Monetary Policy Report

For use at 11:00 a.m., E.D.T. Thursday July 22, 1999 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 July 22, 1999 Letter of Transmittal BOARDOFGOVERNORSOFTHE FEDERALRESERVESYSTEM Washington,D.C.,July22,1999 THEPRESIDENTOFTHESENATE THESPEAKEROFTHEHOUSEOFREPRESENTATIVES TheBoardofGovernorsispleasedtosubmititsMonetaryPolicyReporttotheCongress,pursuanttothe FullEmploymentandBalancedGrowthActof1978. Sincerely, AlanGreenspan,Chairman Table of Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 1999 4 Monetary Policy Report to the Congress Report submitted to the Congress on July 22, 1999, importsfelllessrapidly,raisingoverallinflationrates. pursuant to the Full Employment and Balanced Despite improvements in technology and business GrowthActof1978 processes that have yielded striking gains in effi- ciency, the robust growth of aggregate demand, fueled by rising equity wealth and readily available MONETARY POLICY AND THE ECONOMIC credit,producedeventighterlabormarketsinthefirst OUTLOOK half of 1999 than in the second half of 1998. If this trend were to continue, labor compensation would The U.S. economy has continued to perform well in begin climbing increasingly faster than warranted by 1999. The ongoing economic expansion has moved productivity growth and put upward pressure on intoanear-recordninthyear,withrealoutputexpand- prices. Moreover, the Federal Open Market Commit- ing vigorously, the unemployment rate hovering tee(FOMC)wasconcernedthataseconomicactivity around lows last seen in 1970, and underlying trends abroad strengthened, the firming of commodity and in inflation remaining subdued. Responding to the other prices might also foster a less favorable infla- availability of new technologies at increasingly tion environment. To gain some greater assurance attractiveprices,firmshavebeeninvestingheavilyin that the good inflation performance of the economy new capital equipment; this investment has boosted would continue, the Committee decided at its June productivityandlivingstandardswhileholdingdown meetingtoreverseaportionoftheeasingundertaken theriseincostsandprices. last fall when global financial markets were dis- Two of the major threats faced by the economy in rupted; the Committee’s target for the overnight fed- late 1998—economic downturns in many foreign eral funds rate, a key indicator of money market nations and turmoil in financial markets around the conditions,wasraisedfrom43⁄ 4 percentto5percent. world—receded over the first half of this year. Eco- nomicconditionsoverseasimprovedonabroadfront. In Asia, activity picked up in the emerging-market Monetary Policy, Financial Markets, and the economies that had been battered by the financial Economy over the First Half of 1999 crises of 1997. The Brazilian economy—Latin America’s largest—exhibited a great deal of resil- The FOMC met in February and March against the iencewithsupportfromtheinternationalcommunity, backdrop of continued rapid expansion of the U.S. in the wake of the devaluation and subsequent float- economy. Demand was strong, employment growth ingoftherealinJanuary.Thesedevelopments,along wasbrisk,andlabormarketsweretight.Nonetheless, with the considerable easing of monetary policy in price inflation was still low, held in check by a sub- late 1998 and early 1999 in a number of regions, stantial gain in productivity, ample manufacturing including Europe, Japan, and the United States, fos- capacity,andlowinflationexpectations. tered a markedly better tone in the world’s financial Activity was supported by a further settling down markets.Onbalance,U.S.equitypricesrosesubstan- of financial markets in the first quarter after a period tially, and in credit markets, risk spreads receded ofconsiderableturmoilinthelatesummerandfallof toward more typical levels. Issuance of private debt 1998. In that earlier period, which followed Russia’s securities ballooned in late 1998 and early 1999, in moratorium on a substantial portion of its debt pay- part making up for borrowing that was postponed ments in mid-August, the normal functioning of U.S. whenmarketsweredisrupted. financial markets had been impaired as investors cut As these potentially contractionary forces dissi- back sharply their credit risk exposures and market pated,theriskofhigherinflationintheUnitedStates liquidity dried up. The Federal Reserve responded resurfaced as the greatest concern for monetary pol- to these developments by trimming its target for the icy. Although underlying inflation trends generally overnight federal funds rate by 75 basis points in remained quiescent, oil prices rose sharply, other threesteps.Inearly1999,thedevaluationandsubse- commodity prices trended up, and prices of non-oil quent floating of the Brazilian real in mid-January 2 Monetary Policy Report to the Congress July 1999 Selectedinterestrates Percent Thirty-yearTreasury Two-yearTreasury 7 6 5 Discount Three-monthTreasury 4 Targetfederalfunds 2/5 3/25 5/20 7/2 8/19 9/30 11/1212/16 2/4 3/31 5/19 7/1 8/18 9/2910/1511/1712/22 2/3 3/30 5/18 6/30 1997 1998 1999 Note. The data are daily. Vertical lines indicate the days on which the talaxisarethoseonwhicheithertheFOMCheldascheduledmeetingora FederalReserveannouncedamonetarypolicyaction.Thedatesonthehorizon- policyactionwasannounced.LastobservationsareforJuly19,1999. heightened concerns for a while, but market condi- apart from a big jump in energy prices—were tionsoverallimprovedconsiderably. reportedtohaveregisteredasizableriseinApril. At its February and March meetings, the FOMC AtitsMaymeeting,theFOMCbelievedthatthese left the stance of monetary policy unchanged. The developments tilted the risks toward further robust Committee expected that the growth of output might growth that would exert additional pressure on well slow sufficiently to bring production into close already taut labor markets and ultimately show enough alignment with the economy’s enhanced through to inflation. Moreover, a turnaround in oil potential to forestall the emergence of a trend of ris- and other commodity markets meant that prices of ing inflation. Although domestic demand was still these goods would no longer be holding down infla- increasing rapidly, it was anticipated to moderate tion,astheyhadoverthepastyear.Yet,theeconomy over time in response to the buildup of large stocks to date had shown a remarkable ability to accommo- of business equipment, housing units, and durable date increases in demand without generating greater goodsandmorerestrainedexpansioninwealthinthe underlying inflation trends, as the continued growth absence of appreciable further increases in equity oflaborproductivityhadhelpedtocontaincostpres- prices. Furthermore, the FOMC, after taking account sures. The uncertainty about the prospects for prices, ofthenear-termeffectsoftheriseincrudeoilprices, demand pressures, and productivity was large, and saw few signs that cost and price inflation was in the the Committee decided to defer any policy action. process of picking up. The unusual combination of However, in light of its increased concern about veryhighlaborresourceutilizationandsustainedlow the outlook for inflation, the Committee adopted inflationsuggestedconsiderableuncertaintyaboutthe anasymmetricdirectivetiltedtowardapossiblefirm- relationship between output and prices. In this envi- ing of policy. The Committee also wanted to inform ronment, the Committee concluded that it could wait the public of this significant revision in its view, and for additional information about the balance of risks it announced a change in the directive immediately totheeconomicexpansion. after the meeting. The announcement was the first By the time of the May FOMC meeting, demand undertheCommittee’spolicyofannouncingchanges was still showing considerable forward momentum, in the tilt of the domestic directive when it wants to and growth in economic activity still appeared to communicate a major shift in its view about the be running in excess of the rate of increase of the balanceofriskstotheeconomyorthelikelydirection economy’s long-run capacity to expand output. Bor- ofitsfutureactions. rowers’ heavy demands for credit were being met on In the time leading up to the FOMC’s June meet- relatively favorable terms, and wealth was further ing,economicactivityintheUnitedStatescontinued boosted by rapidly rising equity prices. Also, the to move forward at a brisk pace, and prospects in a economic and financial outlook for many emerging- number of foreign economies showed additional market countries was brighter. Trends in inflation improvement. Labor markets tightened slightly fur- were still subdued, although consumer prices—even ther. The federal funds rate, however, remained at Board of Governors of the Federal Reserve System 3 the lower level established in November 1998, when between the fourth quarters of 1998 and 1999. For the Committee took its last of three steps to counter 2000, the forecasts of real GDP are mainly in severe financial market strains. With those strains the 21⁄ 2 percent to 3 percent range. With this pace largely gone, the Committee believed that the time of expansion, the civilian unemployment rate is had come to reverse some of that accommodation, expected to remain close to the recent 41⁄ 4 percent anditraisedthetargetedovernightfederalfundsrate leveloverthenextsixquarters. 25 basis points, to 5 percent. Looking ahead, the The increases in income and wealth that have Committee expected demand to remain strong, but bolstered consumer demand over the first half of this it also noted the possibility that a further pickup in year and the desire to invest in new high-technology productivity could allow the economy to accommo- equipment that has boosted business demand during date this demand for some time without added infla- the same period should continue to stimulate spend- tionary pressure. In light of these conflicting forces ingoverthequartersahead.However,severalfactors in the economy, the FOMC returned to a symmetric areexpectedtoexertsomerestraintontheeconomy’s directive. Nonetheless, with labor markets already momentum by next year. With purchases of durable tight,theCommitteerecognizedthatitneededtostay goods by both consumers and businesses having especially alert to signs that inflationary forces were risen still further and running at high levels, the emerging that could prove inimical to the economic stocksofsuchgoodsprobablyarerisingmorerapidly expansion. than is likely to be desired in the longer run, and the growth of spending should moderate. The increase in market interest rates should help to damp Economic Projections for 1999 and 2000 spending as well. And unless the extraordinary gains in equity prices of the past few years are extended, The members of the Board of Governors and the theimpetustospendingfromincreasesinwealthwill Federal Reserve Bank presidents see good prospects diminish. forsustained,solideconomicexpansionthroughnext Federal Reserve policymakers believe that this year. For this year, the central tendency of their year’s rise in the consumer price index (CPI) will be forecasts of growth of real gross domestic product is larger than that in 1998, largely because of the 31⁄ 2 percent to 33⁄ 4 percent, measured as the change rebound in retail energy prices that has already occurred. Crude oil prices have moved up sharply, reversing the decline posted in 1998 and leading to a 1. Economicprojectionsfor1999and2000 jumpintheCPIthisspring.Fornextyear,theFOMC Percent participants expect the increase in the CPI to remain FederalReservegovernors around this year’s pace, with a central tendency of andReserveBankpresidents Indicator Administration1 2 percent to 21⁄ 2 percent. Futures market quotes sug- Central Range tendency gestthattheprevailingexpectationisthattherebound in oil prices has run its course now, and ample 1999 industrial capacity and productivity gains may help Change,fourthquarter limitinflationarypressuresincomingmonthsaswell. tofourthquarter2 NominalGDP........... 43⁄4–51⁄2 5–51⁄2 4.8 Withlaborutilizationveryhigh,though,anddemand R C e o a n l su G m D e P rp .. ri . c . e .. in .. d . e . x . 3 .. . . . . 1 3 3 1 ⁄ ⁄ 4 4 – – 2 4 1⁄2 2 31 1 ⁄ ⁄ 2 4 – – 3 2 3 1 ⁄ ⁄ 4 2 3 2 . . 2 4 still strong, significant risks remain even after the recent policy firming that economic and financial Averagelevel, fourthquarter conditionsmayturnouttobeinconsistentwithkeep- Civilianunemployment rate ................ 