Monetary Policy Report

For use at 2:00 p.m., E.D.T. Tuesday July 22, 1997 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 July 22, 1997 Letter of Transmittal BOARDOFGOVERNORSOFTHE FEDERALRESERVESYSTEM Washington,D.C.,July22,1997 THEPRESIDENTOFTHESENATE THESPEAKEROFTHEHOUSEOFREPRESENTATIVES TheBoardofGovernorsispleasedtosubmititsMonetaryPolicyReporttotheCongress,pursuanttothe FullEmploymentandBalancedGrowthActof1978. Sincerely, AlanGreenspan,Chairman Table of Contents Page Section 1: Monetary Policy and the Economic Outlook 1 Section 2: Economic and Financial Developments in 1997 6 Section 1: Monetary Policy and the Economic Outlook The economy continued to perform exceptionally an outcome, the Committee tightened policy slightly. well in the first half of 1997. Real output grew Withthesofteningofdemandinthespring,theCom- briskly, while inflation ebbed. Sizable further mittee was able to maintain a steady posture in the increases in payrolls pushed the unemployment rate money market while closely monitoring economic below 5 percent for the first time in nearly twenty- developments. The ongoing objective of monetary five years. Although growth in real gross domestic policyistohelpthenationachievemaximumsustain- product appears to have slowed in the spring, this able economic growth and the highest average liv- slackening came on the heels of a dramatic surge in ing standards. The Federal Reserve recognizes that it the opening months of the year; all indications are can best accomplish this objective by keeping infla- that the expansion remains well intact. The members tionincheck,becauseanenvironmentofpricestabil- of the Board of Governors and the Reserve Bank ityismostconducivetosound,long-termplanningby presidents anticipate that the economy will grow at a households and businesses. moderate pace in the second half of this year and in 1998andthatinflationwillremainlow.Conditionsin Monetary Policy, Financial Markets, and financialmarketsaresupportiveofcontinuedgrowth: the Economy over the First Half of 1997 Longer-term interest rates are in the lower portion of the range observed in this decade, the stock market The rapid economic growth observed in the clos- has registered all-time highs, and credit remains ing months of 1996 continued in the first quarter of readily available to private borrowers. this year, with real GDP advancing almost 6 percent at an annual rate. Consumer spending surged, fueled SincetheFebruaryreportonmonetarypolicy,Fed- by a significant increase in income, upbeat consumer eral Reserve policymakers have revised upward their attitudes, and the effects of the huge run-up in equity expectations for growth of real activity in 1997 and pricesoverthepastcoupleofyearsonhouseholdnet trimmed their forecasts of inflation. This combina- worth. Business fixed investment was strong, and tion of revisions highlights the extraordinarily posi- companiesrestockedinventoriesthathadbecomethin tive conditions still prevailing more than six years as sales soared. The advance in real output provided into the current economic expansion. In part, the support for considerable new hiring; rising pay and recentconfluenceofhigher-than-expectedoutputand greater job availability drew additional people into lower inflation has reflected the favorable influences theworkforce,liftingthelaborforceparticipationrate on prices of retreating oil prices and a strong dollar. toanewhighduringthefirstquarteroftheyear.The But it may also be attributable to more durable underlying trend in consumer price inflation was still changes in our economy, notably a greater flex- subdued. Inflation pressures were held in check by ibility and competitiveness in labor and product smallerfoodpriceincreases,decliningpricesfornon- markets and more rapid, technology-driven gains in oilimports,themarkedexpansionofindustrialcapac- efficiency. In essence, the economy may be experi- ity in recent years, and continuing efforts by busi- encing an upward shift in its longer-range output nesses to boost efficiency. potential. At their meeting in late March, Federal Open To the extent that aggregate supply is expanding Market Committee (FOMC) members expected that more rapidly, monetary policy can accommodate the growth of economic activity would ease in the extra growth in demand without fostering increased coming months, but they were uncertain about the inflationary pressures. In late March, however, the likely extent of that slowing. Although the first- FederalOpenMarketCommitteeconcludedthatthere quarter burst in production had owed importantly was a significant risk that aggregate demand would to a number of temporary factors, many of the grow faster in the coming quarters than available fundamentals underlying consumer and business supply, which, with utilization already at a very demandremainedquitepositive.TheCommitteewas high level, would place the economy’s resources concernedabouttheriskthatifoutsizedgainsinreal under increasing strain. If such unsustainable outputcontinued,pressuresoncostsandpriceswould growth persisted, the resulting inflationary imbal- emerge that could eventually undermine the expan- ances would eventually undermine the health of the sion.Therefore,tohelpfostermoresustainabletrends expansion—the all too frequent pattern of past busi- in output and guard against potential inflationary ness cycles. To protect against the possibility of such imbalances, the Committee firmed policy slightly by 1 Selected Interest Rates Percent Daily 8 Three-year Thirty-year Treasury Treasury 7 6 IntendedFederal FundsRate 5 Discountrate Three-month Treasury 4 5/23 7/6 8/22 9/26 11/1512/19 1/31 3/26 5/21 7/3 8/20 9/24 11/1312/17 2/5 3/25 5/20 7/2 1995 1996 1997 Note. DottedverticallinesindicatedaysonwhichtheFederal action. The dates on the horizontal axis are those on which OpenMarketCommittee(FOMC)announcedamonetarypolicy theFOMCheldmeetings.LastobservationsareforJuly18,1997. raising the expected federal funds rate from around Despite high levels of employment and production 51⁄ 4 percent to around 51⁄ 2 percent. throughthefirsthalfoftheyear,therewerefewsigns that inflation was deviating significantly from recent Theunsustainablystrongpaceofeconomicgrowth trends. Although overall consumer price inflation in the first quarter weighed on financial markets. dipped in the second quarter as energy prices Interest rates rose substantially, even before the declined,consumerpricesexcludingfoodandenergy System’s action, despite favorable news on infla- increased at about the same pace in the first half of tion. Because the policy tightening was widely the year as in 1996. anticipated,rateswerelittleaffectedbytheannounce- ment, but they moved up a little more in the follow- Continued favorable price movements and the ing weeks as incoming data suggested persistent slowing of economic growth suggested to financial strengthineconomicactivity.Equitypricesroseearly market participants that inflation might remain in the first quarter and then declined, changing damped without a further tightening of financial relatively little on net. The trade-weighted value of conditions,andthisbeliefpromptedasubstantialdrop the dollar in terms of the other G-10 currencies in interest rates from late April to mid-July, revers- increased about 7 percent in the first quarter, reflect- ingtheearlieradvance.Withresourceutilizationstill ing the unexpectedly strong economic growth in the at very high levels, and with economic and financial United States and market uncertainty about eco- conditions conducive to robust increases in spend- nomic performance abroad. ing,theFOMCatitsMaymeetingcontinuedtoview As the second quarter progressed, it became the risks as skewed toward the re-emergence of increasingly evident that economic activity had inflationary pressures. But the moderation in aggre- indeed decelerated. The expansion of consumer gate demand and uncertainty about the relationship spending eased considerably, while business fixed between utilization rates and inflation led the Com- investment remained strong. Employment continued mittee to leave reserve conditions unchanged in May to climb rapidly, pushing the unemployment rate andagaininJuly.Thedropinmarketinterestratesin down below 5 percent on average in the second thesecondquartermayalsohavebeenencouragedby quarter—the lowest level since the early 1970s. favorable news about this year’s federal budget 2 deficit and by the agreement between the President 2 percent to 21⁄ 2 percent. With this pace of continued and the Congress to balance the budget in fiscal year economic expansion over the next six quarters, the 2002. Spurred by lower rates and greater optimism central tendency of forecasts for the civilian about the long-term outlook for earnings, the stock unemployment rate remains a little under 5 percent market surged in the second quarter and into July. through 1998, about the average for the second The value of the dollar rose somewhat further in quarter of this year. foreign-exchange markets, on balance, an increase Economic activity appears to have entered the more than accounted for by an appreciation against second half with considerable positive momentum. continental European currencies. Households have experienced hefty gains in employ- During the first half of the year, credit remained ment, income, and wealth, and their optimism about available on favorable terms to most households and the future is quite high. These factors seem likely to businesses. High delinquency rates for consumer outweigh any drag on consumer demand that might loans encouraged many banks to tighten standards, be associated with the debt-servicing problems that but consumer loan rates generally stayed fairly low some households have experienced. Lower mort- relative to benchmark Treasury rates, and consumer gage rates are buttressing demand for homes. In the credit continued to grow faster than income and only businesssector,healthybalancesheetsandprofitsand a little below the pace of 1996. Home mortgage debt a moderate cost of external funds, along with a advanced at a moderate rate, with home equity loans continuing desire to install new technology, are expanding especially rapidly in the spring. Busi- providing support and impetus for investment in nesses continued to have access to ample external equipment. Meanwhile, investment in structures funding both directly in capital markets and through should follow last year’s strong performance with financial intermediaries. The spreads between yields further increases, because of declining vacancy rates on corporate bonds and Treasury securities stayed in some sectors and ready access to financing. loworfellfurther,and,relativetomarketrates,bank business loan rates held near the lower end of the Notwithstanding the economy’s positive momen- range seen in the current expansion. tum, growth is expected to be more moderate in the next year and a half than in the first half of 1997. In Total domestic nonfinancial debt expanded more part, this deceleration is likely to reflect the influ- slowly in the first half of 1997 than in 1996, mainly ence on demand of the substantial buildup of stocks because of a reduced pace of federal borrowing. of household durables and business plant and equip- Trends in the monetary aggregates during the first ment thus far in