FOMC Minutes

March 22, 2005

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, March 22, 2005, at 9:00 a.m.

Present:

Mr. Greenspan, Chairman

Mr. Geithner, Vice Chairman

Mr. Bernanke

Ms. Bies

Mr. Ferguson

Mr. Gramlich

Mr. Kohn

Mr. Moskow

Mr. Olson

Mr. Santomero

Mr. Stern

Ms. Cumming, Messrs. Guynn and Lacker, Mses. Pianalto and Yellen, Alternate

Members of the Federal Open Market Committee

Mr. Hoenig, Ms. Minehan, and Mr. Poole, Presidents of the Federal Reserve Banks of

Kansas City, Boston, and St. Louis respectively

Ms. Holcomb, First Vice President, Federal Reserve Bank of Dallas

Mr. Reinhart, Secretary and Economist

Ms. Smith, Assistant Secretary

Mr. Alvarez, General Counsel

Ms. Johnson, Economist

Mr. Stockton, Economist

Messrs. Connors, Evans, and Madigan, Ms. Mester, Messrs. Oliner, Rolnick,

Rosenblum, and Wilcox, Associate Economists

Mr. Kos, Manager, System Open Market Account

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

Messrs. Kamin and Slifman, Associate Directors, Divisions of International Finance

and Research and Statistics, respectively, Board of Governors

Mr. Whitesell, Deputy Associate Director, Division of Monetary Affairs, Board of

Governors

Messrs. English and Leahy, Assistant Directors, Divisions of Monetary Affairs and

International Finance, respectively, Board of Governors

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

Governors

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

Governors

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

Mr. Nelson, Section Chief, Division of Monetary Affairs, Board of Governors

Mr. Carpenter, Senior Economist, Division of Monetary Affairs, Board of Governors

Messrs. Kumasaka and Luecke, Senior Financial Analysts, Division of Monetary

Affairs, Board of Governors

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

Governors

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

Messrs. Eisenbeis, Fuhrer, Goodfriend, Hakkio, Rasche, Sniderman, and Steindel,

Senior Vice Presidents, Federal Reserve Banks of Atlanta, Boston, Richmond,

Kansas City, St. Louis, Cleveland, and New York respectively

Mr. Elsasser, Vice President, Federal Reserve Bank of New York

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

developments in domestic financial markets and on System open market transactions in

government securities and federal agency obligations during the period February 2, 2005,

through March 21, 2005. By unanimous vote, the Committee ratified these transactions.

The information reviewed at this meeting suggested that the economy was expanding at a

solid pace in the first quarter of the year. Employment was improving. Consumer spending

still appeared to be growing briskly, and residential construction expenditures continued to

move higher. Business spending on equipment and software showed notable gains early in

the quarter, and industrial production increased moderately in the first two months of the

year. Consumer prices moved higher in January after being unchanged in December.

The labor market continued to improve in February. Private nonfarm payrolls grew at a solid

pace, and these gains were widespread across industries. Of particular note, manufacturing

employment, which had been declining, edged higher. On balance, surveys of employers and

of households pointed to firming labor demand. With the average workweek unchanged,

aggregate hours increased moderately in February. Although the unemployment rate in

February ticked back up to its December level, the set of available information on the labor

market suggested that resource slack was diminishing.

Industrial production posted a moderate gain in February, led by a surge in motor vehicle

production. Production of high-tech equipment rose, with the increase in output of

communications equipment far outpacing sluggish growth of computer production.

Production of consumer goods, both durable and nondurable, also rose. In contrast, the

production of non-high-tech business equipment edged down, and the output of construction

and business supplies and materials dropped back. Mining output edged up, but the output of

utilities fell for a second consecutive month amid a generally warm winter.

Supported by strong income gains and higher wealth, consumer spending had increased at a

robust rate in the last quarter of 2004 and appeared to be on track to post another strong

advance in the first quarter of the year. Apart from purchases of motor vehicles, which

stepped down early this year after a year-end surge, the increases in outlays had been broad

based. On average, real disposable income increased at a vigorous pace in December and

January, well above that seen over most of last year. Increases in equity prices and in house

values pushed up the wealth-to-income ratio in the fourth quarter, and the saving rate

remained low by historical standards.

