1. 1 DOMESTIC ECONOMIC CONDITIONS Jeff Fuhrer Director of Research Federal Reserve Bank of Boston Equipment Leasing and Finance Association Credit and Collections Management Conference June 12, 2007

2. 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. 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. 4 Improvements in net worth and income have supported consumer spending … … including continued improvements in housing equity Consumer spending: Slowing, but still growing … as has growth in labor income, supported by continued employment growth

5. 5 Overall, consumers are well-positioned to continue spending in 2007-8

6. 6 U.S. export growth will be boosted by sustained strength in our trading partners 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. 7 The Risks: Housing Housing sales have fallen 30% from their peak … …prompting reductions in construction Months’ supply of new homes for sale at current sales rate Builders still have a large stock of unsold homes to move

8. 8 The Risks: 1. Housing Sources: Census, OFHEO, National Association of Realtors, FRB 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. 9 Price increases have slowed, albeit with significant regional variation. Source: Office of Federal Housing Enterprise Oversight, FRBB Calculations MA prices slowed earlier than some other regions

10. 10 MUCH recent attention has focused on the unraveling of the subprime mortgage market Source: Mortgage Bankers Association Foreclosures initiated in quarter as a percentage of loans – US through Q4-06 Foreclosures initiated in quarter as a percentage of loans – RI, through Q4-06 It’s happened earlier in RI, perhaps because prices 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. 11 The risks: 2. Capital spending has been weaker than expected. Weak capital spending is a bit of a puzzle, as underlying supports for investment still appear solid Global Insight Forecast for Real spending on Equipment and Software

12. 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. 13 Servicing foreign markets Servicing U.S. markets Capital installed abroad Capital installed domestically a 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. 14 Most of the surprise came in high-tech investment goods Predicted exceeds actual over past 3-4 years

15. 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 Unemployment is low and actual output is near potential, posing some upside risk to inflation. *s indicate trends without March data

16. 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