Full text of Economic Trends (Federal Reserve Bank of Cleveland) : Economic Trends - December 2007

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal Reserve Bank of Cleveland

Economic Trends
December 2007
(Covering November 8, 2006–December 13, 2007)

In This Issue
Economy in Perspective
A Capital Idea...
Inflation and Prices
October Price Statistics
Money, Financial Markets, and Monetary Policy
The Funds Rate, Liquidity, and the Term Auction Facility
Inflation Expectations
What is the Yield Curve Telling Us?
International Markets
Dollar Depreciations and Inflation
Trade and the Dollar
Economic Activity and Labor Markets
The Employment Situation
The Housing Market
Third-Quarter Preliminary GDP Release
Women in the Labor Force
Regional Activity
Business Establishments
Fourth District Employment Conditions, September
Banking and Financial Institutions
Fourth District Community Banks

1

A Capital Idea
12.19.07
by Mark S. Sniderman
Traditionally, banks have made money by holding assets on their balance sheets that could not always be readily sold
for cash at face value. Banks have earned their profits by learning how to take prudent risks with the funds entrusted
to them. After all, once a loan is made, the lender often has little ability to dispose of it without taking a loss. Consequently, banks have always had strong incentives to know their borrowers and how to work with them to keep loan
payments current.
Over time, some bankers changed their business model from “originate and hold” to “originate and sell.” In the
second model, banks and others, such as independent mortgage companies, underwrite loans but then sell them off
to a third party. This third party, which might be an investment bank, can pool together large numbers of loans and
sell fractional interests in the pool to other investors, such as insurance companies and pension funds, in the form
of securities. These are often called asset-backed securities because the repayment of principal and interest ultimately
depends on the performance of the underlying loans to back investors’ claims.
The advent of securitized markets for mortgage and other loans enabled banks to build on their fundamental skills
in loan origination and to tie up less of their capital than they would have, had they kept the loans on their own
books. In addition, some traditional lenders gained another revenue stream by selling off their loan servicing rights
to specialized financial companies that could operate the servicing business more profitably on a larger scale. Loan
servicing companies operate on behalf of those who own the loan and expect a return from principal and interest
payments. When loans do not perform as expected, the servicing companies decide when, how, and if the terms of
the loan should be modified.
The media have made much of how badly the securitization of residential mortgage loans has turned out, both for
investors in asset-backed securities and for many people who obtained mortgages as a result of lax underwriting standards and the unprecedented availability of funding. It is still not clear whether we have seen the worst of mortgage
loan defaults and foreclosures, nor do we yet know the full extent of the losses to investors in mortgage-backed securities. Financial markets continue to be agitated by these uncertainties, to be sure, but now the turmoil is calling into
question the banking system’s willingness and ability to provide credit to sound borrowers. But why should commercial lending in Boston and Cleveland be affected by mortgage foreclosures in Florida and California?
Unexpected complications have resulted from financial engineers’ piece de résistance—designing financial instruments backed by pools of securities that were themselves backed by pools of other securities. Billions of dollars worth
of these instruments were offered to investors through special-purpose financial entities that existed for no other
reason than to distance them from their sponsors. Having created this separation, the sponsors—often commercial
banking organizations—believed that they need not hold much, if any, capital against potential losses suffered by
their progeny. However, just as some parents worry that their children’s financial misfortunes could damage their
own credit, some sponsors of special-purpose entities are standing behind their progeny and taking the assets back
onto their own balance sheets. These sponsors are acting to preserve their reputation with customers and investors,
even though such actions dilute capital ratios.
In much the same way, secondary markets for various loans have been affected by investors’ concerns about the quality of the underlying assets, whether or not those assets are funded through special-purpose vehicles. Some banks
that have come to rely on secondary markets to take loans off their balance sheets are now obliged to fund these assets themselves. Such unplanned funding needs have made it more difficult for certain banks to find stable sources of
2

funding—at a cost they consider reasonable—to replace sources that used to be available.
During the next several months, we will learn more about the magnitude of losses for financial institutions, mortgage insurers, and investors. Though it is possible that some financial institutions will allow their balance sheets to
shrink to fit what capital they have, others will find investors to put in more capital. In fact, some prominent financial institutions have already announced new capital infusions. Over time, the current turmoil will dissipate, and
lending markets will normalize. What will then constitute “normal” for these markets is still uncertain, but it seems
likely that the new financial architecture will benefit from a sounder capital footing.

Inflation and Prices

October Price Statistics
11.29.07
by Michael F. Bryan and Brent Meyer

October Price Statistics
Percent change, last
1mo.a

3mo.a

6mo.a

12mo.

5yr.a

2006
avg.

All items

3.6

1.7

2.8

3.5

2.9

2.6

Less food and
energy

1.9

2.4

2.3

2.2

2.1

2.6

Medianb

3.2

2.8

2.6

2.8

2.5

3.1

16% trimmed
meanb

3.4

2.6

2.3

2.5

2.3

2.7

Finished goods

0.7

–0.7

2.1

6.1

3.6

1.6

Less food and
energy

0.0

1.0

1.8

2.5

1.5

2.1

Consumer Price Index

Producer Price Index

a. Annualized.
b. Calculated by the Federal Reserve Bank of Cleveland.
Sources: U.S. Department of Labor, Bureau of Labor Statistics; and Federal
Reserve Bank of Cleveland.

CPI, Core CPI and Trimmed-Mean
CPI Measures
12-month percent change
4.75
4.50
4.25
4.00
CPI
3.75
a
Median CPI
3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
a
1.25
16% trimmed-mean CPI
1.00
1995
1997
1999
2001

C ore C P I
2003

2005

2007

a. Calculated by the Federal Reserve Bank of Cleveland.
Sources: U.S. Department of Labor, Bureau of Labor Statistics, and Federal
Reserve Bank of Cleveland

The Consumer Price Index (CPI) rose at an annualized rate of 3.6 percent in October—the second
straight increase since the index’s 1.7 percent drop
in August. Year-to-date, the CPI has advanced 3.6
percent (at an annualized rate), which is ahead of
2006’s annual increase of 2.5 percent. Growth in
the CPI excluding food and energy prices (core
CPI) slowed to 1.9 percent, after having climbed to
2.7 percent in September. However, both the median and 16 percent trimmed-mean CPI indicators
posted increases above 3 percent in October (3.2
percent and 3.4 percent, respectively), outpacing
their 3-, 6-, and 12-month averages.
The 12-month growth rate in the CPI rose from
2.8 percent in September to 3.5 percent in October
and has increased 1.5 percentage points over the
last two months to the highest it has been since
August 2006. The 12-month trends of the core CPI
and the 16 percent trimmed-mean CPI inched up
during the month, to 2.2 percent and 2.5 percent,
respectively. The longer-term trend in the median
CPI held steady at 2.8 percent, which is down from
a recent high of 3.2 percent in March.
Roughly 53 percent of the CPI’s components increased in excess of 3 percent in October, compared
to 45 percent over the previous three months. Some
interesting and possibly transitory component-price
increases led to overall acceleration in the index.
Public transportation prices, which increased 3.1
percent in the third quarter, jumped 16 percent in
October because of a 23.5 percent spike in airline
fares. Hospital and related services, which had been
3

increasing moderately for most of the year, rose 14
percent, the largest increase of this CPI component
in five years.

CPI Component Price-Change
Distributions
Weighted Frequency
45
October

40

Average over previous three months
35
30
25
20
15
10
5
0
<0

0 to 1
1 to 2
2 to 3
3 to 4
4 to 5
Annualized monthly percent change

>5

Sources: U.S. Department of Labor, Bureau of Labor Statistics.

CPI Rent of Shelter
12-month percent change
6

5

R ent of primary res idenc e

4

3

2
Owners ’ equivalent rent
1
1995

1997

1999

2001

2003

2005

There were also some unusual price changes in the
shelter category. Rent of primary residence, which
had been moderating in recent months, posted
its largest increase in six years, rising 5.6 percent
in October. In contrast, owners’ equivalent rent
(OER) increased 2.7 percent during the month,
after increasing 3.4 percent last month. The 12month trend in OER has lessened considerably
more than rent of primary residence. Another
interesting price move in this month’s CPI report
was in lodging away from home, which has risen
5.5 percent year-to-date but fell 16.3 percent in
October.
Following a couple of somewhat unfavorable CPI
reports, household inflation expectations, as measured by the University of Michigan’s Survey of
Consumers, ticked upward in November. Expected
average short-run inflation rose from 3.7 percent in
October to 4.3 percent for the year ahead. Longerterm expectations (5 to 10 years out), posted a
slight increase (from 3.1 percent to 3.4 percent in
November), but remain near the ten-year average of
3.4 percent.

2007

Source: U.S. Department of Labor, Bureau of Labor Statistics

Household Inflation Expectations*
12-month percent change
6.0
5.5

One year ahead

5.0
4.5

F ive to ten years ahead

4.0
3.5
3.0
2.5
2.0
1.5
1.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
*Mean expected change as measured by the University of Michigan’s
Survey of Consumers
Source: University of Michigan

4

Money, Financial Markets, and Monetary Policy

The Funds Rate, Liquidity, and the Term Auction Facility
12.14.07
by Charles T. Carlstrom and Sarah Wakefield

Reserve Market Rates

At its December 11 meeting, the Federal Open
Market Committee (FOMC) voted to lower the
target federal funds rate 25 basis points to 4.25 percent. This followed on the heels of a 50 basis point
cut at its September 18 meeting and a 25 basis
point cut at the October 30-31 meeting.

