1

DOMESTIC ECONOMIC

CONDITIONSJeff Fuhrer

Director of ResearchFederal Reserve Bank of Boston

Equipment Leasing and Finance AssociationCredit and Collections Management Conference

June 12, 2007

2

Overview• Monetary policy is balancing risks

– Risk of a slowing real economy• Although there are some upside risks to growth as well

– Risk that inflation will remain a bit elevated

• Risks to spending– Effects of the housing slowdown– Slower business investment?– Stronger consumer spending?

• Inflation risks– Recent data have been reassuring– But it’s too early to say that success has been achieved– High resource utilization is a potential risk for inflation

3

The good news: Much of the economy is doing well

• Most sectors– Particularly consumer spending, net

exports

• The exceptions– Housing– Uncertainty about investment in equipment

and software

4

Improvements in net worth and income have supported consumer spending …

35000

40000

45000

50000

55000

60000

2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1

10000

12000

14000

16000

18000

20000

22000

Household net worth (FOF, right scale)

Net worth in Owner-occupied housing (left scale)

… including continued improvements in housing equity

Consumer spending: Slowing, but still growing

0

1

2

3

4

5

6

7

8

2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.54-qtr. % chg. in wage and salary income (left scale)

4-qtr. % chg. in nonfarm employment (right scale)

… as has growth in labor income, supported by continued employment growth

5

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

1979:Q1 1985:Q1 1991:Q1 1997:Q1 2003:Q1

-2

-1

0

1

2

3

4

5

6

7

8

Consumer sentiment (left scale)

4-qtr. % chg. in real consumerspending (right scale)

Overall, consumers are well-positioned to continue spending in 2007-8

6

U.S. export growth will be boosted by sustained strength in our trading partners

0

12

34

56

7

1994q1 1996q3 1999q1 2001q3 2004q1 2006q3

4-q

uar

ter

% c

han

ge

-15

-10-5

05

1015

20

4-q

uar

ter

% c

han

ge

Avg GDP growth of largest trading partners (left scale)

Growth in U.S. exports (right scale)

70

100

130

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Ind

ex

Real, trade-weighted exchange value of the dollar

Recent declines in the dollar will also support U.S. exports.

Sources: Bureau of Economic Analysis, IMF, Federal Reserve, FRBB Calculations

What’s doing well: Net exports

7

The Risks: Housing

Housing sales have fallen 30% from their peak …

…prompting reductions in construction

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1999:Jan 2001:Jan 2003:Jan 2005:Jan 2007:Jan

Months’ supply of new homes for sale at current sales rate

Builders still have a large stock of unsold homes to move

500600700800900

100011001200130014001500

199501 199601 199701 199801 199901 200001 200101 200201 200301 200401 200501 200601 2007011000

1200

1400

1600

1800

2000

2200

2400

New Home SalesPermits

8

The Risks: 1. Housing

Sources: Census, OFHEO, National Association of Realtors, FRB

-4-202468

1012141618

1996:Q1 1997:Q1 1998:Q1 1999:Q1 2000:Q1 2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1

4-qtr. % chg., OFHEO

4-qtr. % chg., Census

Still, house prices have yet to decline nationally

If they did, that would be the “other shoe” dropping

The housing correction has resulted in limited spillovers to the rest of the

economy to date• Consumer spending remained robust

even as housing plummeted• Employment growth has been strong

9

Price increases have slowed, albeit with significant regional variation.

Source: Office of Federal Housing Enterprise Oversight, FRBB Calculations

Four-Quarter Growth Rates in OFHEO House Price Index12.7

9.8

7.987.7

2.3

0.45

2.39

10.33

0

2

4

6

8

10

12

14

US New England MA Providence

Per

cen

t

2005:Q4

2006:Q4 MA pricesslowed earlier

than some otherregions

10

MUCH recent attention has focused on the unraveling of the subprime mortgage market

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Q1-98 Q1-00 Q1-02 Q1-04 Q1-06

Prime Fixed Prime AdjustableSubprime Fixed Subprime Adjustable

Source: Mortgage Bankers Association

Foreclosures initiated in quarter as a percentage of loans – US through Q4-06

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Q1-98 Q1-00 Q1-02 Q1-04 Q1-06

Prime fixed Prime adjustableSubprime fixed Subprime adjustable

Foreclosures initiated in quarter as a percentage of loans – RI, through Q4-06

It’s happened earlier inRI, perhaps becauseprices turned down earlier

Implications: (1) Some homeowners will suffer; (2) Subprime mortgages hard to get (3) Macro effects: Limited spending effect or financial spillover

due to market segmentation

US RI

11

The risks: 2. Capital spending has been weaker than

expected.

0123456789

10

2001:Q1 2002:Q1 2003:Q1 2004:Q1 2005:Q1 2006:Q1 2007:Q1

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Profit share of GDP (left scale)

Nonfarm productivity growth (right scale)

Weak capital spending is a bit of a puzzle, as underlying supports for investment still appear solid

-8-6-4-202468

101214

2000 2001 2002 2003 2004 2005 2006

Ye

ar-

to-y

ea

r %

ch

an

ge Actual

Forecast

Global Insight Forecast forReal spending on Equipment and Software

12

Possible explanations for slowing capital spending

1. Capital spending shifting overseas

2. Capital spending is slow in sectors with

slow employment growth (doesn’t seem

to explain much)

3. Capital spending was associated with a

one-time improvement in technology

The boom is over now?

13

Servicing foreign markets

Servicing U.S. markets

Capital installedabroad

Capital installed

domesticallya b d c

• What’s happening?– c decreasing because domestic demand

weak?– a increasing, raising share in total

capital spending?– b substituting for c?– a substituting for d?– Import substitution (foreign producers)

Foreign producers

14

Most of the surprise came in high-tech investment goods

Predictedexceeds

actual overpast 3-4

years

15

The Risks:3. Inflation may not moderate as expected

The expected moderation in inflation is not compelling in the data yet

Sources: Department of Energy, Bureau of Labor Statistics

-10

-8

-6

-4

-2

0

2

4

6

19802 19832 19862 19892 19922 19952 19982 20012 20042

Per

cen

t

Actual Output / CBO Potential Output(with ± 1% uncertainty range)

Unemployment is low and actual output is near potential, posing some upside risk to inflation.

0

0.5

1

1.5

2

2.5

3

3.5

4

2001:Jan 2002:Jan 2003:Jan 2004:Jan 2005:Jan 2006:Jan 2007:Jan

CPI 12-mo

CPI 6-mo

CPI 3-mo

*s indicatetrends without

March data

16

Summary

• Risks to the real economy– Key downside risks

• Housing sector, capital spending– But some upside risk too

• Consumer spending is projected to slow quite a bit, with a rise in the saving rate

• The rise in savings doesn’t have to happen

• Risks to inflation as well– Recent data do not conclusively show a downtrend in

inflation– The economy is at or near full employment

• Policy is attempting to balance these risks at its current setting