4–41⁄2 4–41⁄4 4.3 ingcostsandpricesfromescalating. Although interest rates currently are a bit higher 2000 than anticipated in the economic assumptions under- Change,fourthquarter lying the budget projections in the Administration’s tofourthquarter2 NominalGDP........... 4–51⁄4 4–5 4.2 Mid-Session Review, there is no apparent tension RealGDP............... 2–31⁄2 21⁄2–3 2.1 Consumerpriceindex3 .. 11⁄2–23⁄4 2–21⁄2 2.4 between the Administration’s plans and the Fed- eral Reserve policymakers’ views. In fact, Federal Averagelevel, fourthquarter Reserve officials project somewhat faster growth in Civilianunemployment rate ................ 4–41⁄2 41⁄4–41⁄2 4.7 realGDPandslightlylowerunemploymentratesinto 1. FromtheMid-SessionReviewofthebudget. 2000thantheAdministrationdoes,whiletheAdmin- 2. Changefromaverageforfourthquarterofpreviousyeartoaveragefor istration’s projections for inflation are within the fourthquarterofyearindicated. 3. Allurbanconsumers. FederalReserve’scentraltendencies. 4 Monetary Policy Report to the Congress July 1999 2. Rangesforgrowthofmonetaryanddebtaggregates mittee’s projections of nominal GDP growth. This Percent relativelyrapidexpansioninnominalincomereflects faster expected growth in productivity than when the Provisionalfor Aggregate 1998 1999 2000 price-stability ranges were established in the mid- 1990s and inflation that is still in excess of price M2 ............ 1–5 1–5 1–5 M3 ............ 2–6 2–6 2–6 stability.Themorerapidincreaseinproductivity,ifit Debt........... 3–7 3–7 3–7 persists for a while and is sufficiently large, might in Note. Changefromaverageforfourthquarterofprecedingyeartoaverage thefuturesuggestanupwardadjustmenttothemoney forfourthquarterofyearindicated. ranges consistent with price stability. However, con- siderable uncertainty attends the trend in productiv- Money and Debt Ranges for 1999 and 2000 ity,andtheCommitteechosenottoadjusttheranges atitsmostrecentmeeting. AtitsmeetinginlateJune,theFOMCreaffirmedthe Debt of the nonfinancial sectors has expanded at rangesfor1999growthofmoneyanddebtthatithad roughlythesamepaceasnominalincomethisyear— established in February: 1 percent to 5 percent for itstypicalpattern.Giventhestabilityofthisrelation- M2, 2 percent to 6 percent for M3, and 3 percent to ship, the Committee selected a growth range for the 7 percent for debt of the domestic nonfinancial sec- debt aggregate that encompasses its expectations for tors. The FOMC set the same ranges for 2000 on a debt growth in both years. The Committee expects provisionalbasis. growth in nominal income to slow in 2000, and with As has been the case since the mid-1990s, the it,debtgrowth.Nonetheless,growthofthisaggregate FOMCviewstherangesformoneygrowthasbench- isprojectedtoremainwithintherangeof3percentto marks for growth under conditions of price stability 7percent. and the historically typical relationship between money and nominal income. The disruption of the historically typical pattern of the velocities of M2 ECONOMIC AND FINANCIAL DEVELOPMENTS andM3(theratioofnominalGDPtotheaggregates) IN 1999 during the 1990s implies that the Committee cannot establish, with any confidence, specific target ranges The economy has continued to grow rapidly so far forexpectedmoneygrowthforagivenyearthatwill thisyear.Realgrossdomesticproductrosemorethan be consistent with the economic performance that 4percentatanannualrateinthefirstquarterof1999, it desires. However, persistently fast or slow money and available data point to another significant gain growth can accompany, or even precede, deviations in the second quarter.1 The rise in activity has been fromdesirableeconomicoutcomes.Thus,thebehav- ior of the monetary aggregates, evaluated in the con- 1. Allfiguresfromthenationalincomeandproductaccountscited text of other financial and nonfinancial indicators, here are subject to change in the quinquennial benchmark revisions willcontinuetobeofinteresttoCommitteemembers slatedforthisfall. intheirpolicydeliberations. ChangeinrealGDP ThevelocitiesofM2andM3declinedagaininthe firsthalfofthisyear,albeitmoreslowlythanin1998. Percent, annual rate The Committee’s easing of monetary policy in the fall of 1998 contributed to the decline, but only to a Q1 modestextent.Itisnotclearwhatotherfactorsledto 4 thedrop,althoughtheconsiderableincreaseinwealth relativetoincomeresultingfromthesubstantialgains in equity prices over the past few years may have 2 played a role. Investors could be rebalancing their portfolios, which have become skewed toward equi- + ties, by reallocating some wealth to other assets, 0 – includingthoseinM2. EvenifthevelocitiesofM2andM3weretoreturn to their historically typical patterns over the balance 1994 1995 1996 1997 1998 1999 of 1999 and in 2000, M2 and M3 likely would be at the upper bounds of, or above, their longer-term Note. Inthischartandinsubsequentchartsthatshowthecomponentsof realGDP,changesaremeasuredfromthefinalquarterofthepreviousperiodto price-stability ranges in both years, given the Com- thefinalquarteroftheperiodindicated. Board of Governors of the Federal Reserve System 5 briskenoughtoproducefurthersubstantialgrowthof as measured, for example, by the University of employment and a reduction in the unemployment Michigan Survey Research Center (SRC) and Con- rateto41⁄ 4 percent.Growthinoutputhasbeendriven ferenceBoardsurveys—hasremainedquiteupbeatin by strong domestic demand, which in turn has been thisenvironment. supportedbyfurtherincreasesinequityprices,bythe Growth of consumer spending in the first quarter continuingsalutaryeffectsofgovernmentsavingand was strong in all expenditure categories. Outlays inflows of foreign investment on the cost of capital, for durable goods rose sharply, reflecting sizable and by more smoothly functioning financial markets increases in spending on electronic equipment (espe- as the turbulence that marked the latter part of 1998 ciallycomputers)andonawiderangeofothergoods, subsided. Against the background of the easing of including household furnishings. Purchases of cars monetary policy last fall and continuing robust and light trucks remained at a high level, supported economic activity, investors became more willing to by declining relative prices as well as by the funda- advance funds to businesses; risk spreads have mentals that have buoyed consumer spending more recededandcorporatedebtissuancehasbeenbrisk. generally. Outlays for nondurable goods were also Inflation developments were mixed over the first robust, reflecting in part a sharp increase in expendi- half of the year. The consumer price index increased tures for apparel. Finally, spending on services more rapidly owing to a sharp rebound in energy climbed steeply as well early this year, paced by prices. Nevertheless, price inflation outside of the sizable increases in spending on recreation and bro- energy area generally remained subdued despite the kerage services. In the second quarter, consumers slight further tightening of labor markets, as sizable apparently boosted their purchases of motor vehicles gains in labor productivity and ample industrial further. In all, real personal consumption expendi- capacityhelddownpriceincreases. tures rose at more than a 4 percent annual rate in April and May, an increase that is below the first- quarter pace but is still quite rapid by historical The Household Sector standards. Consumer Spending Wealthandsaving Ratio Percent Real personal consumption expenditures surged 63⁄ 4 percent at an annual rate in the first quarter, and 12 morerecentdatapointtoasizablefurtheradvancein the second quarter. The underlying fundamentals for 6 Wealth-to-incomeratio 10 Q1 thehouseholdsectorhaveremainedextremelyfavor- 8 able. Real incomes have continued to rise briskly 5 6 with strong growth of employment and real wages, and consumers have benefited from substantial gains 4 in wealth. Not surprisingly, consumer confidence— 4 2 Personalsavingrate Q1 + 0 – Changeinrealincomeandconsumption 1978 1982 1986 1990 1994 1998 Percent, annual rate Note. Thewealth-to-incomeratioistheratioofnetworthofhouseholdsto Disposablepersonalincome disposablepersonalincome. Personalconsumptionexpenditures 8 Q1 Realdisposableincomeincreasedatanannualrate 6 of 31⁄ 2 percent in the first quarter, with the strong labor market generating marked increases in wages 4 and salaries. Even so, income grew less rapidly than expenditures, and the personal saving rate declined 2 further; indeed, by May the saving rate had moved + below negative 1 percent. Much of the decline in the 0 – saving rate in recent years can be explained by the sharp rise in household net worth relative to dispos- 1994 1995 1996 1997 1998 1999 able income that is associated with the appreciation 6 Monetary Policy Report to the Congress July 1999 Privatehousingstarts ended in 1999:Q1, up from 31⁄ 4 percent over the precedingfour-quarterperiod.Therepeatsalesindex Millions of units, annual rate of existing home prices also rose about 5 percent Q2 between1998:Q1and1999:Q1,butthisseriesposted even larger increases in the year-earlier period. On Single-family 1.2 the cost side, tight supplies have led to rising prices for some building materials; prices of plywood, lum- ber,gypsumwallboard,andinsulationhaveallmoved .8 up sharply over the past twelve months. In addition, hourlycompensationcostshavebeenrisingrelatively Multifamily Q2 rapidlyintheconstructionsector. .4 Starts of multifamily units surged to 384,000 at an annual rate in the first quarter and ran at a pace a bit under 300,000 units in the second quarter. As in the 1988 1990 1992 1994 1996 1998 single-family sector, demand has been supported by strong fundamentals, builders have been faced with tight supplies of some materials, and prices have of households’ stock market assets since 1995. This beenrisingbriskly:Indeed,apartmentpropertyvalues rise in wealth has given households the wherewithal have been increasing at around a 10 percent annual to spend at levels beyond what current incomes rateforthreeyearsnow. would otherwise allow. As share values moved up further in the first half of this year, the wealth-to- income ratio continued to edge higher despite the Household Finance absenceofsavingoutofdisposableincome. Inadditiontorisingwealthandrapidincomegrowth, thestrongexpendituresofhouseholdsonhousingand Residential Investment consumer goods over the first half of 1999 were encouraged by the decline in interest rates in the Housing activity remained robust in the first half of latter part of 1998. Households borrowed heavily to this year. In the single-family sector, positive funda- finance spending. Their debt expanded at a 91⁄ 2 per- mentalsandunseasonablygoodweatherhelpedboost cent annual rate in the first quarter, up from the starts to a pace of 1.39 million units in the first 83⁄ 4 percent pace over 1998, and preliminary data for quarter—thehighestlevelofactivityintwentyyears. the second quarter indicate continued robust growth. This extremely strong level of building activity Mortgage borrowing, fueled by the vigorous housing strained the availability of labor and some materials; market and favorable mortgage interest rates, was as a result, builders had trouble achieving the usual particularly brisk in the first quarter, with mortgage seasonal increase in the second quarter, and starts debt rising at an annual rate of 10 percent. In the edged off to a still-high pace of 1.31 million units. second quarter, mortgage rates moved up consider- Home sales moderated in the spring: Sales of both ably, but preliminary data indicate that borrowing new and existing homes were off some in May from wasstillsubstantial. their earlier peaks, and consumers’ perceptions of Consumercreditgrowthacceleratedinthefirsthalf homebuyingconditionsasmeasuredbytheMichigan of1999.Itexpandedataboutan8percentannualrate SRC survey have declined from the very high marks compared with 51⁄ 2 percent for all of 1998. The recorded in late 1998 and early this year. Nonethe- growth of nonrevolving credit picked up, reflecting less, demand has remained quite robust, even in the brisk sales and attractive financing rates for automo- faceofabackupinmortgageinterestrates:Builders’ biles and other consumer durable goods. The expan- evaluationsofnewhomesalesremainedveryhighat sion of revolving credit, which includes credit card mid-year, and mortgage applications for home pur- loans,slowedabitfromitspacein1998. chasesshowedstrengthintoJuly. Householdsapparentlyhavenotencounteredadded With strong demand pushing up against limited difficulties meeting the payments associated with capacity, home prices have risen substantially, their greater indebtedness, as measures of household although evidence is mixed as to whether the rate of financial stress improved a bit on balance in the first increase is picking up. The quality-adjusted price of quarter. Personal bankruptcies dropped off consid- new homes rose 5 percent over the four quarters erably, although part of the decline may reflect Board of Governors of the Federal Reserve System 7 Delinquencyratesonhouseholdloans 1999. Investment spending continued to be driven by buoyant expectations of sales prospects as well Percent as by rapidly declining prices of computers and otherhigh-techequipment.Inrecentquarters,spend- ing also may have been boosted by the desire to Creditcardaccounts 5 atbanks upgrade computer equipment in advance of the roll- Q1 over to the year 2000. Real investment has been 4 rising rapidly for several years now; indeed, the Autoloansatdomestic averageincreaseof10percentannuallyoverthepast autofinancecompanies 3 five years represents the most rapid sustained expan- Q1 sion of investment in more than thirty years. 