Percent
8
Effective federal funds rate

7

a

6
5
Primary credit rate

4

b

3
2
1

Discount rate b
0
1999 2000 2001

Intended federal funds rate
2002

2004

2005

2006

b

2007

a. Weekly average of daily figures.
b. Daily observations.
Source: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical Releases, H.15.

December Meeting Predictions
Implied probability
1.0
0.9
Employment report and index of
consumer sentiment
Productivity and costs
4.25%

0.8
0.7
0.6
0.5
0.4

4.50%

0.3
0.2
0.1

4.00%

3.75%
4.75%

0.0
11/02 11/06 11/10 11/14 11/18 11/22 11/26 11/30 12/04 12/08
Note: Probabilities are calculated using trading-day closing prices from
options on federal funds futures that trade on the Chicago Board of Trade.
Sources: Chicago Board of Trade; and Bloomberg Financial Services.

S&P Index
1525
1520
1515
1510
1505
1500
1495
1490
1485
1480
1475
1470
1465

Markets
close
FOMC announcement

12/11 9:30

2:15 pm
12/11 15:30

The committee supported the move by stating that
“incoming information suggests that economic
growth is slowing, reflecting the intensification of
the housing correction and some softening in business and consumer spending. Moreover, strains in
financial markets have increased in recent weeks.”
Prior to the meeting, participants in the Chicago
Board of Trade’s federal funds options market
thought there was a 70 percent probability that
the Fed would announce a 25 basis point cut. The
remainder thought that a more aggressive policy cut
of 50 basis points would occur.
While the modest rate cut was not a big surprise
to markets, the stock market fell nearly 2 percent
after the Fed’s announcement. This large drop was
probably due more to the Fed’s decision to keep the
spread between the primary credit rate and the discount rate at 50 basis points rather than its decision
to cut the fed funds target by only 25 basis points.
Many had expected the committee to lower the primary credit rate more aggressively in order to boost
discount window borrowing. Discount window or
primary credit borrowing is particularly important
during times of financial crisis. While the statement
mentioned the “strains in financial markets,” the
fear was that the Fed was not doing enough to address those strains.
Signs of increasing financial strains included the
widening spread between the London Inter-Bank
Offer Rate (LIBOR) and a comparable short-term
Treasury bill. LIBOR is the interest rate that the
banks internationally charge each other for loans.

Source: Bloomberg Financial Services.

5

Discount Window Lending
Billions of dollars
7
Russian default
6

Sept. 11, 2001

5
4

Total borrowed

3
Primary credit
2
1
0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Source: Board of Governors of the Federal Reserve System.

LIBOR Spread
Percent
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2001

2002

2003

2004

2005

2006

2007

Note: Daily observations. LIBOR spread is the one-month LIBOR rate minus
the one-month Treasury bill yield.
Source: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical Releases, H.15.

But what was not known at the time of the FOMC
announcement was that more extensive efforts were
already being planned to deal with these liquidity
issues. At 9 a.m. on December 12 (the day following the meeting), a press release was issued that
stated: “Today, the Bank of Canada, the Bank of
England, the European Central Bank, the Federal
Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.” One of the
major changes for the Federal Reserve System was
the institution of a “term auction facility” (TAF)
to supplement regular discount window borrowing. This facility is designed to give the Fed greater
control of how much borrowing will actually occur
and to aid the channeling of funds to those financial institutions experiencing the greatest liquidity
pressures.
Policymakers are concerned that banks are not
borrowing enough at the discount window because
of the so-called “stigma effect”—the belief that
borrowing at the window is a signal that a bank is
financially weak. If banks are afraid to come to the
window when they need to, they might be forced
to sell off assets quickly at fire sale prices because
of immediate liquidity needs. The hope is that the
term auction facility will lessen the stigma effect,
thereby helping to ensure that banks that most
need the loans will receive them.
The terms of the auction are to be as follows: “The
minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate
corresponding to the maturity of the credit being
auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over
the relevant term.”

OIS and Federal Funds Rate
Percent
6
5
4

OIS a,b

3
Intended federal funds rate

b

2

Setting the minimum bid to the OIS rate is pretty
much the same as setting the minimum bid to an
interest rate with no penalty. Of course, this is the
minimum bid, and market forces will determine
how large a penalty rate there will actually be.

1
0
2001

2002

2003

2004

2005

2006

a. One-month Overnight Index Swap.
b. Daily observations.
Sources: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical Releases, H.15.; and Bloomberg
Financial Services.

2007

The amount being auctioned off is quite substantial. “The first TAF auction of $20 billion is scheduled for Monday, December 17, with settlement on
Thursday, December 20; this auction will provide
28-day term funds, maturing Thursday, January 17,
6

2008. The second auction of up to $20 billion is
scheduled for Thursday, December 20, with settlement on Thursday, December 27; this auction will
provide 35-day funds, maturing Thursday, January
31, 2008.” There will also be a third and fourth
auction on January 14 and 28 of unannounced
quantities. After that, “the Federal Reserve may
conduct additional auctions in subsequent months,
depending in part on evolving market conditions.”

Repurchase Agreements
Billions of dollars
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Board of Governors of the Federal Reserve System.

S&P Index
1525
1520
1515
1510
1505
1500
1495
1490
1485
1480
1475
1470
1465

The market reacted favorably to the announcement
of the term auction facility. While stock prices had
dropped around 2 percent following the fed funds
rate decision, following the announcement of the
TAF, stocks regained most of what they had lost.
Later in the day, stocks retraced their earlier gains,
but that was probably due to higher oil prices.

FOMC announcement
FOMC press release

Markets close

Markets open,
TAF press
release

2:15 pm
12/11
12/11
12:00
18:00

12/12
0:00

12/12
6:00

9:00 am
12/12
12:00

Source: Bloomberg Financial Services.

FOMC announcement

425
420
415

Financial stocks also benefited from the news, but
interestingly, their increase was less than that of
the broader market. Undoubtedly, other news had
come out overnight, which was reflected in their
opening price.
The two-year Treasury rate is thought to reflect
current liquidity pressures as well as expectations
of those of the future. Liquidity concerns raise the
price (cut the yield) of safe assets such as the twoyear Treasury bill, because investors turn to safer assets at such times. Prices on two-year Treasury bills
increased substantially after the Fed rate announcement, but subsequently fell back down following
the TAF announcement. Even in the time between
the two announcements, some of the earlier declines had been erased, as there was speculation of a
forthcoming Fed announcement.

S&P Financial Index
430

One way to gain some perspective on the magnitude of the December 20 and December 27 credit
auctions is to compare these amounts with Federal
Reserve System repurchase agreements (REPOs).
REPOs are collateralized loans from the Fed to
dealers, typically for 28 days or less, used to supply
reserves to the banking system.

Markets open;
TAF press
release

410
405
400
Markets close
395
390
2:15 pm
12/11
12/11
12:00
18:00

12/12
0:00

Source: Bloomberg Financial Services.

12/12
6:00

9:00 am
12/12
12:00

Even with the cut in the funds rate and the introduction of the new term auction facility, the market
is still betting on another cut at the end of January.
Whether this cut materializes depends partly on
whether the strains in financial markets lessen over
7

the next six weeks. The hope is that they will, since
some of the current pressures are probably because
of year-end financing needs. The unwinding of
these pressures, along with the past funds rate cuts
and the new auction facility, will hopefully reduce
these strains by the January meeting.

Two-Year Treasury Rate
Dollars
101.90

FOMC announcement
TAF
press release

101.80
101.70
101.60
101.50
101.40
101.30

2:15pm
12/11
12/11
12:00
18:00

12/12
0:00

12/12
6:00

9:00am
12/12
12:00

Source: Bloomberg Financial Services.

January Meeting Predictions
Implied probability
1.0
0.9

Import/export prices and international trade

0.8

FOMC statement/ rate action

0.7
0.6
4.00%

0.5
0.4
0.3

4.25%

3.50%

0.2
4.50%

0.1
0.0
11/08

3.75%
11/12

11/16

11/20

11/24

11/28

12/02

12/06

12/10

Note: Probabilities are calculated using trading-day closing prices from
options on federal funds futures that trade on the Chicago Board of Trade.
Sources: Chicago Board of Trade; and Bloomberg Financial Service

Money, Financial Markets, and Monetary Policy

Inflation Expectations
12.04.07
by Charles T. Carlstrom and Sarah Wakefield
Household Inflation Expectations,
Survey-Derived (Mean Expected Change)
Percent, annual average
6.0
One year ahead

5.5
5.0
4.5

F ive to ten years ahead

4.0
3.5
3.0
2.5
2.0
1.5
1.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: University of Michigan, Survey of Consumers.