Activity in the housing market continued to expand early this year. Starts of single-family

homes in January and February were well above their fourth-quarter pace, although

indicators of future production pointed to some slowing. Similarly, in the multifamily sector,

starts increased substantially in the first two months of the year but appeared poised to

moderate this month. Although both new and existing home sales declined somewhat in

January, demand continued to be supported by low mortgage rates.

Business spending on equipment and software increased sharply in the fourth quarter and,

excluding motor vehicles, appeared to be growing briskly in the first quarter. The expiration

at the end of 2004 of the special tax provisions that permitted partial expensing of investment

expenditures seemed not to be retarding capital spending. Presumably contributing to the

vigor of capital spending were further increases in business output, strong cash positions of

corporations, and an attractive cost of capital amid generally low interest rates. Shipments

and orders for high-tech equipment remained strong in January. Outside the high-tech sector,

shipments posted a sizable and broad-based increase in January, and the rising backlog of

orders pointed to further gains in the near future. Spending on nonresidential construction

was subdued, as it had been for some time.

Increased inventory accumulation contributed significantly to the rise in economic output in

the fourth quarter of last year and appeared likely to make an additional contribution in the

first quarter of this year. In January, manufacturers' book-value inventories increased at

nearly twice the rate seen in the fourth quarter, while wholesale and retail inventories about

kept pace with the advance in the previous quarter. The rapid buildup in inventories left the

inventory-to-sales ratio unchanged rather than on the downtrend of recent years. However,

the available evidence suggested that firms generally were not uncomfortable with their

inventory positions.

The U.S. international trade deficit widened in January, primarily reflecting a surge in

imported non-oil goods and services. After a general slowdown in the fourth quarter of last

year, indicators for major foreign industrial countries revealed a broad pickup in economic

growth in the first quarter, with industrial production rising in Japan and the major euro-area

countries. Meanwhile, consumer price inflation across most industrial economies remained

subdued. Among the emerging-market economies, indicators of economic activity were

mixed.

Consumer prices edged higher in January after having been flat in December. Core consumer

prices rose a bit faster than overall prices, with price increases widespread across

commodities and services. Consumer energy prices fell in January but turned back up in

February and early March. For the twelve-month period ended in January, overall consumer

prices were boosted significantly by higher oil prices, but core consumer price inflation over

the same period was fairly subdued. A survey measure of near-term inflation expectations

moved up in early March, but long-term expectations had changed little since the end of last

year. Producer prices and commodity indexes were broadly higher in January, with the

exception of prices for core crude materials. With regard to labor costs, average hourly

earnings rose slowly over January and February. Over the preceding year, compensation costs

increased moderately, contributing to a small rise in unit labor costs.

At its February meeting, the Committee decided to increase the target federal funds rate 25

basis points, to 2½ percent. In its accompanying statement, the Committee indicated that the

upside and downside risks to the attainment of both sustainable growth and price stability

were roughly equal. In addition, the Committee noted that the economy appeared to be

growing at a moderate rate despite increases in energy prices, that labor market conditions

continued to improve gradually, and that inflation and inflation expectations remained well

contained. As a consequence, the Committee again judged that policy accommodation could

be removed at a pace that was likely to be measured, although the path of policy would

depend importantly on evolving economic prospects.

The Committee's decision to change the target rate was universally anticipated by market

participants, as was the tenor of the statement. As a result, the reaction in financial markets

was muted. Over the intermeeting period, however, the Chairman's semiannual testimony on

monetary policy, higher oil prices, and incoming data that showed a pickup in price inflation

led market participants to mark up their expectations for the trajectory of the target federal

funds rate. Consistent with the upward revision to policy expectations, yields on Treasury

securities rose significantly. Some of the increase in nominal rates likely owed to higher

inflation expectations, as inflation compensation, measured from the spread between

Treasury nominal debt and comparable inflation-indexed securities, rose. However, staff

analysis suggested that the increases were concentrated over the next few years and that

long-term inflation expectations were little changed. Risk spreads on most corporate bonds

narrowed on balance, significantly so for speculative-grade debt, amid generally strong

corporate balance sheets and good credit performance. Broad stock market indexes edged up

over the intermeeting period. In foreign exchange markets, the trade-weighted value of the

dollar depreciated slightly, with the declines widespread against the currencies of

industrialized countries other than Japan.

