Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Your first international exhibit (exhibit 9) covers recent market developments. As shown by the green line in the top left panel, oil prices dropped further this month, bringing the West Texas intermediate spot price back to pre- Katrina levels. The IMF index of nonfuel commodity prices (the red line) was little changed this month after a year of remarkable increases. Readings from futures markets imply a flattening out of nonfuel commodity prices and only a moderate increase in oil prices going forward. The top right panel shows that our real trade- weighted dollar indexes declined on balance last year. In recent weeks the dollar rebounded modestly against the major industrial-country currencies (the red line), but we estimate that it continued to decline in real terms against the currencies of our other important trading partners (the green line). As usual, our forecast calls for a small downward trend from current levels, reflecting our belief that the risk of significant depreciation is slightly greater than the risk of significant appreciation, owing to the unsustainably large U.S. trade deficit. The bottom panels report equity market indexes, with industrial countries shown on the left. The lines are set to equal 100 in March 2000, the previous peak month for the Wilshire 5000. Equity prices have risen broadly across the industrial countries over the past two years and are now just above their March 2000 levels in the United States, the United Kingdom, and Japan, but not in the euro area (the red line). For major emerging markets, on the right, equity indexes are well above March 2000 levels. In Mexico (the blue line), equity prices have more than tripled over this period. In Thailand (the green line), the government’s recent attempts to slow capital inflows and relieve upward pressure on the currency have taken their toll on equity prices, but contagion to other emerging equity markets has been minimal. Overall, commodity and financial market developments are consistent with expectations of strong global growth.

Exhibit 10 focuses on financial flows between emerging markets and industrial countries. As shown in the top left panel, the major developing regions have continued the downward trend in their reliance on external borrowing. Fiscal deficits have declined in most countries, and many governments have turned increasingly to local, rather than external, borrowing. The panel to the right shows that yield spreads on dollar-denominated sovereign debt of emerging market countries have dropped to historically low levels.

But emerging markets, in the aggregate, have gone much further than just reducing their borrowing. In recent years, emerging markets have experienced record outflows of official capital (the gold bars in the middle panel). These official outflows are composed of the accumulation of foreign exchange reserves, the servicing and paying down of sovereign debt, and the purchase of foreign assets by government-run investment funds such as the Kuwait Investment Authority. In all the emerging market regions, official capital outflows have recently exceeded current account surpluses (the blue bars), which are themselves at record levels. For example, the IMF estimates that in 2006, governments in emerging Asia invested on balance $270 billion outside their borders, a sum that greatly exceeds their combined current account surplus of $185 billion. Most of these official flows have taken the form of additions to foreign exchange reserves, as governments have built up war chests against future financial crises and sought to counter upward pressures on their currencies.

The bottom panel looks at these flows from the point of view of the industrial countries, plotting aggregate emerging market net official flows (the gold bars) relative to industrial-country GDP, with negative values denoting net flows into the industrial countries. The statistical accounts do not report the destinations of all these flows, but the available evidence suggests that the overwhelming majority is destined for the industrial countries. Before 2003, net official inflows or outflows from the emerging markets had never exceeded 1 percent of industrial-country GDP. But since 2003, things have changed. Net official outflows from emerging markets are now estimated to equal 2½ percent of the combined GDP of the industrial countries. As shown in the panel, the timing of this unprecedented increase in net official flows corresponds well with the puzzling decline in real short-term interest rates in the industrial countries (the green line) that persisted long after industrial-country GDP growth (the purple line) rebounded from the slowdown early in this decade. The evidence suggests that aggregate policy-driven capital flows from the emerging markets may be an important factor behind low real interest rates in the industrial countries. Moreover, low real rates are not limited to short-maturity instruments.

The top panels of exhibit 11 show that ten-year indexed bond yields are also low and have been for several years in the major industrial countries. These rates have ticked up over the past month or two, but only by a small amount. Long-term inflation compensation (shown in the middle row of panels) remains contained. Indeed, in Japan and Canada (the two panels on the right) inflation compensation has moved down in recent months. In the euro area and the United Kingdom (the two panels on the left), where inflation compensation lingers above policymakers’ targets, we project modest additional policy tightening early this year, shown in the bottom row of panels.

