FOMC Minutes

May 3, 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, May 3, 2005 at 9:00 a.m.

Present:

Mr. Greenspan, Chairman

Mr. Geithner, Vice Chairman

Ms. Bies

Mr. Ferguson

Mr. Fisher1

Mr. Gramlich

Mr. Kohn

Mr. Moskow

Mr. Olson

Mr. Santomero

Mr. Stern

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

Mr. Reinhart, Secretary and Economist

Ms. Danker, Deputy Secretary

Ms. Smith, Assistant Secretary

Mr. Alvarez, General Counsel

Mr. Baxter, Deputy General Counsel

Ms. Johnson, Economist

Mr. Stockton, Economist

Messrs. Connors, Evans, and Madigan, Ms. Mester, Messrs. Oliner, 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. Freeman, Slifman, and Struckmeyer, Associate Directors, Divisions of

International Finance, Research and Statistics, and Research and Statistics,

respectively, Board of Governors

Messrs. Clouse and Whitesell, Deputy Associate Directors, 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. Brady, Section Chief, 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. Lyon, First Vice President, Federal Reserve Bank of Minneapolis

Messrs. Eisenbeis, Goodfriend, Hakkio, Rasche, Rudebusch, and Sniderman, Senior

Vice Presidents, Federal Reserve Banks of Atlanta, Richmond, Kansas City, St.

Louis, San Francisco, and Cleveland, respectively

Mr. Elsasser, Ms. Little, and Messrs. Peach and Todd, Vice Presidents, Federal

Reserve Banks of New York, Boston, New York, and Minneapolis, respectively

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 since the previous

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

By unanimous vote, the Committee voted to extend for one year beginning in mid-December

2005 the reciprocal currency ("swap") arrangements with the Bank of Canada and the Banco

de Mexico. The arrangement with the Bank of Canada is in the amount of $2 billion

equivalent and that with the Banco de Mexico in the amount of $3 billion equivalent. Both

arrangements are associated with the Federal Reserve's participation in the North American

Framework Agreement of 1994. The vote to renew the System's participation in the swap

arrangements maturing in December was taken at this meeting because of the provision that

each party must provide six months prior notice of an intention to terminate its participation.

The information received at this meeting suggested that the growth of economic activity had

unexpectedly moderated during the first quarter from the rapid pace seen during the second

half of 2004. Gains in private payroll employment over the first quarter were similar to the

average for the second half of 2004 but weakened in March, and manufacturing production

rose only a little, on balance, over February and March. Consumers appeared to have turned

somewhat cautious in their spending, likely a reflection of higher energy prices. Housing

starts fell in March after a sustained stretch of very high readings, but home sales continued

at a rapid rate throughout the quarter. Growth of capital spending, while strong in the first

quarter, was down from the brisk rates of previous quarters. Sharp increases in energy prices

pushed up headline inflation, and core measures were also somewhat elevated. Labor costs,

however, advanced at a moderate rate. Employment continued to expand in March, although

the increase was less than the strong advance in February. Employment declined in

manufacturing, retail trade, and temporary help services, but most other sectors registered

gains. The average workweek remained at its recent level, and aggregate hours posted a small

gain. The unemployment rate moved down to 5.2 percent in March. Also suggesting a

gradual erosion of slack in labor markets were surveys indicating that some employers were

finding some jobs requiring special skills harder to fill and that households were

experiencing increases in job availability. Nevertheless, survey measures of expected

conditions in labor markets softened somewhat in the early months of the year, and the labor

market participation rate remained low in March.

Industrial production continued to expand in the first quarter, but the pace was slower than in

the final months of 2004. Gains were restrained by a decline in manufacturing output,

particularly for motor vehicles and parts, and by a reduction in energy generation at utilities,

which was held down by unseasonably warm weather early in the year. Mining output,

however, accelerated, as did production in the business equipment and defense and space

equipment industries. Capacity utilization in manufacturing edged up on average in the first

quarter, but moved down in March and remained a bit below its thirty-year average.

Consumer spending advanced solidly in the first quarter despite some slowing in automobile

sales. However, much of that strength was registered early in the quarter, and spending in

March was subdued. Measures of consumer confidence declined in the early months of the

year but remained well above the lows of two years ago. Other factors underlying consumer

spending also remained favorable: Real wages and salaries continued to rise, and the ratio of

wealth to income remained high, although it was down a bit because of a decline in equity

prices. The personal saving rate stayed low over the first quarter of the year.

Housing starts slowed in March, after exceptional strength in the prior two months. However,

a substantial increase in the level of permits in March suggested that starts likely turned back

up in April. A similar pattern was observed in the multifamily sector. The thirty-year

mortgage rate in the first quarter stayed in a range around its average level for the past two

years. Sales of existing homes were rapid throughout the quarter, and sales of new homes

rose to another record level in March. House prices continued to rise rapidly over the first

quarter, although recent data suggested some slowing.

