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1
•

•

The Economy in Perspective

FRB Cleveland • October 2004

Normalization, of a sort…The current expansion,
which began in November 2001, followed a mild
eight-month contraction (since 1945, the average
length of contractions has been 10 months). In one
sense, all contractions are alike because the
National Bureau of Economic Research (NBER) determines the dates of business cycle peaks and
troughs by applying a standard set of measurement
criteria. In a nutshell, the NBER defines a contraction as a period of significant decline in economic
activity, lasting more than a few months, and in
which the decline is spread across the economy
and evident in spending, income, sales, production,
and employment. An expansion begins when these
patterns no longer are evident, although the NBER
notes that when an upturn begins, economic activity is “…typically below normal and sometimes remains so well into the expansion.”
Many aspects of economic activity have returned
to normal, or nearly normal, conditions. Orders and
shipments for manufactured goods have been
steadily rising during the past year as business
firms, flush with cash, have finally begun to step up
the pace of their capital spending. Households have
continued buying homes and automobiles in large
quantities, but the pace of overall retail sales has
been somewhat more subdued. Capacity utilization
has been climbing, and the overall rate is now on
track with the average of past expansions. Most economic forecasters expect the economy to extend its
three-year-long expansion into 2005 and beyond.
The economy seems to be on a sustainable expansion track, inflation and inflation expectations are
low, and the Federal Reserve has been patiently removing its policy accommodation during the past
several months.
Labor markets have performed in a conspicuously atypical manner. Typically, employment continues to fall in the early stages of an expansion, but
stops falling in about a year; after two years, employment returns to its prerecession peak. In this
expansion, payroll employment did not stop falling
for nearly two and one-half years; it has yet to
return to its previous peak. The weak pattern
seems fairly broad based, suggesting that whatever
forces are holding back the pace of net job creation
are affecting most industries and regions.
A number of explanations have been advanced
for the unusually slow rate of job growth, but analysts have yet to reach a consensus. Some focus on

subpar total demand in the economy, while others
consider possible mismatches between the labor
skills that are in demand by employers and the
labor skills being offered in the market. In this view,
some employers are constrained from hiring by
shortages in the skills they seek, while others can
choose workers from an abundant pool. Another
analysis holds that job creation, calculated from
data collected through the household survey, is
stronger than the payroll data indicate. The available evidence does not yet provide a firm explanation for all the facts, and it may well be that no
convincing explanation will emerge at all, or at least
not without the passage of more time.
In the interim, although some observers question the very sustainability of the expansion in the
face of slow employment growth, most others seem
to have accepted the notion that the expansion will
continue despite the labor market picture. After all,
the unemployment rate has gradually declined during the expansion to 5.4%, half a percentage point
below its 40-year average. From this perspective,
labor markets may be somewhat closer to being in
balance than they would be if employment growth
were the sole criterion for normalcy.
It is no secret that advances in information processing and telecommunications technologies have
profoundly affected how, where, and what businesses
produce. These changes have created incentives to
replace old capital with new, an activity that proceeded at a feverish pace during the last expansion.
At the same time, demand has risen for skills that
complement the new technologies and declined for
the skills that are most wedded to the old.
When asked why hiring is atypically slow, some
business executives say they are being cautious, but
others say they can meet growing demand without
adding more workers. To achieve this result businesses may acquire more productive equipment,
restructure their processes, or do both. Whatever
they do, they are finding ways to increase their productivity and, as we know, productivity in this
expansion has been growing abnormally fast.
Perhaps all of this just goes to show that labeling
business cycles and their components “normal” or
“typical” loses its value rather quickly. As Sigmund
Freud once said, “Every normal person, in fact, is
only normal on the average.” His observation may
apply as much to economies as to people.

2
•

•

Inflation and Prices
Dollars per barrel
50 WEST TEXAS INTERMEDIATE OIL PRICES AND FORECAST c

August Price Statistics
Percent change, last:
a
a
a
1 mo. 3 mo. 12 mo. 5 yr.

2003
avg.

45
Consensus

Highest
10%

Consumer prices
All items

0.6

1.3

2.7

2.5

1.9

Less food
and energy

0.6

1.0

1.7

2.1

1.1

Medianb

3.0

2.3

2.5

2.9

2.1

30
Lowest
10%

Producer prices
Finished goods –0.8 –1.1

3.4

2.2

4.4

Less food and
energy

1.5

1.0

1.1

–1.6

0.5

10
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

12-month percent change
4.25 CPI AND CPI EXCLUDING FOOD AND ENERGY

12-month percent change
3.50 PCE AND PCE EXCLUDING FOOD AND ENERGY

4.00

3.25

3.75
Median CPI b
3.50

3.00
2.75

3.25
3.00

PCE

2.50

CPI

2.25

2.75
2.00
2.50
1.75
2.25
1.50

2.00

1.25

1.75

1.00

1.50

PCE excluding food and energy

1.25

0.75

CPI excluding food and energy

1.00
1995 1996

1997

1998

1999

2000

2001

2002

2003

2004

0.50
1995 1996

1997

1998

1999

2000

2001

2002

2003

2004

FRB Cleveland • October 2004

a. Annualized.
b. Calculated by the Federal Reserve Bank of Cleveland.
c. Blue Chip panel of economists.
SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and Federal Reserve Bank of Cleveland.

The August inflation data show continued moderation in retail prices.
The Consumer Price Index (CPI) rose
a mere 0.6% (annualized rate) during
the month, reversing August’s 0.6%
decline. Energy costs dropped at a
3.1% annual rate (the second consecutive monthly decline), even as oil
prices approached their forecasted
peak. The core CPI, which excludes
the volatile food and energy components, also rose—at a 0.6% annualized rate, its slowest monthly growth

rate this year—while the median CPI
increased at a 3.0% annualized rate.
Longer-term trends in the price
measures continue to indicate that
retail price increases are stabilizing
despite escalating energy prices. The
CPI increased 2.7% from August 2003,
less than July’s 12-month growth rate
of 3.0%. The 12-month core CPI
growth rate fell 0.1 percentage point
(pp) to 1.7%, while the median CPI’s
rose 0.1 pp to 2.5%. The Personal Consumption Expenditures Price Index

(PCE), which measures prices in an
alternative consumer goods market
basket, reveals similar patterns. The
PCE increased 2.1% since August 2003,
down from July’s 12-month growth
rate of 2.4%, while the 12-month
growth rate of the core PCE remained
stable at 1.4%.
Beyond the near-term price disturbances, caused by oil among other
important factors, are the longerterm issues that could accelerate
inflation—a persistent rise in the

(continued on next page)

3
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•

Inflation and Prices (cont.)
Four-quarter percent change (seasonally adjusted annualized rate)
10 COMPENSATION AND PRODUCTIVITY AND FORECASTS a