It is crucial that monetary policymakers know
what expectations the public has for inflation rates
over the short and long term. One reason is that
inflation expectations help policymakers to gauge
the public’s perception of the central bank’s commitment to maintaining a low and stable rate of
inflation. Even more important is the fact that
long-term inflation expectations—if they are
stable—often mute short-term movements in inflation. So keeping long-term inflation expectations
well-contained is desirable.
Inflation expectations, despite their importance, are
8

Household Inflation Expectations,
Survey-Derived (Median Expected Change)
Percent, annual average
5.5
5.0
4.5

One year ahead

4.0
3.5

F ive to ten years ahead

3.0
2.5
2.0
1.5
1.0
0.5
0.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: University of Michigan, Survey of Consumers.

TIPS-Derived Inflation Expectations,
January 2003-July 2007*
Percent
3.00
20 year

2.75
2.50
2.25

10 year

2.00
7 year

1.75
1.50
1.25

5 year

1.00
1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07
*January 2003 is the first TIPS data available.
Source: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical Releases, H. 15.

TIPS-Derived Inflation Expectations,
Recent Two-Year Period
Percent
3.00
2.75

20 year

2.50

5 year

2.25

10 year

7 year

2.00
1.75
1.50
1.25
1.00
1/06

4/06

7/06

10/06

7/07

4/07

7/07

10/07

Source: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical Releases, H. 15.

notoriously difficult to measure. One well-known
measure comes from the University of Michigan’s
Survey of Consumers. Households are asked what
they expect inflation will be on average over the
next year (short-term expectations) as well as in
the next 5 to 10 years (long-term expectations).
According to this measure, mean short-term inflation expectations have crept up more than 50 basis
points since the beginning of 2007. Over the past
month alone they increased 50 basis points, although part of that increase served to erase some of
the improvement that had occurred over the summer. Longer-term expectations have remained fairly
steady, not showing any discernible movement over
the year.
Survey measures are greeted with skepticism in
some quarters. Since they do not reflect market
transactions, responses do not necessarily reflect
what market participants are truly expecting to
happen. Furthermore, while there is evidence to
suggest that changes in survey measures may be
informative, the levels themselves are clearly not
very accurate. It is doubtful that people really
expect inflation to average 3.5 percent over the next
5 to 10 years. For that reason, many simply report
the median versus the mean response from survey
participants. This pushes down the average inflation
rate that people expect over the next 5 to 10 years
to 3 percent. Even this seems high, but it does not
strain credulity as much.
As an alternative, many economists have looked
to the TIPS market to get a truer sense of what
markets are expecting inflation to average. In
theory, the yields on two different kinds of Treasury
securities—nominal Treasury notes and Treasury
inflation-protected securities (TIPS)—can be used
to calculate a market-based estimate of expected
inflation. Nominal Treasury notes earn a fixed
nominal rate of interest on a fixed amount of principal, whereas the principal of TIPS is adjusted for
inflation. Because the return on nominal Treasuries
is vulnerable to inflation, it compensates investors
for inflation over the time they hold the bonds. In
principle, one ought to be able to simply subtract
the real yield on TIPS from the nominal yield of
Treasury notes of the same maturity to derive expected inflation.
9

Using this method, one can derive inflation expectations over the next 5, 7, 10, and 20 years. This
measure suggests that expected inflation in the next
5 or 7 years is around 2.25 percent. Over the next
10 years it is slightly higher, 2.4 percent, but in 20
years, it jumps to 2.6 percent.

Liquidity Premium
0.45

Asian crisis

Russian default

0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05

/0
7
2/
3

/0
6

/0
5

2/
3

2/
3

2/
3

/0
4

/0
3

/0
2

2/
3

2/
3

2/
3

/0
1

/0
0

/9
9

2/
3

/9
8

2/
3

2/
3

2/
3

/9
7

0.00

Expected Inflation, TIPS-Derived for Ten
Years Ahead (Adjusted and Unadjusted)
4.00

Asian Crisis
Russian Default

3.50

Adjusted

3.00
2.50
2.00

Is it really realistic that market participants expect
inflation to average a full one-half percentage point
more over the next 20 years than in the next 7
years? Perhaps, but the fact that expectations for inflation in 20 years consistently run above those for
other time frames suggests that something else may
be going on. The answer is that TIPS estimates of
inflation expectations are also imperfect. There are
two factors that cause TIPS to be a biased predictor of expected inflation: an inflation-risk premium
and a liquidity premium. To make matters more
difficult, these biases likely go in different directions.

1.50
Unadjusted
1.00
0.50

/0
7
2/
3

/0
6
2/
3

/0
5
2/
3

/0
4
2/
3

/0
3
2/
3

/0
2
2/
3

/0
1
2/
3

/0
0
2/
3

/9
9
2/
3

2/
3

2/
3

/9
7

/9
8

0.00

Source: Federal Reserve Board.

Marketable Inflation-Protected
Securities Outstanding
Millions of dollars
500,000
450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000

The existence of inflation risk suggests that the
TIPS measure of expected inflation likely overestimates actual expected inflation. Nominal securities
must compensate investors for the risk that inflation will change and affect the securities’ returns
but by definition, a TIPS real return is constant.
Because nominal securities include an inflation-risk
premium but TIPS do not, the real return on TIPS
will be less than the average return on nominal
bonds. Over short periods of time the compensation for inflation risk will be pretty small, but over
long periods like 20 years it can be quite substantial. Studies suggest that because of inflation risk,
even the 10-year TIPS-derived measure will overestimate actual expected inflation by 50 to 100 basis
points. Although this bias may not be constant over
very long periods of time, monthly movements in
the bias are probably not too important.

50,000
0
2/97 2/98 2/99 2/00 2/01 2/02 2/03 2/04 2/05 2/06 2/07
Source: U.S. Treasury

In contrast, TIPS returns contain a premium to
compensate investors for liquidity risk. While the
TIPS market is deep, it is probably less liquid than
the market for nominal Treasury securities. Because
of this relative liquidity difference, a TIPS real
return should be greater than the real return on
nominal government securities. As a result, TIPSderived expected inflation will underestimate actual
expected inflation. This difference, while typically
10

Expected Inflation, TIPS-Derived for
Seven to Ten Years Ahead
Percent
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07
Source: Board of Governors of the Federal Reserve System, “Selected
Interest Rates,” Federal Reserve Statistical releases, H. 15.

small, can be important during periods in which
there are severe liquidity concerns. While potentially important, the bias due to liquidity risk is more
difficult to correct for than the bias due to inflation
risk because it is likely not constant over time.
One measure of the market’s liquidity concerns is
the difference in the yields on nominal Treasuries
in the primary and secondary markets. (The primary market refers to bonds bought directly from
the Treasury at auction, and the secondary market
refers to bonds bought from other investors.) This
difference, although small, can pick up broader
liquidity concerns in the market. For example,
during the Asian crisis this measure increased
little, from less than 10 basis points to 15–20 basis
points. The Russian default crisis saw a much more
dramatic increase, with the difference in yields
increasing nearly 30 basis points over the months
of the crisis. Recently, this measure has increased
10 basis points, similar to the magnitude of the
increase during the Asian crisis.
A 2004 study used this measure of the liquidity
premium to correct TIPS 10-year expected inflation
for liquidity risk. The study was largely a statistical
exercise and, if correct, has pretty alarming implications for today. Given recent financial turmoil,
liquidity-adjusted inflation expectations have
increased nearly 50 basis points. According to this
measure, market participants are expecting inflation
to average nearly 3 percent over the next 10 years.
The liquidity correction used in this study, however,
almost assuredly overcorrects. This is because the
study was done when the TIPS market was a lot
less liquid and deep than it is today. For example,
volume in the market has doubled since then.
While the recent increase in TIPS-derived adjusted
inflation expectations deserves our attention, it is
still not clear that long-term inflation expectations
have truly increased 50 basis points in the past two
months.
A better measure of inflation expectations might be
to use the separate 7-year and 10-year TIPS-derived
inflation expectations to construct a measure of
expectations for the combined period—7 to 10
years out. The problem of the liquidity premium
11

is probably minor since liquidity concerns for 7and 10-year TIPS are probably negligible. There is
undoubtedly more inflation risk over 10 years than
over 7, but this probably only biases up by a small
degree the measure of inflation expectations 7–10
years out.
Unfortunately, this measure shows the same qualitative pattern as the 10-year liquidity-adjusted
measure. According to the 7–10 year measure, there
has been a marked increase since early summer in
long-term inflation expectations of nearly 50 basis
points.
Both the liquidity-adjusted measure of long-term
inflation expectations and the measure for 7–10
years out suggest that inflation expectations may
have crept up in response to the latest federal funds
rate cuts and the probability of possible future rate
cuts. Of course, these moves in the funds rate may
be appropriate considering the recent financial turmoil caused by the housing market correction, and
the possible specter of a recession.

