures of Board For cost of currency Change in funded status of benefit plans2 39,066 198 872 296 576 324 35,147 -159 793 301 492 Net income before payments to Treasury Dividends paid Transferred to (from) surplus and change in accumulated other comprehensive income 38,716 992 34,195 871 3,126 4,272 34,598 29,052 Item Payments to Treasury 3 ... 1. Includes a net periodic pension expense of $110 million in 2007 and $53 million in 2006. 2. Subsequent to the adoption of SFAS 158 in 2006, the Reserve Banks began to recognize the change in funded status of benefit plans as an element of other comprehensive income. 3. Interest on Federal Reserve notes. . . . Not applicable. duction of dividends paid and of the amount necessary to equate the Reserve Banks' surplus to paid-in capital. In the "Statistical Tables" section of this report, table 10 details the income and expenses of each Reserve Bank for 2007 and table 11 shows a condensed statement for each Bank for the years 1914 through 2007; table 9 is a statement of condition for each Bank, and table 13 gives the number and annual salaries of officers and employees for each Bank. A detailed account of the assessments and expenditures of the Board of Governors appears in the section "Board of Governors Financial Statements." lion, an increase of $28,243 million from 2006 (table). U.S. government securities holdings increased $26,124 million, and loans increased $1,297 million. In December 2007, the Federal Reserve established a Term Auction Facility (TAF) under which the Reserve Banks conduct auctions for a fixed amount of funds for a fixed term, with the interest rate determined by the auction process, subject to a minimum bid rate. All advances under the TAF must be fully collateralized. In 2007, average daily holdings of Term Auction Credit (TAC) under the TAF amounted to $822 million. The average rate of interest earned on the Reserve Banks' holdings of government securities increased to 4.95 percent, from 4.63 percent in 2006, and the average rate of interest earned on loans decreased to 2.18 percent, from 5.36 percent. The average interest rate on TAC was 4.66 percent. Holdings of Securities and Loans The Federal Reserve Banks' average daily holdings of securities and loans during 2007 amounted to $816,115 mil- 162 94th Annual Report, 2007 Securities and Loans of the Federal Reserve Banks, 2005-2007 Millions of dollars except as noted Item and year Average daily holdings4 2005 5 20065 2007 Earnings b 2005 2006 2007 Average interest rate (percent) 2005 5 20065 2007 .. . Term Auction Credit3 Total U.S. government securities1 Loans 2 753,748 787,872 816,115 753,549 787,648 813,772 199 224 1,521 822 28,966 36,464 40,369 28,959 36,452 40,298 7 12 33 38 3.84 4.63 4.95 3.84 4.63 4.95 3.52 5.36 2.18 4.66 1. Includes federal agency obligations. 2. Does not include indebtedness assumed by the Federal Deposit Insurance Corporation. 3. Reflects temporary Term Auction Facility activity beginning in 2007. 4. Based on holdings at opening of business. 5. Amounts in bold are restatements due to changes in previously reported data. 6. Earnings have not been netted with the interest expense on securities sold under agreements to repurchase. . . . Not applicable. Volume of Operations law enforcement officers (FRLEOs). The 240-hour program covers a variety of topics related to the mission of an FRLEO. The Federal Reserve was granted federal law enforcement authority by the USA Patriot Act to protect and safeguard Board and Federal Reserve Bank premises, grounds, property, personnel, and operations. Table 12 in the "Statistical Tables" section shows the volume of operations in the principal departments of the Federal Reserve Banks for the years 2004 through 2007. Federal Reserve Law Enforcement In November, the Federal Reserve System became the eleventh federal law enforcement agency to be awarded accreditation from the Federal Law Enforcement Training Accreditation board of directors for its Basic Law Enforcement Course (BLEC). The primary benefit of accreditation is increased public confidence in the integrity, professionalism, and accountability of the law enforcement agencies. Accreditation is considered a "best practice" for federal law enforcement agencies and signifies compliance with 63 stringent standards. All law enforcement candidates complete the Federal Reserve's BLEC prior to their designation as Federal Reserve Federal Reserve Bank Premises In 2007, construction was largely completed on the Kansas City Bank's new headquarters building and the San Francisco Bank's new Seattle Branch building. The multiyear renovation program at the New York Bank's headquarters building continued. The St. Louis Bank continued a long-term facility redevelopment program that includes the ongoing construction of an addition to the Bank's headquarters building. Security enhancement programs continued at several facilities. Construction of security improvements to the Richmond Bank's headquarters building is Federal Reserve Banks ongoing. The Philadelphia Bank completed the purchase of property behind its headquarters building for the construction of a remote vehicle-screening facility and is developing the facility's design. Design development of a similar screening facility for the Dallas Bank also continued. During 2007, the Board approved the 163 final design of a new parking garage to be constructed adjacent to the Richmond Bank's headquarters building. Efforts to sell the St. Louis Bank's Little Rock Branch building continued. Table 14 in the "Statistical Tables" section of this report details the acquisition costs and net book value of the Federal Reserve Banks and Branches. • 164 94th Annual Report, 2007 Pro Forma Financial Statements for Federal Reserve Priced Services Pro Forma Balance Sheet for Priced Services, December 31, 2007 and 2006 Millions of dollars Short-term assets (Note 1) Imputed reserve requirements on clearing balances Imputed investments Receivables Materials and supplies Prepaid expenses Items in process of collection Total short-term assets Long-term assets (Note 2) Premises Furniture and equipment Leases, leasehold improvements, and long-term prepayments Prepaid pension costs Deferred tax asset Total long-term assets Long-term liabilities Long-term debt Postretirement/postemployment benefits obligation Total long-term liabilities 11,518.9 9,088.0 453.5 130.2 424.9 127.9 64.2 484.6 109.4 83.3 453.0 130.0 1,242.0 1,219.0 10,330.0 12,737.9 8,015.6 3,592.5 0.0 100.4 7,641.1 1,685.1 0.0 102.4 11,708.4 9,428.5 0.0 0.0 392.6 385.0 Total liabilities Equity (including accumulated other comprehensive loss of $237.9 million and $306.1 million at December 31, 2007 and 2006, respectively) Total liabilities and equity (Note 3) . . . NOTE: Components may not sum to totals because of rounding. Amounts in bold are restated due to changes in previously reported data. 821.7 7,207.5 73.6 0.9 24.2 3,391.0 755.7 6,465.7 66.7 1.8 28.5 1,769.6 Total assets Short-term liabilities Clearing balances and balances arising from early credit of uncollected items Deferred-availability items Short-term debt Short-term payables Total short-term liabilities 2006 2007 Item 385.0 392.6 9,813.5 12,101.0 516.5 636.9 10,330.0 12,737.9 The accompanying notes are an integral part of these pro forma priced services financial statements. Federal Reserve Banks 165 Pro Forma Income Statement for Federal Reserve Priced Services, 2007 and 2006 Millions of dollars Item Revenue from services provided to depository institutions (Note 4) — Operating expenses (Note 5) Income from operations Imputed costs (Note 6) Interest on float Interest on debt Sales taxes FDIC insurance Income from operations after imputed costs Other income and expenses (Note 7) Investment income Earnings credits Income before income taxes Imputed income taxes (Note 6) Net income MEMO: Targeted return on equity (Note 6) 2006 2007 908.4 803.5 104.8 878.4 888.2 -9.8 -32.0 0.0 11.6 0.0 -4.9 0.0 10.8 0.0 -20.4 5.9 98.9 10.6 362.3 -228.5 NOTE: Components may not sum to totals because of rounding. 383.6 -260.8 133.8 144.5 45.5 98.9 80.4 122.8 221.8 66.1 155.7 72.0 The accompanying notes are an integral part of these pro forma priced services financial statements. Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2007 Millions of dollars Item Total Commercial check collection Revenue from services (Note 4) 878.4 705.0 88.3 64.4 20.6 Operating expenses (Note 5) 888 2 733 6 78 3 56 9 19 3 Income from operations -9.8 -28.6 10.0 7.5 1.3 Imputed costs (Note 6) -20.4 -21.8 0.2 0.9 0.3 Income from operations after imputed costs Commercial ACH Fedwire funds Fedwire securities 106 -6 7 97 66 10 Other income and expenses, net (Note 7) 133.8 106.9 13.7 10.1 3.2 Income before income taxes 4.2 144.5 100.2 23.4 16.6 Imputed income taxes (Note 6) 45 5 31 6 74 52 1 3 Net income 98 9 68 6 160 11 4 29 MEMO: Targeted return on equity (Note 6) 80.4 63.2 8.8 6.3 2.0 101.9 100.7 107.6 107.3 103.7 MEMO: Cost recovery (percent) (Note 8) NOTE: Components may not sum to totals because of rounding. The accompanying notes are an integral part of these pro forma priced services financial statements. 166 94th Annual Report, 2007 FEDERAL RESERVE BANKS NOTES TO PRO FORMA FINANCIAL STATEMENTS FOR PRICED SERVICES (1) SHORT-TERM ASSETS The imputed reserve requirement on clearing balances held at Reserve Banks by depository institutions reflects a treatment comparable to that of compensating balances held at correspondent banks by respondent institutions. The reserve requirement imposed on respondent balances must be held as vault cash or as non-earning balances maintained at a Reserve Bank; thus, a portion of priced services clearing balances held with the Federal Reserve is shown as required reserves on the asset side of the balance sheet. Another portion of the clearing balances is used to finance short-term and long-term assets. The remainder of clearing balances is assumed to be invested in a portfolio of investments, shown as imputed investments. Receivables are (1) amounts due the Reserve Banks for priced services and (2) the share of suspense-account and difference-account balances related to priced services. Materials and supplies are the inventory value of shortterm assets. Prepaid expenses include salary advances and travel advances for priced-service personnel. Items in process of collection is gross Federal Reserve cash items in process of collection (CIPC) stated on a basis comparable to that of a commercial bank. It reflects adjustments for intra-System items that would otherwise be double-counted on a consolidated Federal Reserve balance sheet; adjustments for items associated with nonpriced items, such as those collected for government agencies; and adjustments for items associated with providing fixed availability or credit before items are received and processed. Among the costs to be recovered under the Monetary Control Act is the cost of float, or net CIPC during the period (the difference between gross CIPC and deferred-availability items, which is the portion of gross CIPC that involves a financing cost), valued at the federal funds rate. (2) LONG-TERM ASSETS Long-term assets consist of long-term assets used solely in priced services, the priced-service portion of long-term assets shared with nonpriced services, and an estimate of the assets of the Board of Governors used in the development of priced services. Effective December 31, 2006, the Reserve Banks implemented the Financial Accounting Standard Board's Statement of Financial Accounting Standards (SFAS) No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, which requires an employer to record the funded status of its benefit plans on its balance sheet. This resulted in a reduction to the prepaid pension asset related to priced services and the recognition of an associated deferred tax asset with an offsetting adjustment, net of tax, to accumulated other comprehensive income (AOCI) (see Note 3). (3) LIABILITIES AND EQUITY Under the matched-book capital structure for assets, short-term assets are financed with short-term payables and core clearing balances. Long-term assets are financed with long-term liabilities and clearing balances. As a result, no short- or long-term debt is imputed. Other shortterm liabilities include clearing balances maintained at Reserve Banks and deposit balances arising from float. Other long-term liabilities consist of accrued postemployment, postretirement, and nonqualified pension benefits costs and obligations on capital leases. In order to reflect the funded status of its benefit plans as required by SFAS No. 158, the Reserve Banks recognized the deferred items related to these plans, which include prior service costs and actuarial gains or losses, on the balance sheet. In 2007, this resulted in a decrease to the benefits obligation related to the priced services with an offsetting adjustment, net of tax, to AOCI, which is included in equity. Equity is imputed at 5 percent of total assets. (4) REVENUE Revenue represents charges to depository institutions for priced services and is realized from each institution through one of two methods: direct charges to an institution's account or charges against its accumulated earnings credits (see Note 7). (5) OPERATING EXPENSES Operating expenses consist of the direct, indirect, and other general administrative expenses of the Reserve Banks for priced services plus the expenses for staff members of the Board of Governors working directly on the development of priced services. The expenses for Board staff members were $6.7 million in 2007 and $7.5 million in 2006. Effective January 1, 1987, the Reserve Banks implemented SFAS No. 87, Employers' Accounting for Pensions. Accordingly, the Reserve Banks recognized operating expenses for the qualified pension plan of $21.3 million in 2007 and $11.5 million in 2006. Operating expenses also include the nonqualified pension expense of $3.1 million in 2007 and $3.2 million in 2006. The implementation of SFAS No. 158 does not change the systematic approach required by generally accepted accounting principles to recognize the expenses associated with the Reserve Banks' benefit plans in the income statement. The income statement by service reflects revenue, operating expenses, imputed costs, and cost recovery. Certain corporate overhead costs not closely related to any particular priced service are allocated to priced services based on an expense-ratio method. Corporate overhead was allocated among the priced services during 2007 and 2006 as follows (in millions): 2007 2006 Check ACH Fedwire funds Fedwire securities 34.7 4.3 3.0 1.7 30.6 4.1 2.8 1.5 Total 43.7 39.0 Federal Reserve Banks (6) IMPUTED COSTS Imputed costs consist of income taxes, return on equity, interest on debt, sales taxes, the FDIC assessment, and interest on float. Many imputed costs are derived from the private-sector adjustment factor (PSAF) model. The cost of debt and the effective tax rate are derived from bank holding company data, which serves as the proxy for the financial data of a representative private-sector firm, and are used to impute debt and income taxes in the PSAF model. The after-tax rate of return on equity is based on the returns of the equity market as a whole and is used to impute the profit that would have been earned had the services been provided by a private-sector firm. Interest is imputed on the debt assumed necessary to finance priced-service assets; however, no debt was imputed in 2007 or 2006. Effective in 2007, the Reserve Bank priced services imputed a one-time FDIC assessment credit of $16.6 million. In 2007, the credit fully offset the imputed $4.0 million assessment, resulting in a remaining credit of $12.6 million. The remaining credit can be used to offset up to 90 percent of the assessment in the future. Interest on float is derived from the value of float to be recovered, either explicitly or through per-item fees, during the period. Float costs include costs for the Check, Fedwire Funds, National Settlement Service, ACH, and Fedwire Securities services. Float cost or income is based on the actual float incurred for each priced service. Other imputed costs are allocated among priced services according to the ratio of operating expenses, less shipping expenses, for each service to the total expenses, less the total shipping expenses, for all services. The following shows the daily average recovery of actual float by the Reserve Banks for 2007 in millions of dollars: Total float Unrecovered float Float subject to recovery -603.3 24.1 -627.4 Sources of recovery of float Income on clearing balances As-of adjustments Direct charges Per-item fees -62.7 -1.6 267.3 -833.6 167 Unrecovered float includes float generated by services to government agencies and by other central bank services. Float recovered through income on clearing balances is the result of the increase in investable clearing balances; the increase is produced by a deduction for float for CIPC, which reduces imputed reserve requirements. The income on clearing balances reduces the float to be recovered through other means. As-of adjustments and direct charges refer to float that is created by interterritory check transportation and the observance of non-standard holidays by some depository institutions. Such float may be recovered from the depository institutions through adjustments to institution reserve or clearing balances or by billing institutions directly. Float recovered through direct charges and per-item fees is valued at the federal funds rate; credit float recovered through per-item fees has been subtracted from the cost base subject to recovery in 2007. (7) OTHER INCOME AND EXPENSES Other income and expenses consist of investment income on clearing balances and the cost of earnings credits. Investment income on clearing balances for 2007 and 2006 represents the average coupon-equivalent yield on three-month Treasury bills plus a constant spread, based on the return on a portfolio of investments. The return is applied to the total clearing balance maintained, adjusted for the effect of reserve requirements on clearing balances. Expenses for earnings credits granted to depository institutions on their clearing balances are derived by applying a discounted average coupon-equivalent yield on three-month Treasury bills to the required portion of the clearing balances, adjusted for the net effect of reserve requirements on clearing balances. (8) COST RECOVERY Annual cost recovery is the ratio of revenue to the sum of operating expenses, imputed costs, imputed income taxes, and targeted return on equity. 169 The Board of Governors and the Government Performance and Results Act The Government Performance and Results Act (GPRA) of 1993 requires that federal agencies, in consultation with Congress and outside stakeholders, prepare a strategic plan covering a multiyear period and submit an annual performance plan and performance report. Although the Federal Reserve is not covered by the GPRA, the Board of Governors voluntarily complies with the spirit of the act. Strategic Plan, Performance Plan, and Performance Report The Board's strategic plan articulates the Board's mission, sets forth major goals, outlines strategies for achieving those goals, and discusses the environment and other factors that could affect their achievement. It also addresses issues that cross agency jurisdictional lines, identifies key quantitative performance measures, and discusses performance evaluation. The most recent strategic plan covers the period 2006-09. Both the performance plan and the performance report are prepared every two years. The performance plan includes specific targets for some of the performance measures identified in the strategic plan and describes the operational processes and resources needed to meet those targets. It also discusses data validation and results verification. The most recent performance plan covers the period 2006-07. The performance report discusses the Board's performance in relation to its goals. The report covering the period 2006-07 will be completed in 2008. Pre liminary analysis indicates that the Board generally met its goals for 200607. All of these documents are available on the Board's web site, at www. federalreserve.gov/boarddocs/rptcongress. The Board's mission statement and a summary of the Federal Reserve's goals and objectives, as set forth in the most recently released strategic and performance plans, are listed below. Updated documents will be posted on the website as they are completed. Mission The mission of the Board is to foster the stability, integrity, and efficiency of the nation's monetary, financial, and payment systems so as to promote optimal macroeconomic performance. Goals and Objectives The Federal Reserve has six primary goals with interrelated and mutually reinforcing elements. Goal To conduct monetary policy that promotes the achievement of maximum sustainable long-term growth and the price stability that fosters that goal Objectives • Stay abreast of recent developments and prospects in the U.S. economy and financial markets, and in those abroad, so that monetary policy decisions will be well informed. 170 94th Annual Report, 2007 • Enhance our knowledge of the structural and behavioral relationships in the macroeconomic and financial markets, and improve the quality of the data used to gauge economic performance, through developmental research activities. • Implement monetary policy effectively in rapidly changing economic circumstances and in an evolving financial market structure. • Contribute to the development of U.S. international policies and procedures, in cooperation with the U.S. Department of the Treasury and other agencies. • Promote understanding of Federal Reserve policy among other government policy officials and the general public. Goal To promote a safe, sound, competitive, and accessible banking system and stable financial markets Objectives • Promote overall financial stability, manage and contain systemic risk, and identify emerging financial problems early so that crises can be averted. • Provide a safe, sound, competitive, and accessible banking system through comprehensive and effective supervision of U.S. banks, bank and financial holding companies, foreign banking organizations, and related entities. At the same time, remain sensitive to the burden on supervised institutions. • Provide a dynamic work environment that is challenging and rewarding. Enhance efficiency and effectiveness, while remaining sensitive to the burden on supervised institutions, by addressing the supervision function's procedures, technology, resource allocation, and staffing issues. • Promote compliance by domestic and foreign banking organizations supervised by the Federal Reserve with applicable laws, rules, regulations, policies, and guidelines through a comprehensive and effective supervision program. Goal To effectively implement federal laws designed to inform and protect the consumer, to encourage community development, and to promote access to banking services in historically underserved markets Objectives • Take a leadership role in shaping the national dialogue on consumer protection in financial services, address the rapidly emerging issues that affect today's consumers, strengthen consumer compliance supervision programs when required, and remain sensitive to the burden on supervised institutions. • Promote, develop, and strengthen effective communications and collaborations within the Board, the Federal Reserve Banks, and other agencies and organizations. • Increase public understanding of consumer protection and community development and the Board's role in these areas through increased outreach and by developing programs that address the information needs of consumers and the financial services industry. • Develop a staff that is highly skilled, professional, innovative, and diverse; provide career development opportunities to improve retention; and recruit highly qualified and skilled employees. • Promote an efficient and effective work environment by aligning busi- Government Performance and Results Act ness functions with appropriate work processes and implementing solutions for work products and processes that can be handled more efficiently through automation. 171 cient and reliable operations, effective performance, and sound project management and should assist the Board in the effective discharge of its oversight responsibilities. Goal Goal To foster the integrity, efficiency, and accessibility of U.S. payment and settlement systems To foster the integrity, efficiency, and effectiveness of the Board's programs Objectives • Develop sound, effective policies and regulations that foster payment system integrity, efficiency, and accessibility. Support and assist the Board in overseeing U.S. dollar payment and securities settlement systems by assessing their risks and risk management approaches against relevant policy objectives and standards. • Conduct research and analysis that contributes to policy development and increases the Board's and others' understanding of payment system dynamics and risk. Goal To provide high-quality oversight of Reserve Banks Objective • Produce high-quality assessments and oversight of Federal Reserve System strategies, projects, and operations, including adoption of technology to the business and operational needs of the Federal Reserve. The oversight process should help Federal Reserve management foster and strengthen sound internal control systems, effi- Objectives • Oversee a planning and budget process that clearly identifies the Board's mission, results in concise plans for the effective accomplishment of operations, transmits to the staff the information needed to attain objectives efficiently, and allows the public to measure our accomplishments. • Develop appropriate policies, oversight mechanisms, and measurement criteria to ensure that the recruiting, training, and retention of staff meet Board needs. • Establish, encourage, and enforce a climate of fair and equitable treatment for all employees regardless of race, creed, color, national origin, age, or sex. • Provide financial management support needed for sound business decisions. • Provide cost-effective and secure information resource management services to Board divisions and analyze information technology issues for the Board, Reserve Banks, other financial regulatory institutions, and other nations' central banks. • Efficiently provide safe, modern, and secure facilities and necessary support for activities conducive to efficient and effective Board operations. • Records 175 Record of Policy Actions of the Board of Governors Regulation A Extensions of Credit by Federal Reserve Banks Regulation DD Truth in Savings [Docket Nos. R-1281 through R-1285] [Docket No. R-1304] On December 10, 2007, the Board approved amendments establishing a temporary term auction facility (TAF), with the intention of permitting depository institutions to obtain credit from the Federal Reserve on a secured basis at rates that meet the market demand for credit of relatively short terms. The TAF allows depository institutions to obtain advances from their local Federal Reserve Banks at interest rates determined through auctions. The amendments are effective December 12, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation B Equal Credit Opportunity Regulation E Electronic Fund Transfers Regulation M Consumer Leasing Regulation Z Truth in Lending NOTE: Full texts of the policy actions are available via the online version of the Annual Report, from the "Reading Rooms" on the Board's FOIA web page, and on request from the Board's Freedom of Information Office. On October 23, 2007, the Board approved amendments to the requirements in several regulations and official staff commentaries for electronic disclosures to consumers concerning consumer financial services and fair lending. The amendments simplify and clarify the requirements by withdrawing unnecessary or unduly burdensome provisions in the interim final rules approved in March 2001 and by providing guidance on using electronic disclosures. The amendments are effective December 10, 2007, and compliance is mandatory by October 1, 2008. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. On December 11, 2007, technical amendments were approved, under delegated authority, to clarify certain amendments to the official staff commentaries to Regulations B and Z that were approved by the Board on October 23. The technical amendments are effective January 14, 2008, and compliance is mandatory by October 1, 2008. Regulation D Reserve Requirements of Depository Institutions [Docket No. R-1262] On April 2, 2007, the Board approved revisions to its 1980 interpretation of the 176 94th Annual Report, 2007 regulation, which sets forth criteria for the exemption of bankers' banks from reserve requirements. The revisions allow the Board to make case-by-case determinations as to whether a bankers' bank may, to a limited extent, have as customers certain entities that are not specified in the interpretation without losing its exemption. The revised interpretation is effective May 7, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. [Docket No. R-1297] On September 24, 2007, the Board approved amendments to reflect the annual indexing of the reserve requirement exemption amount and the low reserve tranche. For 2008, the reserve requirement exemption amount is $9.3 million, an increase from $8.5 million in 2007, and the low reserve tranche is $43.9 million, a decrease from $45.8 million in 2007. The Board also adjusted the nonexempt deposit cutoff level ($216.2 million for 2008) and the reduced reporting limit ($1,211 billion for 2008), which are used to determine the frequency of reporting by depository institutions. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation E Electronic Fund Transfers amendments are effective August 6, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation H Membership of State Banking Institutions in the Federal Reserve System Regulation K International Banking Operations [Docket No. R-1279] On September 14, 2007, the Board, acting with the other federal bank and thrift regulatory agencies, approved final rules to extend, from twelve to eighteen months, the on-site examination cycle for certain state member banks and U.S. offices of foreign banks. The extended schedule applies to (1) insured institutions that have up to $500 million in total assets, are well capitalized and well managed, and receive a composite CAMELS rating of 1 or 2 and (2) U.S. branches and agencies of foreign banks that have up to $500 million in total assets and meet comparable criteria. The final rules, which implement the Financial Services Regulatory Relief Act of 2006 and related legislation, are identical to interim final rules approved by the Board on March 16, 2007, and are effective September 25, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. [Docket No. R-1270] On June 25, 2007, the Board approved amendments to the regulation and official staff commentary to exempt electronic fund transfers of $15 or less from the requirement to make paper receipts available to consumers for transactions initiated at electronic terminals. The Regulation H Membership of State Banking Institutions in the Federal Reserve System Regulation Y Bank Holding Companies and Change in Bank Control Record of Policy Actions of the Board of Governors 177 [Docket No. R-1261] On November 2, 2007, the Board, acting with the other federal bank and thrift regulatory agencies, approved a new risk-based capital adequacy framework for banking organizations (which include thrifts), popularly known as Basel II. The new framework requires some banking organizations, and permits other qualifying banking organizations, to calculate their regulatory capital requirements using an internal ratings-based approach for credit risk and advanced measurement approaches for operational risks. Basel II, which modernizes the Basel Capital Accord of 1988, consists of three components, or pillars: minimum regulatory capital requirements (pillar 1), supervisory review of capital adequacy (pillar 2), and market discipline through enhanced disclosure (pillar 3). The final rules set forth the qualifying criteria and applicable risk-based capital requirements for banking organizations operating under the new framework. They are effective April 1,2008. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation L Management Official Interlocks [Docket No. R-1272] On July 9, 2007, the Board, acting with the other federal bank and thrift regulatory agencies, approved a final rule to permit management interlocks between unaffiliated depository institutions that have offices in the same relevant metropolitan statistical area if one of the institutions has less than $50 million (previously $20 million) in total assets. The final rule, which implements provisions of the Financial Services Regulatory Re lief Act of 2006, is identical to an interim final rule approved in December 2006 and is effective July 16, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation O Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks [Docket No. R-1271] On May 23, 2007, the Board approved a final rule to eliminate certain reporting requirements that have not contributed significantly to effective monitoring or to prevention of insider lending abuse. The final rule, which implements provisions of the Financial Services Regulatory Relief Act of 2006, is identical to an interim final rule approved in December 2006 and is effective July 2, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation R Exceptions for Banks from the Definition of Broker in the Securities Exchange Act of 1934 [Docket No. R-1274] On September 24, 2007, the Board, acting with the Securities and Exchange Commission (SEC), approved a single set of joint final rules to implement certain exceptions for banks from the definition of broker under section 3(a)(4) of the Securities Exchange Act of 1934 (Exchange Act), as amended by the socalled push-out provisions of the Gramm-Leach-Bliley Act of 1999. The final rules help define the scope of securities activities that banks may conduct in providing banking services to their 178 94th Annual Report, 2007 customers without registering with the SEC as a securities broker or complying with the SEC's rules. Some portions of the final rules are effective September 28, 2007; the remaining portions are effective December 3, 2007. However, banks are exempt from complying with the final rules and the broker exceptions in section 3(a)(4)(B) of the Exchange Act until the first day of their first fiscal year that begins after September 30, 2008. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Regulation V Fair Credit Reporting [Docket No. R-1203] On October 17, 2007, the Board, acting with the other federal financial institutions regulatory agencies, approved final rules requiring that a financial institution provide notice and a reasonable opportunity to opt out before using information from an affiliate to market its own products and services to a consumer. The final rules, which implement the affiliate-marketing provisions of the Fair and Accurate Credit Transactions Act of 2003, are effective January 1, 2008, and compliance is mandatory by October 1, 2008. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. [Docket No. R-1255] On October 23, 2007, the Board, acting with the other federal financial institutions regulatory agencies and the Federal Trade Commission, approved final rules requiring financial institutions and creditors that open or hold certain accounts to develop and implement a writ ten identity theft prevention program that includes reasonable policies and procedures for detecting, preventing, and mitigating identity theft. The final rules provide guidelines for developing and implementing those programs and examples of "red flags" signaling possible identity theft. In addition, the final rules require (1) debit and credit card issuers to assess the validity of changeof-address notifications under certain circumstances and (2) users of consumer reports to establish and maintain reasonable policies and procedures regarding notifications of address discrepancies they receive from consumer reporting agencies. The final rules and guidelines, which implement provisions of the Fair and Accurate Credit Transactions Act of 2003, are effective January 1, 2008, and compliance is mandatory by November 1, 2008. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Policy Statements and Other Actions Policy on Payments System Risk [Docket No. OP-1259] On January 11, 2007, the Board approved revisions to part 1 of its Policy on Payments System Risk to address risk management in payments and settlement systems. The revisions establish an expectation that payments and settlement systems under the Board's authority that are systemically important will publicly disclose self-assessments of their compliance with the relevant principles or minimum standards set forth in the policy. Self-assessments should be updated after any material change and should be reviewed at least every two years. In addition, the revisions incorpo- Record of Policy Actions of the Board of Governors rate the Recommendations for Central Counterparties, which were developed jointly by international committees of central banks and securities commissions, as the Board's minimum standards for central counterparties. The revisions also clarify the purpose of and revise the scope of part 1 relating to central counterparties. The revisions are effective January 19, 2007, and the initial self-assessments are expected to be completed and published by December 31,2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Bies, Warsh, Kroszner, and Mishkin. Illustrations of Consumer Information for Nontraditional Mortgage Products [Docket No. OP-1267] On May 25, 2007, the Board, acting with the other federal financial institutions regulatory agencies, approved final illustrations of consumer information for nontraditional mortgage products to assist financial institutions in implementing the consumer protection provisions of the Interagency Guidance on Nontraditional Mortgage Product Risks issued in October 2006. Financial institutions may use the illustrations as provided, change their format, or tailor the information to specific transactions or products. The illustrations are effective June 8, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Statement on Subprime Mortgage Lending [Docket No. OP-1278] On June 27, 2007, the Board, acting with the other federal financial institu 179 tions regulatory agencies, approved interagency guidance intended to clarify how financial institutions may offer certain adjustable-rate mortgages in a manner that is safe and sound and also allows for clear disclosure of the risks assumed by the borrower. The guidance is effective July 10, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages On August 29, 2007, the Board, acting with the other federal financial institutions regulatory agencies and the Conference of State Bank Supervisors, approved guidance to encourage federally regulated and state-regulated financial institutions and state-supervised servicers of residential mortgages to pursue strategies to mitigate losses while preserving home ownership to the extent possible and appropriate. Votes for this action: Chairman Bernanke and Governors Warsh, Kroszner, and Mishkin. Absent and not voting: Vice Chairman Kohn. Permissible Complementary Activities for Financial Holding Companies On September 6, 2007, the Board determined under the Gramm-Leach-Bliley Act of 1999 that, subject to certain limitations, disease management and mail-order pharmacy services are complementary activities permissible for financial holding companies. To qualify, an activity must complement a financial activity and not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. The Board concluded that disease management and mail-order pharmacy 180 94th Annual Report, 2007 services complement the financial activity of underwriting and selling health insurance and do not pose a substantial risk. The determination is effective September 7, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. On December 3, 2007, the Board similarly determined that, subject to certain limitations, energy management activities are permissible activities for financial holding companies because they complement the financial activities of engaging as principal in commodity derivatives activities and providing advisory services for derivatives transactions and do not pose a substantial risk. The determination is effective December 4, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Permissible Financial Activities for Financial Holding Companies On October 10, 2007, the Board determined under the Gramm-Leach-Bliley Act of 1999 and after consultation with the Secretary of the Treasury that, subject to certain limitations, the acquisition, management, and operation in the United Kingdom of certain third-party defined benefit pension plans are financial activities permissible for financial holding companies. The determination is effective October 12, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Discount Rates in 2007 Under the Federal Reserve Act, the boards of directors of the Federal Reserve Banks must establish rates on dis count window loans to depository institutions at least every fourteen days, subject to review and determination by the Board of Governors. Primary Credit Primary credit, the Federal Reserve's main lending program, is extended at a rate above the federal funds rate target set by the Federal Open Market Committee (FOMC). It is typically made available with minimal administration for very short terms as a backup source of liquidity to depository institutions that, in the judgment of the lending Federal Reserve Bank, are in generally sound financial condition. During 2007, acting on recommendations of the Reserve Bank boards of directors, the Board approved four reductions in the primary credit rate, bringing the rate from 6!/4 percent to 43A percent. The first of these reductions came on August 17 in response to the emergence of severe financial market strains in previous weeks. The Board approved a temporary narrowing of the spread of the primary credit rate over the FOMC's target rate to 50 basis points, from 100 basis points, and announced a temporary change to the Reserve Banks' discount window lending practices to allow the provision of term financing for as long as thirty days, renewable by the borrower. These changes remained in effect at the end of 2007. In the remaining three instances, the Board reached its determinations on the primary credit rate in conjunction with the FOMC's decisions to lower the target federal funds rate by a cumulative 1 percentage point, from 5V4 percent to 4J/4 percent. Monetary policy developments are reviewed more fully in other parts of this report (see the section "Monetary Policy and Economic Developments" and the minutes of FOMC meetings held in 2007). Record of Policy Actions of the Board of Governors Secondary and Seasonal Credit Secondary credit is available in appropriate circumstances to depository institutions that do not qualify for primary credit. The secondary credit rate is set at a spread above the primary credit rate. Throughout 2007, the spread was set at 50 basis points. Seasonal credit is available to smaller depository institutions to meet liquidity needs that arise from regular swings in their loans and deposits. The rate on seasonal credit is calculated every two weeks as an average of selected moneymarket yields, typically resulting in a rate close to the federal funds rate target. At year-end, the secondary and seasonal credit rates were 5V4 percent and 4.70 percent, respectively. Term Auction Facility Credit In December, the Federal Reserve established a temporary Term Auction Facility (TAF). Under the TAF, the Federal Reserve auctions term funds to depository institutions that are in generally sound financial condition and are eligible to borrow under the primary credit program. The amount of each auction is determined in advance by the Federal Reserve, and the interest rate on TAF credit is determined by the bidding process as the rate at which all bids can be fulfilled, up to the maximum auction amount and subject to a minimum bid rate. The Federal Reserve conducted two TAF auctions in 2007—on December 17 and December 20; the resulting rates were 4.65 percent and 4.67 percent, respectively. Votes on Discount Rate Changes About every two weeks during 2007, the Board approved proposals by the twelve Reserve Banks to maintain the formulas for computing the secondary and sea 181 sonal credit rates. In December, the Board approved proposals by the twelve Reserve Banks to establish the auction method by which the TAF credit rate is set. Details on the four actions by the Board to approve changes in the primary credit rate are provided below. August 16, 2007. The Board approved actions taken by the directors of the Federal Reserve Banks of New York and San Francisco to lower the rate on discounts and advances under the primary credit program by Vi percentage point, to 53/4 percent, effective August 17, 2007. The Board also approved an identical action subsequently taken by the directors of the Federal Reserve Banks of Boston, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and Dallas, effective August 17, 2007, and the Federal Reserve Bank of St. Louis, effective August 20, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Votes against this action: None. September 18, 2007. Effective this date, the Board approved actions taken by the directors of the Federal Reserve Banks of Boston, New York, Cleveland, Minneapolis, Kansas City, and San Francisco to lower the rate on discounts and advances under the primary credit program by Vi percentage point, to 5]A percent. The same change was approved for the Federal Reserve Bank of St. Louis, effective September 19, 2007. The Board also approved an identical action subsequently taken by the directors of the Federal Reserve Banks of Richmond, Atlanta, and Dallas, effective September 19, 2007, and the Federal Reserve Banks of Philadelphia and Chicago, effective September 20, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors 182 94th Annual Report, 2007 Warsh, Kroszner, and Mishkin. Votes against this action: None. October 31, 2007. Effective this date, the Board approved actions taken by the directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, and San Francisco to lower the rate on discounts and advances under the primary credit program by V* percentage point, to 5 percent. The same change was approved for the Federal Reserve Bank of St. Louis, effective November 1, 2007. The Board also approved an identical action subsequently taken by the directors of the Federal Reserve Banks of Boston, Philadelphia, Cleveland, Minneapolis, Kansas City, and Dallas effective November 1, 2007. December 11, 2007. Effective this date, the Board approved actions taken by the directors of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, and Chicago to lower the rate on discounts and advances under the primary credit program by l A percentage point, to 43A percent. The same change was approved for the Federal Reserve Bank of St. Louis, effective December 12, 2007. The Board also approved identical actions subsequently taken by the directors of the Federal Reserve Banks of San Francisco, effective December 11, 2007; Boston, Minneapolis, and Dallas, effective December 12, 2007; and Kansas City, effective December 13, 2007. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Votes against this action: None. Votes for this action: Chairman Bernanke, Vice Chairman Kohn, and Governors Warsh, Kroszner, and Mishkin. Votes against this action: None. • 183 Minutes of Federal Open Market Committee Meetings The policy actions of the Federal Open Market Committee, contained in the minutes of its meetings, are presented in the Annual Report of the Board of Governors pursuant to the requirements of section 10 of the Federal Reserve Act. That section provides that the Board shall keep a complete record of the actions taken by the Board and by the Federal Open Market Committee on all questions of policy relating to open market operations, that it shall record therein the votes taken in connection with the determination of open market policies and the reasons underlying each policy action, and that it shall include in its annual report to Congress a full account of such actions. The minutes of the meetings contain the votes on the policy decisions made at those meetings as well as a summary of the information and discussions that led to the decisions. In addition, four times a year, starting with the October 2007 Committee meeting, a Summary of Economic Projections is published as an addendum to the minutes. The descriptions of economic and financial conditions in the minutes and the Summary of Economic Projections are based solely on the information that was available to the Committee at the time of the meetings. Members of the Committee voting for a particular action may differ among themselves as to the reasons for their votes; in such cases, the range of their views is noted in the minutes. When members dissent from a decision, they are identified in the minutes and a summary of the reasons for their dissent is provided. Policy directives of the Federal Open Market Committee are issued to the Federal Reserve Bank of New York as the Bank selected by the Committee to execute transactions for the System Open Market Account. In the area of domestic open market operations, the Federal Reserve Bank of New York operates under instructions from the Federal Open Market Committee that take the form of an Authorization for Domestic Open Market Operations and a Domestic Policy Directive. (A new Domestic Policy Directive is adopted at each regularly scheduled meeting.) In the foreign currency area, the Federal Reserve Bank of New York operates under an Authorization for Foreign Currency Operations, a Foreign Currency Directive, and Procedural Instructions with Respect to Foreign Currency Operations.1 Changes in the instruments during the year are reported in the minutes for the individual meetings. 1. As of January 1, 2007, the Federal Reserve Bank of New York was operating under the Domestic Policy Directive approved at the December 12, 2006, Committee meeting. The other policy instruments (the Authorization for Domestic Open Market Operations, the Authorization for Foreign Currency Operations, the Foreign Currency Directive, and Procedural Instructions with Respect to Foreign Currency Operations) in effect as of January 1, 2007, were approved at the January 31, 2006, meeting. 184 94th Annual Report, 2007 Meeting Held on January 30-31, 2007 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, January 30, 2007 at 2:00 p.m., and continued on Wednesday, January 31, 2007 at 9:00 a.m. Present: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Ms. Bies Mr. Hoenig Mr. Kohn Mr. Kroszner Ms. Minehan Mr. Mishkin Mr. Moskow Mr. Poole Mr. Warsh Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Mr. Lacker and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond and San Francisco, respectively Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta Mr. Reinhart, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Ms. Johnson, Economist Mr. Stockton, Economist Ms. Liang and Mr. Struckmeyer, Associate Directors, Division of Research and Statistics, Board of Governors Messrs. Gagnon, Reifschneider, and Wascher, Deputy Associate Directors, Divisions of International Finance, Research and Statistics, and Research and Statistics, respectively, Board of Governors Messrs. Dale and Orphanides, Senior Advisers, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Ms. Kole2 and Mr. Lebow,2 Section Chiefs, Divisions of International Finance, and Research and Statistics, respectively, Board of Governors Messrs. Doyle,2 Schindler,3 and Wood,2 Senior Economists, Division of International Finance, Board of Governors Messrs. Engen3 and Tetlow,2 Senior Economists, Division of Research and Statistics, Board of Governors Ms. Weinbach, Senior Economist, Division of Monetary Affairs, Board of Governors Ms. Roush,3 Economist, Division of Monetary Affairs, Board of Governors Mr. Hambley,2 Assistant to the Board, Office of Board Members, Board of Governors Mr. Gross, Special Assistant to the Board, Office of Board Members, Board of Governors Messrs. Connors, Evans, Fuhrer, Kamin, Madigan, Rasche, Sellon, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Messrs. Clouse and English, Associate Directors, Division of Monetary Affairs, Board of Governors 2. Attended portion of the meeting relating to the role of economic forecasts in policy communications. 3. Attended portion of the meeting relating to the economic outlook and monetary policy discussion. Minutes of FOMC Meetings, January Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Messrs. Judd and Rosenblum, Executive Vice Presidents, Federal Reserve Banks of San Francisco and Dallas Mses. Mester and Mosser and Messrs. Sniderman and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Philadelphia, New York, Cleveland, and Richmond, respectively Mr. Cunningham, Vice President, Federal Reserve Bank of Atlanta Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis In the agenda for this meeting, it was reported that advices of the election of the following members and alternate members of the Federal Open Market Committee for a term beginning January 30, 2007 had been received and that these individuals had executed their oaths of office. The elected members and alternate members were as follows: 185 W. Fisher, President of the Federal Reserve Bank of Dallas, as alternate. Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City, with Gary H. Stern, President of the Federal Reserve Bank of Minneapolis, as alternate. By unanimous vote, the following officers of the Federal Open Market Committee were selected to serve until the selection of their successors at the first regularly scheduled meeting of the Committee in 2008, with the understanding that in the event of the discontinuance of their official connection with the Board of Governors or with a Federal Reserve Bank, they would cease to have any official connection with the Federal Open Market Committee: Ben S. Bernanke Timothy F. Geithner Vincent R. Reinhart Deborah J. Danker Michelle A. Smith David W. Skidmore Scott G. Alvarez Thomas C. Baxter, Jr. Karen H. Johnson David J. Stockton Chairman Vice Chairman Secretary and Economist Deputy Secretary Assistant Secretary Assistant Secretary General Counsel Deputy General Counsel Economist Economist Thomas A. Connors, Charles L. Evans, Jeffrey C. Fuhrer, Steven B. Kamin, Brian Timothy F. Geithner, President of the FedF. Madigan, Robert H. Rasche, Gordon eral Reserve Bank of New York, with H. Sellon, Lawrence Slifman, Joseph S. Christine M. Cumming, First Vice Tracy, and David W. Wilcox, Associate President of the Federal Reserve Bank Economists of New York, as alternate. By unanimous vote, the Committee Cathy E. Minehan, President of the Federal amended its Rules of Organization by Reserve Bank of Boston, with Charles I. Plosser, President of the Federal Re- making a provision for a backup to the serve Bank of Philadelphia, as alter- Manager of the System Open Market nate. Account should he/she be unable to Michael H. Moskow, President of the Fed- serve, and it made several technical eral Reserve Bank of Chicago, with changes to its Program for Security of Sandra Pianalto, President of the Fed- FOMC Information. eral Reserve Bank of Cleveland, as alBy unanimous vote, the Federal Reternate. serve Bank of New York was selected to William Poole, President of the Federal Re- execute transactions for the System serve Bank of St. Louis, with Richard Open Market Account. 186 94th Annual Report, 2007 By unanimous vote, William C. Dudley was selected to serve at the pleasure of the Committee as Manager, System Open Market Account, on the understanding that his selection was subject to being satisfactory to the Federal Reserve Bank of New York.4 By unanimous vote, the Committee approved the Authorization for domestic Open Market Operations with an amendment to paragraph l(b) that brings the language for repurchase agreements into conformity with the authorization's existing language for outright purchases and reverse repurchase agreements. Accordingly, the Authorization for Domestic Open Market Operations was adopted, effective January 30, 2007, as shown below. Authorization for Domestic Open Market Operations (Amended January 30, 2007) 1. The Federal Open Market Committee authorizes and directs the Federal Reserve Bank of New York, to the extent necessary to carry out the most recent domestic policy directive adopted at a meeting of the Committee: (a) To buy or sell U.S. Government securities, including securities of the Federal Financing Bank, and securities that are direct obligations of, or fully guaranteed as to principal and interest by, any agency of the United States in the open market, from or to securities dealers and foreign and international accounts maintained at the Federal Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the System Open Market Account at market prices, and, for such Account, to exchange maturing U.S. Government and Federal agency securities with the Treasury or the individual agencies or to allow them to mature without replacement; 4. Secretary's note: Advice subsequently was received that the selection of Mr. Dudley as Manager was satisfactory to the board of directors of the Federal Reserve Bank of New York. (b) To buy U.S. Government securities, obligations that are direct obligations of, or fully guaranteed as to principal and interest by, any agency of the United States, from dealers for the account of the System Open Market Account under agreements for repurchase of such securities or obligations in 65 business days or less, at rates that, unless otherwise expressly authorized by the Committee, shall be determined by competitive bidding, after applying reasonable limitations on the volume of agreements with individual dealers. (c) To sell U.S. Government securities and obligations that are direct obligations of, or fully guaranteed as to principal and interest by, any agency of the United States to dealers for System Open Market Account under agreements for the resale by dealers of such securities or obligations in 65 business days or less, at rates that, unless otherwise expressly authorized by the Committee, shall be determined by competitive bidding, after applying reasonable limitations on the volume of agreements with individual dealers. 