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REFLECTIONS MONETARY POLICY  on  FLEXIBILITY, TRANSPARENCY AND INFLATION GUIDELINES  FEDERAL RESERVE BANK OF CHICAGO 2005 ANNUAL REPORT  FRBC 2005 Annual Report  MESSAGE FROM THE PRESIDENT  During the first three quarters of 2005, the U.S. economy grew at a rate about equal to or slightly above its potential growth rate — the rate that can be sustained over the long run without creating inflation pressures. Real GDP growth in the fourth quarter of 2005, however, dropped to an CONTENTS 1  Message from the President  3  Chicago Fed Highlights of 2005  4  Reflections on Monetary Policy:  annual rate of below 2 percent. This appears to have been largely due to transitory factors, and various indicators point to a recovery in growth in early 2006.  Flexibility, Transparency and Inflation Guidelines  18  Directors  20  Management Committee  21  Executive Officers  22  Advisory Councils  23  Executive Changes  24  Operations Volumes  25  Auditor Independence  26  2005 Financial Reports  29  2005 Financial Statements  32  Notes to Financial Statements  When the economy has an abundance of slack resources, as it did after the 2001 recession and the slow recovery that followed, inflation pressures can remain relatively muted even when the economy grows faster than its potential. Over the last couple of years, a highly accommodative monetary policy has helped foster such economic growth, which has removed much of this slack. The unemployment rate has fallen from almost 6 percent at the end of 2003 to under 5 percent at the end of 2005, and the capacity utilization rate in manufacturing has risen from under 77 percent at the end of 2003 to over 80 percent at the end of 2005, near its 30-year average. With the economy growing at a robust, self-sustaining rate, the Federal Open Market Committee (FOMC) began removing policy accommodation at a measured pace in June 2004 to prevent inflation pressures from developing. This continued throughout 2005, with the target federal funds rate (see chart on next page) rising from 2.25 percent at the beginning of 2005 to 4.75 percent after the FOMC meeting in late March of this year, the first one led by new chairman Ben Bernanke, who replaced Alan Greenspan. Still, inflation remains a concern, with the price index for personal consumption expenditures, excluding food and energy, increasing by 2.2 percent in 2004 and 1.9 percent in 2005, compared with an increase of 1.3 percent in 2003. This rate of inflation is near the upper end of the range  Michael H. Moskow  Message from the President  FRBC 2005 Annual Report  FRBC 2005 Annual Report  CHICAGO FED HIGHLIGHTS OF 2005  Target for Fed Funds Rate in 2005 and 2006 5%  4%  In this year’s annual report, we examine the issue of inflation targets in more detail and pose some questions that need to be answered before I feel we can make a final determination on this issue.  Financial Services  Seventh District cash and check processing performed well during the year. ■  Seventh District check revenue goals were exceeded by 15% based upon volumes and increased usage of Check 21 image products.  ■  The Detroit Branch maintained strong performance while shifting its check-processing operations to Cleveland as part of the ongoing effort to consolidate and streamline Federal Reserve financial services.  ■  With the cooperation of the Secret Service, the U.S. Coast Guard and three other law enforcement agencies, the Detroit Branch moved more than $1 billion into its new state-of-the-art facility (see photo above left).  ■  The Midway Facility implemented a quality management program to help improve efficiency. Special attention was paid to managing float and developing Check 21 expertise.  ■  The Des Moines office sustained high productivity all year and scored well on performance and cost measures. In a key indicator of quality control, the internal error rate was among the lowest for check processing in the Federal Reserve System.  2005 Results and Recognition of our Employees and Directors  3%  2% Jan ‘05  April  July  October  Jan ‘06  March  The hard work and dedication of our employees and the leadership and counsel of our directors in 2005 contributed to another successful year at the Chicago Fed. A list of some of our many accomplishments last year follows on the next page.  One of the Bank’s 2005 highlights was the December opening of the new Detroit Branch building.  The target Federal Funds rate rose from 2.25 percent at the beginning of 2005 to 4.75 percent after the FOMC meeting in late March of this year. Source: Federal Reserve System  that I feel is consistent with price stability. Furthermore, with few slack resources in the economy, an extended period of strong activity could generate additional inflation pressures. Soaring energy prices are also an inflation threat. Spot crude oil prices jumped over 30 percent in 2004, and strong worldwide demand, continued geopolitical risks, and the terrible devastation caused by Hurricane Katrina contributed to a 40 percent increase in oil prices in 2005. Natural gas and refined oil product prices also rose sharply in 2005. Like other costs related to production, higher energy prices can pass through to the prices of other goods and services. 2  Finally, there is a concern that if people see a string of higher inflation numbers, they may begin to expect permanently higher inflation. Though  Two individuals completed their service as directors last year and merit separate mention: Connie E. Evans from the Chicago board and Edsel B. Ford II from the Detroit board. Both Connie and Edsel served on their respective boards since 2000, and Edsel served as chairman of the Detroit Branch board for the last two years. I am personally grateful to both for their valuable perspective and guidance. On a related note, Valerie B. Jarrett, managing director and executive vice president of the Habitat Company, joined the Chicago board this year, and Timothy M. Manganello, chairman and CEO of BorgWarner, Inc., joined the Detroit board. I would also like to recognize Alan Greenspan, whom I have known for over 35 years, for his more than 18 years of outstanding service as chairman of the Federal Reserve Board and the FOMC. His contributions will be missed, but I have high regard for his successor, Ben Bernanke. And Chairman Bernanke is taking over a very strong institution. The quality of the people at the Fed and the collegial nature of this organization will continue to contribute to our success in 2006.  Economic Research and Programs  Chicago Fed economists conducted research in support of the monetary policy responsibilities of the Bank’s President and Board of Directors, including special presentations on inflation expectations, the Delphi bankruptcy and housing prices. ■  The department held 29 conferences throughout the District, and 22 Economic Research papers were accepted for publication in refereed journals.  ■  The Inflation Research Center sponsored important initiatives, among them a new measure of core inflationary pressures and a new approach to  Customer Relations and Support Office (CRSO)  short-term inflation forecasting. The Center also  The national office at the Chicago Fed that provides support to Federal Reserve customers nationwide made progress in converting customers to FedLine Advantage, a new electronic access solution.  organized a conference on price stability. Financial Institution Supervision and Regulation  Supervision and Regulation improved core super-  ■  visory functions through enhanced risk analysis, staff development and operational processes. ■  The department conducted more than 1100  inflation expectations are currently contained, one  examinations, inspections and off-site reviews. It  of the goals of monetary policy is to keep these  strengthened its risk-assessment process, putting  expectations in check.  more focus on improving its analysis of the root  Other Activities ■  Money Smart Weeks held in Chicago and Detroit featured more than 700 events that provided financial education to more than 25,000 area consumers.  ■  Record attendance by Federal Reserve executives around the U.S. highlighted the System’s annual leadership conference, which was developed and hosted by the Chicago Fed. The Bank also sponsored similar leadership training for other management staff.  causes of institutional risk. Some have suggested that explicit numerical inflation guidelines can aid the Fed in keeping inflation expectations well anchored at a low level.  Michael H. Moskow President and Chief Executive Officer April 1, 2006  ■  Supervision and Regulation employees spoke at conferences for the Institute of Internal Auditors, the American Bankers Association and the Bank Administration Institute. The department also organized a conference bringing together community bank CEOs from around the five-state region.  More than 3,000 institutions were conducting transactions daily via FedLine Advantage by year-end.  3  FRBC 2005 Annual Report  R E F L E C T I O N S O N M O N E TA RY P O L I C Y  FRBC 2005 Annual Report  Reflections on Monetary Policy  We have learned a lot about monetary policy during the last 25 years — and we’re still learning. We have gained important insights about the tactics of monetary policy as we moved from an environment of moderate inflation to one of price stability. In particular, we have learned a good deal about the benefits of maintaining appropriate flexibility when implementing policy. We also have learned about the importance of communications and transparency in that implementation — notably their role in reducing the uncertainty that households and business owners face when making economic decisions such as how much to spend, save and invest, or what prices to charge for their products.  F L E X I B I L I T Y, T R A N S PA R E N C Y A N D I N F L AT I O N GUIDELINES  Some argue that the best way for central banks to increase transparency and reduce this uncertainty is by adopting explicit numerical targets for inflation. However, there are a number of outstanding questions that should be addressed before a central bank decides to move to a regime of explicit numerical guidelines. Importantly, central banks usually think about these questions only in terms of achieving a target for inflation. But the Federal Reserve has two goals: It is charged with the dual mandate of fostering maximum sustainable growth as well as price stability.  By Michael H. Moskow  When thinking about the interaction between inflation and monetary policy, it’s useful to remember University of Chicago economist Milton Friedman’s important observation: Inflation is always and everywhere a monetary phenomenon. I learned this lesson the hard way in the early 1970s when working at the Council of Economic Advisers and at the Council on Wage and Price Stability. Overly expansive monetary and fiscal policies had contributed to a rise in inflation from near 1 percent in the early 1960s to more than 6 percent in early 1970. These rates were unacceptably high, and wage and price controls were implemented in 1971 to deal with the problem.  President and Chief Executive Officer Federal Reserve Bank of Chicago  Monetary policy has come a long way in the past quarter century. Price stability has always been part of the Federal Reserve’s policy mandate, and 4  one of our major accomplishments of the last 25 years is that we have actually achieved this goal.  Economists have thought a lot about these questions in recent years. In my opinion, they have not yet come up with adequate answers. So these questions continue to challenge a wide range of experts: academic researchers who study monetary theory, economists who advise businesses and households on how monetary policy may affect their investment decisions, and central bankers who try to formulate effective monetary policy in a constantly changing — and inherently uncertain — economic system.  The Tactics of Monetary Policy During the Transition to Price Stability  These controls did more harm than good. They did not break inflationary expectations, and inflation rates spiked back up when the controls were lifted. Furthermore, the distortions to relative wages and prices caused by these policies — and by other controls and guidelines that followed — resulted in the misallocation of productive resources in the economy. Today, many of those involved in implementing wage and price controls have vowed to fight fiercely any future efforts to reinstate them. But that certainly was not doctrine back then. For example, in the 1970s, Federal Reserve Chairman Arthur Burns thought that monetary policy should not take sole responsibility for bringing down inflation. He believed some kind of wage and price review authority was a necessary additional element of anti-inflationary policy. The experiences of the 1970s, however, stress that antiinflationary efforts outside of the realm of monetary policy are far less important for lowering inflation than reversing the accommodative policies pursued by the Fed. Much hard-fought progress against high inflation had occurred by the time of my arrival at the Chicago Fed in September 1994. At that time, the Federal Open Market Committee (FOMC) was embarking on a pre-emptive strike against emerging price pressures in order to prevent inflation from rising. These policy moves were successful. Subsequently, a series of events resulted in the achievement of price stability. The history of this 11-year period highlights the importance of flexibility in the implementation of monetary policy. Part of this flexibility is the willingness to debate and discuss new ideas. A good example is the  5  2004 2000 1999 1995 1994  THE EVOLUTION OF FEDERAL OPEN MARKET COMMITTEE COMMUNICATIONS* FEBRUARY First Press Release After a Federal Open Market Committee (FOMC) Meeting. “Chairman Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. This action is expected to be associated with a small increase in the short-term money  market interest rates. The decision was taken…in order to sustain and enhance the economic expansion….”  