FOMC Minutes

September 21, 2004

A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors

of the Federal Reserve System in Washington, D.C., on Tuesday, September 21, 2004, at 9:00 a.m.

Present:

Mr. Greenspan, Chairman

Mr. Geithner, Vice Chairman

Mr. Bernanke

Ms. Bies

Mr. Ferguson

Mr. Gramlich

Mr. Hoenig

Mr. Kohn

Ms. Minehan

Mr. Olson

Ms. Pianalto

Mr. Poole

Messrs. McTeer, Moskow, Santomero, and Stern, Alternate Members of the Federal

Open Market Committee

Messrs. Guynn and Lacker, and Ms. Yellen, Presidents of the Federal Reserve Banks

of Atlanta, Richmond, and San Francisco respectively

Mr. Reinhart, Secretary and Economist

Mr. Bernard, Deputy Secretary

Ms. Smith, Assistant Secretary

Mr. Alvarez, General Counsel

Mr. Baxter, Deputy General Counsel

Ms. Johnson, Economist

Mr. Stockton, Economist

Messrs. Connors, Fuhrer, Hakkio, Howard, Madigan, Slifman, Tracy, and Wilcox,

Associate Economists

Mr. Kos, Manager, System Open Market Account

Mr. Ettin, Deputy Director, Division of Research and Statistics, Board of Governors

Messrs. Oliner and Struckmeyer, Associate Directors, Division of Research and

Statistics, Board of Governors

Messrs. Clouse and Whitesell, Deputy Associate Directors, Division of Monetary

Affairs, Board of Governors

Mr. English, Assistant Director, Division of Monetary Affairs, Board of Governors

Mr. Simpson, Senior Adviser, Division of Research and Statistics, Board of

Governors

Ms. Danker, Special Assistant to the Board, Division of Monetary Affairs, Board of

Governors

Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors

Mr. Skidmore, Special Assistant to the Board, Office of Board Members, Board of

Governors

Ms. Weinbach, Senior Economist, Division of Monetary Affairs, Board of Governors

Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of

Governors

Ms. Low, Open Market Secretariat Assistant, Division of Monetary Affairs, Board of

Governors

Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta

Mr. Judd, Executive Vice President, Federal Reserve Bank of San Francisco

Messrs. Eisenbeis, Evans, and Goodfriend, Mses. Mester and Perelmuter, and

Messrs. Rolnick and Rosenblum, Senior Vice Presidents, Federal Reserve Banks of

Atlanta, Chicago, Richmond, Philadelphia, New York, Minneapolis, and Dallas

respectively

Messrs. Bryan and Gavin, Vice Presidents, Federal Reserve Banks of Cleveland and

St. Louis respectively

By unanimous vote, the minutes of the meeting of the Federal Open Market Committee held

on August 10, 2004, were approved.

The Manager of the System Open Market Account reported on recent developments in

foreign exchange markets. There were no open market operations in foreign currencies for

the System's account in the period since the previous meeting.

The Manager also reported on recent developments in domestic financial markets and on

System open market transactions in government securities and securities issued or fully

guaranteed by federal agencies during the period August 10, 2004, through September 20,

2004. By unanimous vote, the Committee ratified these transactions.

The information reviewed at this meeting suggested that economic growth regained some

vigor in recent months after having slowed in late spring. The August labor market report

showed a moderate gain in payrolls. After contracting in June, industrial production

strengthened modestly on average in July and August, and the increases were widespread

across sectors. Consumer spending rose sharply in July, housing activity increased further in

August, and business outlays picked up last month. Core consumer price inflation moderated

in June and July, and a decline in energy prices further damped overall inflation in July.

The labor market improved in August, and the unemployment rate edged down to 5.4

percent. Private nonfarm payrolls grew moderately, with gains registered in the

manufacturing, construction, financial activities, and nonbusiness services categories. In

addition, the figures for June and July were revised upward and suggested that the

deceleration in hiring over that period was not as abrupt as had been previously thought. The

average workweek was unchanged in August from the upward-revised July level and was a

bit higher than its second-quarter average. The labor force participation rate edged down in

August.