Growth of business spending on equipment and software moderated substantially in the first

quarter from the very high rates of last year, but appeared to retain considerable momentum;

strong gains occurred in all major categories except motor vehicles. This performance

reflected favorable underlying fundamentals, including solid growth in business output,

strong retained earnings, high levels of liquid assets, and favorable borrowing conditions in

the form of low interest rates and narrow risk spreads in bond and loan markets. At the same

time, construction of nonresidential structures remained quite subdued. Over the first quarter,

outlays for manufacturing facilities picked up a bit, but those for office buildings stayed low

despite some declines in the office vacancy rate, and spending on commercial structures fell.

Nonfarm inventories accumulated in the first two months of the year at a much faster rate

than in the preceding quarter, prompting a small increase in inventory-sales ratios. Inventory

gains were especially strong early in the quarter and were concentrated in the manufacturing

sector.

The U.S. international trade deficit widened in February as exports held steady. The value of

imported oil jumped sharply, and nonoil imports also rose. Economic indicators for major

foreign industrial countries suggested some slowing of growth late in the quarter after a

pickup earlier in the year. In Japan, industrial production rose briskly in January before

falling back; the euro-area industrial sector evidenced a similar pattern. By contrast,

economic activity in China and other developing countries showed greater buoyancy.

Consumer price inflation abroad remained subdued.

U.S. consumer price inflation firmed in recent months as energy prices rose sharply. Core

consumer prices also rose a bit more rapidly recently, but the increase over the twelve months

ending in March was little different than over the year-earlier period. According to survey

information, expectations of near-term inflation picked up in March, consistent with the

increase in energy prices. As for labor costs, the employment cost index for private industry

decelerated over the first quarter from an already moderate pace. The slowing occurred in

both the wages and salaries component and the benefits component and was fairly

widespread across industry groups.

At its March meeting, the Federal Open Market Committee decided to increase the target

level of the federal funds rate 25 basis points, to 2-3/4 percent. In its accompanying

statement, the Committee expressed its perception 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. The Committee also noted that economic output

continued to grow at a solid pace despite the rise in energy prices and that labor market

conditions continued to improve gradually. While pressures on inflation had picked up in

recent months and pricing power was more evident, longer-term inflation expectations

remained well contained. In these circumstances, the Committee believed that policy

accommodation could be removed at a pace that would likely be measured but noted that it

would respond to changes in economic prospects as needed to fulfill its obligation to

maintain price stability.

The FOMC's decision in March to raise the intended level of the federal funds rate 25 basis

points was fully anticipated by the market, as were its retention in the accompanying

statement of the "measured pace" language and its assessment that the risks to price stability

and sustainable economic growth were balanced. Interest rates, however, rose, reportedly in

response to the statement's references to increased price pressures and to more evident

pricing power as well as to the Committee's conditioning of its risk assessment on

"appropriate monetary policy action." Interest rates rose further the next day following the

release of a larger-than-expected increase in the CPI for February. Over subsequent weeks,

however, these increases were more than reversed by weaker-than-expected data on

consumer spending, consumer sentiment, and output. Further downward pressure on interest

rates was exerted by the market's response to the release of the minutes of the March

meeting, as attention focused on the reference to Committee members' judgment that an

accelerated path of policy tightening was not necessary at that time. Despite generally good

first-quarter earnings reports, equity indexes moved down considerably in response to the

signs of weaker economic growth. In foreign exchange markets, the dollar rose on balance,

apparently due, in part, to disappointing news on employment and output abroad.

M2 expanded in March and April at about the same sluggish pace as it did earlier in the year.

The growth of M2 continued to be restrained by increases in its opportunity cost resulting

from rising short-term interest rates. Rates paid on its liquid components particularly lagged

increases in market rates.

Partly in response to the receipt of weaker-than-expected data for spending and output in the

first quarter, the staff marked down somewhat its forecast of economic growth for 2005 and

2006. Even so, the economy was seen as retaining considerable momentum, and growth was

expected to pick up some after the first quarter, paced by business spending on equipment

and software. Consumption expenditures were seen as likely to expand at a moderate rate and

residential investment to slow. With exports forecast to expand a bit more rapidly than

imports, the arithmetic net drag on the economy from trade was expected to lessen. Fiscal

policy was expected to provide a more moderate impetus to growth this year and next,

following the substantial boost estimated for earlier years. Although economic growth was

projected to run a bit above the staff's estimate of the economy's potential, the unemployment

rate was projected to hold around its current level with improvements in job prospects

expected to lure more workers back into the labor force. Inflation was projected to edge

lower over the rest of the year and into 2006, reflecting the attenuation of the impact of

higher energy prices and the effects of a slowed rate of growth of import prices and

remaining slack in resource markets.