Money, Financial Markets, and Monetary Policy

What Is the Yield Curve Telling Us?
11.20.07
by Joseph G. Haubrich and Katie Corcoran

Yield Spread and Real GDP Growth*
Percent
12
10

R eal G DP
growth
(
(year-to-year
p
percent change)

8
6
4
2
0

10 year minus 3 month
y
ld
yield spread

-2
-4
1953

1963

1973

1983

1993

*Shaded bars represent recessions
Sources: Bureau of Economic Analysis; Federal Reserve Board

2003

Since last month, both long-term and short term
interest rates have decreased, with short rates dipping more, leading to a steeper yield curve. One
reason for noting this is that the slope of the yield
curve has achieved some notoriety as a simple
forecaster of economic growth. The rule of thumb
is that an inverted yield curve (short rates above
long rates) indicates a recession in about a year,
and yield curve inversions have preceded each of
the last six recessions (as defined by the NBER).
Very flat yield curves preceded the previous two,
and there have been two notable false positives: an
inversion in late 1966 and a very flat curve in late
1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve
indicates strong growth. One measure of slope, the
spread between 10-year bonds and 3-month T-bills,
bears out this relation, particularly when real GDP
growth is lagged a year to line up growth with the
spread that predicts it.
12

Yield Spread and Lagged Real GDP
Growth
Percent
12
One-year-lagged real G DP growth
(year-to-year percent change)

10
8
6
4
2
0

10 year minus 3 month
yield spread

-2
-4
1953

1963

1973

1983

1993

2003

Sources: Bureau of Economic Analysis; Federal Reserve Board

Predicted GDP Growth and the
Yield Spread
Percent
6
R eal G DP growth
(year-to-year percent change)

5
4

Predicted G DP growth

3
2
1
0

10 year minus 3 month yield s pread

-1
-2
2002

2003

2004

2005

2006

2007

2008

Sources: Bureau of Economic Actvity; Federal Reserve Board

Percent
100
90
P robability of
rec es s ion

70
F orec as t

60

While such an approach predicts when growth is
above or below average, it does not do so well in
predicting the actual number, especially in the case
of recessions. Thus, it is sometimes preferable to
focus on using the yield curve to predict a discrete
event: whether or not the economy is in recession.
Looking at that relationship, the expected chance of
a recession in the next year is 9 percent, down from
October’s 14 percent and September’s 17 percent.
Perhaps the decreasing probability of a recession
seems strange in the midst of recent financial concerns, but one aspect of those concerns has been a
flight to quality, which has lowered Treasury yields,
and a reduction in both the federal funds target rate
and the discount rate by the Federal Reserve, which
tends to steepen the yield curve.
The 9 percent is close to the 9.5 percent calculated
by James Hamilton over at Econbrowser

Probability of Recession Based on the
Yield Spread*

80

The yield curve had been giving a rather pessimistic
view of economic growth for a while, but with an
increasingly steep curve, this is turning around. The
spread remains robustly positive, with the 10-year
rate at 4.22 percent and the 3-month rate at 3.40
percent (both for the week ending November 16).
Standing at 82 basis points, the spread is up from
October’s 67 basis points as well as September’s 38
basis points. Projecting forward using past values of
the spread and GDP growth suggests that real GDP
will grow at about a 2.5 percent rate over the next
year. This is broadly in the range of other forecasts,
if a bit on the low side.

50

(though we are calculating different events: our
number gives a probability that the economy will
be in recession over the next year; Econbrowser
looks at the probability that the second quarter of
2007 was in a recession. )

40
30
20
10
0
1960

1966

1972

1978

1984

1990

1996

*Estimated using probit model
Note: Shaded bars indicate recessions.
Sources: Bureau of Economic Analysis; Federal Reserve Board;
Authors’ calculations

2002

2008

Of course, it might not be advisable to take this
number quite so literally, for two reasons. First,
this probability is itself subject to error, as is the
case with all statistical estimates. Second, other
researchers have postulated that the underlying
determinants of the yield spread today are materially different from the determinants that generated
yield spreads during prior decades. Differences
could arise from changes in international capital
13

flows and inflation expectations, for example. The
bottom line is that yield curves contain important
information for business cycle analysis, but, like
other indicators, should be interpreted with caution.
For more detail on these and other issues related to
using the yield curve to predict recessions, see the
Commentary “Does the Yield Curve Signal Recession?”

International Markets

Dollar Depreciations and Inflation
12.07.07
By Owen F. Humpage and Michael Shenk

Foreign Exchange Indexes
Index, February 2002 = 100
110

Developing countries a

105
100

8%

95
90
85

Broad Dollar Index
Peak 2/02

The dollar has depreciated 24 percent on a broad
trade-weighted basis since its peak in February
2002, posting its biggest losses against currencies of
the major developed countries. Since late January
2002, for example, the dollar has lost 41 percent of
its value against the euro.

24%

80
75
70

36%

Major industrialized countries b

65
60
2002

2003

2004

2005

2006

2007

a: Other Important Trading Partners Index.
b. Major Currencies Index.
Source: Board of Governors of the Federal Reserve System.

Dollar Exchange-Rate Movements
Percent change from:
01/28/2002a

08/06/2007b

Australia

−40.7

−1.4

Canada

−36.4

−3.5

Euro area

−41.0

−5.5

Japan

−16.9

−6.7

Mexico

18.4

−3.7

United Kingdom

−30.4

−0.3

a. Peak in Major Currency Index.

b. Day preceding the August FOMC meeting .
Source: Bloomberg Financial Services.

A dollar depreciation—all else constant—raises the
price of all U.S. traded goods. It directly increases
the dollar price of U.S. imports. Likewise, it directly lowers the foreign-currency prices of U.S.
exports, but this will shift foreign demand toward
our exported goods and, thereby, raise their dollar prices. These price effects are important; they
foster the adjustment in our international trade and
financial accounts.
Exchange-rate-induced price changes—contrary
to popular belief—are not inflationary. Inflation is
a decline in the purchasing power of money that
results when the money supply rises faster than
money demand. Inflation manifests itself as a rise
in all prices. If the rate of inflation in the United
States exceeds the rate of inflation in the rest of the
world, the dollar will depreciate. In fact, exchange
rates may react faster than the prices of goods and
services. In this case, inflation causes a depreciation;
the depreciation does not cause inflation.
Since 2006, however, the dollar has depreciated
because foreign investors have become reluctant to
add dollar assets to their portfolios, not because of
a high U.S. inflation rate or expectations of future
14

Broad Dollar and Import Price Indexes
Percent change, year over year
25
Correlation: -0.45
20
15

Import Price Index:
Nonpetroleum imports

10
5
0
-5
Broad Dollar Index

-10
-15
1984

1989

1994

1999

inflation. The price of trade goods will rise, but as
long as the Federal Reserve does not accommodate
the price pressures by easing excessively, inflation
will not ensue.
All this may sound like an excessive bit of economic
hair splitting. To the average consumer, a price rise
is a price rise. But to a central bank the distinction
is vital. Central banks can prevent inflation; they
cannot always stop relative changes in the price of
traded goods.

2004

Source: Board of Governors of the Federal Reserve System; and Bureau of
Labor Statistics.

Broad Dollar and Export Price Indexes
Percent change, year over year
25

CPI and Import Price Index
Percent change, year over year
12
Correlation: -0.41

Correlation: -0.47

10

20

8
15
Export Price Index

10

6

CPI

4

5

2

0

0

-5

-2

-10
-15
1984

Broad Dollar Index

1989

1994

-4

1999

-6
1986

2004

Import Price Index:
Nonpetroleum imports
1991

1996

2001

2006

Source: Bureau of Labor Statistics

Source: Board of Governors of the Federal Reserve System; and Bureau of
Labor Statistics.

International Markets

Trade and the Dollar
12.06.07
By Owen F. Humpage and Michael Shenk
Our trade deficit is narrowing, with exports growing at four times the pace of imports. In September
2007, the U.S. deficit in goods and services trade
was $677.4 billion (annual rate), down substantially from its recent peak of $811.3 billion in August
2006. In the third quarter of 2007, strong exports
contributed nearly 2 percentage points to real economic growth, a welcome offset to weak residential
investment. Strong export growth is likely to continue through next year because of strong growth
abroad and the dollar’s depreciation.

Trade Balance, Exports and Imports
Billions of dollars
200
150

Imports: goods and services

100
Exports: goods and services
50
0
-50
Balance of trade: goods and services
-100
1995
1997
1999
2001
2003
Source: Census Bureau

2005

2007

A key factor contributing to lower U.S. trade
deficits is phenomenally strong economic growth
15

Real GDP Growth
Annual percent change
8

World
U.S.

7
6
5
4
3
2
1
0
-1
-2
1980

1985

1990

1995

2000

2005

Sources: Board of Governors of the Federal Reserve System; Bureau of
Economic Analysis International Monetary Fund, World Economic Outlook
Database, Oct. 2007; and Action Economics

Real Growth Differential and Trade Balance
Percentage points
4

Billions of U.S. dollars
0

3

-100

2

-200

1

-300

0

-400
-500

-1
Balance of trade:
a
goods and service

-2

-600
-700

-3
World minus U.S. GDP growth

-800

-4
1980

1985

1990

1995

2000

2005

a: 2007 data is the average of the first three quarters
Sources: Board of Governors of the Federal Reserve System; Bureau of
Economic Analysis; International Monetary Fund, World Economic Outlook
Database, Oct. 2007; Action Economics.

