Monetary Policy Report

For use at 10:00 a.m., E.D.T. Tuesday July 21, 1998 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 21, 1998 Letter of Transmittal BOARDOFGOVERNORSOFTHE FEDERALRESERVESYSTEM Washington,D.C.,July21,1998 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 1998 7 Section 1: Monetary Policy and the Economic Outlook The U.S. economy posted significant further gains past few months created added pressures for reform, in the first half of 1998. The unemployment rate and they underscored the depth and scope of the dropped to its lowest level in nearly thirty years, and problems that must be addressed. inflation remained subdued. Real output rose appre- Despite the pronounced weakening of our trade ciably, on balance, although much of the advance balance,thealreadytightU.S.labormarkethascome apparently occurred early in the year. Household under further strain this year owing to robust growth spendingandbusinessfixedinvestment,supportedby of domestic demand. As a result, the outlook for the ongoing rise in equity prices and the continued inflation has taken on a greater degree of risk. low level of long-term interest rates, appear to have Consumerpricesactuallyroseabitlessrapidlyinthe maintained considerable momentum this year. The first half of 1998 than they did in 1997, but transi- sizable advance in capital spending and the result- tory factors—the drop in oil prices, the runup in the ing additions to the capital stock should help bolster dollar, and weak economic activity in Asia—exerted laborproductivity—thekeytorisinglivingstandards. considerable downward pressure on domestic prices. Yet the news this year has not been uniformly Thesefactorswillnotpersistindefinitely.Meanwhile, good. The turmoil that erupted in some Asian thepoolofindividualsinterestedinworkingbutwho countries last year has generated major concerns are not already employed has continued to shrink. about the outlook for those economies and the The extraordinary tightness in labor markets has repercussions for other nations, including the United generated a rising trend of increases in wages and States. Several Asian countries have had sharp related costs, although faster productivity growth has contractions in economic activity, and others have damped the effect on business costs so far. experienced distinctly sub-par growth. Heightened In conducting monetary policy in the first half of uneasinessamonginternationalinvestorshasinduced 1998, the Federal Open Market Committee (FOMC) portfolio shifts away from Asia and, to some extent, closely scrutinized incoming information for signs from other emerging market economies. that the strength of the economy and the taut labor These difficulties have created considerable market were likely to boost inflation and threaten the uncertainty and risk for the U.S. economy, but they durabilityoftheexpansion.However,despiteslightly have also helped to contain potential inflationary larger increases in the CPI in some months, infla- pressures in the near term by reducing import prices tion remained moderate on the whole. Moreover, the and restraining aggregate demand. In particular, the Committee expected that aggregate demand would substantial rise in the foreign exchange value of the slow appreciably because of a rising trade deficit dollar has boosted our real imports and—together and a considerable slackening in domestic spending. with the slower growth in Asia—depressed our real Although the Committee was acutely aware of the exports.Atthesametime,therunupinthedollarand uncertainties in the economic outlook, it believed slack economic conditions in Asia have helped that the deceleration in demand—and the associated produce a sharp drop in the dollar prices of oil and modest easing of pressures on resources—could well other commodities and have pushed down other be sufficient to limit any deterioration in underlying import prices. Shifts in preferences toward dollar- price performance. On balance, the FOMC chose to denominated assets in combination with downward keep the intended federal funds rate at 51⁄ 2 percent. revisions to forecasts of inflation and demand have helped to reduce our interest rates; the lower inter- estrateshaveboostedhouseholdandbusinessspend- Monetary Policy, Financial Markets, and ing, offsetting a portion of the damping of demand the Economy over the First Half of 1998 from the foreign sector. Output grew rapidly in the first quarter, with real The Asian crisis is likely to continue to restrain gross domestic product estimated to have risen U.S. economic activity in coming quarters. The size 51⁄ 2 percent at an annual rate. Business fixed invest- oftheeffectwilldependinlargepartonhowquickly ment soared after a weak fourth quarter, and con- the authorities in the Asian nations can put their sumption and housing expenditures expanded at a troubled financial systems on a sounder footing and strong clip. In addition, contrary to the expectations carry out other essential economic reforms. of many forecasters, inventory investment rose Deterioratingconditionsinmanycountriesduringthe substantially from its already hefty fourth-quarter 1 Selected Interest Rates Percent Daily Thirty-year Treasury 7 Three-year Treasury 6 IntendedFederalFundsRate 5 DiscountRate Three-month Treasury 4 7/3 8/20 9/24 11/1312/17 2/5 3/25 5/20 7/2 8/19 9/30 11/12 12/16 2/4 3/31 5/19 7/1 1996 1997 1998 Note. DottedverticallineindicatesthedayonwhichtheFed- policyaction.Thedatesonthehorizontalaxisarethoseonwhich eral Open Market Committee (FOMC) announced a monetary theFOMCheldmeetings.LastobservationsareforJuly17,1998. pace, with the rise contributing more than rateswerealsorestrainedtoasignificantextentbythe 11⁄ 2 percentage points to overall GDP growth. At the effects of the Asian crisis. Equity prices increased same time, the cumulative effect of the appreciation sharply in the first quarter, extending their remark- of the dollar and faster growth of demand here than able gains of the previous three years in spite of abroad resulted in a sharp drop in real net exports, disappointing news on corporate profits. Households with both rapid import growth and the first quarterly and firms borrowed at a vigorous pace in the first drop in exports in four years. Employment continued quarter, and growth in the debt of domestic to advance briskly, and the unemployment rate held nonfinancialsectorspickedupfromthefourthquarter steady at 43⁄ 4 percent. Hourly compensation acceler- of 1997, as did the growth of the monetary ated somewhat when measured on a year-over-year aggregates. basis, but impressive productivity growth once again At their March meeting, the members of the helpedtorestraintheincreaseinunitlaborcosts.The FOMC confronted unusual cross-currents in the eco- consumer price index rose only 1⁄ 4 percent at an nomic outlook. On the price side, the FOMC noted annual rate over the first three months of the year, as that, although the incoming data were quite favor- a sharp drop in energy prices offset price increases able, transitory factors were possibly masking under- elsewhere. lying tendencies toward higher inflation. Moreover, Falling long-term interest rates and rising equity the available data on household and business spend- prices over the previous year provided substantial ing confirmed the impressive strength of domestic impetus to household and business spending in the demand and highlighted the possibility that develop- first quarter. Interest rates dropped sharply further in ments in the external sector might not provide suffi- early January, and although they moved up a little cient offset in coming quarters to avoid a build-up of over the remainder of the quarter, nominal yields on inflation pressures. At the same time, the FOMC long-term Treasury securities were among the low- noted the substantial uncertainty surrounding the estindecades.Interestratescontinuedtobenefitfrom prospects for the Asian economies. Balancing these the improvement in the federal budget and the considerations, the FOMC kept its policy stance prospect of reduced federal borrowing in the future; unchanged but noted that recent information had 2 altered the inflation risks enough to make tightening precipitate an upturn in inflation over time. Yet the more likely than easing in the period ahead. FOMC believed that the growth of economic activ- ity would slow. It also judged that the risk of The second quarter brought both a marked further significant further deterioration in Asia, which could deteriorationintheoutlookforAsiaandsomeindica- disrupt global financial markets and impair eco- tionsthattheU.S.economymightbecooling.InAsia, nomic activity in the United States, was rising evidenceofsteepoutputdeclinesinseveralcountries somewhat. was combined with mounting concern that eco- nomicandfinancialproblemsinJapanwerenotlikely to be resolved as quickly as many observers had Economic Projections for hopedorexpected.Oneresultwasafurtherriseinthe 1998 and 1999 exchange value of the dollar and a decline in long- The members of the Board of Governors and the term U.S. interest rates. Increasing investor concern Federal Reserve Bank Presidents, all of whom aboutemergingmarketeconomiesraisedriskspreads participate in the deliberations of the FOMC, expect onexternaldebtsinAsia,Russia,andLatinAmerica. economic activity to expand moderately, on average, The higher value of the dollar and the depressed over the next year and a half. For 1998 as a whole, income in many Asian countries continued to take the central tendency of their forecasts for real GDP their toll on U.S. exports and to boost imports in growth spans a range of 3 percent to 31⁄ 4 percent. For the second quarter. In addition, a marked slackening 1999,theseforecastscenteronarangeof2percentto in the pace of inventory accumulation, which was 21⁄ 2 percent. The civilian unemployment rate, which amplified by the effects of a strike in the motor vehi- averaged a bit less than 41⁄ 2 percent in the second cle industry, was reflected in a sharp slowing in quarter of 1998, is expected to stay near this level domestic demand. Nonetheless, the utilization of through the end of this year and to edge higher in labor resources remained very high: In the second 1999.Withlabormarketsremainingtightandsomeof quarter, the unemployment rate averaged a bit less the special factors that helped restrain inflation in the than 41⁄ 2 percent, its lowest quarterly reading in first half of 1998 unlikely to be repeated, inflation is nearlythirtyyears.Thetwelve-monthchangeinaver- anticipatedtorunsomewhathigherinthesecondhalf age hourly earnings indicated that wages were ris- of 1998 and in 1999. ing somewhat more rapidly than they had a year The economy is entering the second half of 1998 earlier. And the CPI rose faster in the second quarter withconsiderablestrengthinhouseholdspendingand than in the first, mainly reflecting a smaller drop in business fixed investment. Consumers are enjoying energy prices. expanding job opportunities, rising real incomes, and Financial conditions in the second quarter and into highlevelsofwealth,allofwhichareprovidingthem July remained supportive of domestic spending. with the confidence and wherewithal to spend. These Yields on private securities declined, although less factors, in conjunction with low mortgage interest thanTreasuryyields,asqualityspreadswidenedabit. rates, are also bolstering housing demand. Business Equity prices rose further in early April before fall- fixed investment appears robust as well: Financial ing back over the next two months in response conditionsremainconducivetocapitalspending,and to renewed earnings disappointments. Prices then firms no doubt are continuing to seek out opportuni- reboundedsubstantially,withmostmajorindexeshit- tiesforproductivitygainsinanenvironmentofrapid ting record highs in July. The growth of money and technological change, falling prices for high-tech credit slowed a little on balance from the first- equipment, and tight labor markets. quarter pace but remained buoyant. Banks and other Nonetheless, a number of factors are expected to lenders continued to compete vigorously, extending exert some restraint on the expansion of activity in creditongenerallyfavorabletermsastheyresponded the quarters ahead. The demand for U.S. exports