2. In order to ensure the effective conduct of open market operations, the Federal Open Market Committee authorizes the Federal Reserve Bank of New York to lend on an overnight basis U.S. Government securities held in the System Open Market Account i:> dealers at rates that shall be determined by competitive bidding. The Federal R^e r ve Bank of New York shall set a minimum lending fee consistent with the objectives of the program and apply reasonable limitations on the total amount of a specific issue that may be auctioned and on the amount of securities that each dealer may borrow. The Federal Reserve Bank of New York may reject bids which could facilitate a dealer's ability to control a single issue as determined solely by the Federal Reserve Bank of New York. 3. In order to ensure the effective conduct of open market operations, while assisting in the provision of short-term investments for foreign and international accounts maintained at the Federal Reserve Bank of New York and accounts maintained at the Federal Reserve Bank of New York as fiscal agent of the United States pursuant to Section 15 of the Federal Reserve Act, the Federal Open Market Committee authorizes and directs Minutes of FOMC Meetings, January 187 the Federal Reserve Bank of New York (a) for System Open Market Account, to sell U.S. Government securities to such accounts on the bases set forth in paragraph l(a) under agreements providing for the resale by such accounts of those securities in 65 business days or less on terms comparable to those available on such transactions in the market; and (b) for New York Bank account, when appropriate, to undertake with dealers, subject to the conditions imposed on purchases and sales of securities in paragraph l(b), repurchase agreements in U.S. Government and agency securities, and to arrange corresponding sale and repurchase agreements between its own account and such foreign, international, and fiscal agency accounts maintained at the Bank. Transactions undertaken with such accounts under the provisions of this paragraph may provide for a service fee when appropriate. the Committee's foreign currency directive and express authorizations by the Committee pursuant thereto, and in conformity with such procedural instructions as the Committee may issue from time to time: A. To purchase and sell the following foreign currencies in the form of cable transfers through spot or forward transactions on the open market at home and abroad, including transactions with the U.S. Treasury, with the U.S. Exchange Stabilization Fund established by Section 10 of the Gold Reserve Act of 1934, with foreign monetary authorities, with the Bank for International Settlements, and with other international financial institutions: 4. In the execution of the Committee's decision regarding policy during any intermeeting period, the Committee authorizes and directs the Federal Reserve Bank of New York, upon the instruction of the Chairman of the Committee, to adjust somewhat in exceptional circumstances the degree of pressure on reserve positions and hence the intended federal funds rate. Any such adjustment shall be made in the context of the Committee's discussion and decision at its most recent meeting and the Committee's long-run objectives for price stability and sustainable economic growth, and shall be based on economic, financial, and monetary developments during the intermeeting period. Consistent with Committee practice, the Chairman, if feasible, will consult with the Committee before making any adjustment. B. To hold balances of, and to have outstanding forward contracts to receive or to deliver, the foreign currencies listed in paragraph A above. C. To draw foreign currencies and to permit foreign banks to draw dollars under the reciprocal currency arrangements listed in paragraph 2 below, provided that drawings by either party to any such arrangement shall be fully liquidated within 12 months after any amount outstanding at that time was first drawn, unless the Committee, because of exceptional circumstances, specifically authorizes a delay. D. To maintain an overall open position in all foreign currencies not exceeding $25.0 billion. For this purpose, the overall open position in all foreign currencies is defined as the sum (disregarding signs) of net positions in individual currencies. The net position in a single foreign currency is defined as holdings of balances in that currency, plus outstanding contracts for future receipt, minus outstanding contracts for future delivery of that currency, i.e., as the sum of these elements with due regard to sign. By unanimous vote, the Authorization for Foreign Currency Operations was reaffirmed in the form shown below. Authorization for Foreign Currency Operations (Reaffirmed January 30, 2007) 1. The Federal Open Market Committee authorizes and directs the Federal Reserve Bank of New York, for System Open Market Account, to the extent necessary to carry out Canadian dollars Danish kroner Euro Pounds sterling Japanese yen Mexican pesos Norwegian kroner Swedish kronor Swiss francs 2. The Federal Open Market Committee directs the Federal Reserve Bank of New York to maintain reciprocal currency arrangements ("swap" arrangements) for the System Open Market Account for periods up to a maximum of 12 months with the following foreign banks, which are among those designated by the Board of Governors of the 188 94th Annual Report, 2007 Federal Reserve System under Section 214.5 of Regulation N, Relations with Foreign Banks and Bankers, and with the approval of the Committee to renew such arrangements on maturity: Foreign bank Bank of Canada Bank of Mexico Amount of arrangement (millions of dollars equivalent) 2,000 3,000 Any changes in the terms of existing swap arrangements, and the proposed terms of any new arrangements that may be authorized, shall be referred for review and approval to the Committee. 3. All transactions in foreign currencies undertaken under paragraph l.A. above shall, unless otherwise expressly authorized by the Committee, be at prevailing market rates. For the purpose of providing an investment return on System holdings of foreign currencies or for the purpose of adjusting interest rates paid or received in connection with swap drawings, transactions with foreign central banks may be undertaken at non-market exchange rates. 4. It shall be the normal practice to arrange with foreign central banks for the coordination of foreign currency transactions. In making operating arrangements with foreign central banks on System holdings of foreign currencies, the Federal Reserve Bank of New York shall not commit itself to maintain any specific balance, unless authorized by the Federal Open Market Committee. Any agreements or understandings concerning the administration of the accounts maintained by the Federal Reserve Bank of New York with the foreign banks designated by the Board of Governors under Section 214.5 of Regulation N shall be referred for review and approval to the Committee. 5. Foreign currency holdings shall be invested to ensure that adequate liquidity is maintained to meet anticipated needs and so that each currency portfolio shall generally have an average duration of no more than 18 months (calculated as Macaulay duration). Such investments may include buying or selling outright obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof; buying such securities under agreements for repurchase of such securities; selling such securities under agreements for the resale of such securities; and holding various time and other deposit accounts at foreign institutions. In addition, when appropriate in connection with arrangements to provide investment facilities for foreign currency holdings, U.S. Government securities may be purchased from foreign central banks under agreements for repurchase of such securities within 30 calendar days. 6. All operations undertaken pursuant to the preceding paragraphs shall be reported promptly to the Foreign Currency Subcommittee and the Committee. The Foreign Currency Subcommittee consists of the Chairman and Vice Chairman of the Committee, the Vice Chairman of the Board of Governors, and such other member of the Board as the Chairman may designate (or in the absence of members of the Board serving on the Subcommittee, other Board members designated by the Chairman as alternates, and in the absence of the Vice Chairman of the Committee, his alternate). Meetings of the Subcommittee shall be called at the request of any member, or at the request of the Manager, System Open Market Account ("Manager"), for the purposes of reviewing recent or contemplated operations and of consulting with the Manager on other matters relating to his responsibilities. At the request of any member of the Subcommittee, questions arising from such reviews and consultations shall be referred for determination to the Federal Open Market Committee. 7. The Chairman is authorized: A. With the approval of the Committee, to enter into any needed agreement or understanding with the Secretary of the Treasury about the division of responsibility for foreign currency operations between the System and the Treasury; B. To keep the Secretary of the Treasury fully advised concerning System foreign currency operations, and to consult with the Secretary on policy matters relating to foreign currency operations; C. From time to time, to transmit appropriate reports and information to the National Advisory Council on International Monetary and Financial Policies. Minutes of FOMC Meetings, January 8. Staff officers of the Committee are authorized to transmit pertinent information on System foreign currency operations to appropriate officials of the Treasury Department. 9. All Federal Reserve Banks shall participate in the foreign currency operations for System Account in accordance with paragraph 3G(1) of the Board of Governors' Statement of Procedure with Respect to Foreign Relationships of Federal Reserve Banks dated January 1, 1944. By unanimous vote, the Foreign Currency Directive was reaffirmed in the form shown below. Foreign Currency Directive (Reaffirmed January 30, 2007) 1. System operations in foreign currencies shall generally be directed at countering disorderly market conditions, provided that market exchange rates for the U.S. dollar reflect actions and behavior consistent with IMF Article IV, Section 1. 2. To achieve this end the System shall: A. Undertake spot and forward purchases and sales of foreign exchange. B. Maintain reciprocal currency ("swap") arrangements with selected foreign central banks. C. Cooperate in other respects with central banks of other countries and with international monetary institutions. 3. Transactions may also be undertaken: A. To adjust System balances in light of probable future needs for currencies. B. To provide means for meeting System and Treasury commitments in particular currencies, and to facilitate operations of the Exchange Stabilization Fund. C. For such other purposes as may be expressly authorized by the Committee. 4. System foreign currency operations shall be conducted: A. In close and continuous consultation and cooperation with the United States Treasury; B. In cooperation, as appropriate, with foreign monetary authorities; and C. In a manner consistent with the obligations of the United States in the Interna 189 tional Monetary Fund regarding exchange arrangements under IMF Article IV. By unanimous vote, the Procedural Instructions with Respect to Foreign Currency Operations were reaffirmed in the form shown below. Procedural Instructions with Respect to Foreign Currency Operations (Reaffirmed January 30, 2007) In conducting operations pursuant to the authorization and direction of the Federal Open Market Committee as set forth in the Authorization for Foreign Currency Operations and the Foreign Currency Directive, the Federal Reserve Bank of New York, through the Manager, System Open Market Account ("Manager"), shall be guided by the following procedural understandings with respect to consultations and clearances with the Committee, the Foreign Currency Subcommittee, and the Chairman of the Committee. All operations undertaken pursuant to such clearances shall be reported promptly to the Committee. 1. The Manager shall clear with the Subcommittee (or with the Chairman, if the Chairman believes that consultation with the Subcommittee is not feasible in the time available): A. Any operation that would result in a change in the System's overall open position in foreign currencies exceeding $300 million on any day or $600 million since the most recent regular meeting of the Committee. B. Any operation that would result in a change on any day in the System's net position in a single foreign currency exceeding $150 million, or $300 million when the operation is associated with repayment of swap drawings. C. Any operation that might generate a substantial volume of trading in a particular currency by the System, even though the change in the System's net position in that currency might be less than the limits specified in I.B. " D. Any swap drawing proposed by a foreign bank not exceeding the larger of (i) $200 million or (ii) 15 percent of the size of the swap arrangement. 190 94th Annual Report, 2007 2. The Manager shall clear with the Committee (or with the Subcommittee, if the Subcommittee believes that consultation with the full Committee is not feasible in the time available, or with the Chairman, if the Chairman believes that consultation with the Subcommittee is not feasible in the time available): A. Any operation that would result in a change in the System's overall open position in foreign currencies exceeding $1.5 billion since the most recent regular meeting of the Committee. B. Any swap drawing proposed by a foreign bank exceeding the larger of (i) $200 million or (ii) 15 percent of the size of the swap arrangement. 3. The Manager shall also consult with the Subcommittee or the Chairman about proposed swap drawings by the System and about any operations that are not of a routine character. The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market transactions in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. The information reviewed at the January meeting, which included the advance data on the national income and product accounts for the fourth quarter, showed that economic expansion had picked up in the fourth quarter of 2006, but was uneven across sectors. Considerable vigor in consumer spending late last year boosted economic growth in the fourth quarter, supported by further increases in employment and income. A surge in net exports and a pickup in defense spending also raised output growth last quarter, but these factors were expected to prove largely transitory. The decline in residential construction continued to weigh on overall activity, but some indications of stabilization in the demand for homes had emerged. Outlays for business fixed investment softened in the fourth quarter. Although a spike in energy prices lifted total consumer price inflation in December, readings on core inflation had edged lower in recent months. The labor market exhibited continued strength through year-end. Nonfarm payrolls rose robustly again in December, driven by further gains in the service-producing sectors. Employment in the manufacturing and construction industries declined further, but by less than in the previous several months. Aggregate hours of private production or nonsupervisory workers edged up further. The unemployment rate held steady at 4.5 percent. Industrial production firmed in December after having softened in the preceding three months. Output of manufacturing industries rose noticeably in December after being flat in November; the increase was associated with sizable gains in the production of semiconductors, computers, and commercial aircraft. Motor vehicle output turned up in November and December, but remained low compared with earlier in the year as vehicle makers continued their efforts to pare inventories. After contracting in November, output in the mining sector increased in December, boosted by a rise in the production of crude oil. In contrast, unseasonably warm weather caused a sharp cutback in the output of utilities in December. Real consumer spending rose briskly in November and December, buoyed by sizable increases in outlays for non-auto consumer goods. Spending on services, in contrast, appeared to be expanding only moderately toward year-end, as Minutes of FOMC Meetings, January warmer-than-usual temperatures led to a drop in real outlays for energy services in November and probably damped expenditures in that category again in December. Real disposable income posted solid gains in October and November and likely rose further in December, reflecting increases in wages and salaries and further declines in energy prices. Although house-price appreciation appeared to have slowed further since the end of the third quarter, robust gains in equity prices likely resulted in a small rise in the ratio of household wealth to disposable income last quarter. Readings on consumer sentiment moved up at the end of last year and held steady in early 2007. Residential construction activity remained quite weak late last year, but home sales showed some tentative signs of stabilization. Single-family housing starts declined modestly in December, reversing about half of November's gain. However, new permit issuance edged up in December after having moved down steadily for nearly a year. Construction in the multifamily sector, which accounts for a much smaller share of new home construction, rose sharply in December to the upper end of the range that has prevailed over the past decade. Sales of existing single-family homes held steady in November and rose in December, while sales of new homes inched up in both months. Inventories of unsold homes remained considerable although they ticked down in December for the second straight month. The most timely indicators of home prices, which are not adjusted for changes in quality or the mix of homes sold, pointed to small declines. After having risen at a solid average pace in the first three quarters of last year, real investment in equipment and software fell in the fourth quarter. Business outlays on transportation equip 191 ment, a volatile spending category, dropped considerably. Sales of light vehicles to business customers declined to their lowest level in two years, which more than offset a surge in sales of medium and heavy trucks ahead of stricter regulations on truck engine emissions that went into effect this year. Spending on high-tech capital goods moderated. Outside of the transportation and hightech sectors, real spending declined last quarter. That weakness appeared to be concentrated in equipment related to construction and motor vehicle manufacturing. Nonresidential construction activity decelerated late last quarter; however, indicators of future expenditures in this sector remained firm, with office and industrial vacancy rates somewhat below their historical averages. Overall, prospects for business spending continued to be supported by robust corporate cash flow and a low cost of capital. Business inventories remained elevated in the fourth quarter. In November, the book-value ratio of inventories to sales for the manufacturing and trade sectors (excluding motor vehicles) stood near its highest level since early 2005. Although relatively high ratios of inventories to sales appeared to be associated in part with developments in the homebuilding and motor vehicle sectors, some indications of inventory imbalances in other sectors had recently become evident. The U.S. international trade deficit narrowed again in October, primarily reflecting declines in both the price and volume of imported oil. In addition, imports of non-oil industrial supplies, capital goods, and automotive products fell, offsetting small increases in imports of consumer goods, food, and services. In November, the trade deficit edged down further—to its smallest level since mid2005—as export growth outpaced a 192 94th Annual Report, 2007 modest increase in non-oil imports, and oil imports remained flat. Economic activity in the advanced foreign economies appeared to have accelerated in the fourth quarter, supported by a broad-based firming of domestic demand and strong employment gains. In the euro area, consumer sentiment was lifted by lower unemployment, and economic growth continued at a solid pace. After contracting in the third quarter, consumption spending in Japan apparently rebounded last quarter, providing significant support to economic activity. The expansion in the United Kingdom's economy strengthened, likely reflecting a pickup in consumption growth. Output growth in Canada seemed to have firmed but likely remained below trend. Recent economic data for the emerging-market economies pointed to some moderation in the pace of growth in the fourth quarter. In China, the most recent evidence suggested that growth had remained strong. While large fluctuations in energy prices continued to cause swings in overall consumer price inflation in recent months, readings on core inflation improved. Overall consumer prices were flat in November, but turned up in December because of a surge in retail energy prices that month. Still, the rise in the price index for personal consumption expenditures over the twelve months ending in December was estimated to have been noticeably less than that of the year-earlier period. Prices for personal consumption expenditures other than those for food and energy were estimated to have increased slightly faster over the twelve months of 2006 than they did a year earlier. However, the three-month change in core prices in December likely was down considerably from its peak in May. Yearover-year increases in average hourly earnings late last year continued to run ahead of those a year earlier. However, hourly compensation of private industry workers, as measured by the employment cost index, rose at a moderate rate in the three months ending in December, a touch below the pace registered in the previous quarter. Survey measures of households' year-ahead inflation expectations held steady through January at levels that were below those reported in the second and third quarters of last year, and respondents' longer-term inflation expectations had been unchanged since ticking down in the middle of 2006. At its December meeting, the Federal Open Market Committee (FOMC) decided to maintain its target for the federal funds rate at 5lA percent. The Committee's accompanying statement noted that economic growth had slowed over the course of the year, partly reflecting a substantial cooling of the housing market. Although recent indicators had been mixed, the economy seemed likely to expand at a moderate pace on balance over coming quarters. Readings on core inflation had been elevated, and the high level of resource utilization had the potential to sustain inflation pressures. However, inflation pressures seemed likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand. Nonetheless, the Committee judged that some inflation risks remained. The extent and timing of any additional firming that may be needed to address these risks would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. The FOMC's decision at the December meeting to leave its target for the federal funds rate unchanged and to retain the language in the statement re- Minutes of FOMC Meetings, January garding the risks to inflation appeared to match investors' expectations. However, the characterization of recent economic growth was reportedly interpreted by market participants as suggesting a slight softening in the Committee's outlook for the expansion. As a result, the expected path of the federal funds rate beyond the near term edged down. The subsequent release of the minutes from the meeting elicited little market reaction. Investors' outlook for economic activity firmed over the intermeeting period, as economic data releases came in stronger than expected and oil prices declined notably. As a result, investors markedly reduced the extent of policy easing anticipated over coming quarters, and yields on nominal and inflationindexed Treasury coupon securities rose. Measures of inflation compensation were little changed on net. Spreads of investment-grade corporate bond yields over those of comparable-maturity Treasury securities moved down a bit, while those of speculative-grade issues declined significantly more. Broad equity indexes edged higher. The foreign exchange value of the dollar against other major currencies rose, on balance, particularly versus the yen. Debt of the domestic nonfinancial sectors was estimated to have expanded in the fourth quarter at a pace that was close to that registered over the first three quarters of the year. A pickup in merger-related borrowing appeared to boost business debt growth last quarter, and a sharp rise in the issuance of bonds and commercial paper more than offset a moderation in bank loans. In the household sector, the ongoing deceleration in house prices further restrained the growth of home mortgage debt. M2 continued to expand briskly in December and January, primarily reflecting strength in its liquid deposit component. 193 In its forecast prepared ahead of the meeting, the staff had revised up its estimate of growth of aggregate economic activity in the fourth quarter. Nonetheless, real GDP in the second half of last year was still projected to have increased at a pace that was a bit below the economy's long-run potential, primarily because of the ongoing adjustment in the housing sector and the lower level of motor vehicle production. Looking ahead, the staff expected the rate of increase in real GDP to be little changed in 2007 relative to the projected pace for the second half of 2006. However, with the contraction in housing activity expected to abate this year, the pace of economic growth was anticipated to edge back up to a level that was close to the staffs estimate of potential output growth by the end of 2007 and to remain in that same range throughout 2008. In light of developments in futures markets, the paths of both energy and import prices were projected to be lower than was previously thought. Against this background and with the rate of increase of shelter prices slowing down, the staff expected core inflation to edge down in 2007 and 2008. The advance data on the national income and product accounts for the fourth quarter that were released on the morning of the second day of the FOMC meeting showed stronger-than-expected net exports and a larger-than-anticipated accumulation of inventories. The staff interpreted this information as suggesting some upward revision to its estimate of output growth in the fourth quarter and perhaps a slight downward revision to its forecast for the current quarter. In their discussion of the economic situation and outlook, meeting participants noted that the economic information received since the last meeting pointed to a somewhat more favorable outlook regarding both inflation and 194 94th Annual Report, 2007 economic growth than they had earlier anticipated. Incoming data suggesting a leveling out in housing demand and strength in consumer spending outside the housing sector supported the view that the expansion remained resilient despite the appreciable decline in housing activity and recent weakness in the manufacturing sector. Over the next several quarters, economic activity would likely advance at a pace at or modestly below the economy's trend rate of growth. Thereafter, growth was likely to return to around its trend rate, which several participants viewed as likely to be higher than the staff's estimate. Favorable readings on core inflation and lower energy prices had also improved the odds that inflation pressures would diminish. However, it was noted that the prevailing level of inflation was uncomfortably high, and resource utilization was elevated. The upside risks to inflation remained the Committee's predominant concern. In preparation for the Federal Reserve's semiannual report to the Congress on the economy and monetary policy, the members of the Board of Governors and the presidents of the Federal Reserve Banks submitted individual projections of the growth of nominal and real GDP, the rate of unemployment, and core consumer price inflation for the years 2007 and 2008, conditioned on their views of the appropriate path for monetary policy. The projections of the growth of nominal GDP were in the range of 43/4 to 5Vi percent for both years, with a central tendency of 5 to 5V2 percent for 2007 and 43/4 to 5lA percent for 2008. Projections of the rate of expansion in real GDP for 2007 were in the 2lA to 3J/4 percent range, with a central tendency of 2Vi to 3 percent; for 2008 the forecasts were in the slightly higher range of 2lh to 3V4 percent, with a central tendency of 23A to 3 percent. These rates of growth were associated with a civilian unemployment rate in the range of AVi to 43/4 percent in the fourth quarter of 2007 and AV2 to 5 percent in the fourth quarter of 2008; the central tendency of these projections was AV2 to 43/4 percent for both years. The rate of inflation, as measured by the core PCE price index, was projected to edge down from a range of 2 to 2lA percent in 2007, with the central tendency being the same, to a range of 1 Vi to 2lA percent in 2008, centered on l3/4 to 2 percent. In their discussion of the major sectors of the economy, participants noted that the housing market showed tentative signs of stabilization in most regions. Anecdotal reports presented a mixed picture, with fairly firm home sales in some areas but continuing decline in others. But aggregate data indicated that home sales, which had been essentially flat since mid-year, had risen a bit during the fourth quarter. Mortgage applications for home purchases had risen from their low levels of last summer. Sentiment among homebuilders reportedly had improved in the past few months, and the inventory of new homes for sale had fallen. Nonetheless, participants noted that inventories remained elevated and needed to be worked down before growth in this sector resumed. Unseasonably warm weather so far this winter complicated the interpretation of recent data, but participants were optimistic that the risk of a much larger contraction in housing had diminished and that the drag on growth from the housing sector would ease later this year. Participants saw continued gains in employment and incomes and lower energy prices as sustaining solid growth in consumer spending. Contacts reported healthy holiday sales in many regions, particularly late in the Christmas season. In addition, the growth of gift cards was Minutes of FOMC Meetings, January mentioned as a factor that likely boosted retail sales in January. To date, weakness in the housing market had not appeared to have spilled over to aggregate consumption, although some such effect could not be ruled out as the growth in households' home equity slowed. The recent strength of consumption spending, together with favorable readings from consumer sentiment surveys, suggested that households were optimistic about prospects for employment and income. Indeed, the possibility that the personal saving rate would fail to rise as in the staff forecast was cited by some participants as posing a significant upside risk to the outlook. Meeting participants noted that continued gains in nonresidential construction spending were offsetting some of the weakness on the residential side. Further advances in nonresidential investment were likely. Office vacancy rates were reported as declining in some areas. However, the recent decrease in energy prices had already led to a reduction in drilling activity and was likely to reduce some investment in alternative fuels. Participants noted that business fixed investment overall continued to be weaker than anticipated, suggesting some caution on the part of businesses in expanding capacity. Nonetheless, participants expected that, going forward, favorable financial conditions, strong corporate balance sheets, high profitability, and growth in sales would support a firming of investment spending. Net exports were unexpectedly strong in the fourth quarter. In part, this development could be attributed to a temporary reduction in petroleum imports as a result of the unseasonably warm weather. Although imports were likely to pick up again, global economic growth, which had been strong of late, was expected to continue to provide ongoing support for growth in exports. 195 The more favorable budget positions of the state and local governments were seen as permitting additional spending by such governmental units and hence as an additional source of stimulus to the economy. Strong federal tax receipts suggested that personal incomes were expanding vigorously. Participants reported some continuing softness in manufacturing, primarily in industries related to housing or automobiles. The recent slackness in manufacturing activity appeared to be largely an inventory correction, which participants expected would be completed this year. Participants noted that the tone of contacts in the industrial sector was generally more positive than at the time of the December meeting, and some survey information pointed to expectations of a rebound in manufacturing activity later this year. However, the recent declines in energy prices were likely to restrain energy extraction as well as activity in associated energy-producing sectors. Many participants observed that labor markets remained relatively taut, with significant wage pressures being reported in some occupations. In addition to the continuing shortages of skilled workers in technical and professional fields, recent reports suggested a scarcity of less skilled and unskilled workers in some areas of the country. One participant observed that some of the sluggishness in manufacturing job growth could be due to difficulties in hiring rather than indicating weakness in demand. So far, aggregate measures of labor compensation were showing only moderate increases, but looking ahead, the possibility that labor costs might rise more rapidly as a result of the tightness in labor market was seen as an upside risk to inflation. All meeting participants expressed some concern about the outlook for inflation. To be sure, incoming data had 196 94th Annual Report, 2007 suggested some improvement in core inflation, and a further gradual decline was seen as the most likely outcome, fostered in part by the continued stability of inflation expectations. However, participants did not yet see a downtrend in core inflation as definitively established. Although lower energy prices, declining core import prices, and a deceleration in owners' equivalent rent were expected to contribute to slower core inflation in coming months, the effects of some of these factors on inflation could well be temporary. The influence of more enduring factors, importantly including pressures in labor and product markets and the behavior of inflation expectations, would primarily determine the extent of more persistent progress. In light of the apparent underlying strength in aggregate demand, risks around the desired path of a further gradual decline in core inflation remained mainly to the upside. Participants emphasized that a failure of inflation to moderate as expected could impair the long-term performance of the economy. In the Committee's discussion of monetary policy for the intermeeting period, all members favored keeping the target federal funds rate at 5VA percent at this meeting. The confluence of betterthan-expected news on economic activity and inflation suggested somewhat smaller downside risks to economic growth as well as improved prospects for core inflation. Recent developments were seen as supporting the Committee's view that maintaining the current target was likely to foster moderate economic growth and to further the gradual reduction of core inflation from its elevated level over the past year. Nonetheless, Committee members saw continued risks to the economic outlook. The ongoing contraction in the housing sector and the potential for spillovers to other sectors remained notable downside risks to economic activity, although those risks had diminished somewhat, and continuing strength in consumption suggested upside risks as well. All members agreed that the predominant concern remained the risk that inflation would fail to moderate as desired. In light of the recent economic data and anecdotal information, the Committee agreed that the statement to be released after the meeting should acknowledge evidence of somewhat firmer economic growth and tentative signs of stabilization in the housing market. They further agreed that the statement should reiterate that the economy seemed likely to expand at a moderate pace over coming quarters. The statement would also note the modest improvement in readings on core inflation and the Committee's view that inflation pressures seemed likely to moderate over time. The members discussed whether the balance of risks language in its recent statements still was the best way to represent the views of the Committee and decided that a change was not warranted at this time. All members agreed that the statement should continue to stress that some inflation risks remained and note that additional policy firming was possible. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The Federal Open Market Committee seeks monetary andfinancialconditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve Minutes of FOMC Meetings, March 197 markets consistent with maintaining the federal funds rate at an average of around 5lA percent. mously approved the minutes of the FOMC meeting held on December 12, 2006. By notation vote completed on JanuThe vote encompassed approval of the text below for inclusion in the state- ary 5, 2007, the Committee unanimously selected William C. Dudley to serve at ment to be released at 2:15 p.m.: the pleasure of the Committee as ManThe Committee judges that some inflation risks remain. The extent and timing of any ager, System Open Market Account, on additional firming that may be needed to the understanding that his selection was address these risks will depend on the evolu- subject to being satisfactory to the Fedtion of the outlook for both inflation and eral Reserve Bank of New York. economic growth, as implied by incoming Secretary's note: Advice subseinformation. quently was received that the selection Votes for this action: Messrs. Bernanke of Mr. Dudley as Manager was satisfacand Geithner, Ms. Bies, Messrs. Hoe- tory to the board of directors of the Fednig, Kohn, and Kroszner, Ms. Minehan, Messrs. Mishkin, Moskow, Poole, and eral Reserve Bank of New York. Warsh. Votes against this action: None. Vincent R. Reinhart Secretary The Committee then moved on to a discussion of the role of economic projections in policy communications. Meeting Held on Meeting participants reviewed the ob- March 20-21, 2007 jectives, advantages, and disadvantages of potential changes to the production A meeting of the Federal Open Market and communication of policymakers' Committee was held in the offices of the forecasts of key economic variables. Board of Governors of the Federal ReThey expressed support for continuing serve System in Washington, D.C., on to report summaries of their individual Tuesday, March 20, 2007 at 2:30 p.m., forecasts, which they now make twice a and continued on Wednesday, March 21, year and which are included in the Mon- 2007 at 9:00 a.m. etary Policy Report. Participants agreed Present: to explore whether changes to current Mr. Bernanke, Chairman practices might facilitate improved comMr. Geithner, Vice Chairman Mr. Hoeni^ munication internally among themselves Mr. Kohn during the policy debate and externally Mr. Kroszner by providing the public with additional Ms. Minehan context for understanding the CommitMr. Mishkin tee's policy decisions. No decisions on Mr. Moskow Mr. Poole any such changes were made at this Mr. Warsh meeting, and a further discussion of communications topics was planned for Ms. Cumming, Mr. Fisher, Ms. Pianthe next FOMC meeting, confirmed for alto, and Messrs. Plosser and Stern, Alternate Members of the March 20-21, 2007. Federal Open Market Committee The meeting adjourned at 2:45 p.m. Notation Votes By notation vote completed on December 29, 2006, the Committee unani Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively 198 94th Annual Report, 2007 Mr. Reinhart, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Ms. Johnson, Economist Mr. Stockton, Economist Mr. Gross, Special Assistant to the Board, Office of Board Members, Board of Governors Messrs. Connors, Evans, Fuhrer, Kamin, Madigan, Rasche, Slifman, and Wilcox, Associate Economists Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Mr. Dudley, Manager, System Open Market Account Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Messrs. Clouse and English,5 Associate Directors, Division of Monetary Affairs, Board of Governors Mr. Struckmeyer, Associate Director, Division of Research and Statistics, Board of Governors Mr. Reifschneider, Deputy Associate Director, Division of Research and Statistics, Board of Governors Messrs. Dale6 and Oliner, Senior Advisers, Divisions of Monetary Affairs and Research and Statistics, respectively. Board of Governors Mr. Hambley,6 Assistant to the Board, Office of Board Members, Board of Governors Mr. Meyer, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Mr. Small,5 Project Manager, Division of Monetary Affairs, Board of Governors Mr. Kiley6 and Ms. Kole,6 Section Chiefs, Divisions of International Finance and Research and Statistics, respectively, Board of Governors Mr. Doyle,6 Ms. Mauskopf,6 and Mr. Wood,6 Senior Economists, Divisions of International Finance, Research and Statistics, and International Finance, respectively, Board of Governors 5. Attended Wednesday's session. 6. Attended portion of the meeting relating to the discussion of communications issues. Ms. Roush, Economist, Division of Monetary Affairs, Board of Governors Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas Mr. Hakkio, Ms. Mester, Messrs. Rolnick, Rudebusch, and Sniderman, Senior Vice Presidents, Federal Reserve Banks of Kansas City, Philadelphia, Minneapolis, San Francisco, and Cleveland, respectively Messrs. Cunningham and Hilton, Vice Presidents, Federal Reserve Banks of Atlanta and New York, respectively Ms. Sbordone, Research Officer, Federal Reserve Bank of New York Mr. Hetzel, Senior Economist, Federal Reserve Bank of Richmond The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market transactions in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. The information reviewed at the March meeting indicated that the economy appeared to be expanding at a Minutes of FOMC Meetings, March 199 modest pace in the first quarter. Declines in residential construction activity continued to weigh on overall activity, and business investment had softened considerably over the preceding several months, especially in equipment used in the construction and motor vehicle industries. However, consumer spending had increased appreciably in the early part of the year, and labor demand continued to expand, albeit at a somewhat slower pace than last year. Meanwhile, the twelve-month increase in core consumer prices remained elevated relative to its pace one year earlier. Employment gains moderated in early 2007. In February, employment in the construction industry contracted considerably, in part because of severe winter storms; manufacturing employment also declined, but hiring in service-producing sectors remained solid. A decline in the average workweek led to a contraction in aggregate hours. At the same time, the unemployment rate edged down from 4.6 percent in January to 4.5 percent in February. Industrial production rose strongly in February and was revised up for both December and January. In February, production was boosted by a rebound in motor vehicle assemblies and by a temporary surge in output at utilities that reflected a swing from unseasonably warm temperatures in January to colder weather in February. Production rose at a solid pace in all major high-tech categories. Output of materials and defense and space equipment expanded as well. In contrast, production of consumer goods and business equipment changed little, while output of construction supplies declined. Real consumer spending appeared on track to rise at a robust pace in the first quarter, buoyed in part by a weatherrelated surge in spending on energy services and by a jump in sales of light motor vehicles. Outside of these areas, however, real consumer spending moderated. The determinants of household spending were mixed. Disposable personal income was estimated to have risen sharply in January, but the increase was partly the result of special factors, such as pay raises for federal and military personnel and cost-of-living adjustments to Social Security payments. Meanwhile, readings on consumer sentiment, which had been favorable in recent months, edged down in early March. The boost to consumer spending from earlier gains in wealth was likely being muted by the lagged effects of the upward trend in borrowing costs. In addition, recent declines in equity prices and slowing house price appreciation pointed to a modest reduction in households' wealth-to-income ratio in the first quarter. Housing starts declined in January, extending the downward trend that had been in place since early 2006, but bounced back in February. However, adjusted permit issuance in the singlefamily sector continued to step down, suggesting that builders were still slowing the pace of new construction to work off elevated inventories. The inventory of new homes for sale remained high, although cuts in residential construction in the last few months had reduced the number of unsold homes. As at the time of the January meeting, available data suggested that housing demand was stabilizing. Sales of both new and existing single-family homes in recent months were, on balance, in line with the pace seen since mid-2006. However, a tightening of standards for subprime borrowers in recent weeks seemed likely to restrain home sales. House price appreciation had slowed further, with some measures showing outright declines in home values. 200 94th Annual Report, 2007 Business fixed investment had been sluggish in recent months. Real spending on equipment and software fell in the fourth quarter, and nominal orders for and shipments of nondefense capital goods excluding aircraft posted widespread declines in January, with transportation equipment showing a very large drop. Business purchases of light vehicles remained low, and new orders for and deliveries of medium and heavy trucks plunged in the last few months after a surge in 2006. Investment in goods and services other than transportation and high-tech equipment softened more than fundamentals had suggested. Declines in spending for capital equipment that is used heavily in the construction and motor vehicle industries accounted for an outsized share of the drop in orders and shipments at manufacturers outside high-tech and transportation in January. Investment in categories such as industrial equipment; electromedical, measuring, and controlling devices; and other electrical equipment also softened. In contrast, computer imports surged in January, suggesting rising domestic purchases, and computer sales appeared to have picked up in February. The ample cash reserves held by firms and ongoing reductions in the user cost of high-tech capital goods remained supportive of investment going forward. Businesses accumulated inventories of items other than motor vehicles at a slower pace in January than in the previous two quarters. Even so, the ratio of inventories to sales for manufacturing and trade excluding motor vehicles remained elevated. In addition, purchasing managers at manufacturing firms, on net, continued to view their customers' inventory levels as too high. The U.S. international trade deficit narrowed considerably in the fourth quarter. Exports rose, partly reflecting a robust increase in deliveries of civilian aircraft to foreign buyers, while imports were pushed down by a fall in the volume and price of imported oil. In January, the trade deficit was little changed. Economic activity in the advanced foreign economies accelerated in the fourth quarter. In Japan, private consumption rebounded strongly, and private investment and net exports continued to boost growth. The pace of economic expansion in the euro area picked up as investment and exports rose. Growth in the United Kingdom firmed because of brisk investment spending and a rebound in consumption growth. In contrast, output in Canada decelerated in the fourth quarter as inventory accumulation turned down sharply. Recent data for the emergingmarket economies pointed to continued strength in activity, although there were signs that growth was moderating in some countries. Growth remained solid in China but decelerated in several other Asian economies and Mexico. In January, the overall PCE price index rose moderately as a decline in energy prices helped to offset a jump in food prices. Meanwhile, the PCE price index excluding food and energy rose at a faster pace than in the previous two months. Increases in consumer energy prices and higher prices for fruits and vegetables in February reflected a period of unusually cold weather and contributed to an acceleration in that month's CPI. Excluding food and energy, core CPI inflation slowed slightly in February but remained elevated. In recent months, prices had risen across a broad range of core goods. On a twelvemonth-change basis, core CPI inflation in February was considerably above its pace a year earlier, largely because of a sharp acceleration in shelter rents over the past year. Average hourly earnings also rose at a noticeably faster pace dur- Minutes of FOMC Meetings, March 201 ing the year ending in February than during the preceding twelve-month period. Surveys indicated that households' expectations of inflation over the next year were little changed in February while households' and professional forecasters' longer-term inflation expectations edged lower. At its January meeting, the Federal Open Market Committee maintained its target for the federal funds rate at 5x/4 percent. The Committee's accompanying statement noted that recent indicators had suggested somewhat firmer economic growth and that some tentative signs of stabilization had appeared in the housing market. Overall, the economy seemed likely to expand at a moderate pace over coming quarters. Readings on core inflation had improved in recent months, and inflation pressures seemed likely to moderate over time, but the high level of resource utilization had the potential to sustain inflation pressures. The Committee judged that some inflation risks remained. The extent and timing of any additional firming that might be needed to address these risks would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. The FOMC's decision at its January meeting was in accord with market expectations, but the accompanying statement reportedly was read as a sign that the Committee was more sanguine about inflation prospects than in December, and the expected path for monetary policy beyond 2007 edged lower. Policy expectations declined a bit more in the wake of the Chairman's semiannual monetary policy testimony, which apparently reinforced investors' beliefs that the FOMC anticipated gradually diminishing inflation pressures. Economic data releases were somewhat weaker than expected on balance over the first few weeks of the intermeeting period, and policy expectations moved appreciably lower on net by mid-February. Financial market volatility increased sharply in the second half of the intermeeting period amid an apparent pullback from risk-taking that was reportedly spurred by mixed news on domestic economic activity, mounting concerns about the subprime mortgage sector, and significant declines in foreign equity prices. On net over the intermeeting period, investors tilted their anticipated path for monetary policy beyond mid2007 down substantially, and yields on two- and ten-year nominal Treasury securities fell 30 to 40 basis points. Yields on inflation-indexed Treasury securities generally declined somewhat less than their nominal counterparts, leaving inflation compensation slightly lower across the term structure. Broad stock price indexes dropped several percent on net over the period. Yields on investment-grade corporate bonds fell about in line with those on Treasury securities of comparable maturity. In contrast, yields on speculative-grade bonds declined only modestly, leaving risk spreads noticeably wider, albeit still narrow by historical standards. Domestic nonfinancial sector debt appeared to be continuing to rise at a relatively brisk rate in the first quarter. Despite the recent volatility in financial markets, funding in the bond and syndicated loan markets appeared to remain readily available. However, borrowing by nonfinancial corporations was estimated to be moderating somewhat in the first quarter, with a step-down in bond issuance associated with merger and acquisition activity. Indicators pointed to a continuing deceleration in house prices this quarter, and home mortgage borrowing probably continued to slow. M2 increased more moderately in February than at the end of 2006 as the expansion 202 94th Annual Report, 2007 of liquid deposits slowed from its outsized fourth-quarter rate. In its forecast prepared for this meeting, the staff marked down the projected increase in real GDP in the first quarter in response to weaker-than-expected incoming data on business equipment spending and federal defense purchases. The recent increase in oil prices and decline in equity prices, along with increased strains in the subprime mortgage sector, were expected to exert some drag on real activity over the remainder of the year. Even so, real GDP growth was expected to pick up to a rate a little below that of the economy's long-run potential for the remainder of 2007, as declines in residential construction activity lessened, and to remain at a similar rate in 2008. The increase in energy prices over the intermeeting period led the staff to revise up its forecast for headline PCE inflation during the first half of this year, but the staff continued to expect that core PCE inflation would edge down over the remainder of this year and next. In their discussion of the economic situation and outlook, meeting participants agreed that, while recent economic data had been mixed, the economy was likely to expand at a moderate pace in coming quarters. Although the housing sector adjustment continued, accumulating data suggested that the demand for homes was leveling out. Business fixed investment had been soft in recent months, but financing conditions and other fundamentals remained favorable for a pickup in capital spending. Moreover, continuing gains in personal income could be expected to support growth in consumer spending. Thus economic growth likely would increase in coming quarters to a pace close to or modestly below the economy's trend growth rate. However, additional evidence of sluggish business investment and recent developments in the subprime mortgage market suggested that the downside risks relative to the expectation of moderate growth had increased in the weeks since the January FOMC meeting. At the same time, the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected; that risk remained the Committee's predominant concern. Participants reported signs of stabilization in housing demand in most regions of the country. At the national level, sales of new and existing homes, while fluctuating in recent months, did not display declining trends. The inventory of new homes for sale reportedly had fallen further from its recently elevated level. Participants noted, however, that such inventories likely would need to be worked down appreciably more before growth in housing construction would resume. The increase in delinquencies on subprime adjustable-rate mortgage loans and the ensuing increase in interest rates and tightening of credit standards in the subprime mortgage market likely would constrain home purchases by some borrowers, perhaps retarding the recovery in the housing sector. However, there was no sign of spillovers from the subprime market to the overall mortgage market; indeed, interest rates on prime mortgage loans had declined somewhat in recent weeks, along with yields on U.S. Treasury securities. Moreover, home-buying attitudes had improved and continuing job growth could be expected to support home sales. Minutes of FOMC Meetings, March 203 Business fixed investment spending had been surprisingly weak of late, given strong corporate balance sheets, high profitability, anticipated growth in sales, and favorable financial conditions. Participants continued to expect these fundamentals to support a firming of investment spending going forward, and they saw no indication that recent market volatility had prompted a reduction in the availability of financing for business investment. Also, declining office vacancy rates in some areas were spurring gains in nonresidential construction activity, and further advances in commercial construction were seen as likely. Energy prices were high enough to encourage continued investment in alternative fuels. However, the relatively slow pace of investment in recent months might be signaling that business executives had become less certain about the outlook, and perhaps that they expected quite modest gains in sales. Participants agreed that the possibility of persistently sluggish investment spending was an important downside risk to the outlook for economic growth. Growth in consumer spending would likely continue to be supported by gains in employment and incomes. Meeting participants noted that weakness in the housing market had not spilled over to aggregate consumption—though the flattening out in house prices likely would contribute to an increase in the personal saving rate—and turmoil in the subprime mortgage market did not appear to be generating any diminution in the availability of other types of household credit. The recent increase in oil prices and the reduction in household net worth resulting from the small net declines in equity prices during the intermeeting period warranted a modest downward adjustment in projected growth of consumer spending. Even so, the possibility that the personal saving rate would fail to rise as projected in the staff forecast remained an upside risk to the outlook. Growth in federal as well as state and local government spending probably would remain a source of stimulus to the economy. Moreover, continued expansion in domestic demand in our major trading partners could be expected to sustain solid growth in U.S. exports. Many participants again reported softness in manufacturing, primarily but not exclusively in industries related to housing or automobiles. However, a number of firms outside of the housing sector— including auto companies—appeared to have made progress in reducing inventories to more comfortable levels, and contacts in the industrial sector were generally optimistic about future growth. Such attitudes were consistent with national and regional surveys that pointed to a rebound in manufacturing activity later this year. Anecdotal and statistical evidence suggested that labor markets remained relatively tight. Business contacts continued to report shortages of skilled workers in technical and professional fields, with significant wage pressures in some occupations, as well as a scarcity of less skilled and unskilled workers in some areas of the country. So far, aggregate measures of labor compensation were showing only moderate increases, but, looking ahead, the possibility that labor costs might rise more rapidly was seen as an upside risk to inflation. It was noted, however, that increases in compensation that exceeded productivity gains might be absorbed to some extent by a narrowing of firms' high profit margins. Participants expected that productivity growth would pick up as firms slowed hiring to a pace more in line with output growth but acknowledged that the improvement might 204 94th Annual Report, 2007 be limited, particularly if business investment spending were to remain soft. Most participants continued to expect a gradual decline in core inflation over the next year or two, fostered by stable inflation expectations, a likely deceleration in shelter costs, and a slight easing of pressures on resources. Nonetheless, all meeting participants expressed concern about the risks to this outlook. The latest readings on core inflation were higher than expected, and it was difficult to discern whether the apparent downward trend in core inflation during the past few quarters was continuing. Also, the recent increases in prices for energy and some non-energy imports likely would boost overall inflation in the near term and might put upward pressure on prices of some core goods and services. Moreover, rates of resource utilization that were near the high end of historical experience suggested a possibility that inflation pressures could build. Participants agreed that risks around the expected and desired path of a gradual decline in core inflation remained mainly to the upside; some noted that upside risks to inflation appeared to have increased slightly in recent months. In the Committee's discussion of monetary policy for the period between its March and May meetings, all members favored keeping the target federal funds rate at 5lA percent. Recent developments were seen as supporting the Committee's view that maintaining the current target was likely to foster moderate economic growth and to further the gradual reduction of core inflation from its elevated level. Nonetheless, the combination of generally weaker-thanexpected economic indicators and uncomfortably high readings on inflation suggested increased downside risks to economic growth and greater uncer tainty that the expected gradual decline in core inflation would materialize. In light of the recent economic data and anecdotal information, the Committee agreed that the statement to be released after the meeting should note that economic indicators had been mixed, that the adjustment in the housing market was ongoing, and that the economy seemed likely to expand at a moderate pace over coming quarters. Members agreed the statement also should indicate that inflation pressures seemed likely to moderate over time, but that recent readings on core inflation had been somewhat elevated and the high level of resource utilization had the potential to sustain inflation pressures. A persistence of inflation at recent rates could eventually have adverse consequences for economic performance. All members agreed the statement should indicate that the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. The Committee agreed that further policy firming might prove necessary to foster lower inflation, but in light of the increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming. Instead, the statement should indicate that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The Federal Open Market Committee seeks monetary andfinancialconditions that Minutes of FOMC Meetings, May 205 will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5lA percent. It was agreed that the next meeting of the Committee would be held on Wednesday, May 9, 2007. The meeting adjourned at 1:30 p.m. The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.: By notation vote completed on February 20, 2007, the Committee unanimously approved the minutes of the FOMC meeting held on January 30-31, 2007. In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Votes for this action: Messrs. Bernanke, Geithner, Hoenig, Kohn, and Kroszner, Ms. Minehan, Messrs. Mishkin, Moskow, Poole, and Warsh. Votes against this action: None. Notation Vote Vincent R. Reinhart Secretary Meeting Held on May 9, 2007 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Wednesday, May 9, 2007 at 8:30 a.m. The Committee then returned to the topic of improving policy communica- Present: Mr. Bernanke, Chairman tions. Participants expressed a range of Mr. Geithner, Vice Chairman views on the possible advantages and Mr. Hoenig disadvantages of specifying a numerical Mr. Kohn price objective for monetary policy and Mr. Kroszner on technical aspects of a quantification. Ms. Minehan Mr. Mishkin Participants emphasized that any such Mr. Moskow move would need to be consistent with Mr. Poole the Committee's statutory objectives for Mr. Warsh promoting maximum employment as Mr. Fisher, Ms. Pianalto, and Messrs. well as price stability. The Committee Plosser and Stern, Alternate Memmade no decisions on this issue. Particibers of the Federal Open Market pants also discussed the communicaCommittee tions role of the economic projections Messrs. Lacker and Lockhart, and Ms. that are made periodically by the memYellen, Presidents of the Federal bers of the Board of Governors and the Reserve Banks of Richmond, AtReserve Bank presidents. A number of lanta, and San Francisco, respectively substantive and practical issues would still need to be evaluated before the Mr. Reinhart, Secretary and Economist Committee could make decisions about Ms. Danker, Deputy Secretary an enhanced role for projections in exMs. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary plaining policy. The Committee planned Mr. Alvarez, General Counsel to continue its review of communication Mr. Baxter, Deputy General Counsel issues at the FOMC meeting in June Ms. Johnson, Economist 2007. Mr. Stockton, Economist 206 94th Annual Report 2007 Messrs. Connors, Evans, Kamin, Madigan, Rasche, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Messrs. Clouse and English, Associate Directors, Division of Monetary Affairs, Board of Governors Ms. Liang and Mr. Struckmeyer, Associate Directors, Division of Research and Statistics, Board of Governors Messrs. Leahy and Wascher, Deputy Associate Directors, Divisions of International Finance and Research and Statistics, respectively Mr. Dale, Senior Adviser, Division of Monetary Affairs Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Mr. Carlson, Economist, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Green, First Vice President, Federal Reserve Bank of Richmond Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas Mr. Hakkio, Ms. Perelmuter, Messrs. Rolnick, Rudebusch, Sniderman, and Weinberg, Senior Vice Presidents, Federal Reserve Banks of Kansas City, New York, Minneapolis, San Francisco, Cleveland, and Richmond, respectively Messrs. Dotsey, Tallman, and Tootell, Vice Presidents, Federal Reserve Banks of Philadelphia, Atlanta, and Boston, respectively The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market transactions in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. By unanimous vote, the Committee extended for one year beginning in midDecember 2007 the reciprocal currency ("swap") arrangements with the Bank of Canada and the Banco de Mexico. The arrangement with the Bank of Canada is in the amount of $2 billion equivalent and that with the Banco de Mexico is in the amount of $3 billion equivalent. Both arrangements are associated with the Federal Reserve's participation in the North American Framework Agreement of 1994. The vote to renew the System's participation in the swap arrangements maturing in December was taken at this meeting because of the provision that each party must provide six months' prior notice of an intention to terminate its participation. The information reviewed at the May meeting suggested that economic activity had expanded at a below-trend pace in recent months. Gains in payroll employment had moderated, and the unemployment rate appeared to have stabilized after a period of decline. Housing construction remained under pressure from weak demand and large inventories of unsold homes, and consumer spending appeared to have slowed in recent months. Business fixed investment Minutes of FOMC Meetings, May 207 remained subdued. Manufacturing pro- and light trucks moved up in the first duction, however, showed signs of quarter, but eased a bit in April. Real strengthening after a period of consider- spending on goods other than motor veable softness. Rising energy prices hicles, which had shown exceptional pushed up total PCE price inflation in vigor late last year, was broadly flat beMarch, while the twelve-month increase tween December and March. However, in core PCE prices was just slightly outlays on non-energy services were reabove its year-earlier pace. ported to have posted solid gains, espeThe average monthly increase in pay- cially in March. Real disposable perroll employment through the first four sonal income rose smartly in the first months of this year was well below the quarter. Wages and salaries increased relatively strong pace recorded in the solidly, on average, and the Bureau of fourth quarter of 2006. In April, the con- Economic Analysis estimated that instruction industry continued to shed come in January was boosted by unusujobs, manufacturing employment de- ally large bonus payments and stock opclined further, and retailers reduced hir- tion exercises. The household wealth-toing after a large gain in March. The un- income ratio likely ticked down in the employment rate stood at 4.5 percent in first quarter, as the stock market rose April, similar to its average in the first only a little and house prices remained quarter, and the labor force participation soft. However, given the surge in stock prices in April, much of the lost ground rate moved down. Industrial production increased at a had probably since been made up. modest annual rate of 1.4 percent in the Residential construction activity refirst quarter, with the monthly pattern mained soft as builders attempted to reflecting fluctuations in the output of work off elevated inventories of unsold utilities, which was influenced impor- new homes. Single-family housing starts tantly by swings in weather conditions. moved up in March, almost certainly Manufacturing output declined, on net, boosted by unusually warm and dry over the six months ending in February weather; single-family permit issuance as a result of inventory-related adjust- also increased. Although existing home ments in a number of industries. How- sales declined in March, the level of ever, factory production turned up in sales was only slightly below the steady March. The output of high-tech indus- pace that had prevailed in the second tries rose briskly; the production of con- half of 2006. By contrast, new home sumer goods increased; and the output sales fell sharply in the first two months of business equipment, construction sup- of the year and had recovered only a bit plies, and materials picked up. The lim- in March. All told, recent readings on ited information available on industrial home sales suggested that housing deproduction for April suggested that out- mand had weakened further. Houseput had been boosted by the scheduled price appreciation continued to slow, pickup in motor vehicle assemblies. and some measures were again showing Real consumer expenditures in- declines in home values. creased at a brisk pace in the first quarReal spending on equipment and softter, although monthly gains in spending ware rose modestly in the first quarter slowed over the course of the quarter, in after having fallen in the fourth quarter part because of swings in weather- of 2006. Spending on high-tech equiprelated outlays on energy goods and en- ment, boosted by a surge in outlays on ergy services. Retail sales of both autos computers, posted a substantial increase 208 94th Annual Report, 2007 in the first quarter. In addition, purchases of communications equipment— which tend to be volatile quarter to quarter—rebounded strongly after a fourth-quarter dip. By contrast, spending on transportation equipment declined significantly: Although domestic spending on aircraft jumped after three weak quarters, purchases of medium and heavy trucks dropped sharply, largely as a consequence of a pull-forward of truck purchases in the latter part of last year in anticipation of the tighter emissions standards that took effect in January. Business investment in equipment other than high-tech and transportation dropped in the first quarter, although the weakness in this broad category appeared to have been especially pronounced around the turn of the year and to have lessened somewhat over the course of the quarter. Robust corporate cash reserves and continuing declines in the user cost of high-tech goods remained supportive of equipment and software spending going forward. Real outlays for nonresidential construction regained some momentum in the first quarter of this year after having hit a lull in late 2006. Real nonfarm inventory investment excluding motor vehicles increased at a slower pace in the first quarter of 2007 than in the previous quarter. The downshift in inventory investment had helped to reduce the apparent overhangs that had emerged in late 2006. In the motor vehicle sector, the sharp decline in the pace of assemblies over the past few quarters appeared to have brought inventories back into line with sales. In April, surveys indicated that the net number of firms who viewed their customers' inventory levels as too high had dropped back from elevated readings over the previous two quarters. The U.S. international trade deficit narrowed in February, reflecting a steep drop in imports, which more than offset a sizable decline in exports. Within imports, the value of oil imports plunged, reflecting decreases in both prices and quantities, and imports of industrial supplies, capital goods, and automotive parts also fell. The lion's share of the February decline in exports was of capital goods. Smaller decreases occurred in exports of industrial supplies, consumer goods, and services. Economic activity in advanced foreign economies appeared to have grown at a steady rate in the first part of the year. Canada's growth seemed to have rebounded from a disappointing fourth quarter. Renewed household demand in Japan pointed to further strong growth in the first quarter, while investment demand seemed to be underpinning growth in the United Kingdom. Although euroarea exports had slowed from the rapid pace set in the fourth quarter and the hike in the German value-added tax likely depressed consumption, overall economic conditions remained solid. Economic activity in the emerging market countries appeared to have continued to advance at a robust pace in the first quarter. Surging growth in China was a highlight of the strong performance of most countries in Asia. In Latin America, indicators pointed to further lackluster growth in Mexico and some weakening in Argentina, but in other countries, especially Brazil, conditions appeared more positive. The total PCE price index rose substantially in both February and March. The advance in February was distributed across a broad range of categories, while the March increase was driven largely by a jump in the index for energy. Core PCE prices were unchanged in March after an upswing in February. Smoothing through the high-frequency movements, the twelve-month change in the core PCE price index in March was Minutes of FOMC Meetings, May 209 just a touch higher than the increase over the year-earlier period. Accelerations in the costs of housing and medical services were major contributors to both core CPI and core PCE inflation over the past year. Household surveys conducted in April indicated that the median expectation for year-ahead inflation had moved up, consistent with the recent pickup in headline CPI inflation. Median expectations of longer-term inflation had edged higher but were still in the narrow range seen over the past few years. Average hourly earnings for production or nonsupervisory workers, which had accelerated noticeably over the past couple of years, posted moderate increases in March and April. At its March meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5V4 percent. The Committee's accompanying statement noted that recent economic indicators had been mixed and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Recent readings on core inflation had been somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Market participants had largely anticipated the FOMC's decision at its March meeting to leave the target federal funds rate unchanged. Nevertheless, the expected path for monetary policy moved lower on the announcement, as investors apparently interpreted the accompany ing statement as suggesting that the Committee's economic outlook had become somewhat more balanced. However, subsequent FOMC communications—including the Chairman's testimony before the Joint Economic Committee, speeches by various FOMC members, and the minutes from the March meeting—were generally seen as emphasizing the Committee's concern about upside risks to inflation. Over the intermeeting period, yields on nominal Treasury securities edged up at all maturities. Measures of inflation compensation based on inflation-indexed Treasury securities were little changed despite a significant rise in oil prices. Yields on investment-grade corporate bonds rose in line with those on comparablematurity Treasury securities, leaving their spreads little changed at fairly low levels. Spreads on speculative-grade corporate bonds narrowed. Equity prices climbed steeply amid solid earnings reports and improved sentiment, more than reversing the declines in the previous intermeeting period. The foreign exchange value of the dollar against other major currencies moved lower, on balance. Gross bond issuance by nonfinancial businesses slowed from its torrid firstquarter pace in April, but acquisitionrelated financing continued to fuel the issuance of both investment- and speculative-grade corporate bonds. Commercial paper outstanding declined, but bank lending accelerated. In the household sector, the rise in home mortgage debt likely slowed a bit further in the first quarter, as home-price appreciation appeared to have remained sluggish. Consumer credit continued to expand at a moderate pace early in the year. M2 accelerated during March and April, primarily reflecting faster growth in liquid deposits, which were likely boosted in April by tax-related flows. 210 94th Annual Report, 2007 In its forecast prepared for this meeting, the staff expected the pace of economic activity to pick up from weak first-quarter growth to a rate a little below that of the economy's long-run potential for the remainder of this year and to increase at a pace broadly in line with potential output in 2008. The projected gradual acceleration in economic activity largely reflected the expected waning of the drag from residential investment, although recent readings on sales and inventories of new homes had been interpreted by the staff as suggesting that the ongoing contraction in residential investment would continue for longer than previously expected. In response to data received over the past year, the staff had marked down slightly its estimate of structural productivity growth and nudged up its estimate for the increase in labor supply—leaving its estimate of the overall growth of potential GDP broadly unchanged. The increases in energy and other commodity prices over the intermeeting period had led the staff to revise up its forecast for headline PCE inflation during the first half of the year. Nonetheless, the staff continued to expect core inflation to edge lower over the course of the next two years. In their discussion of the economic situation and outlook, participants noted that their assessments of the mediumterm prospects for economic growth and inflation had not changed materially from the previous meeting. The pace of economic expansion had slowed in the first part of this year, but the recent subpar performance probably exaggerated the weakness of underlying demand, and the rate of economic growth was expected to pick up in coming quarters. Meeting participants anticipated that real GDP would advance at a pace a little below the economy's trend rate of growth through the remainder of this year and then pick up to a rate broadly in line with the economy's trend rate in 2008. Most participants continued to expect core inflation to slow gradually, although considerable uncertainty surrounded that judgment and the Committee's predominant concern remained the risk that inflation would fail to moderate as expected. The incoming data on new home sales and inventories suggested that the ongoing adjustment in the housing market would probably persist for longer than previously anticipated. In particular, the demand for new homes appeared to have weakened further in recent months, and the stock of unsold homes relative to sales had increased sharply. That said, participants also noted that sales of existing homes appeared to have held up somewhat better since the beginning of the year. Moreover, the turmoil in the subprime market evidently had not spread to the rest of the mortgage market; indeed, mortgage rates available to prime borrowers remained well below their levels of last summer. Nevertheless, most participants agreed that, although the level of inventories of unsold homes that homebuilders desired was uncertain, the correction of the housing sector was likely to continue to weigh heavily on economic activity through most of this year—somewhat longer than previously expected. Growth in consumer spending appeared to have slowed over the past few months. Real spending on goods had flattened out, and contacts in both the retail sector and the consumer credit sector reported a softening in the expansion of demand. In contrast to the rapid gains of recent years, meeting participants expected household expenditure to grow at a more moderate pace in coming quarters. Consumption was likely to be supported by continued advances in employment and incomes, as well as gains in stock prices; but the recent increases Minutes of FOMC Meetings, May 211 in gasoline prices probably would damp households' spending power in the near term, and the effect of the anticipated leveling out in home-price appreciation on household wealth was expected to contribute to a gradual increase in the personal saving rate over the medium run. Participants remained concerned that the housing market correction could have a more pronounced impact on consumer spending than currently expected, especially if house prices were to decline significantly. The growth of business fixed investment seemed most likely to move higher in coming quarters, supported by strong corporate balance sheets and profits, favorable financial conditions, and a gradual strengthening in business output. The downside risks to business capital spending appeared to have diminished somewhat since the previous meeting. In particular, participants took note of the upturn in orders and shipments of capital goods, and of more upbeat surveys of business conditions. However, participants cautioned against drawing too much comfort from the most recent few data observations, and recognized that the current sluggishness of equipment outlays could persist for longer than currently anticipated, especially if financial market conditions became less supportive. Participants were also encouraged that, outside of the construction sector, the correction of inventories to more comfortable levels appeared well advanced, thus reducing the possibility that going forward this adjustment process could trigger shortfalls in business spending and output. Economic activity in the rest of the world continued to advance briskly. Participants noted that strong foreign expansion should help to underpin demand for U.S. exports, but expressed some concern that the strength of global demand could contribute to price pressures at home. Prices of non-energy commodities, especially metals, had moved up markedly since the previous meeting. Moreover, inflationary pressures in a number of overseas economies appeared to have increased of late, perhaps partly in response to heightened levels of capacity utilization in those countries, and this development had the potential to add to the prices of U.S. imports. In that regard, several participants noted that the decline in the foreign exchange value of the dollar over the intermeeting period could reinforce the upward pressure on import prices. Participants discussed how best to reconcile the slowdown in output growth over the past year with the relatively strong performance of the labor market. This apparent tension could partly reflect measurement issues; in particular, participants noted that the more-rapid gains in estimates of gross domestic income over this period might better capture the pace of activity than the modest advances in measured GDP. Aside from measurement problems, a possible explanation was that these differing trends largely related to the lagged adjustment of employment to the slowing pace of expansion. In that regard, several participants observed that the recent moderation in economic growth had been concentrated in the construction sector, but that measured employment in construction had not yet declined by a corresponding amount. This suggested that increases in overall employment in coming quarters may possibly be held down by notable declines in construction employment as the adjustment of the labor force in that sector played out. A slowing in employment could then occur in conjunction with a strengthening in productivity growth. Alternatively, some of the recent weakness in measured productivity growth could reflect a decline in the un- 212 94th Annual Report, 2007 derlying trend in productivity and so might persist. Although this explanation might help account for some of the downshift in measured productivity growth, participants agreed that there appeared to be little other evidence pointing to a significant slowing of advances in structural productivity. In the context of this discussion, many participants commented that their view of potential output growth was somewhat more optimistic than that of the staff. Labor markets appeared to remain relatively tight. Unemployment continued around the low levels seen since last fall, and many business contacts reported difficulties in recruiting suitably qualified workers, especially for certain types of professional and skilled positions. However, several participants observed that aggregate measures of labor compensation had so far increased only modestly, perhaps suggesting that the labor market might be less stretched than it appeared. Moreover, even if wages and salaries did accelerate, the resulting cost pressures might be absorbed by a narrowing in firms' profit margins from current elevated levels, rather than being passed on in the form of higher prices. On the other hand, some participants reported that their business contacts appeared very resistant to any squeeze in profit margins. All told, for most participants, the apparent tightness of the labor market remained a significant source of upside risk to inflation. Nearly all participants viewed core inflation as remaining uncomfortably high and stressed the importance of further moderation. Although readings on core inflation in March had been more favorable, this followed several months of elevated inflation data and price pressures were not yet viewed as convincingly on a downward trend. Most participants expected core inflation to moderate gradually, fostered in part by stable inflation expectations and a likely deceleration in shelter costs. Some participants also expected the anticipated slight easing of pressures on resources to help nudge inflation lower, although others felt that small movements in resource utilization were unlikely to have discernible effects on inflation. All participants agreed that the risks around the anticipated moderation in inflation were to the upside; and some noted that a failure of inflation to moderate could entail significant costs particularly if it led to an upward drift in inflation expectations. In the Committee's discussion of monetary policy for the intermeeting period, all members favored keeping the target federal funds rate at 5lA percent. Recent developments were seen as supporting the Committee's view that maintaining the current target rate was likely to foster moderate economic growth and a gradual ebbing in core inflation. Members continued to view the risks to economic activity as weighted to the downside, although with turmoil in the subprime market appearing to have remained relatively well contained and business spending indicators suggesting a more encouraging outlook, these downside risks were judged to have diminished slightly. Members agreed that considerable uncertainty attended the prospects for inflation, and the risk that inflation would fail to moderate as desired remained the Committee's predominant concern. In light of the recent economic data and anecdotal information, the Committee agreed that the statement to be released after the meeting should acknowledge that economic growth had slowed in the first part of the year. The Committee thought that the statement should reiterate the view that the adjustment in the housing market was ongoing, but that nevertheless the economy seemed likely to expand at a moderate Minutes of FOMC Meetings, June 213 pace over coming quarters. While readings on core inflation were lower in March, members felt that it was appropriate to emphasize that core inflation remained somewhat elevated. The Committee agreed that the statement should continue to note that their predominant policy concern was the risk that inflation would fail to moderate as expected, and that future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The meeting adjourned at 1:15 p.m. Notation Vote By notation vote completed on April 10, 2007, the Committee unanimously approved the minutes of the FOMC meeting held on March 20-21, 2007. Vincent R. Reinhart Secretary Meeting Held on June 27-28, 2007 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Wednesday, June 27, 2007 at 2:00 p.m. and continued on Thursday, June 28, 2007 at 9:00 a.m. The Federal Open Market Committee seeks monetary andfinancialconditions that will foster price stability and promote sus- Present: Mr. Bernanke, Chairman tainable growth in output. To further its Mr. Geithner, Vice Chairman long-run objectives, the Committee in the Mr. Hoenig immediate future seeks conditions in reserve Mr. Kohn markets consistent with maintaining the fedMr. Kroszner eral funds rate at an average of around Ms. Minehan 5V4 percent. Mr. Mishkin The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.: In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Votes for this action: Messrs. Bernanke, Geithner, Hoenig, Kohn, and Kroszner, Ms. Minehan, Messrs. Mishkin, Moskow, Poole, and Warsh. Votes against this action: None. Meeting participants briefly discussed the next steps in their review of communication issues and agreed to consider them at the next FOMC meeting, confirmed for June 27-28, 2007. Mr. Moskow Mr. Poole Mr. Warsh Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Reinhart, Secretary and Economist Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Ms. Johnson, Economist Mr. Stockton, Economist Messrs. Connors, Evans, Fuhrer, Madigan, Rasche, Sellon, Slifman, and Wilcox, Associate Economists 214 94th Annual Report, 2007 Mr. Dudley, Manager, System Open Market Account Messrs. Clouse and English, Associate Directors, Division of Monetary Affairs, Board of Governors Ms. Liang and Mr. Struckmeyer, Associate Directors, Division of Research and Statistics, Board of Governors Messrs. Leahy and Wascher, Deputy Associate Directors, Divisions of International Finance and Research and Statistics, respectively, Board of Governors Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Gross,7 Special Assistant to the Board, Office of Board Members, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Ahmed8 and Ms. Kusko,8 Senior Economists, Divisions of International Finance and Research and Statistics, respectively, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Beechey and Mr. Natalucci,8 Economists, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Moore, First Vice President, Federal Reserve Bank of Cleveland 7. Attended portion of the meeting relating to monetary policy communications. 8. Attended portion of the meeting relating to the economic outlook and monetary policy discussion. Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas Ms. Mester, Messrs. Sniderman, Weinberg, and Williams, Senior Vice Presidents, Federal Reserve Banks of Philadelphia, Cleveland, Richmond, and San Francisco, respectively Ms. McLaughlin and Mr. Tallman, Vice Presidents, Federal Reserve Banks of New York and Atlanta, respectively Ms. McConnell, Assistant Vice President, Federal Reserve Bank of New York Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis The information reviewed at the June meeting suggested that the expansion of economic activity rebounded in the second quarter from its subpar pace in the first quarter. Upswings in net exports and inventory investment were expected to contribute importantly to the rise in real GDP. Consumer spending appeared to have slowed from its rapid pace earlier in the year, while business fixed investment continued to rise at a modest rate. Residential construction remained weak as builders worked further to clear high inventories of unsold homes. Sharp increases in energy prices drove up overall inflation in April and appeared to have done so again in May; core inflation seemed to have remained subdued. Employment continued to rise at a moderate pace; the average monthly increase in payroll employment in April and May was a little below that of the first quarter. In May, employment was boosted by strong hiring in the service sector, but the manufacturing and retail sectors continued to shed jobs. Larger payrolls and a slightly longer average workweek in May led to an increase in Minutes of FOMC Meetings, June 215 aggregate hours; the unemployment rate construction activity. In May, singlefamily housing starts declined, and adheld steady at 4.5 percent. Industrial production increased mod- justed permit issuance for the singleestly in April and May after having been family sector stepped down further, little changed in the first quarter when indicating that builders were intending some manufacturers restrained produc- to slow further the pace of new contion to cope with a buildup in invento- struction. The monthly readings on sales ries. Manufacturing output edged up in of new and existing homes through May recent months, reflecting increases in had fluctuated around levels lower than the output of light motor vehicles, other the average over the second half of consumer durable goods, construction 2006. Some, though not all, of this supplies, and durable materials. The pro- weakening in home sales was likely reduction of high-tech industries also rose, lated to the tightening of lending stanalbeit at a relatively sluggish pace com- dards for nonprime borrowers that bepared with the brisk expansion seen gan in February. Even though the around the turn of the year. Capacity inventory of new homes for sale ticked utilization in the manufacturing sector down in May, the months' supply in in May was close to its long-run average May remained noticeably above its level and slightly below its level one year in late 2006. According to OFHEO's purchase-only price index for existing earlier. The pace of real consumer spending homes, house-price appreciation continappeared to have slowed somewhat in ued to slow in the first quarter. the second quarter after substantial inOutlays for nonresidential construccreases late last year and early this year. tion appeared to have remained robust The deceleration primarily reflected a early in the second quarter. Business flattening out of outlays for goods in spending on equipment and software in recent months; spending on services recent months appeared to be about uncontinued to rise at a solid pace for the changed from the first quarter, although quarter as a whole, although the monthly the softness was largely confined to outpattern was affected by weather-related lays for transportation equipment. Shipswings in outlays on energy services. ments and orders for items other than The determinants of household spend- transportation moved up markedly in ing were broadly supportive. Real dis- March and April after weakness in earposable personal income rose at a mod- lier months, and, even with the small erate pace, on average, in the first four declines in May, the data pointed to a months of the year, boosted not only by healthy rise in outlays in the second ongoing gains in wages and salaries, but quarter. In particular, real spending on also by unusually large bonus payments equipment other than high-tech and and stock option exercises in the first transportation seemed to be rebounding quarter. Although the household wealth- after sizable declines over the previous to-income ratio ticked down in the first two quarters. After a surge in outlays on quarter with the stock market up only a computers in the first quarter, spending little and house prices remaining soft, on high-tech equipment appeared to be the increase in stock prices in the second rising at a more modest pace in April quarter likely made up much of the lost and May. In contrast, spending on transground. portation equipment declined signifiElevated inventories of unsold new cantly. Purchases of medium and heavy homes continued to weigh on residential trucks dropped further in May, continu 216 94th Annual Report, 2007 ing to reflect the payback from sales that were pulled forward into 2005 and 2006 in anticipation of tighter emissions standards that took effect in January. New orders for trucks picked up in May, albeit from very low levels. Shipments data indicated that spending on aircraft dropped back from the elevated level in the first quarter. The downtrend in the cost of capital was likely curtailed in recent weeks by the rise in corporate bond rates. Nonetheless, firms retained ample cash in reserve to finance investment. Real nonfarm inventory investment excluding motor vehicles slowed appreciably in the first quarter of 2007, as firms in most industries appeared to have made considerable progress in addressing the inventory overhangs that developed in 2006. The adjustment apparently continued into the second quarter, as the ratio of inventories to sales for manufacturing and trade excluding motor vehicles ticked down further in April after a March decline. Inventories of light motor vehicles, which were pared down to more comfortable levels during the first quarter, continued to edge lower through May. Indeed, the inventory adjustment reached the point that, for the third month in a row, the May survey of purchasing managers indicated that, on net, more firms viewed their customers' inventory levels as too low rather than too high. After no change between the fourth quarter and first quarter, the U.S. international trade deficit narrowed in April from its March level. The recent narrowing reflected a steep decline in many categories of goods imports and a modest increase in exports, especially of agricultural products. Nominal imports of petroleum were flat in April after surging in March despite steady increases in the price of imported oil. Economic activity in advanced foreign economies appeared to have grown at a solid rate in the first quarter. Economic growth in Canada rebounded sharply from a disappointing fourth quarter, and growth picked up in the United Kingdom, owing primarily to a robust expansion in the service sector. In the euro area, export growth in the first quarter slowed from its rapid fourthquarter pace, and the hike in the German value-added tax likely temporarily depressed first-quarter consumption growth. Consumer spending showed signs of recovering in recent months, and overall, economic conditions in the euro area remained solid. In Japan, recent data suggested that growth in the second quarter had moderated from the vigorous first-quarter pace, with public spending and net exports likely sources of weakness. Recent data indicated that economic activity in emerging-market economies remained strong. Growth in China and India appeared to have moderated somewhat from the very high rates of the first quarter. In Latin America, indicators for Mexico suggested some recovery from the marked slowdown of the previous few quarters, while growth in Argentina and Brazil appeared to pick up as well. Headline consumer price inflation stepped up in recent months, driven by large increases in the index for energy. However, readings on core inflation had declined. Core PCE prices rose 0.1 percent in April and were estimated to have posted a similar, modest increase in May. The recent readings had been held down, in part, by declines in volatile categories such as apparel and tobacco products that were likely to prove transitory; the rent components had also decelerated. The twelve-month change in core PCE prices in May was expected to be lower than the increase over the yearearlier period; however, over that longer Minutes of FOMC Meetings, June 217 period, the decline in core PCE inflation was almost entirely the result of a slowing in its nonmarket component. Household surveys conducted in early June indicated that the median expectation for year-ahead inflation increased further, consistent with the energy-driven acceleration in overall consumer prices in recent months. After edging higher in April and May, median expectations of longer-term inflation fell back in June and remained in the narrow range seen over the past two years. The twelvemonth change in average hourly earnings for production or nonsupervisory workers edged lower in recent months. At its May meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5V4 percent. The Committee's accompanying statement noted that economic growth slowed in the first part of the year and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Core inflation remained somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Market participants had largely anticipated the FOMC's decision at its May meeting to leave the target federal funds rate unchanged, but some market participants were reportedly surprised by the retention of the assessment that inflation was "somewhat elevated." The publication of the minutes of the May meeting elicited little market response. Over the intermeeting period, however, investors seemed to reappraise their beliefs that the economic expansion would slow and that monetary policy easing would be forthcoming. This reappraisal seemed to be based in part on the release of some economic data in the United States and abroad that were more favorable than expected. As a result, the expected path of the federal funds rate over the coming year was marked up sharply in financial markets. Yields on nominal Treasury securities at all maturities also rose over the intermeeting period, with the most pronounced gains in forward rates three to five years ahead. Measures of long-horizon inflation compensation based on inflation-indexed Treasury securities edged slightly higher. Yields on investment-grade corporate bonds rose in line with those on comparablematurity Treasury securities, leaving their spreads little changed. In contrast, spreads on speculative-grade corporate bonds narrowed. Equity prices were volatile at times during the intermeeting period, but broad stock price indexes advanced modestly, on net, as favorable news on the economy and announcements of mergers and acquisitions outweighed the drag of higher bond yields. The foreign exchange value of the dollar against other major currencies was little changed, on balance. Gross bond issuance by nonfinancial businesses surged in May from the already robust pace of earlier in the year. Acquisition-related financing continued to support corporate bond issuance, but a significant share of recent issues was reportedly designated for capital expenditures. Commercial paper outstanding was unchanged in May, but bank lending maintained a strong pace. In the household sector, mortgage debt expanded at a slower pace in the first quarter, reflecting the slowdown in homeprice appreciation over the past year and the lower pace of home sales. Interest 218 94th Annual Report 2007 rates available to prime borrowers on both fixed-rate and variable-rate mortgages increased along with other market interest rates. Consumer credit continued to expand at a moderate pace in the first quarter. After rising at a particularly rapid rate in the first quarter, M2 increased at a more moderate pace in April and May. In preparation for this meeting, the staff reduced its estimate of the increase in real GDP in the first quarter and marked up its forecast of the rebound in economic activity in the second quarter, in large part because of a more substantial swing in inventory investment than previously expected. The revisions, however, left the projection of economic growth over the first half of the year unchanged. As was the case in May, economic activity was expected to increase at a rate a little below that of the economy's long-run potential for the remainder of the year and to rise at a pace broadly in line with potential output growth in 2008. The projected gradual acceleration in economic activity in coming quarters largely reflected the expected waning of the drag from residential investment and improvements in the pace of business fixed investment. Increases in energy and food prices over the intermeeting period led the staff to revise up its forecast for headline PCE inflation during the second quarter, but its projection of core PCE inflation was revised down. Although some of the recent slowing in readings on core PCE inflation was likely due to transitory factors, the staff took some signal from the data and trimmed its forecast for core PCE inflation slightly in coming quarters. Over the next several quarters, total PCE inflation was projected to moderate to a pace close to core PCE inflation. In their discussion of the economic situation and outlook, participants noted that economic activity appeared to have expanded at a moderate pace on balance over the first half of the year. In view of incoming data and anecdotal information, participants continued to anticipate moderate economic growth in coming quarters, with growth rising gradually to a pace close to that of potential output. Participants interpreted the most recent information on business spending, business sentiment, and the labor market as suggesting that the risks to growth were more balanced than at the time of the May meeting, despite the ongoing adjustment in the housing sector and the significant recent increases in longerterm interest rates. Participants generally expected that inflation would probably edge lower over the next two years, reflecting the waning of temporary factors that had boosted prices last year and a slight easing of pressures on resources. Recent data on core consumer prices were encouraging in this regard, but participants were wary of drawing any firm conclusions about future trends from a few monthly readings that could reflect transitory influences and remained concerned about forces that could contribute to inflation pressures. Against this backdrop, participants agreed that the risk that inflation would fail to moderate as expected remained their predominant concern. In preparation for the Federal Reserve's semiannual report to the Congress on the economy and monetary policy, the members of the Board of Governors and the presidents of the Federal Reserve Banks submitted individual projections of the growth of nominal and real GDP, the rate of unemployment, and core consumer price inflation for the years 2007 and 2008, conditioned on their views of the appropriate path for monetary policy. The projections for the growth of nominal GDP were in the range of AVi to 5Vi percent, with a central tendency of AVi to 5 percent for Minutes of FOMC Meetings, June 219 2007; for 2008, the projections for nominal GDP growth ranged between 4Vi to 5Vi with a central tendency of 43/4 to 5 percent. Projections for the rate of expansion in real GDP in 2007 were in a range from 2 to 23A percent in 2007, with a central tendency of 2!/4 to 2x/2 percent; for 2008, the projections ranged between 2Vi to 3 percent, with a central tendency of 2Vi to 23A percent. These rates of growth were associated with civilian unemployment rates in the range of 4Vi to 43A percent in the fourth quarter of 2007 and 4V2 to 5 percent in the fourth quarter of 2008; the central tendency of these projections was 4Vi to 43/4 percent in 2007 and about 43/4 percent in 2008. Projections for the rate of inflation, as measured by the core PCE price index, in 2007 were in a range of 2 to 2lA percent in 2007 and P/4 to 2 percent in 2008. The central tendencies of these projections in 2007 and 2008 were identical to the ranges for those years. Participants generally agreed that the housing sector was likely to remain a drag on growth for some time yet and represented the most significant downside risk to the economic outlook. Although starts of single-family homes had moved up, on balance, over recent months, permits for new construction continued to decline. A number of participants noted that inventories of new homes for sale remained quite elevated. Housing activity was seen as likely to continue to contract for several more quarters. Participants also identified a number of downside risks associated with their outlook for residential construction. The recent increase in interest rates for prime mortgages could further dampen the demand for housing. Moreover, a number of participants pointed to rising mortgage delinquency rates and related difficulties in the subprime mortgage market as factors that could crimp the availability of mortgage credit and the demand for housing. Spillovers from the strains in the housing market to consumption spending had apparently been quite limited to date. To be sure, personal consumption expenditures appeared to be rising more slowly in recent months than earlier in the year, but that development was probably, at least in part, a result of the rise in gasoline prices, which was not expected to be extended. Participants generally anticipated moderate gains in consumption spending over coming months, supported by the strong labor market and solid growth in personal income. Still, the advance in spending was expected to fall short of income growth, and the saving rate was anticipated to trend higher over coming quarters from the unusually low levels of recent years. Some participants noted a risk that the saving rate could rise more than currently foreseen, particularly if household wealth were depressed by a further softening in house prices or by a less buoyant equity market that might accompany a potential slowing in the growth of corporate earnings. Several participants noted that higher interest rates and a potential tightening in credit availability might also be factors that could contribute to a rise in the personal saving rate. At the same time, participants recognized that consumption growth had held up to date and saw a risk that the saving rate could fail to rise as much as currently expected, particularly if equity markets continued to register significant gains. A number of participants remarked that the recent data on business spending were more encouraging than those available at the time of the May meeting. In particular, orders and shipments for nondefense capital goods had stepped up, on balance, from March through May, and survey indicators of 220 94th Annual Report 2007 business conditions had improved of late. Strength in foreign demand for U.S. goods and services was another factor that seemed likely to contribute to the firming of business spending. Participants noted that inventories appeared to be better aligned with sales, boding well for a resumption of inventory accumulation and a pickup in manufacturing activity. At the same time, some recognized the possibility that downside risks to investment spending persisted. Longer-term interest rates and the cost of credit generally had moved higher of late, the growth of business profits seemed to be moderating, and measured productivity growth had been slower. Although credit market conditions seemed to remain generally quite accommodative, in the days just prior to the meeting, the availability of credit to some highly leveraged and other lowerrated borrowers appeared to be tightening a bit and investors seemed to reevaluate the risks associated with investments in complex and illiquid financial instruments. Strength in spending abroad and the decline in the exchange value of the dollar were seen as factors boosting U.S. exports. The rise in global interest rates was cited as evidence of increasing global demand, and some participants pointed to strength of aggregate demand worldwide and its potential effect on the prices of imports and globally traded commodities as contributing to upside risks to U.S. inflation. Most participants judged labor market conditions to remain rather tight, particularly for the most skilled workers. The continued tautness of labor markets was something of a puzzle in light of below-trend economic growth over recent quarters, and this development seemed to be connected with slower productivity growth lately. In their discussion of this issue, partici pants noted that employment data for 2006 could ultimately be revised down, resulting in a corresponding upward revision to productivity. Some participants also pointed to evidence of lags in employment adjustments, particularly in the construction industry, as a factor depressing productivity in recent quarters. These observations suggested that the recent decline in productivity growth might prove smaller than now estimated and largely transitory. Still, some decline in the pace of trend productivity growth could not be ruled out—a development that could have implications for business costs and price pressures. Some participants further noted that the level of the unemployment rate consistent with stable inflation could be lower than previously thought—a possibility that would help to explain the absence of outsized wage pressures in the current environment. The incoming data on core consumer prices were viewed as favorable, but were not seen as convincing evidence that the recent moderation of core inflation would be sustained. Participants noted that monthly data on consumer prices are noisy, and recent readings on core inflation seemed to have been depressed by transitory factors. Moreover, a number of forces could sustain inflation pressures, including the generally high level of resource utilization, elevated energy and commodity prices, the decline in the exchange value of the dollar over recent quarters, and slower productivity growth. In addition, while core consumer price inflation had moderated of late, total consumer price inflation had moved substantially higher, boosted by rising energy and food prices. While total inflation was expected to slow toward the pace of core inflation over time, a number of participants noted that recent elevated readings posed some risk of a deterioration in Minutes of FOMC Meetings, June 221 inflation expectations. On this point, several participants cited the uptick in forward measures of inflation compensation over the intermeeting period derived from Treasury inflation-indexed securities. However, a portion of this increase might be attributed to technical factors, and survey measures of longterm inflation expectations had held steady over recent weeks. Nonetheless, several participants emphasized that holding long-run inflation expectations at or below current levels would likely be necessary for core inflation to moderate as expected over coming quarters. In their discussion of monetary policy for the intermeeting period, members generally regarded the risks to economic growth as more balanced than at the time of the May meeting. Although the housing market remained a key source of uncertainty about the outlook, members thought it most likely that the overall economy would expand at a moderate pace over coming quarters. Members generally anticipated that core inflation would remain relatively subdued but concurred that a sustained moderation in inflation had not yet been convincingly demonstrated. In these circumstances, members agreed that maintaining the target federal funds rate at 5lA percent for this meeting was appropriate and that future policy adjustments would depend on the outlook for economic growth and inflation, as implied by incoming information. In light of the recent economic data and anecdotal information, the Committee agreed that the statement to be released after the meeting should indicate that the economy seemed to be expanding at a moderate pace over the first half of the year. Members agreed that while measures of core inflation had improved lately, the statement should indicate that a sustained moderation of inflation remained in question and that high levels of resource utilization had the potential to fuel inflation pressures. Against this backdrop, members judged that the risk that inflation would fail to moderate as expected remained their predominant concern. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5lA percent. The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.: In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Votes for this action: Messrs. Bernanke, Geithner, Hoenig, Kohn, and Kroszner, Ms. Minehan, Messrs. Mishkin, Moskow, Poole, and Warsh. Votes against this action: None. The Committee then again took up the topic of monetary policy communications. The discussion at this meeting focused on several key elements of the Committee's communications vehicles: the statement released after each FOMC meeting; the minutes of FOMC meetings; and the projections of FOMC participants that are summarized in the Federal Reserve's semiannual monetary policy reports to the Congress. The 222 94th Annual Report, 2007 Committee made no decisions at this meeting, and it was understood that the subcommittee on communications issues would review the Committee's discussions to date on these matters. It was agreed that the next meeting of the Committee would be held on Tuesday, August 7, 2007. The meeting adjourned at 2:20 p.m. Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Ms. Johnson, Economist Messrs. Connors, Evans, Fuhrer, Kamin, Rasche, Sellon, Slifman, Tracy, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Notation Vote By notation vote completed on May 29, 2007, the Committee unanimously approved the minutes of the FOMC meeting held on May 9, 2007. Vincent R. Reinhart Secretary Meeting Held on August 7, 2007 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday August 7, 2007 at 8:30 a.m. Present: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Moskow Mr. Poole Mr. Rosengren Mr. Warsh Ms. Cumming, Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yeilen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management, Board of Governors Messrs. Clouse and English, Senior Associate Directors, Division of Monetary Affairs, Board of Governors Ms. Liang and Mr. Reifschneider, Associate Directors, Division of Research and Statistics, Board of Governors Messrs. Dale and Reinhart, Senior Advisers, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Meyer, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Ms. Dykes, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Mr. Driscoll, Economist, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Connolly, First Vice President, Federal Reserve Bank of Boston Messrs. Judd and Rosenblum, Executive Vice Presidents, Federal Re- Minutes of FOMC Meetings, August 223 serve Banks of San Francisco and Dallas, respectively moderate pace during the first half of the year despite the ongoing drag from Ms. Mosser and Mr. Sniderman, Senior the housing sector. While the growth of Vice Presidents, Federal Reserve consumer spending slowed in the secBanks of New York and Cleve- ond quarter from its rapid pace in prior land, respectively quarters, wages and salaries increased Mr. Cunningham, Vice President, Fed- solidly and household sentiment appeared supportive of further gains in eral Reserve Bank of Atlanta spending. Business fixed investment Mr. Chatterjee, Senior Economic Adpicked up in the second quarter after viser, Federal Reserve Bank of little net change in the preceding two Philadelphia quarters. Inventories generally appeared Mr. Hetzel, Senior Economist, Federal to be well aligned with sales at midyear. Reserve Bank of Richmond Overall inflation receded in June beMr. Weber, Senior Research Officer, cause of a decline in energy prices, Federal Reserve Bank of Minne- while the core personal consumption exapolis penditure (PCE) price index rose a bit In the agenda for this meeting, it was less than its average pace over the past reported that advices of the election of year. Eric S. Rosengren as a member of the Private nonfarm payroll employment Federal Open Market Committee had continued to increase at a healthy pace; been received and that he had executed the rise in July was about equal to the his oath of office. average increase over the first half of By unanimous vote, the Federal Open the year. Solid hiring in the service secMarket Committee selected Brian F. tor was partly offset by declines in conMadigan to serve as Secretary and struction and manufacturing employEconomist until the selection of a suc- ment. Most of the drop in construction cessor at the first regularly scheduled employment occurred in jobs typically meeting of the Committee in 2008. associated with nonresidential construcThe Manager of the System Open tion. Both the average workweek and Market Account reported on recent de- aggregate hours ticked down in July. velopments in foreign exchange mar- The unemployment rate edged up to kets. There were no open market opera- 4.6 percent; it had remained between tions in foreign currencies for the 4.4 percent and 4.6 percent since SepSystem's account in the period since the tember 2006. previous meeting. The Manager also reIndustrial production picked up in the ported on developments in domestic fi- second quarter after little net change nancial markets and on System open over the preceding two quarters. The inmarket operations in government securi- crease was largely attributable to a ties and federal agency obligations dur- smaller drag from inventory liquidation ing the period since the previous meet- and a modest improvement in net exing. By unanimous vote, the Committee ports. Manufacturing production rose ratified these transactions. solidly in the second quarter because of The information reviewed at the Au- substantial increases in the output of gust meeting suggested that economic light motor vehicles, other durable conactivity picked up in the second quarter sumer goods, business equipment, confrom the slow pace in the first quarter. struction supplies, and materials. ProOn average, the economy expanded at a duction in high-tech industries rose 224 94th Annual Report, 2007 relatively modestly in comparison to its longer-run growth. The growth of real consumer spending slowed considerably in the second quarter after substantial increases earlier in the year. The deceleration primarily reflected sharply slower growth in outlays for goods as purchases of motor vehicles decreased noticeably. Although a spike in energy prices eroded real income growth in the second quarter, there were solid gains in wages and salaries. Despite continued softness in house prices, household wealth moved markedly higher in the second quarter, mostly reflecting rising equity prices. Demand for housing in the second quarter was restrained by higher interest rates and by tightening credit conditions in the subprime mortgage market. Sales of new and existing homes in the second quarter were down substantially from their average levels in the second half of 2006. In June, single-family housing starts held steady at their May rate, although adjusted permit issuance slipped further. The combination of decreased sales and unchanged production left inventories of new homes for sale still elevated. House-price appreciation continued to slow, with some measures again showing declines in home values. Outlays for nonresidential construction rose rapidly in the second quarter. Business spending on equipment and software, other than transportation equipment, posted a solid increase after being flat, on net, in the preceding two quarters. The rise was led by a rebound in purchases of industrial machinery. Expenditures for computers, software, and communications equipment grew moderately in the second quarter after a brisk first-quarter increase. Spending on transportation equipment again declined sharply. The drop was largely a continuation of the payback from exceptionally strong purchases of heavy trucks in 2005 and 2006 in anticipation of tighter emissions standards on diesel engines. New orders for medium and heavy trucks edged up in the second quarter, though they remained at low levels, suggesting that the downturn in business spending on motor vehicles may be ending. Real nonfarm inventory investment was a roughly neutral influence on real GDP growth in the second quarter after having held down the growth rate by an average of 1 percentage point in the previous two quarters. Businesses made considerable progress in reducing the apparent inventory overhangs that had emerged at the end of 2006. In the motor vehicle sector, low rates of assemblies in the first half of this year left inventories of domestic light vehicles at the end of the second quarter fairly well aligned with sales; however, inventories rose again in July as production accelerated and sales remained weak. More broadly, the number of purchasing managers who viewed their customers' inventory levels as too high in July only slightly exceeded the number who saw them as too low. The U.S. international trade deficit widened in May, as a rise in imports more than offset an increase in exports. Within imports, most categories of goods recorded an increase, as did services. The value of oil imports rose sharply, boosted by a jump in the price of imported oil. The increase in exports was largely attributable to capital goods, including aircraft, computers and semiconductors, and industrial supplies. Economic activity in advanced foreign economies expanded somewhat less rapidly in the second quarter than in the prior quarter, but nonetheless appeared to have grown faster than trend, reflecting upbeat business and consumer confidence as well as favorable labor market conditions. Although many of those economies recently experienced Minutes of FOMC Meetings, August sharp declines in equity prices and widening credit spreads amid deepening concerns about credit quality, these developments occurred too late in the intermeeting period to have any apparent effect on incoming data. In Japan, survey evidence suggested that its economy expanded moderately. Survey evidence indicated high levels of economic sentiment and strong capital spending plans among large manufacturers. In the euro area, survey measures of business and consumer confidence remained near record highs in July, and labor market conditions generally continued to improve in May and June. In the United Kingdom, real GDP growth rose in the second quarter, an increase driven mainly by robust expansion in the service sector. Canada's growth seemed to continue to pick up from its disappointing rate posted in much of last year. Recent data indicated that economic activity in emerging-market economies remained generally strong. The Chinese economy continued to expand at a rapid pace, and activity elsewhere in emerging Asia appeared to have accelerated. In Latin America, Mexican indicators pointed to a weaker-than-expected rebound in the second quarter, whereas Brazil and Argentina appeared to have experienced solid growth. While equity prices fell and bond spreads widened in several emerging-market economies, particularly in Latin America, there was no evidence that this increased volatility had yet weighed on economic activity. U.S. headline consumer price inflation slowed in June as energy prices flattened out after a rapid increase over the preceding three months. Core PCE prices rose 0.1 percent in June, as a decline in the price index for core goods nearly offset a rise in the index for core services. The readings on core PCE price inflation in recent months had been held down, in part, by declines in prices 225 of some categories of goods, such as apparel, that tend to be volatile on a monthly basis. Household surveys conducted in early July indicated that the median expectation for inflation over the next year remained unchanged from June's elevated level despite declines in gasoline prices in both months. Median expectations of longer-term inflation ticked up and were near the top of the narrow range that had prevailed over the past few years. The employment cost index rose somewhat faster in the second quarter than over the preceding three months, and the twelve-month change was slightly higher than that of a year ago. At its June meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5VA percent. The statement announcing the policy decision noted that economic growth appeared to have been moderate during the first half of the year, despite the ongoing adjustment in the housing sector. The economy seemed likely to continue to expand at a moderate pace over coming quarters. Readings on core inflation had improved modestly in recent months. However, a sustained moderation in inflation pressures had yet to be convincingly demonstrated. Moreover, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. Market participants had largely anticipated the FOMC's decision at its June meeting to leave the target for the federal funds rate unchanged, although the accompanying statement expressed greater concern about inflation than in- 226 94th Annual Report, 2007 vestors reportedly had foreseen and caused the expected path for the federal funds rate to edge higher. Expectations for a policy easing diminished somewhat more in the wake of favorable economic news early in the period. Subsequently, the semiannual Monetary Policy Report to the Congress and the accompanying testimony, which reported lower projections for real GDP growth than investors apparently expected, appeared to prompt a downward shift in investors' expected path for the federal funds rate. Later in the intermeeting period, growing apprehension that turmoil in markets for subprime mortgages and some low-rated corporate debt might have adverse effects on economic growth led investors to mark down their expectations for the future path of policy considerably further. At the same time, measures of long-horizon inflation compensation based on inflation-indexed Treasury securities edged down. Financial market conditions were volatile during the intermeeting period, particularly over the last few weeks of the interval. Yields on nominal Treasury securities fell on balance, possibly reflecting an increased preference by investors for safe assets as well as revisions in policy expectations. Conditions in markets for subprime mortgages and related instruments, including segments of the asset-backed commercial paper market, deteriorated sharply toward the end of the period. Credit conditions for speculative-grade corporate borrowers tightened substantially, as investors pulled back from higher-risk assets. Spreads on speculative-grade bonds increased to near their highest levels in the past four years. A number of high-yield bond and leveraged loan deals intended to finance leveraged buyouts were delayed or restructured, though other highyield bonds were issued. In contrast, credit conditions for investment-grade businesses and prime households were relatively little affected by the market turbulence. Issuance of investmentgrade bonds continued. Yields on investment-grade corporate issues rose relative to yields on Treasury securities, but because yields on Treasuries declined, yields on investment-grade bonds were about unchanged on net. Nonfinancial commercial paper outstanding posted a modest gain in July, while the pace of bank lending to businesses picked up from an already solid clip. Mortgage loans and consumer credit appeared to remain readily available to households with strong balance sheets, although late in the period some evidence pointed to diminishing availability of jumbo mortgages. Broad stock price indexes declined substantially, on net, over the intermeeting period despite generally solid second-quarter earnings reports. Share prices of financial firms fell especially sharply, reportedly a reflection, in part, of concerns about exposures to sub prime mortgages and about the effect of a potential slowdown in merger activity on operating profits. The foreign exchange value of the dollar against other major currencies fell, on balance. Growth of home mortgage debt likely slowed again in the second quarter, mainly reflecting the decline in homeprice appreciation over the past year and the drop in home sales. Overall consumer credit expanded moderately through the year ending in May. The debt of nonfinancial businesses expanded at a robust pace in the second quarter but slowed in July. After rising at a rapid pace in the first half of the year, M2 grew at a more moderate rate in July. In preparation for this meeting, the staff lowered somewhat its forecast of real GDP growth in the second half of Minutes of FOMC Meetings, August 227 2007 and in 2008. The reduction was in part due to the annual revision of national income and product accounts (NIPA), which revealed somewhat less rapid growth in output and productivity during the past three years than previously reported and led the staff to trim its estimates of the growth rates of structural productivity and potential GDP; the reduction also reflected less accommodative financial conditions and the softer tone of some near-term indicators. The near-parallel revisions to the forecasts for potential and actual GDP left the staff's projections for resource utilization about unchanged. Although part of the recent favorable monthly readings on core PCE price changes was expected to be transitory, the staff revised down slightly its forecast for core PCE price inflation in the second half of 2007; however, in light of slower growth in structural productivity and prospects of somewhat greater pressure from import prices, the staff left its projection for core PCE inflation unchanged for 2008. Overall PCE inflation was expected to slow in the second half of 2007 from the elevated pace of the first half, as the effects of the sizable increases in food and energy prices earlier this year abated, and then to move down a bit further in 2008. In their discussion of the economic situation and outlook, meeting participants indicated that they still saw moderate economic expansion in coming quarters as the most likely outcome but that the downside risks to growth had increased. Participants reported that economic expansion had continued at a moderate pace in many regions of the country despite further weakness in the housing sector. Going forward, most participants anticipated that growth in aggregate demand would be supported by rising employment, incomes, and exports, with the result that growth in ac tual output probably would remain close to growth of potential GDP despite the ongoing adjustment in the housing sector. Several mentioned that the revisions to the NIPA pointed to a modest downward adjustment in projected growth of actual and potential GDP, but thought that potential output growth was likely to be a bit higher than forecast by the staff. However, recent spending indicators had been mixed, and credit conditions had become tighter, suggesting greater downside risks to growth. Participants generally expected that core inflation would edge lower over the next two years, reflecting a slight easing of pressures on resources, well-anchored inflation expectations, and the waning of temporary factors that had boosted prices last year and early this year. Participants anticipated that total inflation would slow as well, particularly if market expectations of a modest decline in energy prices in coming quarters were to prove correct. But they were concerned that the high level of resource utilization and slower productivity growth could augment inflation pressures. Against this backdrop, the Committee agreed that the risk that inflation would fail to moderate as expected remained its predominant policy concern. Participants agreed that the housing sector was apt to remain a drag on growth for some time and represented a significant downside risk to the economic outlook. Indeed, developments in mortgage markets during the intermeeting period suggested that the adjustment in the housing sector could well prove to be both deeper and more prolonged than had seemed likely earlier this year. Participants noted that investors had become much more uncertain about the likely future cash flows from subprime and certain other nontraditional mortgages, and thus about the valuation of securities backed by such mortgages. 228 94th Annual Report, 2007 Consequently, the markets for securities backed by subprime and other nontraditional mortgages had become illiquid, and originations of new subprime mortgages had dropped sharply. While these markets were expected to recover over time, it was anticipated that credit standards for these types of mortgages would be tighter, and interest rates higher relative to rates on conforming mortgages, in the future than in recent years. However, participants also observed that mortgage loans remained readily available to most potential borrowers, and that interest rates on conforming, conventional mortgage loans had declined in recent weeks, providing some support to the housing sector. Participants thought that consumer expenditures likely would expand at a moderate pace in coming quarters, supported by solid gains in employment and real income. Though growth in consumer spending had slowed in the second quarter, the slowing likely reflected temporary factors in part, including some payback from unusually strong growth in prior quarters and the surge in gasoline prices. Several participants noted the risks that house prices could decline significantly and that credit standards for home equity loans could be tightened substantially as factors that could weigh on consumer spending. However, the sizable upward revision— from negative to positive—in estimates of the personal saving rate during the past three years suggested somewhat less need for households to rebuild their savings. Participants expected that business investment would be supported by solid fundamentals, including high profits, strong business balance sheets, and moderate growth in output. Recent financial market developments were thought unlikely to have an appreciable adverse effect on capital spending. Al though lenders recently appeared to be less willing to extend credit for financial restructuring, the supply of credit to finance real investment did not appear significantly diminished. Funding had become more costly and difficult to obtain for riskier corporate borrowers, but there had been little net change in the cost of credit for investment-grade businesses. Also, businesses in the aggregate continued to have sufficient internally generated funds to finance the expected level of real investment. Nonetheless, participants recognized that conditions in corporate credit markets could change rapidly, and that adverse effects on business spending were possible. Moreover, heightened asset market volatility and the associated increase in uncertainty, if they were to persist for long, could lead businesses to pare capital spending plans. Still, participants judged that continued growth of investment outlays going forward was the most likely outcome. Rapid economic growth abroad and the decline in the foreign exchange value of the dollar in recent quarters were seen as likely to boost U.S. exports and thus support the economic expansion. Some participants also anticipated that growth in government purchases of goods and services would support continued growth in output. The data on core inflation received during the intermeeting period were favorable, but meeting participants believed that the readings for the past few months likely had been damped by transitory factors and did not provide reliable evidence that the recent level would be sustained. Still, participants thought that a slight decrease in pressures on resources and the stability of inflation expectations likely would foster over time a gradual moderation in core inflation. Participants anticipated that total inflation would slow as well, particu- Minutes of FOMC Meetings, August larly if market expectations for a modest decline in energy prices in coming quarters were to prove correct. Participants remained concerned about factors that could augment inflation pressures, including the continuing high level of resource utilization and slower trend growth in productivity. Some also pointed to the strength of aggregate demand worldwide and the depreciation of the dollar, and their potential effects on the prices of imports and globally traded commodities, as contributing to upside risks to U.S. inflation. Several participants noted significant increases in wages in their Districts, particularly in the service sector, but it was also observed that overall gains in labor compensation had remained moderate, suggesting that sustainable rates of resource utilization could be slightly higher than typically estimated. On balance, participants continued to agree that risks to the outlook for sustained moderation in inflation pressures remained tilted to the upside. In their discussion of monetary policy for the intermeeting period, Committee members again agreed that maintaining the existing stance of policy at this meeting was likely to be consistent with the overall economy expanding at a moderate pace over coming quarters and inflation pressures moderating over time. The expansion would be supported by solid job gains and rising real incomes that would bolster consumption, and by increasing foreign demand for goods and services produced in the United States. The ongoing adjustment in housing markets likely would exert a restraining influence on overall growth for several more quarters and remained a key source of uncertainty about the outlook. The recent strains in financial markets posed additional downside risks to economic growth. Members expected a return to more normal market condi 229 tions, but recognized that the process likely would take some time, particularly in markets related to subprime mortgages. However, a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response. Policymakers would need to watch the situation carefully. For the present, however, given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern. In these circumstances, members agreed that maintaining the target federal funds rate at 5lA percent at this meeting was appropriate. In light of the recent economic data, anecdotal information, and financial market developments, the Committee agreed that the statement to be released after the meeting should indicate that economic growth was moderate during the first half of the year and that the economy seemed likely to continue to expand moderately in coming quarters, supported by solid growth in employment and incomes and by robust economic growth abroad. Members also agreed that the statement should incorporate their view that downside risks to growth had increased somewhat, and should mention volatile financial markets, tighter credit conditions for some households and businesses, and the ongoing correction in the housing market. In addition, the Committee agreed that the statement should again note that readings on core inflation had improved modestly in recent months but did not yet convincingly demonstrate a sustained moderation of inflation pressures, and that the high level of resource utilization had the potential to sustain inflation pressures. Against this backdrop, members judged that the risk that infla- 230 94th Annual Report, 2007 tion would fail to moderate as expected continued to outweigh other policy concerns. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5lA percent. The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.: Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information. Votes for this action: Messrs. Bernanke, Geithner, Hoenig, Kohn, Kroszner, Mishkin, Moskow, Poole, Rosengren, and Warsh. Votes against this action: None. It was agreed that the next meeting of the Committee would be held on Tuesday, September 18, 2007. The meeting adjourned at 1:25 p.m. A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, September 18, 2007 at 8:30 a.m. Present: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Poole Mr. Rosengren Mr. Warsh Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Ms. Johnson, Economist Mr. Stockton, Economist Messrs. Clouse, Connors, Fuhrer, Kamin, Rasche, Slifman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Notation Vote By notation vote completed on July 18, 2007, the Committee unanimously approved the minutes of the FOMC meeting held on June 27-28, 2007. Meeting Held on September 18, 2007 Brian F. Madigan Secretary Ms. J. Johnson,9 Secretary, Office of the Secretary, Board of Governors 9. Attended portion of the meeting relating to the discussion of approaches to stabilizing money markets. Minutes of FOMC Meetings, September 231 Mr. Frierson,9 Deputy Secretary, Office of the Secretary, Board of Governors Ms. Bailey9 and Mr. Roberts,9 Deputy Directors, Division of Banking Supervision and Regulation, Board of Governors Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Ms. Liang and Mr. Reifschneider, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Wright, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. G. Evans,9 Assistant Director, Division of Reserve Bank Operations and Payment Systems, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Meyer, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Natalucci, Senior Economist, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Beattie,9 Assistant to the Secretary, Office of the Secretary, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Holcomb, First Vice President, Federal Reserve Bank of Dallas Messrs. Judd, Rosenblum, and Sniderman, Executive Vice Presidents, Federal Reserve Banks of San Francisco, Dallas, and Cleveland, respectively Messrs. Dzina and Hakkio, Mses. Krieger9 and Mester, and Messrs. Rolnick and Weinberg, Senior Vice Presidents, Federal Reserve Banks of New York, Kansas City, New York, Philadelphia, Minneapolis, and Richmond, respectively Messrs. Krane, Peach, and Robertson, Vice Presidents, Federal Reserve Banks of Chicago, New York, and Atlanta, respectively In the agenda for this meeting, it was reported that advices of the election of Charles L. Evans as a member of the Federal Open Market Committee had been received and that he had executed his oath of office. By unanimous vote, the Federal Open Market Committee selected James A. Clouse and Daniel G. Sullivan to serve as Associate Economists until the selection of their successors at the first regularly scheduled meeting of the Committee in 2008. The Manager of the System Open Market Account (SOMA) reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market operations in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. The information reviewed at the September meeting suggested that economic activity advanced at a moderate rate early in the third quarter. After expand- 232 94th Annual Report 2007 ing at a robust pace in July, retail sales rose at a somewhat slower rate in August. Orders and shipments of capital goods posted solid gains in July. However, residential investment weakened further, even before the recent disruptions in mortgage markets. In addition, private payrolls posted only a small gain in August, and manufacturing production decreased after gains in the previous two months. Meanwhile, core inflation rose a bit from the low rates observed in the spring but remained moderate through July. Private nonfarm payroll employment rose only modestly in August, and the levels of employment in June and July were revised down. The weakness in employment was spread fairly widely across industries. Residential construction and manufacturing posted noticeable declines in jobs, employment in wholesale trade and transportation was little changed, and hiring at business services was well below recent trends. Both the average workweek and aggregate hours were unchanged in August. The unemployment rate held steady at 4.6 percent, 0.1 percentage point above its second-quarter level and equal to its 2006 average. After posting solid gains in June and July, total industrial production edged up only a bit in August. This increase was attributable to a surge in electricity generation, as temperatures swung from mild in July to very warm in August. After large gains in the preceding two months, manufacturing output declined in August, held down by a decrease in the production of motor vehicles and parts. High-tech output rose only modestly in August, but production gains in June and July were revised up considerably. Consumer spending appeared to have strengthened early in the summer from its subdued second-quarter pace. Al though auto sales were weak in July, real outlays for other goods rose briskly. At the same time, spending on services was up moderately despite a drop in outlays for energy associated with relatively cool weather in the eastern part of the United States. In August, consumption appeared to have posted another solid gain. Although nominal retail sales outside the motor vehicle sector were about flat (abstracting from a drop in nominal sales at gasoline stations associated with falling gas prices), vehicle sales stepped up and warmer weather likely caused an increase in energy usage. Real disposable income rose further in July, as wages and salaries posted a strong gain and energy prices came down. However, household wealth likely was providing a diminishing impetus to the pace of spending, reflecting recent declines in stock market wealth and an apparent further deceleration in house prices. Readings on consumer sentiment turned down in August after having risen in July, and the Reuters/ Michigan index remained near its relatively low August level in early September. The housing sector remained exceptionally weak. Home sales had dropped considerably this year: Sales of new and existing single-family homes in July were down substantially from their averages over the second half of last year. Demand was restrained by deteriorating conditions in the subprime mortgage market and by an increase in rates for thirty-year fixed-rate conforming mortgages. In the nonconforming mortgage market, the availability of financing to borrowers recently appeared to have been crimped even further. Most forward-looking indicators of housing demand, including an index of pending home sales, pointed to a further deterioration in sales in the near term. Singlefamily starts slid in July to their lowest Minutes of FOMC Meetings, September 233 reading since 1996, and adjusted permit exceeded the number who saw them as issuance continued on a downward tra- too high. The U.S. international trade deficit jectory. Although single-family housing starts had come down substantially from narrowed slightly in July, as exports intheir peak, the drop had lagged the de- creased more than imports. Sharp incline in demand, and as a result, inven- creases in exports of both aircraft and tories of new homes had risen consider- automobiles contributed importantly to ably. In the multifamily sector, starts in the overall gain. Exports of agricultural July were in line with readings thus far products and consumer goods were also this year and at the low end of the fairly strong. In contrast, exports of industrial narrow range seen since 1997. Mean- supplies and semiconductors exhibited while, house prices generally continued declines. The value of imported goods and services was boosted by a large into decelerate. crease in imports of automotive prodOrders and shipments of capital goods posted a strong gain early in the third ucts. Higher imports of capital goods quarter. In particular, orders and ship- excluding aircraft, computers, and semiments of equipment outside the high- conductors and of oil also contributed to the overall gain in imports. tech and transportation sector registered Economic growth slowed in the seca robust increase in July, and data on ond quarter in most advanced foreign computer production and shipments of high-tech goods pointed to solid in- economies, except the United Kingdom. The step-down was most pronounced in creases in business demand for highJapan, where GDP contracted, but was tech. In contrast, indicators of spending also substantial in the euro area, where for transportation equipment were total domestic demand rose only mixed. Aircraft shipments in July and slightly. Although growth remained ropublic information on Boeing's deliverbust in Canada, data late in the quarter, ies suggested that domestic spending on including retail sales, indicated a more aircraft was retreating somewhat in the significant weakening in activity. This current quarter. While fleet sales of light softness appeared to have continued into vehicles appeared to have moved up in the third quarter in some economies. In July and August, sales of medium and July, indicators for Europe generally heavy trucks remained below the moderated, on balance, from their second-quarter average. More generally, second-quarter levels; those for Canada surveys of business conditions sug- and Japan, however, slowed more notagested that increases in business activity bly. Most of the readings available on were somewhat slower in August than economic developments after August 9, in the second quarter. when financial turmoil intensified, were Book-value data for the manufactur- measures of confidence. They dropped, ing and trade sectors excluding motor on average, but otherwise were consisvehicles and parts suggested that inven- tent with the indicators reported for July. tory accumulation stepped down noticeData through July suggested that ecoably in July from the second-quarter nomic activity in emerging-market pace. Inventories of light motor vehicles countries remained robust. Output in the rose again in July and August. The num- Asian economies soared in the second ber of manufacturing purchasing manag- quarter, and several countries posted ers who viewed their customers' inven- growth at or near double-digit rates. In tory levels as too low in August slightly Latin America, output in Mexico and 234 94th Annual Report, 2007 Venezuela rebounded sharply from earlier weakness. Indicators for China in July pointed to only a modest slowing of output growth from its torrid pace in the first half of the year. The scant data for August received thus far provided little indication that the turmoil in financial markets had a significant negative impact on real economic activity in emerging-market economies. After rapid price increases earlier this year, U.S. headline consumer price inflation was moderate in both June and July. Although food prices continued their string of sizable increases, energy prices fell in June and July and gasoline prices appear to have dropped further in August. Core PCE prices rose 0.2 percent in June and 0.1 percent in July. On a twelve-month-change basis, core PCE inflation in July was below the comparable rate twelve months earlier. Stepdowns in price inflation for prescription drugs, motor vehicles, and nonmarket services accounted for nearly all of the deceleration in core PCE prices. Although owners' equivalent rent decelerated over the past year, this change was largely offset by an acceleration in tenants' rent and lodging away from home. Household surveys indicated that the median expectation for year-ahead inflation declined in August and edged down further in early September to a level only slightly above the reading at the turn of the year; the median expectation of longer-term inflation in early September remained in the range seen over the past couple of years. The producer price index for core intermediate materials rose only modestly in July. Compensation per hour decelerated in the second quarter. Nonetheless, the increase over the four quarters ending in the second quarter was noticeably above the increase in the preceding four quarters and well above the rise in the employment cost index over the same period. At its August meeting, the FOMC decided to maintain its target for the federal funds rate at 5lA percent. In the statement, the Committee acknowledged that financial markets had been volatile in recent weeks, credit conditions had become tighter for some households and businesses, and the housing correction was ongoing. The Committee reiterated its view that the economy seemed likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. Readings on core inflation had improved modestly in recent months. However, a sustained moderation in inflation pressures had yet to be convincingly demonstrated. Moreover, the high level of resource utilization had the potential to sustain these pressures. Although the downside risks to growth had increased somewhat, the Committee repeated that its predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the outlook for both inflation and economic growth, as implied by incoming information. The FOMC's policy decision and the accompanying statement were about in line with market expectations, and reactions in financial markets were muted. In the days after the August FOMC meeting, financial market participants appeared to become more concerned about liquidity and counterparty credit risk. Unsecured bank funding markets showed signs of stress, including volatility in overnight lending rates, elevated term rates, and illiquidity in term funding markets. On August 10, the Federal Reserve issued a statement announcing that it was providing liquidity to facilitate the orderly functioning of financial markets. The Federal Reserve indicated that it would provide reserves as neces- Minutes of FOMC Meetings, September 235 Short-term financial markets came sary through open market operations to promote trading in the federal funds under pressure over the intermeeting pemarket at rates close to the target rate of riod amid heightened investor unease 514 percent. The Federal Reserve also about exposures to subprime mortgages noted that the discount window was and to structured credit products more generally. Rates on asset-backed comavailable as a source of funding. On August 17, the FOMC issued a mercial paper and on low-rated unsestatement noting that financial market cured commercial paper soared, and conditions had deteriorated and that some issuers, particularly asset-backed tighter credit conditions and increased commercial paper programs with investuncertainty had the potential to restrain ments in subprime mortgages, found it economic growth going forward. The difficult to roll over maturing paper. FOMC judged that the downside risks to These developments led several progrowth had increased appreciably, indi- grams to draw on backup lines, exercise cated that it was monitoring the situa- options to extend the maturity of outtion, and stated that it was prepared to standing paper, or even default. As a act as needed to mitigate the adverse result, asset-backed commercial paper effects on the economy arising from the outstanding contracted substantially. Indisruptions in financial markets. Simul- vestors sought the safety and liquidity of taneously, the Federal Reserve Board Treasury securities, and yields on Treaannounced that, to promote the restora- sury bills dropped sharply for a period; tion of orderly conditions in financial trading conditions in the bill market markets, it had approved a 50 basis point were impaired at times. Meanwhile, reduction in the primary credit rate to banks took measures to conserve their 53/4 percent. The Board also announced liquidity and were cautious about couna change to the Reserve Banks' usual terparties' exposures to asset-backed practices to allow the provision of term commercial paper. Term interbank fundfinancing for as long as thirty days, re- ing markets were significantly impaired, newable by the borrower. In addition, with rates rising well above expected the Board noted that the Federal Re- future overnight rates and traders reportserve would continue to accept a broad ing a substantial drop in the availability range of collateral for discount window of term funding. Pressures eased a bit in loans, including home mortgages and re- mid-September, but short-term financial lated assets, while maintaining existing markets remained strained. Conditions in corporate credit marcollateral margins. On August 21, the Federal Reserve Bank of New York an- kets were mixed. Investment- and corporate bond nounced some temporary changes to the speculative-grade terms and conditions of the SOMA se- spreads edged up; they were near their curities lending program, including a re- highest levels in four years, although duction in the minimum fee. The effec- they remained far below the peaks seen tive federal funds rate was somewhat in mid-2002. Investment-grade bond isbelow the target rate for a time over the suance was strong in August as yields intermeeting period, as efforts to keep declined, but issuance of speculativethe funds rate near the target were ham- grade bonds was scant. Speculativepered by technical factors and financial grade bond deals and leveraged loans market volatility. In the days leading up slated to finance leveraged buyouts conto the FOMC meeting, however, the tinued to be delayed or restructured. Bank lending to businesses surged in funds rate traded closer to the target. 236 94th Annual Report, 2007 August, apparently because some banks funded leveraged loans that they had intended to syndicate to institutional investors and perhaps because some firms substituted bank credit for commercial paper. Although markets for nonconforming mortgages were impaired over the intermeeting period, the supply of conforming mortgages seemed to have been largely unaffected by recent developments. Broad stock price indexes were volatile but about unchanged, on net, over the intermeeting period. The foreign exchange value of the dollar against other major currencies fell, on balance. Investors appeared to mark down significantly their expected path for the federal funds rate during the intermeeting period, evidently in response to the strains in money and credit markets and a few key data releases, including weaker-than-expected reports on housing activity and employment. Yields on nominal Treasury securities fell appreciably across the term structure. TIPSbased inflation compensation at the fiveyear horizon was about unchanged, while inflation compensation at longer horizons crept higher. Growth of nonfinancial domestic debt was estimated to have slowed a little in the third quarter from the average pace in the first half of the year. The deceleration in total nonfinancial debt reflected a projected slowdown in borrowing across all major sectors of the economy excluding the federal government. Although it decelerated in the third quarter, business-sector debt continued to advance at a solid pace, boosted by a surge in business loans. In the household sector, mortgage borrowing was estimated to have slowed notably, as mortgage interest rates moved up, nonconforming mortgages became harder to obtain, and as home sales slowed and house prices decelerated. M2 increased at a brisk pace in August. The rise was led by a surge in liquid deposits and in retail money funds as investors adjusted their portfolios in response to the turmoil in financial markets. In preparation for this meeting, the staff continued to estimate that real GDP increased at a moderate rate in the third quarter. However, the staff marked down the fourth-quarter forecast, reflecting a judgment that the recent financial turbulence would impose restraint on economic activity in coming months, particularly in the housing sector. The staff also trimmed its forecast of real GDP growth in 2008 and anticipated a modest increase in unemployment. Softer demand for homes amid a reduction in the availability of mortgage credit would likely curtail construction activity through the middle of next year. Moreover, lower housing wealth, slower gains in employment and income, and reduced confidence seemed likely to restrain consumer spending in 2008. Despite the recent difficulties in some corporate credit markets, financial conditions confronting most nonfinancial businesses did not appear to have tightened appreciably to date. But going forward, the staff anticipated that businesses would scale back their capital spending a touch in response to financing conditions that were likely to become a little less accommodative and to more modest gains in sales. With credit markets expected to largely recover over coming quarters, growth of real GDP was projected to firm in 2009 to a pace a bit above the rate of growth of its potential. Incoming data on consumer price inflation that were slightly to the low side of the previous forecast, in combination with the easing of pressures on resource utilization in the current forecast, led the staff to trim slightly its forecast for core PCE inflation. Headline PCE inflation, which was boosted by sizable increases in en- Minutes of FOMC Meetings, September 237 ergy and food prices earlier in the year, the recent deterioration in various term was expected to slow in 2008 and 2009. funding markets, might well lead banks In their discussion of the economic to tighten the availability of credit to situation and outlook, meeting partici- households and firms. Tighter credit pants focused on the potential for recent conditions were likely to weigh particucredit market developments to restrain larly on residential investment and to a aggregate demand in coming quarters. lesser extent on other components of agThe disruptions to the market for non- gregate demand in coming quarters. conforming mortgages were likely to re- Meeting participants also noted that fiduce further the demand for housing, nancial market conditions, while seemand recent financial developments could ing to have improved somewhat in the well lead to a more general tightening of most recent days, were still fragile and credit availability. Moreover, some re- that further adverse credit market develcent data and anecdotal information opments could well increase the downpointed to a possible nascent slowdown side risks to the economy. Even after in the pace of expansion. Given the un- market volatility subsided and the recent usual nature of the current financial strains eased, risk spreads probably shock, participants regarded the outlook would be wider and credit terms tighter for economic activity as characterized than they had been a few months ago. by particularly high uncertainty, with the Although these developments would risks to growth skewed to the downside. likely be consistent with longer-term fiSome participants cited concerns that a nancial stability, they were likely to exweaker economy could lead to a further ert some restraint on aggregate demand. In their discussion of individual sectightening of financial conditions, which in turn could reinforce the economic tors of the economy, participants noted slowdown. But participants also noted that recent data suggested greater weakthat the resilience of the economy in the ness in the housing market than had preface of a number of previous periods of viously been expected. Furthermore, refinancial market disruptions left open cent financial developments had the the possibility that the macroeconomic potential to deepen further and prolong effects of the financial market turbu- the downturn in the housing market, as subprime mortgages remained essenlence would prove limited. Although financial markets were ex- tially unavailable, little activity was evipected to stabilize over time, partici- dent in the markets for other nonprime pants judged that credit markets were mortgages, and prime jumbo mortgage likely to restrain economic growth in the borrowers faced higher rates and tighter period ahead. Given existing commit- lending standards. The faster pace of ments to customers and the increased foreclosures as subprime mortgage rates resistance of investors to purchasing reset was also seen as posing a downsome securitized products, banks might side risk to the housing market. Noneneed to take a large volume of assets theless, participants observed that cononto their balance sheets over coming forming mortgages remained readily weeks, including leveraged loans, asset- available to creditworthy borrowers and backed commercial paper, and some that rates on these mortgages had detypes of mortgages. Banks' concerns clined in recent weeks. Moreover, condiabout the implications of rapid growth tions in the jumbo mortgage market in their balance sheets for their capital were expected to improve gradually ratios and for their liquidity, as well as over time. 238 94th Annual Report, 2007 Although employment probably was not as weak as the most recent monthly data had suggested, trend growth in jobs had fallen off even prior to the recent financial market strains, and participants judged that some further slowing of employment growth was likely. Indeed, financial services firms had already announced layoffs, largely reflecting mortgage market developments, the demand for temporary workers appeared to have softened, and the most recent weakening in construction employment was likely to continue for a while. Moreover, if declines in house prices were to damp consumption, that could feed back on employment and income, exerting additional restraint on the demand for housing. Nonetheless, to date, initial claims for unemployment insurance did not indicate a substantial and widespread weakening in labor demand, and labor markets across the country generally remained fairly tight, with several participants citing continued reports of shortages of labor from their contacts in some sectors. Participants thought that the most likely prospect was for consumer expenditures to continue to expand at a moderate pace on average over coming quarters, supported by growth in employment and income. However, some participants saw indications of a possible weakening of consumer spending. Sales of automobiles and building materials had flagged of late, and survey measures suggested that consumer confidence had been adversely affected by the recent financial market developments. Also, a further tightening of terms for home equity lines of credit and second mortgages seemed possible, which could weigh on consumer spending, especially for consumer durables. Participants reported that recent financial market developments generally appeared to have had limited effects to date on business capital spending plans and expected that business investment was likely to remain healthy in coming quarters. The access of investment-grade corporate borrowers to credit so far remained unimpeded, and rates on investment-grade bonds had declined in recent weeks. Moreover, participants noted that many capital expenditures were internally financed, making them less sensitive to credit market conditions. Nonetheless, the pace of financing for lower-rated firms—including issuance of both speculative-grade bonds and leveraged loans—had slowed sharply over the summer. Participants also noted that standards and terms for commercial real estate credit reportedly had tightened, and that credit availability for homebuilders could be trimmed going forward. In addition, contacts indicated that business executives in parts of the country had apparently become somewhat more cautious and that some were delaying investment outlays in view of heightened economic and financial uncertainty. Some participants noted that foreign demand remained robust and net exports appeared strong. Port utilization rates reportedly remained high. Participants discussed the turbulence in foreign financial markets and noted that unusually high precautionary demand for dollardenominated term funding in Europe had added to strains in U.S. interbank markets and contributed to a wide spread between libor and federal funds rates. Participants made only modest revisions to their outlook for inflation in the period since the Committee's last regular meeting. Still, they recognized that incoming data on core inflation continued to be favorable, and they generally were a little more confident that the decline in inflation earlier this year would be sustained. Inflation expectations Minutes of FOMC Meetings, September 239 seemed to be contained, and the less With economic growth likely to run berobust economic outlook implied some- low its potential for a while and with what less pressure on resources going incoming inflation data to the favorable forward. Participants nonetheless re- side, the easing of policy seemed unmained concerned about possible upside likely to affect adversely the outlook for risks to inflation. Higher benefit costs, inflation. rising unit labor costs more generally, The Committee agreed that the statereduced markups, and levels of resource ment to be released after the meeting utilization both in the United States and should indicate that the outlook for ecoabroad that remained relatively high nomic growth had shifted appreciably were all cited as factors that could con- since the Committee's last regular meettribute to inflationary pressures. Infla- ing but that the 50 basis point easing in tion risks could be heightened if the policy should help to promote moderate dollar were to continue to depreciate growth over time. They also agreed that significantly. the inflation situation seemed to have In the Committee's discussion of improved slightly and judged that it was policy for the intermeeting period, all no longer appropriate to indicate that a members favored an easing of the stance sustained moderation in inflation presof monetary policy. Members empha- sures had yet to be shown. Nonetheless, sized that because of the recent sharp all agreed that some inflation risks rechange in credit market conditions, the mained and that the statement should incoming data in many cases were of indicate that the Committee would conlimited value in assessing the likely evo- tinue to monitor inflation developments lution of economic activity and prices, carefully. Given the heightened unceron which the Committee's policy deci- tainty about the economic outlook, the sion must be based. Members judged Committee decided to refrain from prothat a lowering of the target funds rate viding an explicit assessment of the balwas appropriate to help offset the effects ance of risks, as such a characterization of tighter financial conditions on the could give the mistaken impression that economic outlook. Without such policy the Committee was more certain about action, members saw a risk that tighten- the economic outlook than was in fact ing credit conditions and an intensifying the case. Future actions would depend housing correction would lead to sig- on how economic prospects were afnificant broader weakness in output and fected by evolving market developments employment. Similarly, the impaired and by other factors. functioning of financial markets might At the conclusion of the discussion, persist for some time or possibly the Committee voted to authorize and worsen, with negative implications for direct the Federal Reserve Bank of New economic activity. In order to help fore- York, until it was instructed otherwise, stall some of the adverse effects on the to execute transactions in the System economy that might otherwise arise, all Account in accordance with the followmembers agreed that a rate cut of 50 baing domestic policy directive: sis points at this meeting was the most The Federal Open Market Committee prudent course of action. Such a measure should not interfere with an adjust- seeks monetary and financial conditions that will foster price stability and promote susment to more realistic pricing of risk or tainable growth in output. To further its with the gains and losses that implied long-run objectives, the Committee in the for participants in financial markets. immediate future seeks conditions in reserve 240 94th Annual Report, 2007 markets consistent with reducing the federal ened in the days since its last meeting. funds rate to an average of around 43A per- Participants discussed the condition of cent. domestic and foreign financial markets, The vote encompassed approval of the Open Market Desk's approach to the text below for inclusion in the state- open market operations, possible adjustments to the discount rate, and the statement to be released at 2:15 p.m.: Developments in financial markets since ment to be issued immediately after the the Committee's last regular meeting have conference call. increased the uncertainty surrounding the On August 16, 2007, the Committee economic outlook. The Committee will con- again met by conference call. With fitinue to assess the effects of these and other nancial market conditions having detedevelopments on economic prospects and will act as needed to foster price stability riorated further, meeting participants discussed the potential usefulness of and sustainable economic growth. Votes for this action: Messrs. Bernanke, various policy responses. The discusGeithner, Evans, Hoenig, Kohn, sion focused primarily on changes assoKroszner, Mishkin, Poole, Rosengren, ciated with the discount window that and Warsh. Votes against this action: would be directed at improving the funcNone. tioning of the money markets. Most parThe Committee then resumed its dis- ticipants expressed strong support for cussion of monetary policy communica- taking such steps, although some contion issues. Subsequently, in a joint ses- cern was noted about the likely sion of the Federal Open Market effectiveness of these measures and one Committee and the Board of Governors, participant also questioned their apBoard members and Reserve Bank propriateness. In light of the risks posed presidents discussed additional policy to the economic outlook by the tighter options to address strains in money mar- credit conditions and the increased kets. No decisions were made in this uncertainty in financial markets, the session, but it was agreed that policy- Committee felt that the downside risks makers should continue to consider such to growth had increased appreciably, but options carefully. that a change in the federal funds rate It was agreed that the next meeting of target was not yet warranted. However, the Committee would be held on the situation bore close watching. Tuesday-Wednesday, October 30-31, At the conclusion of the discussion, 2007. the Committee voted to approve the text The meeting adjourned at 3:55 p.m. below to be released the following morning: Notation Vote Financial market conditions have deteriorated, and tighter credit conditions and By notation vote completed on August increased uncertainty have the potential to 27, 2007, the Committee unanimously restrain economic growth going forward. In approved the minutes of the FOMC these circumstances, although recent data suggest that the economy has continued to meeting held on August 7, 2007. expand at a moderate pace, the Federal Open Market Committee judges that the downside Conference Calls risks to growth have increased appreciably. The Committee is monitoring the situation On August 10, 2007, the Committee re- and is prepared to act as needed to mitigate viewed developments in money and the adverse effects on the economy arising credit markets, where strains had wors- from the disruptions in financial markets. Minutes of FOMC Meetings, October 241 Votes for: Messrs. Bernanke, Geithner, Fisher, Hoenig, Kohn, Kroszner, Mishkin, Moskow, Rosengren, and Warsh. Votes against: None. Mr. Fisher voted as alternate member. Mr. Dudley, Manager, System Open Market Account Brian F. Madigan Secretary Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Meeting Held on October 30-31, 2007 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, October 30, 2007 at 2:00 p.m. and continued on Wednesday, October 31, 2007 at 9:00 a.m. Present: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Poole Mr. Rosengren Mr. Warsh Ms. Cumming, Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Clouse, Connors, Fuhrer, Kami n, Rasche, Slifman, Sullivan, and Wilcox, Associate Economists Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management Messrs. Reifschneider10 and Wascher, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Wright, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. Zakrajsek, Assistant Director, Division of Monetary Affairs, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Ms. K. Johnson, Senior Adviser, Division of International Finance, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Dale,10 Senior Adviser, Division of Monetary Affairs, Board of Governors Mr. Gross,10 Special Assistant to the Board, Office of Board Members, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Messrs. Kumasaka11 and Luecke,12 Senior Financial Analysts, Division of Monetary Affairs, Board of Governors Ms. Judson, Economist, Division of Monetary Affairs, Board of Governors 10. Attended portion of meeting relating to the discussion of communication issues. 11. Attended Tuesday session. 12. Attended Wednesday session. 