Real Broad Dollar and Trade Balance
Index, March 1973 = 100
125
120

Billions of U.S. dollars
100
Real Broad Dollar Index b
0

115

-100

110

-200

105

-300

100

-400

95

-500

90

-600

85

-700

Balance of trade: goods & services a

80

-800
1973

1978

1983

1988

1993

1998

abroad relative to that in the United States. The
slower pace of U.S. growth this year has trimmed
import demand. Growth next year will probably
show only a little improvement. World growth,
in contrast, is well above its average pace, and the
number of countries sharing in that growth is the
largest in most observers’ memories. Holding all
else constant, when foreign growth exceeds U.S.
growth by at least one percentage point, our trade
deficit often shrinks. Foreign growth has outpaced
U.S. growth since 2004 and is likely to do so this
year and next. The big uncertainty, of course, is
the possible global fallout from the U.S. subprime
implosion.
The U.S. trade deficit is getting a boost from the
dollar. The relationship between dollar depreciations and the U.S. trade balance has never been
simple and clear-cut, because it depends critically on why the dollar depreciates. The dollar has
been depreciating since early 2002. Initially, the
depreciation seemed to reflect aggregate demand
pressures emanating from the United States. Such
a home-grown depreciation would not result in a
lower trade deficit. Since 2006, however, a growing
reluctance among international investors to add
dollar-denominated assets to their portfolios seems
to be driving the dollar down. The Federal Reserve’s
rate cuts in September and October encouraged
these portfolio adjustments. This diversification will
lead to a lower trade deficit if not confounded by
inflation fears, and thus far, the federal funds rate
cuts have not had a significant effect on inflation
expectations.
A dollar depreciation in response to an international portfolio shift out of dollars raises the dollar
price of goods produced abroad and lowers the
foreign-currency price of goods manufactured in
the United States. This relative price change shifts
worldwide demand toward the United States and,
if inflation remains subdued, will reduce the U.S.
trade deficit.

2003

a: 2007 data is the average of the first three quarters
b: 2007 data is the average of the first 11 months
Sources: Board of Governors of the Federal Reserve System; Bureau of
Economic Analysis.

16

Economic Activity

The Employment Situation
12.10.07
By Murat Tasci and Beth Mowry

Labor Market Conditions
Average monthly change
(thousands of employees, NAICS)
Jan.–Nov.
2007

November
2007

2004

2005

2006

Payroll employment

172

212

189

118

94

Goods-producing

28

32

9

−24

−33

Construction

26

35

11

−11

−24

Heavy and civil
engineering

2

4

2

–1

–5

Residentiala

9

11

−2

−7

−20

Nonresidentialb

3

4

6

2

1

0

−7

−7

−16

−11

Durable goods

8

2

0

−11

−1

Nondurable
goods

−9

−9

−6

−5

−10

Service-providing

144

180

179

142

127

Retail trade

16

19

−3

6

24

Financial activitiesc

8

14

16

–2

–20

PBSd

38

57

42

23

30

11

18

−1

−4

11

Education and
health services

33

36

41

47

28

Leisure and hospitality

25

23

38

30

26

14

14

20

21

30

8

6

11

7

10

Nonfarm payroll employment grew by 94,000 in
November, just slightly below the forecasted gain of
100,000. This follows October’s strong job growth
of 170,000, revised up from 166,000. However,
gains for September were revised down by more
than half to 44,000. After these revisions, the average monthly increase in employment stands about
118,000 for 2007, significantly lower than the past
three years. The average monthly employment gain
in the third quarter now stands at 77,000, which
is the lowest since the third quarter of 2003. The
unemployment rate remained unchanged from the
previous two months, at 4.7 percent.

Manufacturing

Temporary help
services

Government
Local educational services

Average for period (percent)
Civilian unemployment
rate

5.5

5.1

4.6

4.6

4.7

a. Includes construction of residential buildings and residential specialty trade
contractors.
b. Includes construction of nonresidential buildings and nonresidential specialty
trade contractors.
c. Financial activities include the finance, insurance, and real estate sector and
the rental and leasing sector.
d. PBS is professional business services (professional, scientific, and technical
services, management of companies and enterprises, administrative and support,
and waste management and remediation services.
Source: Bureau of Labor Statistics.

Service-providing industries continued to drive
growth, adding 127,000 jobs during the month on
strong, broad-based gains, with the exception of a
20,000 loss in financial services. This fourth consecutive monthly loss for financial services was largely
due to cuts in credit intermediation (−13,000) and
real estate, rental, and leasing (−10,800). Professional business services remained solid, as did
leisure and hospitality and the government sector,
which added 26,000 and 30,000 to their payrolls,
respectively.
Goods-producing industries were a dark spot in
the report, losing 33,000 jobs. Nondurable goods
manufacturers (−10,000) and specialty trade contractors (−11,000) bore most of the hardship within
this category. Overall, the construction industry
lost 24,000 jobs. Jobs in residential construction
fell by 20,000, reflecting a sharp decline in the
housing sector.
November’s gain in overall employment reflected
a 30,000 increase in government payrolls and a
64,000 increase in private payrolls. The heaviest gains in government were at the local level
(19,000), and the sector as a whole has contributed
positively to growth over the year, with the exceptions of June (−2,000) and July (−24,000).
Professional and business services made a hefty
17

Average Nonfarm Employment Change
Change, thousands of jobs
250

Revised
Previous estimate

200
150
100
50
0
2004 2005 2006 2007 IV
2006

I

II
2007

III

Sep Oct Nov

Source: Bureau of Labor Statistics.

contribution of 30,000 jobs during the month,
led largely by professional and technical services
(23,900) and computer systems design (11,900).
Leisure and hospitality also added an impressive
26,000 to its payrolls, despite pressures on consumers. This sector was led almost exclusively by food
services and accommodation, which experienced
27,800 in payroll gains. Also notable was the
24,000 increase in retail payrolls, which more than
offset the past three-month decline.
Overall, this month’s report suggests that the
economy is still creating jobs at a moderate pace.
However, it is worth noting that monthly numbers
are volatile and subject to revision. In last month’s
report, for instance, the Bureau of Labor Statistics revised September payrolls down by 14,000,
lowering that estimate to a gain of 96,000. The
current report made even more dramatic revisions,
reducing the earlier figure by 52,000 and resulting in September gains of 44,000. Payroll gains in
October and November are subject to revision in
the next report.

Economic Activity

The Housing Market
12.10.07
By Michael Shenk

Single-Family Home Sales
Change, thousands of units
300
200
100
0
-100
-200
-300
-400
-500

Existing homes
New homes

-600
Jan 2005 Jul 2005 Jan 2006 Jul 2006 Jan 2007 Jul 2007
Sources: Census; and National Association of Realtors.

Sales figures for single-family homes were relatively
good in October—the key word being relatively.
In the market for new homes, sales increased 1.7
percent in October, which wouldn’t be noteworthy
under normal conditions. But considering that sales
have fallen an average of 2.4 percent per month
over the past 27 months, a slight increase seems
rather positive. In the market for existing homes,
sales were virtually unchanged in October, which,
again, wouldn’t be noteworthy except for the fact
that it is the best showing in the series since February. In fact, October marked only the fourth time
since the end of 2004 that sales of neither new or
existing single-family homes fell. And though that
seems like great news, keep in mind that both of
these numbers are preliminary and will be revised
in the months to come.
18

Single-Family Home Sales
Millions of units
1.5

Thousands of dollars
280

1.3

250

1.1

220

0.9

190

0.7

160

0.5

130

0.3

100

1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: Census.

Existing Single-Family Home Sales
Millions of units
6.5

Thousands of dollars
250

6.0

230

5.5

210

5.0

190

4.5

170

4.0

150

3.5

130

3.0

110

2.5
1990

90
1994

1998

2002

2006

Source: National Association of Realtors.

New Single-Family Homes for Sale
Thousands of units
600

Months of

Looking at the long-term trend, this month’s positive figures are more or less lost. Since peaking in
mid 2005, new and existing single-family home
sales are still down 47.6 percent and 30.6 percent,
respectively. In addition, the median sales prices
of both new and existing single-family homes are
down a little more than 10 percent from two years
ago.
The inventory story isn’t very pretty either. While
the current inventory level (in terms of months
of supply at the current sales pace) is not unprecedented in either market, levels in both markets are
very much elevated. (Though it is not shown on the
chart below, the inventory of existing single-family
homes on the market relative to the current sales
pace was higher than it is now on several occasions, most recently in 1985.) In the market for
new homes, the actual number of homes on the
market has been declining steadily since July 2006,
as home builders have been adjusting their inventory levels. However, throughout this period sales
have been falling at a faster pace than inventories,
resulting in greater months of supply. In the market for existing homes, where inventories can be
much more difficult to control, the actual number
of homes on the market has generally continued to
increase as the sales pace has declined, resulting in
a very rapid and steady increase in the months of
supply on the market.

Existing Single-Family Homes for Sale
Months of supply
11

Millions of units
4.4
4

10

550
3.6

450

9

3.2

500

8

2.8

7

400

2.4

6

350

2

5

300

1.6

4

250
1990
1994
Source: Census.

1998

2002

2006

1.2
1990

3
1994

1998

2002

2006

Source: National Association of Realtors.