Four-quarter percent change (seasonally adjusted annualized rate)
6 UNIT LABOR COSTS AND FORECAST a
5

8
4

Compensation per hour

2
4

0
2
Output per hour

–1

–2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

12-month percent change
3.5 CORE CPI DECEMBER GROWTH RATE AND FORECAST a
Actual
Consensus forecast

3.0

Highest 10%
2.5

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

12-month percent change
4.0 CORE CPI GROWTH RATE FORECAST ACCURACY b,c
3.5
Actual
Consensus forecast
3.0

Lowest 10%
2.5

2.0
2.0
1.5
1.5
1.0
1.0
0.5

0.5
0

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

2000

2001

2002

2003

2004

FRB Cleveland • October 2004

a. Blue Chip Economic Indicators, September 10, 2004.
b. Blue Chip panel of economists.
c. Forecasts reported in June, July, or August for the 12-month growth rate in December of the following year.
SOURCES: Department of Labor, Bureau of Labor Statistics; and Blue Chip Economic Indicators, July 10, 1999, August 10, 2000, June 10, 2001,
August 10, 2002, June 10, 2003, and September 10, 2004.

overall level of prices. Among the
longer-term factors, economists often
look to patterns in unit labor costs—
the difference between the growth
rate of worker compensation and the
growth rate of their productivity.
Indeed, many economists credit
much of the current expansion’s relatively modest inflation performance to
strong U.S. labor productivity growth,
which has exceeded the growth of
worker compensation over much of
the past four years. In other words, the

trend in U.S. unit labor costs has been
negative since 2001, which may have
put substantial downward pressure on
U.S. prices over this period. The consensus view among economists, however, is that this pattern of strong
growth in productivity relative to compensation will not persist much longer
and, indeed, may have turned around
already. According to Blue Chip Economic Indicators, unit labor costs are
now thought to be trending higher
and should top 2% by year’s end.

The stronger pace of unit labor
costs is consistent with economists’
expectation that the growth rate of
the core CPI will also top 2% this
year and will hold there in 2005,
higher than the annual core CPI
growth rates in 2002 and 2003. However, in each of the previous two
years, economists have overpredicted the core CPI’s growth rate by
a substantial margin.

4
•

•

Monetary Policy
Billions of dollars
850 THE MONETARY BASE

Sweep-adjusted base growth, 1999–2004 a
15
12
Sweep-adjusted base b
9

800

750

700

Sweep-adjusted M1 growth, 1999–2004 a
10
8

2.0
6%
1.8

7%
7%

2
0
8%

6
3
0

Trillions of dollars
2.2 THE M1 AGGREGATE

1.6

Monetary base

650

Sweep-adjusted M1 b

5%
2%
1.4

12%

600

M1
1.2

550

1.0

500
1999

2000

2001

2002

2003

1999

2004

Trillions of dollars
6.8 THE M2 AGGREGATE
7%
M2 growth, 1999–2004 a
12

6.2

4%
10%

12%

0
8%
8%

5.0
5%

8%
5%
4.4

3.8
1999

2001

2000

2001

2002

2003

2002

2003

2004

Growth Rates of Monetary Components
(percent)
Annual
2001 2002

Average,
YTD 1999–
2003 2004 2003

2.1
1.7
6.1
4.3

8.8
8.5
10.2
9.1

7.8
6.7
6.7
8.2

6.2
7.5
5.3
5.9

6.3
7.3
4.7
5.4

7.5
5.9
6.9
7.7

–6.2

8.7

–6.6

8.2

7.7

–0.6

11.9

12.6

15.3

9.8

13.8

13.0

–6.8

5.2

–1.5

7.3

1.7

–0.1

11.4

7.8

–6.5

–11.6 –11.9

2.9

9.6

–5.0

–9.1

–9.3

–2.8

–2.9

6.7

21.7

21.1

15.2

11.4

15.0

5.6

2000

1999
Monetary
12.7
basec
M1c
5.0
M2
6.2
Currency
11.1
Total
reserves
–7.2
Cumulative
sweeps
15.6
Check and
demandd –4.8
Money market
funds
13.6
Small time
deposits –0.7
Savings
deposits 10.1

2000

2004

FRB Cleveland • October 2004

a. The far-right bar refers to the most recent data available. Growth rates are calculated on a fourth-quarter over fourth-quarter basis. The 2004 growth rates for
the sweep-adjusted monetary base and sweep-adjusted M1 are calculated on a July over 2003:IVQ basis. The 2004 growth rate for M2 is calculated on a
September over 2003:IVQ basis. Data are seasonally adjusted.
b. The sweep-adjusted base contains an estimate of required reserves saved when balances are shifted from reservable to nonreservable accounts. Sweepadjusted M1 contains an estimate of balances temporarily moved from M1 to non-M1 accounts.
c. The monetary base and M1 are sweep-adjusted.
d. Refers to demand deposits and other checkable deposits.
SOURCE: Board of Governors of the Federal Reserve System, “Money Stock Measures,” Federal Reserve Statistical Releases, H.6.

Growth in the sweep-adjusted monetary base (total currency in circulation
plus total reserves including depository institutions’ vault cash) has
increased its annualized year-to-date
growth rate to 6.3% in 2004, up
sharply from its year-to-date rate of
3.9% in May. This rise brings it closer
to its five-year average of 7.5%. Current year-to-date annualized growth is
less than 0.1% above 2003. Surprisingly, sweep-adjusted base growth
increased slightly despite declines in
total reserves growth (8.2% in 2003
and 7.7% currently) and currency

growth (5.9% in 2003 and 5.4% currently). The cause is strong growth in
cumulative sweeps—13.8% currently
and 9.8% in 2003.
M1 (currency in the hands of the
public plus demand and other checkable deposits) is a slightly broader
monetary aggregate. So far in 2004,
sweep-adjusted M1 has had an annualized year-to-date growth rate of 7.3%,
down slightly from the 7.5% growth it
registered in 2003, and higher than its
five-year average of 5.9%. The slowdown in M1 growth over the past year
results primarily from slower growth in

demand deposits and other checkable
deposits, which make up nearly half of
M1. Their year-to-date annualized
growth rate is 1.7%, compared to 7.3%
in 2003.
The broader monetary aggregate,
M2 has grown 4.7% in 2004 to date,
2.2 percentage points below its 1999–
2003 average but only 0.6% less than
its growth in 2003. Slower M2 growth
resulted from continued decline in
retail money market mutual funds.
Although the decline in small time
deposits also persisted, it has slowed
since 2003.

5
•

•

Money and Financial Markets
Percent
8 RESERVE MARKET RATES

Percent
2.75 IMPLIED YIELDS ON FEDERAL FUNDS FUTURES

2.50

Effective federal funds rate a

September 29, 2004

2.25

6
Intended federal funds rate b

August 11, 2004 c

2.00

1.75

June 14, 2004
September 22, 2004 c

Discount rate b
1.50

3
Primary credit rate b

July 1, 2004 c

1.25

1.00
0.75

0
2000

2001

2002

2003

May

2004

July

Sept.