JULY First Explicit Mention of the Target for the Federal Funds Rate. “Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to decrease slightly the degree of pressure on reserve positions….Today’s action will be reflected in a 25 basis point decline in the federal funds rate from about 6 percent to about 5-3/4 percent.”  MAY Begin Releasing an Announcement Following Each Meeting Even if There is No Change in the Policy Rate. Announcements Now Include A Description of Economic Conditions. A “Tilt” is Added to Indicate Likely Direction of Next Policy Move. “While the FOMC did not take action today to alter the stance for monetary policy, the Committee was concerned about the potential for a buildup in inflationary imbalances that could undermine the favorable performance of the economy and therefore adopted a directive that is tilted towards the possibility of a firming in the stance of monetary policy. Trend increases in costs and core prices have generally remained quite subdued. But domestic financial markets have recovered and foreign economic prospects have improved since the easing of monetary policy last fall….”  FEBRUARY “Tilt” Replaced with Balance of Risks to Policy Goals. “...Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future....”  DECEMBER Decision to Expedite Release of Minutes. “...the Committee unanimously decided to expedite the release of its minutes. Beginning with this meeting, the minutes of regularly scheduled meetings will be released three weeks after the date of the policy decision. The first set of expedited minutes will be released at 2 p.m. EST on January 4, 2005.”  *Excerpts from press releases following selected FOMC Meetings.  Financial markets pay close attention to wording in the statements released after meetings of the Federal Open Market Committee.  SENDING SIGNAL  a  Reflections on Monetary Policy  FRBC 2005 Annual Report  tactical discussion in 1995 and 1996 about opportunistic disinflation. This was a discussion about whether policymakers should deliberately move to lower inflation or whether they should wait for the reductions that typically occur when the economy softens somewhat. In other words, should the effort to reduce inflation involve daily skirmishes or less regular battles when the opportunity arises?  FRBC 2005 Annual Report  Reflections on Monetary Policy  In some instances, the injection of liquidity ran counter to the inflation risks that the FOMC perceived just before the crisis. But as events bore out, such flexible monetary policy responses did not jeopardize the pursuit of the nation’s long-run goal of price stability. That is because an important element in this “disciplined approach to flexibility” is that long-run policy goals generally have been clearly articulated and are understood by the public.  Interestingly, opportunism won out in a different way. The opportunistic arguments in the mid-1990s largely were based on the idea that inevitable slowdowns in aggregate demand could be exploited to lower inflation. In fact, the productivity acceleration during the second half of the 1990s allowed for lower inflation without reductions in aggregate demand or economic activity — inflation came down at the same time that unemployment was falling. But because productivity growth had been persistently slow for the previous 20 years, few people considered the possibility of a productivity resurgence at the time of the opportunistic-versus-deliberative policy debate. The next episode that is important to highlight occurred in 2003. Following its May 2003 meeting, the FOMC acknowledged a relatively new risk to the economy: the possibility of an unwelcome fall in the inflation rate. For a central bank that had worked steadily for 25 years to reduce inflation, this sure was something new. But it highlighted the fact that with the achievement of price stability, monetary policy had to be based on flexible thinking; it had to acknowledge that inflation could be either too high or too low. And policy had to be conducted in recognition of that fact. These episodes are well-known to business and monetary economists who have studied the path that the U.S. economy has followed to reach the neighborhood of price stability. Interestingly, it is a peculiarly American path. While other central banks pursued a numerical inflation objective, the U.S. achieved price stability without having an explicit numerical target. Of course, it wasn’t that important to have a numerical definition of price stability when actual inflation exceeded price stability by everyone’s measure. At the time, Chairman Alan Greenspan offered a useful, though non-explicit, definition: It’s when businesses and households are not taking inflation into account in their economic decisions. So as long as the plans of households and businesses still accounted for inflation, it seemed clear that price stability had not yet been reached.  8  Furthermore, while other countries have suffered sluggish growth to achieve lower inflation, the U.S. did not. This is because our disinflationary monetary policy could be implemented against the backdrop of a step-up in productivity growth and because monetary policy did not adhere to a rigid mechanical rule, but adapted to the incoming evidence on inflation and output. This flexibility has been an important hallmark of monetary policy tactics over the past 20 years. This has caused heartburn among academics and others who worry about excessive discretion and advocate a more rigid, rules-based policy. Instead, the Greenspan Fed generally has responded adeptly to changing economic conditions and financial risks that threatened macroeconomic performance, and has done so without abandoning the discipline of its dual mandate to pursue maximum sustainable growth and price stability. The Fed’s reaction to financial risk is another hallmark of flexible policy. This actually is an old prescription for central bankers that Walter Bagehot (the founding editor of The Economist) gave in the 19th century: Provide liquidity to solvent financial institutions during financial market crises. Such action was clearly evident during the stock market crash of 1987, the extended monetary accommodation in the face of financial headwinds of the early 1990s, the Russian default in 1998, and the period after the 9/11 terrorist attacks.  The Importance of Communications and Transparency  Another relevant topic is the importance of communications and transparency in the implementation of monetary policy. The changes that have occurred in this area are little short of extraordinary. Remember when central bankers deliberately avoided announcing their decisions? Over the past decade, we have seen a move from central bank secrecy to central bank transparency, a change that reflects a growing appreciation of the enhanced policy credibility and reduced economic uncertainty that accompany public understanding of the goals and rationales underlying monetary policy decisions. It was not until 1994 that the Fed decided to announce policy changes immediately following FOMC meetings (See page 6). The first one went like this: “The Federal Open Market Committee decided to increase slightly the degree of pressure on reserves. The action is expected to be associated with a small increase in money market rates.” The key word was “slightly,” and there was no explicit mention of the federal funds rate. The next step in the evolution of the policy communication was the explicit mention of the target federal funds rate. Then came the announcement of a “tilt” to indicate the likely direction of the next policy move, then the judgment of the balance of risks to the policy objectives, then discussion of two-sided inflation risks, and, finally, the accelerated release of the minutes of FOMC meetings. In addition, media coverage of all FOMC participants’ speeches has exploded, and the Internet makes these readily available to everyone in real time. So, even though there is no rigid numerical rule, the public has a much better idea of the systematic ways in which the committee makes judgments regarding economic developments and translates these into monetary policy decisions. Although transparency requires careful execution of communications strategies, its benefits seem obvious: the well-anchored inflationary expectations and reduced uncertainty mentioned earlier. When the public and financial markets have a clear understanding of Federal Reserve goals and the methods used to achieve these goals, uncertainty is reduced, and consumers and businesses can better plan for future activities. One way this is revealed is in borrowing costs: Policy transparency can lower the risk premia imbedded in interest rates because it reduces the uncertainty over how future rates may vary due to changes in inflation, economic activity, and monetary policy. Appropriately, there will always be risks for entrepreneurs in search of returns, but central banks should not add to those risks by unnecessarily increasing uncertainty regarding monetary policy. At the same time, though, they should not lead markets to think that the path for policy is more certain than it actually is. Finally, when policy is transparent, a central bank can respond to economic events and financial crises that involve liquidity shortages without creating undue risk — the bank can make it clear to markets that it is responding to a short-run problem and not lessening its commitment to price stability.  Questions Regarding Explicit Numerical Guidelines  An important question facing central bankers involves determining the best way to be transparent and communicate policy. Some say explicit numerical guidelines are the ultimate form of transparency and communication, arguing that these guidelines are the best way for a central bank to anchor inflationary expectations and reduce the uncertainty over the future path for policy and interest rates. This leads to a third important topic: the questions that remain to be addressed regarding the advantages and disadvantages of explicit numerical regimes.  9  1998 1992 1991 1990  SELECTED CENTRAL BANKS’ INFLATION GUIDELINES RESERVE BANK OF NEW ZEALAND Policy designed to keep future All Groups Consumer Price Index inflation outcomes  between 1 and 3 percent on average over the “medium term.” When conducting policy, the Bank is directed to “seek to avoid unnecessary instability in output, interest rates, and the exchange rate.”  BANK OF CANADA An “inflation-control target range” for the 12-month change in total CPI inflation of 1 to 3 percent, with policy aimed at the 2 percent midpoint. Also, policy is directed to move inflation to the 2 percent midpoint over the next 6 to 8 quarters. Core inflation is used as a shorter-term operational guide for policy.  BANK OF ENGLAND A target of 2 percent measured by the 12-month change in the total CPI, with policy designed to bring inflation to target “in a reasonable period of time without creating undue instability in the economy.”  EUROPEAN CENTRAL BANK Target defined in terms of the year-on-year increase in the Harmonized Index of Consumer  Prices, with policy designed “to maintain inflation below, but close to, 2 percent over the medium term.” Furthermore, “…without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of….a high level of employment and sustainable noninflationary growth.”  The European Central Bank is one of numerous central banks that has an explicit numerical guideline for inflation.  GUIDELINES for INFLATION  Reflections on Monetary Policy  FRBC 2005 Annual Report  It’s pretty much accepted now by economists that monetary policy cannot permanently alter the unemployment rate or growth rate of the economy. This is often referred to as the vertical, or expectations-augmented, longrun Phillips curve and the natural rate hypothesis of Milton Friedman and Edmund Phelps. According to this hypothesis, attempts by monetary policy to push unemployment below its natural, or equilibrium, rate eventually will lead to pressures on resources and rising inflation and inflationary expectations. The unemployment rate will need to return to its equilibrium level in order to stabilize inflation. Now it wasn’t so long ago that the Humphrey-Hawkins Act placed explicit guidelines on the achievement of both low inflation and maximum employment. The law was enacted in 1978 when the natural rate hypothesis was more controversial. The Humphrey-Hawkins Act set the following targets for unemployment and inflation within five years of the act’s passage: the unemployment rate would be below 3 percent for those older than 19 and below 4 percent for those 16 years old and up; and CPI inflation would be under 4 percent. And the law also stated that by 1988 the inflation rate was to be zero percent. Well, the unemployment rate didn’t drop to 4 percent by 1983, and the inflation rate wasn’t down to zero by 1988. Fortunately, though some would have liked it, the Fed was not held in contempt of Congress. Of course, no one on the FOMC is suggesting that numerical targets for unemployment be reinstated. But FOMC members have expressed a variety of views on numerical inflation measures. Some have suggested an explicit inflation guideline. But no one has proposed full-blown inflation targeting in which we would commit to set policy with the sole aim of achieving a particular numerical inflation rate within some predetermined time period. As an aside, the open discussion the FOMC has had on explicit inflation guidelines has been very healthy. Such debates are a strength of the Federal Reserve and foster much learning. So no matter what the final decision, our discussion of inflation guidelines will help formulate more informed — and better — monetary policy. In any event, some form of an explicit numerical guideline may be embraced some day. But there are many issues that need to be studied and questions that need to be answered before making this decision. The first problem is deciding what the number should be. As noted earlier, former Chairman Greenspan offered a non-explicit definition of price stability: when households and business owners are not taking inflation into account in their economic decisions. This is a useful definition, but it does not easily translate into a particular number for an inflation guideline.  