2 Although a growing portion of this investment has Mortgages gone to cover depreciation on purchases of short- Q1 lived equipment, the investment boom has led to a 1988 1990 1992 1994 1996 1998 notable upgrading and expansion of the capital stock Note. Thedataarequarterly. and in many cases has embodied new technologies. Source. DataoncreditcarddelinquenciesarefrombankCallReports;data These factors likely have been important in the na- onautoloandelinquenciesarefromtheBigThreeautomakers;dataonmort- gagedelinquenciesarefromtheMortgageBankersAssociation. tion’s improved productivity performance over the pastfewyears. the aftermath of a surge in filings in late 1998 that Real outlays for producers’ durable equipment occurred in response to pending legislation that increased at an annual rate of 91⁄ 2 percent in the first would limit the ability of certain debtors to obtain quarteroftheyear,afterhavingsurgednearly17per- forgivenessoftheirobligations.Delinquencyrateson cent last year, and may well have re-accelerated several types of household loans edged lower. Delin- in the second quarter. Outlays on communications quency and charge-off rates on credit card debt equipment were especially robust in the first quarter, moved down from their 1997 peaks but remained at driven by the ongoing effort by telecommunications historically high rates. A number of banks continued companies to upgrade their networks to provide a to tighten credit card lending standards this year, as full range of voice and data transmission services. indicated by banks’ responses to Federal Reserve Purchases of computers and other information pro- surveys. cessing equipment were also up notably in the first quarter,albeitbelowlastyear’sphenomenalspending pace, and shipments of computers surged again in The Business Sector April and May. Shipments of aircraft to domestic carriers apparently soared in the second quarter, and Fixed Investment business spending on motor vehicles, including medium and heavy trucks as well as light vehicles, Real business fixed investment appears to have hasremainedextremelystrongaswell. posted another huge increase over the first half of Real business spending for nonresidential struc- tures has been much less robust than for equipment, Changeinrealbusinessfixedinvestment and spending trends have varied greatly across sec- tors of the market. Real spending on office buildings Percent, annual rate and lodging facilities has been increasing impres- Structures sively, while spending on institutional and industrial Producers’durableequipment structures has been declining—the last reflecting 20 ample capacity in the manufacturing sector. In the first quarter of this year, overall spending on struc- Q1 tureswasreportedinthenationalincomeandproduct 10 accounts to have moved up at a solid 53⁄ 4 percent annual rate, reflecting a further sharp increase in + spending on office buildings and lodging facilities. 0 – However, revised source data indicate a somewhat smaller first-quarter increase in nonresidential con- struction and also point to a slowing in activity in 1994 1995 1996 1997 1998 1999 AprilandMayfromthefirst-quarterpace. 8 Monetary Policy Report to the Congress July 1999 Changeinnonfarmbusinessinventories Before-taxprofitsofnonfinancialcorporations asashareofGDP Percent, annual rate Percent 14 Q1 4 12 Q1 10 + 8 0 – 6 1994 1995 1996 1997 1998 1999 1977 1980 1983 1986 1989 1992 1995 1998 Note. Profitsfromdomesticoperations,withinventoryvaluationandcapital Inventory Investment consumptionadjustments,dividedbythegrossdomesticproductofthenon- financialcorporatesector. Inventory–sales ratios in many industries dropped considerably early this year, as the pace of stock- estlevelintwentyyears.Withnonoticeablesignsof building by nonfarm businesses, which had slowed aslowingindemand,producershavescheduledthird- notably over 1998, remained well below the surge of quarter output to remain at the lofty heights of the consumer and business spending in the first quarter. secondquarter. Although production picked up some in the spring, final demand remained quite strong, and available monthly data suggest that businesses accumulated Corporate Profits and Business Finance inventories in April and May at a rate not much differentfromthemodestfirst-quarterpace. The economic profits of nonfinancial U.S. corpora- In the motor vehicle sector, makers geared up tions rose considerably in the first quarter, even after production in the latter part of 1998 to boost inven- allowing for the depressing effect in the fourth tories from their low levels after last summer’s quarter of payments associated with the settlement strikes. Nevertheless, as with the business sector between the tobacco companies and the states. overall, motor vehicle inventories remained on the Despitethegrowthofprofits,capitalexpendituresby lean side by historical standards in the early part of nonfinancialbusinessescontinuedtooutstripinternal this year as a result of surprisingly strong vehicle cash flow. Moreover, borrowing requirements were sales. As a consequence, manufacturers boosted the enlarged by the net reduction in equity outstanding, pace of assemblies in the second quarter to the high- asthesubstantialvolumeofretirementsfrommerger Grosscorporatebondissuance Billions of dollars 40 35 30 25 20 15 10 5 J F M A M J J A S O N D J F M A M J 1998 1999 Board of Governors of the Federal Reserve System 9 Spreadsofcorporatebondyields ably in the latter part of 1998, also retreated. But in overTreasurysecurityyields mid-July, these spreads were still well above the thin levels prevailing before the period of financial tur- Percentage points moilbutinlinewiththeirhistoricalaverages. Incontrasttosecuritiesmarketparticipants,banks’ 7 Belowinvestmentgrade attitudes toward business lending apparently became 6 somewhat more cautious over the first half of the 5 year,accordingtoFederalReservesurveys.Theaver- age spread of bank lending rates over the FOMC’s 4 intended federal funds rate remained elevated. On 3 net, banks continued to tighten lending terms and BBB standards this year, although the percentage that 2 reported tightening was much smaller than in the AA 1 fall. The overall financial condition of nonfinancial J F M A M J J A S O N D J F M A M J J businesses was strong over the first half of the year, 1998 1999 although a few indicators suggested a slight deterio- Note. The data are daily. The spread for below-investment-grade bonds ration. In the first quarter, the ratio of net interest compares the yield on the Merrill Lynch Master II high-yield bond index compositewiththeyieldfromtheseven-yearTreasuryconstant-maturityseries; payments to corporate cash flow remained close to theothertwospreadscompareyieldsontheappropriateMerrillLynchindexes the modest levels of 1998, as low interest rates con- withthatonaten-yearTreasurysecurity.LastobservationsareforJuly19, 1999. tinued to hold down interest payments. Delinquency rates for commercial and industrial loans from banks activity and share repurchase programs exceeded the ticked up, but they were still modest by historical considerable volume of gross issuance of both initial standards. Similarly, over the first half of the year, and seasoned public equities. As a result, businesses business failures—measured as the ratio of liabilities continued to borrow at a brisk pace: Aggregate debt of failed businesses to total liabilities—stepped up of the nonfinancial business sector expanded at a from the record low in 1998. The default rate on 91⁄ 2 percent annual rate in the first quarter. As finan- below-investment-grade bonds rose to its highest cial market conditions improved after the turmoil of level in several years, an increase stemming in part the fall, businesses returned to the corporate bond from defaults by companies whose earnings were and commercial paper markets for funding, and cor- impaired by the drop in oil and other commodity poratebondissuancereachedarecordhighinMarch. prices last year. The total volume of business debt Some of the proceeds were used to pay off bank thatwasdowngradedexceededslightlythevolumeof loans, which had soared in the fall, and these repay- debtthatwasupgraded. ments curbed the expansion of business loans at banks. Partial data for the second quarter indicate that borrowing by nonfinancial businesses slowed The Government Sector somewhat. Risk spreads have receded on balance this year Federal Government from their elevated levels in the latter part of 1998. From the end of December 1998 through mid-July, The incoming news on the federal budget continues investment-grade corporate bond yields moved up to be quite favorable. Over the first eight months of from historically low levels, but by less than yields fiscal year 1999—the period from October through on comparable Treasury securities, and the spread May—theunifiedbudgetregisteredasurplusofabout between these yields narrowed to a level somewhat $41 billion, compared with $16 billion during the above that prevailing before the Russian crisis. The comparableperiodoffiscal1998.Ifthelatestprojec- rise in investment-grade corporate bond yields was tionsfromtheOfficeofManagementandBudgetand restrainedbyinvestors’apparentlyincreasedwilling- the Congressional Budget Office are realized, the ness to hold such debt, as growing optimism about unifiedbudgetforfiscal1999asawholewillshowa the economy and favorable earnings reports gave surplus of around $100 billion to $120 billion, or investors more confidence about the prospective more than 1 percent of GDP—a striking turnaround financial health of private borrowers. Yield spreads from the outsized budget deficits of previous years, onbelow-investment-gradecorporatedebtovercom- which approached 5 percent of GDP in the early parableTreasurysecurities,whichhadrisenconsider- 1990s. 10 Monetary Policy Report to the Congress July 1999 FederalreceiptsandexpendituresasashareofnominalGDP However, individual income tax payments are up appreciably, reflecting the solid gains in household Percent incomes and perhaps also a rise in capital gains realizations large enough to offset last year’s reduc- tion in capital gains tax rates. At the same time, 24 Totalexpenditures federaloutlaysincreasedonly21⁄ 2 percentinnominal terms and barely at all in real terms during the first 22 eightmonthsofthefiscalyear,relativetothecompa- rable year-earlier period. Spending growth has been 20 restrained in major portions of both the discretionary (notably, defense) and nondiscretionary (notably, net Totalreceipts 18 interest, social security, and Medicare) categories— although this year’s emergency supplemental spend- ing bill, at about $14 billion, was somewhat larger 1982 1986 1990 1994 1998 thansimilarbillsinrecentyears. Note. Dataonreceiptsandexpendituresarefromtheunifiedbudget.Values As for the part of federal spending that is counted for1999areestimatesfromtheCBO’sJuly1economicandbudgetupdate. in GDP, real federal outlays for consumption and gross investment, which had changed little over the As a result of this turnaround, the federal govern- past few years, declined at a 2 percent annual rate ment is now contributing positively to the pool of in the first quarter of 1999. A drop in real defense nationalsaving.Infact,despitetherecentdropinthe outlays more than offset a rise in nondefense expen- personal saving rate, gross saving by households, ditures in the first quarter. And despite the military businesses, and governments has remained above action in the Balkans and the recent emergency 17 percent of GDP in recent quarters—up from the spending bill, defense spending appears to have 14 percent range that prevailed in the early 1990s. declinedinthesecondquarteraswell. This well-maintained pool of national savings, together with the continued willingness of foreigners to finance our current account deficits, has helped Federaldebtheldbyprivateinvestorsasashare holddownthecostofcapital,thuscontributingtoour ofnominalGDP nation’sinvestmentboom. Percent This year’s increase in the federal surplus has reflected continued rapid growth of receipts in com- 50 bination with a modest increase in outlays. Federal receipts were 5 percent higher in the first eight 45 months of fiscal 1999 than in the year-earlier period. 