will in part to the sustained healthy financial condition of continue to be depressed for a while by weak activ- most businesses and households. ity abroad, on average, and by the strong dollar, The FOMC left the intended federal funds rate which will also likely continue to boost imports. The unchanged at its May and June-July meetings. At the effects of these external sector developments on Maymeeting,theFOMCreiterateditsearlierconcern employmentandincomegrowthhaveyettomaterial- that the robust expansion of domestic final demand, izefully.Inaddition,althoughfinancialconditionsare supported by very positive financial conditions, had generally expected to be supportive, real outlays on raised labor market pressures to a point that might housing and business equipment have reached such 3 Economic Projections for 1998 and 1999 Percent Federal Reserve governors andReserveBankpresidents Central Indicator Range tendency Administration 1998 Change,fourthquarter tofourthquarter1 Nominal GDP 41⁄ 4 to 5 41⁄ 2 to 5 4.2 Real GDP 23⁄ 4 to 31⁄ 4 3 to 31⁄ 4 2.4 Consumer price index2 11⁄ 4 to 21⁄ 4 13⁄ 4 to 2 1.6 Averagelevel,fourthquarter Civilian unemployment rate 41⁄ 4 to 41⁄ 2 41⁄ 4 to 41⁄ 2 4.8 1999 Change,fourthquarter tofourthquarter1 Nominal GDP 4 to 51⁄ 2 41⁄ 4 to 5 4.1 Real GDP 2 to 3 2 to 21⁄ 2 2.0 Consumer price index2 11⁄ 2 to 3 2 to 21⁄ 2 2.1 Averagelevel,fourthquarter Civilian unemployment rate 41⁄ 4 to 43⁄ 4 41⁄ 2 to 43⁄ 4 5.0 1. Changefromaverageforfourthquarterofpreviousyear 2. Allurbanconsumers. toaverageforfourthquarterofyearindicated. high levels that gains from here are expected to be labor market will remain tight, suggesting potential more moderate. ongoing pressures on available resources that would tend to raise inflation a bit. The FOMC will remain With the plunge in energy prices in early 1998 alerttothepossibilityofunderlyingimbalancesinthe unlikely to be repeated, most FOMC participants economy that could generate a persisting pickup in expect the CPI for all urban consumers to rise more inflation, which would threaten the economic rapidly in the second half of 1998 than it did in expansion. the first half, resulting in an increase in the CPI of 13⁄ 4 percent to 2 percent for 1998 as a whole. The As noted in past monetary policy reports, the pickup in the second half should be limited, how- Bureau of Labor Statistics is in the process of ever, by further decreases in non-oil import prices, implementing a series of technical adjustments to ample domestic manufacturing capacity, and low make the CPI a more accurate measure of price expected inflation. Looking ahead to next year, the change. These adjustments and the regular updating central tendency is for an increase in the CPI of of the market basket are estimated to have trimmed 2 percent to 21⁄ 2 percent. Absent a further rise in the CPI inflation somewhat over 1995–98, and a dollar, the fall in non-oil import prices should have significant further adjustment is scheduled for 1999. runitscourse.Moreover,evenwiththeexpectededg- All told, the published figures for CPI inflation in ing higher of the unemployment rate next year, the 1999 are expected to be more than 1⁄ 2 percentage 4 Ranges for Growth of Monetary and Debt Aggregates Percent Aggregate 1997 1998 Provisional for 1999 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. point lower than they would have been had the M2 and M3 behavior were disrupted, and the veloci- Bureauretainedthemethodsandformulasinplacein ties of both aggregates climbed well above the levels 1994.Inanyevent,theFOMCwillcontinuetomoni- that were predicted by past relationships. However, tor a variety of price measures besides the CPI as it since 1994 the velocities of M2 and M3 have again attempts to gauge progress toward the long-run goal moved roughly in accord with their pre-1990 experi- of price stability. ence, although their levels remain elevated. Federal Reserve officials project somewhat faster The recent return to historical patterns does not growth in real GDP and slightly higher inflation imply that velocity will be fully predictable or even in 1998 than does the Administration. The that all movements in velocity can be completely Administration’s projections for the growth in real explained in retrospect. Some shifts in velocity arise GDP and inflation in 1999 are around the lower end fromhouseholdandbusinessdecisionstoadjusttheir of the FOMC participants’ central tendencies. portfolios for reasons that are not captured by simple measures of opportunity cost. Some shifts in veloc- ity arise from decisions of depository institutions to Money and Debt Ranges createmoreorlesscreditortofundcreditcreationin for 1998 and 1999 different ways. All these decisions are shaped by the At its most recent meeting, the FOMC reaffirmed rapid pace of innovation in financial institutions and therangesfor1998growthofmoneyanddebtthatit instruments. Between 1994 and early 1997, M2 hadestablishedinFebruary:1percentto5percentfor velocity drifted somewhat higher, probably owing to M2, 2 percent to 6 percent for M3, and 3 percent to somereallocationofhouseholdsavingsintobondand 7 percent for the debt of the domestic nonfinancial equity markets. But M2 velocity has declined over sectors.TheFOMCsetthesesamerangesfor1999on the past year despite little change in its traditionally a provisional basis. defined opportunity cost. One explanation may be that the flatter yield curve has reduced the return on Onceagain,theFOMCchosethegrowthrangesfor longer-term investments relative to the bank depos- the monetary aggregates as benchmarks for growth its and money market mutual funds in M2. Another under conditions of price stability and historical part of the story may be the booming stock market, velocity behavior. For several decades before 1990, which has reduced the share of households’ finan- the velocities of M2 and M3 (defined as the ratios of cial assets represented by monetary assets and may nominal GDP to the aggregates) behaved in a fairly have encouraged households to rebalance their port- consistent way over periods of a year or more. M2 folios by increasing their M2 holdings. M3 velocity velocityshowedlittletrendbutvariedpositivelyfrom has dropped more sharply over the past year, with year to year with changes in a traditional measure of strong growth in large time deposits and in insti- M2 opportunity cost, defined as the interest forgone tutional money funds that are increasingly used by by holding M2 assets rather than short-term market businesses for cash management. instruments such as Treasury bills. M3 velocity moveddownabitovertime,asdepositorycreditand If the velocities of M2 and M3 follow their aver- theassociatedelementsinM3tendedtogrowashade agehistoricalpatternsovertheremainderof1998and faster than GDP. In the early 1990s, these patterns of the growth of nominal GDP matches the expecta- 5 tions of Federal Reserve policymakers, these aggre- In light of the apparent return of velocity changes gates will finish this year above the upper ends of to their pre-1990 behavior, some FOMC members their respective ranges. Part of this relatively rapid have been giving the aggregates greater weight in moneygrowthreflectsnominalGDPgrowthinexcess assessing overall financial conditions and the thrust of that consistent with price stability and sustainable of monetary policy. However, velocity remains growth of real output; the rest represents a decline in somewhatunpredictable,andallCommitteemembers velocity.Absentunusualchangesinvelocityin1999, monitor a wide variety of other financial and eco- policymakers’ expectations of nominal GDP growth nomic indicators to inform their policy delibera- imply that M2 and M3 will be in the upper ends of tions. The FOMC decided that the money and debt theirprice-stabilitygrowthrangesnextyear.Thedebt ranges are best used to emphasize the Committee’s of the domestic nonfinancial sectors is expected to commitment to achieving price stability, so it again remain near the middle of its range this year and in set the ranges as benchmarks for growth under price 1999. stability and historical velocity behavior. 6 Section 2: Economic and Financial Developments in 1998 The U.S. economy continued to perform well in The Household Sector the first half of the year. The economic difficulties ConsumerSpending. The factors that fueled in Asia and the strong dollar reduced the demand for the sizable increase in household expenditures in our exports and intensified the pressures on domes- 1997 continued to spur spending in the first half of tic producers from foreign competition. But these 1998: Growth in employment and real disposable effects were outweighed by robust domestic final income remained very strong, and households in the demand, owing in part to supportive financial condi- aggregate enjoyed significant further gains in net tions, including a higher stock market, ample avail- worth. Reflecting these developments, sentiment ability of credit, and long-term interest rates that in indexes suggest that consumers continued to feel nominaltermswereamongthelowestinmanyyears. extraordinarily upbeat about the current and prospec- Sharp swings in inventory investment were mirrored tive condition of the economy and their own finan- in considerable unevenness in the growth of real cial situations. GDP, which appears to have slowed markedly in the second quarter after having soared to nearly 51⁄ 2 percent at an annual rate in the first quarter. Change in Real Income and Consumption Nonetheless,overthefirsthalfasawhole,therisein realoutputwaslargeenoughtosupportsizablegains Percent,annualrate in employment and to push the unemployment rate Disposablepersonalincome downtotherangeof41⁄ 4 to41⁄ 2 percent,thelowestin decades. Personalconsumptionexpenditures 8 The further tightening of labor markets in recent Q1 quartershasbeenreflectedinamorediscernibleuptilt to the trend in hourly compensation. But price 4 inflation remained subdued in the first half of the year, held down in part by a sharp decline in energy prices and lower prices for non-oil imports. Intense + competition in product markets, ample plant capac- 0 – ity, ongoing productivity gains, and damped infla- tionexpectationsalsohelpedtorestraininflationpres- sures in the face of tight labor markets. 4 1993 1994 1995 1996 1997 1998 In total, real consumer outlays rose at an annual Change in Real GDP rate of 6 percent in the first quarter, and the avail- Percent,annualrate abledatapointtoanotherlargeincreaseinthesecond quarter. Increases in spending were broad-based, but outlays for durable goods were especially strong. Q1 6 Declining prices and ongoing product innovation continued to stimulate demand for personal comput- ers and other home electronic equipment. In addi- 4 tion, purchases of motor vehicles were sustained by a combination of solid fundamentals and attractive pricing. Indeed, since 1994, sales of light vehicles 2 have been running at a brisk pace of 15 million units (annual rate), and, in the second quarter, a round of + 0 very attractive manufacturers’ incentives helped lift – sales to a pace of 16 million units. Spending on services also remained robust in the 2 1993 1994 1995 1996 1997 1998 firsthalfoftheyear,withshort-runvariationsreflect- 7 inginparttheeffectsofweatheronhouseholdenergy startsoverthefirstfivemonthsoftheyear—11⁄ 4 mil- use; outlays on personal business services, includ- lionunitsatanannualrate—was9percentabovethe ing those related to financial transactions, and on pace for 1997 as a whole. Moreover, surveys by the recreation services continued to exhibit remarkable NationalAssociationofHomebuilderssuggestedthat strength. In addition, real outlays for nondurable housing demand remained vigorous at midyear, and goods, which rose only moderately last year, grew the Mortgage Bankers Association reported that loan about61⁄ 2 percentatanannualrateinthefirstquarter, applications for home purchases have been around and they appear to have posted another sizable all-time highs of late. increase in the second quarter. The strong demand for homes has contributed to Real disposable income—that is, after-tax income somefirmingofhouseprices,whicharenowrisingin adjusted for inflation—remained on a strong uptrend the neighborhood of 3 to 5 percent per