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

observed that incoming data over the intermeeting period hinted at possible upside risks for

inflation and downside risks for economic growth. Earlier increases in energy prices seemed

to be an important factor contributing to an uptick in core inflation and a slower pace of

economic activity. With energy prices leveling out more recently, however, and the behavior

of compensation suggesting a lack of pressure in labor markets, underlying inflation

appeared to remain contained. The weakness in spending was widespread and could not be

completely dismissed, but it had appeared only very recently and could be a product of the

inherent noisiness of high-frequency economic data. On balance, economic fundamentals

including low interest rates, robust underlying productivity growth, and strengthened

business balance sheets were expected to support economic growth at a pace sufficient to

gradually eliminate remaining slack in resource utilization. Although the economic outlook

generally seemed favorable, there was also broad recognition of greater uncertainty attending

the outlook for both inflation and output growth.

Capital expenditures advanced briskly over the first quarter, but at a pace significantly below

that registered over the latter half of last year. To some extent, businesses probably had

pulled capital outlays forward from this year into 2004 to benefit from the partial-expensing

tax provision that expired at year-end, but the unexpected weakness in capital goods orders

for February and March seemed hard to attribute to this factor alone. In addition, the

prolonged period of elevated spot energy prices, the sense supported by futures markets that

these higher prices may persist for some time, and the heightened uncertainty about energy

prices going forward, together may have left businesses less confident about the future and

wary of longer-term commitments such as expanding plant capacity or taking on new

workers. A less buoyant and less certain economic outlook seemed apparent in financial

markets as well, where equity prices had fallen and risk spreads had widened. On balance,

though, these financial developments did not appear to signal the onset of a sharp

retrenchment in investors' willingness to bear risk, and capital expenditures were seen as

likely to remain quite robust, spurred by strong economic fundamentals that included

elevated profits, opportunities to raise efficiency by utilizing new technologies, a low cost of

capital, and strong corporate balance sheets. Indeed, a substantial weakening in business

investment in an environment with such favorable fundamentals would be at odds with the

historical record.

Incoming data for the household sector were viewed as mixed. Higher gasoline prices

seemed to be sapping consumer confidence and consumer spending. The pace of

consumption growth had fallen off appreciably toward the end of the first quarter, and some

participants worried about the potential for continued sluggishness in consumer spending if

increasingly cautious households sought to raise their saving rate rapidly. On balance,

though, strong income growth and low interest rates augured well for household spending.

Although housing starts had dropped of late, home sales and other indicators of activity in the

residential real estate market remained at very high levels. House price appreciation was

expected to moderate over coming quarters, but a number of local real estate markets were

still regarded as "hot," with signs of possible speculative excesses in some areas.

The deceleration in final sales over the first quarter had been accompanied by a sizable

accumulation of businesses inventories. The available data suggested that stocks had

accumulated in a variety of industries, but particularly in the motor vehicle sector where the

inventory of new autos had moved appreciably higher. Although difficult to judge, the

inventory buildup was not regarded as likely to have major implications for aggregate

manufacturing beyond some modest production cutbacks in the current quarter.

A relatively high proportion of demand had continued to be met by imports. Some concern

was expressed that incoming data suggested weaker growth in some of our major trading

partners, which posed a downside risk to forecasts for U.S. exports. Moreover, advances in

domestic income were expected to contribute to brisk growth in imports. Looking ahead, the

U.S. economy was expected to continue to run quite substantial current account deficits,

although the impact of past dollar depreciation should work to boost exports and slow the

rise in imports to some extent.

Recent energy price developments garnered considerable attention. Declines in energy prices

in recent weeks were viewed as welcome, but participants noted that far-dated futures prices

for oil remained quite elevated and that persistently high energy prices could trigger a range

of deleterious effects on the economy. High energy prices appeared to be taking a toll on

household and business confidence and might be beginning to crimp corporate profits. In

some cases, firms seemed to be more successfully passing on energy costs to their customers.

Indeed, some portion of recent elevated inflation readings probably represented, at least

partly, such pass-through effects from higher energy costs. However, while pass-through

effects could leave the overall price level higher, their impact on inflation should fade over

time, as long as inflation expectations remain well contained. Still, considerable uncertainty

surrounded the degree of pass-through from energy prices to core consumer prices, and

pass-through effects might be more pronounced when energy price increases were perceived

as more likely to be permanent. Persistently high energy prices were mentioned as a factor

that could trim the level of potential output to a small degree over time, possibly contributing

to additional upward pressure on consumer prices at the margin.