40 With profits leveling off from last year, receipts of corporate taxes have stagnated so far this fiscal year. 35 30 NationalsavingasashareofnominalGDP 25 Percent 20 1978 1983 1988 1993 1998 Note. Federaldebtheldbyprivateinvestorsisgrossfederaldebtlessdebt 20 held by federal government accounts and the Federal Reserve System. The Excludingfederalsaving valuefor1999isanestimatebasedontheCBO’sJuly1economicandbudget update. Q1 16 The budget surpluses of the past two years have led to a notable decline in the stock of federal debt Total Q1 held by private investors as a share of GDP. Since itspeakinMarch1997,thetotalvolumeofTreasury debt held by private investors has fallen by nearly 1982 1986 1990 1994 1998 $130 billion. The Treasury has reduced its issuance Note. Nationalsavingcomprisesthegrosssavingofhouseholds,businesses, andgovernments. of interest-bearing marketable debt in fiscal 1999. Board of Governors of the Federal Reserve System 11 The decrease has been concentrated in nominal cou- U.S.currentaccount pon issues; in 1998, by contrast, the Treasury retired Billions of dollars, annual rate both bill and coupon issues in roughly equal mea- sure. Offerings of inflation-indexed securities have + 0 remained an important part of the Treasury’s overall – borrowing program: Since the beginning of fiscal 50 1999,theTreasuryhassoldnearly$31billionofsuch 100 securities. 150 State and Local Governments 200 250 The fiscal condition of state and local governments has remained quite positive as well. Revenues have Q1 300 been boosted by increases in tax collections due to strong growth of private-sector incomes and 1994 1995 1996 1997 1998 1999 expenditures—increases that were enough to offset an ongoing trend of tax cuts. Meanwhile, outlays and 21⁄ 2 percent of GDP for 1998. A widening of the have continued to be restrained. In all, at the state deficitontradeingoodsandservices,to$215billion level, fiscal 1999 looks to have been the seventh atanannualrateinthefirstquarterfrom$173billion consecutiveyearofimprovingfiscalpositions;ofthe in the fourth quarter of 1998, accounted for the forty-six states whose fiscal years ended on June 30, deterioration in the current account balance. Data for all appear to have run surpluses in their general AprilandMayindicatethatthetradedeficitincreased funds. furtherinthesecondquarter. Real expenditures for consumption and gross The quantity of imports of goods and services investment by states and localities, which had been againgrewvigorouslyinthefirstquarter.Theannual risingonlymoderatelythroughmostof1998,jumped rate of growth of imports, at 131⁄ 2 percent, continued ata73⁄ 4 percentannualrateinthefirstquarterofthis the rapid pace seen over 1998 and reflected the year.Thisincreasewasdrivenbyasurgeinconstruc- strength of U.S. domestic demand and the effects of tionexpendituresthatwashelpedalongbyunseason- past dollar appreciation. Imports of consumer goods, ably favorable weather, and spending data for April automotiveproducts,computers,andsemiconductors and May suggest that much of this rise in construc- were particularly robust. Preliminary data for April tionspendingwasoffsetinthesecondquarter.Asfor and May suggest that real import growth remained employment, state and local governments added jobs strong, as nominal imports rose steadily and non-oil over the first half of the year at about the same pace importpricespostedamoderatedecline. astheydidlastyear. The volume of exports of goods and services Debt of state and local governments expanded at a declined at an annual rate of 5 percent in the first 51⁄ 2 percent rate in the first quarter. The low interest quarter. The decline partially reversed the strong rateenvironmentandstrongeconomyencouragedthe increase in the fourth quarter of last year. The weak- financing of new projects and the refunding of out- standing higher-rate debt. Borrowing slowed to a Changeinrealimportsandexportsofgoodsandservices more modest pace in the second quarter, as yields on Percent, annual rate long-dated municipal bonds moved up, but by less Imports than those on comparable Treasury securities. The Exports 20 credit quality of municipal securities improved fur- ther over the first half of the year, with more issues Q1 15 beingupgradedthandowngraded. 10 External Sector 5 + Trade and the Current Account 0 – 5 Thecurrentaccountdeficitreached$274billionatan annual rate in the first quarter of 1999, a bit more than 3 percent of GDP, compared with $221 billion 1994 1995 1996 1997 1998 1999 12 Monetary Policy Report to the Congress July 1999 nessofeconomicactivityinanumberofU.S.trading Measuresoflaborutilization partners and the strength of the dollar damped Percent demand for U.S. exports. Declines were registered in aircraft, machinery, industrial supplies, and agricul- Augmentedunemploymentrate turalproducts.ExportstoAsiagenerallyturneddown 15 in the first quarter from the elevated levels recorded in the fourth quarter, when they were boosted by 12 recorddeliveriesofaircrafttotheregion.Preliminary data for April and May suggest that real exports 9 advancedslightly. 6 June Civilianunemploymentrate Capital Account 3 Foreign direct investment in the United States and 1970 1975 1980 1985 1990 1995 2000 U.S. direct investment abroad remained robust in the Note. Theaugmentedunemploymentrateisthenumberofunemployedplus first quarter, reflecting brisk cross-border merger and thosewhoarenotinthelaborforceandwantajob,dividedbythecivilianlabor acquisition activity. On balance, net capital flows forceplusthosewhoarenotinthelaborforceandwantajob.Thebreakindata atJanuary1994markstheintroductionofaredesignedsurvey;datafromthat through direct investment registered a modest out- pointonarenotdirectlycomparablewiththoseofearlierperiods. flow in the first quarter compared with a huge net inflow in the fourth quarter. Fourth-quarter inflows 200,000 per month on average, which, although less were swollen by several large mergers. Net foreign rapid than the 244,000 pace registered over 1998, is purchasesofU.S.securitiesalsocontinuedtobequite fasterthanthegrowthoftheworking-agepopulation. sizable but again were well below the extraordinary With the labor force participation rate remaining pace of the fourth quarter. Most of the slowdown in about flat at just over 67 percent, the unemployment the first quarter is attributable to a reduced demand forTreasurysecuritiesonthepartofprivateinvestors rate edged down further from an average of 41⁄ 2 per- abroad. But capital inflows from foreign official cent in 1998 to 41⁄ 4 percent in the first half of this year—the lowest unemployment rate seen in the sourcesalsoslowedinthefirstquarter.U.S.residents UnitedStatesinalmostthirtyyears.Furthermore,the on net sold foreign securities in the first quarter, but pool of potential workers, including not just the ataslowerratethaninthepreviousquarter. unemployed but also individuals who are out of the labor force but report that they want a job, declined The Labor Market late last year to the lowest share of the labor force since collection of these data began in 1970—and it Employment and Labor Supply has remained near that low this year. Not surpris- ingly, businesses in many parts of the country have Labor demand remained very strong during the first perceived workers to be in very short supply, as half of 1999. Payroll employment increased about evidenced by high levels of help-wanted advertising and surveys showing substantial difficulties in filling Changeintotalnonfarmpayrollemployment jobopenings. Employmentgainsintheprivateservice-producing Thousands of jobs, monthly average sector remained sizable in the first six months of the yearandmorethanaccountedfortheriseinnonfarm payrolls over this period. Payrolls continued to rise 400 briskly in the services industry, with firms providing business services (such as help supply services and H1 computer services) adding jobs especially rapidly. 200 Job gains were quite sizable in retail trade as well. Withintheservice-producingsector,onlythefinance, + insurance, and real estate industry has slowed the 0 – pace of net hiring from last year’s rate, reflecting, in part, a slower rate of job gains in the mortgage bankingindustryastherefinancingwavehasebbed. 1991 1993 1995 1997 1999 Within the goods-producing sector, the boom in Board of Governors of the Federal Reserve System 13 construction activity pushed payrolls in that industry component, whose twelve-month change slowed higher in the first six months of this year. But in 3⁄ 4 percentage point from a year earlier. More manufacturing, where employment began declining recently, data on average hourly earnings of produc- more than a year ago in the wake of a drop in export tion or nonsupervisory workers may point to a level- demand, payrolls continued to fall in the first half of ingoff,butnofurtherslowing,ofwagegrowth:This 1999; in all, nearly half a million factory jobs have serieswasupatabouta4percentannualrateoverthe beenshedsinceMarch1998.Despitethesejoblosses, first six months of this year, about the same as the manufacturing output continued to rise in the first increase over 1998. Growth in the benefits compo- half of this year, reflecting large gains in labor nent of the ECI slowed somewhat as well in the year productivity. ended in March, to a 21⁄ 4 percent increase. However, employers’costsforhealthinsuranceareonecompo- nent of benefits that has been rising more rapidly of Labor Costs and Productivity late. After showing essentially no change from 1994 through 1996, the ECI for health insurance acceler- Growth in hourly compensation, which had been on ated to a 33⁄ 4 percent pace over the twelve months an upward trend since 1995, appears to have leveled endedinMarch. off and, by some measures, has slowed in the past A second measure of hourly compensation—the year.Accordingtotheemploymentcostindex(ECI), BureauofLaborStatistics’measureofcompensation hourly compensation costs increased 3 percent over per hour in the nonfarm business sector, which is the twelve months ended in March, down from derived from compensation information from the 31⁄ 2 percent over the preceding twelve-month period. nationalaccounts—hasbeenrisingmorerapidlythan Part of both the earlier acceleration and more recent theECIinthepastfewyearsandhasalsodecelerated decelerationintheECIapparentlyreflectedswingsin less so far this year. Nonfarm compensation per hour commissions,bonuses,andothertypesof‘‘variable’’ increased 4 percent over the four quarters ended in compensation, especially in the finance, insurance, the first quarter of 1999, 1 percentage point more and real estate industry. But in addition, part of the than the rise in the ECI over this period. One reason recent deceleration probably reflects the influence of thesetwocompensationmeasuresmaydivergeisthat restrained price inflation in tempering nominal wage the ECI does not capture certain forms of compensa- increases. Although down from earlier increases, the tion, such as stock options and hiring, retention, and 3 percent rise in the ECI over the twelve months referral bonuses, whereas nonfarm compensation per endedinMarchwaswellabovetheriseinpricesover hour does measure these payments.2 Although the this period and therefore was enough to generate twocompensationmeasuresdifferinnumerousother solidgainsinworkers’realpay. respects as well, the series’ divergence may lend The deceleration in the ECI through March has support to anecdotal evidence that these alternative been most pronounced in the wages and salaries forms of compensation have been increasing espe- ciallyrapidlyinrecentyears.However,becausenon- farm compensation per hour can be revised substan- Measuresofthechangeinhourlycompensation tially, one must be cautious in putting much weight onthemostrecentquarterlyfiguresfromthisseries. Percent, Q4 to Q4 Rapid productivity growth has made it possible Employmentcostindex to sustain these increases in workers’ compensation Nonfarmcompensationperhour without placing great pressure on businesses’ costs. Q1 Labor productivity in the nonfarm business sector 4 posted another sizable gain in the first quarter of 1999,andtheincreaseoverthefourquartersendedin the first quarter of 1999 was 21⁄ 2 percent. Indeed, productivity has increased at a 2 percent pace since 2 1995—well above the trend of roughly 1 percent per 1993 1994 1995 1996 1997 1998 1999 2. However, nonfarm compensation per hour captures the gains Note. TheECIisforprivateindustryexcludingfarmandhouseholdwork- from the actual exercise of stock options, whereas for analyzing ers.Nonfarmcompensationperhourisforthenonfarmbusinesssector.Values compensation trends, one might prefer to measure the value of the for1999:Q1arepercentchangesfrom1998:Q1to1999:Q1. optionsatthetimetheyaregranted. 