Residential construction activity continued to decline steeply through midyear. In July, both single-family housing starts and permit issuance fell further. In the multifamily sector, starts dropped back in July to a rate more in line with its historical range. June's spike in multifamily starts was related to more-stringent building codes that took effect in New York City on July 1, which apparently led developers to pull forward the start date of some planned apartment projects. Recent cutbacks in new residential construction reduced the level of new home inventories, and the relative stability in sales of new homes allowed those inventory reductions to begin to bring down the months' supply of new homes for sale. Even so, the months' supply of new homes for sale remained extremely elevated relative to the level that prevailed before the downturn in the housing market. Sales of existing single-family homes were relatively flat since the end of last year. Tight conditions in mortgage markets over the summer continued to restrain housing demand, especially for borrowers seeking nonconforming mortgages. Several indexes indicated that house prices had declined substantially over the past 12 months, and these prices appeared to remain on a downward trajectory.
In the business sector, investment in equipment and software fell in the second quarter, largely reflecting a sharp drop in spending on motor vehicles. In contrast, growth of real outlays for nontransportation equipment posted a moderate gain. The data on nominal orders and shipments of nondefense capital goods excluding aircraft rose substantially in July, although some of the gain in nominal shipments may have reflected unusually large price increases. Moreover, as in previous months, orders and shipments were likely supported in July by increased foreign demand. Real nonresidential investment increased at a robust rate in the second quarter; however, nominal expenditures declined in July, and forward-looking indicators remained downbeat. Vacancy rates for commercial properties moved higher in the first half of the year and the architectural billings index continued to register weak readings.
Real nonfarm inventories excluding motor vehicles fell in the second quarter. The book value of manufacturing and trade inventories (excluding motor vehicles) stepped up modestly in July from the second-quarter level, but the ratio of these inventories to sales held steady.
The U.S. international trade deficit widened in July, as a surge in the value of imports of goods and services more than offset strong growth in exports. Imports in July were led by a rapid increase in imports of oil, reflecting both higher volumes and higher prices, and were supported by a rise in imports of industrial supplies, capital goods, and services. The strength in exports was broadly based but benefited in particular from robust exports of automotive products.
Economic indicators pointed to a marked deceleration of economic activity in the advanced foreign economies. In the second quarter, gross domestic product (GDP) was flat in Canada and the United Kingdom and fell in both Japan and the euro area. In July, employment continued to weaken in Japan, and retail sales fell in the euro area. Headline inflation in the major advanced foreign economies stayed elevated. Data received over the intermeeting period showed a further slowing of growth in emerging market economies. For Mexico, anemic growth in the second quarter followed a slight contraction in the first. In Asia, output decelerated significantly in the second quarter, as growth moderated in China and weakened more sharply in several other economies. Headline inflation rose in some developing countries but fell in others.
Headline consumer prices in the United States declined slightly in August after having risen rapidly during the preceding three months. Energy prices dropped steeply, and the rate of increase in food prices moderated somewhat. Core consumer prices rose a bit more slowly in August than they had in June and July. Excluding food and energy, producer prices rose modestly in August, although prices for capital goods other than motor vehicles and high-tech equipment posted a large increase. During recent months, some cost pressures eased as the prices of crude oil and other commodities declined and non-oil import prices decelerated. Some measures of inflation expectations were down notably over the intermeeting period. Measures of hourly labor compensation continued to increase moderately with no sign of acceleration.
At its August meeting, the Federal Open Market Committee (FOMC) kept the target federal funds rate unchanged at 2 percent. The Committee's statement noted that economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets had softened further and financial markets remained under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices were likely to weigh on economic growth over the next few quarters. The Committee stated that, over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth. Inflation had been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations had been elevated. The Committee expected inflation to moderate later this year and next year, but the inflation outlook remained highly uncertain. Although downside risks to growth remained, the upside risks to inflation were also of significant concern to the Committee. 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.
Over the intermeeting period, investors marked down considerably their expectations for the path of monetary policy. Policy expectations were largely unaffected by the outcome of the August FOMC meeting, as the Committee's decision to leave the target federal funds rate unchanged was broadly anticipated and the accompanying statement was reportedly in line with investor expectations. Subsequently, the expected future path of monetary policy dropped amid increasing concerns about the health of financial institutions. The market's expectation for the onset of policy tightening was also pushed back as labor market conditions weakened and oil prices declined further, developments that were seen as tempering inflation pressures. Yields on nominal Treasury coupon securities declined over the intermeeting period while yields on inflation-indexed Treasury securities were roughly unchanged, which left inflation compensation noticeably lower. The decrease in inflation compensation was most pronounced at shorter horizons, likely reflecting the drop in oil prices.