year, accord- inearly1998:Itroseabout4percentatanannualrate ing to measures that control for shifts in the regional between the fourth quarter of 1997 and May 1998. composition of sales and attempt to minimize the This increase in part reflected a sharp rise in aggre- effectsofchangesinthemixofthestructuralfeatures gate wages and salaries, which were boosted by siz- of houses sold. In nominal terms, these increases are able gains in both employment and real wage rates; wellwithintherangeofrecentyears;however,inreal dividendsandnonfarmproprietors’incomesalsorose terms, they are among the largest since the mid- appreciably. However, growth in after-tax income 1980s—a development that should reinforce the (as measured in the national income and product investment motive for homeownership. Of course, accounts) was restrained by large increases in risinghousepricesmaymakepurchasinghomesmore personal income tax payments—likely owing in part difficult for some families. But, with income growth totaxespaidonrealizedcapitalgains;capitalgains— strong and mortgage rates around 7 percent (thirty- whether realized or not—are not included in yearconventionalfixed-rateloans),homeownershipis measured income. Reflecting the movements in as affordable as it has been at any time in the past spending and measured income, the personal saving thirtyyears.Moreover,innovativeprogramsthatrelax rate fell from an already low level of about 4 per- the standards for mortgage qualification are helping cent in 1997 to 31⁄ 2 percent during the first five low-income families to finance home purchases. months of 1998. Also, stock market gains have probably boosted demand among higher-income groups, especially in Residential Investment. Housing activity the trade-up and second-home segments of the continuedtostrengtheninthefirsthalfof1998,espe- market. cially in the single-family sector, where starts rose After having surged in the fourth quarter of 1997, noticeably and sales of both new and existing homes multifamilystartssettledbacktoabout325,000units soared. Indeed, the average level of single-family (annualrate)overthefirstfivemonthsof1998,apace only slightly below that recorded over 1997 as a whole. Support for multifamily construction con- Private Housing Starts tinued to come from the overall strength of the econ- Millionsofunits,annualrate omy, which undoubtedly has stimulated more Quarterlyaverage individuals to form households, as well as from low interest rates and an ample supply of financing. In addition, real rents picked up over the past year, and 1.5 the apartment vacancy rate appears to be edging Single-family down. 1.0 HouseholdFinance.Household net worth rose sharply in the first quarter, pushing the wealth-to- Q2 income ratio to another record high. Although the 0.5 flow of new personal saving was quite small, the Multifamily revaluation of existing assets added considerably to wealth, with much of these capital gains accu- mulated on equities held either directly or indirectly 0 1988 1990 1992 1994 1996 1998 through mutual funds and retirement accounts. Of Note. Valuesfor1998:Q2aretheaverageofAprilandMay. course, these gains have been distributed quite 8 Household Net Worth Relative to home purchases suggest a further solid gain in mort- Disposable Personal Income gage debt in the second quarter. Home equity credit Percent at banks increased only 2 percent at an annual rate from the fourth quarter of 1997 through June 1998 Four-quartermovingaverage after having posted a 151⁄ 2 percent gain last year; 575 Q1 this slowdown may reflect a diminished substitution 550 of mortgage debt for consumer debt or simply the increase in mortgage refinancings, which allowed 525 householdstopaydownmoreexpensivehomeequity debtortoconverthousingequityintocashinamore 500 advantageous manner. 475 Despite the further buildup of household indebted- ness, financial stress among households appears to 450 havestabilizedafterseveralyearsofdeterioration.In 425 the aggregate, estimated required payments of loan principal and interest have held about steady rela- 400 tive to disposable personal income—albeit at a high 1968 1978 1988 1998 level—since1996.Overthisperiod,theeffectondebt burdens of faster growth of debt than income has unevenly: The 1995 Survey of Consumer Finances beenroughlyoffsetbydeclininginterestratesandthe reported that 41 percent of U.S. families own equi- associated refinancing of higher interest-rate debt, as ties in some form, but that families with higher well as by a shift toward mortgage debt (which has wealth own a much larger share of total equities. a longer repayment period). Various measures of Inthefirstquarterofthisyear,therunupinwealth, delinquency rates on consumer loans leveled off or together with low interest rates and high levels of declined in 1997, and delinquency rates on mort- confidence about future economic conditions, sup- gages have been at very low levels for several years. portedrobusthouseholdspendingandborrowing.The Personal bankruptcy filings reached a new record expansion of household debt, at an annual rate of high in the first quarter of 1998, but this represented 73⁄ 4 percent, was above last year’s pace and once only 6 percent more filings than four quarters earlier, again outstripped growth in disposable income. The which is the smallest such change in three years. consumer credit component of household debt grew 41⁄ 2 percent at an annual rate in the first quarter, a Household Debt-Service Burden paceroughlydoublethatforthefourthquarteroflast Percentofdisposablepersonalincome year but near the 1997 average. Preliminary data for April and May point to a somewhat smaller advance in the second quarter. Q1 17 Mortgage debt increased 81⁄ 4 percent at an annual rate in the first quarter, the same as its fourth- quarter advance and a little above its 1997 growth 16 rate. Fixed-rate mortgage interest rates were 15 basis points lower in the first quarter than three months 15 earlier and 75 basis points lower than a year earlier, which encouraged both new home purchases and a surge of refinancing of existing mortgages. Within 14 total gross mortgage borrowing, the flattening of the yield curve made adjustable-rate mortgages less attractive relative to fixed-rate mortgages, and their 13 1983 1988 1993 1998 share of originations reached the lowest point in Note. Debt service is the sum of estimated required interest recent years. Net borrowing can be boosted by andprincipalpaymentsonconsumerandhousehold-sectormort- refinancings if households ‘‘cash out’’ some housing gagedebt. equity, but the magnitude of this effect is unclear. In any event, continued expansion of bank real estate These developments have apparently suggested lendingandahighlevelofmortgageapplicationsfor to banks that they have sufficiently tightened terms 9 Delinquency Rates on Household Loans exceptional growth of investment since the early Percent 1990s has been facilitated in part by the increase in nationalsavingassociatedwiththeeliminationofthe federal budget deficit. It has resulted in considerable modernization and expansion of the nation’s capital Creditcard 5 accountsat Q1 stock, which have been important in the improved banks performance of labor productivity over the past few 4 years and which should continue to lift productivity in the future. Moreover, rapid investment in the Autoloansatdomestic manufacturing sector in recent years has resulted in autofinancecompanies Q1 3 large additions to productive capacity, which have helped keep factory operating rates from rising much above average historical levels in the face of appre- 2 Mortgages(over60days) ciable increases in output. Q1 Real outlays for producers’ durable equipment, 1 whichhavebeenrisingmorethan10percentperyear, 1988 1990 1992 1994 1996 1998 on average, since the early 1990s, moved sharply Note. Data on credit-card delinquencies are from the Call Report;dataonmortgagedelinquenciesarefromtheMortgage higher in the first half of 1998. All major categories BankersAssociation. of equipment spending recorded sizable gains in the first quarter; but as has been true throughout the and standards on consumer loans. In the Federal expansion, outlays for computers rose especially Reserve’s May Senior Loan Officer Opinion Survey rapidly. Real computer outlays received particular on Bank Lending Practices, relatively few banks, on impetus in early 1998 from extensive price-cutting. net, reported tightening standards on credit card or Purchases of communications equipment have also other consumer loans. Little change was reported in soared in recent quarters; the rise reflects intense the terms of consumer loans. pressurestoaddcapacitytoaccommodatethegrowth of networking; the rapid pace of technological The Business Sector advance, especially in wireless communications; and regulatory changes. As for the second quarter, data FixedInvestment. Real business fixed invest- on shipments, coupled with another steep decline in ment appears to have posted another hefty gain over computerprices,pointtoafurthersubstantialincrease the first half of 1998 as spending continued to be in real computer outlays. Spending on motor vehi- boostedbypositivesalesexpectationsinmanyindus- cles apparently continued to advance as well while tries; favorable financial conditions; and a perceived demand for other types of capital equipment appears opportunity, if not a necessity, for firms to install to have remained brisk. new technology in order to remain competitive. The In total, real outlays on nonresidential construc- Change in Real Business Fixed Investment tion flattened out in 1997 after four years of gains, and they remained sluggish in early 1998. Construc- Percent,annualrate tion of office buildings remained robust in the first Structures Q1 half of this year, after having risen at double-digit rates in 1996 and 1997, and outlays for institutional Producers’durable equipment 20 buildings continued to trend up. However, expen- ditures for other types of structures were lackluster. Nonetheless, the economic fundamentals for the sec- tor as a whole remain quite favorable: Vacancy rates 10 for office and retail space have continued to fall; real estateprices,thoughstillwellbelowthelevelsofthe mid-1980s in real terms, have risen appreciably in + 0 recentquarters;andfundingfornewprojectsremains – abundant. InventoryInvestment.The pace of stockbuild- 10 1993 1994 1995 1996 1997 1998 ing by nonfarm businesses picked up markedly in 10 1997 and is estimated to have approached $100 bil- Corporate Profits and Net Interest lion (annual rate) in the first quarter of 1998—equal Percentofnationalincome to an annual rate increase of 81⁄ 2 percent in the level of inventories and accounting for more than 11⁄ 2 percentage points of that quarter’s growth in real GDP. The first-quarter accumulation was heavy almost across the board. Among other things, it Netinterest 11 includedalargeincreaseinstocksofpetroleumasthe Q1 unusually warm weather reduced demand for refined products and low prices provided an incentive for refiners and distributors to accumulate stocks. How- ever, overall sales were also very strong, and with 8 only a few exceptions—notably, semiconductors, Corporateprofits chemicals, and textiles—stocks did not seem out of linewithsales.Inanyevent,fragmentarydataforthe second quarter point to a considerable slowing in 5 inventory investment that is especially evident in the 1978 1983 1988 1993 1998 motor vehicle sector, where stocks were depleted by Note. Corporateprofitsincludeinventoryvaluationandcapital the combination of strong sales and GM production consumptionadjustments. shortfalls. In addition, petroleum stocks appear to have grown less rapidly than they did in the first quarter, and stockbuilding elsewhere slowed sharply Overall, a major portion of the increase in profits in April and May. betweenthe1980sandthe1990srepresentsarealign- ment of returns from debt-holders to equity-holders. Change in Real Nonfarm Business Inventories Although their level remains high, the growth of Percent,annualrate profits has slowed: Economic profits rose 43⁄ 4 per- cent at an annual rate in the first quarter compared with 91⁄ 2 percent between the fourth quarter of 1996 and the fourth quarter of 1997. This slowdown may Q1 9 have resulted from various causes, including rising