14 Monetary Policy Report to the Congress July 1999 Changeinoutputperhour Changeinunitlaborcosts Percent, Q4 to Q4 Percent, Q4 to Q4 3.0 3 Q1 2.5 2 2.0 Q1 1.5 1 1.0 + 0 – .5 1991 1993 1995 1997 1999 1991 1992 1993 1994 1995 1996 1997 1998 1999 Note. Nonfarmbusinesssector.Thevaluefor1999:Q1isthepercentchange Note. Nonfarmbusinesssector.Thevaluefor1999:Q1isthepercentchange from1998:Q1to1999:Q1. from1998:Q1to1999:Q1. growth would reduce firms’ capacity to absorb fur- year that had prevailed over the preceding two ther wage gains without putting upward pressure on decades.3 This recent productivity performance is all prices. the more impressive given that businesses are reported to have had to divert considerable resources toward avoiding computer problems associated with Prices the century date change, and given as well that busi- nessesmayhavehadtohireless-skilledworkersthan Price inflation moved up in early 1999 from a level wereavailableearlierintheexpansionwhenthepool in 1998 that was depressed by a transitory drop in of potential workers was not so shallow. Part of the energy and other commodity prices. After increasing strength in productivity growth over the past few years may have been a cyclical response to the rapid onlyabout11⁄ 2 percentover1998,theconsumerprice growth of output over this period. But productivity index rose at a 21⁄ 4 percent annual rate over the first sixmonthsofthisyear,drivenbyasharpturnaround mayalsobereapingamorepersistentpayofffromthe in prices of gasoline and heating oil. However, the boom in business investment and the accompanying so-called ‘‘core’’ CPI, which excludes food and introduction of newer technologies that have oc- energy items, rose at an annual rate of only 1.6 per- curredoverthepastseveralyears. cent over this period—a somewhat smaller increase Even these impressive gains in labor productivity than that registered over 1998 once adjustment is may not have kept up fully with increases in firms’ real compensation costs of late. Over the past two Changeinconsumerprices years, real compensation, measured by the ECI rela- tive to the price of nonfarm business output, has Percent, Dec. to Dec. increasedthesamehefty21⁄ 2 percentperyearaslabor Published productivity; however, measured instead using non- Researchseriesusingcurrentmethods farm compensation per hour, real compensation has 4 increasedsomewhatmorethanproductivityoverthis period, implying a rising share of compensation in 3 total national income. A persistent period of real H1 compensation increases in excess of productivity 2 3. About 1⁄4 percentage point of the improvement in productivity 1 growthsince1995canbeattributedtochangesinpricemeasurement. Themeasureofrealoutputunderlyingtheproductivityfiguressince 1995 is deflated using CPI components that have been constructed 1992 1993 1994 1995 1996 1997 1998 1999 usingageometric-meansformula;thesecomponentstendtoriseless rapidlythantheCPIcomponentsthathadbeenusedintheoutputand Note. Consumerpriceindexforallurbanconsumers.Theresearchseries productivitydatabefore1995.ThesesmallerCPIincreasestranslate hasbeenextendedinto1999usingthepublishedCPI.Valuesfor1999:H1are intomorerapidgrowthofoutputandproductivityinthelaterperiod. percentchangesfromDecember1998toJune1999atanannualrate. Board of Governors of the Federal Reserve System 15 Changeinconsumerpricesexcludingfoodandenergy price declines have not been repeated more recently. Thisyear’sriseinenergypricesistheclearestexam- Percent, Dec. to Dec. ple, but commodity prices more generally have been Published turning up of late. The Journal of Commerce indus- Researchseriesusingcurrentmethods trial price index has moved up about 6 percent so far 4 this year after having declined about 10 percent last year,withespeciallylargeincreasespostedforprices 3 of lumber, plywood, and steel. These price move- ments are starting to be seen at later stages of pro- 2 cessingaswell:Theproducerpriceindexforinterme- H1 diate materials excluding food and energy, which 1 gradually declined about 2 percent over the fifteen monthsthroughFebruary1999,retracedabouthalfof that decrease by June. Furthermore, non-oil import 1992 1993 1994 1995 1996 1997 1998 1999 prices, although continuing to fall this year, have Note. Consumerpriceindexforallurbanconsumers.Theresearchseries moved down at a slower rate than that of the past hasbeenextendedinto1999usingthepublishedCPI.Valuesfor1999:H1are coupleofyearswhenthedollarwasrisingsharplyin percentchangesfromDecember1998toJune1999atanannualrate. foreign exchange markets. Non-oil import prices made for the effects of changes in CPI methodology: declined at a 11⁄ 4 percent annual rate over the first halfof1999,afterhavingfallenata3percentrate,on According to a new research series from the Bureau average,over1997and1998. of Labor Statistics (BLS), the core CPI would have Some other broad measures of prices also showed increased 2.2 percent over 1998 had 1999 methods evidence of acceleration early this year. The chain- beeninplaceinthatyear.4 typepriceindexforGDP—whichcoverspricesofall ThemoderationofthecoreCPIinrecentyearshas goods and services produced in the United States— reflected a variety of factors that have helped hold inflation in check despite what has been by all rose at about a 11⁄ 2 percent annual rate in the first quarter, up from an increase of about 1 percent last accounts a very tight labor market. Price increases year. A portion of this acceleration reflected move- havebeendampedbysubstantialgrowthinmanufac- ments in the chain-type price index for personal turing capacity, which has held plant utilization rates consumption expenditures (PCE) that differed from in most industries at moderate (and in some cases movementsintheCPI. subpar) levels, thereby reinforcing competitive pres- suresinproductmarkets.Furthermore,rapidproduc- tivitygrowthhelpedholdincreasesinunitlaborcosts 3. Alternativemeasuresofpricechange tolowlevelsevenascompensationgrowthwaspick- Percent,annualrate ing up last year. The rise in compensation itself has been constrained by moderate expectations of infla- 1996:Q4 1997:Q4 1998:Q4 Pricemeasure to to to tion, which have been relatively stable. According 1997:Q4 1998:Q4 1999:Q1 to the Michigan SRC survey, the median of one- Fixed-weight year-ahead inflation expectations, which was about Consumerpriceindex................ 1.9 1.5 1.5 Excludingfoodandenergy......... 2.2 2.4 1.6 21⁄ 2 percentlatelastyear,averaged23⁄ 4 percentinthe Chain-type firsthalfofthisyear. Grossdomesticproduct .............. 1.7 .9 1.6 The quiescence of inflation expectations, at least Grossdomesticpurchases ............ 1.3 .4 1.2 Personalconsumptionexpenditures ... 1.5 .7 1.2 through the early part of this year, in turn may have Excludingfoodandenergy......... 1.6 1.2 1.3 come in part from the downward movement in over- Note. A fixed-weight index uses quantity weights from the base year to allinflationlastyearresultingfromdeclinesinprices aggregatepricesfromeachdistinctitemcategory.Achain-typeindexisthe geometricaverageoftwofixed-weightindexesandallowstheweightstochange of imports and of oil and other commodities. These eachyear.Changesarebasedonquarterlyaverages. 4. Themostimportantchangethisyearwastheintroductionofthe AlthoughthecomponentsoftheCPIarekeyinputs geometric-meansformulatoaggregatepricequoteswithinmostofthe into the PCE price index, the two price measures detaileditemcategories.(TheLaspeyresformulacontinuestobeused in constructing higher-level aggregates.) Although these geometric- differ in a variety of respects: They use different meansCPIswereintroducedintotheofficialCPIonlyinJanuaryof aggregation formulas; the weights are derived from thisyear,theBLSgeneratedtheseriesonanexperimentalbasisgoing different sources; the PCE measure does not utilize backseveralyears,allowingthemtobebuiltintothenationalincome andproductaccountsbackto1995. all components of the CPI; and the PCE measure is 16 Monetary Policy Report to the Congress July 1999 broaderinscope,includingnotjusttheout-of-pocket Domesticnonfinancialdebt:Annualrangeandactuallevel expenditures by households that are captured by the Trillions of dollars CPI, but also the portion of expenditures on items such as medical care and education that are paid by 7% 16.6 insurers or governments, consumption of items such 16.5 asbanks’checkingservicesthatareprovidedwithout May explicit charge, and expenditures made by nonprofit 16.4 institutions. Although PCE prices typically rise a bit 16.3 lessrapidlythantheCPI,thePCEpricemeasurewas 16.2 unusually restrained relative to the CPI in the few 3% 16.1 years through 1998, reflecting a combination of the abovefactors. 16.0 Last year’s sharp drop in retail energy prices and 15.9 the subsequent rebound this spring reflected move- mentsinthepriceofcrudeoil.ThespotpriceofWest O N D J F M A M J Texasintermediate(WTI)crudeoil,whichhadstood 1998 1999 at about $20 per barrel through most of 1997, dropped sharply over 1998 and reached $11 per bar- of shelter have slowed thus far in 1999, rising at a relbytheendoftheyear,reflectinginpartaweaken- ing in demand for oil from the distressed Asian 21⁄ 2 percent annual rate versus a 31⁄ 4 percent rise last year. However, airfares and prices of medical ser- nations and increases in supply from Iraq and other vices both have been rising more rapidly so far this countries. But oil prices jumped this year as the year. OPEC nations agreed on production restraints aimed atfirmingprices,andtheWTIspotpricereached$18 per barrel in April and has moved still higher more recently. As a result, gasoline prices, which dropped Debt and the Monetary Aggregates 15 percent over 1998, reversed almost all of that declineoverthefirstsixmonthsofthisyear.Pricesof Debt and Depository Intermediation heating fuel also rebounded after dropping in 1998. In all, the CPI for energy rose at a 10 percent annual The total debt of the U.S. household, government, rateovertheDecember-to-Juneperiod. andnonfinancialbusinesssectorsincreasedatabouta Consumer food prices increased moderately over 6percentannualratefromthefourthquarterof1998 thefirstsixmonthsoftheyear,risingata13⁄ 4 percent throughMay,alittleabovethemidpointofitsgrowth annual rate. Despite the upturn in commodity prices range of 3 percent to 7 percent. Nonfederal debt generally, farm prices have remained quite low and expandedbrisklyatabouta9percentannualpace,in have helped to hold down food price increases. Spot association with continued strong private domestic prices of wheat, soybeans, and sugar have moved spending on consumer durable goods, housing, and down further this year from already depressed levels business investment. By contrast, federal