12  Indeed, as recent history shows, deciding on a number for policy to aim for — let alone if it represents price stability or not — has been the subject of a good deal of debate. There was little debate in the late 1980s. Inflation was around 4-1/2 percent and looked to be heading up — to most, the inflation outlook clearly was too high. However, there was a debate in 1994. Core CPI inflation then was a relatively low 2.8 percent, and according to the minutes and transcripts, inflation was generally heading higher than most FOMC participants wanted. But that view was not universal. Many commentators thought an inflation rate of 3 percent was satisfactory and the Fed should not try to reduce it.1 Today, though, it’s doubtful many people would find 3 percent to be an acceptable point estimate for an inflation guideline. Of course, as I noted earlier when describing policy during 2003, it is possible for inflation to be too low. Importantly, the zero bound on nominal interest rates means that if inflation were too low, the Fed could be limited in its ability to lower short-term real interest rates and thus would have to turn to alternative and largely untested methods if it found it necessary to respond to unfavorable shocks to the economy. A related question involves a seemingly simple issue: Which index should be selected for the inflation guideline? There are many measures of inflation: the Consumer Price Index, the Personal Consumption Expenditures Index, and the GDP price index, to name only a few.2  FRBC 2005 Annual Report  Reflections on Monetary Policy  When inflation rates are high, it typically doesn’t matter which index is selected for the guideline, because all measures of inflation will be high and above the guideline. But when inflation is in the range of price stability, the choice of the index could matter. Indeed, seemingly small differences in the composition of consumption baskets and other measurement methods in principle mean that different indexes could conceivably send mixed signals to policymakers about the appropriate direction policy should take. There are other issues with regard to the choice of the guideline index. The Fed thinks that the price index for personal consumption expenditures, excluding food and energy, is the best measure of underlying trends in consumer inflation. But does that mean it’s the best index for a guideline? For example, the total CPI is used in many private contracts as well as the inflation adjustments in many tax and transfer programs. So should there be a guideline for the CPI as well? Also, in a period of rapidly rising energy costs — such as the present — will the public have confidence in an inflation guideline that excludes energy prices? Would such a guideline achieve its claimed advantages of anchoring expectations and reducing risk premia? Another set of issues centers on the best way to specify the numerical guideline to anchor inflation expectations. Should it be a single hard number or should it be a range of inflation outcomes? And once that has been decided, what is the time frame for achieving and maintaining the numerical values? The problem is to come up with something practical, yet still informative. The advantage of a single number is that it’s precise, so that there is no question how far one is from the guideline. However, actual inflation will inevitably fluctuate, and it’s extremely unlikely that inflation at any point in time will be precisely at the guideline. To get around this problem, a range of acceptable inflation outcomes could be specified. It’s more feasible to achieve inflation rates within a range. Of course, there is the issue of how wide the range should be. A very wide range would be uninformative and therefore not a useful starting point. Under both systems, however, there are difficulties in communicating policy. In the first instance, it’s communicating what kinds of small deviations from the single number policymakers would be willing to ignore. In the second case, it’s communicating what kinds of deviations within the range would require a reaction by policymakers. We don’t want to leave the public with the impression that there necessarily is a “zone of indifference” about inflation whenever it’s in the guideline range. In either case, the difficult communications task would be to explain the role of economic conditions in determining why sometimes the FOMC acts, and other times it doesn’t. Furthermore, the policy prescription needs to include a time period for evaluating the inflation outcome against the inflation guideline. Empirical evidence indicates that monetary policy does not affect the trajectory of inflation before one year, or more likely, two years. So it’s impractical to specify too short of a time period to reach the guideline. In contrast, suppose a very long time period is specified, say 10 to 20 years. It’s doubtful that households and business owners would find this very useful for their financial planning. Obviously, the answer lies somewhere in between. Many central banks that have guidelines refer to the time frame with the qualitative phrase of “over the medium term.” It is difficult to say precisely what this means. Is it three years, or five, or 10? And is it even a constant time period? The time-frame decision becomes even more complicated when one considers another important issue: the Fed’s dual mandate. How does our growth mandate interact with a numerical guideline for inflation? As seen with the Humphrey-Hawkins Act, achieving explicit fixed guidelines for unemployment or real GDP growth is not workable in practice. Theoretically, the equilibrium, or natural, rate of unemployment and the trend in potential GDP growth change over time with demographics, productivity trends, and other factors. For example, a decline in the trend in productivity of the labor force would reduce the potential growth  13  CENTER FOCUSES ON ISSUES RELATED TO PRICE STABILITY The Inflation Research Center (IRC) at the Federal Reserve Bank of Chicago analyzes issues related to the Fed’s mandate of maintaining stable prices to help foster maximum sustainable economic growth. Economists in the IRC use the latest statistical methodology and economic theory in research projects aimed at helping policymakers, including Chicago Fed President Michael Moskow, address practical problems they face formulating national monetary policy on the Federal Open Market Committee. The IRC also encourages policy-relevant research and fosters the dissemination of research findings through the academic and policy-making communities. “The IRC fosters basic and applied research on monetary policy,” said senior economist and economic adviser Jonas Fisher, who manages the Center’s activities. “The center’s economists develop tools for practical policy-making.” The IRC has focused on applying developments in time-series statistics to better measure inflationary pressures. The Chicago Fed National Activity Index (CFNAI) is a good example. The CFNAI is a monthly index that provides a summary measure of economic growth and an assessment of emerging price pressures. The index was developed and produced under the direction of the IRC and is based on recent academic research on inflation forecasting. In addition to developing tools for inflation forecasting, IRC economists examine the determinants of real economic activity, productivity growth, inflationary expectations, and the design of optimal fiscal and monetary policy. The ultimate goal of this research is to gain a better understanding of the forces generating inflationary or deflationary pressures.  ONGOING AND NEW INITIATIVES Numerous other efforts are underway, including: ■ ■  Developing a new model-based statistical measure of core inflationary impulses. Investigating how long-run relationships implied by economic theory can improve short-and medium-run forecasts of inflation and other economic variables.  ■  Examining the use of disaggregated price data to understand the process of price formation at the firm level.  The IRC also carried out a number of outreach efforts in 2005. Well-known experts on inflation and macroeconomic modeling visited the center to present their research and provide feedback on current and potential IRC projects. IRC economists also organized a conference on price stability in November attended by more than 80 leading academic macroeconomists and policymakers. The IRC has a Web site (http://www.chicagofed.org/economic_research_and_data/ inflation_research.cfm) featuring working papers, research articles, and information about IRC conferences, data, and visitors.  The Federal Reserve Bank of Chicago’s Inflation Research Center analyzes issues related to maintaining low and stable consumer price inflation.  RESEARCH INFLATION  on  Reflections on Monetary Policy  FRBC 2005 Annual Report  rate of GDP — and trying to boost output growth higher would only generate inflationary pressures. Furthermore, there are many issues regarding the measurement of these concepts. In any event, monetary policy cannot alter the natural rate, and any influence on potential output from the risk premia channel is at most secondary. As those in Europe are learning, reductions in high rates of structural unemployment require regulatory changes and increased competition. Paradigm changes are needed to remove structural impediments to growth and employment. But even if it is accepted by economists that it does not make sense to set explicit fixed numerical targets for real growth and unemployment, the dual mandate still puts equal weight on price stability and maximum employment. In the academic literature on inflation targeting, a central bank that places substantial weight on both targets is referred to as a “flexible inflation targeter.” As of yet, in my opinion, the proposals for flexible inflation targeting require further elaboration before they can be of practical use to policymakers. Suppose for the sake of argument that the natural rate of unemployment and the level of potential real GDP were known. The key question in formulating explicit guidelines in the context of the dual mandate has two parts: “How fast should we plan to close the deviation in inflation from price stability?” and “How fast should we close the deviation between the unemployment rate and the natural rate?” The answer is complicated because it involves the interaction between the time frame for closing any gap between actual output and its maximum sustainable level and the time frame for bringing inflation in line with price stability. This is because policy dilemmas may arise. Suppose inflation is one percentage point above its guideline. If output is above potential, then there is no policy dilemma, because a contractionary policy aimed at both slowing output growth and reducing inflation would make progress on both objectives. But if output is below potential, there is a conflict in achieving both objectives. The inflation gap points to raising rates, while the output gap suggests lowering them. Flexibility means that the central bank must balance the two deviations; therefore, it would take longer to close either gap in the second case than in the first. And the larger the policy dilemma, the longer it would take to close the gaps. This discussion highlights the serious, and unanswered, question of how to specify formally such variable time periods in a policy environment with explicit numerical guidelines. Even if this problem is solved, other issues then come into play. As a legal matter, would the Fed need Congressional approval to adopt flexible targeting? And in light of the dual mandate, would this eventually lead to adding numerical unemployment guidelines that — like those in the Humphrey-Hawkins legislation — would prove to be incompatible with the natural rate hypothesis? Finally, how do you best explain flexible targeting to the public? It seems that whenever a number is mentioned, the media focuses entirely on the number and forgets all of the caveats. 