Total industrial production advanced modestly on average in July and August, down slightly

from its second-quarter pace. The increases in manufacturing production since the end of the

second quarter were widespread. Output of motor vehicles and parts jumped in August.

Excluding motor vehicles and parts, the expansion in manufacturing output was brisk in July

but more subdued in August. In the high-tech sector, computer production continued to rise

in August, and the output of communications equipment posted its fourth consecutive

monthly increase. In contrast, output at utilities declined further in July and August, while

mining-related production was about flat on average over those same months. The rate of

capacity utilization ticked up in July from its average over the first half of the year and

remained steady in August.

Real consumer spending grew sharply in July after having slowed in the second quarter, and

the available indicators suggest that spending held fairly steady in August. Expenditures on

goods jumped in July and moderated in August, while spending on services moved up

somewhat in July. Purchases of motor vehicles surged in July and fell back in August. For the

two months together, the average pace of these outlays exceeded that seen in the first half of

the year, reflecting in part a further sweetening of incentives. Real disposable income was up

slightly in July, as increases in compensation were largely offset by declines in other income

categories. The latest readings on consumer confidence showed a drop in August amid labor

market slack and near-record gasoline prices, and a further slight decline in September, but

the readings for the third quarter averaged above those for the second quarter.

Housing activity increased further in August. Housing starts for new single-family homes

bounced up in July and remained about unchanged in August, and starts of multi-family

homes rose somewhat each month. Taken together, total housing starts in August reached the

highest level in five months. Home sales remained robust in July for both existing and new

homes, although sales were below the monthly peaks recorded earlier in the year. Interest

rates on thirty-year conventional mortgages receded over the past couple of months, retracing

much of the runup in rates that occurred earlier in the year. Weekly data on mortgage

applications to purchase homes continued to move up, on average, through mid-September.

Business outlays for equipment and software increased at a significant pace in the second

quarter, and the available data pointed to a similar advance more recently. Spending was

being supported by the continued gains in business output, low financing costs, ongoing price

declines for high-tech capital, and the corporate sector's large cushion of liquid assets.

Spending on transportation equipment and other capital goods was brisk in the second

quarter, although expenditures in the high-tech sector decelerated. In July, shipments of

capital goods excluding aircraft fell substantially from the rate seen in the first half of the

year, but orders were relatively strong. Real business investment in nonresidential structures

remained depressed, but the most recent data provided a sign of some improvement. In the

office sector, the vacancy rate came in only a little below its recent peak, although property

values had inched up, and the vacancy rate for industrial space also remained near its high.

The retail sector, in contrast, continued to fare better.

Excluding motor vehicles, the pace of inventory accumulation in July continued at its

second-quarter rate. A decline in stocks in the retail trade segment was more than offset by

stockbuilding in the manufacturing and wholesale trade segments. Although the book value

of manufacturing and trade inventories rose appreciably in July, these gains were again

inflated by price increases in the petroleum sector. Inventory-sales ratios in the

manufacturing sector, as in the retail and wholesale trade sectors (excluding motor vehicles

and parts), remained about flat in July.

The U.S. international trade deficit reached a record high in June, bringing it to a new high in

the second quarter as a percentage of nominal GDP. While the deficit fell back in July, it

remained much above May's reading. In June, exports fell sharply, with declines widespread,

while imports rose, owing in part to a surge in petroleum imports. In July, exports registered

a modest recovery, driven by capital goods, industrial supplies, and automotive products,

while the value of imports fell with the sharp decline in oil imports. Economic activity in the

major foreign industrial countries continued to expand in the second quarter, although growth

slowed in Japan and in the euro area. Indicators to date for the third quarter were mixed.