19

Economic Activity

Third-Quarter Preliminary GDP Release
12.06.07
By Brent Meyer
Real GDP was revised up from 3.9 percent (annualized rate) to 4.9 percent, according to the preliminary estimate released by the Bureau of Economic
Analysis. The one percentage point adjustment was
primarily due to upward revisions to private inventories and exports, and a downward revision to
imports. Private inventories added $27.1 billion in
the third quarter, after a $17.2 billion upward revision. Exports were revised up 2.7 percentage points
to 18.9 percent, while imports dropped a percentage point, resulting in a revised increase of 4.2
percent in the third quarter. Personal consumption
expenditures were revised down from an increase
of 3 percent to 2.7 percent, partially offsetting the
upward revisions. If the preliminary estimate holds,
it will be the largest annualized increase in GDP
since the third quarter of 2003.

Revisions to Real GDP and Components
Annualized percent change
25

2007:IIIQ advance
2007:IIIQ preliminary

20
Business
fixed
investment

15
10
5

Real GDP

0

Personal
consumption

-5

Government
spending

Residential
investment
Exports

Imports

-10
-15
-20
-25
Source: Bureau of Economic Analysis.

Real GDP and Components,
Third-Quarter Advance Estimate
Quarterly change
(billions of 2000$)

Annualized percent change, last
Quarter

Four quarters

Real GDP

139.2

4.9

2.8

Personal consumption

54.2

2.7

2.9

12.0

4.0

4.76

Durables

11.1

1.9

2.2

Services

Nondurables

32.1

2.8

3.0

Business fixed investment

30.9

9.4

5.2

Equipment

18.5

7.2

1.7

Structures

10.2

114.3

13.3

Residential investment

-26.2

-19.7

-16.3

Government spending

19.1

3.8

2.7

National defense

12.2

10.1

5.7

Net exports

40.5

—

—

Exports

60.9

18.9

10.2

Imports

20.4

4.2

1.7

27.1

—

—

Change in business
inventories

Source: Bureau of Economic Analysis.

Compared to the past four quarters, the third quarter’s preliminary estimate is showing a slight deceleration in personal consumption expenditures and
residential investment, while business fixed investment and exports are advancing well above growth
over the past four quarters. The change in business
inventories was the largest increase since the fourth
quarter of 2005.
Net exports have been a hot topic as of late, partly
due to weakness in the dollar, and were a major
contributor to growth in the third quarter. Real
exports increased 18.9 percent, their largest increase
since the fourth quarter of 2003, while imports,
which take away from growth in GDP accounting,
increased only 4.2 percent. While the dollar value
of exports is nowhere near the value of imports
(which is reflected in our –$533.4 net export balance), the recent trend of higher export growth is
starting to close the gap. In fact, the $40.5 billion
change in net exports in the third quarter is the
largest gain the series has ever seen since its start
in 1947. The only quarter that comes close is the
fourth quarter of 1996, which saw a $39.4 billion
20

addition. That being said, net exports haven’t been
positive since the second quarter of 1982.

Imports and Exports
Annualized percent change
30
25

The near-term consensus growth forecast, as produced by the Blue Chip panel of economists, has
GDP dipping down to a growth rate of 1.7 percent
but then rebounding to 2.8 percent by the end of
2008. Compared to their October forecast, this is a
slightly weaker outlook over the next year.

Exports

20

Imports

15
10
5
0
-5
-10
-15
-20
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Note: Shaded bar indicates recession.
Source: Bureau of Economic Analysis.

Real Net Exports

Real GDP Growth

Billions (chained 2000$, SAAR)

Annualized quarterly percent change

100

6

0

Final estimate
Preliminary estimate
Blue Chip forecast

5

-100
-200

4

-300

3

-400
2
-500
-600

1

-700

0

-800
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Note: Shaded bars indicate recessions.
Source: Bureau of Economic Analysis.

IVQ IQ
2005

IIQ IIIQ IVQ IQ
2006

IIQ IIIQ IVQ IQ
2007

IIQ IIIQ IVQ
2008

Sources: Blue Chip Economic Indicators, November 2007 and Bureau of
Economic Analysis.

Labor Force Participation
Percent
95
90
85
80
75
70
65
Total
60
55
50
45
40
35
30
1948 1955 1962 1969
Source: Haver Analytics

Male

Female

1976

1983

1990

1997

2004

21

Economic Activity

Women in the Labor Force
12.05.07
By Murat Tasci and Beth Mowry

Women’s Educational Attainment

That women’s experience in the labor force has
changed in several notable ways over the past few
decades is highlighted in a report just published
by the Bureau of Labor Statistics. Since the 1970s,
women have increased the level of their participation in the labor force, their earnings in real terms
are higher, their attachment to the labor market
is stronger, and they are attaining higher levels of
education.

Percent of those employed
50
High school graduates

45
40
35
30
25

Some college

20

Four years of college or more

15
10
High school dropouts

5
0
1970
1975
1980
1985
Source: Bureau of Labor Statistics

1990

1995

2000

2005

Women’s Occupations, 2006
Total
employed
(thousands)

Percent
women

Total, 16 years and over

144,427

46.3

Management, professional, and related occupations

50,420

50.6

Management, business and financial operations

21,233

41.8

Professional and related occupations

29,187

56.9

Service occupations

23,811

57.3

Sales and office occupations

36,141

63.3

Sales and related occupations

16,641

49.1

Office and administrative support occupations

19,500

75.4

15,830

4.8

961

22.1

9,507

3.1

Natural resources, construction,
and maintenance
Farming, fishing, and forestry occupations
Construction and extraction occupations
Installation, maintenance, and repair occupations

5,362

4.6

Production, transportation, and material moving

18,224

22.8

Production occupations

9,378

30.4

Transportation and material moving occupations

8,846

14.8

The higher participation of women in the labor
force has often been cited as one of the most
important trends in U.S. labor markets. Since the
late 1940s, the rate of female labor force participation has been gradually increasing—from about 32
percent then to about 59 percent in 2007. Interestingly, the significant increase of women in the labor
force did not translate into a comparable increase in
the total labor force participation rate, because the
trend for men’s labor force participation has been
declining. While the rate of female labor force participation jumped dramatically over this period, the
rate of male participation dropped from 87 percent
to 73 percent, leaving the total labor force participation rate at around 66 percent.
The increasing movement of women into the labor
force has been matched by their attainment of
higher levels of education. In 1970, one-third of
women in the labor force were high school dropouts and only one-tenth held bachelor’s degrees. By
2006, these figures had swapped places, with less
than one-tenth of women in the labor force having
dropped out of high school and almost one-third
holding bachelor’s degrees. This rising educational
attainment helps to explain how women in 2006
accounted for more than half of all workers employed in the better-paying management, professional, and related occupations, despite the fact
that women make up only 46.3 percent of the
total number of people employed. Women are also
the majority in service occupations and office and
administrative support positions. However, they
22

are dramatically underrepresented in several occupations, given the share of women in the overall
workforce: construction and extraction; installation, maintenance, and repair; and transportation
and material moving.

Women’s Earnings as a Percent of Men’s
Percent
95
Hispanic or Latino
90

Black or African American

85
Asian

80
75
70

Total

65

White

60
1979

1984

1989

1994

1999

2004

a. Women’s median usual weekly earnings for full-time wage and salary
workers as a percent of men’s
Source: Current Population Survey, U.S. Department of Labor, U.S. Bureau
of Labor Statistics

Women with Work Experience
Usually work full-time

Usually work part-time

Year

Percent
of female
population

Total

Total

1970

52.7

100.0

67.9

40.7

27.2

32.2

10.1

22.1

1975

53.8

100.0

67.1

41.4

25.7

32.8

11.7

21.1

1980

57.7

100.0

67.7

44.7

23.0

32.3

11.9

20.4

1985

59.4

100.0

68.1

48.9

19.2

31.8

12.3

19.5

1990

62.1

100.0

69.8

51.5

18.3

30.2

12.8

17.4

1995

62.8

100.0

70.2

54.3

15.9

29.7

13.3

16.4

2000

64.0

100.0

72.9

58.4

14.5

27.1

13.4

13.7

2005

61.4

100.0

72.7

59.9

12.8

27.3

14.1

13.2

1–49 50–52
1–49 50–52
weeks weeks Total weeks weeks

Wives’ Earnings
Percent

Income disparity between men and women has
continued its narrowing trend. Women in 2006
took home 80 percent of what their male counterparts made, compared to only 62 percent in 1979.
White and Asian women continue to experience
the greatest disparity, earning about 80 percent
as much as white and Asian men, while Hispanic
and African American women make 87 percent as
much as their male counterparts. Meanwhile, wives’
contribution to family incomes rose from 27 percent to 35 percent between 1970 and 2005. More
than 25 percent of wives now earn more than their
husbands, compared to 18 percent in 1987.
Over the past several decades, women have become more attached to the labor force, even when
they are out of a job. This stronger attachment is
suggested by several observations. Since the early
1980s, the unemployment rate for women has
closely followed that of men. In addition, during
the last three recessions, women’s unemployment
rates stayed lower than men’s—and this occurred
during the time the participation of women in the
labor force was steadily increasing. And finally,
more women are working full-time, and fewer
are working part-time. From 1970 to 2005, the
percentage of working females with work experience who were full-timers grew from 68 percent
to about 73 percent, while the percentage of those
who were part-timers fell from 32 percent to about
27 percent.