Nov.

Jan.

Mar.

Probability d
1.0 IMPLIED FEDERAL FUNDS RATE CHANGES IN NOVEMBER

Percent, weekly average
6.0 YIELD CURVE e,f

0.9

5.5

September 22, 2004

5.0

0.73
4.5

September 29, 2004

0.7

July

June 18, 2004

0.81

September 15, 2004
0.8

May
2005

2004

September 24, 2004 g
4.0

0.6

0.57

August 13, 2004 g

3.5
0.5
0.4

3.0

0.38

July 2, 2004 g
2.5

0.3

0.24

2.0
0.18

0.2

1.5

0.1

0.05

0
No change

25 basis point
increase

1.0
0.02

0.01

50 basis point
increase

0.5
0

10
Years to maturity

FRB Cleveland • October 2004

a. Weekly average of daily figures.
b. Daily observations.
c. One day after FOMC meeting.
d. Probabilities are calculated using prices from options on November 2004 federal funds futures that trade on the Chicago Board of Trade.
e. All yields are from constant-maturity series.
f. Average of the week ending on the date shown.
g. First weekly average available after the Federal Open Market Committee meeting.
SOURCES: Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15; Chicago Board of Trade;
and Bloomberg Financial Information Services.

On September 21, the Federal Open
Market Committee (FOMC) raised
the target federal funds rate to 1.75%,
25 basis points (bp) higher than the
target established on August 10. Following the decision, the Federal
Reserve’s Board of Governors raised
the primary credit rate 25 bp to
2.75%. The next probable move will
occur in November 2004, as implied
by yields on federal funds futures.
The probability of a 25 bp increase at
the November meeting (there is no
meeting in October) was estimated at

81% on September 29, compared to
57% on September 15, a week before
the previous meeting.
The FOMC stated that “even after
this action, the stance of monetary
policy remains accommodative” and,
together with steady underlying productivity growth, supports economic
activity. The FOMC also believes that
“output growth appears to have
regained some traction” and that
“labor market conditions have improved modestly” despite the hike in
energy prices.

Higher energy prices did not seem
to increase long-term inflation expectations. The yield curve has flattened
continuously over the last few months
and over the past year. The rate reduction was most significant at the long
end. The 10-year rate moved down 24
bp from August’s meeting and 59 bp
from June’s.
The increases in the federal funds
rate appear to reinforce public confidence that the Fed will not let inflation accelerate.

6
•

•

Oil Prices, Monetary Policy, and Recessions
Percent, quarterly average
Dollars per barrel
50
20 OIL PRICES AND EFFECTIVE FEDERAL FUNDS RATE a
18
Effective federal funds rate

16
14

12-month percent change
20 OIL PRICES AND INFLATION

Dollars per barrel
50

West Texas intermediate crude oil price

CPI

0
3/71

3/75

3/79

3/83

3/87

3/91

3/95

12-month percent change
10 FUTURE OIL PRICES AND INFLATION

3/99

15
Core CPI b

5
0
3/71

3/03

Dollars per barrel
50

3/75

3/79

3/83

3/87

3/91

3/95

Percent
10 FUTURE OIL PRICES AND HOUSEHOLD
INFLATION EXPECTATIONS
9

3/99

3/03

Dollars per barrel
50

6
12-month futures c

30
12-month futures c

Core CPI b

2
CPI

1
0
12/88

12/90

12/92

12/94

12/96

12/98

12/00

12/02

Household inflation expectations one year ahead d

5
0

12/88

12/90

12/92

12/94

12/96

12/98

12/00

12/02

FRB Cleveland • October 2004

a. Shaded bars indicate periods of recession.
b. Excluding food and energy.
c. Light sweet crude oil price futures.West Texas intermediate crude oil qualifies for delivery.
d. Mean expected change as measured by the University of Michigan’s Survey of Consumers.
SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve
Statistical Releases, H.15; University of Michigan; and Bloomberg Financial Information Services.

Oil price increases seem to have
accompanied every recession since
1971. Yet concluding that oil price
shocks cause recessions is problematic because increases in the funds
rate also have tended to precede recessions during this period. Are recessions caused by spikes in oil
prices or by sharp increases in monetary policy?
Some analysts blame oil, but only indirectly. They conclude that recessions
are caused not by oil price shocks but
by the Federal Reserve’s tendency to
tighten monetary policy in response to

those shocks. The large funds rate increases preceding the 1975 and 1979
recessions are good examples. The
funds rate increased dramatically as
inflation took off during these periods,
but since then there has been virtually
no correlation between oil prices
and inflation.
Possibly, rising oil prices cause
inflation only if they are expected to
be permanent. Although oil price
futures are imperfect predictors of
spot prices, we look to see if there
is any correlation between inflation
and the oil price increases that are
expected to occur 12 months out.

There does seem to be a slight correlation between expected inflation
and future oil prices.
Although the data suggest that
there is a small correlation between
inflation and oil price increases, it is
doubtful that oil was the primary
cause of the huge inflation spikes of
the 1974 and 1979 recessions. The
question of whether recessions result
from funds rate increases or from oil
price increases is even more difficult.
Perhaps recessions are caused by
a confluence of both factors—the
so-called perfect storm.

7
•

•

Expected Inflation and the TIIS Market
Percent
8 EXPECTED INFLATION OVER THE NEXT 10 YEARS

Percent
8 10-YEAR TIIS AND 10-YEAR TREASURY RETURNS

10-year Treasury returns
Households’ inflation expectations over the next five to 10 years a
5

10-year TIIS returns

SPF expected inflation over the next 10 years b

0
12/91

12/93

12/95

12/97

12/99

12/01

2/97

12/03

2/98

2/99

2/00

2/01

2/02

2/03

Percent
4.0 EXPECTED INFLATION, TIIS-DERIVED AND SPF

Expected inflation spread, percent
2.5 LIQUIDITY PREMIUM AND SPREAD BETWEEN
TIIS-DERIVED AND SPF EXPECTED INFLATION c

3.5

2.0

2/04

3.0
1.5
SPF expected inflation over the next 10 years b
2.5
1.0
2.0
0.5
1.5
0
1.0
10-year TIIS-derived expected inflation
–0.5

0.5

–1.0

0
2/97

2/98

2/99

2/00

2/01

2/02

2/03

2/04

0.1

0.2
Liquidity premium, percent

0.3

0.4

FRB Cleveland • October 2004

a. Mean expected change in consumer prices as measured by the University of Michigan’s Survey of Consumers.
b. Median expected change in CPI as measured by the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SPF).
c. Liquidity premium is calculated as the difference between yields of on-the-run versus off-the-run conventional Treasuries, using data from the Board of
Governors.
SOURCES: Board of Governors of the Federal Reserve System; Federal Reserve Bank of Philadelphia; University of Michigan; and Bloomberg Financial
Information Services.