employee compensation and the Asian financial crisis. Quantifying the effect of the Asian turmoil is 6 difficult: Although only a small share of the profits of U.S. companies is earned in the directly affected Asian countries, the crisis has reduced the prices of U.S. imports and thereby put downward pressure on 3 domestic prices. Nonfinancial businesses realized annualized eco- 0 nomic profit growth of only 11⁄ 4 percent in the first 1993 1994 1995 1996 1997 1998 quarter. Because capital expenditures (including inventory investment) grew much faster, the financ- Corporate Profits and Business Finance. ing gap—the excess of capital expenditures over Businesses have financed a good part of their invest- retained earnings—widened. As a result, these busi- ment this year through continued strong cash flow, nesses used less of their cash flow to retire out- but they have also increased their reliance on finan- standing equity and continued to borrow at the rapid cial markets. Economic profits (book profits after paceofthefourthquarterof1997,withdebtexpand- inventory valuation and capital consumption adjust- ingatanannualrateof9percentinthefirstquarterof ments)haverunat12percentofnationalincomeover 1998. Outstanding amounts of both bonds and com- the past year, well above the 1980s peak of roughly mercial paper rose especially sharply. The decline in 9 percent. However, the strength in profits has long-term interest rates around year-end encouraged resulted partly from the low level of net interest pay- companies to lock in those yields, and gross bond ments, leaving total capital income at roughly the issuance reached a record high in the first quarter same share of national income as at the 1980s peak. of 1998. Borrowing by nonfinancial businesses 11 increasedataslightlyslowerbutstillrapidclipinthe Net Interest Payments of Nonfinancial secondquarter,withlittlechangeinoutstandingcom- Corporations Relative to Cash Flow mercial paper but very strong net bond issuance and Percent some rebound in bank loans. Despite persistent high borrowing, external fund- ing for businesses remained readily available on 22 favorable terms. The spreads between yields on investment-gradebondsandyieldsonTreasurybonds 18 widenedalittlefromlowlevels,withinvestorsfavor- ing Treasury securities over corporate securities as a haven from Asian turmoil and, perhaps, with disap- 14 pointing profits leading to some minor reassessment of the underlying risk of private obligations. The spreads on high-yield bonds also increased, in part 10 becauseofheavyissuanceofthesebondsthisspring, Q1 but they remain narrow by historical standards. In 6 the Federal Reserve’s May survey on bank lending 1978 1983 1988 1993 1998 practices, banks reported negligible change in busi- ness loan standards; moreover, yield spreads on bank loans remained low for both large and small firms. paymentstocashflow,droppedsubstantiallybetween Surveys by the National Federation of Independent 1990 and 1996 and remains modest, despite edging Business suggest that small firms have been facing up in the first quarter of this year. In addition, most little difficulty in obtaining credit. measures of financial distress have shown favorable readings. The delinquency rate on commercial and industrialbankloanshasstayedverylowsince1995, Spreads Between Yields on preserving the dramatic decline that occurred in the Private and Treasury Securities first half of the decade. After moving up a little in Percent 1996and1997,businessfailuresdecreasedinthefirst five months of 1998; the liabilities of failed busi- nessesasashareoftotalliabilitieswaslessthanone- 10 quarter the value reached in the early 1990s. At the sametime,Moody’supgradedsignificantlymoredebt 8 thanitdowngraded,andtherateofjunkbonddefaults stayed close to its low 1997 level. 6 High-yieldbonds Net equity issuance was less negative in the first quarter of this year than in the fourth quarter of last 4 year,butnonfinancialcorporationsstillretired,onnet, Investment-gradebonds about $100 billion of equity at an annual rate. The June 2 waveofmergerannouncementsthisspringwilllikely generate strong share retirements over the remainder 0 of the year. Gross equity issuance in the first half of 1988 1990 1992 1994 1996 1998 1998 was close to its pace of the past several years, Note. Thespreadonhigh-yieldbondscomparestheyieldon although investors seemed somewhat cautious about the Merrill Lynch Master II Index with that on a seven-year Treasurynote;thespreadoninvestment-gradebondscompares initial public offerings. theyieldonMoody’sindexofA-ratedbondswiththatonaten- yearTreasurynote. The Government Sector The ready availability of credit has stemmed FederalGovernment. The incoming news on importantly from the healthy financial condition of thefederalbudgetcontinuestobeverypositive.Over many businesses, which have enjoyed an extended the twelve months ending in May 1998, the unified period of economic expansion and robust profits. budget registered a surplus of $60 billion, compared The aggregate debt-service burden for nonfinancial withadeficitof$65billionduringthetwelvemonths corporations, measured as the ratio of net interest endinginMay1997.Soaringreceiptscontinuedtobe 12 themainforcedrivingtheimprovementinthebudget, Federal receipts in the twelve months ending in butsubduedgrowthinoutlaysalsoplayedakeyrole. May 1998 were 10 percent higher than in the same IfthelatestprojectionsfromOMBandCBOarereal- period a year earlier—roughly twice the percentage ized, the unified budget for fiscal year 1998 as a increase for nominal GDP over the past year. whole will show a surplus of roughly $40 billion to Individual income tax receipts, which have been $65 billion. rising at double-digit rates since the mid-1990s, continued to do so over the past year as the surge in Withthefederalbudgethavingshiftedintosurplus, capital gains realizations likely persisted and sizable the federal government is now augmenting, rather gains in real income raised the average tax rates on than drawing on, the pool of national saving. In manyhouseholds(theindividualincometaxstructure fact, the improvement in the government’s budget being indexed for inflation but not for growth in real position over the past several years has been large incomes). In contrast to the ongoing strength in enough to generate a considerable rise in gross individual taxes, corporate tax payments increased domestic saving despite a decline in the private sav- only moderately over the past year, echoing the ing rate; all told, gross saving by households, busi- deceleration in corporate profits. nesses, and governments increased from about 141⁄ 2 percent of gross national product in the early Federal expenditures in the twelve months ending 1990s, when federal saving was at a cyclical low, to inMay1998wereonly11⁄ 2 percenthigherinnominal more than 17 percent of GNP in recent quarters. terms than during the twelve months ending in May This increase in domestic saving, along with 1997, with restraint evident in most categories. increased borrowing from abroad, has financed the Outlays for defense were about unchanged, as were surge in domestic investment in this expansion. those for income security programs. In the latter Moreover, this year’s budgetary surplus will con- category, outlays for low-income support fell as tinuetopaybenefitsinfutureyearsbecauseitallows economic activity remained robust, welfare reform the government to reduce its outstanding debt, which capped outlays for family assistance, and enrollment implies smaller future interest payments and, all rates in other programs dropped. In the health area, else equal, makes it easier to keep the budget in spending on Medicaid picked up somewhat after a surplus. If, in fact, the budget outcome over the next period of extraordinarily small increases, whereas several years is as favorable as OMB and CBO now growth in spending for Medicare slowed, in part anticipate under current policies, the reduction in because of the programmatic changes that were the outstanding debt could be substantial. legislated in 1997. And, with interest rates little changed and the stock of outstanding federal debt no longer rising, net interest payments stabilized. Saving and Investment Real federal outlays for consumption and gross PercentofnominalGNP investment, the part of federal spending that is countedinGDP,fellabout2percentbetweenthefirst quarters of 1997 and 1998. The decrease was con- Grossdomesticinvestment centrated in real defense spending, which fell about 23⁄ 4 percent, roughly the same as over the preced- 20 ing four quarters; real nondefense spending was Q1 unchanged, on balance. In the first quarter, real fed- eral outlays fell at a 10 percent annual rate; the drop reflectedaplungeindefensespending,whichappears 16 to have been reversed in the second quarter. Grosssaving Withdebtheldbythepubliccloseto$4trillion,the government will continue to undertake substantial gross borrowing in order to redeem maturing securi- 12 ties. The government will also continue to adjust its 1981 1985 1989 1993 1997 issuanceofshort-termdebttoaccommodateseasonal Note. Gross saving consists of saving of households, busi- swings in receipts and spending. The surplus during nesses,andgovernments.Grossdomesticinvestmentisthesum of gross private domestic investment and government invest- the first half of calendar year 1998—boosted by the ment.Thegapbetweengrosssavingandgrossdomesticinvest- huge inflow of individual income tax receipts— mentisequaltothesumofnetforeigninvestmentandthestatisti- caldiscrepancyfromthenationalincomeandproductaccounts. enabled the Treasury to reduce its outstanding debt 13 Change in Real Federal Expenditures rent expenditures in the national income and product on Consumption and Investment accounts, held steady in the first quarter at around Percent,Q4toQ4 $35 billion (annual rate), roughly where it has been since1995.Stategovernments,whichhavereapedthe mainbenefitsofrisingincometaxes,havefaredespe- ciallywell:Indeed,alloftheforty-sevenstateswhose fiscalyearsendedbyJune30appeartohaveachieved Q1 + balanceortohaverunsurplusesintheirgeneralfunds 0 – budgets in fiscal year 1998. Real expenditures for consumption and gross investment by states and localities have been rising 6 about 2 percent per year, on average, since the early 1990s, and the increase in spending for the first half of 1998 appears to have been a bit below that trend. These governments added jobs over the first half of the year at about the same rate as they did over 1997 12 asawhole.However,realconstructionoutlays,which 1993 1994 1995 1996 1997 1998 have been drifting down since early 1997, posted a Note. Valuefor1998:Q1isaquarterlypercentchangeatan annualrate. sizable decline in the first quarter, and monthly data suggest that spending dropped further in the spring. The weakness in construction spending over the past $57 billion while augmenting its cash balance year has cut across the major categories of construc- $40 billion. The reduction in debt included net tion and is puzzling in light of the sector’s ongoing paydowns of coupon securities and bills. infrastructure needs and the good financial shape of most governments. Looking ahead to projected surpluses for coming years, the Treasury announced that it will no longer issuethree-yearnotesandwillauctionfive-yearnotes Change in Real State and Local Expenditures quarterly rather than monthly. Over the past several on Consumption and Investment years, the Treasury has accommodated the surpris- Percent,Q4toQ4 ing improvement in federal finances by substantially reducingbothbillandcouponissuance.TheTreasury hopes that concentrating future coupon offerings in larger,less-frequentauctionswillmaintaintheliquid- ity of these securities while still allowing for suffi- cient issuance of bills to maintain their liquidity as well. These changes are also intended to prevent 2 further upcreep in the average maturity of the out- standing debt held by private investors, now stand- ing at sixty-five months. The Treasury continues to work on encouraging the market for inflation- Q1 indexedsecurities,issuingathirty-yearindexedbond inApriltocomplementtheexistingfive-yearandten- year indexed notes. 