Monetary Policy Report to the Congress

Report submitted to the Congress on July 20, 2005, pursuant to section 2B of the Federal Reserve Act

MONETARY POLICY AND THE ECONOMIC OUTLOOK

The U.S. economy continued to expand at a solid pace over the first half of 2005 despite the restraint imposed on aggregate demand by a further

rise in crude oil prices. Household spending trended up, propelled by rising wealth and income and by low interest rates, and business outlays received ongoing support from favorable financial conditions, rising sales, and increased profitability. Moreover, the earlier declines in the foreign exchange value of the dollar shifted some domestic and foreign demand toward U.S. producers. Overall, the economic expansion was sufficient to create jobs at roughly the same pace as in late 2004 and to lower the unemployment rate further over the first half of this year.

Higher oil prices boosted retail prices of a broad range of consumer energy products and, as a result, continued to hold up the rate of overall consumer price inflation in the first half of 2005. In addition, the rise in energy prices this year, coupled with increases in the prices of some other commodities, imported goods, and industrial materials, put upward pressure on the costs of many businesses. A portion of these costs was passed on to consumers, which contributed to a higher rate of inflation in core consumer prices (that is, total prices excluding the food and energy components, which are volatile). As measured by the price index for personal consumption expenditures excluding food and energy, core inflation increased from an annual rate of 1 percent in 2004 to about 2 percent between the fourth quarter of 2004 and May 2005. While survey measures of near-term inflation expectations have edged up this year, surveys, as well as readings from financial markets, suggest that expected inflation at longer horizons has remained contained.