35

Unemployment Rates
30

Contribution to family income

Percent
10

25

Female
Male
Total

8

Wives earning more than husband
20

6
15
1970

1975

1980

1985

1990

1995

2000

a. “Contribution to family income” is given in median percent
b. “Wives earning more than husband” data excludes families in which
husband had no earnings from work and includes only families in which both
wives and husbands have earnings
Source: Bureau of Labor Statistics

2005

4

2
1948 1955 1962 1969 1976 1983 1990 1997 2004
Sources: Bureau of Labor Statistics, Haver Analytics

23

Regional Activity

Business Establishments
12.11.07
By Tim Dunne and Kyle Fee

Private Establishment Growth, 2001–2007:I
Percent
50
45
40
35
30
25
20
15
10
5
0
-5

WA OH PA VT LA IN NH AL MO NY MN OK MA SD NE MS NM IL DC AR DE GA OR CA AZ NV
MI WV IA KY CT MT KS ND WI RI NJ HI ME AK TX MD TN NC WY CO VA SC ID UT FL

Private Establishment Growth
Relative to the Nation, 2001–2007:I

Looking across the 50 states, we see quite a range in
the growth rates of the number of establishments.
Nevada had the highest growth rate (47.8 percent)
from 2001 to the first quarter of 2007, while Washington had the lowest (-3.6 percent). Washington’s
low growth rate partially reflects the fact that the
number of establishments in the state peaked in
2001, after it had risen substantially during the
1990s.

U.S. establishment growth = 13.1%

No growth
Growth less than one-half US growth
Growth less than US growth
Growth greater than US growth
Growth more than twice as great as US growth

The Fourth District states of Ohio, Kentucky,
Pennsylvania, and West Virginia stand out because
they are all in the lowest quintile of the 50 states
with respect to the growth in the number of business establishments over this period. Ohio is ranked
48th, West Virginia, 47th, Pennsylvania, 46th, and
Kentucky, 43rd.

Private Establishment Growth
by Industry, 2001–2007:I
Ohio

U.S.

All private industries
Goods-producers
Manufacturing
Service-providers
Trade, transportation,
utilities
Information
Financial activities
Professional/business
services
Education/health
services
Leisure/hospitality
Other services
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22

Percent

Besides providing data on employment, the Quarterly Census of Employment and Wages (QCEW)
program also produces statistics on private business establishments. These statistics can tell us how
the number of private business establishments has
changed over time, as well as whether the number
is growing at different rates in different states. A
business establishment is defined as a location—a
store, an office, or a plant—where business activity
takes place. It may represent an entire firm or simply one location of multi-plant firm. The QCEW
includes all business establishments that employ at
least one worker, but excludes businesses without
employees.

The geographic distribution of establishment
growth is shown on the U.S. map below, as well.
Fast-growth states are generally located in the West
and South, while slow-growth states are in the
Northeast, the Great Lakes region, and the Upper
Midwest.
Comparing Ohio’s growth in the number of business establishments to the nation’s shows that
Ohio’s economy has generated less growth than
the overall U.S. economy in almost all industries.
24

Employment per Private Establishment,
2007:I
Jobs
17
16
15
14
13
12
11
10
9
8

MT ID ME CO WA AK RI SC NJ DE AR NM OK CA VA MA KS MO IA KY MN IL PA WI IN TN
WY CA VT OR SD NH FL ND UT NY WV MD CT LA MS HI NE NC MI DC AL AZ NV TX OH

Growth in the number of goods-producing business
establishments was –7.0 percent; the U.S. growth
rate was 6.0 percent. The difference is largely due
to strong growth in construction-related businesses.
Indeed, growth in manufacturing establishments
looks similar for Ohio (-11.0 percent) and the
United States as a whole (-9.4 percent).
Somewhat surprisingly, the only sector where
Ohio’s growth in the number of business establishments exceeded the nation’s was in the information sector. For the United States as a whole, the
number of establishments providing information
services actually fell from 2001 to the first quarter
of 2007, while in Ohio it actually rose. The reason
for this, in part, is that 2001 was close to the peak
of the Internet boom, and the number of information services firms had expanded markedly in some
states in the late 1990s but less so in Ohio. The
subsequent Internet bust affected information services more strongly in places where expansion had
been particularly strong, like California.
The final chart shows the average size of establishments, measured in terms of number of employees,
in the first quarter of 2007. Again, Ohio is in a
tail of the distribution. The average-sized business
in Ohio has 16 employees—the second-highest
average in nation. Only Tennessee averages a higher
number of employees at each establishment.

Regional Activity

Fourth District Employment Conditions
Unemployment Rates, Fourth District
and Ohio

12.03.07
By Tim Dunne and Kyle Fee

Percent
8
7
Fourth District

a

6
5
United States
4
3
1990 1992 1994 1996 1998 2000 2002 2004 2006
a. Seasonally adjusted using the Census Bureau’s X-11 procedure.
* Shaded bars represent recessions. Some data reflect revised inputs,
reestimation, and new statewidecontrols. For more information, see
http://www.bls.gov/lau/launews1.htm.
Source: U.S. Department of Labor, Bureau of Labor Statistics.

The district’s unemployment rate rose to 5.7 percent for the month of September, an increase of 0.2
percentage point. The jump in the unemployment
rate can be attributed to the increase in the number of unemployed people (3.4 percent) outpacing
increases in the number of people employed (0.3
percent) and the labor force (0.7 percent). Compared to September’s national unemployment rate,
the district’s rate stood 1.0 percent higher, continuing the trend since early 2004 of being consistently
higher than the national rate. Year over year, the
Fourth District’s unemployment rate increased 0.3
25

Unemployment Rates, Fourth District
Regions
Percent
10
9

Fourth District Kentucky a

8

Fourth District Pennsylvania a

7
6
Ohio
5
4

Fourth District a

3
1990 1992 1994 1996 1998 2000 2002 2004 2006
a. Seasonally adjusted using the Census Bureau’s X-11 procedure.
* Shaded bars represent recessions. Some data reflect revised inputs,
reestimation, and new statewide controls. For more information, see
http://www.bls.gov/lau/launews1.htm.
Source: U.S. Department of Labor, Bureau of Labor Statistics.

Unemployment Rates,
September 2007
U.S. unemployment rate = 4.7%

4.0% - 5.0%
5.1% - 6.0%
6.1% - 7.0%
7.1% - 9.0%
9.1% - 11.0%
11.1% - 14.0%
Data are seasonally adjusted using the Census Bureau’s X-11 procedure.
Source: U.S. Department of Labor, Bureau of Labor Statistics.

percentage point, whereas the national unemployment rate increased 0.1 percentage point.
The 4.7 percent unemployment rate in Pennsylvania counties that are in the Fourth District is on
par with the national average. In contrast, all other
areas of the Fourth District—the eastern counties
of Kentucky, Ohio, and the northernmost counties of West Virginia—have unemployment rates
that are well above the national rate. For example,
the rate is 6.7 percent in Kentucky counties of the
Fourth District and 5.9 percent in Ohio. Looking
over a longer term, Fourth District Kentucky has
generally exhibited a higher unemployment rate
than Ohio or Fourth District Pennsylvania. While
Ohio experienced somewhat lower unemployment
rates than Fourth District Pennsylvania prior to the
2001 recession, Fourth District Pennsylvania’s unemployment rate has been consistently below that
of Ohio’s since 2004.
Of the 169 counties in the Fourth District, 13 had
an unemployment rate below the national average
in September, while 156 had a higher unemployment rate than the national average. Rural Appalachian counties continue to experience high levels
of unemployment; Fourth District Kentucky is
home to 9 counties with double-digit unemployment rates. Unemployment rates for the District’s
major metropolitan areas ranged from a low of 4.4
percent in Pittsburgh to a high of 6.5 percent in
Toledo.
Lexington (1.5 percent) is the only metropolitan
area where nonfarm employment grew faster than
the national average (1.2 percent) over the past 12
months. Conversely, Cleveland, Dayton, and Toledo have not seen any change in nonfarm employment over the same time period.
Employment in goods-producing industries increased in Akron (1.7 percent), while all other
Fourth District metropolitan areas lost goodsproducing jobs. Nationally, employment in goodsproducing industries declined 1.2 percent.
Lexington showed the strongest growth in serviceproviding employment (2.0 percent) and was the
only large metro area in the Fourth District to top
the national average (1.6 percent). Information
26

services expanded strongly in Toledo (7.5 percent)
and Lexington (6.5 percent) but contracted in
Cincinnati (–3.2 percent) and Columbus (–0.5
percent). Employment in professional and business
services grew faster than the nation’s 1.9 percent in
Columbus (2.3 percent), Toledo (2.9 percent), and
Akron (2.8 percent). Cincinnati posted stronger job
gains in the education and health services industry
(3.3 percent) than the nation (3.1 percent) over the
past 12 months. All other metropolitan areas in the
Fourth District posted modest gains in the education and health services industry except for Dayton.