0 1993 1994 1995 1996 1997 1998 State and Local Governments. The fiscal Note. Valuefor1998:Q1isaquarterlypercentchangeatan annualrate. position of state and local governments in the aggre- gatehasalsoremainedquitefavorable.Stronggrowth of household income and consumer spending has State and local governments responded to the low continuedtoliftrevenues,despitenumeroussmalltax interest rates during the first half of the year by bor- cuts,andgovernmentshavecontinuedtoholdtheline rowing at a rapid rate, both to refinance outstanding on expenditures. As a result, the consolidated cur- debt and to fund new capital projects. Because debt rentaccountofthesector,asmeasuredbythesurplus retirements eased in the first quarter relative to (net of social insurance funds) of receipts over cur- the fourth quarter of 1997, net issuance increased 14 substantially. Meanwhile, credit quality of state and The quantity of imports of goods and services local debt continued to improve, with much more againgrewvigorouslyinthefirstquarter.Theannual debtupgradedthandowngradedinthefirsthalfofthe rateofexpansionat17percentexceededthatfor1997 year. and reflected the continued strength of U.S. eco- nomic activity and the effects of past dollar appre- ciation. Imports of consumer goods, automotive External Sector products, and machinery were particularly robust. TradeandtheCurrentAccount.The nominal Preliminary data for April and May suggest that real trade deficit on goods and services widened to importgrowthremainedstrong.Non-oilimportprices $140billionatanannualrateinthefirstquarterfrom fell sharply through the second quarter, reflecting the $114 billion in the fourth quarter of last year. The rise in the exchange value of the dollar over the past current account deficit for the first quarter reached year. $189 billion (annual rate), 21⁄ 4 percent of GDP, compared with $155 billion for the year 1997. A Change in Real Imports and Exports largerdeficitonnetinvestmentincomeaswellasthe of Goods and Services widening of the deficit on trade in goods and ser- Percent,Q4toQ4 vices contributed to the deterioration in the first quarter of the current account balance. In April and Imports May, the trade deficit increased further. Exports Q1 20 U.S. Current Account Billionsofdollars,annualrate 10 + 0 + – 0 – 50 10 100 1993 1994 1995 1996 1997 1998 Note. Valuefor1998:Q1isaquarterlypercentchangeatan annualrate. 150 The quantity of exports of goods and services Q1 200 declined at an annual rate of 1 percent in the first quarter, the first such absolute drop since the first 250 quarter of 1994. The weakness of economic activity 1993 1994 1995 1996 1997 1998 in a number of our trading partners, with absolute PercentofnominalGDP declines in several economies in Asia, and the strengthofthedollar,whichalsopartlyresultedfrom the Asian financial crises, largely account for the abrupt halt in the growth of real exports after a 2 10 percent rise last year. Declines were recorded for machinery, industrial supplies, and agricultural + products. Exports to the emerging market economies 0 – in Asia, particularly Korea, as well as exports to Japan were down sharply while exports to western EuropeandCanadarosemoderately.Preliminarydata 2 for April and May suggest that real exports declined Q1 further. The Capital Account. Foreign direct invest- 4 1973 1978 1983 1988 1993 1998 ment in the United States and U.S. direct investment 15 abroad continued at near record levels in the first Unemployment Rate quarter of 1998, spurred by strong merger and Percent acquisition activity across national borders. In the first quarter, the booming U.S. stock market continued to attract large foreign interest. Net 9 purchasesbyprivateforeignerswere$29billion,fol- lowingrecordnetpurchasesof$66billionintheyear 1997. Foreign net purchases of U.S. corporate bonds remained substantial, and net purchases of U.S. 6 government agency bonds reached a record $21 bil- lion. In contrast, net sales of U.S. Treasury securi- June ties by private foreigners, particularly large net sales 3 bookedataCaribbeanfinancialcenter,wererecorded in the first quarter. U.S. net purchases of foreign stocks and bonds were modest. Foreign official assets in the United States 1968 1973 1978 1983 1988 1993 1998 increased$10billioninthefirstquarter.However,the net increase in the second quarter was limited by large dollar sales by Japan. of 1998, posting increases of 115,000 per month, on average. Within services, hiring remained brisk The Labor Market at computer and data-processing firms and at firms providing engineering and managerial services, but Employment and Labor Supply. Labor payrolls at temporary help agencies rose much less demandremainedrobustduringthefirsthalfof1998. rapidlythantheyhadovertheprecedingfewyears— Growthinpayrollemploymentaveraged243,000per apparently in part reflecting difficulties in finding month, only a little less than in 1997 and well above workers, especially for highly skilled and technical the rate consistent with the growth in the working- positions. Sizable increases were also posted at age population. The unemployment rate held steady wholesale and retail trade establishments and in the in the first quarter at 43⁄ 4 percent but dropped to the finance,insurance,andrealestatecategory.Construc- range of 41⁄ 4 percent to 41⁄ 2 percent in the second tionpayrollswerebouncedaroundbyunusualwinter quarter. weather but, on average, rose a brisk 21,000 per The services industry, which accounts for about month—about the same as in 1997. 30 percent of nonfarm employment, continued to be In contrast to the robust gains elsewhere, themainstayofemploymentgrowthoverthefirsthalf manufacturing firms curbed their hiring in the first half of 1998 in the face of slower growth in factory output. After having risen a torrid 61⁄ 4 percent in Change in Payroll Employment 1997, factory output increased at an annual rate of Thousandsofjobs,monthlyaverage about 21⁄ 2 percent between the fourth quarter of last Totalnonfarm year and May 1998; the deceleration reflected the effects of the Asian crisis as well as a downshift in motor vehicle assemblies and the completion of the 400 1996–97ramp-upinaircraftproduction.InJune,fac- toryoutputisestimatedtohavefallen1⁄ 2 percent;the H1 GM strike accounted for the decline. 200 Thelaborforceparticipationrate—whichmeasures the percentage of the working-age population that is either employed or looking for work—trended up + 0 mildly over the past couple of years and stood at – 67.1 percent, on average, in the first half of 1998, slightlyabovethepreviouscyclicalhighsachievedin late 1989 and early 1990. Participation among adult 200 1993 1994 1995 1996 1997 1998 womenhaspickedupnoticeablyinrecentyears,after 16 havingrisenonlyslowlyinthefirsthalfofthe1990s, Change in Employment Cost Index and participation among adult men, which had been Percent,Dec.toDec. onagradualdowntrendthroughmid-decade,appears Hourlycompensation tohaveleveledout.Incontrast,participationratesfor teenagers, for whom school enrollment rates have risen, have continued to sag after having dropped sharply in the early 1990s. Strong labor demand 4 Q1 clearly contributed importantly to the rise in overall participation over the past several years, but the expansion of the earned income tax credit and changes in the welfare system probably provided 2 added stimulus. Labor Force Participation Rate 0 Percent 1991 1993 1995 1997 Note. Dataareforprivateindustry,excludingfarmandhouse- Q2 hold workers. The value for 1998:Q1 is measured from March 1997toMarch1998. 66 overthepastyear,impliesasolidincreaseinrealpay for many workers. 63 Theaccelerationinhourlycompensationcostsover the past year resulted mainly from faster growth of wages and salaries, which rose 4 percent over the 60 twelve months ending in March; this increase was about1⁄ 2 percentagepointlargerthantheonerecorded over the preceding twelve months. Separate data 57 on average hourly earnings of production or 1968 1973 1978 1983 1988 1993 1998 nonsupervisory workers also show an ongoing Note. Databefore1994havebeenadjustedbytheFRBstaff acceleration of wages: The twelve-month change in fortheredesignofthehouseholdsurvey. this series was 4.1 percent in June, 1⁄ 2 percentage point above the reading for the preceding twelve months. LaborCostsandProductivity.Firmsnodoubt are continuing to rely heavily on targeted pay Benefits costs have generally remained subdued, increases and incentives like stock options and with the increase over the year ending in March bonuses to attract and retain workers. But the tight- amounting to only about 21⁄ 4 percent. According to ness of the labor market also appears to be exerting the ECI, employer payments for health insurance some upward pressure on traditional measures of have picked up moderately in recent quarters after hourly compensation, which have exhibited a having been essentially flat over the previous couple somewhat more pronounced uptrend of late. Indeed, of years, and indications are that further increases the twelve-month change in the employment cost may be in the offing. Insurers whose profit margins index (ECI) for private industry workers picked up had been squeezed in recent years by pricing strate- to 31⁄ 2 percent in March, compared with 3 percent giesdesignedtogainmarketsharereportedlyarerais- for the twelve months ending in March 1997 and ingpremiums,andmanymanagedcareplansareadd- 23⁄ 4 percent for the twelve months ending in March inginnovationsthat,whileofferinggreaterflexibility 1996. Hourly compensation accelerated especially andprotectionstoconsumers,mayboostcosts.Addi- rapidly for employees of finance, insurance, and real tional upward pressure on premiums apparently has estate firms, some of whom received sizable bonuses come from higher spending on prescription drugs. and commissions. However, the acceleration was Among other major components of benefits, rising fairly widespread across industries and occupations equity prices have reduced the need for firms to and,giventherelativelysmallriseinconsumerprices pay into defined benefit plans, and costs for state 17 unemployment insurance and workers’ compensa- Prices tion have fallen sharply. Price inflation remained quiescent in the first half Labor productivity in the nonfarm business sector of this year. After having increased 13⁄ 4 percent in posted another sizable advance in the first quarter of 1997, the consumer price index (CPI) slowed to a 1998, bringing the increase over the year ending in crawlinearly1998asenergypricesplummeted,andit thefirstquartertoanimpressive2percent.1Takinga recordedariseofonlyabout11⁄ 2 percentatanannual slightly longer perspective, productivity has risen a rateoverthefirstsixmonthsoftheyear.Theincrease bit more than 11⁄ 2 percent per year, on average, over in the CPI excluding food and energy—the so- the past three years, after having risen less than called‘‘coreCPI’’—pickedupto21⁄ 2 percent(annual 1 percent per year, on average, over the first half rate) over the first half of the year. However, this of the decade. At least in part, the recent strong pickupfollowssomeunusuallysmallincreasesinthe productivity growth has likely been a cyclical response to the marked acceleration of output. But it Change in Consumer Prices isalsopossiblethatthehighlevelsofbusinessinvest- Percent,Dec.toDec. ment over the past several years—and the associ- ated rise in the amount of capital per worker—are translating into a stronger underlying productivity trend. In addition, productivity apparently is being 4 buoyed by the assimilation of new technologies into the workplace. In any event, the faster productivity 3 growthoflateishelpingtooffsettheeffectsofhigher hourly compensation on unit labor costs and prices, thereby allowing wages to rise in real terms. 2 H1 1 Change in Output per Hour Percent,Q4toQ4 0 1991 1993 1995 1997 4 Note. Consumerpriceindexforallurbanconsumers.Valuefor 1998:H1 is the percent change from December 1997 to June 1998atanannualrate. 3 Q1 2 Change in Consumer Prices Excluding Food and Energy 1 Percent,Dec.toDec. + 0 – 5 1 4 1991 1993 1995 1997 Note. Nonfarm business sector. Value for 1998:Q1 is the percentchangefrom1997:Q1to1998:Q1. 