the expansion. As well, the pace of half of 1997 were similar to those in 1996, with M2 inventory investment will need to slacken consider- neartheupperendoftherangesetbytheFOMCand ably relative to that observed in the first part of this M3 somewhat above its range. This outcome was in year, lest stock-to-sales ratios become uncomfort- linewithFOMCexpectations,becausetherangeshad ably high. In the external sector, the strength of the been set to be consistent with conditions of price dollar on exchange markets since last year could stability,andinflation,whiledamped,remainedabove damp export sales and encourage U.S. firms and this level. The behavior of M2 in the first part of the households to purchase foreign-produced goods and yearwasagainreasonablywellexplainedbychanges services. in nominal GDP and interest rates. Federal Reserve policymakers believe that this year’s rise in the CPI will be smaller than that of 1996, mostly because of favorable developments in Economic Projections for 1997 and 1998 the food and, especially, energy sectors. After last Aftergrowingswiftlyonbalanceoverthefirsthalf year’s run-up, crude oil prices have dropped back of the year, economic activity is expected to expand significantly, pulling down the prices of petroleum more moderately in the second half of 1997 and in products. Food price increases also have been 1998. For this year, the central tendency of the GDP subdued this year, as the decline in grain prices that growth forecasts put forth by members of the Board beganinthemiddleoflastyearhasbeenworkingits of Governors and the Reserve Bank presidents is waythroughtotheretaillevel.Lookingaheadtonext 3 percent to 31⁄ 4 percent, measured as the change in year, the governors and Reserve Bank presidents real output between the final quarter of 1996 and the expect larger increases in the CPI, with a central final quarter of 1997. For 1998, most of the forecasts tendency from 21⁄ 2 percent to 3 percent. Food and anticipate growth of real GDP within a range of energy prices are not expected to repeat this year’s 3 Economic Projections for 1997 and 1998 Percent Federal Reserve governors and Reserve Bank presidents Central Indicator Range tendency 1997 Change,fourthquarter tofourthquarter1 Nominal GDP 5 to 6 5 to 51⁄ 2 Real GDP 3 to 31⁄ 2 3 to 31⁄ 4 Consumer price index2 2 to 23⁄ 4 21⁄ 4 to 21⁄ 2 Averagelevelinthe fourthquarter Civilian unemployment rate 43⁄ 4 to 51⁄ 4 43⁄ 4 to 5 1998 Change,fourthquarter tofourthquarter1 Nominal GDP 41⁄ 4 to 53⁄ 4 41⁄ 2 to 5 Real GDP 2 to 3 2 to 21⁄ 2 Consumer price index2 21⁄ 2 to 3 21⁄ 2 to 3 Averagelevelinthe fourthquarter Civilian unemployment rate 41⁄ 2 to 51⁄ 4 43⁄ 4 to 5 1. Changefromaverageforfourthquarterofpreviousyear 2. Allurbanconsumers. toaverageforfourthquarterofyearindicated. salutary performance, and non-oil import prices may placing substantial weight on other price indexes, belessofarestraininginfluencethanin1997,absent along with the CPI, in gauging progress toward the acontinueduptrendinthedollar.Moreover,thereisa long-run goal of price stability. risk that high levels of resource utilization could The Administration has not yet released an update begin putting upward pressure on business costs. of the economic projections contained in the Febru- As noted in past monetary policy reports, the ary Economic Report of the President. The earlier CPI forecasts of Federal Reserve policymakers Administration forecasts were broadly similar to incorporate the technical improvements that the those in the Federal Reserve’s February report, with Bureau of Labor Statistics is making to the CPI in Administration forecasts for growth and inflation 1997 and 1998. A series of technical changes is within or near the range anticipated by Federal estimatedtohavetrimmedreportedratesofCPIinfla- Reserve policymakers in February. Because of tion slightly in recent years, and the additional developments in the economy since that time, the changes will affect the index this year and next. In centraltendencyofforecastsforrealGDPgrowthput light of the challenges of accurately measuring price forth by the members of the Board of Governors changes in a complex and dynamic economy, the and the Reserve Bank presidents has moved higher, governorsandReserveBankpresidentswillcontinue while their forecasts for the CPI have moved down. 4 Ranges for Growth of Monetary and Debt Aggregates Percent Aggregate 1996 1997 Provisional for 1998 M2 1 to 5 1 to 5 1 to 5 M3 2 to 6 2 to 6 2 to 6 Debt 3 to 7 3 to 7 3 to 7 Note. Change from average for fourth quarter of preced- ingyeartoaverageforfourthquarterofyearindicated. Money and Debt Ranges to focus on rebuilding capital. Since mid-1994, the for 1997 and 1998 velocities have been moving more nearly in line with their historical patterns with respect to changes At its meeting earlier this month, the Committee in opportunity costs—albeit at higher levels. This reaffirmed the ranges for 1997 growth of money and recent period of renewed stability is still brief, how- debt that it had established in February: 1 percent to ever, and has occurred at a time of relatively stable 5 percent for M2, 2 percent to 6 percent for M3, and financial and economic conditions, leaving open the 3 percent to 7 percent for the debt of the domestic important question of whether the stability would be nonfinancial sectors. The Committee also set sustained in the future under a wider variety of provisional ranges for 1998 at the same levels as for circumstances. 1997. In choosing the ranges for M2 and M3, the Com- In light of this uncertainty, the Committee again mittee recognized the continuing uncertainty about decided to view the ranges as benchmarks for mone- thefuturebehaviorofthevelocitiesofthetwoaggre- tary growth rates that would be consistent with gates. For several decades until the 1990s, these approximate price stability and historical velocity aggregates exhibited fairly stable trends relative to relationships. If velocities change little over the next nominal spending, and variations in M2 growth yearandahalf,Committeemembers’expectationsof around its trend were reasonably closely related to nominal GDP growth in 1997 and 1998 imply that changes in the spread between market rates and M2 and M3 will likely finish around the upper yields on the assets in M2. These relationships were boundaries of their respective ranges each year. The disrupted in the first part of this decade. Between debt of the domestic nonfinancial sectors is expected 1991 and early 1994, the velocities of M2 and M3 to remain near the middle of its range this year and climbed well above the levels that were predicted by next. The Committee will continue to monitor the past experience, as households shifted substantial behavior of the monetary aggregates and domestic amounts out of lower-yielding deposits into higher- nonfinancial debt—as well as a wide range of other yielding stock and bond mutual funds, and as banks data—for information about economic and financial and thrift institutions sharply curtailed their lending developments. 5 Section 2: Economic and Financial Developments in 1997 The economy has continued to perform exception- Change in Real Income and Consumption ally well this year. Real gross domestic product Percent,annualrate surged almost 6 percent at an annual rate in the first quarterof1997,andavailabledatapointtoahealthy, Disposablepersonalincome thoughsmaller,increaseinthesecondquarter.Finan- Personalconsumptionexpenditures cial conditions remained supportive of spending. 8 Despite a modest tightening of money market condi- Q1 tions by the System, most interest rates were little changed or declined a bit on net during the first half 4 of the year, and equity prices surged ahead. With relatively few exceptions, credit remained readily availablefrombothintermediariesandfinancialmar- + ketsongenerallyfavorableterms.Therapidincreases 0 – in output led to a further tightening of labor mar- kets in the first six months of 1997, and labor costs accelerated a little from the pace of a year earlier. 4 Price inflation has been subdued, held down in part 1992 1993 1994 1995 1996 1997 bydeclinesinenergyprices,smallerincreasesinfood prices,andlowerpricesfornon-oilimportsthathave followed in the wake of the appreciation of the dol- abletofurthersolidgains;notably,realincomeshave lar. In addition, intense competition, adequate plant continued to rise, and many consumers have capacity,andongoingefficiencygainshavehelpedto benefited from sizable gains in wealth. With this restraininflationpressuresinthefaceofrisingwages. good news in hand, consumers have become extraor- dinarily upbeat about the economy’s prospects. Indexes of consumer sentiment—such as those com- Change in Real GDP piledbytheSurveyResearchCenterattheUniversity Percent,annualrate ofMichiganandtheConferenceBoard—havesoared to some of the highest readings since the 1960s. Despite this generally healthy picture, some house- Q1 6 holds still face difficulties meeting debt obligations, and delinquency rates for consumer loans have remained at high levels. 4 Real outlays for consumer durables surged 183⁄ 4 percent (annual rate) in the first quarter of 2 this year but apparently slowed considerably in the secondquarter.Afterchanginglittle,onnet,lastyear, + consumer purchases of motor vehicles increased 0 – rapidly early in the year, a result of sound fundamentals, a bounceback from the strike- 2 depressed fourth quarter, and enlarged incentives 1992 1993 1994 1995 1996 1997 offered by auto makers. In the second quarter, sales were once again held down noticeably by strike- related supply constraints, as well as by some pay- The Household Sector back from the elevated first-quarter pace. Smoothing Spending,Income,andSaving. After post- through the ups and downs, the underlying pace of ingasizableincreasein1996,realpersonalconsump- demand in the first half of the year likely remained tion expenditures jumped 51⁄ 2 percent at an annual reasonably close to the 15 million unit rate that has rateinthefirstquarterof1997.Althoughtheadvance prevailedsincethesecondhalfof1995.Purchasesof in spending slowed thereafter—partly because of durablegoodsotherthanmotorvehiclesalsotookoff unusually cool weather in late spring—underlying in the first quarter; computers and other electronic fundamentals for the household sector remain favor- equipmentwereanareaofnotablestrength,ashouse- 6 holds took advantage of rapidly falling prices to Private Housing Starts acquire the latest technology. According to available Millionsofunits,annualrate monthlydata,purchasesofdurablesotherthanmotor Quarterlyaverage vehicles and electronic equipment moderated in the Multifamily second quarter. Although a pause in the growth of Q2 spendingisnotsurprisingafterthestrongfirstquarter, 1.5 unusually cool spring weather, leading to the post- ponement of purchases of some seasonal items, may also have contributed to the moderation. 