242 94th Annual Report 2007 Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Lyon, First Vice President, Federal Reserve Bank of Minneapolis Messrs. Judd and Sniderman, Executive Vice Presidents, Federal Reserve Banks of San Francisco and Cleveland, respectively Mr. Altig and Ms. Mester, Senior Vice Presidents, Federal Reserve Banks of Atlanta and Philadelphia, respectively Mr. Hakkio, Special Adviser, Federal Reserve Bank of Kansas City Messrs. Hilton, Koenig, and Potter, Vice Presidents, Federal Reserve Banks of New York, Dallas, and New York, respectively Mr. Weber, Senior Research Officer, Federal Reserve Bank of Minneapolis Mr. Hetzel, Senior Economist, Federal Reserve Bank of Richmond By unanimous vote, the Federal Open Market Committee selected D. Nathan Sheets to serve as Economist until the selection of his successor at the first regularly scheduled meeting of the Committee in 2008. The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market operations in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. The information provided to the Committee on the first day of the meeting, prior to the release of the advance esti mates of the third-quarter national income and product accounts, indicated that economic activity expanded at a solid pace in the third quarter. Consumer spending rose more strongly after a tepid increase in the second quarter, and the pace of expansion of business outlays for equipment and structures remained reasonably solid. Manufacturing posted a sizable gain for the third quarter as a whole. In contrast, the slump in residential investment intensified during the third quarter, at least partly because of ongoing disruptions in the markets for nonconforming mortgages. The average monthly gain in private employment also slowed significantly. Headline inflation eased during the third quarter, reflecting a decline in energy prices; core inflation continued to be moderate. Employment increased more slowly in the third quarter than in the first half of the year. Private payroll employment registered a considerably smaller average monthly gain; employment in residential construction, manufacturing, and industries related to mortgage lending continued to decline, but most serviceproducing industries added jobs at a moderate pace. With gains in employment smaller and the workweek flat, the growth of aggregate hours of private production or nonsupervisory workers stepped down from its second-quarter pace. The labor force participation rate was unchanged, on average, in the third quarter, and the unemployment rate ticked up to 4.7 percent in September. Industrial production changed little in August and September after having posted solid advances in June and July. Manufacturing output expanded in the third quarter overall at about the same pace as in the second quarter but declined modestly on net in August and September. During those two months, production was damped by declines in the output of motor vehicles and parts. Minutes of FOMC Meetings, October 243 In addition, output of construction supplies and products fell, likely reflecting the ongoing decline in residential investment. Meanwhile, production in the high-tech sector rose at a moderate rate. Consumer spending was well maintained in August and September. Motor vehicle sales improved, and real spending on other goods posted solid gains in both months. Real outlays on consumer services were strong in August because of a weather-induced jump in energy services. Solid increases in nominal wages and salaries and lower headline inflation led to robust gains in real income over the summer. However, other factors affecting consumer spending were mixed. Short-term interest rates dropped and stock prices rose, on balance, after August. By contrast, house prices continued to decelerate, standards on consumer and mortgage credit tightened after midsummer, and the turmoil in financial markets that started in the summer likely exerted some restraint on consumer spending. Moreover, measures of consumer confidence had declined in recent months. The housing downturn deepened as sales of new and existing single-family homes continued to fall. Deterioration in nonprime mortgage markets as well as higher mortgage interest rates and tighter lending conditions for prime jumbo loans since earlier in the year appeared to be restraining housing demand. Forward-looking indicators, including an index of pending home sales and adjusted single-family permit issuance, continued to point to a further slowing in housing activity over the near term. Single-family housing starts declined significantly over August and September. Nonetheless, with singlefamily home sales continuing to sag, inventories of unsold homes remained quite elevated. In the multifamily sector, starts declined sharply in September; however, the third-quarter reading remained within the fairly narrow range observed over the past decade. Orders and shipments of nondefense capital goods excluding aircraft rose on average over August and September. In the high-tech category, orders and shipments of computers and peripherals posted robust gains over the same period. Shipments of communication equipment also rose in August and September, but orders were little changed on balance over the same period. Outside the technology sector, shipments of nondefense capital goods excluding aircraft increased at a solid rate over August and September but orders declined in August and were flat in September. Sales of medium and heavy trucks leveled off in the third quarter after a sharp drop in the first half of the year. Domestic outlays for aircraft likely stepped down somewhat in the third quarter. Nonresidential building activity remained vigorous through August after having posted very strong gains in the second quarter; anecdotal evidence through early October indicated that the recent turbulence in commercial credit markets had done little to slow the pace of commercial construction. More generally, surveys of business conditions continued to point to further near-term gains in spending, although reports from business contacts indicated that some firms had marked down their capital spending plans. Data on the book value of business inventories through August suggested that real nonfarm inventory investment excluding motor vehicles moved down in the third quarter after having risen at a moderate pace in the second quarter. The ratio of book-value inventories to sales in the manufacturing and trade sector excluding motor vehicles, which was available through August, remained well below the elevated values seen around 244 94th Annual Report, 2007 the turn of the year. Purchasing managers, on average, viewed the level of their customers' inventories as about right in September. The U.S. international trade deficit narrowed in August as exports increased and imports decreased. Goods exports were boosted by a jump in exports of agricultural products and of gold, which more than offset a decline in exports of other goods. Exports of automotive products fell back sharply after a surge in July. Exports of capital goods contracted slightly, led by a drop in aircraft exports. Exports of semiconductors declined, while exports of computers were about flat. On the import side, the decline was concentrated in goods; service imports were flat. Higher imports of oil and of capital goods, particularly computers and semiconductors, were more than offset by lower imports of automotive products, consumer goods, and industrial supplies excluding oil. Indicators of economic activity in the third quarter for advanced foreign economies were solid on balance. In the euro area, production and sales picked up in the third quarter from their secondquarter levels. However, recent survey data, including the purchasing managers' index for the service sector in the euro area, pointed to a possible slowing in the pace of growth. Likewise, notwithstanding a strong preliminary estimate of third-quarter GDP growth in the United Kingdom, more recent surveys pointed to some softening. Recent Canadian data were mixed, with relatively strong employment growth and some weakness in retail sales. In contrast, Japan's retail sales and exports rebounded in August, and the October Tankan survey seemed to suggest that the second quarter's sharp contraction in investment was temporary. In emerging-market economies, recent information, mostly through Au gust, gave no signs that the turmoil in financial markets was having a significant negative effect on real economic activity. In emerging Asia, activity appeared to have remained robust, although growth slowed from its elevated second-quarter pace. Economic indicators for Mexico pointed to moderate growth in the third quarter. In South America, activity was strong, boosted by high prices for commodities and, in Argentina and Venezuela, by expansionary macroeconomic policies. Food prices continued to be a major source of inflationary pressures in emergingmarket economies, and Chinese authorities took several steps aimed at quelling rising prices. After having risen rapidly in the first half of the year, headline consumer prices decelerated considerably over the summer, largely because of a fall in energy prices. Over September and October, gasoline prices appeared to have risen only moderately despite a jump in crude oil costs. Consumer food prices posted further sizable increases in August and September and continued to run well above the change in core prices. Core consumer price inflation remained moderate in August and September and, on a twelve-month change basis, was down noticeably from a year earlier. Core goods prices fell over the year ending in September after having risen little over the preceding year; noticeable decelerations occurred in the prices of apparel, prescription drugs, and motor vehicles. In addition, increases in owners' equivalent rent slowed noticeably, while rent inflation remained about the same as a year earlier. The producer price index for core intermediate materials edged up in September. The twelvemonth change in that index stepped down considerably from last year, in part because of softer prices for a variety of energy-intensive and Minutes of FOMC Meetings, October 245 construction-related items. Household surveys indicated that median yearahead inflation expectations inched down in September and October to about the level observed in the first quarter, and longer-term inflation expectations slipped to their lowest level in two years. Average hourly earnings posted a moderate increase over the twelve months ending in September. At its September meeting, the FOMC lowered its target for the federal funds rate 50 basis points, to 43A percent. The Board of Governors also approved a 50 basis point decrease in the discount rate, to 5lA percent, leaving the gap between the federal funds rate target and the discount rate at 50 basis points. The Committee's statement noted that, while economic growth had been moderate during the first half of the year, the tightening of credit conditions had the potential to intensify the housing correction and to restrain economic growth more generally. The Committee indicated that its action was intended to help forestall some of the adverse effects on the broader economy that could otherwise arise from the disruptions in financial markets and to promote moderate growth over time. Readings on core inflation had improved modestly during the year, but the Committee judged that some inflation risks remained, and the Committee planned to continue to monitor inflation developments carefully. The Committee further noted that developments in financial markets since the last regular FOMC meeting had increased the uncertainty surrounding the economic outlook. Accordingly, the Committee would continue to assess the effects of these and other developments on economic prospects and remained ready to act as needed to foster price stability and sustainable economic growth. The expected path for monetary policy as inferred from futures markets declined in the wake of the September policy action, as many investors were surprised by the magnitude of the reduction in the target rate. Over the intermeeting period, many investors came to expect that the Committee would reduce the target federal funds rate at its October meeting; in addition, the anticipated policy path further ahead moved down a bit more, on net, over the remainder of the intermeeting period, apparently in response to heightened concerns among investors about economic growth. Early in the intermeeting period, the functioning of short-term funding markets improved somewhat, but conditions in these markets remained strained. The effective federal funds rate was very close to the target, on average, but the average absolute daily deviation of the effective rate from the target and the intraday standard deviation remained elevated. Credit spreads declined in the commercial paper and term interbank funding markets but stayed well above longer-term norms. Liquidity in the Treasury bill market was poor at times. Corporate bond spreads narrowed somewhat, leaving private yields a little lower. Nonfinancial bond issuance was robust; speculative-grade offerings increased markedly. The credit quality of most households remained strong, but delinquency rates on subprime mortgages climbed further. Securitization of nonconforming mortgages remained limited, and spreads on jumbo mortgages relative to conforming mortgages stayed high. Two-year Treasury yields declined roughly in line with the lower expected policy path, while yields on ten-year Treasuries were little changed, on net. TIPS-based inflation compensation was about unchanged on balance over the intermeeting period despite a sharp rise in spot oil prices. Stock prices jumped early in the intermeeting period in response to the cut in the target fed- 246 94th Annual Report, 2007 eral funds rate and some favorable economic news but later dropped back, leaving broad indexes up only a bit on net. The foreign exchange value of the dollar against other major currencies declined notably. Debt of the domestic nonfinancial sectors was estimated to have expanded slightly more quickly in the third quarter than in the previous quarter. Despite evidence that bank lending standards and terms had tightened over the previous three months, business debt was still rising strongly, reflecting a continued surge in commercial and industrial (C&I) lending by banks and robust issuance of investment-grade bonds. The expansion of business loans was apparently due in part to financings for leveraged buyouts that underwriters could not syndicate to institutional investors. Household mortgage borrowing was estimated to have decelerated again in the third quarter. M2 increased significantly more slowly in September and October than the rapid pace observed in August, when the financial market turmoil apparently drove investors to the safety of M2 assets. Inflows to retail money market funds and small time deposits were especially strong in September and October; small time deposits were apparently boosted by the attractive rates that banks were offering in order to help fund their expanding loan portfolios. In the forecast prepared for this meeting, which was formulated prior to the release of the advance estimates of the third-quarter national income and product accounts, the staff revised up its estimate of aggregate economic activity in the third quarter from its forecast presented at the September meeting in light of available indicators that suggested that consumer spending, business investment, and exports were stronger than previously expected. Nonetheless, the staff expected real GDP growth to be considerably slower in the fourth quarter, reflecting steepening declines in residential construction, reductions in the pace of motor vehicle production, and a smaller contribution from net exports. Looking forward, the staff expected residential investment to remain weak in 2008 with modest declines in house prices. In addition, the staff continued to expect the stress in credit markets and the appreciably higher oil prices indicated by futures markets to restrain spending by businesses and consumers, although the lower foreign exchange value of the dollar suggested some boost to net exports. On balance, real GDP growth for 2008 was projected to slow to a pace a bit below that of its potential, and unemployment was expected to creep up slightly. For 2009, the forecast called for real output growth to step up to a pace slightly above potential as the drags on economic activity exerted by the contraction in residential investment and financial strains were expected to abate. The staff's forecast for core PCE inflation was little changed from that presented at the September meeting because favorable incoming figures on core PCE inflation were offset by expectations for some limited feed-through into retail prices of recent increases in energy prices and for slightly less easing in resource utilization. The forecast for headline inflation was in the same range as that for core inflation in 2008 and 2009, reflecting expectations that energy prices would level off and then turn down and that increases in food prices would slow to a pace more in line with core inflation. The advance data on the national income and product accounts for the third quarter, which were released on the morning of the second day of the FOMC meeting, indicated a stronger increase in real GDP than the staff had forecast, Minutes of FOMC Meetings, October 247 mostly because inventory investment was estimated to be higher than projected by the staff. The staff interpreted this information as suggesting some upward revision to its estimate of output growth in the third quarter, a small downward revision to its forecast of growth in the current quarter, and no significant change to its forecast for coming quarters. In conjunction with the FOMC meeting in October, all meeting participants (Federal Reserve Board members and Reserve Bank presidents) provided annual projections for economic growth, unemployment, and inflation for the period 2007 through 2010. The projections are described in the Summary of Economic Projections, which is attached as an addendum to these minutes. In their discussion of the economic outlook and situation, and in the projections that they had submitted for this meeting, participants noted that economic activity had expanded at a somewhat faster pace in the third quarter than previously anticipated and that there was scant evidence of negative spillovers from the ongoing housing correction to other sectors of the economy. Conditions in financial markets had improved since the September FOMC meeting, but functioning in a number of markets remained strained. Even with some further easing of monetary policy, participants expected economic growth to slow over the next few quarters, reflecting continued sharp declines in the housing sector and tighter lending standards and terms across a broad range of credit products. The slowing of growth was likely to produce a modest increase in the unemployment rate from its recent levels, leading to the emergence of a little slack in labor markets. Looking further ahead, participants noted that economic growth should increase gradually to around its trend rate by 2009 as weakness in the housing sector abated and stresses in financial markets subsided. With aggregate demand showing somewhat greater than expected strength in the third quarter and little evidence of significant spillovers from the housing sector to other components of spending, participants viewed the downside risks to growth as somewhat smaller than at the time of the September meeting, but those risks were still seen as significant. Participants generally expected that inflation would edge down over the next few years, a projection consistent with the recent string of encouraging releases on core consumer prices, futures prices pointing to a flattening of energy costs, and the anticipated easing of pressures on resources. Nonetheless, some upside risks to inflation remained, reflecting in part the potential feed-through to inflation expectations of increases in energy and import prices. Financial market functioning was judged to have improved somewhat since the previous FOMC meeting, but the situation in a number of markets remained strained, and credit market conditions were thought likely to weigh on economic growth over coming quarters. In light of some improvement in the commercial paper and leveraged loan markets over the intermeeting period, participants were somewhat less concerned that banks would not have sufficient balance-sheet capacity to absorb large volumes of assets. Conditions in corporate credit markets also had improved in recent weeks, and most businesses were apparently having little difficulty raising external funds, as evidenced by strong issuance of investment-grade corporate bonds, a pickup in speculative-grade issuance, and surging C&I loans. Markets for nonconforming mortgages, by contrast, remained disrupted. Meeting participants also mentioned that while financial 248 94th Annual Report, 2007 market conditions had improved, the functioning of some markets remained somewhat impaired. Indeed, several participants noted some relapse in financial conditions late in the intermeeting period. Moreover, unusual pressures in funding markets persisted. Participants generally viewed financial markets as still fragile and were concerned that an adverse shock—such as a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses—could further dent investor confidence and significantly increase the downside risks to the economy. Participants were also concerned about a potential scenario in which unexpected economic weakness could cause a further tightening of credit conditions that could in turn reinforce weakness in aggregate demand. In their discussion of individual sectors of the economy, participants noted that the recent declines in housing activity—while substantial—had largely been anticipated. Nonetheless, the potential for significant further weakening in housing activity and home prices represented a downside risk to the economic outlook. Most participants pointed to the deterioration in nonprime mortgage markets as well as higher interest rates and tighter credit standards for prime nonconforming mortgages as factors that had exacerbated the deterioration in housing markets, and they noted that these developments could further limit the availability of mortgage credit and depress the demand for housing. Some participants also pointed to downside risks to the housing market stemming from the large volume of substantial upward interestrate resets that were likely on subprime mortgages in coming quarters, which could lead to a faster pace of foreclosures in the near term, thereby intensify ing the downward pressure on house prices. Participants generally agreed that the available data suggested that consumer spending had been well maintained over the past several months and that spillovers from the strains in the housing market had apparently been quite limited to date. Nevertheless, a number of participants cited notable declines in survey measures of consumer confidence since the onset of financial turbulence in midsummer, along with sharply higher oil prices, declines in house prices, and tighter underwriting standards for home equity loans and some types of consumer loans, as factors likely to restrain consumer spending going forward. Moreover, anecdotal reports by business contacts suggested a softening in retail sales in some regions of the country. Participants expressed a concern that larger-than-expected declines in house prices could further sap consumer confidence as well as net worth, causing a pullback in consumer spending. All told, however, participants envisioned that the most likely scenario was for consumer spending to continue to advance at a moderate rate in coming quarters, supported by the generally strong labor market and further gains in real personal income. Meeting participants noted that capital expenditures had grown at a solid pace in recent months and that the financial turmoil generally appeared to have had a limited effect on business capital spending plans to date. Nevertheless, business sentiment appeared to have eroded somewhat amid heightened economic and financial uncertainty, potentially restraining investment outlays in some industries. However, participants noted that conditions in corporate bond markets had improved since the September FOMC meeting, and that credit availability generally appeared to be Minutes of FOMC Meetings, October 249 ample, albeit on somewhat tighter terms. Participants judged that moderate growth of investment outlays going forward was the most likely outcome. A number of participants saw downside risk to the outlook for nonresidential building activity, reflecting elevated spreads on commercial-mortgagebacked securities and a further tightening of banks' lending standards for commercial real estate loans. Data on economic growth outside the United States indicated that the global expansion, though likely to slow somewhat in coming quarters, was nevertheless on a firm footing. The continued strength of global growth and the recent decline in the foreign exchange value of the dollar were seen as likely to support U.S. exports going forward. Readings on core inflation received during the intermeeting period continued to be generally favorable, and meeting participants agreed that the recent moderation in core inflation would likely be sustained. The slower pace of economic expansion anticipated for the next few quarters would help ease inflationary pressures. Nonetheless, participants expressed concern about the upside risks to the outlook for inflation. The recent increases in the prices of energy and other commodities, along with the significant decline in the foreign exchange value of the dollar, were cited as factors that could exert upward pressure on prices of some core goods and services in the near term. Increases in unit labor costs also could add to inflationary pressures. Moreover, participants expressed concern that some measures of inflation compensation calculated from TIPS securities had risen this year, although they viewed inflation expectations generally as remaining contained. Participants were concerned that if headline inflation remained above core measures for a sustained period, then longer term inflation expectations could move higher, a development that could lead to greater inflation pressures over the longer term and be costly to reverse. In the Committee's discussion of policy for the intermeeting period, members discussed the relative merits of lowering the target federal funds rate 25 basis points, to 4V2 percent, at this meeting or awaiting additional information on prospects for economic activity and inflation before assessing whether a further adjustment in the stance of monetary policy was necessary. Many members noted that this policy decision was a close call. However, on balance, nearly all members supported a 25 basis point reduction in the target federal funds rate. The stance of monetary policy appeared still to be somewhat restrictive, partly because of the effects of tighter credit conditions on aggregate demand. Moreover, most members saw substantial downside risks to the economic outlook and judged that a rate reduction at this meeting would provide valuable additional insurance against an unexpectedly severe weakening in economic activity. Many members were concerned about the still-sensitive state of financial markets and thought that an easing of policy would help to support improvements in market functioning, thereby mitigating some of the downside risks to economic growth. With real GDP likely to expand below its potential over coming quarters, recent price trends favorable, and inflation expectations appearing reasonably well anchored, the easing of policy at this meeting seemed unlikely to affect adversely the outlook for inflation. A number of members noted that the recent policy moves could readily be reversed if circumstances evolved in a manner that would warrant such action. The Committee agreed that the statement to be released at this meeting 250 94th Annual Report, 2007 should indicate that economic growth was solid in the third quarter and that strains in financial markets had eased somewhat on balance. Members also agreed that economic growth seemed likely to slow over coming quarters, but that the easing action taken at the meeting—combined with the 50 basis point cut in the target federal funds rate at the September meeting—should help to promote moderate growth over time, although some downside risks to growth would remain. Members felt that it was appropriate to underscore the upside risks to inflation stemming from the recent increases in the prices of energy and other commodities, even though recent readings on core inflation had been favorable. While the Committee saw uncertainty regarding the economic outlook as still elevated, it judged that, after this action, the upside risks to inflation roughly balanced the downside risks to growth. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions infinancialmarkets and promote moderate growth over time. Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects offinancialand other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. Votes for this action: Messrs. Bernanke, Geithner, Evans, Kohn, Kroszner, Mishkin, Poole, Rosengren, and Warsh. Votes against this action: Mr. Hoenig. Mr. Hoenig dissented because he believed that policy should remain unchanged at this meeting. Projections for the U.S. and global economies suggested that growth was likely to proceed at a The Federal Open Market Committee reasonable pace over the outlook period. seeks monetary and financial conditions that To better assure that outcome, the will foster price stability and promote sus- FOMC had moved rates down signifitainable growth in output. To further its cantly at its September meeting. At this long-run objectives, the Committee in the meeting, inflation risks appeared elimmediate future seeks conditions in reserve markets consistent with reducing the federal evated and Mr. Hoenig felt that the tarfunds rate to an average of around 41/2 per- get federal funds rate was currently close to neutral. In these circumstances, cent. The vote encompassed approval of he judged that policy needed to be the statement below to be released at slightly firm to better hold inflation in check. Going forward, if the data sug2:15 p.m.: gested the Committee needed to ease The Federal Open Market Committee further, it could do so. He also recogdecided today to lower its target for the Fed- nized that liquidity remains a near-term eral funds rate 25 basis points to AVi percent. Economic growth was solid in the third challenge and that the Federal Reserve quarter, and strains in financial markets have would be prepared to act if needed. Mr. Minutes of FOMC Meetings, October 251 Hoenig saw the risks to both economic growth and inflation to be elevated and preferred to wait, watch, and be ready to act depending on how events developed. The Committee then resumed its discussion of an enhanced role for the economic projections that are made periodically by the members of the Board of Governors and the Reserve Bank presidents. At this meeting, participants reached a consensus on increasing the frequency and expanding the content of the projections that in the past have been released to the public in summary form twice a year. They agreed to publish with the minutes a summary of participants' economic projections made for this meeting and to release a press statement describing the plan for the future. The release of more frequent forecasts covering longer time spans and accompanied by explanations of those forecasts was seen as providing the public with more context for understanding the Committee's monetary policy decisions. It was agreed that the next meeting of the Committee would be held on Tuesday, December 11,2007. The meeting adjourned at 12:00 noon. Summary of Economic Projections The projections, which are summarized in table 1 and chart 1, suggest that FOMC participants expected that, in the near term, output will grow at a pace somewhat below its trend rate and the unemployment rate will edge higher, owing primarily to weakness in housing markets and to the tightening in the availability of credit resulting from recent strains in financial markets. Further ahead, output was projected to expand at a pace close to its long-run trend. Total inflation was expected to be lower in 2008 than in 2007, and then to edge down further in subsequent years. In conjunction with the October 2007 FOMC meeting, the members of the Board of Governors and the presidents of the Federal Reserve Banks, all of whom participate in the deliberations of the FOMC, provided projections for economic growth, unemployment, and inflation in 2007, 2008, 2009, and 2010. Projections were based on information available through the conclusion of the October meeting, on each participant's assumptions regarding a range of factors likely to affect economic outcomes, and his or her assessment of appropriate monetary policy. "Appropriate monetary policy" is defined as the future policy most likely to foster outcomes for economic activity and inflation that best satisfy the participant's interpretation of the Federal Reserve's dual objectives of maximum employment and price stability. Notation Vote By notation vote completed on October 5, 2007, the Committee unanimously approved the minutes of the FOMC meeting held on September 18, 2007 and of the conference calls on August 10, 2007 and August 16, 2007. Brian F. Madigan Secretary The Outlook Data available at the time of the October FOMC meeting indicated that economic growth had been solid during the second and third quarters, and evidence that the contraction in the housing sector had begun to spill over substantially to other sectors of the economy remained scant. Consequently, despite the recent finan- 252 94th Annual Report, 2007 1. Economic Projections of Federal Reserve Governors and Reserve Bank Presidents1 2007 Central Tendencies Real GDP Growth .. June Projections .. Unemployment Rate June Projections .. PCE Inflation Core PCE Inflation .. June Projections .. Ranges Real GDP Growth .. June Projections .. Unemployment Rate June Projections .. PCE Inflation Core PCE Inflation .. June Projections .. 2.4 to 2.5 V/4 tO Vh 4.7 to 4.8 4Vi to 43A 2.9 to 3.0 1.8 to 1.9 2008 2009 2010 1.8 to 2.5 2.3 to 2.7 2.5 to 2.6 4.8 to 4.9 4.7 to 4.9 1.7 to 2.0 1.7 to 1.9 1.6 to 1.9 1.6 to 1.9 2.0 to 2.8 2.2 to 2.7 4.6 to 5.0 4.6 to 5.0 1.5 to 2.2 1.5 to 2.0 1.5 to 2.0 1.5 to 2.0 V/2 tO 23/4 4.8 to 4.9 about 43/4 1.8 to 2.1 1.7 to 1.9 2 to 2V4 P/4 tO 2 2.2 to 2.7 4.7 to 4.8 1.6 to 2.6 V/2 to 3 4.6 to 5.0 4Vi to 43M 4*/2 to 5 2.7 to 3.2 1.8 to 2.1 1.7 to 2.3 1.7 to 2.0 PA to 2 2 to 23/4 2 to 2V4 1. Projections of real GDP growth, PCE inflation, and core PCE inflation are fourth-quarter-to-fourth-quarter growth rates, that is, percentage changes from the fourth quarter of the prior year to the fourth quarter of the indicated year. PCE inflation and core PCE inflation are the percentage rates of change in the price index for personal consumption expenditures and the price index for personal consumption expenditures excluding food and energy, respectively. Projections for the unemploy- ment rate are for the average civilian unemployment rate in the fourth quarter of each year. Each participant's projections are based on his or her assessment of appropriate monetary policy. The range for each variable in a given year includes all participants' projections, from lowest to highest, for that variable in the given year; the central tendencies exclude the three highest and three lowest projections for each variable in each year. cial market turmoil, the central tendency of participants' projections for real GDP growth in 2007, at 2.4 to 2.5 percent, was little changed from the central tendency of the projections provided in conjunction with the June FOMC meeting and included in the Board's Monetary Policy Report to the Congress in July. However, the central tendency of participants' projections for real GDP growth in 2008 was revised down to 1.8 to 2.5 percent, notably below the 2l/i to 23/4 percent central tendency in June. These revisions to the 2008 outlook since June stemmed from a number of factors, including the tightened terms and reduced availability of subprime and jumbo mortgages, weaker-than-expected housing data, and rising oil prices. Partly in response to declining housing wealth, the personal saving rate was expected to rise over the next few years, contributing to restraint on the growth of personal consumption expenditures. How- ever, net exports were expected to provide some support to growth. The subpar economic growth projected in the near term was not anticipated to persist. Growth was expected to pick up as the adjustment in housing markets ran its course, financial markets gradually resumed more-normal functioning, and as the monetary policy easing at the September and October FOMC meetings provided support to aggregate demand. Economic activity was projected to expand at a pace broadly in line with participants' estimates of the rate of expansion of the economy's productive potential in 2009 and to continue at much the same pace in 2010. Participants read last summer's benchmark revisions to the national income and product accounts as suggesting a somewhat slower rate of trend growth than previously thought. Most participants expected that, with output growth running somewhat below Minutes of FOMC Meetings, October 253 1. Central Tendencies and Ranges of Economic Projections* Real GDP Growth H i Central tendency of projections Z1Z Range of projections Unemployment Rate PCE Inflation Core PCE Inflation Percent ^— 2002 2003 — • =£ == — 2004 * See notes to table 1 for variable definitions. trend over the next year or so, the unemployment rate would increase modestly. The central tendency of participants' projections for the average rate of unemployment in the fourth quarter of 2008 was 4.8 to 4.9 percent, slightly above the 43/4 percent unemployment rate forecasted in June; these projections suggested the emergence of a little slack in labor markets. The central tendency of participants' projections was for the unemployment rate to stabilize in 2009 and to fall back a bit in 2010 as output and employment growth pick up. Overall inflation was expected to edge down over the next few years, fostered by an assumed flattening of energy prices about in line with futures markets 254 94th Annual Report, 2007 quotes, a modest easing of pressures on conditions, which could in turn slow the resource utilization, and fairly well an- economy further. The potential for a chored inflation expectations. Partici- more severe contraction in the housing pants' projections for core inflation this sector and a substantial decline in house year and next were marked down from prices was also perceived as a risk to the those provided at the time of the June central outlook for economic growth. FOMC meeting, partly in light of recent But participants also noted that in recent generally favorable core inflation data decades, the U.S. economy had proved that pointed to some reduction in under- quite resilient to episodes of financial lying inflation pressures. The central distress, suggesting that the adverse eftendency of projections for core PCE fects of financial developments on ecoinflation in 2007 was 1.8 to 1.9 percent, nomic activity outside of the housing down from 2 to 2VA percent in June. The sector could prove to be more modest central tendency of core inflation projec- than anticipated. tions for 2008 was 1.7 to 1.9 percent. Participants were more persuaded Participants' projections for PCE infla- than they had been in June that the detion in 2009 and 2010 were importantly cline in core inflation readings this year influenced by their judgments about the represented a sustained albeit modest measured rates of inflation consistent step-down rather than the effect of tranwith the Federal Reserve's dual man- sitory influences. Nonetheless, particidate to promote maximum employment pants saw some upside risks to their inand price stability and about the time flation projections. Recent increases in frame over which policy should aim to energy and commodity prices and the attain those rates given current eco- pass-through of dollar depreciation into nomic conditions. The central tendency import prices would raise inflation over of participants' projections for both core the medium term. That increase could and total inflation in 2010 ranged from lead to an upward drift in inflation ex1.6 to 1.9 percent. pectations that would add to price pressures and could be costly to reverse. Risks to the Outlook The possibility that financial market Most participants viewed the risks to turbulence could have larger-thantheir GDP projections as weighted to the anticipated adverse effects on household downside and the associated risks to and business spending heightened partheir projections of unemployment as ticipants' uncertainty about the outlook tilted to the upside. Financial market for economic activity. Most participants conditions had deteriorated sharply in judged that the uncertainty attending August, and although there had been their October projections for real GDP some signs of improvement since then, growth was above typical levels seen in markets remained strained. The possi- the past. (Table 2 provides an estimate bilities that markets could relapse or that of average ranges of forecast uncertainty current tighter credit conditions could for GDP growth, unemployment, and inexert unexpectedly large restraint on flation over the past twenty years.13) In household and business spending were viewed as downside risks to economic 13. The box "Forecast Uncertainty" at the end activity. Participants were concerned about the possibility for adverse feed- of this summary discusses the sources and interpretation of uncertainty in economic forecasts and backs in which economic weakness explains the approach used to assess the uncercould lead to further tightening in credit tainty and risks attending participants' projections. Minutes of FOMC Meetings, October 255 tions for real GDP growth in 2008 was markedly wider than in June. The dispersion of participants' projections for 2007 2008 2009 2010 growth next year seemed largely to re2 ±0.6 ±1.3 ±1.4 ±1.4 Real GDP flect differing assessments of the likely ±0.2 ±0.6 ±0.9 ±1.1 Unemployment rate3 Total consumer prices2 ... ±0.3 ±1.0 ±1.0 ±1.0 depth and duration of the correction in the housing market, the effect of finan1. "Average historical projection error ranges" for the cial market disruptions on real activity years 2007 through 2010 are measured as plus or minus the root mean squared error of projections that were reoutside of the housing sector, and the leased in the autumn from 1986 through 2006 for the speed with which financial markets will current and following three years hy various private and government forecasters. As described in the forecast unreturn to more normal functioning. The certainty box, under certain assumptions, there is about a dispersion of participants' projections 70 percent probability that actual outcomes for real activfor the rate of unemployment over the ity, unemployment, and inflation will fall in ranges implied by the average size of projection errors made in the next year or so had changed little. Parpast. For further information, see David Reifschneider ticipants' longer-term projections for and Peter Tulip, "Gauging the Uncertainty of the Ecoreal GDP growth and for the rate of nomic Outlook from Historical Forecast Errors," Federal Reserve Board Financial and Economics Discussion Seunemployment were more heavily influries #2007-60 (November 2007). enced by their views about, respectively, 2. Overall consumer price index, as this is the price measure that has been most widely used in government the economy's trend growth rate and the and private economic forecasts. Percent change, fourth unemployment rate that would be conquarter of year relative to fourth quarter of preceding sistent over time with maximum emyear. 3. Percent, fourth-quarter average. ployment. The dispersion of the projections for PCE inflation in the near term contrast, the uncertainty attached to par- partly reflected different weights atticipants' inflation projections was gen- tached to the various factors expected to erally viewed as being broadly in line foster a moderation of inflation. Some with past experience, although several participants judged that the anticipated participants judged that the degree of modest easing in resource pressures was uncertainty about total inflation was unlikely to have a marked effect on inhigher than usual, reflecting the possi- flation. Similarly, views differed about bility that the recent volatility in food the influence that inflation expectations and energy prices might persist. would exert on inflation over the short and medium run. Participants' projecDiversity of Participants' Views tions further out were also influenced by Charts 2(a) and 2(b) provide more detail their views about the rate of inflation on the diversity of participants' views. consistent with the Federal Reserve's The dispersion of participants' projec- dual mandate. 2. Average Historical Projection Error Ranges1 256 94th Annual Report, 2007 2(a). Distribution of Participants' Projections (percent)* Unemployment Rate Real GDP 2007 2007 Number of Participants Number of Participants 1 1 1 June Projections i n 1 1 : October Projections ] June Projections October Projeclio • 16 12 1 8 4 1 ill 2008 0 2008 Number of Participants Number of Participants T--H I 1 mm•::;-;••:-:••• 1.6-1.7 1.8-1.9 2.0-2.1 2.2-2.3 2.4-2.5 2.6-2.7 2.8-2.9 3.0-3.1 2009 4.44.5 4.64.7 ~ ——-.—I 4.8-4.9 5.0-5.1 5.2-5.3 2009 Number of Participants i i 4.44.5 2010 4.6-4.7 4.84.9 5.0-5.1 5.2-5.3 2010 Number of Participants Number of Participants . 4.44.5 _ 4.6-4.7 4.8-4.9 5.0-5.1 5.2-5.3 * See notes to table 1 for variable definitions. Those participants' June projections that were provided in quarter points have been rounded to the nearest tenth for the construction of these histograms. Minutes of FOMC Meetings, October 257 2(b). Distribution of Participants' Projections (percent)* PCE Inflation Core PCE Inflation 2007 2007 Number of Participants Number of Participants 16 October Projections 1 6 June Projections October Projections 1 2 12 i ! 4 1.71.8 1.92.0 1.3-1.4 2.12.2 2008 liii •111! 0 1.51.6 1.5-1.6 1.7-1.8 8 1 8 4 i 0 1.9-2.0 2008 Number of Participants Number of Participants II 1.3-1.4 2009 1.5-1.6 1.7-1.8 1.9-2.0 2009 Number of Participants Number of Participants I 1.3-1.4 2010 1.5-1.6 1.7-1.8 1.9-2.0 2.1-2.2 2.3-2.4 2010 Number of Participants Number of Participants 16 12 • 1.51.6 4 0 1.7- 1.9- 2.1- 2.3- 2.5- 2.7- 2.9- 3.1- 1.3-1.4 1.5-1.6 1.7-1.8 1.9-2.0 2.1-2.2 2.3-2.4 • See notes to table 1 for variable definitions. Those participants' June projections that were provided in quarter points have been rounded to the nearest tenth for the construction of these histograms. 258 94th Annual Report, 2007 Forecast Uncertainty The economic projections provided by the members of the Board of Governors and the presidents of the Federal Reserve Banks help shape monetary policy and can aid public understanding of the basis for policy actions. Considerable uncertainty attends these projections, however. The economic and statistical models and relationships used to help produce economic forecasts are necessarily imperfect descriptions of the real world. And the future path of the economy can be affected by myriad unforeseen developments and events. Thus, in setting the stance of monetary policy, participants consider not only what appears to be the most likely economic outcome as embodied in their projections, but also the range of alternative possibilities, the likelihood of their occurring, and the potential costs to the economy should they occur. Table 2 summarizes the average historical accuracy of a range of forecasts, including those reported in past Monetary Policy Reports and those prepared by Federal Reserve Board staff in advance of meetings of the Federal Open Market Committee. The projection error ranges shown in the table illustrate the considerable uncertainty associated with economic forecasts. For example, suppose a participant projects that real GDP and total consumer prices will rise steadily at annual rates of, respectively, 3 percent and 2 percent. If the uncertainty attending those projections is similar to that experienced in the past and the risks around the projections are broadly balanced, the numbers reported in table 2 might imply a probability of about 70 percent that actual GDP would expand 2.4 percent to 3.6 percent in the current year, 1.7 percent to 4.3 percent next year, and 1.6 percent to 4.4 percent in the third and fourth years. The corresponding 70 percent confidence intervals for overall inflation would be 1.7 percent to 2.3 percent in the current year and 1.0 percent to 3.0 percent in the second, third, and fourth years. Because current conditions may differ from those that prevailed on average over history, participants provide judgments as to whether the uncertainty attached to their projections of each variable is greater than, smaller than, or broadly similar to typical levels of forecast uncertainty in the past as shown in table 2. Participants also provide judgments as to whether the risks to their projections are weighted to the upside, downside, or are broadly balanced. That is, participants judge whether each variable is more likely to be above or below their projections of the most likely outcome. These judgments about the uncertainty and the risks attending each participant's projections are distinct from the diversity of participants' views about the most likely outcomes. Forecast uncertainty is concerned with the risks associated with a particular projection, rather than with divergences across a number of different projections. Minutes of FOMC Meetings, December 259 Meeting Held on December 11, 2007 Ms. Liang and Mr. Wascher, Associate Directors, Division of Research and Statistics, Board of Governors A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, December 11, 2007, at 8:00 a.m. Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Present: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Poole Mr. Rosengren Mr. Warsh Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Ms. Cumming, Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Mr. Sheets, Economist Mr. Stockton, Economist Messrs. Clouse, Connors, Fuhrer, Kamin, Rasche, Sellon, Slifman, Sullivan, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Mr. Struckmeyer, Deputy Staff Director, Office of Staff Director for Management Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Mr. Meyer, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas Mr. Altig, Ms. Perelmuter, Messrs. Rolnick, Weinberg, and Williams, Senior Vice Presidents, Federal Reserve Banks of Atlanta, New York, Minneapolis, Richmond, and San Francisco, respectively Messrs. Bryan and Yi, Vice Presidents, Federal Reserve Banks of Cleveland and Philadelphia, respectively Mr. McCarthy, Research Officer, Federal Reserve Bank of New York The Manager of the System Open Market Account reported on recent developments in foreign exchange markets. There were no open market operations in foreign currencies for the System's account in the period since the previous meeting. The Manager also reported on developments in domestic financial markets and on System open market operations in government securities and federal agency obligations during the period since the previous meeting. By unanimous vote, the Committee ratified these transactions. 260 94th Annual Report, 2007 The Committee approved a foreign currency swap arrangement with the Swiss National Bank that paralleled the arrangement with the European Central Bank approved during the Committee's conference call on December 6, 2007. With Mr. Poole dissenting, the Committee voted to direct the Federal Reserve Bank of New York to establish and maintain a reciprocal currency (swap) arrangement for the System Open Market Account with the Swiss National Bank in an amount not to exceed $4 billion. The Committee authorized associated draws of up to the full amount of $4 billion, and the arrangement itself was authorized for a period of up to 180 days unless extended by the FOMC. Mr. Poole dissented because he viewed the swap agreement as unnecessary in light of the size of the Swiss National Bank's dollar-denominated foreign exchange reserves. The information reviewed at the December meeting indicated that, after the robust gains of the summer, economic activity decelerated significantly in the fourth quarter. Consumption growth slowed, and survey measures of sentiment dropped further. Many readings from the business sector were also softer: Industrial production fell in October, as did orders and shipments of capital goods. Employment gains stepped down during the four months ending in November from their pace earlier in the year. Headline consumer price inflation moved higher in September and October as energy prices increased significantly; core inflation also rose but remained moderate. The slowing in private employment gains was due in large part to the ongoing weakness in the housing market. Employment in residential construction posted its fourth month of sizable declines in November, and employment in housing-related sectors such as finance, real estate, and building-material and garden-supply retailers continued to trend down. Elsewhere, factory jobs declined again, while employment in most service-producing industries continued to move up. Aggregate hours of production or nonsupervisory workers edged up in October and November. Some indicators from the household survey also suggested softening in the labor market, but the unemployment rate held steady at 4.7 percent through November. Industrial production fell in October after small increases in the previous two months. The index for motor vehicles and parts fell for the third consecutive month, and the index for construction supplies moved down for the fourth straight month. Materials output also declined in October, with production likely curbed by weak demand from the construction and motor vehicle sectors. Production in high-tech industries, however, increased modestly, and commercial aircraft production registered another solid gain. In November, output appeared to have edged up in manufacturing sectors (with the exception of the motor vehicles sector) for which weekly physical product data were available. After posting notable gains in the summer, real consumer spending was nearly flat in September and October. Spending on goods excluding motor vehicles was little changed on net over that period. Spending on services edged down, reflecting an extraordinarily large drop in securities commissions in September. The most recent readings on weekly chain store sales as well as industry reports and surveys suggested subdued gains in November and an uneven start to the holiday shopping season. Sales of light motor vehicles in November remained close to the pace that had prevailed since the second quarter. Real disposable income was about unchanged in September and October. The Minutes of FOMC Meetings, December 261 Reuters/University of Michigan index of consumer sentiment ticked down further in early December as respondents took a more pessimistic view of the outlook for their personal finances and for business conditions in the year ahead. In the housing market, new home sales were below their third-quarter pace, and sales of existing homes were flat in October following sharp declines in August and September. These declines likely were exacerbated by the deterioration in nonprime mortgage markets and by the higher interest rates and tighter lending conditions for jumbo loans. Single-family housing starts stepped down again in October after substantial declines in the JuneSeptember period. Yet, because of sagging sales, builders made only limited progress in paring down their substantial inventories. Single-family permit issuance continued along the steep downward trajectory that had begun two years earlier, which pointed toward further slowing in homebuilding over the near term. Multifamily starts rebounded in October from an unusually low reading in September, and the level of multifamily starts was near the midpoint of the range in which this series had fluctuated over the past ten years. Real spending on equipment and software posted a solid increase in the third quarter. In October, however, orders and shipments of nondefense capital goods excluding aircraft declined, suggesting that some deceleration in spending was under way in the fourth quarter. The October decline in orders and shipments was led by weakness in the high-tech sector: Shipments of computers and peripheral equipment declined while the industrial production index for computers was flat; orders and shipments for communications equipment plunged. Some of that weakness may have been attributable to temporary production dis ruptions stemming from the wildfires in Southern California; cutbacks in demand from large financial institutions affected by market turmoil may have contributed as well. In the transportation equipment category, purchases of medium and heavy trucks changed little, and orders data suggested that sales would remain near their current levels in the coming months. Orders for equipment outside high-tech and transportation rose in October, but shipments were about flat, pointing to a weaker fourth quarter for business spending after two quarters of brisk increases. Some prominent surveys of business conditions remained consistent with modest gains in spending on equipment and software during the fourth quarter, but other surveys were less sanguine. In addition, although the cost of capital was little changed for borrowers in the investment-grade corporate bond market, costs for borrowers in the high-yield corporate bond market were up significantly. In the third quarter, corporate cash flows appeared to have dropped off, leaving firms with diminished internally generated funds for financing investment. Data available through October suggested that nonresidential building activity remained vigorous. Real nonfarm inventory investment excluding motor vehicles increased slightly faster in the third quarter than in the second quarter. Outside of motor vehicles, the ratio of book-value inventories to sales had ticked up slightly in September but remained near the low end of its range in recent years. Bookvalue estimates of the inventory investment of manufacturers—the only inventory data available beyond the third quarter—were up in October at about the third-quarter pace. The U.S. international trade deficit narrowed slightly in September as an increase in exports more than offset 262 94th Annual Report, 2007 higher imports. The September gain in exports primarily reflected higher exports of goods; services exports recorded moderate growth. Exports of agricultural products exhibited particularly robust growth, with both higher prices and greater volumes. Exports of industrial supplies and consumer goods also moved up smartly in September. Automotive products exports, in contrast, were flat, and capital goods exports fell, led by a decline in aircraft. The increase in imports primarily reflected higher imports of capital goods, with imports of computers showing particularly strong growth. Imports of automotive products, consumer goods, and services also increased. Imports of petroleum, however, were flat, and imports of industrial supplies fell. Output growth in the advanced foreign economies picked up in the third quarter. In Japan, real output rebounded, led by exports. In the euro area, GDP growth returned to a solid pace in the third quarter on the back of a strong recovery in investment. In Canada and the United Kingdom, output growth moderated but remained robust, as vigorous domestic demand was partly offset by rapid growth of imports. Indicators of fourth-quarter activity in the advanced foreign economies were less robust on net. Confidence indicators had deteriorated in most major economies in the wake of the financial turmoil and remained relatively weak. In November, the euro-area and U.K. purchasing managers indexes for services were well below their level over the first half of the year; nevertheless they pointed to moderate expansion. Labor market conditions generally remained relatively strong in recent months. Incoming data on emerging-market economies were positive on balance. Overall, growth in emerging Asia moderated somewhat in the third quarter from its double-digit pace in the second quarter, but remained strong. Economic growth was also solid in Latin America, largely reflecting stronger-than-expected activity in Mexico. In the United States, headline consumer price inflation increased in September and October from its low rates in the summer as the surge in crude oil prices began to be reflected in retail energy prices. In addition, though the rise in food prices in October was slower than in August and September, it remained above that of core consumer prices. Excluding food and energy, inflation was moderate, although it was up from its low rates in the spring. The pickup in core consumer inflation over this period reflected an acceleration in some prices that were unusually soft last spring, such as those for apparel, prescription drugs, and medical services, as well as nonmarket prices. On a twelvemonth-change basis, core consumer price inflation was down noticeably from a year earlier. In October, the producer price index for core intermediate materials moved up only slightly for a second month, and the twelve-month increase in these prices was considerably below that of the year-earlier period. This pattern reflected, in part, a deceleration in the prices of a wide variety of construction materials, such as cement and gypsum, and in the prices of some metal products. In response to rising energy prices, household survey measures of expectations for year-ahead inflation picked up in November and then edged higher in December. Households' longer-term inflation expectations also edged up in both November and December. Average hourly earnings increased faster in November than in the previous two months. Over the twelve months that ended in November, however, this wage measure rose a bit more slowly than over the previous twelve months. Minutes of FOMC Meetings, December 263 expected path for policy. During the intermeeting period, the release of the FOMC minutes and associated summary of economic projections, as well as various data releases, elicited only modest market reaction. In contrast, markets were buffeted by concerns about the potential adverse effects on credit availability and economic growth of sizable losses at large financial institutions and of financial market strains in general. Market participants marked down their expected path for policy substantially, and by the time of the December meeting, investors were virtually certain of a rate cut. Two-year Treasury yields fell on net over the intermeeting period by an amount about in line with revisions to policy expectations. Ten-year Treasury yields also declined, but less than shorter-term yields. The steepening of the yield curve was due mostly to sharply lower short- and intermediateterm forward rates, consistent with investors' apparently more pessimistic outlook for economic growth. TIPS yields fell less than their nominal counterparts, implying modest declines in inflation compensation both at the fiveyear and longer horizons. After showing some signs of improvement in late September and October, conditions in financial markets worsened over the intermeeting period. Heightened worries about counterparty credit risk, balance sheet constraints, and liquidity pressures affected interbank funding markets and commercial paper markets, where spreads over riskfree rates rose to levels that were, in some cases, higher than those seen in The Committee's action at its Octo- August. Strains in those markets were ber meeting was largely expected by exacerbated by concerns related to yearmarket participants, although the assess- end pressures. In longer-term corporment that the upside risks to inflation ate markets, both investment- and balanced the downside risks to growth speculative-grade credit spreads widwas not fully anticipated and apparently ened considerably; issuance slowed but led investors to revise up slightly the remained strong. In housing finance, At its October meeting, the FOMC lowered its target for the federal funds rate 25 basis points, to 4Vi percent. The Board of Governors also approved a 25 basis point decrease in the discount rate, to 5 percent, leaving the gap between the federal funds rate target and the discount rate at 50 basis points. The Committee's statement noted that, while economic growth was solid in the third quarter and strains in financial markets had eased somewhat on balance, the pace of economic expansion would likely slow in the near term, partly reflecting the intensification of the housing correction. The Committee indicated that its action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should promote moderate growth over time. Readings on core inflation had improved modestly during the year, but the statement noted that recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judged that some inflation risks remained and indicated that it would continue to monitor inflation developments carefully. The Committee also judged that, after this action, the upside risks to inflation roughly balanced the downside risks to growth. The Committee said that it would continue to assess the effects of financial and other developments on economic prospects and would act as needed to foster price stability and sustainable economic growth. 