Core consumer prices edged up slightly over the months of June and July, as inflation in both

goods and services moderated. The core PCE price index was flat in July but, like the core

CPI, was up a bit on balance over June and July. The twelve-month change in core consumer

prices based on either measure was somewhat higher this July than for the same period last

year. Retail energy prices fell in July, led by a drop in gasoline prices after large gains in a

number of earlier months. During the summer, gasoline inventories climbed above seasonal

norms because of lower demand and increased imports, and the resulting downward pressure

on margins led gasoline prices to fall even as crude oil prices moved higher. Owing to the

decline in energy prices in July, inflation in overall consumer prices slowed that month. In

August, households' expectations for consumer inflation in the year ahead edged lower for

the second consecutive month. Meanwhile, after a small rise in July, the prices of finished

goods faced by producers moved down a bit in August. Turning to labor costs, hourly

compensation in the nonfarm business sector rose at a faster pace in the second quarter than it

did in the first, but the advance was in line with the average rate of increase over the

preceding four quarters. Unit labor costs measured at nonfinancial corporations also

registered an increase in the second quarter.

At its meeting on August 10, 2004, the Federal Open Market Committee decided to increase

the target federal funds rate by 25 basis points, to 1½ percent, and to retain its assessment of

balanced risks with respect to sustainable economic growth and price stability. In its

announcement, the Committee noted that output growth had moderated in recent months and

that the pace of improvement in labor market conditions had slowed, but that the softness

likely owed importantly to the substantial rise in energy prices. It also noted that while

inflation was somewhat elevated this year, a portion of the pickup seemed to reflect transitory

factors. The Committee went on to comment that the economy appeared poised to resume a

stronger pace of expansion going forward, that it continued to believe that policy

accommodation could be removed at a pace that was likely to be measured, and that it would

respond to changes in economic prospects as needed to fulfill its obligation to maintain price

stability.

Although the Committee's decision to raise the intended level of the federal funds rate by 25

basis points was widely anticipated in financial markets, the accompanying statement was

read as setting a more optimistic tone about economic prospects than had been anticipated

and prompted investors to mark up their expectations for the near-term path of policy. That

sentiment was apparently reinforced over the remainder of the period by the comments of

several Federal Reserve officials and the release of the August employment report, which

seemed to convey the view that the economy was emerging from its "soft patch." As a result,

policy rate expectations for the next two quarters ended the intermeeting period slightly

firmer. Longer-term policy expectations, however, moved noticeably lower, reflecting the

release of relatively benign readings on inflation and the Chairman's comments on the

inflation outlook in testimony to the House Budget Committee. In line with these revised

expectations for the path of policy, the term structure of interest rates flattened over the

intermeeting period, as the two-year Treasury yield ended about unchanged and the ten-year

Treasury yield dropped somewhat. While credit spreads on investment-grade corporate bonds

narrowed a bit, spreads on speculative-grade issues fell significantly more, particularly in

riskier segments of the market, probably reflecting greater confidence about prospects in the

business sector. Further evidence of such confidence was visible in equity markets, where

broad indexes advanced 5½ to 7½ percent. The exchange value of the dollar against other

major currencies was about unchanged over the intermeeting period.

M2 balances were about flat on average over the previous two months: After contracting a bit

in July, M2 expanded slightly in August. Money growth was damped by a rise in the

opportunity cost of holding M2 assets (as typically occurs in periods of policy tightening). In

addition, the lift to M2 from mortgage refinancings in evidence during the spring was likely

still unwinding over the past couple of months, depressing the growth of liquid deposits.

Business loans at banks expanded in August for the third consecutive month.

The staff forecast prepared for this meeting suggested that the economy would continue

expanding at a solid pace through the end of 2006. Labor market improvements and

accommodative monetary policy were seen as counterbalancing the drag from the swing in

fiscal policy from considerable stimulus this year to modest restraint next year. Consumer

spending was expected to pick up in conjunction with the strengthening labor market and

associated gains in wages and salaries that would offset the effects of an anticipated rise in

the savings rate from its recent low level. The contour of business spending was expected to

be affected by the expiration of the partial-expensing tax provisions at year-end, which gave

an incentive for businesses to invest more heavily this year. Supported by a favorable

financing environment, ample stocks of liquid assets, and the ongoing need to replace aging

or obsolete equipment and software, investment outlays were expected to grow robustly once

the tax-related swings were completed. After the current period of below-average

employment gains, employers were expected to hire at a relatively robust pace next year. At

the same time, as labor market conditions improved, individuals who had withdrawn from

the labor force were thought likely to return, so that job gains were expected to have a muted

effect on the unemployment rate. Consumer price inflation was projected to remain at or

below its current level. Slack in resource utilization, continued rapid growth in structural

productivity, and the pass-through of declining energy prices were expected to contribute to

the restraint on inflation.