3 H1 1. Accordingtothepublisheddata,productivityrose1.1percent 2 at an annual rate in the first quarter. However, these data are distortedbyinconsistenciesinthemeasurementofhoursassociated withvaryinglengthsofpayperiodsacrossmonths.Althoughthe 1 BureauofLaborStatisticshasalreadyrevisedthemonthlyhours andearningsdatatoaccountfortheseinconsistencies,itwillnot updatetheproductivitystatisticsuntilAugust.Allelsebeingequal, 0 adjustingtheproductivitydatatoreflecttheBureau’srevisionsto 1991 1993 1995 1997 hours would substantially raise productivity growth in the first Note. Consumerpriceindexforallurbanconsumers.Valuefor quarter,butitwouldhavelittleeffectonthechangeoverthefour 1998:H1 is the percent change from December 1997 to June quartersendinginthefirstquarter. 1998atanannualrate. 18 Alternative Measures of Price Change Percent 1996:Q1 1997:Q1 to to Price measure 1997:Q1 1998:Q1 Fixedweight Consumer price index 2.9 1.5 Excluding food and energy 2.5 2.3 Chaintype Personal consumption expenditures 2.6 1.0 Excluding food and energy 2.3 1.4 Gross domestic product 2.2 1.4 Note. Changesarebasedonquarterlyaverages. second half of 1997, and the twelve-month change TheCPIforgoodsotherthanfoodandenergyrose has held fairly steady at about 21⁄ 4 percent since late atanannualrateof1percentoverthefirstsixmonths last summer. The chain price index for personal of 1998, only a bit above the meager 1⁄ 2 percent consumption expenditures on items other than food rise over 1997 as a whole. In the main, the step-up and energy rose only 11⁄ 2 percent over the year end- reflected a turnaround in prices of used cars and ing in the first quarter of 1998—the most recent trucks, and prices of tobacco products and prescrip- informationavailable;thismeasuretypicallyrisesless tion drugs also rose considerably faster than they rapidly than does the core CPI, in part because it is had in 1997. More generally, prices continued to be less affected by so-called ‘‘substitution bias.’’ restrained by the effect of the strong dollar on prices ofimport-sensitivegoods.Forexample,pricesofnew The relatively favorable price performance in the vehicles fell slightly over the first half of the year first half of 1998 reflected a number of factors that, whilepricesofotherimport-sensitivegoods—suchas taken together, continued to exert enough restraint apparel and audio-video equipment—were flat or to offset the upward pressures from strong aggre- down. In the producer price index, prices of capital gatedemandandhighlevelsoflaborutilization.One equipment were little changed, on balance, over the wasthedropinoilprices.Inaddition,non-oilimport first half of 1998; they, too, were damped by the prices continued to fall, thus further lowering input competitive effects of falling import prices. costs for many domestic industries and limiting the ability of firms facing foreign competition to raise The CPI for non-energy services increased prices for fear of losing sales to producers abroad. 3 percent over the first six months of 1998, about Pricesofmanufacturedgoodswerealsoheldincheck the same as last year’s pace. After having fallen by the sizable increase in domestic industrial capac- somewhatlastyear,airfarespickedupinthefirsthalf ity in recent years and by developments in Asia, of the year, and owner’s equivalent rent seems to be which, among other things, led to a considerable rising a bit faster than it did in 1997. In addition, softening of commodity prices. Moreover, the vari- increases in prices of medical services, which had oussurveysofconsumersandforecasterssuggestthat slowed to about 3 percent per year in 1996–97, have inflation expectations stayed low—even declined been running somewhat higher so far this year. Price in some measures. For example, according to the changes for most other major categories of services Michigan survey, median one-year inflation expecta- were similar to or smaller than those recorded in tionsdroppedabitfurtherthisyear,afterhavingheld 1997. fairly steady over 1996 and 1997, and inflation expectationsforthenextfivetotenyearsedgeddown Energypricesfellsharplyinearly1998astheprice from about 3 percent, on average, in 1996 and 1997 of crude oil came under severe downward pressure to 23⁄ 4 percent in the second quarter of 1998. from weak demand in Asia, a decision by key OPEC 19 producers to increase output, and a relatively warm Debt: Annual Range and Actual Level winter in the Northern Hemisphere. After averaging Trillionsofdollars about$20perbarrelinthefourthquarterof1997,the Domesticnonfinancialsectors spot price of West Texas intermediate dropped to a 7% monthlyaverageof$15perbarrelinMarch,whereit 15.8 more or less remained through the spring. Crude prices dropped sharply in June following reports of 15.6 high levels of inventories and revised estimates of oil consumption in Asia but have since firmed in response to an agreement by major oil producers to 15.4 restrict supply in the months ahead; they now stand at $141⁄ 2 per barrel. Reflecting the decline in crude 3% 15.2 prices, retail energy prices fell at an annual rate of 12 percent over the first half of the year, led by a 15.0 steep drop in gasoline prices. Developmentsintheagriculturalsectoralsohelped 14.8 torestrainoverallinflationinthefirsthalfofthisyear. O N D J F M A M J J Excluding the prices of fruits and vegetables— 1997 1998 which tend to be bounced around by short-term swingsintheweather—foodpriceshavebeenrisinga the second. This slowdown was especially acute in scant 0.1 percent per month, on average, since late securities holdings, which had surged in both the 1997. Although farmers in some regions of the fourth quarter of 1997 and the first quarter of this country are experiencing more prolonged weather year.ResponsestotheFederalReserve’sMaysurvey problems, conditions in the major crop-producing on bank lending practices suggest that the earlier areas of the Midwest still look relatively favorable, runup in securities reflected the efforts of banks to and it appears that aggregate farm production will be boost returns on equity by increasing leverage; much sufficient to maintain ample supplies over the com- of the rise in securities holdings was concentrated at ing year, especially in the context of sluggish export banks that were constrained by recent mergers from demand. using their profits to repurchase shares. Loan growth also slowed in the second quarter, although the vari- ous loan categories behaved quite differently: Real Credit and the Monetary Aggregates estate lending expanded most slowly in May and CreditandDepositoryIntermediation. The June, whereas business lending rebounded in those total debt of U.S. households, governments, and months after stalling out in March and April. Out- nonfinancialbusinessesincreasedatanannualrateof standing loans at branches and agencies of foreign 53⁄ 4 percent from the fourth quarter of 1997 through banks declined in the second quarter, and survey May of this year. Domestic nonfinancial debt now responses identified an actual or expected weaken- stands a little above the midpoint of the 3 percent ing in the capital position of the parent banks as the to 7 percent range established by the FOMC for primary impetus for a tightening of loan terms and 1998. Debt growth has picked up since 1997, as an standards. acceleration of private credit associated with strong The Report of Condition and Income (the Call domestic demand and readily available supply has Report) showed that banks’ return on equity was more than offset reduced federal borrowing. Indeed, about unchanged in the first quarter, staying in the federal debt declined 11⁄ 4 percent at an annual rate elevated range it has occupied since 1993. Call between the fourth quarter of 1997 and May 1998, Report data also indicated that delinquency and whereas nonfederal debt increased 81⁄ 4 percent charge-off rates on commercial and industrial loans annualizedoverthesameperiod.Thegrowthofnon- and on real estate loans remain quite low, while federal debt has slowed only slightly over the past delinquency and charge-off rates on consumer loans several months. haveleveledoffaftertheirpreviousrise.Indeed,bank Credit on the books of depository institutions rose profits have benefited importantly in recent years atroughlythesamepaceastotalcreditinthefirsthalf from a low level of provisioning for loan losses. oftheyear.Commercialbankcreditadvancedrapidly Nevertheless, bank supervisors have been concerned in the first quarter and at a more subdued rate in that intense competition and favorable economic 20 conditions might be leading banks to ease standards hasnotincreasedbankingconcentrationinmostlocal excessively. They reminded depositories that credit markets. assessments should take account of the possibility of less positive economic circumstances in the future. TheMonetaryAggregates.The broad mone- The trend toward consolidation in the banking tary aggregates grew more rapidly in the first half of industry continued in the first half of the year. Some 1998thantheydidin1997,althoughthepaceoftheir of the announced mergers involve combinations of expansion has slowed noticeably in recent months. banks and nonbank financial institutions, such as M2 grew 71⁄ 4 percent at an annual rate between the thrifts and insurance companies. Many of the merg- fourth quarter of last year and June of this year, ers were designed to capitalize on the economies of placing it well above the top of its 1 percent to scale and diversification of risk in nationwide bank- 5percentgrowthrange.WhentheFOMCestablished ing; other mergers were undertaken to expand the this range in February, it noted that annual ranges range of services offered to customers. Although represented benchmarks for money growth under some observers are concerned that consolidation conditions of stable prices and velocity behavior in might raise banks’ market power, greater national accordancewithitspre-1990historicalexperience.In concentration in banking over the past several years fact,nominalspendingandincomehavegrownmore Growth of Money and Debt Percent Domestic Period M1 M2 M3 nonfinancial debt Annual1 1988 4.3 5.7 6.3 9.1 1989 0.5 5.2 4.0 7.5 1990 4.2 4.1 1.8 6.7 1991 7.9 3.1 1.2 4.5 1992 14.4 1.8 0.6 4.5 1993 10.6 1.3 1.1 4.9 1994 2.5 0.6 1.7 4.9 1995 - 1.6 3.9 6.1 5.4 1996 - 4.5 4.6 6.8 5.3 1997 - 1.2 5.7 8.8 5.0 Quarterly (annualrate)2 1998 Q1 3.0 8.0 11.0 6.2 Q2 0.3 7.3 9.6 n.a. Year-to-date3 1998 0.9 7.3 9.8 5.8 1. From average for fourth quarter of preceding year to 3. Fromaverageforfourthquarterof1997toaveragefor averageforfourthquarterofyearindicated. June(Mayinthecaseofdomesticnonfinancialdebt). 2. From average for preceding quarter to average for quarterindicated. 