16  This brings me to a final question. Suppose a central bank successfully adopted a formal inflation guideline that respects a dual mandate by flexibly adjusting the time horizons for achieving both its guidelines. Would this policy look any different from current Fed policy? Some academics who study inflationtargeting central banks say no.3 They say that, effectively, the Federal Reserve does engage in flexible inflation targeting. This is a bit puzzling since there are no announced explicit guidelines. Still, financial markets and the public do not seem to be overly bothered by the lack of an explicit number for future inflationary expectations, and at the present time, inflationary expectations are well anchored. Our actual policy appears to have successfully obtained one of the most important benefits ascribed to a regime based on formal guidelines. Then what is it that distinguishes current policy from simple discretionary ones that have the potential to produce large run-ups in inflation, like those in the 1970s? It’s that central bankers now know that even without rigid rules or numerical guidelines, their actual approach to policy must be aimed at keeping inflation expectations anchored at a low level. They see this as a prerequisite to achieving maximum  FRBC 2005 Annual Report  Reflections on Monetary Policy  sustainable growth over the long run. Central bankers also know that anchoring inflationary expectations sometimes requires pre-emptive policy tightening before the actual inflation numbers start to rise — moves that might prove unpopular with the public, but are necessary to keep inflation in check. A lot of questions have been raised in this essay concerning inflation guidelines and flexible targeting. There is not a pressing need to make an immediate decision on guidelines one way or the other. However, the topic is one of the most important issues currently on the table regarding the appropriate strategies for conducting monetary policy. There clearly are many issues regarding guidelines and targeting for researchers, business economists, and policymakers to study and debate. And this debate is going to be a healthy process. No matter what answers surface, more will be learned about the best ways to conduct monetary policy in our complicated and ever-changing economy. Looking ahead, Ben Bernanke, the new chairman of the Federal Reserve, has been a proponent of more explicit inflation guidelines, and the FOMC clearly will be discussing the issue further. These discussions will take place with full consideration given to formulating such guidelines in the context of maintaining policy flexibility and respecting the Federal Reserve’s dual mandate. As Chairman Bernanke said in his confirmation hearings: “I view the explicit statement of a long-run inflation objective as fully consistent with the Federal Reserve’s current policy approach, including its appropriate emphasis on the role of judgment and flexibility in policymaking. Most important, this step would in no way reduce the importance of maximum employment as a policy goal. Indeed, a key justification for this action is its potential to contribute to stronger and more stable employment growth by further stabilizing inflation and inflation expectations. In any case, I assure this Committee that, if I am confirmed, I will take no precipitate steps in the direction of quantifying the definition of long-run price stability. This matter requires further study at the Federal Reserve as well as extensive discussion and consultation. I would propose further action only if a consensus can be developed that taking such a step would further enhance the ability of the FOMC to satisfy its dual mandate of achieving both stable prices and maximum sustainable employment.” Of course, whatever the outcome of this discussion, the FOMC’s decisions regarding inflation guidelines will not be the final say on what constitutes the appropriate tactics for conducting monetary policy. Paradigms will continue to shift, and new personalities will arrive on the scene. And central bankers will continue to grapple with the best ways to implement monetary policy and convey to the public how we aim to achieve the fundamental long-run goals of price stability and maximum sustainable growth. Indeed, some people have complained that when Alan Greenspan retired after his extremely successful chairmanship of the Fed, he didn’t write down his secret for running outstanding monetary policy — “He didn’t leave a playbook.” But that’s fine — the most important legacies of the Greenspan era may be the lessons that central bankers teach themselves as they reflect on the conduct of monetary policy over the past 18 years. ■  ■  ■  ■  ■  The views presented here are those of Federal Reserve Bank of Chicago President Michael Moskow and not necessarily those of the Federal Open Market Committee or the Federal Reserve System. Major portions of this essay are based on a speech presented September 26, 2005, by the author to the National Association for Business Economics. Economic Research Senior Vice President Charles Evans and Vice President Spencer Krane contributed to development of the speech and this essay. 1  A sophisticated expression of this view was offered by George A. Akerlof, William T. Dickens, and George L. Perry, “The Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity, no. 1 (1996). It is based on the hypothesis that even though real wages determine purchasing power, workers have an extra aversion to seeing real wages lowered through a reduction in nominal wages. This results in nominal wages being sticky on the downside. These authors calibrate a model in which an inflation rate of 3 percent allows most realignments of real wages to occur without reducing nominal wages. 2  Most central banks that have targets use a consumer or retail index, and this has some grounding in economic theory since it is ultimately the well-being of consumers that matters for utility theory. For example, good business decisions among intermediate goods producers ultimately benefit consumers through their effect on final products and returns to investors who are also consumers. 3  See, for example, Marvin Goodfriend, “Inflation Targeting in the United States,” NBER Working Paper no. 9981, September 2003.  17  FRBC 2005 Annual Report  BOARD OF DIRECTORS  FRBC 2005 Annual Report  BOARD OF DIRECTORS  FEDERAL RESERVE BANK of CHICAGO  DETROIT BRANCH  Chairman  Deputy Chairman  John A. Canning, Jr.  Connie E. Evans  Chairman  Ralph W. Babb, Jr.  Roger A. Cregg  Linda S. Likely  W. James Farrell  Miles D. White Chairman and Chief Executive Officer Abbott Laboratories Abbott Park, Illinois  President and Chief Executive Officer WSEP Ventures Chicago, Illinois  Edsel B. Ford II  Chairman Illinois Tool Works Glenview, Illinois  Chairman and Chief Executive Officer Madison Dearborn Partners, Inc. Chicago, Illinois  Director Ford Motor Company Dearborn, Michigan  Chairman, President and Chief Executive Officer Comerica, Inc. Detroit, Michigan  Executive Vice President and Chief Financial Officer Pulte Homes, Inc. Bloomfield Hills, Michigan  Director of Housing and Community Development Kent County Community Development Department and Housing Commission Grand Rapids, Michigan  Mark T. Gaffney  Michael L. Kubacki  Mindy C. Meads  William A. Osborn  Michael M. Magee, Jr.  Irvin D. Reid  Tommi A. White  President Michigan State AFL-CIO Lansing, Michigan  Chairman, President and Chief Executive Officer Lake City Bank and Lakeland Financial Corp. Warsaw, Indiana  Former President and Chief Executive Officer Lands’ End, Inc. Dodgeville, Wisconsin  Chairman and Chief Executive Officer Northern Trust Corp. and The Northern Trust Co. Chicago, Illinois  President and Chief Executive Officer Independent Bank Corp. Ionia, Michigan  President Wayne State University Detroit, Michigan  Chief Operating Officer Compuware Corporation Detroit, Michigan  18  One director joined the Chicago Board in 2006:  One director joined the Detroit Branch Board in 2006:  The new director is Valerie B. Jarrett, Managing Director and Executive Vice President of The Habitat Company in Chicago, Illinois. She replaced Connie E. Evans, who completed six years of service.  The new director is Timothy M. Manganello, Chairman and Chief Executive Officer of BorgWarner, Inc. in Auburn Hills, Michigan. He replaced Edsel B. Ford, who completed six years of service, two as Branch board chairman.  19  Jeff Plagge President and Chief Executive Officer The First National Bank of Waverly Waverly, Iowa  FRBC 2005 Annual Report  MANAGEMENT COMMITTEE  FEDERAL RESERVE BANK of CHICAGO  FRBC 2005 Annual Report  EXECUTIVE OFFICERS  Michael H. Moskow President and Chief Executive Officer  Gordon Werkema First Vice President and Chief Operating Officer  Central Bank Activities  Risk Specialists Richard C. Cahill Vice President  Charles L. Evans Senior Vice President and Director of Research  Detroit Branch Operations, Cash Operations and Corporate Communications  Services to Depository Institutions  Glenn C. Hansen Senior Vice President  Regional Economics  Customer Relations and Support Office (CRSO)  Cash Operations  William A. Testa Vice President and Economic Advisor  William A. Barouski Senior Vice President  Jerome D. Nicolas Vice President  Fedline Services  Corporate Communications  Economic Research and Programs  Michael H. Moskow  Gordon Werkema  William A. Barouski  Barbara D. Benson  President and Chief Executive Officer  First Vice President and Chief Operating Officer  Senior Vice President Customer Relations and Support Office (CRSO)  Senior Vice President Strategy, Finance and People Practices  Banking and Financial Markets Douglas D. Evanoff Vice President and Economic Advisor  Glenn C. Hansen  Elizabeth A. Knospe  Margaret K. Koenigs  Senior Vice President and Director of Research  Senior Vice President Detroit Branch, Cash Operations and Corporate Communications  Senior Vice President, General Counsel, and Secretary Legal Relations, Office of the Directors and Enterprise Risk Management  Vice President and General Auditor  Information Technology, Administration, Statistical and Financial Reports  David Marshall Vice President and Economic Advisor  Ellen J. Bromagen Vice President and Program Director  Angela D. Robinson Senior Vice President and EEO Officer  Spencer D. Krane Vice President and Economic Advisor  National Marketing and Communications  Administrative Services  Microeconomic Policy Research Daniel G. Sullivan Vice President and Economic Advisor Payments Studies Richard D. Porter Vice President Consumer and Community Affairs  20  Catharine Lemieux  Angela D. Robinson  Robert G. Wiley  Senior Vice President Supervision and Regulation  Senior Vice President and EEO Officer Information Technology, Administration, Statistical and Financial Reports  Senior Vice President Financial Services Group  Laura J. Hughes Vice President and Program Director National Sales Sean Rodriguez Vice President and Program Director Michael J. Hoppe Vice President and National Account Manager  Financial Services Group  Alicia Williams Vice President  Robert G. Wiley Senior Vice President  Supervision and Regulation  Brian Egan Vice President (Dedicated to the Retail Payments Office)  Catharine Lemieux Senior Vice President Operations Douglas J. Kasl Vice President  Cynthia L. Rasche Vice President (Dedicated to the Retail Payments Office)  Midway Operations Institutions As of December 31, 2005  Mark H. Kawa Vice President  Mary H. Sherburne Vice President, Midway Site Manager  Anna M. Voytovich Vice President and Associate General Counsel  Office of the General Auditor Margaret K. Koenigs Vice President and General Auditor  G. Douglas Tillett Vice President  Financial Planning and Controls, Budget, Forecasting, Revenue Management  Macroeconomic Policy Research  Charles L. Evans  Ira R. Zilist Vice President and Program Director  Yurii Skorin Vice President and Associate General Counsel  Kristi L. Zimmermann Vice President Statistics Valerie J. Van Meter Vice President  People Practices, Strategic Planning, Loans and Reserves, Finance Barbara D. Benson Senior Vice President  21  Budget Reporting Jeffrey S. Anderson Vice President Accounting, Loans and Reserves Gerard J. Nick Vice President  Legal Relations & Financial Systems Risk Management Elizabeth A. Knospe Senior Vice President, General Counsel, and Secretary  As of December 31, 2005  FRBC 2005 Annual Report  ADVISORY COUNCILS  Federal Advisory Council Seventh District Representative  Leslie Smith Miller Iowa State Savings Bank Knoxville, Iowa  Dennis J. Kuester Marshall & Ilsley Corporation Milwaukee, Wisconsin  David Newby Wisconsin State AFL-CIO Milwaukee, Wisconsin  Seventh District Advisory Council Thomas Kendall Brown Ford Motor Company Dearborn, Michigan Carl T. Camden Kelly Services, Inc. Troy, Michigan  Matthew Paull McDonald’s Corporation Oak Brook, Illinois Robert G. Potter United Food and Commercial Workers Local 951 Grand Rapids, Michigan Quintin E. Primo III Capri Capital Chicago, Illinois  Richard L. Clarke Healthcare Financial Management Association Westchester, Illinois  Donald J. Schneider Schneider National, Inc. Green Bay, Wisconsin  Erroll B. Davis, Jr. Alliant Energy Madison, Wisconsin  Leland Strom Strom Farm Elgin, Illinois  Darcy L. Evon Illinois Institute of Technology Chicago, Illinois  Jim Theisen Theisen Home Farm Auto Dubuque, Iowa  Christopher P. LaMothe Ascendanci Ventures, LLC Indianapolis, Indiana  Jean Wojtowicz Cambridge Capital Management Corp. Indianapolis, Indiana  Bret R. Maxwell MK Capital Chicago, Illinois  FRBC 2005 Annual Report  EXECUTIVE CHANGES  Money Smart Advisory Councils  Directors  Advisory Councils  The Federal Reserve Bank of Chicago and its Detroit Branch coordinate Money Smart Advisory Councils in both Chicago and Detroit. They are made up of representatives of community, financial, government and educational organizations working together to promote financial literacy. Each council sponsors an annual Money Smart Week, which features a variety of activities for consumers that promote financial education. For a list of council members, please visit our Web site at chicagofed.org and go to “Advisory Councils” in the “About the Fed” section.  Members of the Federal Reserve Bank of Chicago’s boards of directors are selected to represent a cross section of the Seventh District economy, including consumers, industry, agriculture, the service sector, labor and commercial banks of various sizes.  The Federal Advisory Council, which meets quarterly to discuss business and financial conditions with the Board of Governors in Washington, D.C., is composed of one person from each of the 12 Federal Reserve Districts.  The Chicago board consists of nine members. Member banks elect three bankers and three non-bankers. The Board of Governors appoints three additional non-bankers and designates the Reserve Bank chair and deputy chair from among its three appointees. The Detroit Branch has a seven-member board of directors. The Board of Governors appoints three non-bankers, and the Chicago Reserve Bank board appoints four additional directors. The Branch board selects its own chair each year, with the approval of the Chicago board. All Reserve Bank and Branch directors serve three-year terms, with a twoterm maximum.  Director appointments and elections at the Chicago Reserve Bank and its Detroit Branch effective in 2005 were: W. James Farrell re-appointed to a second one-year term as board chairman. Miles D. White re-appointed to a second three-year term as a director through 2007 and a second one-year term as deputy chairman Mindy C. Meads elected a director through 2007  Each year the Chicago Reserve Bank’s board of directors selects a representative to this group. Dennis J. Kuester, president and chief executive officer, Marshall & Ilsley Corporation, Milwaukee, Wisconsin, was selected to be the 2006 representative. The Seventh District Advisory Council members meet twice a year to provide their views on current business conditions to Chicago Fed President Michael Moskow and other senior officials of the Bank. Input from Council members on regional economic conditions helps contribute to the Federal Reserve System’s formulation of national monetary policy.  