In the Committee's discussion of current and prospective developments, the members agreed

that the economy had strengthened somewhat after going through a "soft patch" in late spring

and early summer. Recent data and anecdotal information suggested solid growth ahead, but

at a pace that could well be less brisk than previously anticipated. Consumer spending

appeared to have rebounded in the third quarter. Business investment also was robust, but

executives, especially those at larger firms, seemed more cautious about the outlook than

they had been several months ago. Although higher energy prices had played an important

role in damping growth, questions remained about the reasons for the shortfall from

expectations held this spring, and several policymakers remarked that their uncertainty about

the likely pace of the expansion going forward had risen. Members commented that the

benign incoming data on prices tended to confirm their previous judgment that the increase in

inflation earlier in the year had importantly reflected temporary factors and that core inflation

would probably remain relatively low.

In their discussion of developments in key sectors of the economy, policymakers agreed that

business investment would most likely continue to provide considerable impetus to the

overall economic expansion going forward. The anticipated further expansion of aggregate

demand should boost investment. Also, low real interest rates, strong business balance

sheets, and high levels of profits and cash flow were expected to support capital spending.

However, the extent to which the federal tax provision permitting partial expensing of most

investment expenditures had been boosting capital expenditures was difficult to discern, and

it was possible that the expiration of that provision at year-end could result in a fairly sharp

slowing in investment, at least for a time. In addition, recent discussions with business

contacts, as well as a range of statistical information, suggested a persisting tendency for

corporate executives to limit capital spending commitments. The reasons for this tendency

were unclear, but a continuing focus on corporate governance issues might still be playing a

role, and business concerns about terrorism and other geopolitical risks might have risen this

year. Some members also noted that the pace of technological advance could be slowing a

bit, trimming the rate of decline in the cost of capital for high-tech equipment and software.

High vacancy rates for office buildings and industrial structures would likely continue to

weigh on nonresidential investment, although activity in that sector was showing some signs

of revival.

Committee members interpreted recent data and anecdotal information as indicating that

growth in consumer spending was rebounding fr om its relatively slow rate of late spring.

They saw household spending as most likely continuing to expand at a solid pace going

forward. Gains in nominal income, partly resulting from gradual increases in employment,

were expected to continue to support consumer spending and low interest rates to buoy

residential investment. However, members perceived several possible sources of downside

risk to household spending. In particular, households might hold back on spending in an

attempt to increase their saving, which had fallen to a very low level relative to income. The

ebbing of stimulus from last year's tax cuts also could tend to slow growth in consumer

spending. And a failure of employment to accelerate as expected could undermine consumer

confidence as well as hold down the growth in personal income.

With regard to the external sector, foreign economies were seen as generally expanding

steadily, with the high level of crude oil prices apparently having restrained growth abroad

somewhat less than in the United States. Still, expectations for foreign economic growth had

been marked down somewhat, with adverse implications for U.S. exports and for overall U.S.

growth. Indeed, some policymakers noted that domestic demand in several major U.S.

trading partners was relatively weak and that aggregate demand in those economies was

being sustained importantly by exports to the United States. That pattern was contributing to

a worrisome further widening of the U.S. trade and current account balances, and the

Committee discussed the significance of wide external deficits and various adjustments that

might occur in the process of their return to more sustainable levels.

Committee members generally viewed labor market conditions as having improved modestly

of late. Although payroll growth had been weak in June and July, it registered a somewhat

better performance in August, and initial claims for unemployment insurance continued to

hover around relatively low levels. Some members noted a mismatch between demand and

supply for certain types of labor. In particular, unskilled workers were said to be having

considerable difficulty finding jobs, while firms were facing challenges in hiring workers

with some specific skills, including truck drivers and heavy-equipment operators. Partly as a

result, businesses in a few sectors, such as transportation and construction, reportedly were

experiencing constraints on their output. Overall, however, some slack appeared to remain in

labor markets. Looking forward, policymakers expected gradual improvement in labor

market conditions as the economy expanded. However, anecdotal information suggested that

many firms remained quite cautious about expanding payrolls, citing, among other factors,

continued uncertainty about economic prospects and the high cost of providing health care

benefits.