264 94th Annual Report, 2007 subprime mortgage markets stayed virtually shut, and spreads on jumbo loans apparently widened further. Spreads on conforming mortgage products also widened after reports of losses and reduced capital ratios at the housingrelated government-sponsored enterprises. Broad-based equity indexes were volatile and ended the period down noticeably. Financial stocks were especially hard hit, dropping substantially more than the broad indexes. Similar stresses were evident in the financial markets of major foreign economies. The trade-weighted foreign exchange value of the dollar against major currencies moved up, on balance, over the intermeeting period. Debt in the domestic nonfinancial sector was estimated to be increasing somewhat more slowly in the fourth quarter than in the third quarter. Nonfinancial business debt continued to expand strongly, supported by solid bond issuance and by a small rebound in the issuance of commercial paper. Bank loans outstanding also continued to rise rapidly. Household mortgage debt was expected to expand at a reduced rate in the fourth quarter, reflecting softer home prices and declining home sales, as well as a tightening in credit conditions for some borrowers. Nonmortgage consumer credit in the fourth quarter appeared to be expanding at a moderate pace. In November, M2 growth picked up slightly from its October rate. While liquid deposits continued to grow slowly, heightened demand for safety and liquidity appeared to boost holdings of retail money market mutual funds. Small time deposits continued to expand, likely in part due to high rates offered by some depository institutions to attract retail deposits. Currency outstanding was about flat in November. In the forecast prepared for this meeting, the staff revised down its estimate of growth in aggregate economic activity in the fourth quarter. Although thirdquarter real GDP was revised up sharply, most available indicators of activity in the fourth quarter were more downbeat than had previously been expected. Faster inventory investment contributed importantly to the upward revision to third-quarter real GDP, but part of that upswing was expected to be unwound in the fourth quarter. The available data for domestic final sales also suggested a weaker fourth quarter than had been anticipated. In particular, real personal consumption expenditures had been about unchanged in September and October, and the contraction in singlefamily construction had intensified. Providing a bit of an offset to these factors, however, was further improvement in the external sector. The staff also marked down its projection for the rise in real GDP over the remainder of the forecast period. Real GDP was anticipated to increase at a rate noticeably below its potential in 2008. Conditions in financial markets had deteriorated over the intermeeting period and were expected to impose more restraint on residential construction as well as consumer and business spending in 2008 than previously expected. In addition, compared with the previous forecast, higher oil prices and lower real income were expected to weigh on the pace of real activity throughout 2008 and 2009. By 2009, however, the staff projected that the drag from those factors would lessen and that an improvement in mortgage credit availability would lead to a gradual recovery in the housing market. Accordingly, economic activity was expected to increase at its potential rate in 2009. The external sector was projected to continue to support domestic economic activity throughout the forecast period. Reflecting upward revisions to previously published data, the forecast Minutes of FOMC Meetings, December 265 for core PCE price inflation for 2007 was a bit higher than in the preceding forecast; core inflation was projected to hold steady during 2008 as the indirect effects of higher energy prices on prices of core consumer goods and services were offset by the slight easing of resource pressures and the expected deceleration in the prices of nonfuel imported goods. The forecast for headline PCE inflation anticipated that retail energy prices would rise sharply in the first quarter of 2008 and that food price inflation would outpace core price inflation in the beginning of the year. As pressures from these sources lessened over the remainder of 2008 and in 2009, both core and headline price inflation were projected to edge down, and headline inflation was expected to moderate to a pace slightly below core inflation. In their discussion of the economic situation and outlook, participants generally noted that incoming information pointed to a somewhat weaker outlook for spending than at the time of the October meeting. The decline in housing had steepened, and consumer outlays appeared to be softening more than anticipated, perhaps indicating some spillover from the housing correction to other components of spending. These developments, together with renewed strains in financial markets, suggested that growth in late 2007 and during 2008 was likely to be somewhat more sluggish than participants had indicated in their October projections. Still, looking further ahead, participants continued to expect that, aided by an easing in the stance of monetary policy, economic growth would gradually recover as weakness in the housing sector abated and financial conditions improved, allowing the economy to expand at about its trend rate in 2009. Participants thought that recent increases in energy prices likely would boost headline infla tion temporarily, but with futures prices pointing to a gradual decline in oil prices and with pressures on resource utilization seen as likely to ease a bit, most participants continued to anticipate some moderation in core and especially headline inflation over the next few years. Participants discussed in detail the resurgence of stresses in financial markets in November. The renewed stresses reflected evidence that the performance of mortgage-related assets was deteriorating further, potentially increasing the losses that were being borne in part by a number of major financial firms, including money-center banks, housing-related government-sponsored enterprises, investment banks, and financial guarantors. Moreover, participants recognized that some lenders might be exposed to additional losses: Delinquency rates on credit card loans, auto loans, and other forms of consumer credit, while still moderate, had increased somewhat, particularly in areas hard hit by house price declines and mortgage defaults. Past and prospective losses appeared to be spurring lenders to tighten further the terms on new extensions of credit, not just in the troubled markets for nonconforming mortgages but, in some cases, for other forms of credit as well. In addition, participants noted that some intermediaries were facing balance sheet pressures and could become constrained by concerns about rating-agency or regulatory capital requirements. Among other factors, banks were experiencing unanticipated growth in loans as a result of continuing illiquidity in the market for leveraged loans, persisting problems in the commercial paper market that had sparked draws on back-up lines of credit, and more recently, consolidation of assets of off-balance-sheet affiliates onto banks' balance sheets. 266 94th Annual Report, 2007 Concerns about credit risk and the pressures on banks' balance sheet capacity appeared to be contributing to diminished liquidity in interbank markets and to a pronounced widening in term spreads for periods extending through year-end. A number of participants noted some potential for the Federal Reserve's new Term Auction Facility and accompanying actions by other central banks to ameliorate pressures in term funding markets. Participants recognized, however, that uncertainties about values of mortgage-related assets and related losses, and consequently strains in financial markets, could persist for quite some time. Some participants cited more-positive aspects of recent financial developments. A number of large financial intermediaries had been able to raise substantial amounts of new capital. Moreover, credit losses and asset writedowns at regional and community banks had generally been modest; these institutions typically were not facing balance sheet pressures and reportedly had not tightened lending standards appreciably, except for those on real estate loans. And, although spreads on corporate bonds had widened over the intermeeting period, especially for speculativegrade issues, the cost of credit to most nonfinancial firms remained relatively low; nonfinancial firms outside of the real estate and construction sectors generally reported that credit conditions, while somewhat tighter, were not restricting planned investment spending; and consumer credit remained readily available for most households. Nonetheless, participants agreed that heightened financial stress posed increased downside risks to growth and made the outlook for the economy considerably more uncertain. Participants noted the marked deceleration in consumer spending in the na tional data. Real personal consumption expenditures had shown essentially no growth in September and October, suggesting that tighter credit conditions, higher gasoline prices, and the continuing housing correction might be restraining growth in real consumer spending. Retailers reported weaker results in many regions of the country, but in some, retailers saw solid growth. Job growth rebounded somewhat in October and November, and participants expected continuing gains in employment and income to support rising consumer spending, though they anticipated slower growth of jobs, income, and spending than in recent years. However, consumer confidence recently had dropped by a sizable amount, leading some participants to voice concerns that household spending might increase less than currently anticipated. Recent data and anecdotal information indicated that the housing sector was weaker than participants had expected at the time of the Committee's previous meeting. In light of elevated inventories of unsold homes and the higher cost and reduced availability of nonconforming mortgage loans, participants agreed that the housing correction was likely to be both deeper and more prolonged than they had anticipated in October. Moreover, rising foreclosures and the resulting increase in the supply of homes for sale could put additional downward pressure on prices, leading to a greater decline in household wealth and potentially to further disruptions in the financial markets. Indicators of capital investment for the nation as a whole suggested solid but appreciably less rapid growth in business fixed investment during the fourth quarter than the third. Participants reported that firms in some regions and industries had indicated they would scale back capital spending, while con- Minutes of FOMC Meetings, December 267 tacts in other parts of the country or industries reported no such change. Similarly, business sentiment had deteriorated in many parts of the country, but in other areas firms remained cautiously optimistic. Anecdotal evidence generally suggested that inventories were not out of line with desired levels. Even so, participants expected that inventory accumulation would slow from its elevated third-quarter pace. Several participants remarked that, unlike residential real estate, commercial and industrial real estate activity remained solid in their Districts. But participants also noted the deterioration in the secondary market for commercial real estate loans and the possible effects of that development, should it persist, on building activity. The available data showed strong growth abroad and solid gains in U.S. exports. Participants noted that rising foreign demand was benefiting U.S. producers of manufactured goods and agricultural products, in particular. Exports were unlikely to continue growing at the robust rate reported for the third quarter, but participants anticipated that the combination of the weaker dollar and stillstrong, though perhaps less-rapid, growth abroad would mean continued firm growth in U.S. exports. Several participants observed, however, that strong growth in foreign economies and U.S. exports might not persist if global financial conditions were to deteriorate further. Recent readings on inflation generally were seen as slightly less favorable than in earlier months, partly due to upward revisions to previously published data. Moreover, earlier increases in energy and food prices likely would imply higher headline inflation in the next few months, and past declines in the dollar would put upward pressure on import prices. Some participants said that higher input costs and rising prices of imports were leading more firms to seek price increases for goods and services. However, few business contacts had reported unusually large wage increases. Downward revisions to earlier compensation data, along with the latest readings on compensation and productivity, indicated only moderate pressure on unit labor costs. With futures prices pointing to a gradual decline in oil prices and with an anticipation of some easing of pressures on resource utilization, participants generally continued to see core PCE inflation as likely to trend down a bit over the next few years, as in their October projections, and headline inflation as likely to slow more substantially from its currently elevated level. Nonetheless, participants remained concerned about upside risks to inflation stemming from elevated prices of energy and nonenergy commodities; some also cited the weaker dollar. Participants agreed that continued stable inflation expectations would be essential to achieving and sustaining a downward trend to inflation, that well-anchored expectations couldn't be taken for granted, and that policymakers would need to continue to watch inflation expectations closely. In the Committee's discussion of monetary policy for the intermeeting period, members judged that the softening in the outlook for economic growth warranted an easing of the stance of policy at this meeting. In view of the further tightening of credit and deterioration of financial market conditions, the stance of monetary policy now appeared to be somewhat restrictive. Moreover, the downside risks to the expansion, resulting particularly from the weakening of the housing sector and the deterioration in credit market conditions, had risen. In these circumstances, policy easing would help foster maximum sustainable growth and provide some additional in- 268 94th Annual Report, 2007 surance against risks. At the same time, members noted that policy had already been eased by 75 basis points and that the effects of those actions on the real economy would be evident only with a lag. And some data, including readings on the labor market, suggested that the economy retained forward momentum. Members generally saw overall inflation as likely to be lower next year, and core inflation as likely to be stable, even if policy were eased somewhat at this meeting; but they judged that some inflation pressures and risks remained, including pressures from elevated commodity and energy prices and the possibility of upward drift in the public's expectations of inflation. Weighing these considerations, nearly all members judged that a 25 basis point reduction in the Committee's target for the federal funds rate would be appropriate at this meeting. Although members agreed that the stance of policy should be eased, they also recognized that the situation was quite fluid and the economic outlook unusually uncertain. Financial stresses could increase further, intensifying the contraction in housing markets and restraining other forms of spending. Some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit; such an adverse development could require a substantial further easing of policy. Members also recognized that financial market conditions might improve more rapidly than members expected, in which case a reversal of some of the rate cuts might become appropriate. The Committee agreed that the statement to be released after this meeting should indicate that economic growth appeared to be slowing, reflecting the intensification of the housing correction and some softening in business and con sumer spending, and that strains in financial markets had increased. The characterization of the inflation situation could be largely unchanged from that of the previous meeting. Members agreed that the resurgence of financial stresses in November had increased uncertainty about the outlook. Given the heightened uncertainty, the Committee decided to refrain from providing an explicit assessment of the balance of risks. The Committee agreed on the need to remain exceptionally alert to economic and financial developments and their effects on the outlook, and members would be prepared to adjust the stance of monetary policy if prospects for economic growth or inflation were to worsen. At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the lfederal funds rate to an average of around 4 A percent. The vote encompassed approval of the statement below to be released at 2:15 p.m.: The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4V4 percent. Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time. Minutes of FOMC Meetings, December 269 Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. Votes for this action: Messrs. Bernanke, Geithner, Evans, Hoenig, Kohn, Kroszner, Mishkin, Poole, and Warsh. Votes against this action: Mr. Rosengren. Mr. Rosengren dissented because he regarded the weakness in the incoming economic data and in the outlook for the economy as warranting a more aggressive policy response. In his view, the combination of a deteriorating housing sector, slowing consumer and business spending, high energy prices, and illfunctioning financial markets suggested heightened risk of continued economic weakness. In light of that possibility, a more decisive policy response was called for to minimize that risk. In any case, he felt that well-anchored inflation expectations and the Committee's ability to reverse course on policy would limit the inflation risks of a larger easing move, should the economy instead prove significantly stronger than anticipated. It was agreed that the next meeting of the Committee would be held on Tuesday-Wednesday, January 29-30, 2008. The meeting adjourned at 1:15 p.m. Notation Vote By notation vote completed on November 19, 2007, the Committee unani mously approved the minutes of the FOMC meeting held on October 30-31, 2007. Conference Call On December 6, 2007, in a joint session of the Federal Open Market Committee and the Board of Governors, Board members and Reserve Bank presidents reviewed conditions in domestic and foreign financial markets and discussed two proposals aimed at improving market functioning. The first proposal was for the establishment of a temporary Term Auction Facility (TAF), which would provide term funding to eligible depository institutions through an auction mechanism beginning in midDecember. Meeting participants recognized that a TAF would not address all of the factors giving rise to stresses in money and credit markets, notably the ongoing concerns about credit quality and balance sheet pressures. Nonetheless, most participants viewed the TAF, which would provide liquidity to more counterparties and against a broader range of collateral than used for open market operations, as a potentially useful tool. Some mentioned that a TAF could help alleviate year-end pressures in money markets. A few participants, however, questioned the need for and the likely efficacy of the proposal, expressed concerns about the longer-run incentive effects of a TAF, and felt that the possible drawbacks could well outweigh any benefits.14 Participants generally regarded the second proposal, to set up a foreign exchange swap arrangement with the European Central Bank, as a positive step in international coop- 14. Secretary's Note: The Board of Governors approved the TAF via notation vote on December 10, 2007 after the staff finalized its proposal for specifications of the TAF. 270 94th Annual Report, 2007 eration to address elevated pressures in short-term dollar funding markets. At the conclusion of the discussion, with Mr. Poole dissenting, the Committee voted to direct the Federal Reserve Bank of New York to establish and maintain a reciprocal currency (swap) arrangement for the System Open Market Account with the European Central Bank in an amount not to exceed $20 billion. Within that aggregate limit, draws of up to $10 billion were autho- rized, and the arrangement itself was authorized for a period of up to 180 days, unless extended by the FOMC. Mr. Poole dissented because he viewed the swap agreement as unnecessary in light of the size of the European Central Bank's dollar-denominated foreign exchange reserves. Brian F. Madigan Secretary 271 Litigation During 2007, the Board of Governors motion for summary judgment in a Freewas a party in one lawsuit and one ap- dom of Information Act case. On Seppeal filed that year and in six other cases tember 11, 2006, the court of appeals pending from previous years, for a total affirmed in part and reversed in part the of eight cases; in 2006, the Board had ruling of the district court, and rebeen a party in a total of seven cases. As manded the case. 463 F.3d 239. On of December 31, 2007, six cases were March 20, 2007, the case was dismissed by stipulation of the parties. pending. Interactive Media Entertainment and Barnes v. Greenspan, No. 04-CVGaming Association, Inc. v. Federal Re- 1989 (CKK) (D. District of Columbia, serve System, No. 07-2625 (D. New Jer- filed November 15, 2004), is a case unsey, filed June 5, 2007), is an action der the Age Discrimination in Employchallenging the implementation of the ment Act. Unlawful Internet Gambling EnforceJones v. Greenspan, No. 04-CV-1696 ment Act of 2006. (RMU) (D. District of Columbia, filed Smith v. Bernanke, No. 07-1710 October 4, 2004), is an employment dis(Sixth Circuit, filed June 4, 2007), is an crimination action. On December 13, appeal of the dismissal of a district court 2005, the district court granted in part action (No. 07-10453 (E.D. Michigan)) and denied in part the Board's motion to challenging the Federal Reserve's han- dismiss and for summary judgment. 402 dling of appellant's consumer com- F. Supp. 2d 294. On June 11, 2007, the plaint. court granted the Board's motion for Chandler v. Bernanke, No. 06-2082 summary judgment as to Counts I and II (D. District of Columbia, filed Decem- of the plaintiff's First Amended Comber 6, 2006), is an employment discrimi- plaint. 493 F. Supp. 2d 18. nation action. Artis v. Greenspan, No. 01-0400 (D. Price v. Bernanke, No. 06-1569 (D. District of Columbia, filed February 22, District of Columbia, filed September 8, 2001), is an employment discrimination 2006), was an employment discrimina- action. An identical action, No. 99-2073 tion action. The action was dismissed (EGS) (D. District of Columbia, filed voluntarily on November 20, 2007. August 3, 1999), was consolidated with Inner City Press/Community on the this action on August 15, 2001. On Move v. Board of Governors, No. 05- January 31, 2007, the District Court 6162 (Second Circuit, filed November granted the Board's renewed motion to 21, 2005), was an appeal of the district dismiss the action. 474 F. Supp. 2d 16. court's order (No. 04-CV-8337, 380 F. The plaintiffs' motion to alter or amend Supp. 2d 211 (S.D.N.Y. 2005)) granting judgment is pending. • in part and denying in part the Board's Federal Reserve System Organization Federal Reserve System Organization 275 Board of Governors December 31,2007 Members OFFICE OF THE SECRETARY Term expires January 31, BEN S. BERNANKE, Chairman1 2020 DONALD L. KOHN, Vice Chairman1 . . 2016 KEVIN M. WARSH 2018 RANDALL S. KROSZNER 2014 Secretary 2008 FREDERIC S. MISHKIN JENNIFER J. JOHNSON, Secretary ROBERT DEV. FRIERSON, Deputy Secretary MARGARET M. SHANKS, Associate DIVISION OF INTERNATIONAL FINANCE Officers OFFICE OF BOARD MEMBERS MICHELLE A. SMITH, Director LARICKE D. BLANCHARD, Assistant to the Board WINTHROP P. HAMBLEY, Assistant to the Board ROSANNA PIANALTO-CAMERON, Assistant to the Board DAVID W. SKIDMORE, Assistant to the Board BRIAN J. GROSS, Special Assistant to the Board for Congressional Liaison ROBERT M. PRIBBLE, Special Assistant to the Board for Congressional Liaison LEGAL DIVISION SCOTT G. ALVAREZ, General Counsel RICHARD M. ASHTON, Deputy General Counsel KATHLEEN M. O'DAY, Deputy General Counsel STEPHANIE MARTIN, Associate General D. NATHAN SHEETS, Director THOMAS A. CONNORS, Senior Associate Director RICHARD T. FREEMAN, Associate Director STEVEN B. KAMIN, Associate Director DALE W. HENDERSON, Senior Adviser KAREN H. JOHNSON, Senior Adviser JOSEPH E. GAGNON, Deputy Associate Director MICHAEL P. LEAHY, Deputy Associate Director RALPH W. TRYON, Deputy Associate Director TREVOR A. REEVE, Assistant Director JOHN ROGERS, Assistant Director DIVISION OF MONETARY AFFAIRS BRIAN F. MADIGAN, Director JAMES A. CLOUSE, Senior Associate Director Counsel ANN MISBACK, Associate General Counsel DEBORAH J. DANKER, Senior Associate KATHERINE H. WHEATLEY, Associate WILLIAM B. ENGLISH, Senior Associate General Counsel KIERAN J. FALLON, Assistant General Counsel STEPHEN H. MEYER, Assistant General Counsel PATRICIA A. ROBINSON, Assistant General Counsel CARY K. WILLIAMS, Assistant General Counsel 1. The designations as Chairman and Vice Chairman expire on January 31, 2010, and June 22, 2010, respectively, unless the service of these members of the Board terminates sooner. Director Director CHERYL L. EDWARDS, Associate Director ANDREW T. LEVIN, Deputy Associate Director WILLIAM NELSON, Deputy Associate Director SETH B. CARPENTER, Assistant Director JOHN B. DURHAM, Assistant Director ROBERTO PEILI, Assistant Director GRETCHEN C. WEINBACH, Assistant Director JONATHAN H. WRIGHT, Assistant Director EGON ZAKRAJSEK, Assistant Director 276 94th Annual Report, 2007 Board of Governors—Continued DIVISION OF RESEARCH AND STATISTICS WILLIAM F. TREACY, Adviser DAVID J. STOCKTON, Director NORAH M. BARGER, Associate Director BETSY CROSS, Associate Director PATRICK M. PARKINSON, Deputy Director DAVID W. WILCOX, Deputy Director MYRON L. KWAST, Senior Associate Director LAWRENCE SLIFMAN, Senior Associate Director J. NELLIE LIANG, Associate Director DAVID L. REIFSCHNEIDER, Associate Director JANICE SHACK-MARQUEZ, Associate Director WILLIAM L. WASCHER III, Associate Director ALICE PATRICIA WHITE, Associate Director GLENN B. CANNER, Senior Adviser DAVID S. JONES, Senior Adviser STEPHEN D. OLINER, Senior Adviser MICHAEL S. GIBSON, Deputy Associate Director S. WAYNE PASSMORE, Deputy Associate Director DANIEL E. SICHEL, Deputy Associate Director JOYCE K. ZICKLER, Deputy Associate Director MICHAEL S. CRINGOLI, Assistant Director KAREN E. DYNAN, Assistant Director DIANA HANCOCK, Assistant Director MICHAEL T. KILEY, Assistant Director MICHAEL G. PALUMBO, Assistant Director ROBIN A. PRAGER, Assistant Director MARY M. WEST, Assistant Director DANIEL M. COVITZ, Assistant Director and Chief DAVID E. LEBOW, Assistant Director and Chief DIVISION OF BANKING SUPERVISION AND REGULATION ROGER T. COLE, Director DEBORAH P BAILEY, Deputy Director PETER J. PURCELL, Deputy Director STEVEN M. ROBERTS, Deputy Director SARKIS YOGHOURTDJIAN, Adviser GERALD A. EDWARDS, JR., Associate Director JON D. GREENLEE, Associate Director CHARLES H. HOLM, Associate Director JACK P. JENNINGS II, Associate Director ROBIN L. LUMSDAINE, Associate Director WILLIAM G. SPANIEL, Associate Director CORYANN STEFANSSON, Associate Director MOLLY S. WASSOM, Associate Director DAVID M. WRIGHT, Associate Director KEVIN M. BERTSCH, Deputy Associate Director BARBARA J. BOUCHARD, Deputy Associate Director JAMES A. EMBERSIT, Deputy Associate Director ARTHUR W. LINDO, Deputy Associate Director WILLIAM C. SCHNEIDER, JR., Deputy Associate Director ROBERT T. ASHMAN, Assistant Director LISA M. DEFERRARI, Assistant Director ROBERT T. MAAS, Assistant Director RICHARD A. NAYLOR II, Assistant Director NINA A. NICHOLS, Assistant Director DANA E. PAYNE, Assistant Director NANCY J. PERKINS, Assistant Director SABETH I. SIDDIQUE, Assistant Director DIVISION OF CONSUMER AND COMMUNITY AFFAIRS SANDRA F. BRAUNSTEIN, Director GLENN E. LONEY, Deputy Director LEONARD CHANIN, Associate Director MARY T. JOHNSEN, Associate Director TONDA E. PRICE, Associate Director MARYANN F. HUNTER, Adviser SHEILA F. MAITH, Adviser TIMOTHY R. BURNISTON, Assistant Director SUZANNE G. KILLIAN, Assistant Director JAMES A. MICHAELS, Assistant Director Federal Reserve System Organization 277 Board of Governors—Continued DIVISION OF RESERVE BANK OPERATIONS AND PAYMENT SYSTEMS DIVISION OF INFORMATION TECHNOLOGY LOUISE L. ROSEMAN, Director GEARY L. CUNNINGHAM, Deputy Director SHARON L. MOWRY, Deputy Director WAYNE A. EDMONDSON, Associate Director LISA M. BELL, Assistant Director TILLENA G. CLARK, Assistant Director DONALD V. HAMMOND, Deputy Director JEFFREY C. MARQUARDT, Deputy Director PAUL W. BETTGE, Senior Adviser KENNETH D. BUCKLEY, Associate Director DOROTHY LACHAPELLE, Associate Director JACK K. WALTON II, Associate Director JEFF J. STEHM, Deputy Associate Director GREGORY L. EVANS, Assistant Director LISA HOSKINS, Assistant Director MICHAEL J. LAMBERT, Assistant Director MAUREEN T. HANNAN, Director Po KYUNG KIM, Assistant Director SUSAN F. MARYCZ, Assistant Director RAYMOND ROMERO, Assistant Director JILL R. ROSEN, Assistant Director KOFI A. SAPONG, Assistant Director OFFICE OF INSPECTOR GENERAL OFFICE O F STAFF DIRECTOR FOR MANAGEMENT STEPHEN R. MALPHRUS, Staff Director for Management CHARLES S. STRUCKMEYER, Deputy Staff Director ELIZABETH A. COLEMAN, Inspector General ANTHONY J. CASTALDO, Assistant Inspector General LAURENCE A. FROEHLICH, Assistant Inspector General SHEILA CLARK, Equal Employment WILLIAM L. MITCHELL, Assistant Inspector Opportunity Programs Director LYNN S. FOX, Senior Adviser HARVEY WITHERSPOON, Assistant Inspector ADRIENNE D. HURT, Adviser MANAGEMENT DIVISION H. FAY PETERS, Director DARRELL R. PAULEY, Deputy Director TODD A. GLISSMAN, Senior Associate Director MARSHA W. REIDHILL, Senior Associate Director BILLY J. SAULS, Senior Associate Director DONALD A. SPICER, Senior Associate Director CHRISTINE M. FIELDS, Associate Director JAMES R. RIESZ, Deputy Associate Director KEITH F. BATES, Assistant Director ELAINE M. BOUTILIER, Assistant Director CHARLES F. O'MALLEY, Assistant Director TARA C. TINSLEY-PELITERE, Assistant Director General General 278 94th Annual Report 2007 Federal Open Market Committee December 31,2007 Members Officers BEN S. BERNANKE, Chairman, Board of Governors BRIAN F. MADIGAN, Secretary and TIMOTHY F. GEITHNER, Vice Chairman, DEBORAH J. DANKER, Deputy Secretary MICHELLE A. SMITH, Assistant Secretary DAVID W. SKIDMORE, Assistant Secretary SCOTT G. ALVAREZ, General Counsel THOMAS C. BAXTER, JR., Deputy General President, Federal Reserve Bank of New York CHARLES L. EVANS, President, Federal Reserve Bank of Chicago THOMAS M. HOENIG, President, Federal Reserve Bank of Kansas City Economist Counsel D. NATHAN SHEETS, Economist DONALD L. KOHN, Board of Governors DAVID J. STOCKTON, Economist RANDALL S. KROSZNER, Board of JAMES A. CLOUSE, Associate Economist THOMAS A. CONNORS, Associate Economist JEFFREY C. FUHRER, Associate Economist STEVEN B. KAMIN, Associate Economist ROBERT H. RASCHE, Associate Economist Governors FREDERIC S. MISHKIN, Board of Governors WILLIAM POOLE, President, Federal Reserve Bank of St. Louis ERIC S. ROSENGREN, President, Federal Reserve Bank of Boston KEVIN M. WARSH, Board of Governors Alternate Members CHRISTINE M. CUMMING, First Vice President, Federal Reserve Bank of New York RICHARD W. FISHER, President, Federal Reserve Bank of Dallas SANDRA PIANALTO, President, Federal Reserve Bank of Cleveland CHARLES I. PLOSSER, President, Federal Reserve Bank of Philadelphia GARY H. STERN, President, Federal Reserve Bank of Minneapolis GORDON H. SELLON, JR., Associate Economist LAWRENCE SLIFMAN, Associate Economist DANIEL G. SULLIVAN, Associate Economist JOSEPH S. TRACY, Associate Economist DAVID W. WILCOX, Associate Economist WILLIAM C. DUDLEY, Manager, System Open Market Account The Federal Open Market Committee is made up of the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. During 2007 the Federal Open Market Committee held eight regularly scheduled meetings and three conference calls (see "Minutes of Federal Open Market Committee Meetings" in this volume). Federal Reserve System Organization 279 Federal Advisory Council December 31, 2007 District 10—DAVID C. BOYLES, Chairman Members District 1—JAMES C. SMITH, Chairman and Chief Executive Officer, Webster Bank, N.A. and Webster Financial Corporation, Waterbury, Conn. District 2—THOMAS A. RENYI, Chairman and Chief Executive Officer, The Bank of New York, New York, N.Y District 3—TED T. CECALA, Chairman and Chief Executive Officer, Wilmington Trust Company, Wilmington, Del. District 4—GEORGE A. SCHAEFER, JR., President and Chief Executive Officer, Fifth Third Bancorp, Cincinnati, Ohio. District 5—G. KENNEDY THOMPSON, Chair- man, President, and Chief Executive Officer, Wachovia Corporation, Charlotte, N.C. District 6—FRED L. GREEN III, President and Chief Operating Officer, Synovus Financial Corporation, Columbus, Ga. District 7—WILLIAM DOWNE, Chief Execu- tive Officer, Bank of Montreal, Chicago, 111. District 8—ROBERT G. JONES, President and Chief Executive Officer, Old National Bancorp, Evansville, Ind. District 9—LYLE R. KNIGHT, President and Chief Executive Officer, First Interstate BancSystem, Inc., Billings, Mont. and Director, Colombine Capital Corp., Denver, Colo. District 11—JAMES GOUDGE, Chairman and Chief Executive Officer, Broadway Bank, San Antonio, Tex. District 12—RICHARD M. KOVACEVICH, Chairman, President, and Chief Executive Officer, Wells Fargo and Company, San Francisco, Calif. Officers G. KENNEDY THOMPSON, President JAMES C. SMITH, Vice President JAMES E. ANNABLE, Secretary The Federal Advisory Council—a statutory body established under the Federal Reserve Act—consults with, and advises, the Board of Governors on all matters within the Board's jurisdiction. It is composed of one representative from each Federal Reserve District, chosen by the Reserve Bank in that District. The Federal Reserve Act requires the council to meet in Washington, D.C., at least four times a year. In 2007, it met on February 8-9, May 10-11, September 6-7, and December 6-7. The council met with the Board on February 9, May 11, September 7, and December 7, 2007. 280 94th Annual Report, 2007 Consumer Advisory Council December 31,2007 Members ANNA MCDONALD RENTSCHLER, BSA STELLA ADAMS, Founder, S J Adams Con- sulting, Durham, N.C. FAITH L. ANDERSON, Vice President—Legal Compliance and General Counsel, American Airlines Federal Credit Union, Fort Worth, Tex. DOROTHY BRIDGES, Chief Executive Officer and President, Franklin National Bank of Minneapolis, Minneapolis, Minn. Of- ficer, Central Bancompany, Jefferson City, Mo. EDNA SAWADY, Managing Director, Market Innovations, Inc., Orange, Ohio FAITH ARNOLD SCHWARTZ, Executive Director, Hope Now Alliance, The Financial Services Roundtable, Washington, D.C. EDWARD SIVAK, Director of Policy and Evaluation, Enterprise Corporation of the CAROLYN CARTER, Attorney, National ConDelta, Jackson, Miss. sumer Law Center, Boston, Mass. H. COOKE SUNOO, Director, Asian Pacific MICHAEL COOK, Vice President of Finance Islander Small Business Program, Los and Assistant Treasurer, Wal-Mart Stores, Angeles, Calif. Inc., Bentonville, Ark. STERGIOS THEOLOGIDES, Executive Vice DONALD S. CURRIE, Executive Director, President, General Counsel, Morgan Community Development Corporation of Stanley Home Loans, Fort Worth, Tex. Brownsville, Brownsville, Tex. LINDA TINNEY, Vice President, Community Development, West Metro Region ManKURT EGGERT, Professor of Law and Director of Clinical Legal Education, Chapman ager, US Bank, Denver, Colo. University School of Law, Orange, Calif. Luz URRUTIA, President and Chief Operating Officer, Banuestra Financial CorporaJASON ENGEL, Vice President and Chief Regtion, Roswell, Ga. ulatory Counsel, Experian, Costa Mesa, ANSELMO VILLARREAL, Executive Director, Calif. LaCasa de Esperanza, Inc., Waukesha, JOSEPH FALK, Consultant, Akerman SenterWis. fitt, Miami, Fla. LOUISE GISSENDANER, Senior Vice Pres- ALAN WHITE, Assistant Professor, Valparaiso University Law School, Valparaiso, ident, Director of Community DevelopInd. ment, Fifth Third Bank, Cleveland, Ohio PATRICIA A. HASSON, President, Consumer Credit Counseling Service of Delaware Valley, Inc., Philadelphia, Pa. DEBORAH HICKOK, Former Vice President, MoneyGram Payment Systems, Inc., Ooltewah, Tenn. THOMAS P. JAMES, Senior Assistant Attorney General—Consumer Counsel, Office of the Illinois Attorney General, Consumer Fraud Bureau, Chicago, 111. SARAH LUDWIG, Executive Director, Neighborhood Economic Development Advocacy Project, New York, N.Y. MARK K. METZ, Senior Vice President and Deputy General Counsel, Wachovia Corporation, Charlotte, N.C. LANCE MORGAN, President, Ho-Chunk, Incorporated, Winnebago Tribe of Nebraska, Winnebago, Neb. JOSHUA PEIREZ, Chief Payment System Integrity Officer, MasterCard Worldwide, Purchase, N.Y. MARVA E. WILLIAMS, Senior Program Officer, Chicago LISC, Chicago, 111. Officers LISA SODEIKA, Chair, Executive Vice President—Corporate Affairs, HSBC North America Holdings, Inc., Prospect Heights, 111. TONY T. BROWN, Vice Chair, President and Chief Executive Officer, Uptown Consortium, Inc., Cincinnati, Ohio The Consumer Advisory Council—a statutory body established pursuant to the 1976 amendments to the Equal Credit Opportunity Act—advises the Board of Governors on consumer financial services. Its members, who are appointed by the Board, are academics, state and local government officials, and representatives of the financial services industry and of consumer and community interests. In 2007, the council met with the Board on March 8, June 21, and October 25. Federal Reserve System Organization 281 Thrift Institutions Advisory Council December 31, 2007 DAVID E. POULSEN, President and Chief Members FRANK E. BERRISH, President and Chief Executive Officer, Visions Federal Credit Union, Endicott, N.Y. ROBERT M. CLEMENTS, Chairman and Chief Executive Officer, Everbank Financial Corp., Jacksonville, Fla. A. THOMAS HOOD, President and Chief Executive Officer, First Federal Savings and Loan Association, Charleston, S.C. KERRY KILLINGER, Chairman and Chief Executive Officer, Washington Mutual, Inc., Seattle, Wa. KENNETH KORANDA, President, Mid America Bank, Downers Grove, 111. ARKADI KUHLMANN, Chairman, President, and Chief Executive Officer, ING DIRECT USA, Wilmington, Del. HARRIET MAY, President and Chief Executive Officer, Government Employees Credit Union, El Paso, Tex. THOMAS C. MEUSER, Chairman and Chief Executive Officer, El Dorado Savings Bank, Placerville, Calif. F. WELLER MEYER, Chairman, President and Chief Executive Officer, Acacia Federal Savings Bank, Falls Church, Va. Executive Officer, American Express Centurion Bank, Salt Lake City, Utah STEVEN J. SWIONTEK, Chairman, President, and Chief Executive Officer, Gate City Bank, Fargo, N.D. DAVID RUSSELL TAYLOR, President and Chief Executive Officer, Rahway Savings Institution, Rahway, N.J. Officers DAVID RUSSELL TAYLOR, President F. WELLER MEYER, Vice President The Thrift Institutions Advisory Council was established by the Board of Governors to consult with, and advise, the Board on issues pertaining to the thrift industry and on other matters within the Board's jurisdiction. Its members, who are appointed by the Board, represent credit unions, savings and loan associations, and savings banks. In 2007, the council met with the Board on March 16, June 29, and December 14. 282 94th Annual Report, 2007 Federal Reserve Banks and Branches December 31,2007 Officers Chairman* Deputy Chairman President First Vice President BOSTON2 Lisa M. Lynch Henri A. Termeer Eric S. Rosengren Paul M. Connolly NEW YORK2 Jerry I. Speyer Denis M. Hughes Timothy F. Geithner Christine M. Cumming Buffalo Alphonso O'NeilWhite PHILADELPHIA Doris M. Damm William F. Hecht Charles I. Plosser William H. Stone, Jr. CLEVELAND Tanny B. Crane Alfred M. Rankin, Jr. James M. Anderson Robert O. Agbede Sandra Pianalto R. Chris Moore Thomas J. Mackell, Jr. Lemuel E. Lewis Cynthia Collins Allner Jim Lowry Jeffrey M. Lacker Sarah G. Green V. Larkin Martin D. Scott Davis Mary am B. Head H. Britt Landrum, Jr. Gay Rebel Thompson Debra K. London Dave Dennis Dennis P. Lockhart Patrick K. Barron Miles D. White John A. Canning, Jr. Timothy M. Manganello Charles L. Evans Gordon Werkema William Poole David A. Sapenaro Little Rock Louisville Irl F. Engelhardt Cynthia J. Brinkley C. Sam Walls John L. Huber Memphis Meredith B. Allen MINNEAPOLIS Frank L. Sims James J. Hynes Lawrence R. Simkins BANK or Branch Cincinnati Pittsburgh RICHMOND Baltimore Charlotte ATLANTA Birmingham Jacksonville Miami Nashville New Orleans CHICAGO2 Detroit ST.LOUIS Helena Officer in charge of Branch Kausar Hamdani Barbara B. Henshaw Robert B. Schaub David Beck Jeffrey S. Kane Lee C. Jones Christopher L. Oakley Juan del Busto Melvyn K. Purcell Robert J. Musso Robert Wiley Robert A. Hopkins Maria Gerwing Hampton Martha Perine Beard Gary H. Stern James M. Lyon R. Paul Drake Federal Reserve System Organization 283 Officers—Continued BANK or Branch KANSAS CITY ... Denver Oklahoma City .... Omaha DALLAS El Paso Houston San Antonio SAN FRANCISCO Los Angeles Portland Salt Lake City Seattle Chairman1 Deputy Chairman President First Vice President Robert A. Funk Lu M. Cordova Kristy A. Schloss Richard K. Ratcliffe James A. Timmerman Thomas M. Hoenig Richard K. Rasdall, Jr. James T. Hackett Anthony R. Chase Ron C. Helm Lupe Fraga J. Dan Bates Richard W. Fisher Helen E. Holcomb David K.Y. Tang T. Gary Rogers James L. Sanford James H. Rudd Clark D. Ivory Mic R. Dinsmore Janet L. Yellen John F. Moore Officer in charge of Branch Mark Schweitzer Chad Wilkerson Jason Henderson Robert W. Gilmer Robert Smith III Blake Hastings Mark L. Mullinix Mary E. Lee Andrea P. Wolcott Mark A. Gould 1. The chairman of a Federal Reserve Bank serves, by statute, as Federal Reserve agent. 2. Additional offices of these Banks are located at Windsor Locks, Connecticut; Utica at Oriskany, New York; East Rutherford, New Jersey; Des Moines, Iowa; Midway at Bedford Park, Illinois; and Phoenix, Arizona. Conference of Chairmen Conference of Presidents The chairmen of the Federal Reserve Banks are organized into the Conference of Chairmen, which meets to consider matters of common interest and to consult with and advise the Board of Governors. Such meetings, also attended by the deputy chairmen, were held in Washington, D.C., on May 30 and 31, and on November 28 and 29, 2007. The members of the executive committee of the Conference of Chairmen during 2007 were, Robert A. Funk, chair; V. Larkin Martin, vice chair; and Miles D. White, member. On November 29, the conference elected its executive committee for 2008, naming V. Larkin Martin as chair; Lisa M. Lynch as vice chair; and David K.Y. Tang as the third member. The presidents of the Federal Reserve Banks are organized into the Conference of Presidents, which meets periodically to consider matters of common interest and to consult with and advise the Board of Governors. Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, served as chair of the conference in 2007, and Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, served as vice chair. Gregory L. Stefani, of the Federal Reserve Bank of Cleveland, served as secretary, and Sandra Tormoen, of the Federal Reserve Bank of Richmond, served as assistant secretary. 284 94th Annual Report, 2007 Conference of First Vice Presidents The Conference of First Vice Presidents of the Federal Reserve Banks was organized in 1969 to meet periodically for the consideration of operations and other matters. Helen E. Holcomb, first vice president of the Federal Reserve Bank of Dallas, served as chair of the conference in 2007, and James M. Lyon, first vice president of the Federal Reserve Bank of Minneapolis, served as vice chair. Harvey R. Mitchell, of the Federal Reserve Bank of Dallas, served as secretary, and Sheryl L. Britsch, of the Federal Reserve Bank of Minneapolis, served as assistant secretary. On October 22, 2007, the conference elected James M. Lyon as chair for 2008-09 and R. Chris Moore, first vice president of the Federal Reserve Bank of Cleveland, as vice chair. Directors Each Federal Reserve Bank has a nine member board: three Class A and three Class B directors, who are elected by the stockholding member banks, and three Class C directors, who are appointed by the Board of Governors. Class A directors represent the stockholding member banks in each Federal Reserve District. Class B and Class C directors represent the public and are chosen with due, but not exclusive, consideration to the interests of agriculture, commerce, industry, services, labor, and consumers; they may not be officers, directors, or employees of any bank or bank holding company. In addition, Class C directors may not be stockholders of any bank or bank holding company. For the election of Class A and Class B directors, the member banks of each Federal Reserve District are classified into three groups. Each group, which comprises banks with similar capitalization, elects one Class A director and one Class B director. Annually, the Board of Governors designates one of the Class C directors as chair of the board and Federal Reserve agent of each District Bank, and it designates another Class C director as deputy chair. Federal Reserve Branches have either five or seven directors, a majority of whom are appointed by the parent Federal Reserve Bank; the others are appointed by the Board of Governors. One of the directors appointed by the Board is designated annually as chair of the board of that Branch in a manner prescribed by the parent Federal Reserve Bank. The chairs and deputy chairs of the Reserve Bank boards of directors, and the chairs of the Branches, are listed in the preceding table, titled "Officers." The directors of the Banks and Branches are listed in the following table. For each director, the class of directorship, the director's principal organizational affiliation, and the date the director's term expires are shown. Federal Reserve System Organization 285 Directors December 31, 2007 BANK or BRANCH, Category Name Title Term expires Dec. 31 DISTRICT 1—BOSTON RESERVE BANK Class A Ronald E. Logue Kathleen C. Marcum David A. Lentini Class B Robert K. Kraft Michael T. Wedge Stuart H. Reese Class C Samuel O. Thier, M.D Henri A. Termeer Lisa M. Lynch Chairman and Chief Executive Officer, State Street Corporation, Boston, Massachusetts President and Chief Executive Officer, Millbury National Bank, Millbury, Massachusetts Chairman, President and Chief Executive Officer, The Connecticut Bank and Trust Company, Hartford, Connecticut 2007 Chairman and Chief Executive Officer, The Kraft Group, Foxborough, Massachusetts Former President and Chief Executive Officer, BJ's Wholesale Club, Inc., Natick, Massachusetts Chairman, President and Chief Executive Officer, MassMutual Financial Group, Springfield, Massachusetts 2007 Professor of Medicine and Professor of Health Care Policy-Harvard Medical School, Massachusetts General Hospital, Boston, Massachusetts Chairman, President and Chief Executive Officer, Genzyme Corporation, Cambridge, Massachusetts William L. Clayton Professor of International Economic Affairs, The Fletcher School of Law and Diplomacy, Tufts University, Medford, Massachusetts 2007 2008 2009 2008 2009 2008 2009 DISTRICT 2—NEW YORK RESERVE BANK Class A Jill M. Considine Charles V. Wait James Dimon Class B Richard S. Fuld, Jr. Jeffrey R. Immelt Indra K. Nooyi Senior Advisor, The Depository Trust Company, New York, New York President, Chief Executive Officer, and Chairman, The Adirondack Trust Company, Saratoga Springs, New York Chairman and Chief Executive Officer, JPMorgan Chase & Co., New York, New York Chairman and Chief Executive Officer, Lehman Brothers, New York, New York Chairman and Chief Executive Officer, General Electric Company, Fairfield, Connecticut Chairman and Chief Executive Officer, PepsiCo, Inc., Purchase, New York 2007 2008 2009 2007 2008 2009 286 94th Annual Report 2007 Directors—Continued BANK or BRANCH, Category Name Class C Jerry I. Speyer Denis M. Hughes Lee C. Bollinger Titlf i me Term expires Dec. 31 President and Chief Executive Officer, Tishman Speyer, New York, New York President, New York State AFL-CIO, New York, New York President, Columbia University, New York, New York 2007 Executive Vice President and Chief Information Officer, M&T Bank, Buffalo, New York Regional Director-Region 9, United Auto Workers, Amherst, New York Co-Owner, Zuber Farms, LLC, Churchville, New York President and Chief Executive Officer, Paychex, Inc., Rochester, New York 2007 President and Chief Executive Officer, Rochester Gas and Electric Corporation and New York State Electric and Gas Corporation, Rochester, New York 2007 2008 2009 BUFFALO BRANCH Appointed by the Federal Reserve Bank Michele D. Trolli Joseph J. Ashton Kim J. Zuber Jonathan J. Judge Appointed by the Board of Governors James P. Laurito Vacancy Alphonso O'Neil-White .... President and Chief Executive Officer, HealthNow New York Inc., Buffalo, New York 2008 2009 2009 2008 2009 DISTRICT 3—PHILADELPHIA RESERVE BANK Class A Wayne R. Weidner John G. Gerlach Aaron L. Groff, Jr. Chairman, National Penn Bancshares, Inc., Boyertown, Pennsylvania President and Chief Executive Officer, Pocono Community Bank, Stroudsburg, Pennsylvania Chairman, President and Chief Executive Officer, Ephrata National Bank, Ephrata, Pennsylvania Class B P. Coleman Townsend, Jr. .. Chairman and Chief Executive Officer, Townsends, Inc. Wilmington, Delaware Michael F. Camardo Retired Executive Vice President, Lockheed Martin ITS Cherry Hill, New Jersey Garry L. Maddox President and Chief Executive Officer, A. Pomerantz & Company, Philadelphia, Pennsylvania Class C Doris M. Damm Charles P. Pizzi William F. Hecht President and Chief Executive Officer, ACCU Staffing Services, Cherry Hill, New Jersey President and Chief Executive Officer, Tasty Baking Company, Philadelphia, Pennsylvania Retired Chairman, President, and Chief Executive Officer, PPL Corporation, Allentown, Pennsylvania 2007 2008 2009 2007 2008 2009 2007 2008 2009 Federal Reserve System Organization 287 BANK or BRANCH, Category Name Titlp i nit Term expires Dec. 31 DISTRICT 4—CLEVELAND RESERVE BANK Class A Henry L. Meyer III Bick Weissenrieder C. Daniel DeLawder Class B Les C. Vinney Vacancy V. Ann Hailey Class C Roy W.Haley Alfred M. Rankin, Jr. Tanny B. Crane Chairman and Chief Executive Officer, KeyCorp, Cleveland, Ohio Chairman and Chief Executive Officer, Hocking Valley Bank, Athens, Ohio Chairman and Chief Executive Officer, Park National Bank, Newark, Ohio 2007 Retired President and Chief Executive Officer, STERIS Corporation, Mentor, Ohio 2007 Retired Executive Vice President, Corporate Development, Limited Brands, Columbus, Ohio 2008 2009 2008 2009 Chairman and Chief Executive Officer, WESCO International, Inc., Pittsburgh, Pennsylvania Chairman, President and Chief Executive Officer, NACCO Industries, Inc., Cleveland, Ohio President and Chief Executive Officer, Crane Group Company, Columbus, Ohio 2007 President, Czar Coal Corporation, Lovely, Kentucky Principal Partner, Global Lead Management Consulting, Cincinnati, Ohio President, Lexington Market, JPMorgan Chase Bank, NA, Lexington, Kentucky President and Chief Executive Officer, Great Lakes Bankers Bank, Gahanna, Ohio 2007 2008 Senior Vice President, Western and Southern Financial Group, Cincinnati, Ohio President and Chief Executive Officer, Cincinnati Children's Hospital Medical Center, Cincinnati, Ohio President and Chief Executive Officer, Long-Stanton Manufacturing Companies, Cincinnati, Ohio 2007 President and Chief Executive Officer, Iron and Glass Bank, Pittsburgh, Pennsylvania 2007 2008 2009 CINCINNATI BRANCH Appointed by the Federal Reserve Bank James H. Booth Janet B.Reid Glenn D. Leveridge Charlotte W. Martin Appointed by the Board of Governors Herbert R. Brown James M. Anderson Daniel B. Cunningham 2008 2009 2008 2009 PITTSBURGH BRANCH Appointed by the Federal Reserve Bank Michael J. Hagan 288 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Howard W. Hanna III Georgiana N. Riley Margaret Irvine Weir Appointed by the Board of Governors Robert O. Agbede Sunil T. Wadhwani Robert A. Paul Titlp i me Term expires Dec. 31 Chairman and Chief Executive Officer, Howard Hanna Real Estate Services, Pittsburgh, Pennsylvania President and Chief Executive Officer, TIGG Corporation, Bridgeville, Pennsylvania President, NexTier Bank, Butler, Pennsylvania 2008 President and Chief Executive Officer, Chester Engineers, Inc., Pittsburgh, Pennsylvania Chief Executive Officer and Co-founder, iGATE Corporation, Pittsburgh, Pennsylvania Chairman and Chief Executive Officer, AmpcoPittsburgh Corporation, Pittsburgh, Pennsylvania 2007 2008 2009 2008 2009 DISTRICT 5—RICHMOND RESERVE BANK Class A Kathleen Walsh CanHunter R. Hollar Dwight V. Neese Class B Harry M. Lightsey, III Dana S. Boole Kenneth R. Sparks Class C Margaret E. McDermid Thomas J. Mackell, Jr. Lemuel E. Lewis President, Cardinal Bank Washington, Washington, D.C President and Chief Executive Officer, Sandy Spring Bancorp and Sandy Spring Bank, Olney, Maryland Director, President, and Chief Executive Officer, Provident Community Bank and Provident Community Bancshares, Inc., Rock Hill, South Carolina 2007 2008 Senior Vice President-Southern Region Legislative and External Affairs, AT&T, Columbia, South Carolina President and Chief Executive Officer, Community Affordable Housing Equity Corporation, Raleigh, North Carolina President and Chief Executive Officer, Ken Sparks Associates LLC, White Stone, Virginia 2007 Senior Vice President and Chief Information Officer, Dominion Resources, Inc., Richmond, Virginia President, Association of Benefit Administrators, Warrenton, Virginia Director, Landmark Communications, Inc., Norfolk, Virginia 2007 President and Chief Executive Officer, SunTrust Bank, Maryland, Baltimore, Maryland President and Chief Executive Officer, Hemingway's Inc., Stevensville, Maryland Managing Director-Mid-Atlantic, Ballantrae International, Ltd., Ijamsville, Maryland 2007 2009 2008 2009 2008 2009 BALTIMORE BRANCH Appointed by the Federal Reserve Bank Donald P. Hutchinson Biana J. Arentz James T. Brady 2008 2009 Federal Reserve System Organization 289 BANK or BRANCH, Category Name Michael L. Middleton Appointed by the Board of Governors William R. Roberts .. Cynthia Collins Allner Ronald Blackwell Title Term expires Dec. 31 Chairman and President, Community Bank of Tri-County, Waldorf, Maryland 2009 President - Verizon Maryland/DC, Verizon Maryland Inc., Baltimore, Maryland Principal, Miles & Stockbridge P.C., Baltimore, Maryland Chief Economist, AFL-CIO, Washington, D.C. 2007 President and Chief Executive Officer, First South Bancorp, Inc. and First South Bank, Spartanburg, South Carolina President and Chief Executive Officer, North Carolina Mutual Life Insurance Company, Durham, North Carolina Chairman and President, FNB United Corp. and CommunityONE Bank, N.A., Asheboro, North Carolina Chief Risk Officer, Wachovia Corporation, Charlotte, North Carolina 2007 Dean, Clemson University, College of Business and Behavioral Science, Clemson, South Carolina President, PML Associates, Inc., Greenwood, South Carolina Automotive Consultant, High Point, North Carolina 2007 2008 2009 CHARLOTTE BRANCH Appointed by the Federal Reserve Bank Barry L. Slider James H. Speed, Jr Michael C. Miller Donald K. Truslow Appointed by the Board of Governors Claude C. Lilly Linda L. Dolny Jim Lowry 2008 2009 2009 2008 2009 DISTRICT 6—ATLANTA RESERVE BANK Class A James F. Beall L. Phillip Humann Rudy E. Schupp Class B Lee M. Thomas Egbert L.J. Perry Teri G. Fontenot Chairman, President, and Chief Executive Officer, Farmers & Merchants Bank, Centre, Alabama Executive Chairman, SunTrust Banks, Inc., Atlanta, Georgia President and Chief Executive Officer, 1st United Bank, Boca Raton, Florida 2007 Chairman, President and Chief Executive Officer, Rayonier, Jacksonville, Florida Chairman and Chief Executive Officer, The Integral Group, LLC, Atlanta, Georgia President and Chief Executive Officer, Woman's Hospital, Baton Rouge, Louisiana 2007 2008 2009 2008 2009 290 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Class C David M. Ratcliffe V. Larkin Martin D. Scott Davis Titlp i me Term expires Dec. 31 Chairman, President, and Chief Executive Officer, Southern Company, Atlanta, Georgia Managing Partner, Martin Farm, Courtland, Alabama Chief Financial Officer and Vice Chairman, United Parcel Service, Atlanta, Georgia 2007 Monroeville President, BankTrust, Monroeville, Alabama Chairman and Chief Executive Officer, Alabama National Bancorporation, Birmingham, Alabama Consultant, International Union of Operating EngineersLocal 312, Birmingham, Alabama Managing Partner, Lewis Properties, LLC and Anderson Investments, LLC, Huntsville, Alabama 2007 President, Ram Tool and Supply Company, Inc., Birmingham, Alabama Chairman of the Board, HOME Place Farms, Inc., Prattville, Alabama President and Chief Executive Officer, Randall-Reilly Publishing Co., Tuscaloosa, Alabama 2007 President, Amelia Island Plantation Company, Amelia Island, Florida President and Chief Executive Officer, The First Commercial Bank of Florida, Orlando, Florida President and Chief Executive Officer, GTE Federal Credit Union, Tampa, Florida President, E.T. Consultants, Winter Park, Florida 2007 President and Chief Executive Officer, Landrum Human Resource Companies, Inc., Pensacola, Florida President and Founder, US-Africa Free Enterprise Education Foundation, Tampa, Florida President and Chief Executive Officer, Prudential Network Realty, Jacksonville, Florida 2007 2008 2009 BIRMINGHAM BRANCH Appointed by the Federal Reserve Bank John B. Barnett III John H. Holcomb III Samuel F. Dodson Bobby A. Bradley Appointed by the Board of Governors Maryam B. Head James H. Sanford F. Michael Reilly 2008 2009 2009 2008 2009 JACKSONVILLE BRANCH Appointed by the Federal Reserve Bank Jack B. Healan, Jr Alan Rowe Wendell A. Sebastian Ellen S. Titen Appointed by the Board of Governors H. Britt Landrum, Jr Fassil Gabremariam Linda H. Sherrer 2008 2009 2009 2008 2009 Federal Reserve System Organization 291 BANK or BRANCH, Category Name Titlp 1 me Term expires Dec. 31 MIAMI BRANCH Appointed by the Federal Reserve Bank Dennis S. Hudson III Thomas H. Shea Walter Banks Leonard L. Abess Appointed by the Board of Governors Gay Rebel Thompson Edwin A. Jones, Jr Marvin O'Quinn Chairman and Chief Executive Officer, Seacoast Banking Corporation of Florida, Stuart, Florida Regional Chief Executive Officer, Right Management, Fort Lauderdale, Florida President, Lago Mar Resort and Club, Fort Lauderdale, Florida Chairman, President, and Chief Executive Officer, City National Bank of Florida, Miami, Florida 2007 President and Chief Executive Officer, Cement Industries, Inc., Fort Myers, Florida President, Angus Investments, Inc., Port St. Lucie, Florida President and Chief Executive Officer, Jackson Health System, Miami, Florida 2007 Chairman and Chief Executive Officer, Citizens National Bank, Athens, Tennessee Chairman, First National Bank, Oneida, Tennessee Retired Senior Vice President, North American Manufacturing and Supply Chain Management, Nissan North America, Inc., Smyrna, Tennessee President and Chief Executive Officer, Tennessee Bun Company, Nashville, Tennessee 2007 President and Chief Executive Officer, St. Mary's Health System, Knoxville, Tennessee President and Chief Executive Officer, The Sage Group, Brentwood, Tennessee Vice Chancellor and General Counsel, Vanderbilt University, Nashville, Tennessee 2007 2008 2008 2009 2008 2009 NASHVILLE BRANCH Appointed by the Federal Reser\>e Bank Paul G. Willson Michael B. Swain Daniel A. Gaudette Cordia W. Harrington Appointed by the Board of Governors Debra K. London Richard Q. Ford David Williams 11 2008 2009 2009 2008 2009 NEW ORLEANS BRANCH Appointed by the Federal Reserve Bank David E. Johnson Chairman and Chief Executive Officer, The First Bancshares, Inc., and The First, A National Banking Association, Hattiesburg, Mississippi R. King Milling Vice Chairman, Whitney Holding Corporation & Whitney National Bank, New Orleans, Louisiana Matthew G. Stuller, Sr. .... Chairman and Chief Executive Officer, Stuller, Inc., Lafayette, Louisiana Christel C. Slaughter Partner, SSA Consultants, LLC, Baton Rouge, Louisianai 2007 2008 2009 2009 292 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Appointed by the Board of Governors Dave Dennis Earl L. Shipp Robert S. Boh Titlp President and Chief Executive Officer, Specialty Contractors & Associates, Inc., Gulfport, Mississippi President-Basic Chemicals Group, The Dow Chemical Company, Dubai, United Arab Emirates President and Chief Executive Officer, Boh Bros. Construction Co., LLC, New Orleans, Louisiana Term expires Dec. 31 2007 2008 2009 DISTRICT 7—CHICAGO RESERVE BANK Class A JeffPlagge Dennis J. Kuester Michael L. Kubacki Class B Ann D. Murtlow Vacancy Mark T. Gaffney Class C Miles D. White John A. Canning, Jr. William C. Foote Chairman, Chief Executive Officer, and President, Midwest Heritage Bank, Clive, Iowa Chairman, Marshall & Ilsley Corporation, Milwaukee, Wisconsin Chairman, President, and Chief Executive Officer, Lakeland Financial Corporation, Warsaw, Indiana 2007 President and Chief Executive Officer, Indianapolis Power & Light Company, Indianapolis, Indiana 2007 President, Michigan AFL-CIO, Lansing, Michigan 2008 2009 2008 2009 Chairman and Chief Executive Officer, Abbott, Abbott Park, Illinois Chairman, Madison Dearborn Partners, LLC, Chicago, Illinois Chairman and Chief Executive Officer, USG Corporation, Chicago, Illinois 2007 President and Chief Executive Officer, Independent Bank Corporation, Ionia, Michigan Executive Vice President and Chief Financial Officer, Pulte Homes, Inc., Bloomfield Hills, Michigan Chief Executive