Monetary policy report to the Congress, February 27, 2002

Last year was a difficult one for the economy of the United States. The slowdown in the growth of economic activity that had become apparent in late 2000 intensified in the first half of 2001, as businesses slashed investment spending and declines in manufacturing output steepened. Foreign economies also slowed, further reducing the demand for U.S. production. The aggressive actions by the Federal Reserve to ease the stance of monetary policy in the first half of the year provided support to consumer spending and the housing sector. Nevertheless, the weakening in activity became more widespread through the summer, job losses mounted further, and the unemployment rate moved higher. The devastating events of September 11 further set back an already fragile economy. The economic fallout of the events of September 11 led the Federal Open Market Committee (FOMC) to cut the target federal funds rate early the following week and again at each meeting through the end of the year. Firms moved quickly to reduce payrolls and cut production after mid-September; manufacturing and industries related to travel, hospitality, and entertainment bore the brunt of the downturn. Consumer spending, however, remained surprisingly solid over the final three months of the year in the face of enormous economic uncertainty, widespread job losses, and further deterioration of household balance sheets from the sharp drop in equity prices immediately following September 11. With businesses having positioned themselves to absorb a falloff of demand, the surprising strength in household spending late in the year resulted in a dramatic liquidation of inventories. In the end, real GDP posted a much better performance than had been anticipated in the immediate aftermath of the attacks. More recently, there have been encouraging signs that economic activity is beginning to firm. The FOMC left its target for the federal funds rate unchanged in its meeting in January 2002, but reflecting a concern that growth could be weaker than the economy's potential for a time, the Committee retained its assessment that the balance of risks were tilted unacceptably toward economic weakness. The extent and persistence of any recovery in production will, of course, depend critically on the trajectory of final demand in the period ahead, a period in which the economy faces considerable risk of subpar economic performance.