Partly reflecting the likely persistence of some economic slack, members expected inflation

to stay low. Although non-energy commodity prices remained relatively high, energy prices

had declined noticeably from record levels in recent weeks, and the effects of the energy

price shock on inflation were expected to wane. In this regard, a number of policymakers

commented that data on consumer and producer inflation had generally come in at or below

expectations over the intermeeting period, tending to confirm the Committee's judgment that

the upturn in inflation earlier in the year had owed importantly to temporary factors.

Moreover, inflation expectations appeared to be well-contained, although those expectations

probably were conditioned in part on investors' anticipation that the stance of monetary

policy would likely be tightened over time.

In the Committee's discussion of policy for the intermeeting period, all of the members

favored raising the target for the federal funds rate by 25 basis points to 1¾ percent at this

meeting. The expansion evidently was resilient and self-sustaining and appeared no longer to

require the unusual degree of monetary stimulus that had previously been necessary. A

gradual increase in interest rates seemed likely to be consistent with continued solid

economic growth that would be sufficient to erode remaining margins of slack in resource

utilization over time. In view of these considerations, the Committee believed that another

modest reduction in the degree of monetary policy accommodation at today's meeting was

warranted. With today's action, the real federal funds rate--measured as the difference

between the nominal funds rate and a moving average of core PCE inflation--would move

slightly into positive territory.

With regard to the Committee's announcement to be released after the meeting, the members

agreed that the statement should indicate that, after moderating earlier in the year, partly in

response to the substantial rise in energy prices, output growth appeared to have regained

some traction and that labor market conditions had improved modestly. In addition,

policymakers concurred that the statement should indicate that inflation and inflation

expectations had eased in recent months. They also agreed again to characterize the risks to

sustainable growth and price stability as balanced. Members commented that recent evidence

had boosted their confidence that moderate economic growth would continue and that

inflation would be contained. With aggregate demand probably expanding at least as rapidly

as the economy's potential to produce over the next several quarters, policymakers continued

to see economic conditions as likely to warrant a further reduction in policy accommodation

in coming quarters. However, in the view of many members, policy actions would need to be

increasingly keyed to incoming data. Indeed, it was noted that market participants now

appeared to anticipate some slowing in the pace of policy firming before long and did not

interpret the removal of policy accommodation at a measured rate as necessarily involving

the same policy action at each meeting.

At the conclusion of the discussion, the Committee voted to authorize and direct the Federal

Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the

System Account in accordance with the following domestic policy directive.

"The Federal Open Market Committee seeks monetary and financial conditions

that will foster price stability and promote sustainable growth in output. To

further its long-run objectives, the Committee in the immediate future seeks

conditions in reserve markets consistent with increasing the federal funds rate to

an average of around 1¾ percent."

The vote encompassed approval of the paragraph below for inclusion in the press statement

to be released shortly after the meeting:

"The Committee perceives the upside and downside risks to the attainment of

both sustainable growth and price stability for the next few quarters to be

roughly equal. With underlying inflation expected to be relatively low, the

Committee believes that policy accommodation can be removed at a pace that is

likely to be measured. Nonetheless, the Committee will respond to changes in

economic prospects as needed to fulfill its obligation to maintain price stability."

Votes for this action:Messrs. Greenspan, Geithner, Bernanke, Ms. Bies, Messrs.

Ferguson, Gramlich, Hoenig, Kohn, Ms. Minehan, Mr. Olson, Ms. Pianalto, and

Mr. Poole.

Vote against this action: None.

The Committee noted that Deputy Secretary Normand R. V. Bernard had announced his

intention to retire in the period before the next FOMC meeting, following more than four

decades at the Federal Reserve. The Committee thanked Mr. Bernard for his dedication,

integrity, and steadfast support through the more than 345 FOMC meetings he attended

during his career.

It was agreed that the next meeting of the Committee would be held on Wednesday,

November 10, 2004.

The meeting adjourned at 1:15 p.m.

Vincent R. Reinhart

Secretary

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