Officer, ER-One, Inc., Livonia, Michigan Chairman, President, and Chief Executive Officer, Comerica Inc., Dallas, Texas 2007 2008 2009 DETROIT BRANCH Appointed by the Federal Reserve Bank Michael M. Magee, Jr Roger A. Cregg Tommi A. White Ralph W. Babb, Jr. 2008 2008 2009 Federal Reseme System Organization 293 BANK or BRANCH, Category Name Titlp 11UC Appointed by the Board of Governors Irvin D.Reid President, Wayne State University, Detroit, Michigan Timothy M. Manganello ... Chairman and Chief Executive Officer, BorgWarner Inc., Auburn Hills, Michigan Linda S. Likely Director of Housing and Community Development, Kent County Community Development Department and Housing Commission, Grand Rapids, Michigan Term expires Dec. 31 2007 2008 2009 DISTRICT 8—ST. LOUIS RESERVE BANK Class A Lewis F. Mallory, Jr J. Thomas May David R. Pirsein Class B Paul T. Combs Vacancy A. Rogers Yarnell, II Class C Irl F. Engelhardt Cynthia J. Brinkley Steven H. Lipstein Chairman and Chief Executive Officer, Cadence Financial Corporation, Starkville, Mississippi Chairman and Chief Executive Officer, Simmons First National Corporation, Pine Bluff, Arkansas President and Chief Executive Officer, First National Bank in Pinckneyville, Pinckneyville, Illinois 2007 President, Baker Implement Company, Kennett, Missouri 2007 President, Yarnell Ice Cream Company, Inc., Searcy, Arkansas 2008 2009 2008 2009 Chairman, Patriot Coal Corporation, St. Louis, Missouri President, AT&T Missouri, St. Louis, Missouri President and Chief Executive Officer, BJC Healthcare, St. Louis, Missouri 2007 2008 2009 Executive Director, Downtown Little Rock Partnership, Little Rock, Arkansas Chairman, Arkansas Best Corporation, Fort Smith, Arkansas President and Chief Executive Officer, Southern Bancorp, Arkadelphia, Arkansas President, First Security Bancorp, Searcy, Arkansas 2007 Chief Executive Officer, E-Z Mart Stores, Inc., Texarkana, Texas 2007 LITTLE ROCK BRANCH Appointed by the Federal Reserve Bank Sharon Priest Robert A. Young III Phillip N. Baldwin William C. Scholl Appointed by the Board of Governors Sonja Yates Hubbard 2008 2008 2009 294 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Cal McCastlain C.Sam Walls Titlp 111IC Term expires Dec. 31 Partner, Pender & McCastlain, P.A., Little Rock, Arkansas Chief Executive Officer, Arkansas Capital Corporation, Little Rock, Arkansas 2008 Chairman and Chief Executive Officer, Republic Bank & Trust Company, Louisville, Kentucky Chief Executive Officer, Ephraim McDowell Health, Danville, Kentucky President, Wabash Plastics, Inc., Evansville, Indiana Consultant, Marion, Kentucky 2007 President, Western Kentucky University, Bowling Green, Kentucky Consultant, Louisville, Kentucky Chief Executive Officer, Schuler Bauer Real Estate Services, New Albany, Indiana 2007 2009 LOUISVILLE BRANCH Appointed by the Federal Reserve Bank Steven E. Trager L. Clark Taylor, Jr John C. Schroeder Gordon B. Guess Appointed by the Board of Governors Gary A. Ransdell John L. Huber Barbara Ann Pop 2008 2008 2009 2008 2009 MEMPHIS BRANCH Appointed by the Federal Reserve Bank Thomas G. Miller President, Southern Hardware Company, Inc., West Helena, Arkansas Director of Sales, Regions Morgan Keegan Private Levon Mathews Banking, Memphis, Tennessee Hunter Simmons President and Chief Executive Officer, First South Bank Jackson, Tennessee David P. Rumbarger, Jr. .... President and Chief Executive Officer, Community Development Foundation, Tupelo, Mississippi Appointed by the Board of Governors Charles S. Blatteis Meredith B. Allen Nick Clark Member (Partner), The Bogatin Law Firm, PLC, Memphis, Tennessee Vice President, Marketing, Staple Cotton Cooperative Association, Greenwood, Mississippi Partner, Clark & Clark, Memphis, Tennessee 2007 2008 2008 2009 2007 2008 2009 DISTRICT 9—MINNEAPOLIS RESERVE BANK Class A John H. Hoeven, Jr Peter J. Haddeland Thomas W. Scott Chairman, First Western Bank & Trust, Minot, North Dakota President and Chief Executive Officer, First National Bank, Mahnomen, Minnesota Chairman of the Board, First Interstate BancSystem, Inc., Billings, Montana 2007 2008 2009 Federal Reserve System Organization 295 BANK or BRANCH, Category Name Class B Todd L. Johnson Randy Peterson William J. Shorma Class C Frank L. Sims John W. Marvin James J. Hynes Title Term expires Dec. 31 Chairman and Chief Executive Officer, Reuben Johnson & Son, Inc. and Affiliated Companies, Superior, Wisconsin Facility Director, Lake Superior State University, Sault Ste. Marie, Michigan President, Shur-Co., Yankton, South Dakota 2007 Corporate Vice President, Transportation, Cargill, Inc., Wayzata, Minnesota Chairman and Chief Executive Officer, Marvin Windows and Doors, Warroad, Minnesota Executive Administrator, Twin City Pipe Trades Service Association, St. Paul, Minnesota 2007 Regional President and Chief Executive Officer, Wells Fargo Bank Montana, N.A., Billings, Montana President and Chief Executive Officer, 1 st Bank, Sidney, Montana Chief Executive Officer, Anderson ZurMuehlen & Company, P C , Helena, Montana 2007 General Manager and Chief Executive Officer, Wheat Montana Farms and Bakery, Three Forks, Montana President, Washington Corporations, Missoula, Montana 2008 2008 2009 2008 2009 HELENA BRANCH Appointed by the Federal Reserve Bank Joy N. Ott John L. Franklin Timothy J. Bartz Appointed by the Board of Governors Dean Folkvord Lawrence R. Simkins 2008 2009 2009 DISTRICT 10—KANSAS CITY RESERVE BANK Class A Robert C. Fricke President and Chief Executive Officer, Farmers & Merchants National Bank, Ashland, Nebraska Chief Executive Officer, Dickinson Financial Rick L. Smalley Corporation, Kansas City, Missouri Mark W. Schifferdecker .... President and Chief Executive Officer, Girard National Bank, Girard, Kansas Class B Vacancy Dan L. Dillingham Kevin K. Nunnink Chief Executive Officer, Dillingham Insurance, Enid, Oklahoma Chairman, Integra Realty Resources, Westwood, Kansas 2007 2008 2009 2007 2008 2009 296 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Class C Terry L. Moore Lu M. Cordova Robert A. Funk Titlp 1 IllC Term expires Dec. 31 President, Omaha Federation of Labor, Omaha, Nebraska Chief Executive Officer, Corlund Industries, LLC; President and General Manager, Almacen Storage Group, Boulder, Colorado Chairman and Chief Executive Officer, Express Personnel Services, Oklahoma City, Oklahoma 2007 President and Chief Executive Officer, First State Bancorporation, Albuquerque, New Mexico President and Chief Executive Officer, Vectra Bank Colorado, Denver, Colorado President, Pearson Real Estate Co., Inc., Buffalo, Wyoming 2007 2008 2009 DENVER BRANCH Appointed by the Federal Reserve Bank Michael R. Stanford Bruce K. Alexander John D. Pearson Diane Leavesley Thomas Williams 2009 2009 Vacancy Appointed by the Board of Governors Kristy A. Schloss 2008 President and Chief Executive Officer, Schloss Engineered Equipment, Inc., Aurora, Colorado President, Mercy Loan Fund, Denver, Colorado President and Chief Executive Officer, Williams Group LLC, Golden, Colorado 2007 Chairman of the Board, FirstBank, Antlers, Oklahoma President, Oklahoma Community Capital Corporation, Broken Arrow, Oklahoma President, RGF, Inc., Oklahoma City, Oklahoma Board Vice-Chairman, President and Chief Operating Officer, LSB Industries, Inc., Oklahoma City, Oklahoma 2007 2007 President, Agee Energy, LLC, Oklahoma City, Oklahoma 2007 2008 2009 OKLAHOMA CITY BRANCH Appointed by the Federal Reserve Bank Steve Burrage Terry M. Almon Fred M. Ramos Barry H. Golsen Appointed by the Board of Governors Steven C. Agee Vacancy Richard K. Ratcliffe Chairman, Ratcliffe's Inc., Weatherford, Oklahoma 2008 2009 2008 2009 Federal Reserve System Organization 297 BANK or BRANCH, Categoiy Name Title Term expires Dec. 31 OMAHA BRANCH Appointed by the Federal Reserve Bank Cynthia Hardin Milligan ... Dean-College of Business Administration, University of Nebraska-Lincoln, Lincoln, Nebraska President and Chief Executive Officer, Platte Valley Mark A. Sutko State Bank, Kearney, Nebraska President and Chief Executive Officer, AmeriSphere Rodrigo Lopez Multifamily Finance, L.L.C., Omaha, Nebraska Chief Executive Officer and Trust Officer, Adams Bank Todd S. Adams & Trust, Ogallala, Nebraska Appointed by the Board of Governors Lyn Wallin Ziegenbein James A. Timmerman Charles R. Hermes Executive Director, Peter Kiewit Foundation, Omaha, Nebraska Chief Financial Officer, Timmerman and Sons Feeding Company, Springfield, Nebraska President, Dutton-Lainson Company, Hastings, Nebraska 2007 2008 2009 2009 2007 2008 2009 DISTRICT 11—DALLAS RESERVE BANK Class A David S. Barnard Richard W. Evans, Jr Pete Cook Class B Robert A. Estrada James B. Bexley Margaret H. Jordan Class C Herb Kelleher James T. Hackett Anthony R. Chase Chairman and Chief Executive Officer, The National Banks of Central Texas, Gatesville, Texas Chairman and Chief Executive Officer, Cullen/Frost Bankers, Inc., San Antonio, Texas President and Chief Executive Officer, First National Bank of Alamogordo, Alamogordo, New Mexico 2007 Chairman, Estrada Hinojosa & Company, Inc., Dallas, Texas Professor, Finance, Sam Houston State University, Huntsville, Texas President and Chief Executive Officer, Dallas Medical Resource, Dallas, Texas 2007 Executive Chairman, Southwest Airlines, Dallas, Texas Chairman, President, and Chief Executive Officer, Anadarko Petroleum Corporation, Houston, Texas Chairman and Chief Executive Officer, ChaseSource, L.P., Houston, Texas 2007 2008 Regional President, State National Bank, El Paso, Texas 2007 2008 2009 2008 2009 2009 EL PASO BRANCH Appointed by the Federal Reserve Bank F. James Volk 298 94th Annual Report 2007 Directors—Continued BANK or BRANCH, Category Name D. Kirk Edwards Fred J. Loya Gerald J. Rubin Appointed by the Board of Governors Cecilia Ochoa Levine Ron C. Helm William V. Flores Titlp 1 lllc Term expires Dec. 31 President, MacLondon Royalty Company, Odessa, Texas Chairman, Fred Loya Insurance, El Paso, Texas Chairman, President, and Chief Executive Officer, Helen of Troy Limited, El Paso, Texas 2008 President, MFI International Mfg., LLC, El Paso, Texas Owner, Helm Land and Cattle Company, Van Horn, Texas Deputy Secretary, New Mexico Higher Education Department, Santa Fe, New Mexico 2007 2008 Managing Director, RBC Capital Markets, Houston, Texas Chairman, President, and Chief Executive Officer, DX Service Company, Inc., Houston, Texas President and Chief Executive Officer, Baylor College of Medicine, Houston, Texas Chairman and Chief Executive Officer, The First National Bank of Bryan, Bryan, Texas 2007 President and Chief Executive Officer, El Paso Corporation, Houston, Texas Chairman and Chief Executive Officer, Tejas Office Products, Inc., Houston, Texas President, Apex Enterprises, Inc., Houston, Texas 2007 Owner, Gur Parsaad Properties, Ltd., San Antonio, Texas Chairman and Chief Executive Officer, U.S. Packers & Processors, Harlingen, Texas President, Southern Distributing, Laredo, Texas Founder and President, SRV Holdings, Austin, Texas 2007 President, The University of Texas at San Antonio, San Antonio, Texas Chairman and Chief Executive Officer, Richter Architects, Corpus Christi, Texas President, Southwest Research Institute, San Antonio, Texas 2007 2008 2009 2009 HOUSTON BRANCH Appointed by the Federal Reserve Bank Jodie L. Jiles S. Reed Morian Peter G. Traber, M.D. Timothy N. Bryan Appointed by the Board of Governors Douglas L. Foshee Lupe Fraga Nancy T. Chang 2008 2008 2009 2008 2009 SAN ANTONIO BRANCH Appointed by the Federal Reserve Bank G.P.Singh Matt F. Gorges Guillermo F. Trevino Steven R. Vandegrift Appointed by the Board of Governors Ricardo Romo Elizabeth Chu Richter J. Dan Bates 2008 2008 2009 2008 2009 Federal Reserve System Organization 299 BANK or BRANCH, Category Name Titlp 1 Hit; Term expires Dec. 31 DISTRICT 12—SAN FRANCISCO RESERVE BANK Class A Richard W. Decker, Jr Candace H. Wiest Kenneth P. Wilcox Class B Jack McNally Karla S. Chambers . Blake W. Nordstrom Class C David K.Y. Tang Douglas W. Shorenstein T. Gary Rogers Chairman and Co-Founder, Belvedere Capital Partners LLC, San Francisco, California President and Chief Executive Officer, West Valley National Bank, Avondale, Arizona President and Chief Executive Officer, S VB Financial Group and Silicon Valley Bank, Santa Clara, California 2007 Principal, JKM Consulting, Sacramento, California Vice President and Co-Owner, Stahlbush Island Farms, Inc., Corvallis, Oregon President, Nordstrom, Inc., Seattle, Washington 2007 2008 Managing Partner, Asia, K&L Gates, Seattle, Washington Chairman and Chief Executive Officer, Shorenstein Properties LLC, San Francisco, California Retired Chairman and Chief Executive Officer, Dreyer's Grand Ice Cream, Inc., Oakland, California 2007 Chairman, President, and Chief Executive Officer, East West Bank, Pasadena, California Managing Partner, Thomas & Mack Co., Las Vegas, Nevada 2007 2008 2009 2009 2008 2009 Los ANGELES BRANCH Appointed by the Federal Reserve Bank Dominic Ng Peter M. Thomas Vacancy Andrew J. Sale Appointed by the Board of Governors James L. Sanford Ann E. Sewill Anita Santiago Partner, Media and Entertainment Leader - Pacific Southwest Area, Ernst & Young LLP, Los Angeles, California 2008 2009 2009 Corporate Vice President, Northrop Grumman Corporation, Los Angeles, California President, Community Foundation Land Trust, California Community Foundation, Los Angeles, California Chief Executive Officer, Anita Santiago Advertising, Santa Monica, California 2007 Regional President, Wells Fargo Bank, Portland, Oregon President, Don Pancho Authentic Mexican Foods, Inc., Salem, Oregon 2007 2008 2008 2009 PORTLAND BRANCH Appointed by the Federal Reserve Bank Alan V. Johnson George J. Puentes 300 94th Annual Report, 2007 Directors—Continued BANK or BRANCH, Category Name Peggy Y. Fowler Titlp 1 Hie Term expires Dec. 31 Chief Executive Officer and President, Portland General Electric, Portland, Oregon President and Chief Executive Officer, West Coast Bancorp, Lake Oswego, Oregon 2008 Chief Executive Officer and Principal, Ferguson Wellman Capital Management, Inc., Portland, Oregon William D. Thorndike, Jr. .. Chairman and President, Medford Fabrication, Medford, Oregon David Y. Chen Managing Director, Equilibrium Capital Group LLC, Portland, Oregon 2007 Robert D. Sznewajs Appointed by the Board of Governors James H. Rudd 2009 2008 2009 SALT LAKE CITY BRANCH Appointed by the Federal Reserve Bank Michael M. Mooney A. Scott Anderson Deborah S. Bayle Scott L. Hymas Appointed by the Board of Governors Gary L. Crocker Clark D. Ivory Edwin E. Dahlberg President, Idaho Region, Bank of the Cascades, Boise, Idaho President and Chief Executive Officer, Zions Bank, Salt Lake City, Utah President and Chief Executive Officer, United Way of Salt Lake, Salt Lake City, Utah Chief Executive Officer, RC Willey, Salt Lake City, Utah 2007 Chairman of the Board, Merrimack Pharmaceuticals, Inc., Salt Lake City, Utah Chief Executive Officer, Ivory Homes, Ltd., Salt Lake City, Utah President and Chief Executive Officer, St. Luke's Healthi System, Boise, Idaho 2007 2008 2008 2009 2008 2009 SEATTLE BRANCH Appointed by the Federal Reserve Bank Vacancy Kenneth M. Kirkpatrick .... President, Washington State, U.S. Bank, Seattle, Washington H. Stewart Parker President and Chief Executive Officer, Targeted Genetics Corporation, Seattle, Washington President and Chief Executive Officer, Cascade Carol K. Nelson Financial Corporation, Everett, Washington Appointed by the Board of Governors Mic R. Dinsmore James R. Gill Helvi K. Sandvik President, Infrastructure Investment Division, Stark Investments, Seattle, Washington President, Pacific Northwest Title Holding Company, Seattle, Washington President, NANA Development Corporation, Anchorage, Alaska 2007 2008 2008 2009 2007 2008 2009 Members of the Board of Governors, 1913-2007 301 Members of the Board of Governors, 1913-2007 Appointed Members Federal Reserve District Date initially took oath of office Charles S. Hamlin Boston Aug. 10, 1914 Paul M. Warburg Frederic A. Delano W.P.G. Harding Adolph C. Miller New York Chicago Atlanta San Francisco Aug. Aug. Aug. Aug. Albert Strauss Henry A. Moehlenpah Edmund Platt New York Chicago New York Oct. 26, 1918 Nov. 10, 1919 June 8, 1920 David C. Wills John R. Mitchell Milo D. Campbell Daniel R. Crissinger George R. James Cleveland Minneapolis Chicago Cleveland St. Louis Sept. 29, 1920 May 12, 1921 Mar. 14, 1923 May 1, 1923 May 14, 1923 Edward H. Cunningham Roy A. Young Eugene Meyer Wayland W. Magee Eugene R. Black M.S. Szymczak Chicago Minneapolis New York Kansas City Atlanta Chicago May 14, 1923 Oct. 4, 1927 Sept. 16, 1930 May 18, 1931 May 19, 1933 June 14, 1933 J.J. Thomas Marriner S. Eccles Kansas City San Francisco June 14, 1933 Nov. 15, 1934 Joseph A. Broderick John K. McKee Ronald Ransom Ralph W. Morrison Chester C. Davis New York Cleveland Atlanta Dallas Richmond Feb.3,1936 Feb. 3, 1936 Feb. 3,1936 Feb. 10, 1936 June 25, 1936 Ernest G. Draper Rudolph M. Evans James K. Vardaman, Jr. Lawrence Clayton Thomas B. McCabe Edward L. Norton Oliver S. Powell Wm. McC. Martin, Jr. New York Richmond St. Louis Boston Philadelphia Atlanta Minneapolis New York Mar. 30, 1938 Mar. 14, 1942 Apr. 4, 1946 Feb. 14, 1947 Apr. 15, 1948 Sept. 1, 1950 Sept. 1, 1950 Apr. 2, 1951 A.L. Mills, Jr. San Francisco Feb. 18, 1952 J.L. Robertson Kansas City Feb. 18, 1952 C. Canby Balderston Paul E. Miller Philadelphia Minneapolis Aug. 12, 1954 Aug. 13, 1954 Name 10, 1914 10, 1914 10, 1914 10, 1914 Other datesl Reappointed in 1916 and 1926. Served until Feb. 3, 1936.2 Term expired Aug. 9, 1918. Resigned July 21, 1918. Term expired Aug. 9, 1922. Reappointed in 1924. Reappointed in 1934 from the Richmond District. Served until Feb. 3, 1936.2 Resigned Mar. 15, 1920. Term expired Aug. 9, 1920. Reappointed in 1928. Resigned Sept. 14, 1930. Term expired Mar. 4, 1921. Resigned May 12, 1923. Died Mar. 22, 1923. Resigned Sept. 15, 1927. Reappointed in 1931. Served until Feb. 3, 1936.3 Died Nov. 28, 1930. Resigned Aug. 31, 1930. Resigned May 10, 1933. Term expired Jan. 24, 1933. Resigned Aug. 15, 1934. Reappointed in 1936 and 1948. Resigned May 31, 1961. Served until Feb. 10, 1936.2 Reappointed in 1936, 1940, and 1944. Resigned July 14, 1951. Resigned Sept. 30, 1937. Served until Apr. 4, 1946.2 Reappointed in 1942. Died Dec. 2, 1947. Resigned July 9, 1936. Reappointed in 1940. Resigned Apr. 15, 1941. Served until Sept. 1, 1950.2 Served until Aug. 13, 1954.2 Resigned Nov. 30, 1958. Died Dec. 4, 1949. Resigned Mar. 31, 1951. Resigned Jan. 31, 1952. Resigned June 30, 1952. Reappointed in 1956. Term expired Jan. 31, 1970. Reappointed in 1958. Resigned Feb. 28, 1965. Reappointed in 1964. Resigned Apr. 30, 1973. Served through Feb. 28, 1966. Died Oct. 21, 1954. 302 94th Annual Report, 2007 Appointed Members—Continued Federal Reserve District Date initially took oath of office Chas. N. Shepardson G.H. King, Jr. Dallas Atlanta George W. Mitchell Chicago J. Dewey Daane Sherman J. Maisel Andrew F. Brimmer William W. Sherrill Richmond San Francisco Philadelphia Dallas Arthur F. Burns New York John E. Sheehan Jeffrey M. Bucher Robert C. Holland Henry C. Wallich Philip E. Coldwell Philip C. Jackson, Jr. J. Charles Partee Stephen S. Gardner David M. Lilly G. William Miller Nancy H. Teeters Emmett J. Rice Frederick H. Schultz Paul A. Volcker Lyle E. Gramley Preston Martin Martha R. Seger Wayne D. Angell Manuel H. Johnson H. Robert Heller Edward W. Kelley, Jr. Alan Greenspan John P. LaWare David W. Mullins, Jr. Lawrence B. Lindsey Susan M. Phillips Alan S. Blinder Janet L. Yellen Laurence H. Meyer Alice M. Rivlin Roger W. Ferguson, Jr. Edward M. Gramlich Susan S. Bies Mark W. Olson Ben S. Bernanke Donald L. Kohn Ben. S. Bernanke Kevin M. Warsh Randall S. Kroszner Frederic S. Mishkin St. Louis San Francisco Kansas City Boston Dallas Atlanta Richmond Philadelphia Minneapolis San Francisco Chicago New York Atlanta Philadelphia Kansas City San Francisco Chicago Kansas City Richmond San Francisco Dallas New York Boston St. Louis Richmond Chicago Philadelphia San Francisco St. Louis Philadelphia Boston Richmond Chicago Minneapolis Atlanta Kansas City Atlanta New York Richmond Boston Mar. 17, 1955 Retired Apr. 30, 1967. Mar. 25, 1959 Reappointed in 1960. Resigned Sept. 18, 1963. Aug. 31, 1961 Reappointed in 1962. Served until Feb. 13, 1976.2 Nov. 29, 1963 Served until Mar. 8, 1974.2 Apr. 30, 1965 Served through May 31, 1972. Mar. 9, 1966 Resigned Aug. 31, 1974. May 1, 1967 Reappointed in 1968. Resigned Nov. 15, 1971. Jan. 31, 1970 Term began Feb. 1, 1970. Resigned Mar. 31, 1978. Resigned June 1, 1975. Jan. 4, 1972 Resigned Jan. 2, 1976. June 5, 1972 June 11, 1973 Resigned May 15, 1976. Mar. 8, 1974 Resigned Dec. 15, 1986. Oct. 29, 1974 Served through Feb. 29, 1980. July 14, 1975 Resigned Nov. 17, 1978. Served until Feb. 7, 1986.2 Jan. 5, 1976 Feb. 13, 1976 Died Nov. 19, 1978. Resigned Feb. 24, 1978. June 1, 1976 Mar. 8, 1978 Resigned Aug. 6, 1979. Sept. 18, 1978 Served through June 27, 1984. June 20, 1979 Resigned Dec. 31, 1986. July 27, 1979 Served through Feb. 11, 1982. Aug. 6, 1979 Resigned Aug. 11, 1987. May 28, 1980 Resigned Sept. 1, 1985. Mar. 31, 1982 Resigned Apr. 30, 1986. July 2, 1984 Resigned Mar. 11, 1991. Served through Feb. 9, 1994. Feb. 7, 1986 Resigned Aug. 3, 1990. Feb. 7, 1986 Aug. 19, 1986 Resigned July 31, 1989. May 26, 1987 Resigned Dec. 31,2001. Aug. 11, 1987 Resigned Jan. 31,2006. Aug. 15, 1988 Resigned Apr. 30, 1995. May 21, 1990 Resigned Feb. 14, 1994. Nov. 26, 1991 Resigned Feb. 5, 1997. Served through June 30, 1998. Dec. 2, 1991 June 27, 1994 Term expired Jan. 31, 1996. Aug. 12, 1994 Resigned Feb. 17, 1997. June 24, 1996 Term expired Jan. 31, 2002. June 25, 1996 Resigned July 16, 1999. Nov. 5, 1997 Resigned Apr. 28, 2006. Nov. 5, 1997 Resigned Aug. 31,2005. Resigned Mar. 30, 2007 Dec. 7, 2001 Dec. 7, 2001 Resigned June 20, 2006. Resigned June 21, 2005. Aug. 5, 2002 Aug. 5, 2002 Feb. 1,2006 Feb. 24, 2006 Mar. 1,2006 Sept. 5, 2006 Name Other dates1 Members of the Board of Governors, 1913-2007 303 Appointed Members—Continued Name Term Chairmen3 Charles S. Hamlin W.P.G. Harding Daniel R. Crissinger Roy A. Young Eugene Meyer Eugene R. Black Marriner S. Eccles Thomas B. McCabe Wm. McC. Martin, Jr. Arthur F. Burns G. William Miller Paul A. Volcker Alan Greenspan Ben Bernanke Aug. 10, 1914-Aug. 9, 1916 Aug. 10, 1916-Aug. 9, 1922 May 1, 1923-Sept. 15, 1927 Oct. 4, 1927-Aug. 31,1930 Sept. 16, 1930-May 10, 1933 May 19, 1933-Aug. 15, 1934 Nov. 15, 1934-Jan. 31, 19484 Apr. 15, 1948-Mar. 31, 1951 Apr. 2, 1951-Jan. 31, 1970 Feb. 1, 1970-Jan. 31, 1978 Mar. 8, 1978-Aug. 6, 1979 Aug. 6, 1979-Aug. 11, 1987 Aug. 11, 1987-Jan. 31, 20065 Feb. 1,2006- Vice Chairmen3 Frederic A. Delano Paul M. Warburg Albert Strauss Edmund Platt J.J. Thomas Ronald Ransom C. Canby Balderston J.L. Robertson George W. Mitchell Stephen S. Gardner Frederick H. Schultz Preston Martin Manuel H. Johnson David W. Mullins, Jr. Alan S. Blinder Alice M. Rivlin Roger W. Ferguson, Jr. Donald L. Kohn Aug. 10, 1914-Aug. 9, 1916 Aug. 10, 1916-Aug. 9, 1918 Oct. 26, 1918-Mar. 15, 1920 July 23, 1920-Sept. 14, 1930 Aug. 21, 1934-Feb. 10, 1936 Aug. 6, 1936-Dec. 2, 1947 Mar. 11, 1955-Feb. 28, 1966 Mar. 1, 1966-Apr. 30, 1973 May 1,1973-Feb. 13, 1976 Feb. 13, 1976-Nov. 19, 1978 July 27, 1979-Feb. 11, 1982 Mar. 31, 1982-Apr. 30, 1986 Aug. 4, 1986-Aug. 3, 1990 July 24, 1991-Feb. 14, 1994 June 27, 1994-Jan. 31, 1996 June 25, 1996-July 16, 1999 Oct. 5, 1999-Apr. 28, 2006 June 23, 2006- NOTE: Under the original Federal Reserve Act, the Federal Reserve Board was composed of five appointed members, the Secretary of the Treasury (ex officio chairman of the Board), and the Comptroller of the Currency. The original term of office was ten years; the five original appointed members had terms of two, four, six, eight, and ten years. In 1922 the number of appointed members was increased to six, and in 1933 the term of office was raised to twelve years. The Banking Act of 1935 changed the name to the Board of Governors of the Federal Reserve System and provided that the Board be composed of seven appointed members; that the Secretary of the Treasury and the Comptroller of the Currency continue to serve until Feb. 1, 1936; that the appointed members in office on Aug. 23, 1935, continue to serve until Feb. 1, 1936, or until their successors were appointed and had qualified; and that thereafter the terms of members be fourteen years and that the designation of Chairman and Vice Chairman of the Board be for four years. 1. Date following "Resigned" and "Retired" denotes final day of service. 2. Successor took office on this date. 3. Before Aug. 23, 1935, Chairmen and Vice Chairmen were designated Governor and Vice Governor. 4. Served as Chairman Pro Tempore from Feb. 3, 1948, to Apr. 15, 1948. 5. Served as Chairman Pro Tempore from Mar. 3, 1996, to June 20, 1996. 304 94th Annual Report, 2007 Ex Officio Members Name Term Secretaries of the Treasury W.G. McAdoo Carter Glass David F. Houston Andrew W. Mellon Ogden L. Mills William H. Woodin Henry Morgenthau, Jr. Dec. 23, 1913-Dec. 15, 1918 Dec. 16, 1918-Feb. 1, 1920 Feb. 2, 1920-Mar. 3, 1921 Mar. 4, 1921-Feb. 12, 1932 Feb. 12, 1932-Mar.4, 1933 Mar. 4, 1933-Dec. 31, 1933 Jan. 1, 1934-Feb. 1, 1936 Comptrollers of the Currency John Skelton Williams Daniel R. Crissinger Henry M. Dawes Joseph W. Mclntosh J.W. Pole J.F.T. O'Connor Feb. 2, 1914-Mar. 2, 1921 Mar. 17, 1921-Apr. 30, 1923 May 1, 1923-Dec. 17, 1924 Dec. 20, 1924-Nov. 20, 1928 Nov.21,1928-Sept.20, 1932 May 11, 1933-Feb. 1, 1936 Statistical Tables 306 94th Annual Report, 2007 1. Federal Reserve Open Market Transactions, 2007 Millions of dollars Type of security and transaction Apr. U.S. TREASURY SECURITIES1 0 0 66,169 66,169 0 0 0 70,706 70,706 0 0 0 88,466 88,466 0 0 0 76,560 76,560 0 Others within 1 year Gross purchases .. Gross sales Maturity shifts . . . Exchanges Redemptions ooooo 817 0 0 0 0 ooooo 1,394 0 0 0 0 1 to 5 years Gross purchases . Gross sales Maturity shifts .. Exchanges oooo 1,061 0 0 0 oooo 3,742 0 0 0 5 to 10 years Gross purchases Gross sales Maturity shifts Exchanges oooo oooo oooo 290 0 0 0 More than 10 years Gross purchases . Gross sales Maturity shifts .. Exchanges oooo oooo oooo 640 0 0 0 All maturities Gross purchases . . . Gross sales Redemptions ooo 1,878 0 0 ooo Outright transactions 2 Treasury bills Gross purchases Gross sales Exchanges For new bills Redemptions 6,066 0 0 Net change in U.S. Treasury securities For notes see end of table. 1,878 6,066 Statistical Tables 307 1.—Continued 0 0 75,502 75,502 10,000 0 0 62,083 62,083 0 0 0 62,143 62,143 0 0 0 83,590 83,590 0 0 0 24,580 24,580 39,178 0 0 839,687 839,687 49,178 0 0 39,178 10,680 0 50,414 0 0 -39,178 -39,734 oooo oooo ooooo oooo oooo ooooo oooo oooo ooo ooooo 0 oooo -11,236 oooo oooo ooo 0 ooo ooooo oooo oooo oooo ooooo oooo oooo oooo 0 0 0 11,236 oooo 2,736 7,539 0 0 0 oooo ooo oooo oooo 2,736 0 0 2,211 0 0 0 1,236 oooo 2,736 0 0 0 Total oooo 0 0 0 0 1,236 Dec. ooo ooooo 0 0 72,690 72,690 0 Nov. oooo 0 0 62,340 62,340 0 Oct. oooo 0 0 94,858 94,858 0 Sept. Aug. ooooo July oooo June oooo May 308 94th Annual Report, 2007 1. Federal Reserve Open Market Transactions, 2007—Continued Millions of dollars Type of security and transaction Jan. Feb. Mar. Apr. FEDERAL AGENCY OBLIGATIONS Outright transactions 2 Gross purchases Gross sales Redemptions 0 0 0 0 0 0 0 0 0 0 0 0 Repurchase agreements3 Gross purchases Gross sales 176,000 184,750 193,750 180,500 228,250 240,250 179,500 161,250 Reverse repurchase agreements 4 Gross purchases Gross sales 630,544 633,309 696,788 704,054 843,250 840,887 739,145 739,251 -11,515 5,984 -9,637 18,143 -11,515 7,862 -9,637 24,209 Net change in federal agency obligations TEMPORARY TRANSACTIONS Net change in temporary transactions Total net change in System Open Market Account NOTE: Sales, redemptions, and negative figures reduce holdings of the System Open Market Account; all other figures increase such holdings. Components may not sum to totals because of rounding. 1. Transactions exclude changes in compensation for the effects of inflation on the principal of inflationindexed securities. Transactions include the rollover of inflation compensation into new securities. 2. Excludes the effect of temporary transactions— repurchase agreements, matched sale-purchase agreements (MSPs), and reverse repurchase agreements (RRPs). 3. Cash value of agreements, which are collateralized by U.S. government and federal agency securities. 4. Cash value of agreements, which are collateralized by U.S. Treasury securities. Statistical Tables 309 1.—Continued May July June 0 0 0 0 0 Sept. Aug. Oct. Nov. Dec. Total 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 174,250 190,000 177,750 188,250 185,000 180,000 209,000 200,750 236,500 230,250 268,750 265,000 318,750 319,750 249,250 250,250 2,596,750 2,591,000 752,100 749,528 672,056 669,588 673,157 673,778 722,358 725,162 669,935 669,850 786,360 788,726 715,682 713,543 761,133 769,202 8,662,508 8,676,878 -13,178 -8,032 4,379 5,446 6,334 1,385 1,139 -9.070 -8,622 -10,442 -8,032 4,379 -5,791 6,334 1,385 1,139 -48,248 -48357 310 94th Annual Report, 2007 2. Federal Reserve Bank Holdings of U.S. Treasury and Federal Agency Securities, December 31, 2005-2007 Millions of dollars December 31 Change Description 2007 2006 2005 2006 to 2007 2005 to 2006 740,611 778,915 744,215 -38,304 34,700 U.S. TREASURY SECURITIES Held outright1 By remaining maturity Bills 1-90 days 91 days to 1 year Notes and bonds 1 year or less More than 1 year through 5 years More than 5 years through 10 years More than 10 years 153,829 74,012 193,034 83,985 187,370 83,900 -39,205 -9,973 5,664 85 101,447 240,562 81,947 88,814 129,594 224,177 67,645 80,479 128,287 210,745 56,699 77,215 -28,147 16,385 14,302 8,335 1,307 13,432 10,946 3,264 By type Bills Notes Bonds 227,841 401,776 110,995 277,019 402,367 99,528 271,270 380,118 92,827 -49,178 -591 11,467 5,749 22,249 6,701 FEDERAL AGENCY SECURITIES Held outrightl By remaining maturity 1 year or less More than 1 year through 5 years More than 5 years through 10 years More than 10 years 0 0 0 0 0 0 0 0 0 0 46,500 40,750 46,750 5,750 -6,000 Matched sale-purchase agreements Foreign official and international accounts Dealers 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Reverse repurchase agreements3 Foreign official and international accounts Dealers 43,985 43,985 0 29,615 29,615 0 30,505 30,505 0 14,370 14,370 0 -890 -890 0 0 0 0 0 0 0 0 0 0 0 By issuer Federal National Mortgage Association TEMPORARY TRANSACTIONS Repurchase agreements2 NOTE: Components may not sum to totals because of rounding. 1. Excludes the effect of temporary transactions— repurchase agreements, matched sale-purchase agreements (MSPs), and reverse repurchase agreements (RRPs). 2. Cash value of agreements, which are collateralized by U.S. government and federal agency securities. 3. Cash value of agreements, which are collateralized by U.S. Treasury securities. Statistical Tables 31 3. Federal Reserve Bank Interest Rates on Loans to Depository Institutions, December 31, 2007 Reserve Bank All Federal Reserve Banks Primary credit1 Secondary credit2 Seasonal credit3 4.75 5.25 4.70 NOTE: For details on rate changes over the course of 2007, see the section on discount rates in the chapter "Record of Policy Actions of the Board of Governors." 1. Primary credit is generally available for very short terms as a backup source of liquidity to depository institutions that are in generally sound financial condition in the judgment of the lending Federal Reserve Bank. 2. Secondary credit is available in appropriate circumstances to depository institutions that do not qualify for primary credit. 3. Seasonal credit is available to help relatively small depository institutions meet regular seasonal needs for funds that arise from a clear pattern of intra-yearly movements in their deposits and loans. The discount rate on seasonal credit takes into account rates charged by market sources of funds and is reestablished on the first business day of each two-week reserve maintenance period. 312 94th Annual Report, 2007 4. Reserve Requirements of Depository Institutions, December 31, 2007 Requirements Type of deposit Percentage of deposits Effective date 0 3 10 12-20-07 12-20-07 12-20-07 Nonpersonal time deposits 0 12-27-90 Eurocurrency liabilities 0 12-27-90 Net transaction accounts1 $0 million-$9.3 million2 More than $9.3 million-$43.9 million3 More than $43.9 million NOTE: Required reserves must be held in the form of vault cash and, if vault cash is insufficient, also in the form of a deposit with a Federal Reserve Bank. An institution that is a member of the Federal Reserve System must hold that deposit directly with a Reserve Bank; an institution that is not a member of the System can maintain that deposit directly with a Reserve Bank or with another institution in a pass-through relationship. Reserve requirements are imposed on commercial banks, savings banks, savings and loan associations, credit unions, U.S. branches and agencies of foreign banks, Edge corporations, and agreement corporations. 1. Total transaction accounts consists of demand deposits, automatic transfer service (ATS) accounts, NOW accounts, share draft accounts, telephone or preauthorized transfer accounts, ineligible banker's acceptances, and affiliate-issued obligations maturing in seven days or less. Net transaction accounts are total transaction accounts less amounts due from other depository institutions and less cash items in the process of collection. For a more detailed description of these deposit types, see Form FR 2900 at www.federalreserve.gov/boarddocs/ reportforms/. 2. The amount of net transaction accounts subject to a reserve requirement ratio of 0 percent (the "exemption amount") is adjusted each year by statute. The exemption amount is adjusted upward by 80 percent of the previous year's (June 30 to June 30) rate of increase in total reservable liabilities at all depository institutions. No adjustment is made in the event of a decrease in such liabilities. 3. The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent is the "low reserve tranche." By statute, the upper limit of the low reserve tranche is adjusted each year by 80 percent of the previous year's (June 30 to June 30) rate of increase or decrease in net transaction accounts held by all depository institutions. Statistical Tables 313 5. Banking Offices and Banks Affiliated with Bank Holding Companies in the United States, December 31, 2006 and 2007 Commercial banks ! Type of office Member Total Nonmember Total Total National Statechartered savings banks State All banking offices BANKS Number, Dec. 31, 2006 7,731 Changes during 2007 New banks Banks converted into branches Ceased banking operation" Other^ Net change Number, Dec. 31, 2007 7^67 2,592 1,695 897 4,775 364 181 173 40 27 13 133 8 -272 -268 -115 -79 -36 -153 -4 -39 0 -130 -31 0 -126 -13 -15 -103 -8 -20 -80 -5 5 -23 -18 15 -23 -8 0 -4 7,601 7,241 2,489 1,615 874 4,752 360 80,872 77,792 55,099 40,760 14^39 22,693 3,080 BRANCHES AND ADDITIONAL OFFICES Number, Dec. 31, 2006 Changes during 2007 New branches Branches converted from banks Discontinued2 Other3 Net Change 3,258 3,088 1,966 1,474 492 1,122 170 272 -3,338 0 192 258 -3,275 84 155 133 -2,662 1,067 504 91 -2,152 1,157 570 42 -510 -90 -66 125 -613 -983 -349 -63 -84 37 Number, Dec. 31, 2007 81,064 77,947 55,603 41330 14,273 22344 3,117 14 Banks affiliated with bank holding companies BANKS Number, Dec. 31, 2006 6,187 6,062 2,274 1,477 797 3,788 125 Changes during 2007 BHC-affiliated new banks Banks converted into branches Ceased banking operation" Other Net Change 190 180 54 38 16 126 10 -224 -220 -96 -65 -31 -124 -4 -35 0 -69 -29 0 -69 -13 -16 -71 -8 -16 -51 -5 0 -20 -16 16 2 -6 0 0 Number, Dec. 31, 2007 6,118 5,993 2,203 1,426 777 3,790 125 NOTE: Includes banking offices and BHCs in U.S. territories and possessions. 1. For purposes of this table, banks are entities that are defined as banks in the Bank Holding Company Act, as amended, which is implemented by Federal Reserve Regulation Y. Generally, a bank is any institution that accepts demand deposits and is engaged in the business of making commercial loans or any institution that is defined as an insured bank in section 3(h) of the FDIC Act. Covers entities in the United States and its territories and possessions (affiliated insular areas). 2. Institutions that no longer meet the Regulation Y definition of bank. 3. Interclass changes and sales of branches. 314 94th Annual Report, 2007 6A. Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items, Year-End 1984-2007 and Month-End 2007 Millions of dollars Factors supplying reserve funds Federal Reserve Bank credit outstanding Period Securities held outright1 Repurchase agreements2 Loans Gold stock Special drawing rights certificate account Treasury currency outstanding 3 Other Federal Reserve assets Total 833 12,347 186,384 11,096 4,618 16,418 Float 1984 167,612 2,015 3,577 1985 1986 1987 1988 1989 186,025 205,454 226,459 240,628 233,300 5,223 16,005 4,961 6,861 2,117 3,060 1,565 3,815 2,170 481 988 1,261 811 1,286 1.093 15,302 17,475 15,837 18,803 39,631 210,598 241,760 251,883 269,748 276,622 11,090 11,084 11,078 11,060 11,059 4,718 5,018 5,018 5,018 8,518 17,075 17,567 18,177 18,799 19,628 1990 1991 1992 1993 1994 241,431 272,531 300,423 336,654 368,156 18,354 15,898 8,094 13,212 10,590 190 218 675 94 223 2,566 1,026 3,350 963 740 39,880 34,524 30,278 33,394 33,441 302.421 324,197 342,820 384,317 413,150 11.058 11,059 11,056 11.053 11,051 10,018 10,018 8,018 8,018 8,018 20,402 21,014 21,447 22,095 22,994 1995 1996 1997 1998 1999 380,831 393,132 431,420 452,478 478,144 13,862 21,583 23,840 30,376 140,640 135 85 2,035 17 233 231 5,297 561 1,009 407 33,483 32,222 32,044 37,692 34,799 428,543 452,319 489,901 521,573 654,223 11,050 11,048 11,047 11,046 11,048 10,168 9,718 9,200 9,200 6,200 24,003 24,966 25,543 26,270 28,013 2000 2001 2002 2003 2004 511,833 551,685 629,416 666,665 717,819 43,375 50,250 39,500 43,750 33,000 110 34 40 62 43 795 698 832 211 927 36,896 36,885 38,574 40,214 42,161 593,009 639,552 708,363 750,901 793,950 11,046 11,045 11,043 11,043 11,045 2,200 2,200 2,200 2,200 2,200 31,643 33,017 34,597 35,468r 36,434 2005 2006 2007 744,215 778,915 740,611 46,750 40,750 46,500 72 67 48,636 891 -326 -8 39,319 39,885 66,308 831,247 859,290 902,048 11,043 11,041 11,041 2,200 2,200 2,200 36,540 38,206r 38,681 For notes see end of table. Statistical Tables 315 6 A.—Continued Factors absorbing reserve funds Currency in circulation Reverse repurchase agreements4 Treasury cash holdings5 Deposits with Federal Reserve Banks, other than reserve balances Treasury Foreign Required clearing balances Other Other Federal Reserve liabilities and capital Reserve balances with Federal Reserve Banks 6 513 5,316 253 867 1,126 5,952 20,693 197,488 211,995 230,205 247,649 260,456 0 0 0 0 0 550 447 454 395 450 9,351 7,588 5,313 8,656 6,217 480 287 244 347 589 1,041 1,490 1,812 1,687 1,605 1,618 5,940 6,088 7,129 7,683 8,486 27,141 46,295 40,097 37,742 36,713 286,963 307,756 334,701 365,271 403,843 0 0 0 0 0 561 636 508 377 335 8,960 17,697 7,492 14,809 7,161 369 968 206 386 250 1,960 3,946 5,897 6,332 4,196 8,147 8,113 7,984 9,292 11,959 36,698 25,467 26,182 28,619 26,593 424,244 450,648 482,327 517,484 628,359 0 0 0 0 0 270 249 225 85 109 5,979 7,742 5,444 6,086 28,402 386 167 457 167 71 5,167 6,601 6,679 6,781 7,482 12,342 13,829 15,500 16,354 17,256 24,444 17,923 24,159 19,525 16,545 593,694 643,301 687,518 724.187 754,877 0 0 450 425 367 321 270 5,149 6,645 4,420 5,723 5,912 216 61 136 162 80 1,382 21,091 25,652 30,783 6,332 8,525 10,534 11,829 9,963 17,962 17,083 18,977 19,793 26,378 12,713 8,953 12,007 11,229 14,080 794,014 820.1761 828.938 30,505 29,615 43,985 202 252 259 4,573 4,708 16,120 83 98 96 2,144 8,650' 6,842 6,615 30,466 36,231 41.975 10,393 11.857 14,152 183,796 917 1,027 548 1,298 242 1,706 372 397 876 932 892 900 1,605 1,261 820 1,152 717 1,285 958 1,830 316 94th Annual Report, 2007 6A. Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items, Year-End 1984-2007 and Month-End 2007—Continued Millions of dollars Factors supplying reserve funds Federal Reserve Bank credit outstanding Gold stock Special drawing rights certificate account Treasury currency outstanding 3 11,041 11,041 11,041 11,041 11,041 11,041 11,041 11.041 11,041 11,041 11,041 11,041 2,200 2,200 2,200 2,200 2,200 2,200 2,200 2,200 2,200 2,200 2.200 2,200 38,254 38,305 38,371 38,414 38,462 38,521 38,541 38,595 38,639 38,695 38,765 38,681 Period Securities held outright1 2007 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Repurchase agreements2 778,863 780,793 780,901 787,188 790,272 790,522 790,800 779,642 779,632 779,586 779,701 740,611 32,000 45,250 33,250 51,500 35,750 25,250 30,250 38,500 44,750 48,500 47,500 46.500 Loans 1,326 22 27 70 115 204 247 Float -1,482 -1,012 -869 102 202 92 33 -622 -1,273 -1,164 -714 -729 -745 -814 48,636 -8 1,342 Other Federal Reserve assets Total 40,335 37,940 40,048 40,986 38,759 40,610 41,471 38,905 41,355 42,054 40,545 66,308 851,042 862,993 853,357 879.846 864,274 855,313 861,604 857,674 865,210 869,487 866,965 902,048 Statistical Tables 317 6 A.—Continued Factors absorbing reserve funds Currency in circulation Reverse repurchase agreements4 Treasury cash holdings5 Deposits with Federal Reserve Banks, other than reserve balances Treasury 802,599 808,078 805,586 806,998 814,007 812,794 813.387 815,020 810,607 815,303 817,259 828,938 32,379 39,645 37,283 37,389 34,817 32,349 32,970 35,774 35,689 38,055 35,916 43,985 175 204 301 299 286 306 300 329 336 301 266 259 Foreign 90 91 91 95 93 197 94 94 112 601 97 96 285 274 224 316 256 210 305 330 245 287 285 1,830 NOTE: Components may not sum to totals because of rounding. 1. Includes U.S. Treasury and federal agency securities. U.S. Treasury securities include securities lent to dealers, which are fully collateralized by other U.S. Treasury securities. Federal agency securities are included at face value. 2. Cash value of agreements, which are collateralized by U.S. Treasury and federal agency securities. 3. Includes currency and coin (other than gold) issued directly by the Treasury. The largest components are 6,836 6,738 6,990 6,508 6,580 6,395 6,466 6,613 6,469 6,586 6,486 6,615 36,727 38,147 38,912 39,069 39.275 39,277 39.667 40,612 41,548 41,849 42,571 41,975 Other 6,053 5,194 4,245 29,504 5,340 4,649 5,126 4,579 5,539 4,307 4,669 16,120 Required clearing balances Other Federal Reserve liabilities and capital Reserve balances with Federal Reserve Banks6 17,392 16,168 11,338 11,322 15,322 10,898 15,071 6,158 16,545 14.134 11,421 14,152 fractional and dollar coins. For details see "U.S. Currency and Coin Outstanding and in Circulation," Treasury Bulletin. 4. Cash value of agreements, which are collateralized by U.S. Treasury securities. 5. Coin and paper currency held by the Treasury, as well as any gold in excess of the gold certificates issued to the Reserve Bank. 6. Excludes required clearing balances and adjustments to compensate for float. r Revised. 318 94th Annual Report, 2007 6B. Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items, Year-End 1918-1983 Millions of dollars Factors supplying reserve funds Federal Reserve Bank credit outstanding Period Securities held outright1 Repurchase agreements 2 Loans Float3 All other4 Other Federal Reserve assets5 Gold stock 6 Total Special drawing rights certificate account Treasury currency outstanding 7 1918 1919 239 300 0 0 1,766 2,215 199 201 294 575 0 0 2,498 3,292 2,873 2,707 1,795 1,707 1920 1921 1922 1923 1924 287 234 436 80 536 0 0 0 54 4 2,687 1,144 119 40 78 27 52 262 146 273 355 390 0 0 0 0 0 3,355 1,563 1,405 1,238 1,302 2,639 3,373 3,642 3,957 4,212 1,709 1,842 1,958 2,009 2,025 1925 1926 1927 1928 1929 367 312 560 197 488 8 3 57 31 23 643 637 582 63 45 63 24 34 378 384 393 500 405 0 0 0 0 0 1,459 1,381 1,655 1,809 1,583 4,112 4,205 4,092 3,854 3,997 1,977 1,991 2,006 2,012 2,022 1930 1931 1932 1933 1934 686 775 43 42 4 2 0 251 638 1,851 2,435 2,430 372 378 41 137 21 0 0 0 98 7 21 20 14 15 5 0 1,373 1,853 2,145 2 688 2,463 4,306 4,173 4,226 4,036 8,238 2,027 2.035 2,204 2,303 2,511 1935 1936 1937 1938 1939 2.430 2,430 2,564 2,564 2,484 1 0 0 0 0 5 3 10 4 7 12 39 19 17 91 38 28 19 16 11 0 0 0 0 0 2,486 2,500 2,612 2,601 2,593 10,125 11,258 12,760 14,512 17,644 2,476 2,532 2,637 2,798 2,963 1940 1941 1942 1943 1944 2,184 2,254 6,189 11,543 18,846 0 0 0 0 0 3 3 6 5 80 80 94 471 681 815 8 10 14 10 4 0 0 0 0 0 2,274 2,361 6,679 12,239 19,745 21,995 22,737 22,726 21,938 20,619 3,087 3,247 3,648 4,094 4,131 1945 1946 1947 1948 1949 24,252 23,350 22,559 23,333 18,885 0 0 0 0 0 249 163 85 223 78 578 580 535 541 534 2 1 1 1 2 0 0 0 0 0 15,091 24,093 23,181 24,097 19,499 20,065 20,529 22,754 24,244 24,427 4,339 4,562 4.562 4,589 4,598 1950 1951 1952 1953 1954 20,725 23,605 24.034 25,318 24,888 53 196 663 598 44 67 19 156 28 143 1,368 1,184 967 935 808 3 5 4 2 1 0 0 0 0 0 22,216 25,009 25,825 26,880 25,885 22,706 22,695 23,187 22,030 21,713 4,636 4,709 4,812 4,894 4,985 1955 1956 1957 1958 1959 24,391 24,610 23,719 26,252 26.607 394 305 519 95 41 108 50 55 64 458 1,585 1.665 1,424 1,296 1,590 29 70 66 49 75 0 0 0 0 0 26,507 26,699 25,784 27,755 28,771 21,690 21,949 22,781 20,534 19,456 5,008 5,066 5,146 5,234 5,311 For notes see end of table. 618 723 320 1,056 632 235 o Statistical Tables 319 6B.—Continued Factors absorbing reserve funds Currency in circulation Deposits with Federal Reserve Banks, other than reserve balances Treasury cash holdings8 Treasury Foreign Member bank reserves9 Other Required Federal clearing Reserve 5 balances accounts Other Other Federal Reserve liabilities and capital5 With Federal Reserve Banks Currency and coin10 51 68 0 1,884 2,161 0 99 0 14 59 0 0 0 0 0 2,256 2.250 2,424 2.430 2,428 -AA -56 63 -41 -73 2 All 1,961 2,509 2,729 4,096 0 0 0 0 0 2,375 1,994 1,933 1,870 2,282 96 -33 576 859 1,814 0 0 0 0 0 5,587 6,606 7,027 8,724 11,653 0 0 0 0 0 2,743 4,622 5,815 5,519 6,444 2,844 1,984 1,212 3,205 5,209 0 0 0 0 0 0 0 0 0 0 4,026 12,450 13,117 12,886 14,373 0 0 0 0 0 7.411 9,365 11,129 11,650 12,748 6,615 3,085 1.988 1,236 1,625 495 607 563 590 106 0 0 0 0 0 0 0 0 0 0 15,915 16,139 17,899 20,479 16,568 0 0 0 0 0 14,457 15,577 16,400 19,277 15,550 1,458 565 363 455 493 441 714 746 111 839 907 0 0 0 0 0 0 0 0 0 0 17,681 20,056 19,950 20,160 18,876 0 0 0 0 0 16,509 19,667 20,520 19,397 18,618 1,172 554 426 246 391 694 925 901 998 0 0 0 0 0 0 0 0 0 0 19,005 19,059 19,034 18,504 18,174 0 0 0 0 310 18,903 19,089 19,091 18.574 18,619 102 -30 -57 -70 288 385 51 51 96 73 25 28 118 208 0 0 0 0 1,636 1,890 0 0 5,325 4,403 4,530 4,757 4,760 218 214 225 213 211 57 96 11 38 51 5 12 3 4 19 18 15 26 19 20 298 285 276 275 258 0 0 0 0 0 0 0 0 0 0 1,781 1,753 1,934 1,898 2,220 0 0 0 0 0 4,817 4,808 4,716 4,686 4,578 203 201 208 202 216 16 17 18 23 29 8 46 5 6 6 21 19 21 21 24 272 293 301 348 393 0 0 0 0 0 0 0 0 0 0 2,212 2,194 2,487 2,389 2,355 4.603 5,360 5,388 5,519 5,536 211 222 272 284 3,029 19 54 8 3 121 6 79 19 4 20 22 31 24 128 169 375 354 355 360 241 0 0 0 0 0 0 0 0 0 0 5,882 6,543 6,550 6,856 7,598 2,566 2,376 3,619 2.706 2,409 544 244 142 923 634 29 99 226 160 235 242 256 253 261 263 260 251 0 0 0 0 0 8,732 11,160 15.410 20,499 25,307 2,213 2.215 2,193 2.303 2,375 368 867 799 579 440 1,133 1,360 1,204 599 586 485 356 394 284 291 256 339 402 28,515 28,952 28,868 28,224 27.600 2,287 2,272 1,336 1,325 1,312 977 393 870 821 862 508 392 642 767 446 314 569 547 750 27,741 29,206 30,433 30.781 30,509 1,293 1,270 1,270 761 796 668 247 389 346 563 895 526 550 423 490 31,158 31,790 31.834 32,193 32,591 767 775 761 683 391 394 441 481 358 504 402 322 356 111 345 172 774 793 1.123 Excess 11 - 12 1,585 1,822 4,951 5,091 199 397 Required11 1,122 841 1,654 0 562 1,499 1,202 1,018 389 -570 763 258 -135 320 94th Annual Report, 2007 6B. Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items, Year-End 1918-1983—Continued Millions of dollars Factors supplying reserve funds Federal Reserve Bank credit outstanding Period Gold stock 6 Special drawing rights certificate account Treasury currency outstanding 7 Securities held outright1 Repurchase agreements 2 Loans Float 3 All other4 Other Federal Reserve assets 5 1960 1961 1962 1963 1964 26,984 30,478 28,722 33,582 36,506 400 159 342 11 538 33 130 38 63 186 1,847 2,300 2,903 2,600 2,606 74 51 110 162 94 0 0 0 0 0 29,338 31,362 33,871 36,418 39,930 17.767 16,889 15,978 15,513 15,388 5,398 5,585 5 567 5,578 5,405 1965 1966 1967 1968 1969 40,478 43,655 48,980 52,937 57,154 290 661 170 0 0 137 173 141 186 183 2,248 2,495 2,576 3,443 3,440 187 193 164 58 64 0 0 0 0 2,743 43,340 47,177 52,031 56,624 64,584 13,733 13,159 11,982 10.367 10,367 5,575 6,317 6,784 6,795 6,852 1970 1971 1972 1973 1974 62,142 69,481 71,119 80,395 84,760 0 335 39 4,261 4,343 3,974 3,099 2,001 57 261 106 68 999 1,123 1,068 1,260 1,152 3,195 67,918 76,515 78,551 86,072 92,208 10,732 10,132 10,410 11,567 11,652 400 400 400 400 400 7,147 7,710 8.313 8.716 9,253 1975 1976 1977 1978 1979 3,688 2,601 3,810 6,432 6,767 1.126 3,312 3,182 2,442 4,543 5,613 102,461 110,892 118,745 131,327 140,705 11,599 11,598 11,718 11,671 11,172 500 1,200 1,250 1,300 1,800 10,218 10,810 11,331 11,831 13,083 1980 1981 1982 1983 4,467 1,762 2,735 1,605 776 195 8,739 9,230 9,890 8,728 146,383 153,136 63,659 172,464 11,160 11,151 11,148 11,121 2,518 3,318 4,618 4,618 13,427 13,687 13,786 15,732 1,323 111 100 954 1,981 1,258 92,789 100,062 108,922 117,374 124,507 1,335 4,031 2,352 1,217 1,660 211 128,038 136,863 144,544 159,203 2,554 3,485 4,293 1,592 299 25 265 1,174 1,454 1,809 1,601 111 918 991 954 587 704 1,480 N O T E : For a description of figures and discussion of their significance, see Banking and Monetary Statistics, 1941-1970 (Board of Governors of the Federal Reserve System, 1976), pp. 507-23. Components may not sum to totals because of rounding. 1. In 1969 and thereafter, includes securities loaned— fully guaranteed by U.S. government securities pledged with Federal Reserve Banks—and excludes securities sold and scheduled to be bought back under matched sale-purchase transactions. On September 29, 1971, and thereafter, includes federal agency issues bought outright. 2. On December 1, 1966, and thereafter, includes federal agency obligations held under repurchase agreements. 3. In 1960 and thereafter, figures reflect a minor change in concept; see Federal Reserve Bulletin, vol. 47 (February 1961), p. 164. 418 Total 4. Principally acceptances and, until August 21, 1959, industrial loans, the authority for which expired on that date. 5. For the period before April 16, 1969, includes the total of Federal Reserve capital paid in, surplus, other capital accounts, and other liabilities and accrued dividends, less the sum of bank premises and other assets, and is reported as "Other Federal Reserve accounts"; thereafter, "Other Federal Reserve assets" and "Other Federal Reserve liabilities and capital" are shown separately. 6. Before January 30, 1934, includes gold held in Federal Reserve Banks and in circulation. 7. Includes currency and coin (other than gold) issued directly by the Treasury. The largest components are fractional and dollar coins. For details see "US. Currency and Coin Outstanding and in Circulation," Treasury Bulletin. Statistical Tables 321 6B.—Continued Factors absorbing reserve funds Currency in circulation 32,869 33,918 35,338 37.692 39,619 Deposits with Federal Reserve Banks, other than reserve balances Treasury cash holdings8 Treasury 377 422 380 361 612 Foreign 217 279 247 171 229 533 320 393 291 321 668 416 355 588 563 747 807 Other Required Federal clearing Reserve balances 5 accounts Other 485 465 597 880 820 Member bank reserves9 Other Federal Reserve liabilities and capital5 With Federal Reserve Banks Currency and coin10 Required11 Excess 11 - 12 0 0 0 0 0 0 0 0 0 0 17,081 17,387 17,454 17,049 18,086 2,544 2,544 3,262 4,099 4,151 18,988 18,988 20,071 20,677 21.663 637 96 645 471 574 0 0 0 0 0 0 0 0 0 0 1,919 18,447 19,779 21,092 21,818 22,085 4,163 4,310 4,631 4,921 5,187 22,848 24,321 25,905 27,439 28.173 -238 -232 -182 -700 -901 0 0 0 0 0 1,986 2,131 2,143 2,669 2,935 24.150 27,788 25,647 27,060 25,843 5,423 5,743 6,216 6,781 7,370 30,033 32.496 32,044 35,268 37,011 -460 1,035 9gi2 -1,360 -3,798 941 1,044 1,007 1,065 1,036 1,176 1,344 1,123 695 596 1,312 150 174 135 216 134 57,903 61,068 66,516 72,497 79,743 431 460 345 317 185 1,156 2.020 1,855 2.542 2,113 148 294 325 251 418 1,233 1.41913 1.275 li 0 0 0 0 0 86,547 93,717 103,811 114,645 125,600 483 460 392 240 494 7,285 10,393 7,114 4,196 4,075 353 352 379 368 429 1,090 1,357 1,187 1,256 1,412 0 0 0 0 0 0 0 0 0 0 2,968 3,063 3,292 4,275 4,957 26,052 25,158 26,870 31,152 29,792 8,036 8,628 9,421 10,538 11,429 35.197 35,461 37,615 42,694 44,217 -1,10314 -1,535 -1,265 -893 -2,835 136,829 144,774 154,908 171,935 441 443 429 479 3,062 4,301 5,033 3,661 411 505 328 191 617 781 0 0 0 0 0 117 436 4,671 5,261 4,990 5,392 27,456 25,111 26,053 20,413 13,654 15,576 16.666 17,821 40,558 42.145 41.391 39.179 675 -1.442 1,328 -945 42,056 44.663 47,226 50,961 53,950 760 703 999 840 1,033 851 211 -147 -773 -1,353 8. Coin and paper currency held by the Treasury, as well as any gold in excess of the gold certificates issued to the Reserve Bank. 9. In November 1979 and thereafter, includes reserves of member banks, Edge Act corporations, and U.S. agencies and branches of foreign banks. On November 13, 1980, and thereafter, includes reserves of all depository institutions. 10. Between December 1, 1959, and November 23, 1960, part was allowed as reserves; thereafter, all was allowed. 11. Estimated through 1958. Before 1929, data were available only on call dates (in 1920 and 1922 the call date was December 29). Since September 12, 1968, the amount has been based on close-of-business figures for the reserve period two weeks before the report date. 12. For the week ending November 15, 1972, and thereafter, includes $450 million of reserve deficiencies on which Federal Reserve Banks are allowed to waive penalties for a transition period in connection with bank adaptation to Regulation J as amended, effective November 9, 1972. Allowable deficiencies are as follows (beginning with first statement week of quarter, in millions): 1,013 1973—Ql, $279; Q2, $172; Q3, $112; Q4, $84; 1974—Ql, $67; Q2, $58. The transition period ended with the second quarter of 1974. 13. For the period before July 1973, includes certain deposits of domestic nonmember banks and foreignowned banking institutions held with member banks and redeposited in full with Federal Reserve Banks in connection with voluntary participation by nonmember institutions in the Federal Reserve System program of credit restraint. As of December 12, 1974, the amount of voluntary nonmember bank and foreign-agency and branch deposits at Federal Reserve Banks that are associated with marginal reserves is no longer reported. However, two amounts are reported: (1) deposits voluntarily held as reserves by agencies and branches of foreign banks operating in the United States and (2) Eurodollar liabilities. 14. Adjusted to include waivers of penalties for reserve deficiencies, in accordance with change in Board policy, effective November 19, 1975. . . . Not applicable. 322 94th Annual Report, 2007 7. Principal Assets and Liabilities of Insured Commercial Banks, by Class of Bank, June 30, 2007 and 2006 Millions of dollars, except as noted Member banks Item Total Total National State Nonmember banks 2007 ASSETS 7,204,435 5,604,391 5,601,554 1,600,044 5,626,102 4,347,814 4,345,747 1,278,288 4,530,594 3,514,026 3,512,167 1,016,568 1,095,508 833,788 833,580 261,720 1,578,333 1,256,577 1,255,807 321,756 258,968 1,341,075 262,729 142,174 1,136,113 209,416 91,109 925,459 173,718 51,065 210,654 35,698 116,794 204,962 53,313 5,461,849 80,081 636,731 4,745,036 1,041,223 4,080,633 65,636 457,956 3,557,041 831,355 3,266,165 53,471 365,853 2,846,842 675,149 814,468 12,165 92,104 710,199 156,206 1,381,216 14,445 178,775 1,187,995 209,867 7,322 Loans and investments Loans, gross Net Investments U.S. Treasury and federal agency securities Other Cash assets, total 2,553 1,673 880 4,769 LIABILITIES Deposits, total Interbank Other transactions Other nontransactions Equity capital Number of banks 2006 ASSETS Loans and investments Loans, gross Net Investments U.S. Treasury and federal agency securities Other Cash assets, total 6,782,584 5,177,276 5,175,292 1,605,308 5,298,487 4,018,755 4,017,598 1,279,731 4,224,793 3,218,246 3,217,313 1,006,547 1,073,694 800,509 800,285 273,184 1,484,097 1,158,520 1,157,693 325,576 285,687 1,319,621 277,134 162,185 1,117,546 219,429 102,455 904,092 182,292 59,730 213,454 37,137 123,502 202,075 57,704 5,255,716 88,201 679,778 4,487,738 949,489 3,987,644 74,038 485,240 3,428,366 760,868 3,185,042 60,177 38,663 2,738,202 624,281 802,603 13,861 98,577 690,164 136,587 1,268,072 14,163 194,538 1,059,372 188,621 7,453 2,672 1,776 896 4,781 LIABILITIES Deposits, total Interbank Other transactions Other nontransactions Equity capital Number of banks NOTE: Includes U.S.-insured commercial banks located in the United States but not U.S.-insured commercial banks operating in U.S. territories or possessions. Data are domestic assets and liabilities (except for those components reported on a consolidated basis only). Components may not sum to totals because of rounding. Statistical Tables 323 Initial Margin Requirements under Regulations T, U, and X Percent of market value Effective date 1934, Oct. 1 . 1936, Feb. 1 . Apr. 1 . 1937, Nov. 1 . 1945, Feb. 5 . July 5 . 1946, Jan. 21 . 1947, Feb. 1 . 1949, Mar. 3 . 1951, Jan. 17 . 1953, Feb. 20 1955, Jan. 4 .. Apr. 23 1958, Jan. 16 . Aug. 5 . Oct. 16 1960, July 28 1962, July 10 1963, Nov. 6 1968, Mar. 11 June 8 . 1970, May 6 . 1971, Dec. 6 1972, Nov. 24 1974, Jan. 3 . Margin stocks 25-45 25-55 55 40 50 75 100 75 50 75 50 60 70 50 70 90 70 50 70 70 80 65 55 65 50 NOTE: These regulations, adopted by the Board of Governors pursuant to the Securities Exchange Act of 1934, limit the amount of credit that may be extended for the purpose of purchasing or carrying "margin securities" (as defined in the regulations) when the loan is collateralized by such securities. The margin requirement, expressed as a percentage, is the difference between the market value of the securities being purchased or carried (100 percent) and the maximum loan value of the Convertible bonds Short sales, T only1 50 60 50 50 50 50 50 50 75 100 75 50 75 50 60 70 50 70 90 70 50 70 70 80 65 55 65 50 collateral as prescribed by the Board. Regulation T was adopted effective October 1, 1934; Regulation U, effective May 1, 1936; and Regulation X, effective November 1, 1971. The former Regulation G, which was adopted effective March 11, 1968, was merged into Regulation U, effective April 1, 1998. 1. From October 1, 1934, to October 31, 1937, the requirement was the margin "customarily required" by brokers and dealers. 324 94th Annual Report, 2007 9. Statement of Condition of the Federal Reserve Banks, by Bank, December 31, 2007 and 2006 Millions of dollars Total Boston Item 2007 2006 2007 2006 ASSETS Gold certificate account Special drawing rights certificate account Coin Loans Term auction credit1 Other loans to depository institutions ... Securities purchased under agreements to resell (triparty)2 U.S. Treasury securities bought outright3 Total loans and securities Items in process of collection Bank premises Other assets Denominated in foreign currencies 4 Other5 Interdistrict settlement account Total assets 11,037 2,200 1,179 40,000 8,636 11,037 2,200 801 ' ' 67 449 115 36 0 178 486 115 27 i o 46,500 740,611 835,748 2,220 2,144 40,750 778,915 819,731 4,276 1,953 2,143 34,132 36,453 82 120 37,169 37,178 97 117 47,295 16,915 0 918,737 20,482 18,015 0 878,494 1,222 822 -1,356 37,942 491 782 124 39,416 1,010,262 218,571 791,691 43,985 958,680 175,661 783,019 29,615 38,832 5,886 32,946 2,027 39,020 3,020 36,000 1,413 20,767 16,120 96 2,020 39,003 2,227 4,930 881,837 18,699 4,708 98 1,496 25,002 4,602 5,608 847,846 531 0 1 31 563 92 215 35,843 549 0 1 42 592 18,450 18,450 918,737 15,324 15,324 878,494 1,049 1,049 37,942 1,010,262 218.571 791,691 958,680 175,661 783,019 11,037 2,200 35,328 743,126 791,691 11,037 2,200 0 769,782 783,019 LIABILITIES Federal Reserve notes outstanding (issued to Bank) .. Less: Notes held by Federal Reserve Bank Federal Reserve notes, net Securities sold under agreements to repurchase Deposits Depository institutions U.S. Treasury, general account Foreign, official accounts Other6 Total deposits Deferred credit items Other liabilities and accrued dividends7 Total liabilities 352 267 38,624 CAPITAL ACCOUNTS Capital paid in Surplus Total liabilities and capital accounts . FEDERAL RESERVE NOTE STATEMENT Federal Reserve notes outstanding Less: Held by Banks not subject to collateralization Collateralized Federal Reserve notes Collateral for Federal Reserve notes Gold certificate account Special drawing rights certificate account Other eligible assets U.S. Treasury and federal agency securities Total collateral For notes see end of table. 396 396 39,416 Statistical Tables 325 9.