debt con- attheendof1998,andpricesofcornandcoffeehave tractedata3percentannualrate,asbudgetsurpluses remainedlowaswell. reinedinfederalgovernmentfinancingneeds. The CPI for goods other than food and energy Creditextendedbydepositoryinstitutionsslumped declined at about a 1⁄ 2 percent annual rate over the over the first half of 1999, after having expanded first six months of 1999, after having risen 11⁄ 4 per- quite briskly in 1998. A fair-sized portion of the cent over 1998. The 1998 increase reflected a sharp expansion in 1998 came in the fourth quarter and rise in tobacco prices in December associated with stemmed from the turmoil in financial markets. In thesettlementoflitigationbetweenthetobaccocom- that turbulent environment, depository institutions panies and the states; excluding tobacco, the CPI for postponed securitization of mortgages, and busi- coregoodswasaboutflatlastyear.Thedeclineinthe nesses shifted their funding demand from securities first half of this year was concentrated in durable markets to depository institutions, where borrowing goods, where prices softened for a wide range of costs in some cases were governed by pre-existing items, including motor vehicles. The CPI for non- lending commitments. Depository institutions also energy services increased about 21⁄ 2 percent at an acquired mortgage-backed securities and other pri- annual rate in the first half, down a little from the vate debt instruments in volume, as their yields evi- increase over 1998. Increases in the CPI for rent dently rose relative to depository funding costs. As Board of Governors of the Federal Reserve System 17 M3:Annualrangeandactuallevel deposits. Growth of institutional money market mutual funds also moderated from its rapid pace in Trillions of dollars 1998. Rates on money market funds tend to lag the June 6% movements in market rates because the average rate of return on the portfolio of securities held by the 6.1 fund changes more slowly than market rates. In the fall,ratesoninstitutionalmoneymarketfundsdidnot decline as fast as market rates after the Federal 2% 6.0 Reserve eased monetary policy, and the growth of these funds soared. As rates on these funds moved back into alignment with market rates this year, 5.9 growthofthesefundsebbed. M2advancedata61⁄ 4 percentannualratefromthe fourth quarter of 1998 through June. M2 growth had been elevated in late 1998 by unsettled financial O N D J F M A M J J conditions,whichraisedthedemandforliquidmoney 1998 1999 balances,andbytheeasingofmonetarypolicy,which reduced the opportunity costs of holding the assets financial stresses unwound, securitization resumed, included in the monetary aggregates. M2 growth business borrowers returned to securities markets, moderated over the first half of 1999, as the height- and net purchases of securities slowed. From the ened demand for money waned; in June this aggre- fourthquarterof1998throughJune,bankcreditrose gate was above its 1 percent to 5 percent price- ata3percentannualizedpace,afteradjustingforthe stability growth range. The growth in M2 over the estimatedeffectsofmark-to-marketaccountingrules. first half of the year again outpaced that of nominal income, although the decline in M2 velocity—the ratioofnominalincometoM2—wasataslowerrate Monetary Aggregates than in 1998. The decline this year reflected in part a continuing lagged response to the policy easing in The growth of M3, the broadest monetary aggregate, the fall; however, the drop in M2 velocity was again slowed appreciably over the first half of 1999. M3 larger than predicted on the basis of the historical expanded at a 6 percent annual pace from the fourth relationship between the velocity of M2 and the quarterof1998throughJuneofthisyear,placingthis opportunity costs of holding M2—measured as the aggregate at the top of the 2 percent to 6 percent difference between the rate on three-month Treasury price-stability growth range set by the FOMC at its bills and the average return on M2 assets. The rea- February meeting. With depository credit growing sons for the decline of M2 velocity this year are not modestly, depository institutions trimmed the man- aged liabilities included in M3, such as large time M2velocityandtheopportunitycostofholdingM2 M2:Annualrangeandactuallevel Ratio scale Percentage points, ratio scale Trillions of dollars 2.0 M2velocity June 25 5% Q1 4.50 1.9 M2 10 opportunity 4.45 1.8 cost 4 3 4.40 2 1.7 Q1 1% 1 4.35 1978 1983 1988 1993 1998 Note. Thedataarequarterly.ThevelocityofM2istheratioofnominal O N D J F M A M J J grossdomesticproducttothestockofM2.TheopportunitycostofM2isa two-quartermovingaverageofthedifferencebetweenthethree-monthTreasury 1998 1999 billrateandtheweighted-averagereturnonassetsincludedinM2. 18 Monetary Policy Report to the Congress July 1999 4. Growthofmoneyanddebt Percent Domestic Period M1 M2 M3 nonfinancialdebt Annual1 1989.............................................. .6 5.2 4.1 7.5 1990.............................................. 4.2 4.2 1.9 6.7 1991.............................................. 8.0 3.1 1.2 4.5 1992.............................................. 14.3 1.8 .6 4.5 1993.............................................. 10.6 1.3 1.0 4.9 1994.............................................. 2.5 .6 1.7 4.9 1995.............................................. - 1.6 3.9 6.1 5.4 1996.............................................. - 4.5 4.6 6.8 5.1 1997.............................................. - 1.2 5.8 8.8 4.8 1998.............................................. 1.8 8.5 10.9 6.1 Quarterly(annualrate)2 1999:1 ............................................ 2.8 7.2 7.3 5.9 2 ............................................ 3.4 5.7 5.0 Year-to-date3 1999.............................................. 2.0 6.2 6.0 6.1 Note. M1consistsofcurrency,travelerschecks,demanddeposits,andother ments, households and nonprofit organizations, nonfinancial businesses, and checkabledeposits.M2consistsofM1plussavingsdeposits(includingmoney farms. marketdepositaccounts),small-denominationtimedeposits,andbalancesin 1. Fromaverageforfourthquarterofprecedingyeartoaverageforfourth retailmoneymarketfunds.M3consistsofM2pluslarge-denominationtime quarterofyearindicated. deposits,balancesininstitutionalmoneymarketfunds,RPliabilities(overnight 2. Fromaverageforprecedingquartertoaverageforquarterindicated. and term), and Eurodollars (overnight and term). Debt consists of the out- 3. Fromaverageforfourthquarterof1998toaverageforJune(Mayinthe standing credit market debt of the U.S. government, state and local govern- caseofdomesticnonfinancialdebt). clear; the drop extends a trend in velocity evident yearsbecausemostofthedepositoryinstitutionsthat since mid-1997 and may in part owe to households’ wouldbenefitfromsuchprogramshadalreadyimple- efforts to allocate some wealth to the assets included mentedthem. in M2, such as deposits and money market mutual As a consequence of retail sweep programs, the fundshares,afterseveralyearsofsubstantialgainsin balances that depository institutions are required to equity prices that greatly raised the share of wealth holdattheFederalReservehavefallenabout60per- heldinequities. cent since 1994. This development has the potential M1 increased at a 2 percent annualized pace from to complicate reserve management by the Federal the fourth quarter of 1998 through June, in line with Reserveanddepositoryinstitutionsandthusraisethe its advance in 1998. The currency component of M1 volatility of the federal funds rate. It would do so expanded quite rapidly. The strength appeared to by making the demand for balances at the Federal stem from domestic, rather than foreign, demand, Reserve more variable and less predictable. Before perhaps reflecting vigorous consumer spending, the introduction of sweeps, the demand for balances although currency growth was more robust than was high and stable because reserve balance require- might be expected for the rise in spending. The ments were large, and the requirements were satis- deposits in M1—demand deposits and other check- fied by the average of daily balances held over a abledeposits—contractedfurther,asretailsweeppro- maintenance period. With sweep programs reducing grams continued to be introduced. These programs, required balances to low levels, depository institu- which first began in 1994, shift funds from a deposi- tionshavefoundthattheytargetbalancesinexcessof tor’s checking account, which is subject to reserve their required balances in order to gain sufficient requirements, to a special-purpose money market protection against unanticipated debits that could deposit account, which is not. Funds are then shifted leave their accounts overdrawn at the end of the day. back to the checking account when the depositor’s This payment-related demand for balances varies account balance falls below a given level. The more from day to day than the requirement-related depository institution benefits from a retail sweep demand.Thusfar,thegreatervariationinthedemand programbecausetheprogramcutsitsreserverequire- for balances has not made the federal funds rate ment and thus the amount of non-interest-bearing appreciably more volatile, in part reflecting the suc- reserve balances that it must hold at its Federal cessful efforts of depository institutions and the Fed- Reserve Bank. New sweep programs depressed the eral Reserve to adapt to lower balances. For its part, growth of M1 by about 51⁄ 4 percentage points over theFederalReservehasconductedmoreopenmarket thefirsthalfof1999,somewhatlessthaninprevious operations that mature the next business day to bet- Board of Governors of the Federal Reserve System 19 ter align daily supply with demand. Nonetheless, Impliedvolatilities required balances at the Federal Reserve could drop Percent Percent to levels at which the volatility of the funds rate becomes pronounced. One way to address the prob- lem of declining required balances would be to per- 13 S&P500 40 mittheFederalReservetopayinterestonthereserve 12 35 balances that depository institutions hold. Paying interest on reserve balances would reduce consider- 11 30 ably the incentives of depository institutions to de- 10 25 velop reserve-avoidance practices that may compli- catetheimplementationofmonetarypolicy. 9 20 8 Long-term 15 Treasurybond U.S. Financial Markets J F M A M J J A S O N D J F M A M J J 1998 1999 Yields on Treasury securities have risen this year in Note. The data are daily. Implied volatilities are calculated from options response to the ebbing of the financial market strains prices.LastobservationsareforJuly19,1999. of late 1998, surprisingly strong economic activity, concerns about the potential for increasing inflation, not so acute, and yields on these securities were in and the consequent anticipation of tighter monetary somewhatcloseralignmentwithyieldsonissuesthat policy. In January, yields on Treasury securities hadbeenoutstandinglonger.Dealersweremorewill- moved in a narrow range, as lingering safe-haven ing to put capital at risk to make markets, and bid– demandsfordollar-denominatedassets,owinginpart asked spreads in Treasury securities narrowed some- to the devaluation and subsequent floating of the what, though, in June they were still a bit wider than Brazilian real, about offset the effect on yields of had been typical. Market expectations of asset price stronger-than-expected economic data. Over subse- volatility, as reflected in prices on Treasury bond quentmonths,however,yieldsonTreasurysecurities, options contracts, receded on balance. The implied especiallyatintermediateandlongmaturities,moved volatility of bond prices dropped off until April and up substantially. The demand for the safest and most then turned back up, as uncertainty about the timing liquidassets,whichhadpulleddownTreasuryyields and extent of a possible tightening of monetary pol- inthefall,abatedasthestrengthineconomicactivity icyincreased. and favorable earnings reports engendered optimism Yields on inflation-indexed Treasury securities aboutthefinancialconditionofprivateborrowersand haveonlyedgedupthisyear,andthespreadsbetween encouraged investors to buy private securities. In yields on nominal Treasury securities and those on addition, rising commodity prices, tight labor mar- comparable inflation-indexed securities have wid- kets,androbusteconomicactivityledmarketpartici- enedconsiderably.Yieldsoninflation-indexedsecuri- pantstoconcludethatmonetarypolicywouldneedto ties did not decline in late 1998 like those of their be tightened, perhaps in a series of steps. This view, nominalcounterparts,inpartbecausethesesecurities accentuated by the FOMC’s announcement after its were not perceived as being as liquid as nominal May meeting that it had adopted a directive tilted Treasury securities. Thus, as the safe-haven demand toward tightening policy, also boosted yields. for nominal Treasury securities unwound and nomi- Between the end of 1998 and mid-July, Treasury nal yields rose, yields on inflation-indexed securities yieldsaddedabout80basispointsto110basispoints, did not move up concomitantly. Moreover, these onbalance,withthelargerincreasesintheintermedi- yields were held down by some improvement in ate maturities. The rise in Treasury bill rates, the liquidity of the market for inflation-indexed anchoredbythemodestupwardmoveintheFOMC’s securities, as suggested by reports of narrower bid– target federal funds rate, was much less, about asked spreads, which provided additional impetus 10basispointsto40basispoints. for investors to acquire these securities. Because of Therecoveryinfixed-incomemarketsoverthefirst such considerations, the value of the yield spread halfoftheyearwasevidentinanumberofindicators between nominal and inflation-indexed Treasury of market conditions. Market liquidity was generally securities as an indicator of inflation expectations is better, and volatility was lower. The relative demand limited. Nonetheless, the widening of the spread for the most liquid Treasury securities—the most this year may have reflected some rise in inflation recently auctioned security at each maturity—was expectations. 