M2 growth slowed in the first two months of the year, as the opportunity cost of holding

money rose with monetary policy tightening. Rates paid on liquid deposits were little

changed, but those on small time deposits tracked market rates more closely. As a result,

growth in liquid deposits was depressed, while that of small time deposits was vigorous.

Flows into equity and bond funds picked up in the first two months of the year.

In the staff forecast prepared for this meeting, the economy was seen as likely to expand at a

rate above the growth of potential this year and next, led by strong business demand for

equipment and software. Consequently, labor markets were expected to continue to firm and

the unemployment rate to decline gradually. In light of the robust expansion of capital

spending thus far this year, the outlook for business investment spending was revised up

appreciably, as more of the strength over the latter part of 2004 was attributed to underlying

demand and less to the effects of the partial-expensing tax provision. Steadily rising sales, an

ongoing need to replace and upgrade software and equipment, and favorable financing costs

were all expected to continue to buoy business spending this year and next. Household

spending, supported by rising disposable income and, to a lesser degree, by increasing

wealth, was projected to expand at a solid rate. Net exports were seen as exerting less of an

arithmetic drag on economic growth than in 2004. Measures of overall consumer price

inflation were expected to be lower this year than last and to step down again next year as

energy prices retreated. Inflation in core consumer prices was seen as being boosted a bit by

the effects of higher import and energy costs in the near term but still largely contained by

continued strong growth in underlying labor productivity and remaining slack in resource

markets.

In their discussion of current conditions and the economic outlook, many participants said

that circumstances had changed from those anticipated at the time of the Committee's

meeting in early February. In particular, incoming data and anecdotal information indicated

that economic activity had appreciably more forward momentum than previously perceived

and that inflation pressures could be intensifying. While underlying inflation appeared to

have moved up only modestly and nearly all participants thought that core and total inflation

going forward would be relatively low, they had become less certain of that outlook for the

next few quarters.

Many participants noted that the most recent data and business commentary indicated that

investment was running considerably stronger in the first quarter of the year than had

previously been anticipated. Underlying trends in capital spending appeared to be more

robust than had earlier been recognized, perhaps partly in response to unusually supportive

financial conditions, and that strength was thought likely to carry forward. Business contacts

were more confident about economic prospects, and that confidence was bolstering firms'

willingness to invest. Anecdotal information suggested that firms were investing in part to

expand capacity and in part to boost productivity and lower costs. Some investment was

being prompted by a need to replace equipment that was becoming obsolete, in part because

of the higher level of energy prices. Increased demand was reported for a wide variety of

categories of capital goods, ranging from several types of heavy equipment, including trucks,

farm machinery, and construction equipment, to software and high-tech equipment.

Nonresidential construction, however, remained soft in many regions, damped by relatively

high vacancy rates for office buildings and other commercial real estate.

Spending on housing and consumer goods and services was also seen as underpinning

economic expansion. With single-family housing starts at record levels, residential

investment expenditures apparently continued to be spurred by relatively low interest rates. A

few participants cited some evidence of speculative activity in the housing market in several

regions. However, recent house price developments were mixed, with reports of incipient

softness in some markets, including high-end properties, and overall house price inflation

was seen as likely to slow in coming quarters. Consumer expenditures were expected to

continue to advance at a solid pace, buoyed by strong gains in personal income, although

high energy prices could exert some restraint on spending. The possibility of an appreciable

rise in the personal saving rate, which was near its historical low, represented another

possible downside risk to consumer spending. The recent sharp slowing in motor vehicle

sales, which appeared to be related in part to the paring of purchase incentives and perhaps

also to the high level of energy prices, raised some concerns about the expansion of

economic activity in some regions.

