Determining and conducting monetary policy is one of the responsibilities of the Federal Reserve. As part of this process, twice a year the chairman of the Fed's Board of Governors is required to provide Congress with a report on the state of the economy and how it has and will be affected by various factors, including the market and the current political arena.
Mr. Chairman and members of the committee, I am pleased this morning to present the Federal Reserve's semi-annual Monetary Policy Report to the Congress. I will begin by reviewing the state of the U.S. economy and the conduct of monetary policy and then turn to some key issues related to the federal budget.
When I testified before this committee last July, I noted that, while the growth of economic activity over the first half of the year had been spurred importantly by a swing from rapid inventory drawdown to modest inventory accumulation, that source of impetus would surely wind down in subsequent quarters, as it did. We at the Federal Reserve recognized that a strengthening of final sales was an essential element of putting the expansion on a firm and sustainable track. To support such a strengthening, monetary policy was set to continue its accommodative stance.
In the event, final sales continued to grow only modestly, and business outlays remained soft. Concerns about corporate governance, which intensified for a time, were compounded over the late summer and into the fall by growing geopolitical tensions. In particular, worries about the situation in Iraq contributed to an appreciable increase in oil prices. These uncertainties, coupled with ongoing concerns surrounding macroeconomic prospects, heightened investors' perception of risk and, perhaps, their aversion to such risk. Equity prices weakened further, the expected volatility of equity prices rose to unusually high levels, spreads on corporate debt and credit default swaps deteriorated, and liquidity in corporate debt markets declined. The economic data and the anecdotal information suggested that firms were tightly limiting hiring and capital spending and keeping an unusually short leash on inventories. With capital markets inhospitable and commercial banks firming terms and standards on business loans, corporations relied to an unusual extent on a drawdown of their liquid assets rather than on borrowing to fund their limited expenditures.
By early November, conditions in financial markets had firmed somewhat on reports of improved corporate profitability. But on November 6, with economic performance remaining subpar, the Federal Open Market Committee chose to ease the stance of monetary policy, reducing the federal funds rate 50 basis points, to 1-1/4 percent. We viewed that action as insurance against the possibility that the still widespread weakness would become entrenched. With inflation expectations well contained, this additional monetary stimulus seemed to offer worthwhile insurance against the threat of persistent economic weakness and unwelcome substantial declines in inflation from already low levels.
In the weeks that followed, financial market conditions continued to improve, but only haltingly. The additional monetary stimulus and the absence of further revelations of major corporate wrongdoing seemed to provide some reassurance to investors. Equity prices rose, volatility declined, risk spreads narrowed, and market liquidity increased, albeit not to levels that might be associated with robust economic conditions. At the same time, mounting concerns about geopolitical risks and energy supplies, amplified by the turmoil in Venezuela, were mirrored by the worrisome surge in oil prices, continued skittishness in financial markets, and substantial uncertainty among businesses about the outlook.
Partly as a result, growth of economic activity slowed markedly late in the summer and in the fourth quarter, continuing the choppy pattern that prevailed over the past year. According to the advance estimate, real GDP expanded at an annual rate of only 3/4 percent last quarter after surging 4 percent in the third quarter. Much of that deceleration reflected a falloff in the production of motor vehicles from the near-record level that had been reached in the third quarter when low financing rates and other incentive programs sparked a jump in sales. The slowing in aggregate output also reflected aggressive attempts by businesses more generally to ensure that inventories remained under control. Thus far, those efforts have proven successful in that business inventories, with only a few exceptions, have stayed lean—a circumstance that should help support production this year. Indeed, after dropping back a bit in the fall, manufacturing activity turned up in December, and reports from purchasing managers suggest that improvement has continued into this year.