21 M2: Annual Range and Actual Level andopportunitycosthaveagainbeenmovingroughly Trillionsofdollars together, though not in lockstep. Indeed, velocity has declined recently despite almost no change in the standard measure of opportunity cost. The dip in 4.25 velocity may be partly attributable to the flatter yield curve, which has reduced the return on longer-term 4.20 investmentsrelativetoM2assets—bankdepositsand money market mutual funds. Money demand may 5% 4.15 also be bolstered by the efforts of households to rebalance their portfolios in the face of a booming 4.10 stockmarket.Bytheendof1997,households’mone- tary assets had ebbed to the smallest share of their 4.05 total financial assets in many years, and households 1% may want to reduce the concentration of their assets 4.00 in relatively risky equities and increase their hold- ings of less volatile M2 assets. However, in spite of 3.95 both the flatter yield curve and the rebalancing O N D J F M A M J J motive, flows into both bond mutual funds and stock 1997 1998 mutual funds have been quite heavy this year. rapidly than is consistent with price stability and M2 increased 71⁄ 4 percent at an annual rate in the sustainable real growth, and the velocity of M2 second quarter, compared with 8 percent in the first (defined as the ratio of nominal GDP to M2) has quarter. A buildup in household liquid accounts in fallen relative to the behavior predicted by the pre- preparation for individual income tax payments 1990 experience. substantially boosted money growth in April; the clearingofthesepaymentsdepressedMaygrowthby For several decades before 1990, M2 velocity a roughly equal amount. At an annual rate, M2 showed little overall trend but varied positively from increased about 6 percent on average over April and year-to-year with changes in M2 opportunity cost, May and about 5 percent in June, suggesting a larger which is generally defined as the interest forgone by deceleration than is shown by the quarterly average holding M2 assets rather than short-term market figures. instruments such as Treasury bills. The relationship was disturbed in the early 1990s by a sharp increase M3: Annual Range and Actual Level in velocity; however, since mid-1994, M2 velocity Trillionsofdollars M2 Velocity and the Opportunity Cost of Holding M2 Ratioscale Percentagepoints,ratioscale 5.6 6% 2.0 M2 5.5 velocity Q1 25 1.9 5.4 10 M2 2% opportunity 1.8 cost 5.3 4 3 2 1.7 Q1 5.2 O N D J F M A M J J 1 1997 1998 1.6 1978 1983 1988 1993 1998 M3grew93⁄ 4 percentatanannualratebetweenthe Note. M2opportunitycostisatwo-quartermovingaverageof fourth quarter of last year and June, placing it far thethree-monthTreasurybillratelesstheweighted-averagerate paidonM2components. above the top of its 2 percent to 6 percent growth 22 range. As with M2, the FOMC chose the growth on only a two-week average basis. As a result, the rangeforM3asabenchmarkforgrowthundercondi- Federal Reserve has generally been able to supply a tions of price stability and historical velocity quantity of reserves that is close to the quantity behavior. The components of M3 not included in M2 demanded at the federal funds rate intended by increased171⁄ 2 percentatanannualrateoverthefirst the FOMC, and banks have accommodated many half of the year, following an even faster runup in unanticipated imbalances in reserve supply by vary- 1997. Rapid expansion of large time deposits in the ing the quantity demanded across days. Banks also first quarter was driven importantly by strong credit hold reserve balances to avoid overdrafts after mak- growthatdepositoryinstitutions.Morerecently,gains ing payments to other banks. But this precautionary in this category have diminished as bank credit demand is more variable and difficult to predict than growth has slowed. Holdings of institutional money requirement-related demand, and it cannot be marketmutualfundsclimbedmorethan20percentin substituted across days. As required reserves drop, each of the past three years, and that strength has more banks will hold deposits at the Federal Reserve mounted in 1998 as businesses’ interest in outsourc- only to meet these day-to-day demands, reducing the ing their cash management evidently has intensified. potential for rate-smoothing behavior. Because in-house management often involves short- So far, however, the federal funds rate has not term assets that are not included in M3, the shift to become noticeably more volatile on a maintenance- mutual funds boosts M3 growth. period average basis. This outcome has occurred M1 rose 1 percent at an annual rate between the partly because the Federal Reserve has responded to fourth quarter of 1997 and June of this year. Cur- the changing nature of reserve demand by conduct- rency expanded 61⁄ 2 percent annualized over that ing open market operations on more days than had period, a bit below its increase last year. Foreign been customary and by arranging more operations demand for U.S. currency apparently weakened with overnight maturity, thereby bringing the daily substantially in the first five months of the year, with reserve supply more closely in line with demand. At an especially large decline in shipments to Russia. thesametime,bankshaveborrowedmorereservesat Deposits in M1 declined in the first half of the year thediscountwindowandhaveimprovedthemanage- owing to the continued introduction of ‘‘sweep’’ ment of their accounts at Reserve Banks. Between programs. M1 growth has been depressed for several 1995 and 1997, banks also significantly increased years by the spread of these programs, which sweep their required clearing balances, which they pre- balances out of transactions accounts, which are commit to hold and which earn credits that can be subject to reserve requirements, and into savings applied to Federal Reserve priced services. Like accounts,whicharenot.Depositorsareunaffectedby required reserve balances, required clearing balances this arrangement because the funds are swept back are predictable by the Federal Reserve and can be when needed; banks benefit because they can reduce substituted across days within the two-week their holdings of reserves, which earn no interest. maintenance period. Going forward, the Federal Newsweepsofothercheckabledepositshaveslowed Reserve’s recent decision to use lagged reserve sharply, but sweeps of demand deposits into savings accounting rather than contemporaneous reserve deposits—an activity that has become popular more accounting will increase somewhat the predictability recently—continue to spread. Because many banks of reserve demand by both banks and the Federal have already reduced their required reserves to Reserve. Still, further declines in required reserves minimallevels,thetotalflowofnewsweepprograms might increase funds-rate volatility. Moreover, one- is tapering off, although it remains considerable. thirdofthebanksrespondingtotheFederalReserve’s recent Senior Financial Officer Survey report that Thedropintransactionsaccountsinthefirsthalfof reserve management is more difficult today than theyearcausedrequiredreservestofall33⁄ 4 percentat in the past. One way to diminish these problems an annual rate, a much slower decline than in 1997. would be to pay interest on reserve balances, which The monetary base grew 51⁄ 2 percent over the same would reduce banks’ incentives to minimize those period, as the runoff in required reserves was more balances. than offset by the increased demand for currency. The substantial decline in required reserves over Financial Markets thepastseveralyearshasraisedconcernthatthefed- eralfundsratemightbecomemorevolatile.Required InterestRates.Yieldsonintermediate-andlong- reservesarefairlypredictableandmustbemaintained term Treasury securities moved in a fairly narrow 23 Selected Nominal Treasury Rates economies. Lastly, diminished borrowing by the fed- Percent eral government has restrained interest rates by reducing the competition for private domestic sav- ing and for borrowed funds from abroad. Assessingtherelativeimportanceofsomeofthese 15 factors might be aided, in principle, by comparing yields on nominal and inflation-indexed Treasury Thirty-year notes.Betweenthesecondquartersof1997and1998, bond 10 the nominal ten-year yield fell more than 1 percent- age point, whereas the inflation-indexed ten-year yield increased a bit. Unfortunately, the relatively recentintroductionofinflation-indexedsecuritiesand 5 Q2 the thinness of trading makes interpreting their yield Three-month Five-year bill note levels and movements difficult. In particular, light trading may lead investors to view these new securi- 0 ties as providing less liquidity than traditional 1968 1978 1988 1998 Treasury notes, and investors may value liquidity Note. The twenty-year Treasury bond rate is shown until the firstissuanceofthethirty-yearTreasurybondinFebruary1977. especiallyhighlynowinthefaceofuncertaintyabout developments in Asia. TheyieldcurveforTreasurysecuritieshasrecently band during the first half of 1998, centered a little been flatter than at any point since the beginning of below the levels that prevailed in the latter part of the decade. For example, the difference between the 1997. The thirty-year bond yield touched its lowest ten-year-noteyieldandthethree-month-billyieldwas value since the bond was introduced to the regular smallerinthefirsthalfof1998thaninanyotherhalf- auction calendar in 1977; it was also lower than any year period since early 1990. In that earlier episode, sustained yield on the twenty-year bond (the longest the yield curve had been flattened by a sharp runup maturity Treasury security before the issuance of the in short-term interest rates as the Federal Reserve thirty-year bond) since 1968. Meanwhile, the aver- tried to check an upcreep in inflation. In the current ageyieldonfive-yearnotesinthefirsthalfoftheyear episode, short rates have held fairly steady, while was the lowest since early 1994. long-term rates have declined significantly. Some of Several factors have contributed to the decline in the current flatness of the term structure probably intermediate- and long-term interest rates over the stems from the apparent reduction in term premiums past year. For one, developments in the U.S. econ- notedabove.Buttheflatyieldcurvemayalsoreflect omy and overseas reduced expected inflation and, the expectation that short-term real interest rates, perhaps, uncertainty about future inflation. Between which have been boosted by the decline in inflation the second quarter of 1997 and the second quarter of over the past year, will drop in the future. Support- 1998, the median long-term inflation expectation in ing that notion, the yield curve for inflation-indexed the Michigan SRC survey of households dropped debt has become inverted this year, as the return on 1⁄ 4 percentage point, and the average expectation in the five-year indexed note has risen above the return the Philadelphia Federal Reserve’s Survey of Profes- on the ten-year indexed note, which exceeds the sional Forecasters fell almost 1⁄ 2 percentage point. return on the new thirty-year indexed bond. Overthesameperiod,thevarianceoflong-terminfla- tionexpectationsintheMichigansurveywashalved. Equity Prices. Equity markets have remained This greater consensus of expectations suggests that ebullient this year. The S&P 500 composite index people may now place less weight on the possibility rose sharply in the first several months of 1998; it of a sharp acceleration in prices; a reduction in then fell back a little before moving up to a new perceived inflation risk would tend to reduce term record in July. The NASDAQ composite, NYSE premiums and thereby cut long-term interest rates. A composite, and Dow Jones Industrial Average fol- dampingofexpectedgrowthinrealdemandhereand lowed roughly similar patterns, and these indexes abroad, triggered importantly by the Asian financial now stand about 17 to 28 percent above their year- crisis, also has probably pulled rates lower, as has an endmarks.Smallcapitalizationstockshavenotfared apparent shift in desired portfolios away from Asia so well this year, with the Russell 2000 index up and, to some extent, from other emerging market about a third as much on net. 24 Major Stock Price Indexes survey—is little changed since year-end. As a result, Index(December31,1996=100) theforward-earningsyieldonstocksexceedsthereal yield on bonds by one of the smallest amounts in Daily many years. Apparently, investors share analysts’ 160 expectations of robust long-term earnings growth, or S&P500 150 theyarecontentwithamuchsmallerequitypremium than the historical average. 