Some participants mentioned that expansion abroad was apparently strengthening early this

year, particularly in emerging-market economies. This development, in turn, was likely to

help support U.S. exports. Several participants noted that past declines in the foreign

exchange value of the dollar were contributing to U.S. economic activity. Tourism from

abroad, for example, was being spurred by relative currency values. At the same time,

though, it was recognized that growth in U.S. domestic demand would likely continue to be

met in part by imports, tending to trim the increase in domestic output.

U.S. industrial activity was increasing steadily, pushing capacity utilization higher.

Production was expanding in a broad range of manufacturing categories, notably including

high-tech and defense industries. Business contacts indicated that the high level of energy

prices was spurring coal mining activity. Drilling for oil and gas was also increasing,

although extraction was said to be crimped in some instances by a scarcity of experienced rig

hands as well as spot shortages of certain key production inputs, such as drilling pipe.

Around the nation, labor markets conditions were reported to be stable to improving, and

meeting participants perceived that slack in labor markets was gradually diminishing. In

general, business executives indicated that labor was readily available, although again

workers with certain skills and in certain occupations, such as trucking, were becoming

increasingly difficult to hire. Some commented that the failure of labor force participation to

rise as expected as the expansion gained momentum likely portended somewhat weaker labor

force growth than previously anticipated; such a development, at the margin, would tend to

reduce the expansion of potential output. Still, pressures on prices stemming from labor costs

seemed well contained and were expected to remain damped in coming quarters. National

data and anecdotal information suggested that wages generally continued to increase

moderately. However, health-care expenses were a persistent source of pressure on costs.

Growth in unit labor costs had continued to be held down by growth of output per hour

worked, which had continued to perform surprisingly well. Although productivity growth

had slowed from the extraordinarily rapid pace that prevailed earlier in the expansion, data

for the fourth quarter of 2004, as well as preliminary indications for the first quarter of this

year, suggested that gains from efficiency remained substantial. Participants remarked that

many business executives were seeking further advances in productivity through

organizational improvements as well as through investment in equipment and software.

Regarding the latter, some evidence suggested that rapid technological progress was being

sustained, which would continue to drive down the cost of many forms of productive capital

and thus boost returns on investment. Moreover, the stronger picture of capital spending that

had emerged of late boded well for the performance of productivity going forward. Still,

considerable uncertainty persisted about longer-run prospects for productivity growth, unit

labor costs, and cost pressures on profits and prices.

Meeting participants commented in particular detail on the inflation situation. They noted

with some concern the recent elevated readings on inflation in prices of core personal

consumption expenditures, the producer price index, and indicators of prices at earlier stages

of production, as well as the sizable further increase in energy prices. Nonetheless, many

participants stated that they expected total inflation to diminish and any rise in core consumer

inflation to be limited. One source of upward pressure on inflation had been the rise in

energy prices, and it seemed reasonable to expect that these prices would level out or even

decline mildly, as built into futures prices. Unit labor costs were still being held down by

moderate wage growth and rising productivity. Indeed, a few saw a distinct possibility of

further positive productivity surprises, representing a downside risk to the inflation outlook.

Moreover, the markup of prices over costs in nonfarm businesses remained quite high, and

firms would likely be pressed by competition to absorb a portion of any step-up in the growth

of unit labor costs, at least if that acceleration were limited in extent and duration. In

addition, prices of many non-energy commodities had risen in recent weeks, but such inputs

constituted a relatively small fraction of overall business costs, and, partly for that reason, in

the past commodity prices had demonstrated little predictive content for broad inflation rates.

While short-term inflation expectations had risen somewhat, longer-term inflation

expectations remained well contained. And lastly, monetary policy would be aimed at

preserving price stability.

Still, many participants indicated that their uncertainty about the intensity of inflation

pressures had risen in response to recent developments and that, in particular, the distribution

of possible inflation outcomes was now tilted a little to the upside. Although monthly

statistical releases could be quite volatile, the recent data showing consumer inflation a little

above previous expectations were of concern. Also, anecdotal indications of price increases

were becoming more common across a number of industries. Some business executives

reportedly believed that, with aggregate demand expanding robustly and the lower foreign

exchange value of the dollar putting upward pressure on import prices, a degree of "pricing

power" had returned. Moreover, the recent rebound in spot crude oil prices, and especially

the substantial advance in prices of crude oil futures contracts for delivery well into the

future, suggested that a significant unwinding of higher energy costs might not be in

prospect. Several participants indicated that, in current circumstances, they viewed an upside

surprise to inflation as potentially more harmful than an equivalent downside surprise, partly

because such an outcome could well impart additional upward momentum to inflation

expectations.