Ascertaining long-term inflation expectations is notoriously difficult. Survey
measures are available but not necessarily reliable. When surveyed, households report that they expect inflation
to register 3.1% over the next five to 10
years. But the Survey of Professional
Forecasters indicates that they expect
inflation to register only 2.5% over the
next 10 years. Households’ inflation
expectations, in fact, are consistently
about 50 basis points (bp) higher than
professional forecasters’.
Treasury Inflation-Indexed Securities
(TIIS), introduced in 1997, promised

investors a real return without the
inflation premium present in ordinary Treasury notes. In principle, subtracting TIIS from nominal T-notes of
the same maturity should give economists a market-based measure of
expected inflation, but these securities have not achieved that goal.
Expected inflation from the TIIS market has tended to be around 50 bp
lower than professional forecasters’
expectations and a full percentage
point lower than households’.
One reason expected inflation
from TIIS data might underestimate
actual expected inflation is that the

market for TIIS is less liquid than
other government bonds; thus, their
real returns are overstated. It is difficult
to estimate the magnitude of the
liquidity premium, which probably
varies over time. Fortunately, there is a
measure of the liquidity premium for
T-notes; it is their on-the-run/off-therun spread, which may be correlated
with the liquidity premium in the TIIS
market. Indeed, this appears to be so.
This premium is highly correlated with
the difference between Blue Chip forecasts of expected inflation and those
derived from the TIIS market.

8
•

•

Predicting Oil Prices
Dollars per barrel
50 CRUDE OIL PRICES a

Futures Forecast Errorsa,c

Three
months

Six
months

Mean

0.76

1.61

2.83

Median

0.54

1.47

1.36

Maximum

14.38

14.87

22.09

Minimum

–9.25

–8.65

–7.22

Futures Prices

West Texas intermediate spot price b

12
months

Futures prices
25

Standard
deviation

3.01

4.46

6.05

Number of
observations

217

214

185

15
12/01

6/02

12/02

6/03

12/03

6/04

12/04

6/05

Correlation among Spot, Futures, and Future
Spot Pricesa,b

Futures prices

Current and future spot prices
Two mo. Five mo. 11 mo.
Spot
spot
spot
spot

One month

0.998

Three months

0.989

0.890

Six months

0.972

0.886

0.736

12 months

0.938

0.862

0.722

0.466

Spot

1.000

0.882

0.715

0.462

Dollars per barrel, daily
50 CRUDE OIL PRICES
45
40
35

West Texas Intermediate spot price b

30
25
20
15

12-month futures

10
5
0
1990

1992

1994

1996

1998

2000

2002

2004

FRB Cleveland • October 2004

a. Data are taken from the last trading day for one-month-ahead futures, typically the third business day before the 25th of the month.
b. For days before the 25th of the month, the spot price measures oil that is deliverable from the 25th of the current month to the 25th of the next month.
c. Prices are in dollars per barrel.
SOURCES: New York Mercantile Exchange; and Bloomberg Financial Information Services.

Bad as the economic consequences
of higher oil prices may be, the fog
surrounding their future path compounds the problem. To gain some
clarity, many observers have looked
to oil futures prices as a quick and
easy means of forecasting where
spot oil prices are headed. Unfortunately, futures prices are not very
accurate predictors.
Futures markets in crude petroleum exist to provide producers,
traders, and major users of oil with
a low-cost way to hedge against

unanticipated changes in oil prices.
In providing the hedge, futures markets immediately fold all available
information that is relevant to the
pricing of crude into current futures
prices. Their informational efficiency,
however, does not necessarily make
futures prices good predictors.
Futures prices are statistically correlated with the spot prices that they
presumably predict, but none of
these correlations is substantially
higher than the correlation between
current and future spot prices. This
indicates that spot prices and futures

prices both incorporate the same
information about prospective
changes in oil prices. Moreover, the
prediction errors associated with oil
futures are statistically large, and the
further out one looks, the larger the
forecast errors grow. This is not surprising, but the forecast errors also
indicate that oil futures prices typically underpredict future spot prices.
Large, skewed prediction errors suggest the need for caution when using
futures markets to divine what path
oil prices will take.

9
•

•

The U.S. Current Account Deficit
Billions of dollars, annualized
200 200

Percent of GDP
2 CURRENT ACCOUNT BALANCE
1

100

–1

–100

–2

–200

–3

–300

–4

–400

–5

–500

–6

–600

Billions of dollars
600 NET FINANCIAL FLOWS a

Offical capital
All other b

400

Total

200

–700

–7
1990

1992

1994

1996

1998

2000

Percent of GDP
20 NET INTERNATIONAL INVESTMENT POSITION c

2002

2004

Trillions of dollars
2.0

1.5

1.0

0.5

–5

–0.5

–10

–1.0

–15

–1.5

–20

–2.0

–25

–2.5

–30

–3.0

–200
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Percent of GDP
12 SAVING AND INVESTMENT

Net domestic investment

–35

–3.5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

4
Net saving
2

0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

FRB Cleveland • October 2004

a. Includes capital account transactions.
b. Includes direct investment, portfolio investment, other miscellaneous financial flows, and capital account transactions.
c. The net international investment position for 2004 is estimated by adding the annualized current account deficit for the first half of 2004 to the investment
position for 2003. GDP for 2004 is estimated by averaging GDP for the first two quarters with Blue Chip forecasts for the last two quarters.
SOURCE: U.S. Department of Commerce, Bureau Economic Analysis.

The U.S. current account deficit
reached a record high in 2004:IIQ,
renewing concerns that its continued
growth could cause a flight from the
dollar, adversely affecting economic
growth, and complicating monetary
policy.
The U.S. has financed a long string
of current account deficits by issuing
net financial claims to foreigners,
including official claims to foreign governments. As a consequence, foreigners now hold substantially more
claims on the U.S. than we hold on

the rest of the world. This is shown by
our negative net international investment position, which could equal
$3 trillion or roughly 25% of our GDP
by year’s end.
The net international investment
position cannot fall indefinitely as
a share of GDP. Eventually, foreign
investors will become hesitant to add
any more dollar-denominated assets
to their portfolios, triggering a dollar
depreciation and a rise in U.S. real
interest rates. These adjustments will
probably shrink the current account

deficit, but they also can affect investment and prices in the U.S. We do
not know if, when, or how fast this
adjustment will take place.
Foreign investors’ attitudes may
depend on U.S. saving and investment. During much of the 1990s,
rapid growth in domestic saving and
investment—implying a rising potential for future growth—accompanied
an expanding U.S. current account
deficit. Since 2000, saving and investment have fallen relative to GDP, but
the trend may be reversing.