1.0 Growth of real spending for nondurables also appears to have slowed considerably from a strong first-quarter pace. Within services, weather condi- 0.5 Single-family tionshelddowngrowthofrealoutlaysforenergyser- vices in the first quarter and boosted them in the second. Growth of real outlays for other services— 0 typically the steadiest component of consumption— 1987 1989 1991 1993 1995 1997 picked up at the end of 1996 and appears to have stayed ahead of last year’s 21⁄ 2 percent pace in the aged 1.14 million units at an annual rate, a shade first half of 1997. below the pace of starts in 1996. Although starts dipped in the second quarter, the decline was from a Consumer spending continued to draw support first-quarterlevelthat,doubtless,wasboostedbymild fromhealthyadvancesinincomethisyear,asgainsin weather. Mortgage rates have zig-zagged moderately wages and salaries boosted personal disposable thisyear;theaveragelevelhasdifferedlittlefromthat income.Thesegainstranslatedintoa4percentannual in1996.Withmortgagerateslowandincomegrowth rate advance in real disposable income in the first strong, a relatively large proportion of families has quarter, after a significant 23⁄ 4 percent advance last been able to afford the monthly cost of purchasing year. Although month-to-month movements were af- a home. Home sales have remained strong, helping fected by unevenness in the timing of tax payments, to keep inventories of unsold new units relatively the underlying trend in real disposable income lean—a favorable factor for prospective building remained strong into the second quarter. activity. Other indicators of demand remain quite On top of rising incomes, further increases in net positive. According to the latest survey by the worth—primarily related to the soaring stock National Association of Homebuilders, builders’ market—have given many households the financial ratings of new home sales strengthened in recent wherewithaltospend.Inlightoftheverylargegains months to the highest level since last August. in wealth, the impetus to consumption appears to Moreover, consumers’ assessments of conditions for have been smaller than might have been anticipated homebuying, as reported by the Survey Research on the basis of historical relationships, suggesting Center at the University of Michigan, remained very that other factors may be offsetting the effect of favorable into July. In addition, the volume of appli- higher net worth. One such factor could be a greater cations for mortgages to purchase homes has moved focus on retirement savings, particularly among the up recently to a high level. large cohort of the population reaching middle age. The pace of multifamily starts has been well Concerns about the adequacy of saving for retire- maintained. These starts averaged close to 320,000 menthavelikelybeenheightenedbyincreasedpublic units at an annual rate from January to June, a little discussion of the financial problems of social secu- abovelastyear’sfigureforstarts.Evenso,thepaceof rity and federal health programs. In addition, debt multifamilyconstructionremainswellbelowpeaksin problems may be restraining the spending of some the1970sand1980s,partlybecauseofchangesinthe households. nation’s demographic composition as the bulge of renters in the 1980s has moved on to home owner- ResidentialInvestment. The underlying pace ship. Another factor that has restrained multifamily of housing activity has remained at a high level this construction is the growing popularity of manufac- year, even though some indicators suggest that activ- tured housing (‘‘mobile homes’’), which provides an ity has edged off a bit from last year’s pace. In the alternative to rental housing for some households. In single-familysector,housingstartsthroughJuneaver- particular, the price of a typical manufactured unit 7 is considerably less than that of a new single-family Household Debt-Service Burden house,makingmanufacturedhomesespeciallyattrac- Percentofdisposablepersonalincome tive to first-time buyers and to people purchasing Quarterly second houses or retirement homes. Shipments of Q1 thesehomestrendedupthroughlastfallandthenflat- 17 tened out at a relatively high level. HouseholdFinance.Household balance sheets 16 strengthened in the aggregate during the first half of 1997,butdebt-paymentproblemscontinuedatahigh level in several market segments. Indebtedness grew 15 less rapidly than it had in 1996, and further gains in equity markets pushed up the ratio of household net 14 worth to disposable personal income to its highest markinrecentdecades.Consumercreditincreasedat a 61⁄ 4 percent annual rate between December 1996 13 and May 1997, compared with 81⁄ 4 percent in 1996. 1982 1987 1992 1997 The growth of mortgage debt was somewhat slower Note. Debt service is the estimated sum of required interest andprincipalpaymentsonconsumerandhousehold-sectormort- in the first quarter than in 1996 and, according to gagedebt. available indicators, probably stayed at roughly the same rate during the second quarter. Indicators of households’ ability to service their debthavebeenmixed.Thedelinquencyrateformort- gage loans past due sixty days or more is at its low- Household Net Worth est level in two decades, but delinquency rates for Percentofdisposablepersonalincome consumerloansarerelativelyhigh.Accordingtodata from the Report of Condition and Income filed by Four-quartermovingaverage Q1 banks (the Call Report), the delinquency rate for 500 credit card loans was roughly unchanged in the first quarter of 1997, remaining at its highest value since 475 late 1992, when the economy was in the midst of a sluggish recovery and the unemployment rate was more than 2 percentage points higher than today. For 450 425 Delinquency Rates on Household Loans Percent 400 Quarterly Creditcard 5 1965 1975 1985 1995 accountsat Q1 banks 4 The estimated ratio of required payments of loan Q1 principal and interest to disposable personal income Autoloansat remained high in the first quarter, after climbing financecompanies 3 rapidly between early 1994 and early 1996 and ris- ing more slowly in the second half of last year. This 2 measureofthedebt-serviceburdenofhouseholdshas Mortgages(over60days) nearlyreturnedtothepeakreachedtowardtheendof Q1 the last business cycle expansion. Adding estimated 1 payments on auto leases to households’ scheduled 1987 1989 1991 1993 1995 1997 monthly debt payments boosts the ratio a little more Note. Data on credit-card delinquencies are from the Call than 1 percentage point and places it just above its Report;dataonmortgagedelinquenciesarefromtheMortgage BankersAssociation. previous peak. 8 autoloansatthefinancecompaniesaffiliatedwiththe sizableincreasesincashflow,andafavorablecostof major manufacturers, the delinquency rate rose again capital, especially for high-tech equipment. To be in the first quarter, continuing the steady run-up in sure,asignificantportionofthisinvestmenthasbeen this measure over the past three years. required to update and replace depreciated plant and equipment; nevertheless, the current pace of invest- Anecdotal evidence suggests that the recent ment implies an appreciable expansion of the capital increases in consumer credit delinquency rates had stock. been partly anticipated by lenders, reflecting the normalseasoningofloansaswellasbanks’effortsto Real outlays for producers’ durable equipment stimulate borrowing by making credit more broadly jumped at an annual rate of 123⁄ 4 percent in the first available and automakers’ attempts to stimulate sales quarter of this year after rising 93⁄ 4 percent last year. using the same approach. During the past several As in recent years, purchases of computers and years,lendershaveaggressivelysoughtbusinessfrom other information processing equipment contributed people who might not have been granted credit pre- importantly to this gain. The computer sector has viously, in part because of lenders’ confidence in been propelled by declining prices of new and more new ‘‘credit scoring’’ models that statistically evalu- powerfulproductsandbyadriveinthebusinesssec- ate an individual’s creditworthiness. Despite these tortoimproveefficiencywiththeselatesttechnologi- newtools,banksevidentlyhavebeensurprisedbythe cal developments. Real purchases of communica- extent of the deterioration of their consumer loans tions equipment also have been robust, boosted by and have tightened lending standards as a result. rapidly growing demand for wireless phone services Nearly half the banks responding to the Federal and Internet connections as well as by upgrades to Reserve’s May survey on bank lending practices had telephone switching and transmission equipment in imposedmorestringentstandardsfornewcreditcard anticipation of eventual deregulation of local phone accounts over the preceding three months, with a markets. In addition, purchases of aircraft by domes- smaller fraction reining in other consumer loans. tic airlines moved higher on net in 1995 and 1996 About one-third more of the responding banks and—on the basis of orders and production plans of expected charge-off rates on consumer loans to aircraft makers—are expected to rise considerably increase further over the remainder of the year than further this year. For the second quarter, data on expected charge-off rates to decrease; many of those orders and shipments of nondefense capital goods in expecting an increase cited consumers’ growing April and May imply that healthy increases in equip- willingnesstodeclarebankruptcy.Risingdelinquency ment investment have continued. rates have also put pressure on firms specializing in Real business spending for nonresidential struc- subprime auto loans, with some reporting reduced tures posted another sizable increase in the first profits and acute liquidity problems. quarter after advancing a hefty 9 percent in 1996. According to the most recently available data, Althoughthelatestdatasuggestaslowingofthepace personalbankruptciessurgedagaininthefirstquarter of the year after rising 30 percent in 1996. The rapid increases of late are partly related to the same Change in Real Business Fixed Investment increaseinfinancialstressevidentinthedelinquency Percent,annualrate statistics, but they may also be tied to more wide- spread use of bankruptcy as a means of dealing with Structures suchstress.Changesinfederalbankruptcylaweffec- Producers’durable tive at the start of 1995 increased the value of assets equipment 20 thatmaybeprotectedfromliquidation,andtheremay also be a secular trend toward less stigma being Q1 associated with declaring bankruptcy. 10 The Business Sector + Investment Expenditures. Following a fifth 0 – year of sizable increases in 1996, real business fixed investmentroseatanannualrateof11percentinthe first quarter. The underlying determinants of invest- 10 ment spending remain solid: strong business sales, 1992 1993 1994 1995 1996 1997 9 of advance in the second quarter, the economic Before-Tax Profit Share of GDP factors underlying this sector point to continued Percent increases. Vacancy rates have been falling and rents Nonfinancialcorporations have been improving. Financing for commercial construction reportedly is in abundant supply, espe- cially with substantial amounts of capital flowing to Q1 real estate investment trusts (REITs). 