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

members favored boosting the target for the federal funds rate by 25 basis points to 2-3/4

percent at this meeting. Monetary conditions evidently were still quite accommodative,

economic activity appeared to have more momentum than had previously been perceived,

and, while core inflation most probably would stay low, pressures on inflation seemed to

have risen. Prospects for legislative action to apply significant fiscal restraint were unclear,

even as the expansion became increasingly well established and private demand proved

strong and resilient. Although the required amount of cumulative tightening may have

increased, members noted that an accelerated pace of policy tightening did not appear

necessary at this time, as a degree of economic slack apparently remained, productivity

growth would probably continue to damp increases in unit labor costs and prices, and

inflation would most likely continue to be contained. In these circumstances, Committee

members judged that the measured removal of policy accommodation was appropriate for

now.

In discussing the announcement to be released after the meeting, members agreed that it was

appropriate to acknowledge the recent evolution in the inflation situation by indicating that

"though longer-term inflation expectations remain well contained, pressures on inflation have

picked up in recent months and pricing power is more evident. The rise in energy prices,

however, has not notably fed through to core consumer prices." Regarding the risks to

sustainable growth and price stability, members discussed a proposal to make the

Committee's assessment explicitly conditional on an assumption of appropriate monetary

policy so as to underscore that maintaining balanced risks would require policy action. It was

noted that the Committee's assessment of balanced risks over the past nine months--a period

in which monetary policy had been steadily tightened--necessarily had to be interpreted as

based implicitly on an assumption that policy accommodation would be removed. A number

of members believed that formulaic language by its nature was too rigid to reflect evolving

economic circumstances in a satisfactory manner, especially when developments were subtle

or complex, and some of these members believed that the risk assessment should be

discontinued. All the members ultimately approved making the risk assessment in the policy

announcement following this meeting explicitly conditional on appropriate policy.

Members also focused on the issue of whether to reiterate the judgment expressed in the

Committee's recent statements that ". . . policy accommodation can be removed at a pace that

is likely to be measured." Some expressed the view that such language could constrain future

policy inappropriately; while these concerns were not new, they were now felt to be more

pressing, as the odds that the Committee might need to step up the pace of policy firming

were thought to have increased. Members noted, however, that the existing "measured pace"

language was clearly conditional on the economy evolving in a way that promised a gradual

return to high levels of resource utilization and on inflation remaining low, and thus believed

that the wording did not rule out either picking up the pace of firming or pausing in the

process of removing policy accommodation should circumstances warrant. They also noted

that the language had not precluded a notable increase in medium- and longer-term interest

rates over the intermeeting period as markets extended the expected gradual increase in

policy rates. Some discomfort was expressed with language that related so explicitly to the

likely trajectory of future policy action. But it was also averred that the Committee should, to

the extent possible, provide information that would help the public anticipate the probable

course of monetary policy; providing such information would tend to increase the

effectiveness of monetary policy. More generally, members recognized that the Committee's

statement would need to evolve over time.

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 2-3/4 percent."

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

released shortly after the meeting:

"The Committee perceives that, with appropriate monetary policy action, the

upside and downside risks to the attainment of both sustainable growth and price

stability should be kept roughly equal. With underlying inflation expected to be

contained, 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, Guynn, Kohn, Moskow, Olson, Santomero, and Stern.

Vote against this action: None.

Mr. Guynn voted as alternate member.

It was agreed that the next meeting of the Committee would be held on Tuesday, May 3,

2005.

The meeting adjourned at 1:25 p.m.

Notation Vote

By notation vote completed on February 22, 2005, the Committee unanimously approved the

minutes of the meeting of the Federal Open Market Committee held on February 1-2, 2005.

Vincent R. Reinhart

Secretary

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Last update: April 12, 2005, 2:00 PM