10
•

•

Economic Activity
Percentage points
4.0 CONTRIBUTION TO PERCENT CHANGE IN REAL GDP c

a,b,c

Real GDP and Components, 2004:IIQ
(Final estimate)

Annualized
Change, percent change, last:
billions
Four
of 2000 $
Quarter
quarters

Real GDP
87.2
Personal consumption 29.4
Durables
–0.8
Nondurables
0.7
Services
28.3
Business fixed
investment
34.9
Equipment
31.8
Structures
4.0
Residential investment 21.1
Government spending 10.7
National defense
2/3
Net exports
–30.2
Exports
19.4
Imports
49.6
Change in business
inventories
21.1

3.3
1.6
–0.3
0.1
2.7

4.8
3.6
5.4
4.7
2.7

12.4
14.2
6.9
16.5
2.2
1.9
__
7.3
12.6

10.8
13.9
1.3
13.2
1.6
3.8
__
10.8
10.7

Last four quarters
3.0

2004:IQ
2004:IIQ

Personal
consumption
2.0
Residential
investment

1.0

Exports

Government
spending

0
Business fixed
investment

Change in
inventories

–1.0

–2.0

Imports

–3.0

Percent change from previous year
7 REAL PERSONAL INCOME AND SPENDING TRENDS a,c

Percent change from previous quarter
8 REAL GDP AND BLUE CHIP FORECAST c
7
Final percent change
Blue Chip forecast d
6

Final estimate

6
Real disposable personal income

Real personal
consumption expenditures

5
4
4
3
3
2
2
1

0
IQ

IIQ

IIIQ
2003

IVQ

IIQ

IIIQ
2004

IVQ

IIQ
2005

2000

2001

2002

2003

2004

FRB Cleveland • October 2004

a. Chain-weighted data in billions of 2000 dollars.
b. Components of real GDP need not add to the total because the total and all components are deflated using independent chain-weighted price indexes.
c. Data are seasonally adjusted and annualized.
d. Blue Chip panel of economists.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; National Bureau of Economic Research; and Blue Chip Economic Indicators,
September 10, 2004.

According to the U.S. Commerce
Department’s final estimate, the
annualized growth rate of real GDP
in 2004:IIQ was 3.3%, up from the
preliminary estimate of 2.8%. This
increase resulted partly from upward
revisions to business inventories,
residential investment, and business
fixed investment. In addition, exports were higher and imports were
lower than originally reported, with
the revision increasing the change in
net exports by $8.4 billion.
Given its larger share, personal consumption is usually the component

with the largest positive contribution
to GDP. In 2004:IIQ, however, business
fixed investment’s contribution was
the largest (1.2 percentage points),
while personal consumption’s was 1.1
percentage points (pp). Exports were
unchanged from 2004:IQ, although
imports’ negative impact increased
0.31 pp.
The final growth estimate for
2004:IIQ was slightly higher than Blue
Chip forecasters’ prediction. They expect growth to be slightly higher over
the next four quarters, with estimates

coming in at or above 3.5% for each
quarter. If these predictions are correct, the economy should perform
well above the 30-year average in the
upcoming quarters.
Since the beginning of 2004, yearover-year-growth in both real disposable personal income and real
personal consumption expenditures
has slowed. Real disposable personal
income growth slowed by 2.7 pp
from August 2003 to August 2004,
while growth in real personal consumption expenditures slowed by
(continued on next page)

11
•

•

Economic Activity (cont.)
Percent change from previous business peak a
4
CAPACITY UTILIZATION: MANUFACTURING b

Billions of dollars
Billions of dollars c
375 MANUFACTURERS' INVENTORIES AND NEW ORDERS
490

2
Upper
0

1990–2001

365

481

355

472

345

463

–2
2001–present

–4

New orders
335

–6

454

Average

Inventories
325

445

315

436

–8

–10
–12

305
0

15 18 21 24 27
Months from previous peak

Percent change from previous quarter c
30 REAL BUSINESS FIXED INVESTMENT AND COMPONENTS

7/01

1/02

7/02

1/03

7/03

1/04

7/04

Billions of dollars c
1,200 CORPORATE PROFITS d
1,150

Total real business fixed investment

427
1/01

1,100
Structures

1,050

10
Equipment and software

1,000

950
900

–10
850
–20

800
750

–30
700
–40
1/00

650
7/00

1/01

7/01

1/02

7/02

1/03

7/03

1/04

7/04

1/00

7/00

1/01

7/01

1/02

7/02

1/03

7/03

1/04

7/04

FRB Cleveland • October 2004

a. Seasonally adjusted.
b. The shading represents a 95% confidence interval (the 1948–2000 average, plus or minus two times the standard error).
c. Seasonally adjusted annual rates.
d. Corporate profits with inventory valuation and capital consumption adjustments.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; U.S. Department of Labor, Bureau of Labor Statistics; and Federal Reserve Board.

a more modest 0.9 pp in the same
period.
Conditions in manufacturing have
improved markedly over the last
year. At 76.8%, manufacturing capacity utilization has now rebounded to
the level last recorded at the beginning of the most recent economic
downturn in March 2001. Because
manufacturing capacity utilization
peaked in April 2000, earlier than the
economy as a whole, capacity utilization has not yet reached the 82.2%
level observed then. During the current business cycle, this indicator

performed better than average in the
period right after the last peak, but
over the past two years its performance has been fairly typical.
Another sign of health in manufacturing is that new orders increased
11.8%, or $39 billion, from July 2003
to July 2004, with inventories rising a
more modest 3.9% over that period
to support the higher level of sales.
Bolstered by the inflow of orders,
business fixed investment has also
continued to rebound, up 12.4% at a
seasonally adjusted annual rate
(SAAR) in 2004:IIQ and 10.8% from

2003:IIQ to 2004:IIQ. Investment in
equipment and software has grown
even more strongly, up 14.2% SAAR
and 13.9% over the last year. Investment in structures has been less
steady, rising 6.9% SAAR in 2004:IIQ
but only 1.3% since 2003:IIQ.
In a further reflection of improved
performance, corporate profits have
surged 19% ($188 billion) from
2003:IIQ to 2004:IIQ. Something to
watch, however, is that the pace did
slacken from the first to the second
quarter, rising only 2.9% SAAR.