12 Trends in construction continue to differ among sectors. Increases in office construction were espe- cially robust in recent quarters, as vacancy rates fell for both downtown and suburban properties. With 9 office-based employment expanding, this sector has continuedtorecoverfromthesevereslumpofthelate 1980sandearly1990s;evenso,thelevelofconstruc- tion activity is barely more than half that of the mid- 6 1980s. Construction of other commercial buildings 1977 1982 1987 1992 1997 has increased steadily during the past five years, and Note. Profits from domestic operations with inventory valua- the gain in the first quarter of this year was sizable. tion and capital consumption adjustments, divided by gross domesticproductofthenonfinancialcorporatesector. Since the current expansion began, the non-office commercial sector has provided a large contribution to overall construction spending. Industrial construc- eased.Nevertheless,withextraordinarilystrongsales, tiondroppedbackinthefirstquarterafterjumpingat inventory–sales ratios still moved down further in theendoflastyear;thetrendforthissectorhasbeen the major sectors. Available monthly data suggest relatively flat on balance in recent years. that vigorous inventory investment outside of motor During 1996, investment in real nonfarm business vehicles continued through mid-spring, as firms inventories was modest compared with the growth of respondedtostrengthincurrentandprospectivesales. sales, and the year ended with lean inventories in Formotorvehicles,inventoriesmovedupsomeinthe many sectors. In the first quarter of this year, busi- first quarter of this year, after strike-related reduc- nessesmovedtorebuildstocks,andinventoryinvest- tions in the fourth quarter. In the second quarter, the ment picked up substantially. Outside of motor vehi- monthly pattern of motor vehicles stocks was cles, stocks rose in the first quarter, with particularly bouncedaroundsomewhatbystrikes;cuttingthrough sizable increases coming from a continued ramp-up the noise, inventories of light vehicles still appear to in production of aircraft and from a restocking of be in balance. petroleum products during a period when prices Corporate Profits and Business Finance. The continued rapid advance of business investment Change in Real Nonfarm Business Inventories this year has been financed through both strong cash flow and substantial borrowing at relatively favor- Percent,annualrate able terms. Economic profits (book profits after inventory valuation and capital consumption adjust- ments) in the first quarter were 73⁄ 4 percent higher Q1 than a year earlier. For the nonfinancial sector, domestic profits were more than 9 percent higher, 4 reaching their highest share of those firms’ domestic output in the current expansion. Despite abundant profits, the financing gap for these companies—the + excess of capital expenditures (including inventory 0 investment) over internally generated funds—has – widenedsomewhatsincethemiddleof1996.Tofund that gap, and the ongoing net retirement of equity shares, nonfinancial corporations increased their debt 4 61⁄ 2 percent at an annual rate in the first quarter, 1992 1993 1994 1995 1996 1997 compared with 51⁄ 4 percent during 1996. 10 External funding has remained readily available to Moreover, delinquency rates for business loans at businesses on favorable terms. The spreads between banks have stayed extremely low, as has the default yields on investment-grade bonds and yields on rate on speculative-grade debt. Treasury securities have stayed low since the begin- The increase in the pace of business borrowing in ning of the year, while the spreads on high-yield the first half of 1997 was widespread across sources bonds have declined further to historically narrow offinance.Nonfinancialcorporationssteppeduptheir levels. Price–earnings ratios are high, implying a borrowing from banks. The outstanding commercial low cost of equity financing. Further, banks remain paperofthesecorporationsalsoincreasedonnetfrom accommodative lenders to businesses. According to December through June, after declining a little in the Federal Reserve’s most recent survey of busi- 1996. Meanwhile, these businesses’ net issuance of ness lending, the spreads between loan rates and long-termbondsinthefirsthalfoftheyearexceeded market rates have held about steady for borrowers of last year’s pace, with speculative-grade offerings all sizes, with rate spreads for large loans near the accounting for the highest share of gross issuance on lower end of the range seen over the past decade. record. Moreover, surveys by the National Federation of Independent Business indicate that small businesses At the same time, the pace of gross equity issu- have not had difficulty obtaining credit. ance by nonfinancial corporations dropped consider- ably in the first half of this year. In particular, the market for initial public offerings has been cooler Spreads Between Yields on thanin1996,despitesomepickupoflate;newissues Private and Treasury Securities have been priced below the intended range more Percent oftenthanaboveit,andfirst-daytradingreturnshave been relatively low. Net equity issuance has been Monthly deeplynegativeagainthisyear,asgrossissuancehas 10 been more than offset by retirements through share repurchases and mergers. The bulk of merger activ- 8 ity in the 1980s involved share retirements financed by borrowing, but the recent surge—which largely involves friendly intra-industry mergers—has been High-yieldbonds 6 financed about equally through borrowing and stock swaps. Structuring deals as stock swaps can reduce 4 shareholders’ tax liabilities and enable the combined Investment-gradebonds firm to use a more advantageous method of finan- June 2 cial accounting. The dollar value of nonfinancial mergersinwhichthetargetfirmwasworthmorethan 0 a billion dollars set a record in 1996, and merger 1987 1989 1991 1993 1995 1997 activityappearstobeonaverystrongtrackthisyear Note. YieldonMerrillLynchMasterIIIndexofhigh-yieldbonds as well. is compared with that on a seven-year Treasury note; yield on Moody’s index of A-rated investment-grade bonds is compared withthatonaten-yearTreasurynote. The Government Sector The plentiful supply of credit probably stems from Federal. The federal budget deficit has come several factors. Most banks are well positioned to down considerably in recent years and should lend:Theirprofitsarestrong,ratesofreturnonequity register another substantial decline this fiscal year. and on assets are high, and capital is ample. In addi- Over the first eight months of fiscal year 1997—the tion, continued substantial inflows into stock and period October through May—the deficit in the uni- high-yield bond mutual funds suggest that investors fied budget was $65 billion, down $43 billion from may now perceive less risk in these areas or may be the comparable period of fiscal 1996. The recent morewillingtoacceptrisk.Infact,businessesgener- reduction in the deficit primarily reflected extremely ally are in very good financial condition, with the rapid growth of receipts for the second year in a estimated ratio of operating cash flow to interest row, although a continuation of subdued growth in expense for the median nonfinancial corporation outlays also contributed to the improvement. Given remaining quite high in the first part of the year. recent developments, the budget deficit as a share 11 of nominal GDP this fiscal year is likely to be at its As for the part of federal spending that is included lowest level since 1974. directly in GDP, real federal expenditures on con- sumption and gross investment declined 31⁄ 4 percent Federal receipts were almost 81⁄ 2 percent higher in in the first quarter of 1997, a shade more than the the first eight months of fiscal year 1997 than in the averagerateofdeclineinrecentyears.Anincreasein year-earlier period and apparently are on track to real nondefense spending was more than offset by a outpace the growth of nominal GDP for the fifth decline in real defense outlays. year in a row. Individual income tax payments have risen sharply this fiscal year—on top of a hefty The substantial drop in the unified budget deficit increase last year—reflecting strong increases in reduced federal borrowing in the first half of 1997 households’ taxable labor and capital income; compared with the first half of 1996. The Treasury preliminary data from the Daily Treasury Statement responded to the smaller-than-expected borrowing indicatethatindividualincometaxrevenuesremained need by reducing sales of bills; this traditional strong in June. Moreover, corporate tax payments strategyofallowingborrowingswingstobeabsorbed posted another sizable advance through May of this primarily by variation in bill issuance enables the fiscal year. Treasury to have predictable coupon auctions and to issue sufficient quantities of coupon securities to Federal outlays during the first eight months of maintain their liquidity. The result this past spring the fiscal year rose 31⁄ 2 percent in nominal terms wasanunusuallylargenetredemptionofbills,which from the comparable period last year. Although this pushed yields on short-term bills down relative to increase is up from the restrained rate of growth in yields on other Treasury securities and on short- fiscal 1996—which was held down by the govern- term private paper. ment shutdown—spending growth remained sub- The issuance of inflation-indexed securities at dued across most categories. Outlays for income severalmaturitieshasbeenamajorinnovationinfed- security programs rose modestly in the first eight eral debt management this year. The Treasury sold months of the fiscal year, partly as a result of the indexed ten-year notes in January and April and continued strong economy, and spending on the added five-year notes earlier this month. A small major health programs grew somewhat more slowly number of agency and other borrowers issued their than their average pace in recent years. Although owninflation-indexeddebtimmediatelyafterthefirst still restrained, outlays for defense have ticked up Treasury auction, and the Chicago Board of Trade this fiscal year after trending down for several recently introduced futures and options contracts years. based on inflation-indexed securities. As one would expect at this stage, however, the market for indexed debt has not yet fully matured: Trading volume as a shareoftheoutstandingamountismuchsmallerthan Change in Real Federal Expenditures for nominal debt, and a market for stripped securi- on Consumption and Investment ties has yet to emerge. Percent,Q4toQ4 StateandLocal.Thefiscalconditionofstateand local governments has remained positive over the past year, as the surplus of receipts over current + expenditureshasbeenstableatarelativelyhighlevel. 