Despite recent and expected future inflation rates close to zero, the Bank of Japan seems poised to tighten gradually over the next two years. In Canada, policy is expected to remain on hold. If these projections prove to be the peak policy rates for this cycle, they will be the lowest cyclical peaks for short-term interest rates in these countries for at least forty years. Nevertheless, we judge that these policy stances are likely to be consistent with low and stable inflation this year and next. The large capital inflows and low real interest rates in the industrial countries have contributed to rising housing prices in many of these countries. Higher home prices in turn have stimulated housing construction. The top panel of exhibit 12 shows that the extent and timing of the house-price boom differs markedly across countries. The Netherlands (the blue line) was one of the leaders of the global housing boom, with prices rising continuously since the early 1990s, though at much slower rates in recent years. Japan (the green line), on the other hand, is a notable exception to the trend of rising house prices in recent years, reflecting the lingering effects of the bursting of the 1980s asset bubble and Japan’s extended economic slump. The middle panels focus on two countries that experienced strong house-price increases (the purple lines) early in this decade but where house-price increases subsequently halted, at least temporarily. In both Australia and the United Kingdom, as in the United States, residential investment (the green lines) responded positively to higher house prices. In Australia, on the left, real house prices have been flat for the past three years, and residential investment has declined gradually about 1 percentage point of GDP, though it remains above its historical average. In the United Kingdom, on the right, house prices stabilized in 2005 and picked up again modestly last year. Despite lower house-price inflation, residential investment has continued to rise toward historically high levels. The relevance of these foreign experiences for the United States is difficult to gauge, but they provide some support for Larry’s forecast that the downturn in U.S. housing is nearly over.

In light of the signals from financial and commodity markets, as well as other real-side indicators, we project continued solid growth in the foreign economies at rates that are not likely to strain resources or to put upward pressure on inflation. As shown in the bottom panel, total foreign growth (line 1) is estimated to have stepped down last year from 4½ percent in the first half to about 3½ percent in the second half, and it is projected to remain around 3½ percent over the forecast period. This projection is about 1 percentage point stronger than the staff’s projection for U.S. growth, shown at the bottom of the panel. The foreign industrial economies (line 2) overall are projected to grow at about the same rate as the United States, Japan a bit slower (line 4), and Canada a bit faster (line 5). The emerging market economies (line 6) are projected to grow at nearly twice the pace of the industrial economies over the forecast period. We expect that emerging Asia (line 7) will continue to grow very rapidly and that Latin America (line 8) will grow at a solid, though not exceptional, rate. Our forecast assumes that the Chinese government will take additional measures if necessary to reduce the growth rate of investment, and we project that Chinese GDP growth will be slower this year than last. But the risks to our growth forecast for China are probably greater on the upside.

Exhibit 13 provides an assessment of what all these foreign influences mean for the U.S. economy. Overall import prices, the black line in the top left panel, fell sharply last quarter and are projected to continue to fall in the current quarter, primarily owing to the drop in the price of imported oil. As oil prices stop falling and begin to move gradually back up, overall import price inflation should turn positive. Prices of imported core goods (the red line), which exclude oil, gas, computers, and semiconductors, rose at a rate of nearly 4 percent in the middle of last year, primarily owing to sharply higher prices of nonfuel commodities. With commodity prices projected to stabilize and with only a small depreciation of the dollar in our forecast, prices of imported core goods should increase at a subdued pace over the next two years.

The contributions of exports and imports to U.S. GDP growth are shown in the lower panel. We now estimate that the external sector made a positive arithmetic contribution to growth last year, the first positive annual contribution since 1995. Import growth stepped down from previous years as U.S. GDP grew more slowly. Export growth benefited from robust foreign economic activity, but exports turned out even stronger than our models project. Line 1 in the top right panel shows that, for the first eleven months of last year at an annual rate, exports of goods grew 10½ percent from the previous year in real terms. Lines 2 through 4 show that three categories of capital goods—aircraft, machinery, and semiconductors—contributed nearly half of total export growth. Although it is possible that blistering growth rates in exports of these goods may continue, we base our forecast on a return of export growth to a rate more consistent with historical relationships. With the vast majority of aircraft production being exported in recent months and with aircraft factories running at high utilization rates, further large increases in exports from this sector, at least, do not seem likely.

Returning to the bottom panel, we project that the negative arithmetic contribution of imports (the red bars) to GDP growth will outweigh the export contribution (the blue bars) in 2007 and 2008 by about ¼ percentage point (the black line). This projection is driven by the historical tendency of U.S. imports to grow at a much faster rate than U.S. GDP. In addition, the larger value of imports relative to exports means that, even if imports and exports were to grow at the same rate, the negative contribution of imports would be greater than the positive contribution of exports. The projected strong growth rates of foreign GDP, discussed in your previous exhibit, are not large enough to outweigh these factors over the next two years. On balance, relative prices have little effect on net exports over the forecast period, as the real trade-weighted dollar has moved in a relatively narrow range over the past couple years and is not projected to move substantially over the forecast period. And now Larry will complete our presentation.

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