In the business sector, real spending on equipment and software declined in the second quarter as outlays on transportation equipment dropped sharply. Spending on computers and software rose at a moderate rate in the second quarter, while outlays on other equipment improved a bit last quarter after having declined in the preceding two quarters. Data through June continued to show a robust increase in nonresidential construction activity. However, vacancy rates for commercial properties ticked up in the first quarter, and the architectural billings index registered a string of weak readings from February to June.
Real nonfarm inventories excluding motor vehicles fell sharply in the second quarter. The ratio of book-value inventories to sales (excluding motor vehicles) ticked down again in May.
The U.S. international trade deficit narrowed in May, as a large increase in exports of goods and services more than offset a moderate increase in imports. Most major categories of non-oil imports rose in May; imports of consumer goods increased rapidly. In contrast, the value of petroleum imports fell back despite higher prices, and imports of automotive products also fell. The increase in exports was supported by strong exports of industrial supplies, particularly petroleum products, and services.
Across the advanced foreign economies, information received since the last meeting pointed to subdued growth in the second quarter and increasing inflation pressures. Weak second-quarter data on industrial production and sentiment in the euro area as well as on consumer expenditures and exports in Japan suggested that the first-quarter strength in output growth was not sustained. Conditions worsened considerably in the United Kingdom, with a deepening slump in the housing sector. In all the major advanced foreign economies, rising food and fuel prices continued to drive overall inflation to recent highs, but core measures of inflation generally rose only modestly. Recent indicators for emerging market economies pointed to some slowing of growth in the second quarter. Real GDP growth in China moderated but remained strong. Incoming data suggested further slowing elsewhere in emerging Asia, and second-quarter activity appeared to have remained sluggish in Mexico. Headline inflation rose further in much of the developing world, largely owing to higher food and energy prices, and several countries continued to face upward pressure on core inflation as well.
Headline consumer price inflation in the United States stepped up in recent months, largely as a result of sizable increases in food and energy prices. Excluding these categories, core consumer price inflation was elevated in June but, on balance, was running this year at about the same rate as last year. Some survey-based measures of year-ahead inflation expectations moved up sharply in recent months; longer-term inflation expectations were little changed recently but remained above their levels at the end of 2007. Excluding food and energy, sharp increases in the prices of products and services at earlier stages of processing continued to put upward pressures on business costs and consumer prices. Unit labor costs apparently continued to increase at a restrained pace during the second quarter, reflecting only moderate gains in worker compensation and relatively strong productivity performance, with little sign of higher overall inflation passing through to higher worker compensation.
At its June 24-25 meeting, the Federal Open Market Committee (FOMC) kept its target for the federal funds rate at 2 percent. The Committee's statement noted that recent information indicated that overall economic activity continued to expand, partly because of some firming in household spending. However, labor markets softened further and financial markets remained under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices were likely to weigh on economic growth over the next few quarters. The Committee expected inflation to moderate later this year and next. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remained high. The Committee stated that the substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help promote moderate growth over time. Although downside risks to growth remained, they appeared to have diminished somewhat, and the upside risks to inflation and inflation expectations increased. The Committee indicated that it would continue to monitor economic and financial developments and would act as needed to promote sustainable economic growth and price stability.
The market's expected path of monetary policy moved down following the announcement of the Committee's decision at its June meeting to leave the target federal funds rate unchanged. Although the decision was largely anticipated, the policy statement was reportedly viewed by investors as placing more emphasis on the downside risks to growth than they had anticipated. Subsequently, the semiannual Monetary Policy Report to the Congress and the accompanying testimony also led investors to mark down the expected path for the federal funds rate, as did intensifying concerns about the health of financial institutions and the outlook for the housing-related government-sponsored enterprises (GSEs). Consistent with the revision in policy expectations, yields on short- and medium-term nominal Treasury coupon securities fell over the intermeeting period. Yields on long-term Treasury securities declined less than those on shorter-term instruments, and the yield curve steepened. Measures of shorter-horizon inflation compensation derived from yields on inflation-indexed Treasury securities dropped over the intermeeting period as energy prices reversed some of their earlier rise, while measures of longer-term inflation compensation rose slightly.