0 Strong growth in sales and incomes has led to robust – growth in revenues, despite numerous small tax cuts, andmanystateshaveheldthelineonspendinginthe past several years. Additionally, the welfare reform Q1 legislation passed in August 1996, while presenting 5 long-term challenges to state and local governments, actually has eased fiscal pressures in recent quarters: Block grants to states are based largely on 1992–94 grant levels, but caseloads more recently have been 10 falling. Overall, at the state level, accumulated 1992 1993 1994 1995 1996 1997 surpluses—current surpluses plus those from past Note. Valuefor1997:Q1isaquarterlypercentchangeatan annualrate. years—were on track to end fiscal year 1997 at a 12 Change in Real State and Local Expenditures The pace of gross issuance of state and local debt on Consumption and Investment wasroughlythesameinthefirsthalfoftheyearasin Percent,Q4toQ4 1996. Net issuance turned up noticeably, however, as retirements of debt that had been pre-refunded in the early 1990s waned. The External Sector Q1 TradeandtheCurrentAccount.The nominal 2 deficit on trade in goods and services was $116 bil- lion at an annual rate in the first quarter, somewhat larger than the $105 billion in the fourth quarter of last year. The current account deficit of $164 bil- lion (annual rate) in the first quarter exceeded the $148 billion deficit for 1996 as a whole because of the widening of the trade deficit and further 0 1992 1993 1994 1995 1996 1997 declinesinnetinvestmentincome.InAprilandMay, the trade deficit was slightly narrower than in the Note. Valuefor1997:Q1isaquarterlypercentchangeatan annualrate. first quarter. healthy level, according to a survey by the National Change in Real Imports and Exports Association of State Budget Officers taken shortly of Goods and Services before the end of most states’ fiscal years. Percent,Q4toQ4 Real expenditures for consumption and gross Imports investment by state and local governments increased moderately in the first quarter of this year, about the Exports sameasthepaceofadvanceinthepasttwoyears.For Q1 construction, the average level of real outlays dur- 20 ingthefirstfivemonthsoftheyearwasalittlehigher than in the fourth quarter. Hiring by state and local governments over the first half of the year was somewhat above last year’s pace, with most of the 10 increase at the local level. U.S. Current Account 0 Billionsofdollars,annualrate 1992 1993 1994 1995 1996 1997 Note. Valuefor1997:Q1isaquarterlypercentchangeatan + annualrate. 0 – The quantity of U.S. imports of goods and ser- 50 vices surged in the first quarter at an annual rate of about 20 percent. Continued strength in the pace of 100 U.S.economicactivitylargelyaccountedfortherapid growth, but a rebound in automotive imports from 150 Canada from their strike-depressed fourth-quarter Q1 level boosted imports as well. Preliminary data for 200 AprilandMaysuggestthatstrongrealimportgrowth continued. Non-oil import prices fell through the second quarter, extending the generally downward 250 1992 1993 1994 1995 1996 1997 trend that began in mid-1995. 13 The quantity of U.S. exports of goods and ser- weakness is only temporary. In Canada, growth of vices expanded at an annual rate a bit above real output increased to 31⁄ 2 percent at an annual rate 10 percent in the first quarter, about the same rapid in the first quarter. Final domestic demand more than paceasduringthesecondhalfoflastyear.Growthof accounted for this expansion, as business invest- output in our major trading partners, particularly the ment, consumption, and residential construction all industrial countries, helped to sustain the growth of provided significant contributions. Indicators suggest exports,asdidincreaseddeliveriesofcivilianaircraft. that output growth remained healthy in the second Exports to western Europe and to Canada grew quarter. strongly while those to the Asian developing Economic activity has remained vigorous so far countries declined somewhat. Preliminary data for this year in the United Kingdom and appears to have April and May suggest that real exports rose strengthened in Germany and France. In the first moderately. quarter, U.K. real GDP grew at an annual rate of CapitalFlows.Large gross capital inflows and 31⁄ 2 percent as domestic demand, particularly invest- ment, accelerated from its already strong pace in the outflows continued during the first quarter of 1997, fourth quarter. Strong household consumption spend- reflectingthecontinuedtrendtowardglobalizationof ing supported demand in the second quarter. Weak financial and product markets. Both foreign direct demand for exports, associated with the appreciation investmentintheUnitedStatesandU.S.directinvest- of the pound since mid-1996, and some tightening of ment abroad were very strong, swelled by mergers monetary conditions should moderate growth in the and acquisitions. current quarter. In Germany, economic expansion Private foreign net purchases of U.S. securities revivedinthefirstquarterandappearstohavefirmed amounted to $85 billion in the first quarter, down in the second quarter. After growing very little in the somewhat from the very high figure in the previous fourth quarter of last year, German real GDP rose at quarter but still above the record pace for 1996 as a an annual rate of 13⁄ 4 percent in the first quarter, led whole.NetpurchasesofU.S.Treasurysecuritieswere by government consumption, equipment investment, particularly robust. Private foreigners also showed and exports. Manufacturing orders and indicators increased interest in the U.S. stock market in the first of business sentiment suggest additional gains in quarter of 1997. U.S. net purchases of foreign securi- thesecondquarter.FrenchrealGDPgrewonlythree- tiesamountedto$15billioninthefirstquarter,down quarters percent at an annual rate in the first quarter, from the strong pace of 1996. Private foreigners asdeclinesininvestmentoffsetstrongexportgrowth, continued to add to their holdings of U.S. paper cur- but data on manufacturing output and consumption rency in the first quarter, but at a rate substantially suggest a pick up in activity during the second below earlier peaks. quarter. Foreign official assets in the United States, which In most major Latin American countries, real rose a record $122 billion in 1996, increased another output growth remained vigorous. In Mexico, real $28 billion in the first quarter of 1997. Apart from economic expansion slowed some in the first quarter the oil-producing countries, which benefited from fromitsveryrapidpaceinthesecondhalfoflastyear high oil prices, significant increases in holdings were but remained robust. The industrial sector continued associated with efforts by some emerging-market to be the source of strength, while the service sector countriestotempertheimpactoflargeprivatecapital lagged. A pickup in import growth has resulted in a inflowsontheireconomies.InformationforApriland narrowingofthetradesurplus;throughMay,thetrade May suggests that official inflows have abated. balance of $13⁄ 4 billion was about half the size it was in the same period last year. In Argentina, continued ForeignEconomies.Economic activity in the healthy economic growth in the first quarter has major foreign industrial countries has generally brought real GDP back to its level before the reces- strengthened so far this year from the pace in the sioninducedbytheMexicancrisisof1995.InBrazil, second half of last year. In Japan, real GDP acceler- real output declined in the first quarter after three ated to a 61⁄ 2 percent annual growth rate in the first quarters of strong expansion. quarter, boosted by extremely strong growth of consumer spending ahead of an increase in the Economic growth in our major Asian trading consumptiontaxonApril1.Activityappearstohave partners other than Japan slowed a bit on average in fallen in the second quarter, but continued improve- the first quarter but appears to have rebounded in the ment in business sentiment suggests that the current second quarter. Nationwide labor strikes in Korea 14 affected many of the country’s key export industries Net Change in Payroll Employment and were partly responsible for weakness in first- Thousandsofjobs,averagemonthlychange quarteroutputandaballooningofthecurrentaccount Totalnonfarm deficit. Data for April and May show recovery in industrialproduction,andthetradebalanceimproved in the second quarter. Real output growth in Taiwan 400 remains strong so far this year, though not quite so vigorousasduringthesecondhalfof1996.InChina, H1 real GDP continues to expand at an annual rate of 200 nearly 10 percent, about the same brisk pace as last year. + Despite the pickup in growth, considerable excess 0 – capacity remains in the major foreign industrial countries. As a consequence, inflation has generally remained quiescent. The increase in the Japanese 200 consumption tax lifted the twelve-month change in 1992 1993 1994 1995 1996 1997 the consumer price index to about 11⁄ 2 percent, but elevation of the inflation rate should be temporary. CPIinflationremainslessthan2percentinGermany, Employment gains in the private service- France, Canada, and Italy. Only in the United King- producing sector, in which nearly two-thirds of all dom, where output growth has resulted in tight labor nonfarm workers are employed, accounted for much markets and consumer prices are rising at an annual oftheexpansioninpayrollsthroughJuneofthisyear. rate of more than 21⁄ 2 percent, are inflation pres- Within this sector, higher employment in services, sures currently a concern. transportation, and retail trade contributed impor- tantly to the gain. After advancing substantially for In most major countries in Latin America, infla- several years, payrolls in the personnel supply tioneitherisfallingorisalreadylow.Mexicaninfla- industry—a category that includes temporary help tion continues to improve: The monthly inflation agencies—actually turned down in the second rate was below 1 percent in May and June, the quarter; anecdotal reports suggest that some lowest monthly rates since the 1994 devaluation. temporary help firms are having difficulty finding In Argentina, consumer prices were essentially flat workers, especially for highly skilled and technical through the second quarter after almost no increase positions. last year. Brazilian inflation has declined to his- torically low rates. In contrast, Venezuelan inflation, though it has come down from its 1996 rate of more Civilian Unemployment Rate than 100 percent per year, remains near 50 percent. Consumer price inflation remains generally low in Percent Asia, including in China, where it fell to less than 3 percent in the twelve months through May. 8 The Labor Market Payroll employment continued to expand solidly 6 during the first half of 1997. The growth in nonfarm payrolls averaged about 230,000 per month; this figure may overstate slightly the underlying rate of June employment growth in the first half because techni- 4 cal factors boosted payroll figures in April. The strength in labor demand drew additional people into the job market, raising the labor force participation 2 ratetohistoricalhighsduringthefirsthalf.Neverthe- 1987 1989 1991 1993 1995 1997 less, the civilian unemployment rate moved down to Note. ThebreakindataatJanuary1994markstheintroduc- tionofaredesignedsurvey;thedatafromthatpointonarenot 4.9 percent, on average, in the second quarter. directlycomparablewiththedataofearlierperiods. 