Participants voiced concerns about recent price trends; they expected inflation to remain

contained but also perceived that the risks to that inflation outlook now might be skewed

somewhat to the upside. Core measures of price inflation had moved up over recent quarters

and particularly so over the last few months. A discernable upcreep was apparent in survey

measures of short- and, to a limited extent, long-term inflation expectations over recent

months. Moreover, there were risks that the relative stability of long-term survey measures of

inflation expectations could simply reflect lags in households' perceptions of changing

economic prospects. The success that some businesses seemed to be encountering in passing

through cost increases raised the possibility that competitive pressures and resource slack

were exerting somewhat less restraint on inflation than had been anticipated.

However, available indicators of wages and benefits had registered only modest growth,

suggesting to many that some slack in labor markets persisted. Moreover, market measures of

inflation compensation had ebbed in recent weeks, and survey measures of long-term

inflation expectations, albeit a touch higher of late, remained in the broad range of recent

years. Along with energy prices, import and materials prices apparently had contributed to

the recent uptick in inflation, and pressures on inflation stemming from these three sources

were expected to lessen over coming quarters. On balance, measures of core inflation were

thought likely to remain in check over the remainder of this year and next.

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

favored raising the target federal funds rate 25 basis points to 3 percent at this meeting.

Although downside risks to sustainable growth had become more evident, most members

regarded the recent slower growth of economic activity as likely to be transitory. In this

regard, the ability of the U.S. economy to withstand significant shocks over recent years

buttressed the view that policymakers should not overreact to a comparatively small number

of disappointing indicators, especially when economic fundamentals appeared to remain

quite supportive of continued solid expansion. To be sure, the Committee had raised its

federal funds rate target appreciably over the past year, and, in the view of a few members, a

larger-than-expected moderation of aggregate demand in response to this cumulative policy

action could not be ruled out. However, all members regarded the stance of policy as

accommodative and judged that the current level of short-term rates remained too low to be

consistent with sustainable growth and stable prices in the long run. Against the backdrop of

the recent uptick in core inflation and in some measures of inflation expectations, members

agreed that they should continue along the course of removing policy accommodation at a

measured pace conditional on the outlook for inflation and economic growth.

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

appropriate to acknowledge that rising energy prices seemed to have spurred an increase in

core measures of inflation by dropping the reference from the March statement indicating

that "The rise in energy prices, however, has not notably fed through to core consumer

prices." They likewise all agreed that mention should be made that, on balance, longer-term

inflation expectations remained well contained. Regarding the risks to sustainable growth and

price stability, some members noted that the risk assessment conditioned on "appropriate

policy" no longer seemed to convey useful information regarding the Committee's economic

and policy outlook. Although some members noted that a case could be made that the risks to

inflation were now somewhat skewed to the upside and those to sustainable economic growth

perhaps to the downside, the most likely outcome remained one of stable prices and

sustainable growth, and the Committee agreed that it should retain a balanced assessment of

risks conditional on appropriate policy.

For many, heightened economic uncertainty in the current environment implied greater

uncertainty about the range of possible policy outcomes and placed a premium on flexibility

in setting policy at upcoming meetings. Some members commented that this greater

uncertainty called for eliminating or paring back forward-looking language from the

statement--if not at this meeting, then fairly soon. In the event, most members viewed the

forward-looking language in the statement--including the characterization of the stance of

policy as accommodative as well as the judgment that policy accommodation could be

removed at a pace that is "likely to be measured"--as a reasonable characterization of the

policy stance and its likely evolution over time. Moreover, a number remarked that the

language in its current form was clearly conditioned on economic developments and

therefore would not stand in the way of either a pause or a step-up in policy firming

depending on events. In the end, all members agreed to retain the forward-looking language.

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 3 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 and Geithner, Ms. Bies, Messrs. Ferguson, Fisher,

Gramlich, Kohn, Moskow, Olson, Santomero, and Stern.

Votes against this action: None.

Absent and not voting: Mr. Bernanke

It was agreed that the next meeting of the Committee would be held on WednesdayThursday, June 29-30, 2005.

The meeting adjourned at 1:25 p.m.

Notation Vote

By notation vote completed on April 11, 2005, the Committee unanimously approved the

minutes of the meeting of the Federal Open Market Committee held on March 22, 2005.

Vincent R. Reinhart

Secretary

Footnote

1. Secretary's note: Advice had been received that Richard W. Fisher had been elected by the

directors of the Federal Reserve Banks of Atlanta, Dallas, and St. Louis, as a member of the

Federal Open Market Committee for the period commencing April 4, 2005, and that he had

executed his oath of office. Return to text

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