Executive Officers The Bank’s board of directors acted on the following vice president promotion during 2005: Cynthia L. Rasche to Vice President, Retail Payments Office  The following executive officer retired during 2005: David Ritter, Vice President, Technology Group, after 23 years of service  Jeff Plagge elected a director through 2007 Michael M. Magee, Jr. appointed a Branch director through 2007 Edsel B. Ford ll re-appointed to a second one-year term as Detroit Branch board chairman through 2005 Irvin D. Reid re-appointed to serve a second three-year term as a Branch director through 2007  At the end of 2005 the following appointments and elections to terms beginning in 2006 were announced: Miles White was appointed to a one-year term as Chicago Board chairman  22  John Canning was re-appointed to a three-year term as Chicago director and appointed to a one-year term as Chicago board deputy chairman Roger Cregg appointed to a one-year term as Detroit Branch chairman Bill Osborn re-elected to serve another year as Chicago director Linda Likely re-appointed to serve a three-year term as Detroit Branch director Tommi White re-appointed to serve a second three-year term as Detroit Branch director Valerie B. Jarrett was elected to a three-year term as a Chicago director Timothy M. Manganello was appointed to a three-year term as a Detroit Branch director  23  FRBC 2005 Annual Report  OPERATIONS VOLUMES  AUDITOR INDEPENDENCE  Dollar Amount  2005  Number of Items  2004  2005  2004  1.4 Billion  2.0 Billion  1.4 Million  15.1 Million  —  116.2 Million  92.3 Million  —  32.1 Million  Check and Electronic Payments  Checks, NOWs and Share Drafts Processed Fine Sort and Packaged Checks Handled Images Captured Check 21 Items Received  1.5 Trillion  1.7 Trillion  851.0 Million  10.3 Billion  — 215.9 Billion  —  Cash Operations  Currency Received and Counted  52.7 Billion  53.2 Billion  Unfit Currency Destroyed  5.6 Billion  6.5 Billion  583.1 Million  602.3 Million  Coin Bags Paid and Received  1.8 Billion  1.7 Billion  4.3 Million  4.0 Million  128.7 Billion  132.7 Billion  8.5 Billion  8.5 Billion  1.4 Billion  1.5 Billion  1.4 Thousand  1.3 Thousand  Number of Notes Paid and Received  3.7 Billion  3.7 Billion  Loans to Depository Institutions  Total Loans Made During Year  24  FRBC 2005 Annual Report  The fir m engaged by the Board of Gover nors for the audits of the indiv idual and combined financial statements of the Reser ve Banks for 2005 was PricewaterhouseCoopers LLP (PwC). Fees for these ser v ices totaled $4.6 million. To ensure auditor independence, the Board of Gover nors requires that PwC be independent in all matters relating to the audit. Specifically, PwC may not perfor m ser v ices for the Reser ve Banks or others that would place it in a position of auditing its own work, making management decisions on behalf of the Reser ve Banks, or in any other way impair ing its audit independence. In 2005, the Bank did not engage PwC for any material adv isor y ser v ices.  FRBC 2005 Annual Report  FRBC 2005 Annual Report  2005 Financial Reports  2005 FINANCIAL REPORTS  PricewaterhouseCoopers LLP One North Wacker Chicago, IL 60606 Telephone (312) 298-2000 Facsimile (312) 298-2001  Management Assertion March 2, 2006  Report of Independent Accountants  To the Board of Directors of the Federal Reserve Bank of Chicago  To the Board of Directors of The Federal Reserve Bank of Chicago  The management of the Federal Reserve Bank of Chicago (“FRBC”) is responsible for the preparation and fair presentation of the Statement of Financial Condition, Statement of Income, and Statement of Changes in Capital as of December 31, 2005 (the “Financial Statements”). The Financial Statements have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve System and as set forth in the Financial Accounting Manual for the Federal Reserve Banks (“Manual”), and as such, include amounts, some of which are based on judgments and estimates of management. To our knowledge, the Financial Statements are, in all material respects, fairly presented in conformity with the accounting principles, policies, and practices documented in the Manual and include all disclosures necessary for such fair presentation.  We have examined management’s assertion, included in the accompanying Management Assertion, that the Federal Reserve Bank of Chicago (“FRBC”) maintained effective internal control over financial reporting and the safeguarding of assets as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. FRBC’s management is responsible for maintaining effective internal control over financial reporting and safeguarding of assets. Our responsibility is to express an opinion on management’s assertion based on our examination.  The management of the FRBC is responsible for maintaining an effective process of internal controls over financial reporting including the safeguarding of assets as they relate to the Financial Statements. Such internal controls are designed to provide reasonable assurance to management and to the Board of Directors regarding the preparation of reliable Financial Statements. This process of internal controls contains self-monitoring mechanisms, including, but not limited to, divisions of responsibility and a code of conduct. Once identified, any material deficiencies in the process of internal controls are reported to management, and appropriate corrective measures are implemented. Even an effective process of internal controls, no matter how well designed, has inherent limitations, including the possibility of human error, and therefore can provide only reasonable assurance with respect to the preparation of reliable financial statements.  26  The management of the FRBC assessed its process of internal controls over financial reporting including the safeguarding of assets reflected in the Financial Statements, based upon the criteria established in the “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, we believe that the FRBC maintained an effective process of internal controls over financial reporting including the safeguarding of assets as they relate to the Financial Statements.  Our examination was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants and, accordingly, included obtaining an understanding of internal control over financial reporting, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. Because of inherent limitations in any internal control, misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of internal control over financial reporting to future periods are subject to the risk that the internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assertion that FRBC maintained effective internal control over financial reporting and over the safeguarding of assets as of December 31, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. This report is intended solely for the information and use of management and the Board of Directors and Audit Committee of FRBC, and any organization with legally defined oversight responsibilities and is not intended to be and should not be used by anyone other than these specified parties.  Federal Reserve Bank of Chicago  Michael Moskow  Gordon Werkema  Gerard J. Nick  President  First Vice President  Vice President and Controller  March 8, 2006  27  2005 Financial Reports  FRBC 2005 Annual Report  FRBC 2005 Annual Report  2005 FINANCIAL STATEMENTS  PricewaterhouseCoopers LLP One North Wacker Chicago, IL 60606 Telephone (312) 298-2000 Facsimile (312) 298-2001  Statements of Condition, in Millions.  As of December 31,  Report of Independent Auditors  Special drawing rights certificates  To the Board of Governors of The Federal Reserve System and  Coin  the Board of Directors of The Federal Reserve Bank of Chicago  Items in process of collection  $  928  $  924  212  212  76  111  414  559  Loans to depository institutions  26  14  U.S. government securities, net  67,559  65,359  1,228  2,232  Investments denominated in foreign currencies Accrued interest receivable Interdistrict settlement account Bank premises and equipment, net Other assets  We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.  2004  Assets Gold certificates  We have audited the accompanying statements of condition of the Federal Reserve Bank of Chicago (the “Bank”) as of December 31, 2005 and 2004, and the related statements of income and changes in capital for the years then ended, which have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve System. These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audits.  2005  Total Assets  525  458  1,908  225  245  186  32  40  $  73,153  $  70,320  $  66,524  $  63,471  Liabilities and Capital Liabilities: Federal Reserve notes outstanding, net Securities sold under agreements to repurchase  2,747  2,773  1,590  1,762  Deposits:  As described in Note 3, these financial statements were prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve System. These principles, policies, and practices, which were designed to meet the specialized accounting and reporting needs of the Federal Reserve System, are set forth in the Financial Accounting Manual for Federal Reserve Banks and constitute a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Bank as of December 31, 2005 and 2004, and results of its operations for the years then ended, on the basis of accounting described in Note 3.  Depository institutions Other deposits  4  4  349  421  Interest on Federal Reserve notes due U.S. Treasury  71  244  Accrued benefit costs  80  83  Other liabilities  36  36  71,401  68,794  Capital paid-in  876  763  Surplus  876  763  1,752  1,526  Deferred credit items  Total Liabilities  Capital:  28  29  Total Capital  Total Liabilities and Capital  March 8, 2006  The accompanying notes are an integral part of these financial statements.  $  73,153  $  70,320  2005 Financial Statements  Statements of Income, in Millions.  For the years ended December 31,  FRBC 2005 Annual Report  2005  2004  2005 Financial Statements  Statements of Changes in Capital, in Millions. For the years ended December 31, 2005 and December 31, 2004  Interest Income: Interest on U.S. government securities  FRBC 2005 Annual Report  $  Interest on investments denominated in foreign currencies Interest on loans to depository institutions  2,532  $  Capital Paid-in  Total Capital  2,041  19  28  2  1  2,553  2,070  Balance at January 1, 2004 (18.5 million shares)  $  Transferred from surplus Total Interest Income  Surplus  Net change in capital stock redeemed (3.2 million shares)  924  $  924  $  1,848  –  (161)  (161)  (161)  –  (161)  Interest Expense: Interest expense on securities sold under agreements to repurchase Net Interest Income  73  28  2,480  2,042  Balance at December 31, 2004 (15.3 million shares)  $  Transferred to surplus Net change in capital stock issued (2.2 million shares)  Other Operating (Loss) Income: Income from services  49  114  Compensation received for check services provided  54  –  5  7  (193)  129  11  7  (74)  257  136  143  20  21  Reimbursable services to government agencies Foreign currency (losses) gains, net Other income Total Other Operating (Loss) Income  Balance at December 31, 2005 (17.5 million shares)  $  763  $  763  $  1,526  –  113  113  113  –  113  876  $  876  $  1,752  The accompanying notes are an integral part of these financial statements.  Operating Expenses: Salaries and other benefits Occupancy expense Equipment expense  11  16  Assessments by Board of Governors  70  76  Other expenses  87  83  324  339  Total Operating Expenses Net Income Prior to Distribution  $  2,082  $  1,960  30  31 Distribution of Net Income: Dividends paid to member banks  $  Transferred to (from) surplus Payments to U.S. Treasury as interest on Federal Reserve notes Total Distribution  The accompanying notes are an integral part of these financial statements.  $  50  $  57  113  (161)  1,919  2,064  2,082  $  1,960  FRBC 2005 Annual Report  FRBC 2005 Annual Report  Notes to Financial Statements  NOTES TO FINANCIAL STATEMENTS  1. Structure  The Federal Reserve Bank of Chicago (“Bank”) is part of the Federal Reserve System (“System”) and one of the twelve Reserve Banks (“Reserve Banks”) created by Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”), which established the central bank of the United States. The Reserve Banks are chartered by the federal government and possess a unique set of governmental, corporate, and central bank characteristics. The Bank and its branch in Detroit, Michigan serve the Seventh Federal Reserve District, which includes Iowa, and portions of Michigan, Illinois, Wisconsin and Indiana. In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a Board of Directors. The Federal Reserve Act specifies the composition of the Board of Directors for each of the Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including those designated as Chairman and Deputy Chairman, are appointed by the Board of Governors, and six directors are elected by member banks. Banks that are members of the System include all national banks and any state-chartered banks that apply and are approved for membership in the System. Member banks are divided into three classes according to size. Member banks in each class elect one director representing member banks and one representing the public. In any election of directors, each member bank receives one vote, regardless of the number of shares of Reserve Bank stock it holds.  