15 Employment gains were also posted in the goods- of real output has increased considerably faster than producing sector. In the construction industry, pay- the expenditure-side measure in recent years, raising rolls increased substantially between December and the possibility that productivity growth has been June. Factory employment moved somewhat higher somewhat better than reported in the official indexes. in the first part of the year after declining a little Measurement difficulties may also affect estimates during 1996, and manufacturing overtime hours of the longer-term trajectory of productivity growth. remained at a high level. Producers of durable goods In particular, if inflation were overstated by official increasedemploymentfurtherbetweenDecemberand measures—as a considerable amount of recent June, while makers of nondurable goods continued research suggests it is—then real output growth to reduce payrolls. Since the end of 1994, factory would be understated. This understatement would employment and total hours worked in manufactur- arise because too much inflation would be removed ing have changed little. Even so, manufacturers have from nominal output growth in the calculation of boosted output considerably over this period, pri- real output growth. Indeed, productivity growth for marily through ongoing improvements in worker nonfinancial corporations—a sector for which output productivity. growth arguably is measured more accurately than Although productivity for the broader nonfarm in broader sectors—has been more rapid than for businesssectorrosesubstantiallyinthefirstquarter,it nonfarm business overall. In particular, productivity was just 1 percent above its value a year earlier. for nonfinancial corporations increased at an aver- Moreover,outputperhourchangedlittlefromtheend age annual pace of about 11⁄ 2 percent between 1990 of 1992 to the last quarter of 1995. The average rate and 1996, while productivity in the nonfarm busi- of measured productivity growth in the 1990s is still ness sector rose a little less than 1 percent per somewhatbelowthatofthe1980sandisevenfurther year over the same period. This difference—which below the average gains realized in the twenty-five implies very weak measured productivity growth years after World War II. The slower reported pro- outside of the nonfinancial corporate sector—raises ductivity growth during this expansion could partly the possibility that overall productivity growth is reflect measurement problems. Productivity is the stronger than indicated by official indexes for ratio of real output to hours worked, and official nonfarm business.1 Of course, a critical—and still productivity indexes rely on a measure of real output unanswered—question is the extent to which any basedonexpenditures.Intheory,amatchingmeasure understatement of productivity growth has become of real output should be derivable by summing labor larger over time. If productivity growth were more and capital inputs on the ‘‘income side’’ of the rapid than indicated by official statistics, then the nationalaccounts.However,theincome-sidemeasure economy’s capacity to produce goods and services would be increasing faster than indicated by current official statistics. But if the amount of mismeasure- Change in Output per Hour, menthasnotincreasedovertime,thentheeconomy’s Nonfarm Business Sector productive capacity also increased more rapidly Percent,Q4toQ4 in earlier years than shown by published measures. In this case, the official statistics on productivity growth—though perhaps understated—would not give a misleading impression about changes in pro- 4 ductivity trends. After changing little, on net, since the late 1980s, the labor force participation rate turned up early 2 last year; it reached a record high 67.3 percent in Q1 March of this year and remained at an elevated 67.1 percent in the second quarter. Better employ- + mentopportunitieshavedrawnadditionalpeopleinto 0 – the workforce. Although the recent welfare reform 2 1. MoredetailisprovidedinapaperbyLawrenceSlifmanand 1990 1992 1994 1996 CarolCorrado,‘‘DecompositionofProductivityandUnitCosts,’’ Note. Valuefor1997:Q1isthepercentchangefrom1996:Q1 BoardofGovernorsoftheFederalReserveSystem,November18, to1997:Q1. 1996. 16 Labor Force Participation Rate regions and industries mention the difficulties firms Percent are having hiring workers, especially workers with specialized skills. With this tightness, labor com- pensation costs have accelerated slightly. Although Q2 hourly labor costs, as measured by the employment cost index (ECI), increased only 2.5 percent at an 66 annual rate during the first three months of this year, they were up 3.0 percent over the twelve months ended in March, compared with 2.7 percent over 63 the preceding twelve months. These increases are smaller than might have been expected based on historical relationships, perhaps partly reflecting 60 persistent worker concerns about job security. In addition, modest increases in employer-paid benefits have partly offset faster increases in wages and salaries in the past couple of years. With smaller 57 1972 1977 1982 1987 1992 1997 increases in health care costs than earlier in the Note. Databefore1994havebeenadjustedfortheredesignof decade, shifts of employees into managed care plans, thehouseholdsurvey. and requirements that employees assume a greater share of health care costs, employer costs for health- legislation probably has not yet had a large effect on related benefits have been well contained. However, aggregate labor force dynamics, it may generate an growth in employer health care costs may be in the additional,albeitsmall,boosttolaborforceparticipa- process of bottoming out, as reports of rising tion rates over the next few years. Since the begin- premiums for health insurance have become more ning of 1996, the increases in the labor force associ- common. Moreover, the wages and salaries com- ated with a higher participation rate have eased ponent of the ECI has continued to accelerate, ris- pressures on labor markets, as additional workers ing 3.4 percent during the twelve months ending in have stepped in to satisfy continuing strong demand March 1997, about one-quarter percentage point for labor. Nevertheless, hiring was sufficiently brisk faster than during the previous twelve months and duringthefirsthalfofthisyeartopulltheunemploy- roughly half a percentage point faster than in 1994 ment rate down about one-quarter percentage point and 1995. between December and June. Just as the low unemployment rate points to tight- ness in labor markets, anecdotal reports from many Prices The underlying trend of price inflation has Change in Employment Cost Index remained favorable this year. In particular, the CPI Percent,Dec.toDec. excluding food and energy—often referred to as Hourlycompensation the ‘‘core’’ CPI—increased at an annual rate of 21⁄ 2 percent over the first two quarters of the year, about the same pace as in 1996. The overall CPI registered a smaller increase than the core CPI dur- 4 ingthefirsthalfofthisyear.BoththeoverallCPIand thecoreCPIhavebeenaffectedbyaseriesoftechni- Q1 cal changes implemented by the Bureau of Labor Statistics over the past two and one-half years to 2 obtain a more accurate measure of price changes. If notforthesechanges,increasesintheCPIsince1994 would be marginally larger. Other measures of prices also suggest that favor- 0 able inflation trends continued into 1997. Measured 1990 1992 1994 1996 fromthefirstquarteroflastyeartothefirstquarterof Note. Dataareforprivateindustry,excludingfarmandhouse- thisyear,thechainpriceindexforpersonalconsump- hold workers. The value for 1997:Q1 is measured from March 1996toMarch1997. tion expenditures excluding food and energy rose 17 Change in Consumer Prices Excluding andreduceunitcosts,upwardpressureonpricesmay Food and Energy be reduced. Finally, an extended period of relatively Percent,Q4toQ4 low and steady inflation has reinforced a belief among households and businesses that the trend of inflation should remain muted, and consequently helped to hold down inflation expectations. 6 Change in Consumer Prices 4 Percent,Q4toQ4 H1 2 6 0 1990 1992 1994 1996 4 Note. Consumerpriceindexforallurbanconsumers.Valuefor 1997:H1isthepercentchangefrom1996:Q4to1997:Q2atan annualrate. H1 2 2 percent, the same as in the four-quarter period a year earlier.2 Similarly, the chain price index for overall GDP—which covers prices of all goods and 0 1990 1992 1994 1996 servicesproducedintheUnitedStates—andthechain Note. Consumerpriceindexforallurbanconsumers.Valuefor measure for gross domestic purchases—which cov- 1997:H1isthepercentchangefrom1996:Q4to1997:Q2atan ers prices of all goods purchased in the United annualrate. States—increasedthesameamountovertheyearend- ing in the first quarter of 1997 as during the previ- ous four quarters. Developments in the food and energy sectors were favorable to consumers in the first half of 1997. All of these price measures indicate that inflation Consumer energy prices declined in the first half of remainsmuted,despitehighlevelsofresourceutiliza- the year as the price of crude oil dropped back fol- tion. Several factors have contributed to the recent lowing last year’s run-up. In 1996, the price of crude favorable performance of price inflation. Energy oil was boosted by refinery disruptions, uncertainty prices have declined this year. Non-oil import prices about the timing of Iraqi oil sales, and unusual alsohavefallensignificantly,reducinginputcostsfor weather patterns that increased energy demand for some domestic companies and likely restraining the heating and cooling. As these factors receded this prices charged by domestic businesses that compete year, crude oil prices fell. Although the downward with foreign producers. Besides being restrained trend was interrupted by some transitory spikes in by some price competition from imported materials prices—as in May when tensions in the Middle East and supplies, prices of manufactured goods at earlier flared up—the price of crude is now roughly back to stages of processing have been held in check by an the range that prevailed before last year’s run-up. expansion of industrial capacity that has been rapid Since December, gasoline prices have tumbled more enough to restrain increases in utilization rates over than 16 percent at an annual rate, and heating oil the past year. Also, to the extent that firms have suc- prices have fallen significantly. Natural gas prices ceededintheireffortstorealizelargeefficiencygains also fell as stocks, which had dwindled over the winter, were replenished. Reflecting the declines in fuel prices, the CPI for energy fell about 9 percent at 2. The price measure for personal consumption expenditures an annual rate between December 1996 and June (PCE)iscloselyrelatedtotheCPIbecausecomponentsoftheCPI 1997. are key inputs in the construction of the PCE price measure. Nevertheless, the PCE price measure has the advantage that by Consumer food prices increased at an annual rate usingchainweightingratherthanfixedweightsitavoidssomeof thesubstitutionbiasthataffectstheCPI. of only about 1 percent in the first half of the year. 18 Alternative Measures of Price Change Percent 1995:Q1 1996:Q1 to to Price measure 1996:Q1 1997:Q1 Fixedweight Consumer price index 2.7 2.9 Excluding food and energy 2.9 2.5 Chaintype Personal consumption expenditures 2.0 2.5 Excluding food and energy 2.0 2.0 Gross domestic purchases 2.2 2.2 Gross domestic product 2.2 2.2 Deflator Gross domestic product 2.1 1.8 Note. Changesarebasedonquarterlyaverages. Although coffee prices jumped, the prices of many prices were still lower in June than in December. other food items were flat or edged lower. Most Increasesinpricesofmedicalservicesalsocontinued notably, declines in grain prices that began in mid- to slow somewhat this year.3 In addition, the CPI for 1996 have been working their way to the retail level auto finance fell in May and June as automakers and have held down prices for a variety of grain- sweetened incentives. In contrast, price increases in