Payroll Employment by Metropolitan Statistical Area
12-month percent change, August 2007
Cleveland
Total nonfarm

Columbus Cincinnati Pittsburgh

Dayton

Toledo

Akron

Lexington

U.S.

0.0

0.8

0.1

0.3

0.0

0.0

1.1

1.5

1.2

Goods-producing

-1.2

-1.2

-2.3

-1.3

-0.1

-2.3

1.7

-0.4

-1.2

Manufacturing

-2.1

-1.2

-1.6

-0.7

-0.4

-2.6

1.5

-1.4

-1.4

Natural resources, mining, construction

1.8

-2.2

-3.9

-2.3

0.6

-1.3

2.5

2.3

-0.9

0.3

1.1

0.6

0.5

0.0

0.6

1.0

2.0

1.6

0.1

0.0

-0.4

-0.4

-1.7

-1.2

0.6

-1.5

1.1

Service-providing
Trade, transportation, utilities
Information

1.1

-0.5

-3.2

-0.9

1.0

7.5

2.2

6.5

1.2

Financial activities

-0.1

-1.2

-1.1

-0.4

2.5

-0.8

0.0

0.0

0.4

Professional and business services

1.0

2.3

0.4

1.3

-0.2

2.9

2.8

-0.3

1.9

Education and health services

1.2

1.2

1.3

1.8

0.0

1.0

1.5

1.9

3.1

Leisure and hospitality

0.2

2.7

1.9

0.4

0.3

-1.2

0.0

7.3

3.1

Other services

0.7

-0.8

0.0

-1.4

0.6

0.7

0.0

-1.0

0.7

1.2

2.0

-0.1

0.2

0.6

1.7

0.2

4.8

0.9

6.0

5.0

5.3

4.4

6.1

6.5

5.6

5.0

4.7

Government
August unemployment rate (sa, percent)

Source: U.S. Department of Labor, Bureau of Labor Statistics.

27

Banking and Financial Institutions

Fourth District Community Banks
12.21.07
by Ed Nosal and Saeed Zaman

Annual Asset Growth
Percent

Most of the 283 banks headquartered in the Fourth
Federal Reserve District as of September 30, 2007,
are community banks—commercial banks with
less than $1 billion in total assets. There are 259
such banks headquartered in the District, a number
that, as a result of bank mergers, has declined since
1998, when there were 337.

5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-5.0
-6.0
1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
a. Growth rates for 2007:I, 2007:II, and 2007:III are annualized year-to-date asset
growth. For other years, fourth-quarter year-over-year rates are used.
Source: Authors’ calculation from Federal Financial Institutions Examination Council,
Quarterly Banking Reports of Condition and Income.

Fourth District Community Banks by
Asset Size
Number of community banks
200
175

Assets < $100 million
Assets $100 million-$500 million
Assets $500 million-$1 billion

150
125
100
75
50
25
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Income Stream
Percent
5.0

Percent of assets
1

4.5
4.0

Net interest margin

3.5
3.0

ROA before tax and
2.5 extraordinary items

0.9
Income earned
but not received

0.8
0.7

2.0
0.6

1.5
1.0

0.5

0.5
0.0

0.4
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3

Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Total asset growth for Fourth District community
banks decreased 0.68 percent in the third quarter of
2007 (annualized rate), but this number has fluctuated in the past few years. A decline in the community banking assets within the district does not
necessarily mean that any banks closed shop or left
the district. A community bank might no longer be
included among the Fourth District’s banks if it is
acquired by bank holding company that is headquartered in another district or if it merges with
another Fourth District bank and the total assets of
the merged institution push it above the $1 billion
cutoff. For example, community bank assets declined sharply in 2000 and 2004—years in which a
great number of institutions consolidated or left the
population of Fourth District community banks.
The structure of the market has changed since
2000, when the majority of the community banks
in the district had less than $100 million in total
assets. Since then, banks in the mid-size category
($100 million to $500 million) have constituted
the majority.
The income stream of Fourth District community
banks has been deteriorating slightly in recent
years. Return on assets (ROA) fell from 1.7 percent in 1998 to 1.3 percent in the third quarter of
2007. (ROA is measured by income before tax and
extraordinary items, because one bank’s extraordinary items can distort the averages in some years.)
The decline is in part due to weakening net interest
margins (interest income minus interest expense divided by earning assets). Currently at 3.63 percent,
the net interest margin is at its lowest level in over
28

eight years.

Balance Sheet Composition
Percent of assets
52
Real estate loans
42

32

22

12

Consumer loans
Mortgage-backed loans
Commercial loans

2
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Fourth District community banks are heavily
engaged in real estate-related lending. In the third
quarter of 2007, 51.4 percent of their assets were
in loans secured by real estate. Including mortgagebacked-securities, the share of real estate-related
assets on the balance sheet was 58.4 percent.

Liabilities
Percent of liabilities
90
80
70 Total time deposits
60
50
40
30
a,b
20 Total demand deposits
FHLB advances
10
Total brokered deposits
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
a. Federal Home Loan Bank advances.
b. Data start in 2001.
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Problem Loans
Percent of loans
5.0
4.5

Commercial loans

4.0
3.5
3.0
2.5
2.0
1.5

Real estate loans

1.0
0.5
0.0

One probable cause of concern is the elevated level
of income earned but not received. At 0.68 percent,
this figure is at its highest level in 10 years. The last
time it was close to this figure was in 2001. If a
loan agreement allows a borrower to pay an amount
that does not cover the interest accrued on the loan,
the uncollected interest is booked as income even
though there is no cash inflow. The assumption
is that the unpaid interest will eventually be paid
before the loan matures. However, if an economic
slowdown or other some other factor forces an
unusually large number of borrowers to default on
their loans, the bank’s capital may be impaired.

Consumer loans
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3

Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income

Fourth District community banks finance their assets primarily through time deposits (about 77 percent of total liabilities). Brokered deposits —which
are a riskier type of deposit for banks because they
chase higher yields and are not a dependable source
of funding—are used less frequently. Federal Home
Loan Bank (FHLB) advances are loans from the
FHLBs that are collateralized by the bank’s small
business loans and home mortgages. Although they
have gained some popularity in recent years, FHLB
advances are still a small fraction of community
banks’ liabilities (7.8 percent of total liabilities) and
remain an important source of backup liquidity for
most Fourth District community financial institutions.
Problem loans include loans that are past due for
more than 90 days but are still receiving interest
payments , as well as loans that are no longer accruing interest. Problem commercial loans rose sharply
in 2001 and have returned to their 1998-2000
levels in recent years. Currently, 2.52 percent of all
commercial loans are problem loans. Problem real
estate loans are only 1.21 percent of all outstanding
real estate-related loans, but they are at their highest
level in over 9 years. Problem consumer loans continued their downward trend in the third quarter
29

of 2007. Currently, 0.43 percent of all outstanding
consumer loans (credit cards, installment loans,
etc.) are problem loans.

Net Charge-Offs
Percent of loans
4.0
3.5
3.0
2.5
Commercial loans
2.0
1.5
1.0
Consumer loans
0.5
Real estate loans
0.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Capitalization
Percent
12.0
11.5
11.0
10.5

Risk-based capital ratio

10.0
9.5

Leverage ratio

9.0
8.5
8.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

Coverage Ratio a
Dollars
25

20

15

Net charge-offs are loans that are removed from the
balance sheet because they are deemed unrecoverable minus the loans that were deemed unrecoverable in the past but are recovered in the current
year. As with problem loans, there was a sharp increase in the net charge-offs of commercial loans in
2001 and 2002. Consumer loans followed a similar
path but have remained slightly elevated since the
recession. Fortunately, the charge-off level for commercial loans has retuned to its pre-recession level.
Net charge-offs in the third quarter of 2007 were
limited to 0.66 percent of outstanding commercial
loans, 0.71 percent of outstanding consumer loans,
and 0.13 percent of outstanding real estate loans.
Capital is a bank’s cushion against unexpected
losses. The recent trend in capital ratios indicates
that Fourth District community banks are protected by a large cushion. The leverage ratio (balance
sheet capital over total assets) was above 10 percent,
and the risk -based capital ratio (a ratio determined
by assigning a larger capital charge on riskier assets)
was about 11 percent in the third quarter of 2007.
The growing ratios are signs of strength for community banks.
An alternative measure of balance sheet strength
is the coverage ratio. The coverage ratio measures
the size of the bank’s capital and loan -loss reserves
relative to its problem assets. As of the third quarter
of 2007, Fourth District community banks had
almost $15 in capital and reserves for each $1 of
problem assets. While the coverage ratio declined
considerably following the high charge-off periods
of the early 2000s, balance sheets are still strong.

10

5

0

1998 1999 2000 2001 2002 2003 2004 2005 2006 07-q1 07-q2 07-q3

a. Ratio of capital and loan loss reserves to problem assets.
Source: Authors’ calculation from Federal Financial Institutions Examination
Council, Quarterly Banking Reports of Condition and Income.

30

Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland.
Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted
provided that the source is credited.
If you’d like to subscribe to a free e-mail service that tells you when Trends is updated, please send an empty email message to econpubs-on@mail-list.com. No commands in either the subject header or message body are required.
ISSN 0748-2922

31