—Continued New York 2007 Philadelphia 2006 2007 Cleveland 2006 2007 Richmond 2006 2007 2006 4.053 874 55 4,139 874 47 455 83 88 463 83 53 428 104 113 446 104 73 869 147 134 853 147 78 33,957 5,888 0 0 0 0 12 841 0 775 130 0 16,838 268,173 324,856 42 216 40,750 288,297 329,047 70 212 2,057 32,765 34,822 317 64 33,817 33,817 649 58 1,903 30,308 33,064 268 153 33,633 33,633 451 158 4,029 64,168 69,102 154 186 64,704 64,704 237 170 11,503 6,700 -12,606 335,691 5,707 7,099 -29,471 317,724 5,587 713 794 42,924 1,152 1,055 836 38,166 3,354 750 -741 37,494 1,569 759 -2,264 34,929 12,633 1,446 -1,177 83,494 5,625 1,502 4,858 78,174 356,941 74,297 282,644 15,927 341,947 56,821 285,126 10,961 41,729 7,564 34,165 1,946 38,658 6,957 31,700 1,286 39,353 7,130 32,223 1,800 36,516 6,709 29,807 1,279 80,552 13,767 66,785 3,811 75,090 11,394 63,695 2,460 9,158 16,120 66 698 26,042 51 1,790 326,454 6.609 4,708 69 821 12,207 111 1,864 310,270 2,664 0 5 92 2,760 215 211 39,297 584 0 2 1 587 718 255 34,547 447 0 3 12 461 200 228 34,912 954 0 3 32 990 405 275 32,756 1,780 0 11 503 2,294 112 500 73302 2,748 0 11 121 2,880 384 569 69,987 4,619 4,619 335,691 3,727 3,727 317,724 1,813 1,813 42,924 1,810 1,810 38,166 1,291 1,291 37,494 1,087 1,087 34,929 4,996 4,996 83,494 4,093 4,093 78,174 326 94th Annual Report, 2007 9. Statement of Condition of the Federal Reserve Banks, by Bank, December 31, 2007 and 2006—Continued Millions of dollars Atlanta Chicago Item 2007 2006 2007 2006 ASSETS Gold certificate account Special drawing rights certificate account Coin Loans Term auction credit1 Other loans to depository institutions Securities purchased under agreements to resell (triparty)2 US. Treasury securities bought outright3 Total loans and securities Items in process of collection Bank premises Other assets Denominated in foreign currencies4 Other5 Interdistrict settlement account Total assets 1,117 166 153 25 0 1,023 166 93 '' 3 903 212 137 947 212 100 1,080 1,259 24 71,520 71,544 241 206 4,313 68,690 73,028 229 230 65,208 65,211 324 232 3,900 62,120 68,359 155 205 3,939 1,473 3,909 84,243 1,382 1,430 12,404 82,264 2,648 1,258 6,133 80,010 1,357 1,481 -3,742 111,626 36,017 75,609 4,080 98,175 23,938 74,237 2,479 86,265 13,560 72,705 3,689 79,818 14,202 65,616 2,719 975 0 3 166 1,144 143 418 8133 1,980 0 3 63 2,046 473 476 79,711 910 0 2 161 1,073 516 396 78381 1,395 0 3 105 1,503 276 515 70,630 1,425 1.425 1,276 1.276 814 814 858 858 84,243 82,264 80,010 72346 72346 LIABILITIES Federal Reserve notes outstanding (issued to Banks) Less: Notes held by Federal Reserve Banks Federal Reserve notes, net Securities sold under repurchase agreements Deposits Depository institutions U.S. Treasury, general account Foreign, official accounts Other6 Total deposits Deferred credit items Other liabilities and accrued dividends7 Total liabilities CAPITAL ACCOUNTS Capital paid in Surplus Total liabilities and capital accounts NOTE: Components may not sum to totals because of rounding. 1. In December 2007, the System established the temporary Term Auction Facility, which provides credit to eligible depository institutions. 2. On February 15, 2007, the System began allocating the activity related to securities purchased under agreements to resell to all Reserve Banks. 3. Includes securities loaned—fully collateralized by U.S. Treasury securities pledged with Federal Reserve Banks—and excludes securities purchased under agreements to resell. 4. Valued daily at market exchange rates. Includes deposits held under foreign currency arrangements with two central banks of $24 million at December 31, 2007. Statistical Tables 327 9.—Continued Minneapolis St. Louis 2007 2006 2007 326 71 50 328 71 39 203 30 45 1,050 0 0 0 3 1,486 23,671 26,207 13 115 24,747 24,747 196 80 928 14,777 15,708 97 113 513 515 223 552 851 316 2006 2007 San Francisco Dallas Kansas City 2006 2007 2006 2007 2006 335 66 72 324 66 62 613 98 130 575 98 81 1,286 234 165 1,242 234 117 0 7 7 1,400 0 ' 0 1,701 330 'l 15,835 15,857 219 116 1,505 23,974 25,486 214 269 22,808 22,815 560 159 2,043 32,540 35,983 126 257 34,957 34,957 348 260 5,355 85,293 92,680 522 218 86^218 86,219 884 185 380 348 544 513 271 480 653 690 236 751 3,848 1,720 2,089 1,777 211 30 31 ' "22 3,742 1,807 2.140 -237 5,239 4,734 -2,425 3,537 -3,651 7,414 31,551 28,045 19,503 16,955 32,740 29,469 36,124 40,844 97,021 100,160 32,982 3,770 29,212 29,169 3,175 25,994 19,219 2,790 16,429 17,442 2,549 14,893 33,316 3,212 30,103 30,770 3,717 27,053 57,270 24,860 32,410 57,150 19,391 37,759 112,177 25,719 86,459 114,925 23,787 91,138 1,406 941 878 602 1,424 867 1,933 1,329 5,066 3,278 289 0 0 55 344 434 0 0 24 458 1,104 0 1 38 1,143 455 0 1 18 474 449 0 0 45 495 546 0 1 32 579 635 0 1 59 695 705 0 0 37 742 1,823 0 3 161 1,987 1,741 0 4 200 1,946 38 192 103 217 223 122 288 147 157 172 435 183 129 230 306 284 353 456 749 556 31,192 27,713 18,794 16,404 32352 29,117 35397 40,420 94,321 97,667 180 180 166 166 355 355 276 276 194 194 176 176 363 363 212 212 1,350 1,350 1,247 1,247 31,551 28,045 19,503 16,955 32,740 29,469 36,124 40,844 97,021 100,160 5. The System total includes depository institution overdrafts of $6 million for 2007 and $2 million for 2006. 6. Includes international organization deposits of $144 million for 2007 and 2006. These deposits are primarily held by the Federal Reserve Bank of New York. 7. Includes exchange-translation account reflecting the monthly revaluation of foreign exchange commitments at market exchange rates. . . . Not applicable. 328 94th Annual Report, 2007 10. Income and Expenses of the Federal Reserve Banks, by Bank, 2007 Thousands of dollars Item Total Boston New York Philadelphia Cleveland Loans U.S. Treasury securities Foreign currencies Priced services Compensation received for services provided1 Other 71,345 40,297,924 574,525 878,405 275 1.868,185 14,775 0 54,696 14,791,753 141,114 65,475 142 1,765,843 65,450 0 940 1,668,195 40,965 0 634,819 119.007 46,972 2,967 38,486 2,663 79,931 2,893 Total 42,576,025 1,933,174 29,040 72,331 15,154,409 1,872,583 1,792,924 1,499,112 505,516 109,849 132,372 71,187 141,444 82,288 22,023 1,271 4,009 3,337 2,885 302,889 92,280 103,149 13,120 9,947 20,876 70,493 25,444 173 2,047 2,469 8,460 93,093 34,555 243 5,913 4,648 21,457 81,675 43,320 70,668 1.517 788 5,065 2,475 3,392 9,140 2,302 521 5,321 6,214 869 6,733 32,610 92,998 39,285 49.166 39.883 4,976 6,737 4.300 3,183 1,663 4,765 16,209 7,833 14,929 6,822 1,567 4,066 2.739 326 2,205 1.954 8.767 2,771 187 3,625 28,060 3.592 117,996 78,276 3,142 281 6,444 4,394 3,972 1,434 10,459 7,491 1,155 412 6,066 4,694 1,372 162 7,887 6,390 CURRENT INCOME CURRENT EXPENSES Salaries and other personnel expenses Retirement and other benefits . Net periodic pension expense2 Fees Travel Software expenses Postage and other shipping costs Communications Materials and supplies Building expenses Taxes on real estate Property depreciation Utilities Rent Other Equipment Purchases Rentals Depreciation Repairs and maintenance Earnings credit costs Compensation paid for service costs incurred1 Other Recoveries Expenses capitalized3 240.354 12,415 65,453 9.140 15,618 634,819 81,956 -104.730 -20,873 0 21,453 -15.658 -1,615 28,955 71,392 -13,831 -9,547 0 11,746 -3,569 -339 0 15,994 -3,755 -516 Total Reimbursements Net expenses 3,968,537 -458,331 3,510,206 174,897 -25,073 149.824 773,605 -109,437 664,168 157,437 -30,812 126,625 234,181 -62,455 171,726 For notes see end of table. Statistical Tables 329 10.—Continued Dallas San Francisco 954 1,263,466 6,678 0 2,199 1,773,992 7,849 0 1.873 4,570.014 47.550 0 78,665 1,215 81,241 1,847 47,010 2.409 69,178 8,678 1,317,356 896,765 1,354,187 1,833,458 4,697,294 114.948 46,292 439 10,174 7,452 4,866 77,558 27,363 449 7,719 3,910 5,256 79,344 25,979 565 2,631 3,147 3,878 96,941 27.660 664 7,011 5,242 4,535 83,391 33,613 164 1,565 3,737 5.300 150.765 46,892 1,220 3,592 9,113 5,656 45,885 1,786 7,942 3,819 1.429 5,726 2,203 1,277 3,059 2,480 1,883 3,902 1,939 1,277 4,516 4,252 1,791 5,304 5,168 1,743 5.834 2,408 8,990 3,740 16,146 3,728 3,293 9.419 4,063 566 3,975 2.231 11,380 2,294 5,933 5,724 637 5.247 1,634 1,738 1,481 3,186 4,702 1,976 253 1,731 201 982 677 4,518 399 3,914 8,975 4,027 199 4,945 3,479 7,523 3,232 1,188 3,585 4,709 249 37,635 16.668 2,471 417 8,597 9.556 1,780 295 9.714 6.544 1,071 143 5,318 2,770 1,460 18 4,603 2,798 2,704 28 6,358 3,470 1,579 88 5,326 5,367 2.644 65 9,590 8,134 53,827 15,051 22,197 4,612 4,138 6,913 5,616 25,374 0 -282,072 -28,656 -2,610 596.523 25,921 -8.174 -640 9,341 56,591 -8,038 -345 0 79,734 -2,313 -1,158 0 19,214 -993 -611 0 16,823 -4,473 -863 0 30,145 -9,366 -488 0 15,016 -5,905 -2,141 292,034 -29,720 262,314 930,868 -12,264 918,603 320,790 -5,238 315,551 229,709 -114,707 115,003 166,285 -29,292 136,993 187,521 -11,028 176,493 199,444 -15,021 184,423 301,765 -13.283 288.483 Minneapolis Kansas City Richmond Atlanta Chicago St. Louis 3,505 3,435,771 153,751 0 137 3,617,951 47,228 753,440 2,514 3,457,351 32,571 59,491 2.596 1,280,394 6,233 0 1,515 805,010 10,360 0 55,800 11,376 459 5,448 81,786 5,299 26,252 1,881 3,660,202 4,424,663 3,639,012 212,395 76,590 774 62,831 10,765 55,807 135,008 46,823 740 11,761 7,420 2,467 3,421 26,566 8,125 330 94th Annual Report, 2007 10. Income and Expenses of the Federal Reserve Banks, by Bank, 2007—Continued Thousands of dollars Item Total Boston New York Philadelphia Cleveland 39,065,820 1,783,349 14,490,241 1,745,959 1,621,198 1,885,770 580 1,886,350 49,346 17 49,363 447,281 29 447,310 242,599 91 242,690 131,895 236 132,131 -1,687,918 -9 -1,687,927 -78,664 0 -78,664 -615,495 0 -615,495 -74,232 0 -74,232 -70,285 -8 -70,293 198,423 -29,301 -168,185 168,458 61,839 6 0 2 4 0 296,125 576,306 7,534 30,970 74,183 123,566 34,464 32,084 20,766 26,174 38,391,806 1,715,543 14,124,306 1,847,864 1,636,096 324,481 3,596 228,568 4,924 5,345 38,716,287 1,719,139 14,352,874 1,852,789 1,641,441 992,353 34,714 253,678 108,613 65,679 34,598,401 1,031,048 13,207,574 1,740,672 1,371,427 3,125,533 653,378 891,622 3,504 204,335 15,324,288 18,449,821 396,093 1,049,471 3,727,084 4,618,706 1,809,826 1,813,329 1,086.735 1,291,070 PROFIT AND LOSS Current net income Additions to (+) and deductions from (—) current net income4 Profits on foreign exchange transactions Other additions Total additions Interest expense on reverse repurchase agreements Other deductions Total deductions Net addition to (+) or deduction from (-) current net income Cost of unreimbursed Treasury services Assessments by Board Board expenditures 5 ... Cost of currency Net income before payment to U.S. Treasury Change in funded status of benefit plans6 Comprehensive income before payment to U.S. Treasury . Dividends paid Payments to U.S. Treasury (interest on Federal Reserve notes) Transferred to/from surplus and change in accumulated other comprehensive income Surplus, January 1 Surplus, December 31 . NOTE: Components may not sum to totals because of rounding. 1. The Federal Reserve Bank of Atlanta has overall responsibility for managing the Reserve Banks' provision of check and ACH services and recognizes total System revenue for these services. The Federal Reserve Bank of New York has overall responsibility for managing the Reserve Banks' provision of Fedwire funds transfer and securities transfer services and recognizes the total System revenue for these services. The Federal Reserve Bank of Chicago has overall responsibility for managing the Reserve Banks' provision of electronic access services to depository institutions and recognizes the total System revenue for these services. The Federal Reserve Bank of Atlanta, the Federal Reserve Bank of New York, and the Federal Reserve Bank of Chicago compensate the other Reserve Banks for the costs incurred in providing these services. 2. Reflects the effect of Financial Accounting Standards Board Statement of Financial Accounting StanDigitizeddardsFRASER for No. 87, Employers' Accounting for Pensions (SFAS 87). The System Retirement Plan for employees is recorded on behalf of the System on the books of the Federal Reserve Bank of New York, resulting in an increase in expenses of $97,419 thousand. The expenses related to the Retirement Benefit Equalization Plan and the Supplemental Employee Retirement Plan are recorded by each Federal Reserve Bank. 3. Includes expenses for labor and materials capitalized and depreciated or amortized as charges to activities in the periods benefited. 4. Includes reimbursement from the U.S. Treasury for uncut sheets of Federal Reserve notes, gains and losses on the sale of Reserve Bank buildings, counterfeit currency that is not charged back to the depositing institution, and stale Reserve Bank checks that are written off. 5. For additional details, see the chapter "Board of Governors Financial Statements." 6. Subsquent to the adoption of SFAS 158 at December 31, 2006, the Reserve Banks recognize the change in funded status of pension and postretirement benefit plans as an element of other comprehensive income. Statistical Tables 331 10.—Continued Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco 3,397.889 3,506,059 3.323,461 1,202,353 759,772 1,177,694 1,649,035 4,408.811 501,282 18 501,300 162.120 40 162,160 102,302 51 102,354 20,439 23 20.461 33,756 17 33,773 21,153 5 21,158 26,785 16 26,800 146.812 37 146,849 -144.330 0 -144,330 -151,710 0 -151,710 -145,835 0 -145,835 -53,846 0 -53,846 -33,880 0 -33,880 -52,984 0 -52,984 -74,666 0 -74,666 -191,992 0 -191,992 356,970 10,450 -43,481 -33,385 -107 -31,825 -47,866 -45,143 0 0 0 0 0 0 0 0 77.265 51,241 24.941 78,926 16,506 56,393 3,198 19,551 5,485 14,880 3,421 23,518 4,380 30,903 23.982 88,099 3.626,352 3,412,643 3,207,080 1,146,219 739,300 1,118,929 1,565,886 4,251,587 22.519 5,717 14,711 3,536 10,627 3,547 13,535 7,854 3,648,871 3.418,359 3,221,792 1,149,756 749,927 1,122,477 1,579,422 4,259.441 263,167 78,220 52,775 10,398 19,522 11.109 17,019 77,460 2,483,025 3,191,589 3,212,649 1,125,614 651,634 1,093.644 1,410,713 4,078,811 902,679 148,551 -43,632 13,743 78,771 17,724 151,689 103,171 4.093,301 4,995,979 1,276,288 1,424,838 858.091 814,459 166,206 179,950 275.762 354,533 176,344 194,068 211,742 363,431 1,246,817 1,349,988 332 94th Annual Report 2007 11. Income and Expenses of the Federal Reserve Banks, 1914-2007 Thousands of dollars Federal Reserve Bank and period Current income Net expenses Net additions or deductions (-) 1 Assessments by Board of Governors Board expenditures Costs of currency All Banks 1914-15 1916 1917 1918 1919 2,173 5,218 16,128 67,584 102,381 2,018 2,082 4,922 10,577 18,745 6 -193 -1,387 -3,909 -4,673 302 192 238 383 595 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 181,297 122,866 50,499 50,709 38,340 41,801 47,600 43,024 64,053 70,955 27,549 33,722 28,837 29,062 27,768 26,819 24.914 24,894 25,401 25,810 -3,744 -6,315 -4,442 -8,233 -6,191 -4,823 -3,638 -2,457 -5,026 -4,862 710 741 723 703 663 709 722 779 698 782 1,714 1,845 806 3,099 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 36,424 29,701 50,019 49,487 48,903 42,752 37,901 41,233 36,261 38,501 25,358 24,843 24,457 25,918 26,844 28,695 26,016 25,295 25,557 25,669 810 719 729 800 1,372 1,406 ,680 ,748 ,725 ,621 2,176 1,479 1,106 2,505 1,026 1,477 2,178 1.757 1,630 1,356 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 43,538 41,380 52,663 69,306 104,392 142,210 150,385 158,656 304,161 316,537 25,951 28,536 32,051 35,794 39,659 41,666 50,493 58,191 64,280 67,931 -93 311 -1,413 -12,307 -4,430 -1,737 486 -1,631 2,232 2,390 11,488 721 -1,568 23,768 3,222 -830 -626 1,973 -34,318 -12,122 ,704 ,840 ,746 2,416 2,296 2,341 2,260 2,640 3,244 3,243 1,511 2,588 4,826 5,336 7,220 4,710 4,482 4,562 5,186 6,304 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 275,839 394,656 456,060 513,037 438,486 412,488 595,649 763,348 742,068 886,226 69,822 83,793 92,051 98,493 99,068 101,159 110,240 117,932 125,831 131.848 36,294 -2,128 1,584 -1,059 -134 -265 -23 -7,141 124 98,247 3,434 4,095 4,122 4,100 4,175 4,194 5,340 7,508 5,917 6,471 7,316 7,581 8,521 10,922 6,490 4,707 5,603 6,374 5,973 6,384 For notes see end of table. Change in funded status of benefit plans Statistical Tables 333 11.—Continued Payments to J.S. Treasury Dividends paid Trn n O fV^ITfH I ItlllolCllCU Statutory transfers2 Interest on Federal Reserve notes to/from surplus (section 13b) Transferred to/from surplus and change in accumulated other comprehensive income (section 7) 217 1,743 6,804 5,541 5,012 2,704 U34 48,334 70,652 5,654 6,120 6,307 6,553 6,682 6,916 7,329 7,755 8,458 9,584 60,725 59,974 10,851 3,613 114 59 818 250 2,585 4,283 82,916 15,993 -660 2,546 -3,078 2,474 8,464 5,044 21,079 22,536 10.269 10,030 9,282 8,874 8,782 8,505 7,830 7,941 8,019 8,110 17 -2,298 -7,058 11,021 -917 6,510 607 353 2,616 1,862 4,534 1,134 8,215 8,430 8,669 8,911 9,500 10,183 10,962 11,523 11,920 12,329 13,083 13,865 14,682 15,558 16.442 17,712 18,905 20,081 21,197 22,722 2,011 ' 298 227 177 120 25 -60 28 103 67 -419 -426 82 141 198 245 327 248 67 36 -54 -4 50 135 201 262 28 87 75,284 166,690 193,146 196,629 254,874 291,935 342,568 276,289 251,741 401,556 542,708 524,059 910,650 17,617 571 3,554 40,327 48,410 81,970 81,467 8,366 18,523 21,462 21,849 28.321 46,334 40,337 35,888 32,710 53,983 61,604 59,215 -93,601 334 94th Annual Report, 2007 11. Income and Expenses of the Federal Reserve Banks, 1914-2007—Continued Thousands of dollars Federal Reserve Bank and period Current income Net expenses Net additions or deductions (-) Assessments by Board of Governors Board expenditures Costs of currency Change in funded status of benefit plans 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1,103,385 941,648 1,048,508 1,151,120 1,343,747 1,559,484 1,908,500 2,190,404 2,764,446 3,373,361 139,894 148,254 161,451 169,638 171,511 172,111 178,212 190,561 207,678 237,828 13,875 3,482 -56 615 726 1,022 996 2,094 8,520 -558 6,534 6,265 6,655 7,573 8,655 8.576 9,022 10,770 14,198 15,020 7,455 6,756 8,030 10,063 17,230 23,603 20,167 18,790 20,474 22,126 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 3,877,218 3,723,370 3,792,335 5,016,769 6,280,091 6,257,937 6,623,220 6,891,317 8,455,309 10,310,148 276,572 319,608 347,917 416,879 476,235 514,359 558,129 568,851 592,558 625,168 11,442 94,266 -49,616 -80,653 -78,487 -202,370 7,311 -177,033 -633,123 -151,148 21,228 32,634 35,234 44,412 41,117 33,577 41,828 47,366 53,322 50,530 23,574 24,943 31,455 33,826 30,190 37,130 48,819 55,008 60,059 68,391 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 12,802,319 15,508,350 16,517,385 16,068,362 18,068,821 18,131,983 17,464,528 17,633,012 19,526,431 22,249,276 718,033 814,190 926,034 1,023,678 1,102,444 1,127,744 1,156,868 1,146,911 1,205,960 1,332,161 -115,386 -372,879 -68,833 -400,366 -412,943 1,301,624 1,975,893 1,796,594 -516,910 1,254,613 62,231 63,163 61,813 71,551 82,116 77,378 97,338 81,870 84,411 89,580 73,124 82,924 98,441 152,135 162,606 173,739 180,780 170,675 164,245 175,044 1990... 1991... 1992... 1993... 1994... 1995... 1996 . . 1997 . . 1998 . . 1999 . . 23,476,604 22,553,002 20,235,028 18,914,251 20,910,742 25,395,148 25,164,303 26,917,213 28,149,477 29,346,836 1,349,726 1,429,322 1,474,531 1,657,800 1,795,328 1,818,416 1,947,861 1,976,453 1,833,436 1,852,162 2,099,328 405,729 -987,788 -230,268 2,363,862 857,788 -1,676,716 -2,611,570 1,906,037 -533,557 103,752 109,631 128,955 140,466 146,866 161,348 162,642 174,407 178,009 213,790 193,007 261,316 295,401 355,947 368,187 370,203 402,517 364,454 408,544 484,959 2000 . . 2001 . . 2002 . . 2003 . . 2004 . . 2005 . . 2006 . . 2007 . . 33,963,992 31,870,721 26,760,113 23,792,725 23,539,942 30,729,357 38,410,427 42,576,025 1,971,688 2,084,708 2,227,078 2,462,658 2,238,705 2,889,544 3,263,844 3,510,206 -1,500,027 -1,117,435 2,149,328 2,481,127 917,870 -3,576,903 -158,846 198,417 188,067 295,056 205,111 297,020 272,331 265,742 301,014 296,125 435,838 338,537 429,568 508,144 503,784 477,087 491,962 576,306 324,481 5,000,926 9,408318 324,481 Total, 1914-2007 753,465,666 58,857,462 4,240,213 Statistical Tables 335 11.—Continued Payments to U.S. Treasury Dividends paid Statutory transfers 2 Interest on Federal Reserve notes Tranlsferred X X U l o l v l 1 K/VJ to/from surplus (section 13b) Transferred to/from surplus and change in accumulated other comprehensive income (section 7) 23,948 25,570 27,412 28,912 30,782 32,352 33,696 35,027 36,959 39,237 896,816 687,393 799,366 879,685 1,582,119 1,296,810 1,649,455 1,907,498 2,463,629 3,019,161 42,613 70,892 45,538 55,864 -465,823 27,054 18,944 29,851 30,027 39,432 41,137 43,488 46,184 49,140 52,580 54,610 57,351 60,182 63,280 67,194 3,493,571 3,356,560 3,231,268 4,340,680 5,549,999 5,382,064 5,870,463 5,937,148 7,005,779 9,278,576 32,580 40,403 50,661 51,178 51,483 33,828 53,940 45,728 47,268 69,141 70,355 74,574 79,352 85,152 92,620 103,029 109.588 117,499 125.616 129,885 11,706,370 14,023,723 15,204,591 14,228,816 16,054,095 17,796,464 17,803,895 17,738,880 17,364,319 21,646,417 56,821 76,897 78,320 106,663 161,996 155,253 91,954 173,771 64,971 130,802 140,758 152,553 171,763 195,422 212,090 230,527 255,884 299.652 343,014 373,579 23,608,398 20,777,552 16,774,477 15,986,765 20.470,011 23,389,367 14,565,624 0 8,774,994 25,409,736 180,292 228,356 402,114 347,583 282,122 283,075 635,343 831,705 731,575 479,053 25,343,892 27,089,222 24,495,490 22,021,528 18,078,003 21,467,545 29,051,678 34,598,401 4,114,865 517,580 1,068,598 466,796 2.782,587 1,271,672 4,271,828 3,125,533 5.517,716 20,658,972 17,785,942 409,614 428,183 483,596 517,705 582,402 780,863 871,255 992,353 9,731,130 44,113,958 608,526^61 -4 24^92,209 3 336 94th Annual Report, 2007 11. Income and Expenses of the Federal Reserve Banks, 1914-2007—Continued Thousands of dollars Current income Net expenses Net additions or deductions (-) 1 Aggregate for each Bank, 1914-2007 Boston New York Philadelphia Cleveland Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco 39,756,660 264,885,985 28,242,547 44,376,296 58,583,264 44,873,400 88,896,622 25,558,056 13,120,386 26,840,812 34,245,323 84,086,318 3,566,677 9,049,099* 2,902,768 3,441,220 4,847,517 7,446,218 6,781,169 2,712,204 2,686,112 3,577,546 3,632,776 6,214,156 Total 753,465,666 56,857,462 Federal Reserve Bank and period NOTE: Components may not sum to totals because of rounding. 1. For 1987 and subsequent years, includes the cost of services provided to the Treasury by Federal Reserve Banks for which reimbursement was not received. Assessments by Board of Governors Change in funded status of benefit plans Board expenditures Costs of currency -77,524 665,437 281,126 358,964 1,048,500 300,910 570,303 9,337 129,244 71,878 291,082 590,956 214,794 1,242,376 232,919 363,689 746,343 375,667 542,013 118,324 145,784 150,184 222,824 646,010 549,944 2,904,656 407,154 538,490 776,985 738,885 1,061,746 341,279 171,112 345,207 468,457 1,104,404 3,596 228,568 4,924 5,345 22,519 5,717 14,711 3,536 10.627 3,547 13,535 7,854 4,240,213 5,000,926 9,408,318 324,481 2. Represents transfers made as a franchise tax from 1917 through 1932; transfers made under section 13b of the Federal Reserve Act from 1935 through 1947; and transfers made under section 7 of the Federal Reserve Act for 1996 and 1997. Statistical Tables 337 11.—Continued Payments to U.S. Treasury Dividends paid Transferred to/from surplus (section 13b) Transferred to/from surplus and change in accumulated other comprehensive income (section 7) 5 Statutory transfers2 Interest on Federal Reserve notes 445,359 2,429,684 516,216 715,167 1,667,095 695,724 969,454 218,704 276,350 259,149 367,830 1,170,398 2,579,504 17,307.161 1,312,118 2,827,043 3,083,928 2,713,230 4,593,811 1,833,837 416,227 1,249,703 1,510,802 4,686,594 31,082,719 225,798,033 21,177,901 35,255,476 42,455,863 31,464,800 74,300,302 20.042,912 9,051,982 21,017,971 27,815,769 69,062,633 135 -433 291 -10 -72 5 12 -27 65 -9 55 -17 1,243,599 7,049,415 1,979,232 1,599,529 6,076,623 1,745,497 1,233,130 303,695 512,625 316,487 531,427 1,800,950 9,731,130 44,113,958 608,526,361 -4 24392,209 3 3. The $24,392,209 thousand transferred to surplus was reduced by direct charges of $500 thousand for charge-off on Bank premises (1927); $139,300 thousand for contributions to capital of the Federal Deposit Insurance Corporation (1934); $4 thousand net upon elimination of section 13b surplus (1958); $106,000 thousand (1996), $107,000 thousand (1997), and $3,752,000 thousand (2000) transferred to the Treasury as statutorily required; and $1,848,716 thousand related to the implementation of SFAS No. 158 (2006), and was increased by transfer of $11,131 thousand from reserves for contingencies (1955); leaving a balance of $18,449,821 thousand on December 31, 2007. 4. This amount is reduced by $2,815,225 thousand for expenses of the System Retirement Plan. See note 2, table 10. 5. Beginning in 2006, accumulated other comprehensive income is reported as a component of surplus. . . . Not applicable. 338 94th Annual Report, 2007 12. Operations in Principal Departments of the Federal Reserve Banks, 2004-2007 Operation Millions of pieces Currency processed Currency destroyed Coin received Checks handled U.S. government checks1 Postal money orders All other3 Securities transfers2 Funds transfers Automated clearinghouse transactions Commercial Government Millions of dollars Currency processed Currency destroyed Coin received Checks handled U.S. government checks1 Postal money orders All other3 Securities transfers2 Funds transfers Automated clearinghouse transactions Commercial Government 2005 2004 35,653 6,509 63,255 37,694 6,766 59,705 36,463 6,551 56,080 36,242 6,748 55,655 214 164 10,001 24 135 222 171 11,083 22 134 216 176 12,228 22 132 234 187 13,904 20 125 9,363 1,027 8,231 992 7,339 964 6,486 941 642,168 104,082 6,124 664,592 84,742 5,779 639,832 83,187 5,412 625,127 90,943 5,403 256,994 31,626 15,897,747 435,577,505 670,665,569 269,073 28,066 16,442,820 377,258,592 572,645,790 252,192 28,395 15,684,615 368,896,819 518,546,733 277,649 29,045 14,287,740 313,425,252 478,946,947 14,547,234 3,716,928 13,124,434 3,474,364 12,801,914 3,156,556 12,543,907 2,913,189 1. Starting in 2005, this category includes government checks handled electronically (electronic checks); amounts in bold are restatements to reflect the inclusion of electronic checks. 2. In 2006, the title of this category changed from 2006 2007 previous years, but the composition of the category remained the same. Therefore, the data are comparable with data reported in previous years. 3. Amounts in bold are restatements. Statistical Tables 339 13. Number and Annual Salaries of Officers and Employees of the Federal Reserve Banks, December 31, 2007 President' Federal Reserve Bank (including Branches) Boston New York Philadelphia Cleveland Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco ... Federal Reserve Information Technology .. rotal Employees Number Number Number 300,700 398,200 289,000 294,100 323,000 289,000 289,000 356,000 391.000 356,100 289,000 360,300 66 289 57 57 78 79 83 79 43 78 61 74 11,705,861 58,962,284 9,156,100 9,097,275 12,092,800 13,820,595 13,151,804 12,257,140 6,663,760 13,349,302 9,740,198 14,269,134 834 2,435 964 1,450 1,647 1,822 1,292 937 1,101 1,244 1,172 1,652 68 51 32 36 42 33 53 58 87 23 20 68 60,844,958 209,318,220 55,399,380 74,076,101 97,039,847 108,183,543 86,678,366 55,858,832 63,751,595 71,299,571 66,113,025 119,451,612 969 2,776 1,054 1,544 1,768 1,935 1,429 1,075 1,232 1,346 1,254 1,795 72,851,519 268,678,705 64,844,480 83,467,476 109,455,647 122,293,138 100,119,170 68,471,972 70,806,355 85,004,973 76,142,223 134,081,046 37 5,909,456 770 3 67,164,988 810 73,074,444 9 1,830,900 34 0 2,896,647 43 4,727,547 1,090 192,006,609 17,354 574 3,935,400 Salaries (dollars)2 Salaries (dollars)2 Salary (dollars)2 Office of Employee Benefits . . . . Total Other officers 1. Under current policies, the appointment salaries of Federal Reserve Bank presidents are normally 85 percent of the salary-range midpoint (an 85 compa-ratio), with the exception of the New York Reserve Bank president, whose appointment salary normally is set at a 95 comparatio. The Board has discretion to approve a higher starting salary if requested by a Reserve Bank's board of directors. On January 1 each year, all presidents receive salary increases equal to the percentage increase in the midpoint of their respective salary ranges. In addition, on every third-year anniversary of his or her initial appointment (through year 9), each president receives a salary increase that results in a compa-ratio as follows: year 3, 95 (for the New York Bank, 105); year 6, 105 (New York, 115); year 9, 115 (New York, 125). Fulltime Parttime (dollars)2 1,138,076,686 19,030 1,334,018,695 There continue to be tiered salary ranges for Reserve Bank officers, including presidents, reflecting differences in the costs of labor in the head-office cities. The Board reviews Reserve Bank officer salary ranges and Reserve Bank placement in the salary tiers annually. In 2007, New York and San Francisco were in tier 1, which had a midpoint for presidents' salaries of $379,300. Boston, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, and Dallas were in tier 2, which had a midpoint for presidents' salaries of $340,000. Cleveland, St. Louis, and Kansas City were in tier 3, which had a midpoint for presidents' salaries of $309,600. 2. Annualized salary liability based on salaries in effect on December 31, 2007. . . . Not applicable. 340 94th Annual Report, 2007 14. Acquisition Costs and Net Book Value of the Premises of the Federal Reserve Banks and Branches, December 31, 2007 Thousands of dollars Acquisition costs Federal Reserve Bank or Branch Land Buildings (including vaults)1 Building machinery and equipment Total 2 Net book value BOSTON . . . 27,293 135,431 28,808 191,532 119,760 NEW YORK 20,103 267,634 70,071 357,808 Other real estate 3 215,622 PHILADELPHIA . . . 7,312 90,205 13,999 111,516 64,495 CLEVELAND . Cincinnati Pittsburgh 4,219 2,737 1,739 123,320 29,516 19,388 27,333 14,351 15,361 154,872 46,604 36,488 109,497 23,489 19,674 RICHMOND Baltimore . . . Charlotte 25,539 6,482 3,130 113,311 32,939 34,985 44,779 5,924 6,961 183,628 45,345 45,076 129,047 26,728 29,804 ATLANTA .. Birmingham . Jacksonville . Miami Nashville New Orleans 22,735 5,347 1,779 4,254 603 3,785 149,949 12,749 21,515 24,825 5,690 8,873 16,367 1,525 3,967 4,916 3,542 5,529 189,052 19,621 27,261 33,996 9,835 18,187 163,202 12,962 17,051 22,136 4,529 9,658 CHICAGO Detroit 4,512 9,980 168,948 72,437 20,681 10,690 194,141 93,107 116,158 88,645 ST. LOUIS Little Rock Memphis 8,428 0 2,472 110,052 0 14,127 14,348 0 5,162 132,828 0 21,761 100,552 0 14,048 MINNEAPOLIS Helena 15,666 2,890 104,953 9,716 13,834 943 134,453 13,549 103,464 9,276 KANSAS CITY Denver Oklahoma City . Omaha 37,501 3,511 0 3,559 217,038 9,167 0 7,374 0 4,502 0 1,726 254,539 17,179 0 12,658 254,539 8,039 0 6,207 DALLAS El Paso Houston San Antonio . 36,166 262 23,699 826 110,487 3,426 104,631 8,227 24,205 1,698 8,653 2,491 170,858 5,386 136,983 11,544 119,762 1,182 129,728 6,038 SAN FRANCISCO Los Angeles Salt Lake City Seattle 20,129 6,306 1,294 8,136 98,264 71,643 4,680 73,234 22,650 14,807 1,467 4,545 141,043 92,755 7,441 85,915 79,893 57,963 2,972 77,486 29 322^92 2,258,733 415,838 2,996,963 2,143,606 11,339 Total . NOTE: Components may not sum to totals because of rounding. 1. Includes expenditures for construction at some offices, pending allocation to appropriate accounts. 2. Excludes charge-offs of $17,699 thousand before 1952. 4,106 7,204 3. Covers acquisitions for banking-house purposes and Bank premises formerly occupied and being held pending sale. . . . Not applicable. Federal Reserve System Audits 343 Audits of the Federal Reserve System The Board of Governors, the Federal Reserve Banks, and the Federal Reserve System as a whole are all subject to several levels of audit and review. The Board's financial statements, and its compliance with laws and regulations affecting those statements, are audited annually by an outside auditor retained by the Board's Office of Inspector General. The Office of Inspector General also conducts audits, reviews, and investigations relating to the Board's programs and operations as well as to Board functions delegated to the Reserve Banks. The Reserve Banks' financial statements are audited annually by an independent outside auditor retained by the Board of Governors. In addition, the Reserve Banks are subject to annual examination by the Board. As discussed in the chapter "Federal Reserve Banks," the Board's examination includes a wide range of ongoing oversight activities conducted on and off site by staff of the Board's Division of Reserve Bank Operations and Payment Systems. Federal Reserve operations are also subject to review by the Government Accountability Office. • 345 Board of Governors Financial Statements The financial statements of the Board for 2007 were audited by Deloitte & Touche LLP, independent auditors. Deloitte INDEPENDENT AUDITORS' REPORT The Board of Governors of the Federal Reserve System: We have audited the accompanying balance sheet of the Board of Governors of the Federal Reserve System (the "Board") as of December 31, 2007, and the related statements of revenues and expenses and changes in cumulative results of operations, and cash flows for the year then ended. These financial statements are the responsibility of the Board's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of the Board for the year ended December 31, 2006 were audited by other auditors whose report, dated April 17, 2007, expressed an unqualified opinion on those statements and included an explanatory paragraph related to adoption of the Financial Accounting Standard Board Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans. We conducted our audit in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the 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 consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Board's internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such 2007 financial statements present fairly, in all material respects, the financial position of the Board of Governors of the Federal Reserve System as of December 31, 2007, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. In accordance with Government Auditing Standards, we have also issued our report dated March 19, 2008 on our consideration of the Board's internal control over financial reporting and on our tests of its compliance with certain provisions of laws, regulations, contracts, and agreements and other matters. The purpose of that report is to describe the scope of our testing of internal control over financial reporting and compliance and the results of that testing, and not to provide an opinion on the internal control over financial reporting or on compliance. That report is an integral part of an audit performed in accordance with Government Auditing Standards, and should be considered in assessing the results of our audit. March 19. 2008 Washington, D.C. 346 94th Annual Report, 2007 BALANCE SHEETS Year ending December 31, 2007 2006 ASSETS CURRENT ASSETS Cash Accounts receivable Prepaid expenses and other assets $ 44,613,728 2,996,318 4,653,684 $ 60,030,706 2,625,907 3,916,608 52,263,730 66,573,221 153,350,880 166,119 153,516,999 151,205,386 343,899 151,549,285 $205,780,729 $218,122,506 $ 20,400,282 5,647,053 18,429,601 108,755 702,122 $ 10,950,470 5,421,666 16,334,512 327,663 366,304 45,287,813 33,400,615 0 2,201,675 7,972,469 8,855,613 108,755 1,354,662 8,111,829 6,515,301 Total long-term liabilities 19,029,757 16,090,547 Total liabilities 64,317,570 49,491,162 7,084,672 (17,542,943) 153,408,244 (1,486,814) 33,500,269 (14,325,986) 151,112,867 (1,655,806) 141,463,159 168,631,344 $205,780,729 $218,122,506 Total current assets NONCURRENT ASSETS Property and equipment, net (Note 4) Other assets Total noncurrent assets Total assets LIABILITIES AND CUMULATIVE RESULTS OF OPERATIONS CURRENT LIABILITIES Accounts payable and accrued liabilities Accrued payroll and related taxes Accrued annual leave Capital lease payable (current portion) Unearned revenues and other liabilities Total current liabilities LONG-TERM LIABILITIES Capital lease payable (non-current portion) Accumulated retirement benefit obligation (Note 5) Accumulated postretirement benefit obligation (Note 6) Accumulated postemployment benefit obligation (Note 7) CUMULATIVE RESULTS OF OPERATIONS Working capital Unfunded long-term liabilities Net investment in assets Accumulated other comprehensive income (loss) (Note 8) Total cumulative results of operations Total liabilities and cumulative results of operations See accompanying notes to financial statements. Board of Governors Financial Statements 347 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM STATEMENTS OF REVENUES AND EXPENSES AND CHANGES IN CUMULATIVE RESULTS OF OPERATIONS Year ending December 31, 2007 2006 BOARD OPERATING REVENUES Assessments levied on Federal Reserve Banks for Board operating expenses and capital expenditures Other revenues $296,124,700 10,365,414 $301,013,500 8,508,949 306,490,114 309,522,449 197,656,442 39,451,541 36,300,185 13,557,498 8,998,496 8,619,615 6.678,514 8,836.143 3,890.191 1,976.765 7,861,901 182,239,595 35,853,297 23,944,564 13,058,667 9,185,840 8,820,503 6,637,765 4,560,368 2,634,459 1,505,470 7,435,067 333,827,291 295,875,595 Total operating revenues BOARD OPERATING EXPENSES Salaries Retirement and insurance Contractual services and professional fees Depreciation, amortization, and net losses on disposals Utilities Travel Software Postage and supplies Repairs and maintenance Printing and binding Other expenses Total operating expenses (27,337,177) RESULTS OF OPERATIONS 13,646,854 CURRENCY COSTS Assessments levied on Federal Reserve Banks for currency costs Expenses for printing, transporting, and retiring Federal Reserve Notes 576,306,073 576,306,073 491,962,202 0 CURRENCY ASSESSMENTS OVER (UNDER) EXPENSES 491,962,202 0 TOTAL RESULTS OF OPERATIONS (27,337,177) 13,646,854 CUMULATIVE RESULTS OF OPERATIONS, Beginning of period 168,631,344 156,640,296 OTHER COMPREHENSIVE INCOME Adjustment to initially apply SFAS No. 158 (Note 8) Amortization of prior service cost Amortization of net actuarial loss Net actuarial loss arising during the year 0 (23,831) 113,142 79.681 168,992 Total Other Compehensive Income CUMULATIVE RESULTS OF OPERATIONS, End of period (1,655,806) 0 0 0 (1,655,806) $141,463,159 See accompanying notes to financial statements. $168,631,344 348 94th Annual Report, 2007 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM STATEMENTS OF CASH FLOWS Year ending December 31, 2007 2006 CASH FLOWS FROM OPERATING ACTIVITIES RESULTS OF OPERATIONS $(27,337,177) $13,646,854 13,433,306 124,192 13,047,064 11,603 Adjustments to reconcile results of operations to net cash provided by (used in) operating activities: Depreciation Net losses on disposals of property and equipment Increase (decrease) in assets: Accounts receivable, prepaid expenses and other assets (929,708) (5,955,880) 561,094 878,028 (417,407) 541,165 1,874,539 1,403,936 (1,655,806) 613,676 Net cash provided by operating activities (812,482) 9,449,812 225,387 2,095,089 335,818 847,013 (139,360) 2,340,312 168,992 Increase (decrease) in liabilities: Accounts payable and accrued liabilities Accrued payroll and related taxes Accrued annual leave Unearned revenues and other liabilities Accumulated retirement benefit obligation Accumulated postretirement benefit obligation Accumulated postemployment benefit obligation Accumulated other comprehensive income 23,122,708 CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from disposals Capital expenditures 65,988 (15,768,979) (15,702,991) (8,822,500) (327,663) (239,937) (327,663) Net cash used in investing activities 7,212 (8,829,712) (239,937) CASH FLOWS FROM FINANCING ACTIVITIES Capital lease payments Net cash used in financing activities NET INCREASE (DECREASE) IN CASH (15,416,978) 14,060,271 CASH BALANCE, Beginning of period 60,030,706 45,970,435 $ 44,613,728 $60,030,706 CASH BALANCE, End of period See accompanying notes to financial statements. Board of Governors Financial Statements 349 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM NOTES TO FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDING DECEMBER 31, 2007 AND 2006 (1) STRUCTURE The Federal Reserve System (System) was established by Congress in 1913 and consists of the Board of Governors (Board), the Federal Open Market Committee, the twelve regional Federal Reserve Banks, the Federal Advisory Council, and the private commercial banks that are members of the System. The Board, unlike the Reserve Banks, was established as a federal government agency and is supported by Washington, DC based staff numbering approximately 1,900, as it carries out its responsibilities in conjunction with other components of the Federal Reserve System. The Board is required by the Federal Reserve Act to report its operations to the Speaker of the House of Representatives. The Act also requires the Board, each year, to order a financial audit of each Federal Reserve Bank and to publish each week a statement of the financial condition of each such Reserve Bank and a consolidated statement for all of the Reserve Banks. Accordingly, the Board believes that the best financial disclosure consistent with law is achieved by issuing separate financial statements for the Board and for the Reserve Banks. Therefore, the accompanying financial statements include only the results of operations and activities of the Board. Combined financial statements for the Federal Reserve Banks are included in the Board's annual report to the Speaker of the House of Representatives. (2) OPERATIONS AND SERVICES The Board's responsibilities require thorough analysis of domestic and international financial and economic developments. The Board carries out those responsibilities in conjunction with other components of the Federal Reserve System. The Board also supervises and regulates the operations of the Federal Reserve Banks, exercises broad responsibility in the nation's payments system, and administers most of the nation's laws regarding consumer credit protection. Policy regarding open market operations is established by the Federal Open Market Committee. However, the Board has sole authority over changes in reserve requirements, and it must approve any change in the discount rate initiated by a Federal Reserve Bank. The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks that are members of the Federal Reserve System, bank holding companies, foreign activities of member banks, and U.S. activities of foreign banks. (3) SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting—The Board prepares its financial statements in accordance with accounting principles generally accepted in the United States of America. Revenues—The Board assesses the Federal Reserve Banks for operating expenses and additions to property, which are based on expected cash needs. Currency Costs—Federal Reserve Banks issue new and fit currency to the public and destroy currency already in circulation as it becomes unfit or when a new design is issued. Each year, the Board orders new currency from the U.S. Department of Treasury's Bureau of Engraving and Printing. The Board incurs expenses and assesses the Federal Reserve Banks for printing, transporting, and retiring Federal Reserve Notes. These expenses and assessments are reported separately from the Board's operating transactions in the Board's Statement of Revenues and Expenses and Cumulative Results of Operations. Allowance for Doubtful Accounts—Accounts receivable considered uncollectible are charged against the allowance account in the year they are deemed uncollectible. The allowance for doubtful accounts is adjusted monthly, based upon a review of outstanding receivables. Property, Equipment, and Software—The Board's property, buildings, equipment, and software are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated on a straightline basis over the estimated useful lives of the assets, which range from three to ten years for furniture and equipment, ten to fifty years for building equipment and structures, and two to ten years for software. Upon the sale or other disposition of a depreciable asset, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is recognized. The Board complies with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, which requires that certain costs incurred in the development of internal use software be capitalized and amortized over its useful life. Art Collections—The Board has collections of works of art, historical treasures, and similar assets. These collections are maintained and held for public exhibition in furtherance of public service. Proceeds from any sales of collections are used to acquire other items for collections. As permitted by Statement of Financial Accounting Standards (SFAS) No. 116, Accounting for Contributions Received and Contributions Made, the cost of collections purchased by the Board is charged to expense in the year purchased and donated collection items are not recorded. The value of the Board's collections has not been determined. Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications—Certain 2006 amounts have been reclassified to conform with 2007 presentation. SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans—The Board initially applied the provisions of SFAS 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 post- 350 94th Annual Report, 2007 retirement plan in the Balance Sheets, 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 required applying the provisions as of the end of the year of initial implementation, and the effect as of December 31, 2006 is recorded as "Adjustment to initially apply SFAS No. 158" in the Statements of Revenues and Expenses and Changes in Cumulative Results of Operations. (5) ACCUMULATED RETIREMENT BENEFITS (4) PROPERTY AND EQUIPMENT The following is a summary of the components of the Board's property and equipment, at cost, net of accumulated depreciation and amortization. 2007 Land Buildings and improvements Furniture and equipment Software in use Software in process Construction in process Less accumulated depreciation and amortization Property and equipment, net 2006 $ 18,640,314 $ 18,640,314 149,968,504 147,504,169 55,625,014 14,745,157 2,064,438 47,271,434 13,681,508 941,912 1,550,565 242,593,992 360,967 228,400,304 (89,243,112) (77,194,918) $153,350,880 $151,205,386 Construction in process includes costs incurred in 2007 and 2006 for long-term security projects and building enhancements. The Board entered into capital leases for printing equipment, which terminate in 2008. Furniture and equipment includes $1,230,000 in 2007 and 2006 for capitalized leases. Accumulated depreciation includes $1,123,000 and $867,000 for capitalized leases as of 2007 and 2006, respectively. The Board paid interest related to these capital leases in the amount of $31,000 and $54,000 for 2007 and 2006, respectively. The future minimum lease payments required under the capital leases and the present value of the net minimum lease payments as of December 31, 2007, are as follows: 2008 Total minimum lease payments Less: Amount representing maintenance Net minimum lease payments Less: Amount representing interest Present value of net minimum lease payments Less: Current maturities of capital lease payments .. Long-term capital lease obligations $ 138,279 (26,743) 111,536 (2,781) 108,755 (108,755) $ 0 Substantially all of the Board's employees participate in the Retirement Plan for Employees of the Federal Reserve System (System Plan). The System Plan provides retirement benefits to employees of the Board, the Federal Reserve Banks, and the Office of Employee Benefits of the Federal Reserve System (OEB). The Federal Reserve Bank of New York, on behalf of the System, recognizes the net asset and costs associated with the System Plan in its financial statements. Costs associated with the System Plan are not redistributed to other participating employers. Employees of the Board who became employed prior to 1984 are covered by a contributory defined benefits program under the System Plan. Employees of the Board who became employed after 1983 are covered by a noncontributory defined benefits program under the System Plan. Contributions to the System Plan are actuarially determined and funded by participating employers. Based on actuarial calculations, it was determined that employer funding contributions were not required for the years 2007 and 2006, and the Board was not assessed a contribution for these years. Effective January 1, 1996, Board employees covered under the System Plan are also covered under a Benefits Equalization Plan (BEP). Benefits paid under the BEP are limited to those benefits that cannot be paid from the System Plan due to limitations imposed by Sections 401(a)(17), 415(b) and 415(e) of the Internal Revenue Code of 1986. Activity for the BEP for 2007 and 2006 is summarized in the following tables: 2007 2006 Change in projected benefit obligation Benefit obligation, beginning of year ... $1,354,662 $ 536,339 Service cost 329,282 185,483 Interest cost 87,837 45,004 Plan participants' contributions 0 0 Plan amendments 0 0 Actuarial (gain)/loss 453,526 596,114 Benefits paid (23,632) (8,278) Benefit obligation, end of year $2,201,675 $1,354,662 Accumulated benefit obligation, end of year Weighted-average assumptions used to determine benefit obligation as of December 31 Discount rate Rate of compensation increase Change in plan assets Fair value of plan assets, beginning of year... Employer contributions .. Plan participants' contributions Benefits paid Fair value of plan assets, end of year $ 685,170 $ 546,854 6.25% 5.75% 5.00% 4.50% $ 0 23,632 $ 0 (23,632) $ 0 0 8,278 0 (8,278) $ 0 Board of Governors Financial Statements 351 2006 2007 Reconciliation of funded status, end of year Funded status Net actuarial (gain) loss .. Prior service (credit) cost .. Prepaid (Accrued) pension cost Amounts recognized in the financial statements consist of Prepaid benefit cost Accrued benefit liability .. Intangible asset Accumulated other comprehensive income Net amount recognized .. Components of net periodic benefit cost Service cost—benefits earned during the period Interest cost on projected benefit obligation ... Expected return on plan assets Amortization of prior service (credit) cost .. Amortization of (gains) losses Amortization of initial (asset) obligation ... Net periodic benefit cost (credit) $(2,201,675) 1,006,257 (233,404) $(1,354,662) 580,386 (247,417) $(1,428,822) $(1,021,693) $ $ 0 (1,428,822) 0 (332,969) $(1,354,662) $ 329,282 5; 185,483 87,837 45,004 0 0 (14,013) (14,013) 27,655 Expected benefit payments: 2008 2009 2010 2011 2012 2013-2017 0 430,761 3> 216,474 6.00% 5.75% 4.50% 4.50% $ 82,134 $ 82,134 96,170 109,602 120,750 127,690 724,518 $ 79,561 (14,013) $ 65,548 A relatively small number of Board employees participate in the Civil Service Retirement System (CSRS) or the Federal Employees' Retirement System (FERS). These defined benefit plans are administered by the U.S. Office of Personnel Management, which determines the required employer contribution levels. The Board's contributions to these plans totaled $316,000 and $334,000 in 2007 and 2006, respectively. The Board has no liability for future payments to retirees under these programs and is not accountable for the assets of the plans. Employees of the Board may also participate in the Federal Reserve System's Thrift Plan. Board contributions to members' accounts are based upon a fixed percentage of each member's basic contribution and were $9,542,000 and $8,964,000 in 2007 and 2006, respectively. (6) ACCUMULATED POSTRETIREMEN! BENEFITS The Board provides certain life insurance programs for its active employees and retirees. Activity for 2007 and 2006 is summarized in the following tables: 0 0 Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31 Discount rate Rate of compensation increase Expected cashflows Expected employer contributions: 2008 0 (1,021,693) 0 (772,853) $(2,201,675) $ 2006 2007 Estimated amounts that will be amortized from accumulated other comprehensive income into net periodic benefit cost (credit) in 2008 are shown below: Net actuarial (gain)/loss .. Prior service (credit)/cost .. Total 2007 Change in benefit obligation Benefit obligation, beginning of year ... Service cost Interest cost Plan participants' contributions Plan amendments Actuarial (gain) loss Benefits paid Benefit obligation, end of year 2006 $8,111,829 198,791 479,903 $8,273,831 230,567 470,256 0 0 (533.208) (284,846) $7,972,469 $8,111.829 6.25% 6.00% Weighted-average assumptions used to determine benefit obligation as of December 31 Discount rate Change in plan assets Fair value of plan assets, beginning of year... Employer contribution ... Plan participants' contributions Benefits paid Fair value of plan assets, end of year 0 0 (603,500) (259,325) $ 0 284,846 $ 0 (284,846) $ 0 0 259,325 0 (259,325) $ 0 352 94th Annual Report, 2007 2006 2007 Reconciliation of funded status at end of year Benefit obligations Unrecognized net actuarial (gain) loss .. Unrecognized prior service cost Amount recognized, end of year Amounts recognized in the financial statements consist of Liability: Accrued benefit cost Accumulated other comprehensive income Net amount recognized .. Amounts recognized in accumulated other comprehensive income consist of: Net actuarial loss (gain) .. Prior service cost (credit) .. Transition obligation (asset) Deferred curtailment (gain) loss $(7,972,469) $(8,111,829) 0 0 0 0 $(7,972,469) $(8,111,829) $(7,972,469) $(8,111,829) 0 0 $(7,972,469) 0 0 $(8,111,829) $ 803,702 (89,741) $ 1,422,398 (99,560) 0 $ Components of net periodic benefit cost Service cost—benefits earned during the period Interest cost on projected benefit obligation ... Expected return on plan assets Amortization of prior service (credit) cost .. Amortization of (gains) losses Amortization of initial (asset) obligation ... Net periodic benefit cost (credit) 2007 0 0 713,961 0 $ 1,322,838 Expected cashflows Expected employer contributions: 2008 $ 293,767 Expected benefit payments: 2008 2009 2010 2011 2012 2013-2017 2006 $ 293,767 326,227 352,683 368,728 384,026 2,300,954 Estimated amounts that will be amortized from accumulated other comprehensive income into net periodic benefit cost (credit) in 2008 are shown below: Net actuarial (gain) loss ... Prior service (credit) cost .. Total $ $ 7,425 (9,818) (2,393) The above accumulated postretirement benefit obligation is related to the Board-sponsored life insurance programs. The Board has no liability for future payments to employees who continue coverage under the federally sponsored life and health programs upon retiring. Contributions for active employees participating in federally sponsored health programs totaled $10,311,000 and $9,607,000 in 2007 and 2006, respectively. (7) ACCUMULATED POSTEMPLOYMENT BENEFITS $ 198,791 $ 230,567 479,902 470,256 0 0 (9,818) (9,818) 85,487 0 $ Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31 Discount rate 120,022 0 754,362 5.75% $ 811,027 5.50% The Board provides certain postemployment benefits to eligible former or inactive employees and their dependents during the period subsequent to employment but prior to retirement. Postemployment costs were actuarially determined using a December 31 measurement date and discount rates of 5.75 percent as of December 31, 2007 and 2006. The accrued postemployment benefit costs recognized by the Board for the years ended December 31, 2007 and 2006, were $3,055,000 and $1,963,000, respectively. (8) ACCUMULATED OTHER COMPREHENSIVE INCOME Following is a reconciliation of beginning and ending balances of accumulated other comprehensive income. Board of Governors Financial Statements 353 Amount related to defined benefit retirement plans Balance at January 1, 2006 Adjustment to initially apply SFAS No. 158 Balance at December 31, 2006 Change in funded status of benefit plans: Amortization of prior service costs Amortization of net actuarial gain (loss) .. Net actuarial (gain) loss arising during the year Change in funded status of benefit plans— other comprehensive income gain (loss) .. Balance at December 31, 2007 Amount related to postretirement benefits other than pensions 332,969 1,322,837 332,969 $ 1,322,837 $ Total accumulated other comprehensive income (loss) Change in funded status of benefit plans— other comprehensive income gain (loss) ... Balance at December 31, 2007 168,992 $(1,486,814) Additional detail regarding the classification of accumulated other comprehensive income is included in notes 5 and 6. 14,013 9,818 (27,655) (85,487) 453,526 (533,207) (9) COMMITMENTS AND CONTINGENCIES Leases The Board has entered into several operating leases to secure office, training and warehouse space. Minimum annual payments under the operating leases having an initial or remaining noncancelable lease term in excess of one year at December 31, 2007, are as follows: 2008 2009 2010 2011 After 2011 . . .. 439,884 $ 772,853 (608,876) $ 713,961 $ 1,623,970 1,961,223 2.013,281 1,944,142 9,118,887 $16,661,503 Rental expenses under the operating leases were $539,000 and $193,000 in 2007 and 2006, respectively. Deferred Leases Total accumulated other comprehensive income (loss) Balance at January 1, 2006 Adjustment to initially apply SFAS No. 158 Balance at December 31, 2006 Change in funded status of benefit plans: Amortization of prior service costs Amortization of net actuarial gain (loss) Net actuarial (gain) loss arising during the year $ 0 (1,655,806) The Board's operating leases contain rent abatements and scheduled rent increases. According to accounting principles generally accepted in the United States of America, rent abatements and scheduled rent increases must be considered in determining the annual rent expense to be recognized. The deferred rent represents the difference between the actual lease payments and the rent expense recognized. The current balance of deferred rent is $318,000 and $8,000 in 2007 and 2006, respectively. Commitments $ (1,655,806) (23,831) 113,142 79,681 The Board has entered into an agreement with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, through the Federal Financial Institutions Examination Council (the Council) to fund a portion of enhancements and maintenance fees for a central data repository project through 2013. The estimated total Board expense to support this effort is $7.5 million. In 2007, the Council began a rewrite of the Home Mortgage Disclosure Act processing system, for which the Board provides data processing services. The estimated total Board expense to support this effort is $3.2 million through 2010. 354 94th Annual Report, 2007 Litigation 2007 The Board is subject to contingent liabilities which include litigation cases. These contingent liabilities arise in the normal course of operations and their ultimate disposition is unknown. Based on information currently available to management, it is management's opinion that the expected outcome of these matters, individually or in the aggregate, will not have a materially adverse effect on the financial statements. Management believes the Board has substantial defenses and that the likelihood of an adverse judgment is remote. (io) FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL The Board is one of the five member agencies of the Council, and currently performs certain management functions for the Council. The five agencies which are represented on the Council are the Board, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and Office of Thrift Supervision. The Board's financial statements do not include financial data for the Council. Activity related to the Board and Council for 2007 and 2006 is summarized in the following table: 2007 Council expenses charged to the Board Assessments for operating expenses . Central Data Repository Uniform Bank Performance Report Total Council expenses charged to the Board Board expenses charged to the Council Data processing related services Administrative services Total Board expenses charged to the Council 2006 $ 108,163 $ 109.760 1,167,449 740,003 192,026 204,617 $1,467,638 $1,054,380 $4,457,647 $3,429,499 190,800 183,000 $4,648,447 $3,612,499 2006 $384,142 $395,551 $ 64,087 Accounts receivable due from the Council ... Accounts payable due to the Council 54,870 (11) FEDERAL RESERVE BANKS The Board performs certain functions for the Resrvve Banks in conjunction with its responsibilities for the System, and the Reserve Banks provide certain adminisirative functions for the Board. Activity related to the Board and Reserve Banks for 2007 and 2006 is summarized in the following table: As of December 31, 2007 Reserve Bank expenses charged to the Board Data processing and communication Contingency site Total Reserve Bank expenses charged to the Board 2,064,110 $ 1,152,166 $ 2006 2,161,298 1,087,429 3,216,276 $ 3,248,727 Board expenses charged to the Reserve Banks Assessments for currency costs $576,306,073 $491,962,202 Assessments for operating expenses 296,124,700 301,013,500 of the Board 704,840 731,999 Data processing Total Board expenses charged to the Reserve Banks ... $873,135,613 $793,707,701 Accounts receivable due from Federal Reserve Banks $ Accounts payable due to the Reserve Banks $ 1,270,582 $ 854,142 10 $ 12,417 (12) THE OFFICE OF EMPLOYEE BENEFITS OF THE FEDERAL RESERVE SYSTEM OEB administers certain System benefit programs on behalf of the Board and the Reserve Banks, and costs associated with the OEB's activities are assessed to the Board and Reserve Banks. The Board was assessed $2,866,676 and $2,380,474 in 2007 and 2006, respectively. Board of Governors Financial Statements 355 Deloitte INDEPENDENT AUDITORS' REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING AND ON COMPLIANCE AND OTHER MATTERS BASED UPON THE AUDIT PERFORMED IN ACCORDANCE WITH GOVERNMENT AUDITING STANDARDS To the Board of Governors of the Federal Reserve System: We have audited the financial statements of the Board of Governors of the Federal Reserve System (the "Board") as of and for the year ended December 31, 2007, and have issued our report thereon dated March 19, 2008. We conducted our audit in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the