Conditions in short-term funding markets remained strained for most of the intermeeting period and deteriorated considerably just before the FOMC meeting. The spreads of London interbank offered rates, or Libor, over comparable-maturity overnight index swap rates, especially those beyond the one-month horizon, moved up from already-high levels. In the commercial paper market, spreads on lower-rated nonfinancial and asset-backed commercial paper fluctuated in an elevated range, as did spreads on financial paper. Depository institutions continued to bid aggressively for 28- day funds at the Term Auction Facility (TAF) during the intermeeting period, and demand for funds was strong at both of the 84-day TAF auctions. The amount of overnight primary credit outstanding was about unchanged at a high level, while term primary credit continued to rise. No credit was extended through the Primary Dealer Credit Facility until the final week of the intermeeting period. Conditions in markets for repurchase agreements, or repos, against some types of collateral deteriorated over the intermeeting period, and liquidity in non-Treasury, nonagency term repo markets remained poor.
In longer-term credit markets, yields on investment-grade corporate bonds were not much changed, but yields on speculative-grade bonds rose somewhat. Risk spreads on corporate bonds jumped, as comparable-maturity Treasury yields dropped; most of the increase in risk spreads occurred late in the intermeeting period. Corporate bond issuance moderated a bit further in August, while growth of bank lending to businesses was tepid. Broad equity indexes declined over the intermeeting period. Financial sector equity indexes were volatile and ended the period down sharply.
Liquidity conditions in the money markets of major foreign economies deteriorated over the intermeeting period. Sovereign bond yields moved down, mainly reflecting declines in inflation compensation. On a trade-weighted basis, the dollar rose against the currencies of our major trading partners.
M2 contracted slightly in August following a generally weak performance over the previous few months. The August data showed a considerable reallocation among the components of M2. Liquid deposits and retail money funds fell while small time deposits surged as some banks and thrifts bid aggressively for these deposits.
On September 7, the Treasury Department and the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac had been placed into conservatorship and that Treasury would establish a backstop lending facility for the government-sponsored enterprises (GSEs), purchase preferred stock in the GSEs as necessary to ensure that they maintain a positive net worth, and initiate a program to purchase mortgage-backed securities (MBS). Following the announcement, spreads on Fannie Mae and Freddie Mac debt and on agency MBS narrowed, while share prices for their common and preferred stock fell. Auctions of GSE debt following the conservatorship announcement reportedly attracted heavy demand, but market participants indicated that liquidity in the secondary market for GSE debt remained somewhat lower than normal. Before the conservatorship announcement, interest rates on 30-year fixed-rate mortgages had declined less than those on comparable-maturity Treasury securities, leaving mortgage spreads at the top of their range of the past two decades. Following the Treasury announcement, rates and spreads on new conforming fixed-rate mortgages dropped sharply.
In the days immediately before the FOMC meeting, Lehman Brothers Holdings filed for bankruptcy, Bank of America announced that it would acquire Merrill Lynch, and market concerns about the health of other financial institutions increased. To address potential liquidity pressures in financial markets associated with these developments, the Federal Reserve announced several additional initiatives, including an expansion of collateral eligible for the Primary Dealer Credit Facility and the Term Securities Lending Facility (TSLF), increases in the size and frequency of TSLF auctions, and a temporary relaxation of the limitations on brokerdealers' access to funding from affiliated depository institutions. In addition, a consortium of 10 major banks announced the creation of a liquidity pool from which participants could draw collateralized loans. Despite these enhanced liquidity measures, short-term funding markets remained severely strained, reflecting investors' heightened concerns about the financial condition of other large financial firms, including American International Group, a prominent insurance and financial services company. To further support market liquidity and to help keep the federal funds rate near its target, the Federal Reserve conducted very large reserve- adding open market operations the day before and the morning of the FOMC meeting. Market expectations for the path of monetary policy moved down sharply. Yields on nominal Treasury securities dropped steeply, and credit spreads on corporate bonds widened significantly. Equity markets were volatile and equity prices dropped considerably.
In the forecast prepared for the meeting, the staff left its projection for real GDP growth in the second half of 2008 little changed from the previous meeting, but it marked down its forecast for 2009 slightly. Real GDP was estimated to have increased at a solid pace in the second quarter; however, the available indicators pointed to a sharp deceleration in economic activity in the third quarter. Consumer spending softened appreciably in recent months, and housing construction remained on a steep downtrend. Some of the weakness in the household sector appeared to reflect the ongoing deterioration in the labor market, but the effects of the earlier run-up in oil prices, weakened balance sheets, and restrictive financial conditions also likely put the finances of many households and businesses under pressure. The staff continued to expect that real GDP would advance slowly in the fourth quarter of 2008 and at a faster rate in 2009, but still less than that of its potential. Real GDP growth was expected to pick up to slightly above the rate of potential growth in 2010, as the restraint on household and business spending associated with financial market turmoil gradually eases and the contraction in the housing sector comes to an end. The staff's outlook for both core and overall PCE inflation over the next two years also changed little. The staff continued to project that core inflation would edge lower in 2009 and 2010 as the prices of imports, energy, and other commodities decelerate and the margin of resource slack remains relatively wide.