12
•

•

Labor Markets
Change, thousands of workers
400 AVERAGE MONTHLY NONFARM EMPLOYMENT CHANGE

Labor Market Conditions

350
300
Preliminary

250

Average monthly change
(thousands of employees, NAICS)

Year-to-date average
monthly employment
gain=170,000
Payroll employment

Revised

200

Goods producing
Construction
Manufacturing
Durable goods
Nondurable goods

150
100

Service providing
Retail trade
Financial activitiesa
PBSb
Temporary help svcs.
Education & health svcs.
Government

50
0
–50

2002
–47

2003
–5

–124
–1
–123
–88
–35

–76
–8
–67
–48
–19

–42
7
–48
–30
–18

27
17
7
12
–5

–13
4
–18
–10
–8

–25
–24
8
–63
–37
50
46

29
–11
6
–17
2
40
21

37
–5
6
23
15
28
–4

144
16
12
42
17
24
11

109
–15
26
34
33
8
37

–100

YTD
170

Sept.
2004
96

2001
–149

Average for period (percent)
Civilian unemployment
rate

–150

4.8

5.8

6.0

5.6

5.4

–200
2000 2001 2002 2003

IVQ
2003

IIQ IIIQ
2004

July

Aug. Sept.
2004

Percent
65.0 LABOR MARKET INDICATORS

Percent
6.5

Employment-to-population ratio
64.5

6.0

64.0

5.5

63.5

5.0

Percent
90 DIFFUSION INDEX OF EMPLOYMENT c,d
80
12 months
70

50
One month
63.0

4.5
40

62.5

4.0
Civilian unemployment rate

62.0
1995 1996

3.5
1997

1998

1999

2000

2001

2002

2003

2004

20
1991

1993

1995

1997

1999

2001

2003

FRB Cleveland • October 2004

NOTE: All data are seasonally adjusted
a. Financial activities include the finance, insurance, and real estate sector and the rental and leasing sector.
b. Professional and business services include professional, scientific, and technical services, management of companies and enterprises, administrative and
support, and waste management and remediation services.
c. Percent of total nonfarm industries with increased employment over one month (or 12 months) plus half of those with unchanged employment.
d. Shaded areas indicate recessions as dated by the National Bureau of Economic Research.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

In September, total nonfarm payrolls
increased by 96,000. The Commissioner’s Statement from the Bureau
of Labor Statistics indicated that the
hurricanes had no apparent impact
on employment in September. The
average monthly employment gain in
the third quarter was 103,000, roughly
half of the average gain for the first
half of the year.
Manufacturing employment fell by
18,000 in September, the largest decline since December 2003. Serviceproviding industries added 109,000

net jobs, more than half of them in
financial activities and temporary
help services. Jobs in retail trade
declined by 15,000 in September, the
third consecutive monthly drop after
average gains of 30,000 in the first
half of the year. Government payrolls
rose by 37,000 in September and
103,000 in the third quarter.
September’s unemployment rate
remained at 5.4%. It has fallen 0.3 percentage point (pp) this year after
dropping 0.6 pp in the second half of
2003. The employment-to-population

ratio fell 0.1 pp in September to
62.3%; in contrast to unemployment,
it has not changed significantly in the
last 15 months.
The Diffusion Index of Employment measures the share of industries where employment rose in a
given period. The one-month diffusion index was near 70 in March and
April, when job gains peaked, but has
fallen to just over 55 in the last three
months. The 12-month index has
risen 30 points this year, reaching its
highest level since October 2000.

13
•

•

Education and the Workforce
Percent of workforce, ages 25 to 64
50 EDUCATIONAL ATTAINMENT IN FOURTH DISTRICT
STATES AND U.S., 2003

Percent
100 DISTRIBUTION OF WORKERS BY EDUCATION LEVEL
90
80

Ohio
Pennsylvania
Kentucky
West Virginia

College degree or more

U.S. average: 30.1%
70
Some college

U.S. average: 31.9%
U.S. average: 27.8%

50
40

High school diploma

30
U.S. average: 10.1%
10

20
Less than high school diploma

10
0
1970

0
1974

1978

1982

1986

1990

1994

1998

Less than high
school diploma

2002

Thousands of 2002 dollars
80 REAL AVERAGE ANNUAL EARNINGS

High school
diploma

Some college/
associate’s degree

College/
advanced degree

Percent
20 UNEMPLOYMENT RATE

70
16
60

Less than high school diploma
Advanced degree

College degree
Some college/associate degree

High school diploma
High school diploma

Some college

4
Less than high school diploma

College degree or more
0

0
1975

1980

1985

1990

1995

2000

1975

1980

1985

1990

1995

2000

FRB Cleveland • October 2004

SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and U.S. Department of Commerce, Bureau of the Census.

The American workforce is becoming
increasingly educated as younger generations replace older ones. Over the
past 30 years, the fraction of American
workers who did not graduate from
high school plummeted from about
36% in 1970 to 10% in 2003. Meanwhile, the share of workers with at
least a college degree more than doubled, rising from about 14% to 32%.
In 2003, the proportion of workers in
Fourth District states who had at least
a college degree was below the U.S.
average, while the proportion of
workers with a high school diploma
was above average.

Real (inflation-adjusted) average
annual earnings vary substantially by
education level, suggesting that more
schooling and degrees translate into
higher income. The real average
annual earnings of high school
dropouts and high school graduates
have remained relatively stagnant
since 1975; in contrast, earnings have
increased about 44% for college graduates and 51% for advanced degree
recipients. Moreover, the earnings
disparity between individuals without
a high school diploma and college
graduates—including those with
advanced degrees—has widened. In

1975, the average earnings of those
who continued beyond college were
1
about 2 /2 times more than those
of high school dropouts—by 2003,
this had increased to roughly four
times more.
Variation in earnings by education
may also result partly from differences
in unemployment rates. The more
educated individuals have a better
chance of being employed. Workers
without a high school diploma are
about four times more likely to be unemployed than those who continued
their studies beyond college.

14
•

•

Fourth District Employment and Business Cycles
Percent
8.5 UNEMPLOYMENT RATES a

UNEMPLOYMENT RATES, AUGUST 2004 a

8.0
7.5
7.0
6.5
6.0
U.S.
5.5

U.S. average = 5.4%
Lower than U.S. average

5.0

About the same as U.S. average
(5.1% to 5.7%)

Fourth District
4.5

Higher than U.S. average
More than double U.S. average

4.0
3.5
1990

1993

1996

1999

2002

Payroll Employment in Fourth District Metropolitan Statistical Areas
12-month percent change, August 2004
Total nonfarm
Goods-producing
Manufacturing
Natural resources, mining,
and construction
Service-providing
Trade, transportation, and
utilities
Information
Financial activities
Professional and business
services
Education and health
services
Leisure and hospitality
Other services
Government