140 International Developments 130 Events in Asia, including in Japan, have continued 120 NASDAQ to dominate developments in global asset markets so 110 farin1998.Duringthefirstmonthsoftheyear,many financial markets in Asia appeared to stabilize, and 100 progress in implementing economic and financial reform programs was made in most of the countries 90 J M M J S N J M M J seriously affected by the crises. In early April, the 1997 1998 agreement between Korean banks and their external Note. LastobservationsareforJuly17,1998. bank creditors to stretch out short-term obligations was implemented, ending an interval of rollovers by creditors that was endorsed by the authorities in The increase in equity prices combined with the countries that had pledged to support the Korean recent slowdown in earnings growth has kept many program. Indonesia reached a second revised agree- valuationmeasureswellabovetheirhistoricalranges. ment with the International Monetary Fund (IMF) in The ratio of prices in the S&P 500 to consensus April on a reform program, which was subsequently estimatesofearningsoverthecomingtwelvemonths derailed by political strife and the resignation of the reached a new high in April and has retreated only president in late May; the change in political regime slightly from that point. At the same time, the real was followed by calm, and a new agreement was long-term bond yield—measured either by the ten- reached with the IMF management in late June and year indexed yield or by the difference between the approved by the IMF Executive Board on July 15. ten-year nominal Treasury yield and inflation expectations in the Philadelphia Federal Reserve’s Daily Value of Foreign Currencies Indexof$/foreigncurrencies(July2,1997=100) Equity Valuation and Long-Term Interest Rate Daily Percent Japan 90 18 Thailand S&P500earnings–priceratio 70 15 Ten-yearreal 12 SouthKorea interestrate 50 9 Indonesia 30 6 3 10 June J A S O N D J F M A M J J 0 1997 1998 1978 1983 1988 1993 1998 Note. LastobservationsareforJuly17,1998. Note. The earnings–price ratio is based on the consensus estimateofearningsoverthecomingtwelvemonthsderivedfrom theforecastscollectedbyI/B/E/SInternational,Inc.Therealinter- After rising sharply during the final months of estrateistheyieldontheten-yearTreasurynotelesstheten- 1997 through mid-January of 1998, the exchange yearinflationexpectationsfromthePhiladelphiaFederalReserve SurveyofProfessionalForecasters. value of the dollar in terms of the currencies 25 of Korea, Indonesia, Thailand, and other ASEAN aboutthesustainabilityofcurrentexchangeratepoli- countries partly retraced those gains during Febru- cies in China and Hong Kong. ary, March, and April. Since then, however, market OnJune17,themonetaryauthoritiesintheUnited pressures have again led to further sharp increases in States and Japan cooperated in foreign exchange the exchange value of the dollar in terms of the intervention purchases of yen for dollars. This Indonesian rupiah while the dollar has changed little intervention operation was the first by U.S. authori- againstmostoftheotherAsianemerging-marketcur- ties since August 1995. In announcing the market rencies. Since the end of December, the dollar has intervention,TreasurySecretaryRubincitedJapanese declined, on balance, 24 percent against the Korean government plans to restore the health of their finan- won and nearly 14 percent against the Thai baht and cial system and to strengthen Japanese domestic has risen moderately in terms of the Taiwan dollar demand. He pointed to the stake of Asia and the and increased about 130 percent in terms of the international community as a whole in Japan’s suc- Indonesian rupiah. cess.Theyenrosesomewhatfollowingtheexchange Duringthefirstweeksoftheyear,thedollardepre- marketinterventionandhassincepartiallygivenback ciated in terms of the Japanese yen as improved that gain. In the wake of the recent election, which prospects elsewhere in Asia and market uncertainty cost the LDP numerous seats in the upper house of regarding potential intervention by the Japanese the Diet and precipitated the resignation of Prime monetary authorities lent support to the yen. Indica- Minister Hashimoto, the yen changed little. On bal- tions that significant measures for economic stimulus ance, the dollar has appreciated about 7 percent in might be announced also put upward pressure on the terms of the yen since the end of December. yen. In February, the dollar resumed its appreciation with respect to the yen. The rise in the dollar was Equity prices in the Asian emerging-market only temporarily interrupted by sizable intervention economieshavebeenvolatilesofarthisyearaswell. purchases of dollars by Japanese authorities in April. Thesepricesrecoveredsomewhatinthefirstweeksof Upward pressure on the dollar relative to the yen theyearinresponsetothemarketperceptionthatthe intensified in late May and June. Renewed signs of crisis was easing; after fluctuating narrowly, they cyclical weakness in the Japanese economy and lack beganmovingbackdowninMarchandApril,reach- of market confidence in the announced programs for ing new lows in June in Korea, Thailand, and Hong addressing the chronic problems within the financial Kong. On balance, these equity prices have moved sector contributed to pessimism toward the yen. down about 25 percent (Singapore and Malaysia) to Persistent weakness in the Japanese economy and up about 20 percent (Indonesia) since the end of last theyen,inturn,heightenedconcernsaboutprospects year.EquitypricesinJapanalsoroseearlyintheyear elsewhere in Asia; the lower yen adversely affected onimprovedoptimismbutthengavebackthosegains the competitiveness of goods produced in the Asian over time with the release of indicators suggesting emerging-market economies and raised questions additional weakness in the Japanese economy. Since the middle of June, Japanese equity prices have rebounded on the perception that significant fiscal U.S. Exchange Rates with Japan and Germany stimulus is now more likely. On balance, Japanese equity prices are up about 9 percent from their level Yen/$ DM/$ at the end of last year. Japanese long-term interest Nominal June rates continued through May on their downward 140 1.8 trend that began in mid-1997, declining an addi- Germany tional 50 basis points during the first five months. 130 1.7 Since then, long-term interest rates have retraced more than half of that decline, in part in response to 120 1.6 theannouncementoftheplanforfinancialrestructur- ing and in part in response to the outcome of the 110 1.5 recent election, which heightened expectations of additional fiscal stimulus. 100 1.4 Japan The Asian financial crises have resulted in a sharp 90 1.3 drop in the pace of economic activity in the region. Output declined precipitously in the first quarter 80 1.2 1993 1994 1995 1996 1997 1998 in those countries most affected, such as Korea, 26 U.S. and Foreign Interest Rates halfofthisyear.Inaddition,officialshaveannounced a package of steps directed at restoring the sound- Yield on Three-month Bank Liabilities Percent ness of the financial sector, including (1) introduc- tion of a bridge bank mechanism to facilitate the resolution of failed banks while permitting some of their borrowers to continue to receive credit, 8 (2) measures to improve the disposal of bad bank U.S.largeCD loans, (3) enhanced transparency and disclosure by banks, and (4) strengthened bank supervision. These 6 actionsareintendedtorestoreconfidenceinJapanese financial institutions and in the prospects for the Germaninterbank 4 economy more broadly. June In the other major industrial countries, economic 2 developments so far this year have generally been JapaneseCD favorable. The exchange value of the dollar in terms of the German mark has fluctuated narrowly and, on 0 balance, is little changed since the end of Decem- ber.Marketperceptionsthatprogresstowardthestart Yield on Ten-year Government Securities of the final stage of European Monetary Union Percent (EMU)isgoingsmoothlyandsignsofmomentumin theU.S.andGermaneconomiesresultedinlittlepres- sure in either direction on the exchange rate. The 8 dollaralsofluctuatednarrowlyagainsttheU.K.pound UnitedStates with little net change so far this year. Moves to tighten monetary conditions in the United Kingdom 6 lent support to the pound, countering some tendency Germany for weak external demand to depress the currency. June 4 The Canadian dollar rebounded following a tighten- ing of monetary conditions by the Bank of Canada on January 30. Since early March, however, it has Japan 2 tended to move down as market participants have come to believe that further upward shifts of official interest rates are unlikely and as weakness in global 0 commodity markets, partly the result of reduced eco- 1993 1994 1995 1996 1997 1998 nomic activity in Asia, have weighed on the cur- rency.TheexchangevalueoftheU.S.dollarinterms Indonesia, and Malaysia, and slowed in other Asian of the Canadian dollar reached new highs in July economies, such as China and Taiwan, that have suf- and, on balance so far this year, has risen about fered a loss of competitiveness and reduced external 4 percent. demand as a consequence of the crises. Data for Long-term interest rates have declined and equity recent months suggest that additional slowing has prices have generally risen strongly in European occurred and that the risk of further spread and and Canadian markets this year. Despite signs deepeningofcyclicalweaknessthroughouttheregion of strengthening activity in Germany and other cannot be ruled out. Depreciation of their respective continentalEuropeancountriesandcontinuedhealthy currencies has led to acceleration of domestic prices expansion in the United Kingdom and Canada, long- in several of these economies, particularly in term rates have moved down since December; long Indonesia and Thailand. ratesareabout60basispointslowerinGermanyand Real GDP in Japan also fell sharply in the first less than half that amount lower in Canada. Shifts of quarter, and output indicators suggest a further international portfolios away from Asian assets and decline in the second quarter. Consumer price infla- toward those perceived to be safer have probably tion remains very low. Japanese authorities have contributedtoratedeclinesinContinentalEuropeand announced a series of fiscal measures that are intheUnitedStates.Stockpriceshavealsocontinued expectedtoboostdomesticdemandduringthesecond to rise in Europe and Canada. Since December, the 27 gainshaverangedfromabout40percentinGermany about9percentintermsofthedollarsofarthisyear. and France to about 10 percent in Canada. The Brazilian exchange rate regime of a controlled crawl and the Argentine regime of pegging the peso The pace of real economic activity improved to the dollar remain in place, and Brazilian short- somewhat in the first quarter in Germany and on term interest rates have been lowered from the very averageintheelevencountriesslatedtoproceedwith highlevelstowhichtheywereraisedwhentheAsian currency union on January 1, 1999.2 Production and crisis intensified in late 1997. Equity prices in these employment data for more recent months suggest three Latin American countries have been volatile, continuedexpansion.Businessconfidencehasfirmed rising early in the year and giving back those gains as progress toward EMU has continued. Domestic since April. On balance this year, equity prices have demandisbecomingmorebuoyantinseveralofthese declined about 10 percent in Mexico and Argentina countries, offsetting weakening of external demand and have risen about 8 percent in Brazil. arising from events in Asia. On average, inflation remains subdued within the euro area. In the United Real output growth remains strong in Mexico and Kingdom and Canada, real output continues to Argentina, but the rate has slowed somewhat from expand at a relatively rapid rate. U.K. inflation last year’s vigorous pace. In Brazil, economic activ- threatens to exceed the government’s target of ityhasweakenedmoresharply,inpartinresponseto 21⁄ 2 percent, and the Bank of England raised its the tightening of monetary conditions that followed officiallendingrate25basispointsinJuneinorderto the outbreak of the Asian crisis. lessen price pressures. Consumer price inflation in Lower global oil prices have combined with a Canada remains very low. poorly functioning domestic tax system to trigger a Events in Asia have spilled over to affect develop- financial crisis in Russia. Russian officials have mentsinLatinAmericancountries.Declinesinglobal reached agreement with IMF management on a oil prices have contributed to downward pressure on revised program that includes proposed increased the exchange value of the Mexican peso. The peso funds from the IMF and other sources. To help declined sharply in terms of the dollar at the start of finance this program, the General Arrangements to the year but then stabilized in February through May Borrowarebeingactivatedinlightoftheinadequacy as Asian markets partially recovered. It depreciated of IMF resources to meet actual or expected requests further in May and June, resulting in a net decline of for financing and a need to forestall impairment of the international monetary system. The General Arrangements to Borrow provide the IMF with 2. Those countries are Austria, Belgium, Finland, France, supplementary lines of credit from the G-10 Ireland, Italy, Germany, Luxembourg, the Netherlands, Portugal, andSpain. countries. 28

Federal Reserve (1998, July 20). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19980721

@misc{wtfs_monetary_policy_report_19980721,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1998},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19980721},
  note = {Retrieved via When the Fed Speaks corpus}
}