20 Monetary Policy Report to the Congress July 1999 Majorstockpriceindexes to prices, as measured by the S&P 500 index, was near the record low established in May. Meanwhile, Index, January 2, 1998 = 100 realinterestrates,measuredasthedifferencebetween the yield on the nominal ten-year Treasury note and Nasdaq 170 a survey-based measure of inflation expectations, moved up. Consequently, the risk premium for hold- 150 ing equities remained quite small by historical standards. 130 S&P500 110 Year 2000 Preparedness 90 The Federal Reserve and the banking system have Russell2000 largely completed preparing technical systems to J FMAMJ JASONDJ FMAMJ JASONDJ FMAMJ J ensure that they will function at the century date 1997 1998 1999 change and are taking steps to deal with potential Note. Thedataaredaily.LastobservationsareforJuly19,1999. contingencies. The Federal Reserve successfully completed testing all of its mission-critical computer Equity prices have climbed this year. Major equity systemsforyear2000compliance,includingitssecu- price indexes posted gains of 10 percent to 31 per- rities and funds transfer systems. As a precaution to cent, on balance, between the end of 1998 and assurethepublicthatsufficientcashwillbeavailable July16,whenmostofthemestablishedrecordhighs. in the event that demand for U.S. currency rises The lift to prices from stronger-than-anticipated eco- in advance of the century date change, the Federal nomic activity and corporate profits apparently has Reserve will increase considerably its inventory of offsetthedampingeffectofrisingbondyields.Prices currency by late 1999. In addition, the Federal of technology issues, especially Internet stocks, have Reserve established a Century Date Change Special risen considerably on net, despite some wide swings Liquidity Facility to supply collateralized credit insentiment.Sharepricesoffirmsproducingprimary freelytodepositoryinstitutionsatamodestpenaltyto commodities,whichtumbledinthefall,reboundedto market interest rates in the months surrounding the postlargepricegains,perhapsbecauseofthefirming rollover. This funding should help financially sound of commodity prices amid perceptions that Asian depository institutions commit more confidently to economies were improving. Consensus estimates of supplying loans to other financial institutions and earnings over the coming twelve months have businesses in the closing months of 1999 and early strengthened, but in June the ratio of these estimates monthsof2000. All depository institutions have been subject to special year 2000 examinations by their banking Equityvaluationandtheten-yearrealinterestrate supervisors to ensure their readiness. Banks, in turn, Percent have worked with their customers to encourage year 2000 preparedness by including a review of a 16 customer’s year 2000 preparedness in their under- 14 writing or loan-review standards and documentation. AccordingtotheFederalReserve’sMay1999Senior 12 S&P500earnings–priceratio Loan Officer Opinion Survey, a substantial majority 10 of the respondent banks have largely completed 8 year 2000 preparedness reviews of their material 6 customers. Most banks reported that only a small portionoftheircustomershavenotmadesatisfactory 4 progress. Ten-yearrealinterestrate 2 June Banks in the Federal Reserve’s survey reported little demand from their clients for special contin- 1980 1983 1986 1989 1992 1995 1998 gency lines of credit related to the century date Note. Thedataaremonthly.Theearnings–priceratioisbasedontheI/B/E/S International, Inc., consensus estimate of earnings over the coming twelve change,althoughmanyexpectdemandforsuchlines months.Therealinterestrateistheyieldontheten-yearTreasurynotelessthe to increase somewhat as the year progresses. Almost measureoften-yearinflationexpectationsfromtheFederalReserveBankof PhiladelphiaSurveyofProfessionalForecasters. all domestic respondents reported that they are will- Board of Governors of the Federal Reserve System 21 ing to extend such credit lines, although in some beencut,insteps,fromitsMarchhigh.Theovernight caseswithtighterstandardsorterms. rate was reduced further, to 21 percent by the end of June, but the real fell back only modestly and stood at about 1.80 per dollar in mid-July. Brazil’s stock International Developments marketalsorosesharplyandwasupbyabout65per- centintheyeartodate. Global economic prospects look considerably Several favorable developments have worked to brighter than they did only a few months ago. To support the real and equity prices over the past few an important degree, this improvement owes to the months. Inflation has been lower than expected, with rebound in the Brazilian economy from the turmoil consumer price inflation at an annual rate of around experienced in January and February and to the fact 8 percent for the first half of the year. Greater-than- that the fallout from Brazil on other countries was expectedrealGDPgrowthinthefirstquarter,though much less than it might have been. The fear was that attributable in part to temporary factors, provided the collapse of the Brazilian real last January would some evidence of a bottoming out, and possible unleash a spiral of inflation and further devaluation recovery, in economic activity over the first part of and lead to a default on government domestic debt, this year. And in the fiscal arena, the government destabilizing financial markets and triggering an posted a primary surplus of more than 4 percent of intensified flight of capital from Brazil. In light of GDP in the first quarter—well above the goal in the events following the Russian debt moratorium and International Monetary Fund program. The positive collapse of the ruble last year, concern existed that a turnofeventshasfacilitatedareturnoftheBrazilian collapse of the real could also have negative reper- government and private-sector borrowers to interna- cussions in Latin America more broadly, and possi- tional bond markets, albeit on more restrictive terms blyeveninglobalfinancialmarkets. thanthoseofayearago. Developments in Brazil turned out better than Since the middle of May, however, the road to expected over the weeks after the floating of the real recovery in Brazil has become bumpier. The central in January. Between mid-January and early March, government posted a fiscal deficit in May that was thereallost45percentofitsvalueagainstthedollar, bigger than had been expected. In addition, court reaching a low of 2.2 per dollar, but then started to challenges have called into question fiscal reforms recover after the Brazilian central bank raised the enacted earlier this year that were expected to overnight interest rate from 39 percent to 45 percent improve the government’s fiscal balance by about andmadeclearthatitgaveahighprioritytofighting 1 percent of GDP. In May, the rise in U.S. interest inflation. By mid-May, the real had strengthened ratesassociatedwiththeanticipatedtighteninginthe to 1.65 per dollar, even while the overnight rate had stance of U.S. monetary policy helped push Brady bond yield spreads up more than 200 basis points. Although they narrowed some in June they widened Brazilianfinancialindicators recently on concerns about Argentina’s economic situation. Index, January 1997 = 100 Percent The Brazilian crisis did trigger renewed financial Exchangerateindex stressthroughoutLatinAmerica,asdomesticinterest 180 45 ratesandBradybondyieldspreadsincreasedsharply Stockindex inJanuaryfromlevelsthathadalreadybeenelevated 160 40 by the Russian crisis. Nonetheless, these increases 140 35 were generally smaller than those that had followed the Russian crisis, and as developments in Brazil 120 30 proved more positive than expected, financial condi- tionsintherestoftheregionstabilizedrapidly.Even 100 25 so, the combination of elevated risk premiums and 80 20 diminished access to international credit markets, Overnightinterestrate as well as sharp declines in the prices of commod- ity exports, had significant consequences for GDP J FMAMJ JASONDJ FMAMJ JASONDJ FMAMJ J 1997 1998 1999 growth, which began to slow or turn negative Note. ThestockindexistheBovespaindexfromtheSaoPaoloExchange, throughouttheregioninlate1998andearly1999. lasttradingdayofthemonth.Theovernightinterestrateistheaveragemonthly Mexicoappearstohaveexperiencedtheleastdimi- SELICrate.Theexchangerateindexistheaveragemonthlybilateralexchange nution in economic growth, likely because of its ratewiththeU.S.dollar. 22 Monetary Policy Report to the Congress July 1999 strong trade links with the United States, where StockpricesindevelopingAsiancountries growth has been robust. A flattening in Mexican Index, January 1997 = 100 GDP in the final quarter of 1998 has given way to renewed, but moderate, growth more recently, and 140 the Mexican peso has appreciated by about 51⁄ 2 per- Korea cent relative to the dollar since the start of the year. 120 By contrast, economic activity in Argentina declined sharply in the first quarter, in part because of the 100 devaluation and relatively weak economic activity in Brazil, Argentina’s major trading partner. More Indonesia 80 recently the earlier recovery in Argentina’s financial Thailand 60 markets appears to have backtracked as concern has increased about the medium- to long-run viability of Malaysia 40 the currency peg to the dollar. Several countries in the region, including Venezuela, Chile, and Colom- J FMAMJ JASONDJ FMAMJ JASONDJ FMAMJ J bia, also experienced sharp declines in output in the 1997 1998 1999 firstquarter,stemminginpartfromearlierdeclinesin Note. Thedataareforthelasttradingdayofthemonth.TheJulyobserva- tionsareforJuly19.Indexesarecapitalization-weightedaveragesofallstocks oilandothercommodityprices. tradedonacountry’sstockexchange. In emerging Asia, signs of recovery in financial markets and in real activity are visible in most of the ing slower progress in addressing structural weak- countries that experienced financial crises in late nesses in the financial and corporate sectors. How- 1997. However, the pace and extent of recovery is ever, activity appears to have bottomed out and has uneven across countries. The strongest recovery has recently shown signs of starting to move up in these been in Korea. In 1998, the Korean won reversed countries. nearly half of its sharp depreciation of late 1997. FinancialmarketsinChinaandHongKongexperi- It has been little changed on balance this year, as enced some turbulence at the start of the year when Koreanmonetaryauthoritieshaveintervenedtomod- Chinese authorities put the Guangdong International erate its further appreciation. Korean stock prices