Cleveland
–0.1
–1.4
–2.0

Columbus
0.1
–0.5
–0.7

Cincinnati
0.8
–2.1
–2.1

Dayton
–1.4
–3.1
–2.7

Toledo
–2.1
–1.5
–2.0

Wheeling
2.0
0.0
0.0

Pittsburgh Lexington
–0.1
0.7
1.2
1.1
–1.2
–0.2

0.4
0.2

–0.2
0.2

–1.8
1.4

–4.7
–1.0

0.0
–2.3

0.0
2.3

5.5
–0.4

4.9
0.5

–1.2
0.5
0.5

–1.3
0.0
1.2

1.8
3.2
–0.4

–3.8
0.9
–1.5

–3.1
4.3
3.3

5.0
0.0
3.4

–0.9
–2.0
1.1

–0.4
5.3
–3.6

0.7

2.5

0.9

–4.1

–5.2

4.2

–0.9

–2.9

2.8
0.7
–3.9
–0.4

1.2
–1.5
–2.2
0.9

3.0
3.7
–0.3
–1.4

2.4
–0.7
1.0
0.6

–1.4
–4.9
0.0
–0.9

–0.8
0.0
3.6
2.9

1.3
–0.6
–0.5
–1.9

0.9
7.6
3.8
–0.9

FRB Cleveland • October 2004

NOTE: Data are not seasonally adjusted unless otherwise noted.
a. Seasonally adjusted.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

The Fourth District’s unemployment
rate rose sharply in August to 6.2%,
an increase of 0.3 percentage point
(pp) from July. This was the sharpest
jump in 18 months and the third consecutive increase. Ohio, Pennsylvania, and West Virginia also saw
statewide unemployment increases
of 0.3 pp in August. By contrast, Kentucky’s unemployment rate fell 0.2
pp to 5.1%, the lowest rate of any
state in the District.
Nationally, the unemployment rate
in August was 5.4%. Most counties in
the District—almost three of every

four—reported rates exceeding that.
The month before, unemployment
topped the national average in two
of every three District counties. However, the number of counties where
unemployment was more than double the U.S. average stayed about the
same between July (12 counties) and
August (11).
Among the District’s major metropolitan areas, Wheeling posted the
strongest year-over-year employment
gains. By contrast, Dayton and Toledo
experienced the sharpest declines;
employment in service-providing

industries was hardest hit, especially
in enterprises related to trade, transportation, and utilities, as well as
professional and business services.
Employment in manufacturing industries continued to fall across most of
the District’s major metropolitan
areas, with the most marked declines
in Dayton, Cincinnati, Cleveland, and
Toledo.
Much of the concern about the
current expansion has focused on
weaker-than-expected employment
growth. On average, national employment during past expansions returned
(continued on next page)

15
•

•

Fourth District Employment and Business Cycles (cont.)
Percent change
12.5 BUSINESS CYCLE PATTERN, OHIO EMPLOYMENT

Percent change
12.5 BUSINESS CYCLE PATTERN, PENNSYLVANIA EMPLOYMENT

10.0

7.5

5.0

Ohio, average range, 1948–2001
2.5

2.5

U.S., 2001 onward
–2.5

Pennsylvania, average range, 1948–2001

–2.5
Pennsylvania, 2001 onward

–5.0
Ohio, 2001 onward

–5.0
U.S., 2001 onward

Ohio average, 1948–2001

–7.5

–10.0

Pennsylvania average, 1948–2001

–10.0

–12.5

–12.5
0

10
15
20
25
30
Months from previous business cycle peak

Percent change
12.5 BUSINESS CYCLE PATTERN, KENTUCKY EMPLOYMENT

Percent change
12.5 BUSINESS CYCLE PATTERN, WEST VIRGINIA EMPLOYMENT

10.0

10.0
Kentucky, average range, 1948–2001

7.5

7.5
West Virginia, average range, 1948–2001
5.0

5.0

2.5

West Virginia, 2001 onward

Kentucky average, 1948–2001
0

0
–2.5

–2.5
U.S., 2001 onward

–5.0

Kentucky, 2001 onward
–5.0

–7.5

–10.0

U.S., 2001 onward
West Virginia average, 1948–2001

–12.5

–12.5
0

10
15
20
25
30
Months from previous business cycle peak

FRB Cleveland • October 2004

NOTES: All data are for nonfarm business and are seasonally adjusted. Shaded bands indicate a 95% confidence interval for the states’ 1948–2001 average.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

to pre-recession levels within about
two years of the preceding recession’s start. But now, after more than
three years, U.S. employment has not
yet regained its pre-recession peak,
nor has employment in Fourth
District states.
In percentage terms, employment
since the start of the recent recession
has fallen somewhat less in the U.S.
than in Fourth District states; of
those states, Ohio has fared the
worst by far. While Kentucky, Pennsylvania, and West Virginia have each
lost about 1% of employment since

the start of the last recession—only
slightly more than the nation—Ohio
has lost about 4% of its jobs.
The ranges of past recessions make
it clear that every recession is different.
And during each recession there is
variation among Fourth District states
as well. Ohio usually recovers somewhat more slowly than the nation, but
during this expansion the state’s employment growth has lagged both its
own typical historical experience and
the nation’s current performance.
On average, in previous expansions, Kentuckians could expect

employment to rebound much more
quickly than their counterparts in
other District states—almost a year
sooner. In the current expansion,
however, both Ohioans and Kentuckians have experienced employment
growth that is well below the range of
their historical experience.
Pennsylvania and West Virginia normally regain jobs more slowly than the
U.S. In the most recent recovery, however, these states’ performance has
been in line with the nation’s as well
as their own historical experience.

16
•

•

Fourth District Commercial Banks
Billions of dollars
15.0 FOURTH DISTRICT NET INCOME

Percent
4.50 FOURTH DISTRICT INCOME RATIOS a

13.5

4.35
Annual net income
First two quarters net income (not annualized)

12.0

Percent
40
38

4.20

36
Net interest margin

10.5

4.05

9.0

3.90

7.5

3.75

6.0

3.60

4.5

3.45

26
Non-interest income/income

3.0

3.30

1.5

3.15

3.00
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Percent
70 FOURTH DISTRICT EFFICIENCY a,b

20
1994 1995

1996

1997

1998

1999

2000

2001

2002

Percent
1.8 FOURTH DISTRICT EARNINGS a

2003 2004

Percent
20

68
66
18

1.6
64

Return on equity

62
60

1.4

58
Return on assets

1.2
54
52
50
1994 1995

1996

1997

1998

1999

2000

2001

2002

2003 2004

1.0
1994 1995

12
1996

1997

1998

1999

2000

2001

2002

2003 2004

FRB Cleveland • October 2004

a. Through 2004:IIQ only. Data for 2004 are annualized.
b. Efficiency is operating expenses as a percent of net interest income plus non-interest income.
SOURCES: Author’s calculation from Federal Financial Institutions Examination Council, Quarterly Bank Reports of Condition and Income.