dependent foods, such as beef, poultry, and dairy the first half of the year picked up in some other products.Pricesoffoodsthatdependmoreheavilyon areas; shelter prices rose a bit more rapidly than labor costs have been rising modestly this year. last year, as did tuition and prices for personal care services. Consumer prices for goods other than food and energy rose a restrained three-quarters percent at an Credit and the Monetary Aggregates annual rate between December and June of this year, a touch below last year’s pace. Declining prices for CreditandDepositoryIntermediation. The non-oil imports helped contain prices of goods in the total debt of domestic nonfinancial sectors increased CPI in the first half of the year, in part by constrain- atanannualrateofabout43⁄ 4 percentfromthefourth ing U.S. businesses in competition with importers. quarterof1996throughMayofthisyear,placingthe For example, prices of new and used passenger cars aggregate near the middle of the range for 1997 declinedinthefirstsixmonthsoftheyear,andprices establishedbytheFOMC.Thispaceismorethanhalf of light trucks were essentially flat. Also, prices of a percentage point below that for 1996, reflecting house furnishings were about unchanged, on bal- significantly slower growth of borrowing by the fed- ance, in the first half of the year, although apparel eral government. The total debt of the other sectors prices moved up after declining in recent years. hasrisenataroughlyconstantpaceoverthepastfew The CPI for non-energy services rose about years,eventhoughthegrowthrateofnominaloutput 3 percent at an annual rate between December and has been increasing. June, a touch below last year’s pace. After rising markedly last year, airfares declined, on net, in the 3. InJanuary1997,theBureauofLaborStatisticsintroduceda first half of this year. Fares fell substantially early in newmeasureofthepricesofhospitalservices—whichaccountfor roughly one-third of the CPI for medical services—and this new the year when the excise tax on tickets expired, and measureshould,overtime,provideamoreaccurategaugeofprice evenwiththereimpositionofthetaxinMarch,ticket movementsinthisarea. 19 Debt: Annual Range and Actual Level the velocity of M2 (defined as the ratio of nominal Billionsofdollars GDP to M2) increased a little more than might have been anticipated from its recent relationship to the Domesticnonfinancialsectors opportunity cost of holding M2—the interest earn- ingsforgonebyowningM2assetsratherthanmarket 7% 15,200 instruments such as Treasury bills. M2 may have beenhelddownabitbysavers’preferencesforequity 15,000 market funds, for which inflows were quite strong. GrowthofM2wasmuchslowerinthesecondquarter than in the first quarter (41⁄ 4 percent compared with 14,800 6percentatanannualrate),consistentwiththeslow- 3% ing of the economy and almost unchanged M2 opportunity cost. The monthly pattern of M2 growth 14,600 in the second quarter was heavily influenced by unusually high individual non-withheld tax pay- 14,400 ments. M2 surged in April, as households appar- O N D J F M A M J ently accumulated additional liquid balances in order 1996 1997 to make the larger tax payments, and was about unchanged on a seasonally adjusted basis in May as Credit on the books of depository institutions rose payments cleared and balances returned to normal. more rapidly than total debt in the first half of 1997, indicating that their share of total debt outstanding M2: Annual Range and Actual Level increased. Credit growth at thrift institutions eased late last year and early this year after increasing Billionsofdollars moderately in the first three quarters of 1996. How- ever, commercial bank credit grew at a brisk pace in thefirsthalfoftheyear,withbothsecuritiesandloans 3,950 increasing more rapidly than they did last year. Real 5% estate lending at banks rose about 9 percent at an annual rate between the fourth quarter of 1996 and 3,900 Juneofthisyear,comparedwith4percentin1996.In contrast,outstandinghomemortgagesatthriftinstitu- 3,850 tions grew little in the first part of the year after a large run-up in 1996. Home equity credit lines from 1% banks expanded especially rapidly in the spring, as 3,800 some banks promoted these loans as a substitute for consumer loans. The growth of consumer loans at banks (including loans that were securitized as well 3,750 O N D J F M A M J as loans still on banks’ books) fell from about 1996 1997 11 percent in 1996 to 31⁄ 4 percent at an annual rate between the fourth quarter of 1996 and June of this year. ThecorrespondencebetweenchangesinM2veloc- ity and in opportunity cost during recent years may The Monetary Aggregates. Growth of the represent a return to the roughly stable relationship monetaryaggregatesduringthefirsthalfof1997was observed for several decades until 1990—albeit at similartogrowthin1996.Betweenthefourthquarter a higher level of velocity. The relationship was of last year and June, M2 expanded at an annual rate disturbed in the early 1990s by households’ appar- of almost 5 percent; as the Committee had antici- ent decisions to shift funds out of lower-yielding pated, the aggregate was running close to the upper deposits into higher-yielding stock and bond mutual bound of its growth cone, which had been chosen to funds.Ononehand,the‘‘creditcrunch’’atbanksand beconsistentwithpricestability.ThebehaviorofM2 the resolution of troubled thrifts curbed the eager- over this period can be reasonably well explained by ness of these institutions to attract retail deposits, changes in nominal GDP and interest rates, using holding down the rates of return offered on brokered historical velocity relationships. In the first quarter, deposits and similar accounts relative to the average 20 deposit rates used in constructing measures of M3: Annual Range and Actual Level opportunity cost. At the same time, the appeal of Billionsofdollars longer-term assets was enhanced temporarily by the steeply sloped yield curve and more permanently by the greater variety and lower cost of mutual fund products available to investors. More recently, robust 5,100 inflows into stock funds apparently have substituted toonlyalimitedextentforholdingsofM2assets,and 6% M2 velocity and opportunity cost have again been 5,000 moving roughly together since mid-1994, although velocity has continued to drift up slightly. However, the period of renewed stability in the behavior of 2% M2—three years—is still fairly short, and whether 4,900 the stability will persist is unclear. Variations in opportunity cost and income growth during this period have been rather small, leaving considerable 4,800 doubt about how M2 would respond to more O N D J F M A M J 1996 1997 significant changes in the financial and economic environment. been historically. Growth of institution-only money marketfundseasedjustalittlefromlastyear’storrid M2 Velocity and the Opportunity Cost pace, as the role of these funds in corporate cash of Holding M2 management continued to increase. Ratio Percentagepoints,ratioscale M1contractedata21⁄ 2 percentannualratebetween Quarterly the fourth quarter of 1996 and June of this year. Growth of this aggregate was again depressed by the 2.0 M2 velocity Q1 spread of so-called sweep programs, whereby bal- 25 ances in transactions accounts, which are subject 1.9 to reserve requirements, are ‘‘swept’’ into savings M2 10 accounts, which are not. Sweep programs benefit opportunity depositories by reducing their required holdings of 1.8 cost reserves, which earn no interest. At the same time, 4 3 they do not restrict depositors’ access to their funds 2 fortransactionspurposes,becausethefundsareswept 1.7 Q1 back into transactions accounts when needed. Until 1 late last year, most retail sweep programs were limited to NOW accounts, but demand-deposit 1.6 1978 1982 1986 1990 1994 sweepshaveexpandedmarkedlysincethen.Adjusted fortheestimatedtotalofbalancessweptowingtothe Note. M2opportunitycostisatwo-quartermovingaverageof thethree-monthTreasurybillratelesstheweightedaveragerate introductionofnewsweepprograms,M1expandedat paidonM2components. a 43⁄ 4 percent annual rate between the fourth quarter of 1996 and June 1997, a little below its sweep- adjusted growth rate in 1996. M3 rose about 7 percent at an annual rate between the fourth quarter of 1996 and June of this year. This Thedropintheamountofdepositsheldintransac- paceisalittlefasterthanlastyear’sandagainleftM3 tionsaccountsinthefirsthalfof1997causedrequired above the upper end of its growth cone, which, like reserves to fall about 10 percent at an annual rate, thegrowthconeforM2,wassettobeconsistentwith closetotherateofdeclinelastyear.Nonetheless,the price stability. Large time deposits, which are not monetarybasehasexpandedatamoderatepacesofar included in M2, continued to increase much more in 1997, because the runoff in required reserves has rapidly than other deposits. Banks have been fund- been more than offset—as it was also last year—by ing their asset growth disproportionately through an increase in the demand for currency. Currency wholesale deposits, leaving interest rates on retail growth has been a little higher this year than last, as deposits further below market rates than they have the effects of strong domestic spending more than 21 Growth of Money and Debt Percent Domestic Period M1 M2 M3 nonfinancial debt Annual1 1987 6.3 4.2 5.8 10.0 1988 4.3 5.7 6.3 9.0 1989 0.5 5.2 4.0 7.9 1990 4.1 4.1 1.8 6.9 1991 7.9 3.1 1.2 4.6 1992 14.4 1.8 0.6 4.7 1993 10.6 1.3 1.1 5.2 1994 2.5 0.6 1.7 5.2 1995 - 1.6 4.0 6.2 5.5 1996 - 4.6 4.7 6.8 5.4 Quarterly (annualrate)2 1997 Q1 - 0.7 6.1 8.2 4.5 Q2 - 5.4 4.3 6.8 n.a. Year-to-date3 1997 - 2.6 4.9 7.1 4.8 1. From average for fourth quarter of preceding year to 3. Fromaverageforfourthquarterof1996toaveragefor averageforfourthquarterofyearindicated. June(Mayinthecaseofdomesticnonfinancialdebt). 