32  The System also consists, in part, of the Board of Governors of the Federal Reserve System (“Board of Governors”) and the Federal Open Market Committee (“FOMC”). The Board of Governors, an independent federal agency, is charged by the Federal Reserve Act with a number of specific duties, including general supervision over the Reserve Banks. The FOMC is composed of members of the Board of Governors, the president of the Federal Reserve Bank of New York (“FRBNY”), and on a rotating basis four other Reserve Bank presidents. 2. Operations and Services  The System performs a variety of services and operations. Functions include formulating and conducting monetary policy; participating actively in the payments system including large-dollar transfers of funds, automated clearinghouse (“ACH”) operations,  and check processing; distributing coin and currency; performing fiscal agency functions for the U.S. Treasury and certain federal agencies; serving as the federal government’s bank; providing short-term loans to depository institutions; serving the consumer and the community by providing educational materials and information regarding consumer laws; supervising bank holding companies, state member banks, and U.S. offices of foreign banking organizations; and administering other regulations of the Board of Governors. The System also provides certain services to foreign central banks, governments, and international official institutions. The FOMC, in the conduct of monetary policy, establishes policy regarding domestic open market operations, oversees these operations, and annually issues authorizations and directives to the FRBNY for its execution of transactions. FRBNY is authorized to conduct operations in domestic markets, including direct purchase and sale of U. S. government securities, the purchase of securities under agreements to resell, the sale of securities under agreements to repurchase, and the lending of U.S. government securities. FRBNY executes these open market transactions and holds the resulting securities, with the exception of securities purchased under agreements to resell, in the portfolio known as the System Open Market Account (“SOMA”). In addition to authorizing and directing operations in the domestic securities market, the FOMC authorizes and directs FRBNY to execute operations in foreign markets for major currencies in order to counter disorderly conditions in exchange markets or to meet other needs specified by the FOMC in carrying out the System’s central bank responsibilities. The FRBNY is authorized by the FOMC to hold balances of, and to execute spot and forward foreign exchange (“F/ X”) and securities contracts for nine foreign currencies and to invest such foreign currency holdings ensuring adequate liquidity is maintained. In addition, FRBNY is authorized to maintain reciprocal currency arrangements (“F/X swaps”) with two central banks, and “warehouse” foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the Reserve Banks. In connection with its foreign currency activities, FRBNY may enter into contracts that contain varying degrees of off-balance-sheet market risk, because they represent contractual commitments involving future settlement and counter-party credit risk. The FRBNY  controls credit risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring procedures. Although Reserve Banks are separate legal entities, in the interests of greater efficiency and effectiveness, they collaborate in the delivery of certain operations and services. The collaboration takes the form of centralized competency centers, operations sites, and product or service offices that have responsibility for the delivery of certain services on behalf of the Reserve Banks. Various operational and management models are used and are supported by service agreements between the Reserve Bank providing the service and the other eleven Reserve Banks. In some cases, costs incurred by a Reserve Bank for services provided to other Reserve Banks are not shared; in other cases, Reserve Banks are billed for services provided to them by another Reserve Bank. Major services provided on behalf of the System by the Bank, for which the costs were not redistributed to the other Reserve Banks, include national business development and customer support. Beginning in 2005, the Reserve Banks adopted a new management model for providing check services to depository institutions. Under this new model, the Federal Reserve Bank of Atlanta (“FRBA”) has the overall responsibility for managing the Reserve Banks’ provision of check services and recognizes total System check revenue on its Statements of Income. FRBA compensates the other eleven Banks for the costs incurred to provide check services. This compensation is reported as “Compensation received for check services provided” in the Statements of Income. If the management model had been in place in 2004, the Bank would have reported $71 million as compensation received for check services provided and $94 million in check revenue would have been reported by FRB Atlanta rather than the Bank. 3. Significant Accounting Policies  Accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have not been formulated by the various accounting standard-setting bodies. The Board of Governors has developed specialized accounting principles and practices that it believes are appropriate for the significantly different nature and function of a central bank as compared with the private sector. These accounting principles and practices are documented in the Financial Accounting Manual for Federal  Reserve Banks (“Financial Accounting Manual”), which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply accounting policies and practices that are consistent with the Financial Accounting Manual and the financial statements have been prepared in accordance with the Financial Accounting Manual. Differences exist between the accounting principles and practices in the Financial Accounting Manual and those generally accepted in the United States (“GAAP”) primarily due to the unique nature of the Bank’s powers and responsibilities as part of the nation’s central bank. The primary difference is the presentation of all security holdings at amortized cost, rather than using the fair value presentation requirements in accordance with GAAP. Amortized cost more appropriately reflects the Bank’s security holdings given its unique responsibility to conduct monetary policy. While the application of current market prices to the securities holdings may result in values substantially above or below their carrying values, these unrealized changes in value would have no direct affect on the quantity of reserves available to the banking system or on the prospects for future Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio may involve transactions that result in gains or losses when holdings are sold prior to maturity. Decisions regarding security and foreign currency transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, market values, earnings, and any gains or losses resulting from the sale of such securities and currencies are incidental to the open market operations and do not motivate its activities or policy decisions. In addition, the Bank has elected not to present a Statement of Cash Flows because the liquidity and cash position of the Bank are not a primary concern given the Bank’s unique powers and responsibilities. A Statement of Cash Flows, therefore, would not provide any additional meaningful information. Other information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition, Income, and Changes in Capital. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP. The preparation of the financial statements in conformity with the Financial Accounting Manual requires management to make certain estimates and  33  Notes to Financial Statements  assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Unique accounts and significant accounting policies are explained below. a. Gold and Special Drawing Rights Certificates  The Secretary of the U.S. Treasury is authorized to issue gold and special drawing rights (“SDR”) certificates to the Reserve Banks. Payment for the gold certificates by the Reserve Banks is made by crediting equivalent amounts in dollars into the account established for the U.S. Treasury. These gold certificates held by the Reserve Banks are required to be backed by the gold of the U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any time and the Reserve Banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury’s account is charged, and the Reserve Banks’ gold certificate accounts are lowered. The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy ounce. The Board of Governors allocates the gold certificates among Reserve Banks once a year based on the average Federal Reserve notes outstanding in each Reserve Bank.  34  Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its members in proportion to each member’s quota in the Fund at the time of issuance. SDRs serve as a supplement to international monetary reserves and may be transferred from one national monetary authority to another. Under the law providing for United States participation in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR certificates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent amounts in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’ SDR certificate accounts are increased. The Reserve Banks are required to purchase SDR certificates, at the direction of the U.S. Treasury, for the purpose of financing SDR acquisitions or for financing exchange stabilization operations. At the time SDR transactions occur, the Board of Governors allocates SDR certificate transactions among Reserve Banks based upon Federal Reserve notes outstanding in each District at the end of the preceding year. There were no SDR transactions in 2005 or 2004.  FRBC 2005 Annual Report  b. Loans to Depository Institutions  All depository institutions that maintain reservable transaction accounts or nonpersonal time deposits, as defined in regulations issued by the Board of Governors, have borrowing privileges at the discretion of the Reserve Bank. Borrowers execute certain lending agreements and deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and currently all are considered collectible and fully collateralized. If loans were ever deemed to be uncollectible, an appropriate reserve would be established. Interest is accrued using the applicable discount rate established at least every fourteen days by the Board of Directors of the Reserve Bank, subject to review by the Board of Governors. c. U.S. Government Securities and Investments Denominated in Foreign Currencies  U.S. government securities and investments denominated in foreign currencies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for amortization of premiums or accretion of discounts on a straight-line basis. Interest income is accrued on a straight-line basis. Gains and losses resulting from sales of securities are determined by specific issues based on average cost. Foreigncurrency-denominated assets are revalued daily at current foreign currency market exchange rates in order to report these assets in U.S. dollars. Realized and unrealized gains and losses on investments denominated in foreign currencies are reported as “Foreign currency gains (losses), net.” Activity related to U.S. government securities, including the related premiums, discounts, and realized and unrealized gains and losses, is allocated to each Reserve Bank on a percentage basis derived from an annual settlement of interdistrict clearings that occurs in April of each year. The settlement equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding in each District. Activity related to investments in foreign-currencydenominated assets is allocated to each Reserve Bank based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at the preceding December 31. d. U.S. Government Securities Sold Under Agreements to Repurchase and Securities Lending  Securities sold under agreements to repurchase are accounted for as financing transactions and the associated interest expense is recognized over the life of  FRBC 2005 Annual Report  Notes to Financial Statements  the transaction. These transactions are carried in the Statements of Condition at their contractual amounts and the related accrued interest is reported as a component of “Other liabilities.” U.S. government securities held in the SOMA are lent to U.S. government securities dealers and to banks participating in U.S. government securities clearing arrangements in order to facilitate the effective functioning of the domestic securities market. Securitieslending transactions are fully collateralized by other U.S. government securities and the collateral taken is in excess of the market value of the securities loaned. The FRBNY charges the dealer or bank a fee for borrowing securities and the fees are reported as a component of “Other income” in the Statements of Income. Activity related to U.S. government securities sold under agreements to repurchase and securities lending is allocated to each Reserve Bank on a percentage basis derived from the annual settlement of interdistrict clearings. Securities purchased under agreements to resell are allocated to FRBNY and not to the other Banks. e. Foreign Currency Swaps and Warehousing  F/X swap arrangements are contractual agreements between two parties to exchange specified currencies, at a specified price, on a specified date. The parties agree to exchange their currencies up to a pre-arranged maximum amount and for an agreedupon period of time (up to twelve months), at an agreed-upon interest rate. These arrangements give the FOMC temporary access to the foreign currencies it may need to intervene to support the dollar and give the counterparty temporary access to dollars it may need to support its own currency. Drawings under the F/X swap arrangements can be initiated by either FRBNY or the counterparty (the drawer) and must be agreed to by the drawee. The F/ X swaps are structured so that the party initiating the transaction bears the exchange rate risk upon maturity. FRBNY will generally invest the foreign currency received under an F/X swap in interest-bearing instruments. Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of the U.S. Treasury, U.S. dollars for foreign currencies held by the U.S. Treasury or ESF over a limited period of time. The purpose of the warehousing facility is to supplement the U.S. dollar resources of the U.S. Treasury and ESF for financing purchases of foreign currencies and related international operations.  Foreign currency swaps and warehousing agreements are revalued daily at current market exchange rates. Activity related to these agreements, with the exception of the unrealized gains and losses resulting from the daily revaluation, is allocated to each Reserve Bank based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at the preceding December 31. Unrealized gains and losses resulting from the daily revaluation are allocated to FRBNY and not to the other Reserve Banks. f. Bank Premises, Equipment, and Software  Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on a straight-line basis over estimated useful lives of assets ranging from three to fifty years. Major alterations, renovations, and improvements are capitalized at cost as additions to the asset accounts and are amortized over the remaining useful life of the asset. Maintenance, repairs, and minor replacements are charged to operating expense in the year incurred. Capitalized assets including software, building, leasehold improvements, furniture, and equipment are impaired when it is determined that the net realizable value is significantly less than book value and is not recoverable. Costs incurred for software, either developed internally or acquired for internal use, during the application development stage are capitalized based on the cost of direct services and materials associated with designing, coding, installing, or testing software. Capitalized software costs are amortized on a straightline basis over the estimated useful lives of the software applications, which range from two to five years. g. Interdistrict Settlement Account  At the close of business each day, each Reserve Bank assembles the payments due to or from other Reserve Banks as a result of the day’s transactions that involve depository institution accounts held by other Districts. Such transactions may include funds settlement, check clearing, and ACH operations. The cumulative net amount due to or from the other Reserve Banks is reflected in the “Interdistrict settlement account” in the Statements of Condition. h. Federal Reserve Notes  Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal Reserve agents (the Chairman of the Board of Directors of each Reserve Bank) to the  35  Notes to Financial Statements  Reserve Banks upon deposit with such agents of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides that the collateral security tendered by the Reserve Bank to the Federal Reserve agent must be equal to the sum of the notes applied for by such Reserve Bank. Assets eligible to be pledged as collateral security include all Bank assets. The collateral value is equal to the book value of the collateral tendered, with the exception of securities, whose collateral value is equal to the par value of the securities tendered. The par value of securities pledged for securities sold under agreements to repurchase is deducted. The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize the Federal Reserve notes. To satisfy the obligation to provide sufficient collateral for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes of all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks. Finally, as obligations of the United States, Federal Reserve notes are backed by the full faith and credit of the United States government. The “Federal Reserve notes outstanding, net” account represents the Bank’s Federal Reserve notes outstanding, reduced by the currency issued to the Bank but not in circulation, of $10,216 million, and $9,046 million at December 31, 2005 and 2004, respectively. 36  FRBC 2005 Annual Report  The balance in the “Items in process of collection” line in the Statements of Condition primarily represents amounts attributable to checks that have been deposited for collection by the payee depository institution and, as of the balance sheet date, have not yet been collected from the payor depository institution. Deferred credit items are the counterpart liability to items in process of collection, and the amounts in this account arise from deferring credit for deposited items until the amounts are collected. The balances in both accounts can fluctuate and vary significantly from day to day.  Notes to Financial Statements  j. Capital Paid-in  m. Assessments by the Board of Governors  The Federal Reserve Act requires that each member bank subscribe to the capital stock of the Reserve Bank in an amount equal to 6 percent of the capital and surplus of the member bank. These shares are nonvoting with a par value of $100 and may not be transferred or hypothecated. As a member bank’s capital and surplus changes, its holdings of Reserve Bank stock must be adjusted. Currently, only onehalf of the subscription is paid-in and the remainder is subject to call. By law, each Bank is required to pay each member bank an annual dividend of 6 percent on the paid-in capital stock. This cumulative dividend is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.  The Board of Governors assesses the Reserve Banks to fund its operations based on each Reserve Bank’s capital and surplus balances. The Board of Governors also assesses each Reserve Bank for the expenses incurred for the U.S. Treasury to issue and retire Federal Reserve notes based on each Reserve Bank’s share of the number of notes comprising the System’s net liability for Federal Reserve notes on December 31 of the previous year.  k. Surplus  The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of December 31. This amount is intended to provide additional capital and reduce the possibility that the Reserve Banks would be required to call on member banks for additional capital. Pursuant to Section 16 of the Federal Reserve Act, Reserve Banks are required by the Board of Governors to transfer to the U.S. Treasury as interest on Federal Reserve notes excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount necessary to equate surplus with capital paid-in. In the event of losses or an increase in capital paid-in at a Reserve Bank, payments to the U.S. Treasury are suspended and earnings are retained until the surplus is equal to the capital paid-in. Weekly payments to the U.S. Treasury may vary significantly.  i. Items in Process of Collection and Deferred Credit Items  FRBC 2005 Annual Report  In the event of a decrease in capital paid-in, the excess surplus, after equating capital paid-in and surplus at December 31, is distributed to the U.S. Treasury in the following year. This amount is reported as a component of “Payments to U.S. Treasury as interest on Federal Reserve notes.” l. Income and Costs related to U.S. Treasury Services  The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the United States. By statute, the Department of the Treasury is permitted, but not required, to pay for these services.  n. Taxes  The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property. The Bank’s real property taxes were $3 million and $2 million for the years ended December 31, 2005 and 2004, respectively, and are reported as a component of “Occupancy expense.” o. Restructuring Charges  In 2003, the System began the restructuring of several operations, primarily check, cash, and U.S. Treasury services. The restructuring included streamlining the management and support structures, reducing staff, decreasing the number of processing locations, and increasing processing capacity in the remaining locations. These restructuring activities continued in 2004. Footnote 10 describes the restructuring and provides information about the Bank’s costs and liabilities associated with employee separations and contract terminations. The costs associated with the write-down of certain Bank assets are discussed in footnote 6. Costs and liabilities associated with enhanced pension benefits in connection with the restructuring activities for all Reserve Banks are recorded on the books of the FRBNY and those associated with enhanced post-retirement benefits are discussed in footnote 9. 4. U.S. Government Securities, Securities Sold  2005  2004  U.S. government: Bills Notes Bonds  $ 24,429 34,231 8,360  $ 23,688 32,503 8,469  Total par value  $ 67,020  $ 64,660  794 (255)  847 (148)  67,559  65,359  Par value:  Unamortized premiums Unaccreted discounts Total allocated to Bank  The total of the U.S. government securities, net held in the SOMA was $750,202 million and $725,584 million at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, the total contract amount of securities sold under agreements to repurchase was $30,505 million and $30,783 million, respectively, of which $2,747 million and $2,773 million, were allocated to the Bank. The total par value of the SOMA securities pledged for securities sold under agreements to repurchase at December 31, 2005 and 2004 was $30,559 million and $30,808 million, respectively, of which $2,752 million and $2,775 million was allocated to the Bank. The maturity distribution of U.S. government securities bought outright and securities sold under agreements to repurchase, that were allocated to the Bank at December 31, 2005, was as follows (in millions):  Maturities of Securities Held  Securities Sold Under U.S. Gov’t Agreements to Securities Repurchase (Par value) (Contract amount)  Within 15 days 16 days to 90 days 91 days to 1 year Over 1 year to 5 years Over 5 years to 10 years Over 10 years  $ 3,693 15,513 16,776 18,979 5,106 6,953  $ 2,747 – – – – –  Total  $ 67,020  $ 2,747  Under Agreements to Repurchase, and Securities Lending  The FRBNY, on behalf of the Reserve Banks, holds securities bought outright in the SOMA. The Bank’s allocated share of SOMA balances was approximately 9.005 percent and 9.008 percent at December 31, 2005 and 2004, respectively. The Bank’s allocated share of U.S. Government securities, net, held in the SOMA at December 31, was as follows (in millions):  At December 31, 2005 and 2004, U.S. government securities with par values of $3,776 million and $6,609 million, respectively, were loaned from the SOMA, of which $340 million and $595 million, respectively, were allocated to the Bank. 5. Investments Denominated in Foreign Currencies  The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and the Bank for International Settlements and  37  Notes to Financial Statements  invests in foreign government debt instruments. Foreign government debt instruments held include both securities bought outright and securities purchased under agreements to resell. These investments are guaranteed as to principal and interest by the foreign governments. The Bank’s allocated share of investments denominated in foreign currencies was approximately 6.486 percent and 10.447 percent at December 31, 2005 and 2004, respectively. The Bank’s allocated share of investments denominated in foreign currencies, including accrued interest, valued at current foreign currency market exchange rates at December 31, was as follows (in millions): 2005  2004  Foreign currency deposits  $  352  $  635  Securities purchased under agreements to resell  125  224  Government debt instruments  231  412  Japanese Yen: Foreign currency deposits  170  161  Government debt instruments  350  800  $ 1,228  $ 2,232  Total  Total System investments denominated in foreign currencies were $18,928 million and $21,368 million at December 31, 2005 and 2004, respectively. The maturity distribution of investments denominated in foreign currencies which were allocated to the Bank at December 31, 2005, was as follows (in millions):  38  Within 15 days  European Euro $  219  Japanese Yen $  170  Total $  389  16 days to 90 days  167  44  211  91 days to 1 year  136  65  201  Over 1 year to 5 years  185  241  426  Over 5 years to 10 years  1  –  1  Over 10 years  –  –  –  520  $ 1,228  Total  At December 31, 2005 and 2004, the warehousing facility was $5,000 million, with no balance outstanding. 6. Bank Premises, Equipment, and Software  A summary of bank premises and equipment at December 31 is as follows (in millions): Useful Life Range (in Years)  $  708  $  At December 31, 2005 and 2004, there were no material open or outstanding foreign exchange contracts.  2005  2004  Bank premises and equipment: Land  N/A  $  12  $  9  Buildings  1 to 50  223  153  Building machinery and equipment  1 to 20  31  22  Construction in progress  N/A  12  41  Furniture and equipment  1 to 10  67  66  $ 345  $ 291  (100)  (105)  Bank premises and equipment, net  $ 245  $ 186  Depreciation expense, for the years ended  $  $  Subtotal  European Union Euro:  Maturities of Investments Denominated in Foreign Currencies  FRBC 2005 Annual Report  Accumulated depreciation  12  14  Bank premises and equipment at December 31 include the following amounts for leases that have been capitalized (in millions): 2005 Bank premises and equipment  $  Accumulated depreciation Capitalized leases, net  0.6  2004 $  (0.4) $  0.2  0.3  The Bank leases space to outside tenants with lease terms ranging from one to fifteen years. Rental income from such leases was $4 million and $3 million for the years ended December 31, 2005 and 2004, respectively. Future minimum lease payments under noncancelable agreements in existence at December 31, 2005, were (in millions): 2006 2007 2008 2009 2010 Thereafter  $  $  Notes to Financial Statements  Amortization expense was $2 million and $1 million for the years ended December 31, 2005 and 2004, respectively. Capitalized software assets are reported as a component of “Other assets” and related amortization is reported as a component of “Other expenses.” Assets impaired as a result of the Bank’s restructuring plan as discussed in footnote 10 include software and equipment. Asset impairment losses of $0.5 million for the period ending December 31, 2004, were determined using fair values based on quoted market values or other valuation techniques and are reported as a component of “Other expenses.” The Bank had no impairment losses due to restructuring in 2005. The Bank recognized impairment losses on the Detroit facility of $2 million and $1 million at December 31, 2005 and 2004, respectively, due to its determination that the carry value exceeded the fair value of the property. The impairment was determined using fair values based on quoted market values or other valuation techniques and are reported as a component of “Other expenses.” As of December 31, 2005 the Detroit facility, valued at $3 million, had been moved to Other Real Estate pending its sale.  0.6 (0.3)  $  FRBC 2005 Annual Report  4 3 3 2 2 21 35  The Bank has capitalized software assets, net of amortization, of $4 million and $6 million at December 31, 2005 and 2004, respectively.  