TrustandInvestmentCorporation(GITIC)intobank- havealsostagedanimpressiverecovery—movingup ruptcy, leading to rating downgrades for some Chi- about 75 percent so far in 1999. In the wake of its nese financial institutions, including the major state financial crisis, output in Korea fell sharply, with commercialbanks.TheGITICbankruptcyalsoraised industrial production down about 15 percent by the concerns about Hong Kong financial institutions, middle of last year. Since then, however, production which are heavy creditors to Chinese entities. These has bounced back. With the pace of the recovery concernscontributedtoasubstantialincreaseinyield accelerating this year, all of the post-crisis drop spreads between Hong Kong government debt and in production has been reversed. This turnaround U.S. Treasury securities and to a fall in the Hong reflects both the improvement in Korea’s external Kongstockmarketofabout15percent.Spreadshave position, as the trade balance has swung into sub- narrowed since, falling from about 330 basis points stantial surplus, and the government’s progress in on one-year debt in late January to about 80 basis addressing the structural problems in the financial points by mid-May, and have remained relatively andcorporatesectorsthatcontributedtothecrisis. stable since then. Equity prices also rebounded FinancialmarketsintheSoutheastAsiancountries sharply, rising nearly 50 percent between mid- thatexperiencedcrisesin1997(Thailand,Singapore, February and early May. Despite sizable volatility in Malaysia, Indonesia, and the Philippines) apparently MayandJune,theyarenowroughlyunchangedfrom werelittleaffectedbyspilloverfromBrazil’stroubles earlyMaylevels. earlier this year and have recovered on balance over In Japan, a few indicators suggest that recovery the past year, with exchange rates stabilizing and fromaprolongedrecessionmaybeoccurring.Princi- stockpricesmovinghigher.Financialconditionshave pally, first-quarter GDP growth at an annual rate of been weakest in Indonesia, in large part a result of 7.9 percent was recorded—the first positive growth political uncertainty; but even so, domestic interest in six quarters. This improvement reflects in part a rates have dropped sharply, and the stock market has shift toward more stimulative fiscal and monetary stagedanimpressivereboundsinceApril.Therecov- policies. On the fiscal front, the government ery of economic activity in these countries has been announced a set of measures at the end of last year slowerandlessrobustthaninKorea,possiblyreflect- that were slated for implementation during 1999 and Board of Governors of the Federal Reserve System 23 included permanent cuts in personal and corporate In the other major industrial countries, the pace income taxes, various investment incentives, and of economic growth this year has been mixed. Eco- increases in public expenditures. The large-scale fis- nomic developments in Canada have been quite cal expansion and concern about increases in the favorable. GDP rose 41⁄ 4 percent at an annual rate in supply of government bonds caused bond yields to thefirstquarterafterafourth-quartergainof43⁄ 4 per- morethandoublelatelastyearandearlythisyear,to cent, with production fueled by strong demand for alevelofabout2percentontheten-yearbond. CanadianproductsfromtheUnitedStates.Coreinfla- In mid-February, primarily because of concern tion remains low, near the lower end of the Bank about the prolonged weakness in economic activity of Canada’s target range of 1 percent to 3 percent, and pronounced deflationary pressures but also in although overall inflation rose some in April and responsetotherisingbondyields,theBankofJapan May. Oil prices and other commodity prices have announced a reduction in the target for the overnight risen, and the current account deficit has narrowed call-money rate and subsequently guided the rate to considerably.ThesefactorshavehelpedtheCanadian its present level of 3 basis points by early March. dollar appreciate relative to the U.S. dollar by about This easing of monetary policy had a stimulative 4 percent this year and have facilitated a cut in effect on Japanese financial markets, with the yield short-term interest rates of 50 basis points by the on the ten-year government bond falling more than BankofCanada.Alongwithrisinglong-terminterest 75 basis points, to 1.25 percent by mid-May. More rates elsewhere, long rates have increased in Canada recently, the yield has risen to about 1.8 percent, by about 30 basis points over the course of this year. partially in response to the release of unexpectedly Even so, equity prices have risen about 12 percent strong first-quarter GDP growth. Supportive mone- since the start of the year, although the rise in long- taryconditions,coupledwithrestructuringannounce- termrateshasundercutsomeofthemomentuminthe ments from a number of large Japanese firms and stockmarket. growing optimism about the economic outlook, have In the United Kingdom, output was flat in the first fueled a rise in the Nikkei from around 14,400 over quarter, coming off a year in which GDP growth had the first two months of the year to over 18,500 in already slowed markedly. However, the effects of mid-July. aggressive interest rate reductions undertaken by the TheimprovedeconomicperformanceinJapanalso Bank of England in late 1998 and earlier this year reflects some progress on addressing persistent prob- appear to have emerged in the second quarter, with lems in the financial sector. In March the authorities gains in industrial production, retail sales volume, injected 71⁄ 2 trillion yen of public funds into large and business confidence. Inflationary pressures have financial institutions and began to require increased been well contained, benefiting in part from the con- provisioning against bad loans as well as improved tinued strength in sterling; the Bank of England cut financial disclosure. Although much remains to be interest rates, most recently in June, to reduce the done, these actions appear to have stabilized condi- likelihood of inflation undershooting its target of tions,atleasttemporarily,inthebankingsystem,and 21⁄ 2 percent. Consistent with expectations of an the premium on borrowing rates paid by leading upturn in growth, equity prices have risen more than JapanesebanksdeclinedtozerobyMarch. 15 percent, and long-term bond yields have climbed The yen strengthened in early January, supported nearly80basispointssincetheendoflastyear. by the runup in long-term Japanese interest rates, First-quartergrowthintheEuropeancountriesthat reaching about 110 per dollar—its highest level in have adopted a common currency (euro area) more than two years. However, amid apparent inter- regained some momentum from its slow pace in late vention by the Japanese authorities, the yen retreated 1998 but was nevertheless below potential, as pro- to a level above 116 per dollar, and it remained near duction continued to react to the decline in export that level until the mid-February easing of monetary ordersregisteredoverthecourseof1998andinearly policy and the subsequent decline of interest rates 1999.Still,thedragonoverallproductionfromweak when it depreciated to about 120 per dollar. In mid- exportdemandfromAsiaandeasternEuropeappears June, the Japanese authorities intervened in the for- to have lifted a bit in the past few months, although eign exchange market in an effort to limit apprecia- the signs of a pickup in growth were both tentative tion of the yen after the surprisingly strong first- and uneven across the euro area. In Germany, indus- quarterGDPreleaseincreasedmarketenthusiasmfor trial production was higher in April and May than in that currency. The authorities noted that a premature the preceding two months, and export orders were strengthening of the yen was undesirable and would markedly higher in those months than they had been weighadverselyoneconomicrecovery. at any time since the spring of 1998. But in France, 24 Monetary Policy Report to the Congress July 1999 which had been the strongest of the three largest Nominaldollarexchangerateindexes euro-area economies in 1998, GDP growth was a Index, January 1997 = 100 meager 11⁄ 4 percent at an annual rate in the first quarter,andindustrialproductionslippedinApril. Japan Majorcurrencies Onaverageintheeuroarea,inflationhasremained 120 quitetame,evenasrisingoilprices,adecliningeuro, Euroarea Canada and, at least in Germany, an acceleration in wage 115 rates have raised inflationary pressures this year. The low average rate of inflation as well as the still 110 sluggishpaceofrealactivityinsomeoftheeuro-area 105 countriesledtheEuropeanCentralBanktolowerthe overnight policy rate by 50 basis points in April, on 100 top of cuts in short-term policy rates made by the UnitedKingdom national central banks late last year that, on average, wereworthabout60basispoints. J FMAMJ JASONDJ FMAMJ JASONDJ FMAMJ J Notwithstanding the easing of the policy stance, 1997 1998 1999 long-term government bond yields have risen sub- Note. Thedataaremonthlyaverages.Theeuro-areaexchangerateusesthe restatedGermanmarkbeforeJanuary1999.Themajorcurrencyindexisthe stantially from their January lows in the largest trade-weighted average of the exchange value of the dollar against major economies of the euro area. Ten-year rates spiked in currencies. early March along with U.S. rates, fell back some through mid-May, and then resumed an upward euroandthecurrenciesoftheelevencountriesadopt- coursearoundthetimetheFOMCadoptedatighten- ingtheeuroweresetonDecember31;basedonthese ing bias in mid-May. Since the middle of June, a rates, the value of the euro at the moment of its relativelysharpincreaseinyieldshaspushedthemto creation was $1.16675. Trading in the euro opened about 100 basis points above their values at the start on January 4, and after jumping on the first trading of the year and has narrowed what had been a grow- day, its value has declined relative to the dollar ing interest rate differential between U.S. and Euro- almoststeadilyandisnowabout13percentbelowits pean bonds. In addition to the pressure provided by initial value. The course of the euro–dollar exchange the increase in U.S. rates, the runup in European rate likely has reflected in part the growing diver- yields likely reflects the belief that short-term rates gence in both the cyclical positions and, until have troughed, as the incipient recovery in Asia not recently, long-term bond yields of the euro-area only reduces the drag on European exports but also economies and the United States. Concerns about attenuates deflationary pressures on European import fiscal discipline in Italy—the government raised prices. Concern about the fall in the exchange value its 1999 deficit-to-GDP target from 2.0 percent of the euro may also have contributed to an assess- to 2.4 percent—and about progress on structural mentthatthenextmoveinshort-termrateswouldbe reforms in Germany and France have also been cited up.Gainsinequitypricessofarthisyear—averaging as contributing to weakness in the euro, with the about 121⁄ 2 percent—are also suggestive of the belief European Central Bank recently characterizing that economic activity may be picking up, although national governments’ fiscal policy plans as the range in share price movements is fairly broad, ‘‘unambitious.’’ even considering only the largest economies: French On balance the dollar has appreciated more than equity prices have risen about 20 percent, German 41⁄ 2 percent against an index of the major currencies prices are up 13 percent, and Italian prices are up since the end of last year, owing mainly to its only5percent. strengthening relative to the euro. Nevertheless, it The new European currency, the euro, came into remains below its recent peak in August of last year operation at the start of the year, marking the begin- when the Russian debt moratorium and subsequent ning of Stage Three of European Economic and financial market turmoil sent the dollar on a two- Monetary Union. The rates of exchange between the monthdownwardslide.

Federal Reserve (1999, July 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19990722

@misc{wtfs_monetary_policy_report_19990722,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1999},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19990722},
  note = {Retrieved via When the Fed Speaks corpus}
}