Functioning in the interbank funding markets remained strained over the intermeeting period. Spreads of the London interbank offered rate, or Libor, over comparable-maturity overnight index swap rates were unchanged to slightly higher, and spreads on lower-rated nonfinancial and asset-backed commercial paper remained well above historical norms. Depository institutions' use of both overnight and term primary credit borrowing continued to be strong during the intermeeting period, peaking in late June amid quarter-end pressures. However, new extensions of credit through the Primary Dealer Credit Facility (PDCF) were negligible during July. On July 30, the Board of Governors and the FOMC announced enhancements to existing liquidity facilities, including extension of the PDCF and the Term Securities Lending Facility through January 30, 2009. Conditions in the market for Treasury repurchase agreements were fairly stable, although there was some deterioration of conditions in the market for agency collateral.
In longer-term credit markets, yields on both investment- and speculative-grade corporate bonds rose over the intermeeting period even though comparable-maturity Treasury yields declined slightly, which resulted in a widening of already elevated spreads. Corporate bond issuance slowed further, as did lending by banks to businesses and households, and issuance of leveraged loans remained very weak. Broad equity price indexes were volatile and declined modestly, on net, between the June and August FOMC meetings. Stock prices of financial firms fell sharply in mid-July but subsequently recouped most of those losses. Energy sector stocks significantly underperformed the broad indexes owing to recent declines in oil prices.
Uncertainties about the financial condition of Fannie Mae and Freddie Mac added to market worries about the potential consequences of financial strains for the broader economy over the intermeeting period. On July 13, the Treasury Department proposed a plan to support the liquidity and solvency of the two GSEs, and the Board of Governors of the Federal Reserve System announced that the Federal Reserve Bank of New York was authorized to lend to the two institutions if necessary, reducing somewhat market concerns about the GSEs. Concerns eased further as Congress passed legislation, which was subsequently signed by the President, authorizing the Treasury to provide liquidity and capital to the GSEs. Over the intermeeting period, spreads of rates on conforming residential mortgages over those on comparable-maturity Treasury securities moved higher. Offer rates on 30-year jumbo mortgages also rose, and credit for nonconforming mortgages remained difficult to obtain. In the secondary market, issuance of mortgage-backed securities by GSEs appeared to have slowed in July from its strong second-quarter pace, while issuance of securities backed by nonconforming loans and of commercial mortgage-backed securities remained nil.
Pressures in the money markets of many major foreign economies eased slightly over the intermeeting period. Yields on sovereign debt in the advanced foreign economies fell, mainly because of declines in inflation compensation. The trade-weighted index of the dollar against the currencies of major trading partners rose a bit on net.
M2 expanded at a moderate pace in July, reversing the deceleration in May and June. The expansion was broad based, reflecting an acceleration in liquid deposits as well as renewed inflows to retail money market mutual funds and small time deposits.
In the forecast prepared for the meeting, the staff marked down its forecast of real GDP growth in the second half of 2008 and in 2009. Although the increase in real GDP in the second quarter was a bit faster than anticipated at the time of the June meeting, the labor market continued to weaken significantly, financial conditions remained unfavorable, consumer and business confidence was downbeat, and manufacturing activity was contracting. All told, the staff continued to expect that real GDP would rise at less than its potential rate through the first half of next year. Nonetheless, real GDP growth was anticipated to return to its potential rate in the second half of 2009 as housing activity leveled out and financial conditions became less restrictive. Core PCE price inflation was expected to pick up somewhat in the second half of this year, mostly as a result of the upward pressures from this year's run-ups in prices of energy and imports. Core inflation was then expected to edge down in 2009 as the impetus from prior increases in the prices of imports, energy, and other commodities abated and the margin of slack in resource use widened.