FDIC-insured commercial banks
headquartered in the Fourth Federal
Reserve District continued the past
two years’ strong earnings performance into the first half of 2004. Their
net income was $5.88 billion for these
six months ($11.76 billion on an annual basis); this set a pace that, if
maintained, will break the record of
$11.1 billion in 2003. Overall, Fourth
District bank performance was representative of the U.S. banking industry,
which posted unprecedented earnings in the first half of 2004.
Bank earnings remained strong—
despite continued shrinkage in the

net interest margin caused by low
interest rates—because the yield on
earning assets fell more quickly than
the cost of funds. By the end of
2004:IIQ, Fourth District banks offset
smaller margins with sharp growth in
non-interest income, which made up a
record 35.76% of total income. This
performance was similar to that of
their counterparts nationwide, whose
comparable figure was 36.47%.
Improved efficiency was another
factor in banks’ stellar earnings performance in the past few years. Efficiency
is measured by operating expenses as
a percent of net interest income plus

non-interest income, so lower numbers correspond to greater efficiency.
Although Fourth District banks’
53.6% efficiency ratio at the end of
2004:IIQ did not quite equal their
52.6% at the end of 2002, this ratio
(which is inversely related to efficiency) remained well below its
recent high of 62.6% in 1998.
District banks posted a return on
assets of 1.53% for the first half of
2004, up slightly from 1.49% at the
end of 2003; return on equity also
rose, reaching 19.0%. This compared
favorably with their own first-half
(continued on next page)

17
•

•

Fourth District Commercial Banks (cont.)
Ratio
24 FOURTH DISTRICT COVERAGE RATIO

Percent
1.4 FOURTH DISTRICT ASSET QUALITY a,b
1.2

1.0
18
0.8
Problem assets
15
0.6
Net charge-offs

0.4
9

0.2

0
1994

6
1996

1998

2000

2002

1994

2004

Percent
10 FOURTH DISTRICT CORE CAPITAL (LEVERAGE) RATIO

1996

1998

2000

2002

2004

Percent
10 FOURTH DISTRICT UNPROFITABLE INSTITUTIONS

6
Unprofitable institutions

2
Assets in unprofitable institutions

4
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

–2
1994

1996

1998

2000

2002

2004

FRB Cleveland • October 2004

NOTE: All 2004 data are for the first two quarters.
a. Problem assets are shown as a percent of total assets, net charge-offs as a percent of total loans.
b. For net charge-offs, the 2004 observation is annualized on the basis of the first two quarters.
SOURCES: Author’s calculations from Federal Financial Institutions Examination Counsel, Quarterly Bank Reports on Condition and Income.

profit performance in recent years
and with the nation’s 1.19% return
on assets and 13.72% return on equity.
Overall, financial indicators for
banks in the Fourth Federal Reserve
District point to strengthening balance sheets. Asset quality showed
continued signs of improvement
during the first half of 2004. Net
charge-offs (losses realized on loans
and leases currently in default minus
recoveries on previously charged-off
loans and leases) for the first six
months of the year represented an
annualized 0.56% of total loans. Problem assets (nonperforming loans and

repossessed real estate) as a share of
loans and leases fell to 0.61% from
0.77% at the end of 2003. Fourth District Banks’ improvement in asset
quality mirrored that of the overall
banking industry, in which net chargeoffs were 0.58% of loans and nonperforming loans were 0.59% of assets.
Reflecting an industrywide trend
toward stronger balance sheets,
Fourth District banks held $16.61 in
equity capital and loan loss reserves
for every dollar of problem loans, well
above the recent low in the coverage
ratio of 10.75 at the end of 2002. This
improvement resulted largely from a

marked reduction in problem loans
and a slight strengthening of bank
capital. Equity capital as a percent of
Fourth District banks’ assets rose
somewhat, moving from 8.04% at the
end of 2003 to nearly 8.05% by the
end of 2004:IIQ.
Improved asset quality was also
reflected in the percent of unprofitable institutions, which fell to 5.61%
from nearly 5.88% at the end of 2003.
However, the average size of unprofitable banks increased in 2004 as
assets in unprofitable institutions
increased slightly from 2.02% to 2.63%
of Fourth District banks’ assets.

18
•

•

Foreign Central Banks
Percent, daily
7 MONETARY POLICY TARGETS a
6

Trillions of yen
–35
–30

–25
Bank of England

–20

–15

3
European Central Bank
2

7
6
One-year lending rate
5

–10
–5

Federal Reserve

Percent, monthly
8 CHINA'S ONE-YEAR LENDING RATE AND INFLATION

4
3

–1

Bank of Japan

–2

–3

2
1

–4

–5

–6

35
40

–7
4/1/01

5/6/02

6/10/03

7/14/04

Inflation
0
–1
–2
4/1/01

5/6/02

6/10/03

7/14/04

Central Banks’ Monetary Policy Stances
Accommodative
United States: “accommodation can be removed at a pace that is likely to be measured”
European Central Bank: rate “very low by historical standards...lending support to economic activity”
Japan: “...CPI is still on a declining trend” so “pursue an easy monetary policy even as the economy continues to recover”
Sweden: “rate is low in an historical perspective” and “will need to be raised in the long run”
Switzerland: raised rate to reverse 2003 cut made under “extraordinary circumstances”
Not Accommodative
Brazil: raised rate “to rein in inflation without disrupting...economic recovery”
Canada: raised rate: “to avoid a buildup of inflationary pressures” while “close to production capacity”
New Zealand: raised rate: “looking ahead, we do not have much inflation headroom”

FRB Cleveland • October 2004

a. Federal Reserve: overnight interbank rate. Bank of Japan: a quantity of current account balances (since December 19, 2001, a range of quantity of current
account balances). Bank of England and European Central Bank: repo rate.
SOURCES: Board of Governors of the Federal Reserve System; and Bloomberg Financial Information Services.

The Federal Reserve, alone among the
major central banks, changed its policy rate during the past month, raising
it another 25 basis points to 1.75%.
The Federal Open Market Committee
characterized the policy situation as
one in which “the stance of monetary
policy remains accommodative” but
also said that “policy accommodation
can be removed at a pace that is likely
to be measured.”
“Accommodation” has no precise
definition, but at least seems to imply
that the nominal policy rate would
have to be higher in the longer run if
an economy is expected to achieve

tolerably low inflation and sustainable real growth. Many observers
think that the Peoples Bank of China
is being accommodative by holding
the one-year loan rate at 5.31%,
where it has been for the past two
and a half years, while maintaining
that “price performance in China
remains stable on the whole.” Other
central banks suggest that they are or
have been accommodative, referring
to their policy rates as being at historic lows or at lows that reflect extraordinary conditions.
Not all central banks can afford
to be accommodative lest they risk

letting inflation rise. Some—notably
Brazil, Canada, and New Zealand—
recently raised their rates, arguing
that the absence of excess capacity already makes inflation their dominant
concern. Still other banks perceive
themselves to be in less demanding
situations. The Bank of England is
not convinced that “little or no
remaining spare capacity” prevents
inflation from being “well anchored.”
The Bank of Norway left its rate
unchanged, enjoying the enviable
combination of lower inflation and
stronger real growth.

Full text of Economic Trends (Federal Reserve Bank of Cleveland) : Economic Trends - October 2004

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