The Milwaukee property, which in 2004 was pending sale and carried as Other Real Estate, was sold in 2005. 7. Commitments and Contingencies  At December 31, 2005, the Bank was obligated under noncancelable leases for premises and equipment with terms ranging from one to approximately six years. These leases provide for increased rental payments based upon increases in real estate taxes, operating costs, or selected price indices. Rental expense under operating leases for certain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and maintenance when included in rent), net of sublease rentals, was $3 million and $4 million for the years ended December 31, 2005 and 2004, respectively. Certain of the Bank’s leases have options to renew.  Future minimum rental payments under noncancelable operating leases and capital leases, net of sublease rentals, with terms of one year or more, at December 31, 2005, were (in thousands): Operating 2006 2007 2008 2009 2010 Thereafter  $  718 414 285 274 279 188  Capital $  $ 2,158  286  Amount representing interest Present value of net minimum lease payments  132 132 22 – – –  (27) $  259  At December 31, 2005, there were no other material commitments and long-term obligations in excess of one year. Under the Insurance Agreement of the Federal Reserve Banks, each Reserve Bank has agreed to bear, on a per incident basis, a pro rata share of losses in excess of one percent of the capital paidin of the claiming Reserve Bank, up to 50 percent of the total capital paid-in of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s capital paid-in bears to the total capital paid-in of all Reserve Banks at the beginning of the calendar year in which the loss is shared. No claims were outstanding under such agreement at December 31, 2005 or 2004. The Bank is involved in certain legal actions and claims arising in the ordinary course of business. Although it is difficult to predict the ultimate outcome of these actions, in management’s opinion, based on discussions with counsel, the aforementioned litigation and claims will be resolved without material adverse effect on the financial position or results of operations of the Bank. 8. Retirement and Thrift Plans Retirement Plans  The Bank currently offers three defined benefit retirement plans to its employees, based on length of service and level of compensation. Substantially all of the Bank’s employees participate in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”). Employees at certain compensation levels participate in the Benefit Equalization  39  Notes to Financial Statements  Retirement Plan (“BEP”) and certain Bank officers participate in the Supplemental Employee Retirement Plan (“SERP”). The System Plan is a multi-employer plan with contributions fully funded by participating employers. Participating employers are the Federal Reserve Banks, the Board of Governors of the Federal Reserve System, and the Office of Employee Benefits of the Federal Reserve System. No separate accounting is maintained of assets contributed by the participating employers. The FRBNY acts as a sponsor of the System Plan and the costs associated with the Plan are not redistributed to other participating employers. The Bank’s benefit obligation and net pension costs for the BEP and the SERP at December 31, 2005 and 2004, and for the years then ended, are not material. Thrift Plan  Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled $5 million and $6 million for the years ended December 31, 2005 and 2004, respectively, and are reported as a component of “Salaries and other benefits.” The Bank matches employee contributions based on a specified formula. For the years ended December 31, 2005 and 2004, the Bank matched 80 percent on the first 6 percent of employee contributions for employees with less than five years of service and 100 percent on the first 6 percent of employee contributions for employees with five or more years of service.  FRBC 2005 Annual Report  Accumulated postretirement benefit obligation at January 1  $  and Postemployment Benefits 40  2004  97.0  $ 106.5  2004  Health care cost trend rate assumed for next year  9.00%  9.00%  5.00%  4.75%  2011  2011  1.5  1.9  Interest cost of accumulated benefit obligation  Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)  5.2  5.9  Actuarial loss  0.8  2.3  Year that the rate reaches the ultimate trend rate  –  (1.2)  1.4  1.2  Curtailment gain Contributions by plan participants Benefits paid Plan amendments Accumulated postretirement benefit obligation at December 31  $  (7.3)  (6.6)  –  (13.0)  98.6  $  Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects for the year ended December 31, 2005 (in millions):  97.0  At December 31, 2005 and 2004, the weightedaverage discount rate assumptions used in developing the postretirement benefit obligation were 5.50 percent and 5.75 percent, respectively. Discount rates reflect yields available on high quality corporate bonds that would generate the cash flows necessary to pay the plan’s benefits when due. Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions): 2005  Notes to Financial Statements  2005  Service cost-benefits earned during the period  2004  One Percentage Point Increase Effect on aggregate of service and interest cost components of net periodic postretirement benefit costs  $  0.9  Effect on accumulated postretirement benefit obligation  $  Actual return on plan assets Contributions by the employer Contributions by plan participants  Fair value of plan assets at December 31  Postretirement Benefits other than Pensions  Unfunded postretirement benefit obligation  In addition to the Bank’s retirement plans, employees who have met certain age and length of service requirements are eligible for both medical benefits and life insurance coverage during retirement.  Unrecognized net curtailment gain  $ $  –  $  –  $  Interest cost of accumulated benefit obligation  5.4  Curtailment gain  1.4  1.2  (7.3)  (6.6)  Net periodic postretirement benefit costs (credit)  98.6  $  97.0  –  2.2  Unrecognized prior service cost  11.9  14.4  Unrecognized net actuarial loss  (42.0)  (44.1)  Accrued postretirement benefit costs  $  Total periodic expense  68.5  $  1.5  2004 $  $  5.9  (2.4)  (2.6)  $  7.1  Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”  Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):  For measurement purposes, the assumed health care cost trend rates at December 31 are as follows:  The Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a prescription drug benefit under Medicare (“Medicare Part D”) and a federal subsidy to sponsors of retiree health care benefit plans that provide benefits that are at least actuarially equivalent to Medicare Part D. The benefits provided by the Bank’s plan to certain participants are at least actuarially equivalent to the Medicare Part D prescription drug benefit. The estimated effects of the subsidy, retroactive to January 1, 2004, are reflected in actuarial loss in the accumulated postretirement benefit obligation and net periodic postretirement benefit costs. Following is a summary of expected benefit payments (in millions):  2.1 $  Without Subsidy  7.3  (2.2)  (12.4)  4.9  $ (5.1)  Net postretirement benefit costs are actuarially determined using a January 1 measurement date. At January 1, 2005 and 2004, the weighted-average discount rate assumptions used to determine net periodic postretirement benefit costs were 5.75 percent and 6.25 percent, respectively.  69.5  The Bank funds benefits payable under the medical and life insurance plans as due and, accordingly, has no plan assets.  primarily the result of enhanced retirement benefits provided to employees during the restructuring described in footnote 10. Because the special termination loss is less than $50,000, the amount is not displayed in the tables above. The curtailment gain associated with restructuring programs announced in 2003 was recognized when employees left the Bank in 2004. The curtailment gain associated with restructuring programs announced in 2004 that are described in footnote 10 will be offset by unrecognized actuarial losses and prior service gains. As a result, an unrecognized net curtailment gain was recorded in 2005 when the affected employees terminated employment.  1.9  5.2 2.8  Recognized net actuarial loss  5.9  –  (0.8)  (9.2)  2005 Service cost-benefits earned during the period  –  $  $  The following is a summary of the components of net periodic postretirement benefit costs for the years ended December 31 (in millions):  –  –  One Percentage Point Decrease  10.9  Amortization of prior service cost Fair value of plan assets at January 1  Benefits paid  9. Postretirement Benefits Other Than Pensions  2005  FRBC 2005 Annual Report  Net periodic postretirement benefit costs are reported as a component of “Salaries and other benefits.” A plan amendment that modified the credited service period eligibility requirements created curtailment gains. The recognition of special termination losses is  With Subsidy  2006 2007 2008 2009 2010 2011-2015  $  6.9 7.0 7.1 7.3 7.4 37.7  $  6.3 6.4 6.4 6.6 6.6 33.1  Total  $  73.4  $  65.4  Postemployment Benefits  The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined using a December 31, 2005 measurement date and include the cost of medical and dental insurance, survivor income, and disability benefits. The accrued postemployment benefit costs recognized by the Bank at December 31, 2005 and 2004, were $11 and $12 million, respectively. This cost is included as a component of “Accrued benefit  41  Notes to Financial Statements  costs.” Net periodic postemployment benefit costs included in 2005 and 2004 operating expenses were $(314) thousand and $1 million, respectively and are recorded as a component of “Salaries and other benefits.” 10. Business Restructuring Charges  In 2003, the Bank announced plans for restructuring to streamline operations and reduce costs, including consolidation of check operations and staff reductions in various functions of the Bank. In 2004, additional consolidation and restructuring initiatives were announced in the check operation. These actions resulted in the following business restructuring charges (in millions):  Employee separation Contract termination Total  Total Est. Costs  Accrued Liability 12/31/04  $ 6.3  $ 3.8  0.6  0.6  $ 6.9  $ 4.4  Total Paid  Accrued Liability 12/31/05  $ (1.7) $ 2.0  $ 0.1  Total Charges  –  0.6  –  $(1.7) $ 2.6  $ 0.1  FRBC 2005 Annual Report  There were no charges in 2005. The negative total charges amount is due to unrecognized accrued liabilities adjustments. Employee separation costs are primarily severance costs related to staff reductions of approximately 334, including 72 staff reductions related to restructuring announced in 2004. These costs are reported as a component of “Salaries and other benefits.” Contract termination costs include the charges resulting from terminating existing lease and other contracts and are shown as a component of “Other expenses.” Restructuring costs associated with the writedowns of certain Bank assets, including software, buildings, leasehold improvements, furniture, and equipment are discussed in footnote 6. Costs associated with enhanced pension benefits for all Reserve Banks are recorded on the books of the FRBNY as discussed in footnote 8. Costs associated with enhanced postretirement benefits are disclosed in footnote 9.  OUR MISSION  OUR VISION  The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banks across the United States that, together with the Board of Governors in Washington, D.C., serve as the nation’s central bank. The role of the Federal Reserve System, since its establishment by an act of Congress passed in 1913, has been to foster a strong economy, supported by a stable financial system.  ■  Fu r t h e r t h e p u b l i c i n t e r e s t b y fostering a sound economy and stable financial system  ■  Prov ide products and ser v ices of unmatched value to those we serve  ■  Set the standard for excellence in the Federal Reserve System  ■  Work together, value diversity, communicate openly, be creative and fair  ■  Live by our core values of integrity, respect, responsibility and excellence  To this end, the Federal Reserve Bank of Chicago participates in the formulation and implementation of national monetary policy; supervises and regulates state-member banks, bank holding companies and foreign bank branches; and provides financial services to depository institutions and the U.S. government. Through its head office in Chicago, branch in Detroit, regional office in Des Moines, and facility in Bedford Park, Ill., the Federal Reserve Bank of Chicago serves the Seventh Federal Reserve District, which includes major portions of Illinois, Indiana, Michigan and Wisconsin, plus all of Iowa.  42  Head Office 230 South LaSalle Street P.O. Box 834 Chicago, Illinois 60690-0834 (312) 322-5322 Detroit Branch 1600 East Warren Avenue Detroit, Michigan 48207-1063 (313) 961-6880 Des Moines Office 2200 Rittenhouse Street Suite 150 Des Moines, Iowa 50321 (515) 256-6100 Midway Facility 4944 West 73rd Street Bedford Park, Illinois 60638 (708) 924-8900