2. From average for preceding quarter to average for quarterindicated. offset a slight drop in net shipments of U.S. cur- ances would become more linked to banks’ desire to rency abroad in the first four months of the year. avoid overnight overdrafts when conducting trans- actions through their accounts at Reserve Banks. Further reductions in required reserves have the Demand from this source is more variable than is potential to diminish the Federal Reserve’s ability to requirement-related demand, and it also cannot be control the federal funds rate closely on a day-to- substituted across days; both factors would tend, all day basis. Traditionally, the daily demand for bal- else equal, to increase the volatility of the federal ances at the Federal Reserve largely reflected banks’ funds rate. needs for required reserves, which are fairly predict- able. As a result, the Federal Reserve has generally The decline in required reserves over the past beenabletosupplythequantityofbalancesthatsatis- several years has not created serious problems in the fiesthisdemandattheintendedfundsrate.Moreover, federal funds market, but funds-rate volatility has reserve requirements are specified in terms of an risen a little, and the risk of much greater volatility average level of balances over a two-week period, so would increase if required reserves were to fall if the funds rate on a particular day moves above the substantially further. One factor mitigating an level expected to prevail on ensuing days, banks can increase in funds-rate volatility has been an increase trim their balances and thereby relieve some of the in required clearing balances. These balances, which upward pressure on the funds rate. If required banks can precommit to hold on a two-week aver- reserves were to fall quite low, the demand for bal- age basis, earn credits that banks use to pay for Fed- 22 eral Reserve priced services. Like required reserve economic growth in the second quarter, and interest balances, required clearing balances are predictable rates retraced their earlier advance. by the Federal Reserve and can be substituted across The yield on the inflation-indexed ten-year dayswithinthetwo-weekmaintenanceperiod.Funds- Treasury note was little changed between mid-April rate volatility has also been damped by banks’ and mid-July, suggesting that at least part of the improved management of their balances at Reserve roughly 60-basis-point drop in the nominal ten-year Banks, which in part reflects the improved real-time yield over that period reflected a reduction in access to account information now provided by expectedinflationorinuncertaintyaboutfutureinfla- the Federal Reserve. Whether these factors could tion, or both. Yet, relative movements in these two continue to restrain funds-rate volatility if required yieldsshouldbeinterpretedcarefully,asthemarket’s reserve balances were to become much smaller is as experience in trading indexed debt is relatively brief, yet unclear. Also unclear is whether a moderate makingitspricespotentiallyvulnerabletosmallshifts increase in funds-rate volatility would have any seri- in market sentiment. Moreover, the Treasury an- ousadverseconsequencesforinterestratesfartherout nounced this spring a reduction in the frequency of ontheyieldcurveorforthemacroeconomy.TheFed- nominalten-yearnoteauctions,perhapsputtingdown- eral Reserve continues to monitor the situation wardpressureontheirnominalyields,andsomeinves- closely. tors may have paid renewed attention to upcoming technical adjustments to the CPI, which will reduce Interest Rates, Equity Prices, and measuredinflation.Survey-basedmeasuresofexpected Exchange Rates inflation showed little change in the second quarter. InterestRates.Interest rates on Treasury securi- The interest rate on the three-month Treasury bill ties were little changed or declined a bit, on bal- was held down in recent months by the reduced sup- ance, between the end of 1996 and mid-July. Yields plyofbillsassociatedwiththesmallerfederaldeficit. rose substantially in the first quarter as evidence Between mid-March and mid-July, the spread mounted that the robust economic activity observed between the federal funds rate and the three-month in the closing months of 1996 had continued into yield averaged about 15 basis points above the aver- 1997.BythetimeoftheMarchFOMCmeeting,most age spread in 1996. Interest rates on private short- participants in financial markets were anticipating term instruments increased a little in the second sometighteningofmonetarypolicy,andratesmoved quarter after the small System tightening in March. little when the increase in the intended federal funds ratewasannounced.BeginninginlateApril,keydata Equity Prices. Equity markets have advanced pointed to continued low inflation and a slowing of dramatically again this year. Through mid-July, most broad measures of U.S. stock prices had climbed between 20 percent and 25 percent since year-end. Selected Treasury Rates Stocks began the year strongly, with the major Percent indexes reaching then-record levels in late Janu- Quarterly ary or February. Significant selloffs ensued, partly occasioned by the backup in interest rates, and by early April the NASDAQ index was well below its 15 year-endmarkandtheS&P500compositeindexwas barely above its. Equity prices began rebounding in Thirty-year late April, however, soon pushing these indexes to bond 10 new highs. Stock prices have been somewhat more volatile this year than last. The run-up in stock prices in the spring was 5 bolsteredbyunexpectedlystrongcorporateprofitsfor Q2 Three-month Five-year the first quarter. Still, the ratio of prices in the bill note S&P 500 to consensus estimates of earnings over the 0 coming twelve months has risen further from levels 1965 1975 1985 1995 that were already unusually high. Changes in this Note. The twenty-year Treasury bond rate is shown until the ratio have often been inversely related to changes in firstissuanceofthethirty-yearTreasurybond,inthefirstquarter of1977. long-term Treasury yields, but this year’s stock price 23 Major Stock Price Indexes Exchange Rates. The weighted average for- Index(December31,1996=100) eignexchangevalueofthedollarintermsoftheother G-10 currencies rose sharply in the first quarter from Daily 125 its level in December and has moved up somewhat further since then. On balance, the nominal dollar is more than 10 percent above its level at the end 115 S&P500 of December. A broader measure of the dollar that includes currencies from additional U.S. trading 105 partners and adjusts for changes in relative consumer prices shows appreciation of about 7 percent. After rising nearly 10 percent in terms of the Japanese yen 95 toarecentpeakinlateApril,thedollarretreated;itis NASDAQ currently about unchanged from its value in terms of 85 yenattheendofDecember.Incontrast,thedollarhas risen about 17 percent in terms of the German mark 75 since the end of last year. J F M A M J J A S O N D J F M A M J J 1996 1997 Note. LastobservationsareforJuly18,1997. Weighted Average Exchange Value gainswerenotmatchedbyasignificantnetdeclinein of the U.S. Dollar interest rates. As a result, the yield on ten-year Index,March1973=100 Treasury notes now exceeds the ratio of twelve- Monthly month-aheadearningstopricesbythelargestamount since 1991, when earnings were depressed by the economicslowdown.Oneimportantfactorbehindthe June increase in stock prices this year appears to be a 95 furtherriseinanalysts’reportedexpectationsofearn- ings growth over the next three to five years. The averageoftheseexpectationshasrisenfairlysteadily since early 1995 and currently stands at a level not 85 seen since the steep recession of the early 1980s, when earnings were expected to bounce back from levels that were quite low. Equity Valuation and Long-Term Interest Rate 75 1992 1993 1994 1995 1996 1997 Percent Note. Nominal value in terms of the currencies of the other Monthly G-10countries.Weightsarebasedonthe1972–76globaltrade ofeachofthetencountries. 14 Early in the year, data showing continued strengthening of U.S. economic activity surprised Ten-yearTreasurynoteyield marketparticipants,raisedtheirexpectationsofsome 10 tighteningofU.S.monetarypolicy,andcontributedto upward pressure on the dollar. In light of the FOMC action in late March and the tendency for subsequent 6 S&P500earnings–priceratio economic indicators to suggest a slowing of the July growth of U.S. real output, pressure for dollar appre- ciation abated. While robust economic activity in the 2 UnitedStatesgeneratedariseinU.S.long-terminter- 1982 1987 1992 1997 est rates through April, market uncertainty about the Note. Earnings–price ratio is based on the I/B/E/S Inter- strength of output growth in several foreign indus- national, Inc., consensus estimate of earnings over the coming twelvemonths.Allobservationsreflectpricesatmid-month. trialcountriesledtolittlechange,onbalance,inaver- 24 agelong-term(ten-year)ratesinotherG-10countries. U.S. and Foreign Interest Rates Since then, U.S. rates have returned to near year- Three-month end levels, while rates abroad have moved down. Percent Accordingly, the long-term interest differential, on Monthly balance, has shifted further in favor of dollar assets since December, consistent with the net appreciation Averageforeign of the dollar this year. 8 Despiteindicationsoffurtherrecoveryofoutputin Japan,thedollarroseagainsttheyenearlyintheyear asplannedfiscalpolicyinJapanappearedtobemore 6 restrictive than had been expected, and Japanese long-term interest rates declined in response. State- June ments by G-7 officials at their meeting in Berlin 4 in February and on subsequent occasions suggested some concern that the dollar’s strength and the yen’s U.S.largeCD weakness not become excessive. The dollar moved back down in terms of the yen in May and has since 2 fluctuated narrowly. The yen has been supported Ten-year by data showing a widening of Japanese external Percent surplusesandbyapartialretracingbyJapaneselong- Monthly term rates of their earlier decline, as indicators have suggested that the fiscal measures may not be as Averageforeign contractionary as previously expected. 8 The dollar also rose sharply early in the year in terms of the German mark and other continental European currencies. Market participants have been disappointed that the pace of economic activity has not strengthened further in continental European June 6 countries. In addition, uncertainties about the pros- pects for European Monetary Union, including the U.S.Treasury possibility of delay and the question of which countries will be in the first group proceeding to 4 StageThree,haveresultedinfluctuationsinthemark 1992 1993 1994 1995 1996 1997 and,onbalance,appeartohavestrengthenedthedol- Note. Average foreign rates are the global trade-weighted lar. German long-term interest rates have declined average, for the other G-10 countries, of yields on instruments somewhat on balance this year. comparabletotheU.S.instrumentsshown. Short-term market interest rates in most of the major foreign industrial countries have changed little on average since the end of last year. Rates in the ThetrendinMexicaninflationhasdeclinedthisyear; United Kingdom have risen somewhat as the new nevertheless, the excess of Mexican inflation over government increased the official lending rate one- U.S. inflation implies about a 7 percent real appre- quarter percentage point in May and the Bank of ciation of the peso since December. England raised it by the same amount in June and Since mid-May, financial pressures in Thailand, again in July. Short-term rates in Italy and Switzer- which caused authorities there to raise interest rates land have eased. Stock prices have risen sharply so and have led to depreciation of the currency, have far this year in the major foreign industrial countries, spilledovertoinfluencefinancialmarketsinsomeof particularly in continental Europe. our Asian trading partners, particularly the Philip- Thedollarhaschangedlittleonbalanceintermsof pines and Malaysia. Interest rates in both of these the Mexican peso since December, as improved countries rose sharply. Philippine officials relaxed investor sentiment toward Mexico, reflected in nar- their informal peg of the peso in terms of the dollar, rowing yield spreads between Mexican and U.S. andthecurrencydeclinedsignificantly;theMalaysian dollar-denominated bonds, has supported the peso. ringgit and Indonesian rupiah have also depreciated. 25

Federal Reserve (1997, July 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19970722

@misc{wtfs_monetary_policy_report_19970722,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1997},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19970722},
  note = {Retrieved via When the Fed Speaks corpus}
}