Monetary Policy Report

For use at 10:00 a.m., EDT Wednesday July 18, 2001 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to section 2B of the Federal Reserve Act July 18, 2001 Letter of Transmittal BOARDOFGOVERNORSOFTHE FEDERALRESERVESYSTEM Washington,D.C.,July18,2001 THEPRESIDENTOFTHESENATE THESPEAKEROFTHEHOUSEOFREPRESENTATIVES TheBoardofGovernorsispleasedtosubmititsMonetaryPolicyReporttotheCongress pursuanttosection2BoftheFederalReserveAct. Sincerely, AlanGreenspan,Chairman Table of Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2001 4 Monetary Policy Report to the Congress Report submitted to the Congress on July 18, 2001, contained, and prospects for inflation have become pursuanttosection2BoftheFederalReserveAct less of a concern as rates of resource utilization have declinedandenergypriceshaveshownsignsofturn- ingdown. MONETARY POLICY AND THE Theinformationavailableatmidyearfortherecent ECONOMIC OUTLOOK performance of both the U.S. economy and some of our key trading partners remains somewhat down- When the Federal Reserve submitted its report on beat, on balance. Moreover, with inventories still monetary policy in mid-February, the Federal Open excessive in some sectors, orders for capital goods Market Committee (FOMC) had already reduced its verysoft,andtheeffectsoflowerstockpricesandthe target for the federal funds rate twice to counter weakerjobmarketweighingonconsumers,theecon- emerging weakness in the economy. As the year has omy may expand only slowly, if at all, for a while unfolded, the weakness has become more persistent longer. Nonetheless, a number of factors are in place and widespread than had seemed likely last autumn. thatshouldsetthestageforstrongergrowthlaterthis The shakeout in the high-technology sector has been year and in 2002. In particular, interest rates have especially severe, and with overall sales and profits declined since last fall; the lower rates have helped continuing to disappoint, businesses are curtailing businesses and households strengthen their financial purchasesofothertypesofcapitalequipmentaswell. positions and should show through to aggregate The slump in demand for capital goods has also demandincomingquarters.Therecentlyenactedtax worked against businesses’ efforts to correct the cutsandtheapparentcrestingofenergypricesshould inventoryimbalancesthatemergedinthesecondhalf also bolster aggregate demand fairly soon. In addi- oflastyearandhascontributedtosizabledeclinesin tion, as firms at some point become more satisfied manufacturing output this year. At the same time, with their inventory holdings, the cessation of liqui- foreign economies have slowed, limiting the demand dation will boost production and, in turn, provide a forU.S.exports. lifttoemploymentandincomes;asubsequentshiftto To foster financial conditions that will support inventory accumulation in association with the pro- strengthening economic growth, the FOMC has low- jected strengthening in demand should provide addi- ered its target for the federal funds rate four times tional impetus to production. Moreover, with no since February, bringing the cumulative decline this apparent sign of abatement in the rapid pace of year to 23⁄ 4 percentage points. A number of factors technologicalinnovation,theoutlookforproductivity spurred this unusually steep reduction in the federal growth over the longer run remains favorable. The fundsrate.Inparticular,theslowdowningrowthwas efficiency gains made possible by these innovations rapid and substantial and carried considerable risks should spur demand for the capital equipment that that the sluggish performance of the economy in the embodies the new technologies once the overall eco- first half of this year would persist. Among other nomic situation starts to improve and should support things, the abruptness of the slowing, by jarring consumption by leading to solid increases in real consumer and business confidence, raised the possi- incomesovertime. bility of becoming increasingly self-reinforcing were Eventhoughanappreciablerecoveryinthegrowth households and businesses to postpone spending of economic activity by early next year seems the while reassessing their situations. In addition, other mostlikelyoutcome,thereisasyetnohardevidence financial developments, including a higher foreign that this improvement is in train, and the situation exchangevalueofthedollar,lowerequityprices,and remains very uncertain. In these circumstances, the tighter lending terms and standards at banks, were FOMC continues to believe that the risks are tending to restrain aggregate demand and thus were weighted toward conditions that may generate eco- offsetting some of the influence of the lower federal nomic weakness in the foreseeable future. At the funds rate. Finally, despite some worrisome readings same time, the FOMC recognizes the importance of earlyintheyear,priceincreasesremainedfairlywell sustainingtheenvironmentoflowinflationandwell- 2 Monetary Policy Report to the Congress July 2001 Selectedinterestrates Percent 7.0 Intended federal funds rate Ten-year Treasury 6.5 6.0 5.5 5.0 Discount rate 4.5 Two-year Treasury 4.0 3.5 2/3 3/30 5/18 6/30 8/24 10/5 11/16 12/21 2/3 3/21 5/16 6/28 8/22 10/3 11/1512/191/3 1/31 3/20 4/185/15 6/27 1999 2000 2001 Note. ThedataaredailyandextendthroughJuly12,2001.Thedatesonthehorizontalaxis arethoseofscheduledFOMCmeetingsandofanyintermeetingpolicyactions. anchored inflation expectations that enabled the Fed- The timing and size of the cut in the target rate eral Reserve to react rapidly and forcefully to the seemed to ease somewhat the concerns of financial slowing in real GDP growth over the past several marketparticipantsaboutthelonger-termoutlookfor quarters.When,astheFOMCexpects,activitybegins theeconomy.EquitypricesgenerallyroseinJanuary, to firm, the Committee will continue to ensure that risk spreads on lower-rated corporate bonds nar- financial conditions remain consistent with holding rowed significantly, and the yield curve steepened. inflation in check, a key requirement for maximum However,incomingdataoverthemonthrevealedthat sustainablegrowth. the slowing in consumer and business spending late last year had been sizable. Furthermore, a sharp ero- sion in survey measures of consumer confidence, a Monetary Policy, Financial Markets, backupofinventories,andasteepdeclineincapacity and the Economy over the First Half of 2001 utilization posed the risk that spending could remain depressed for some time. In light of these develop- By the time of the FOMC meeting on December 19, ments, the FOMC at its scheduled meeting on Janu- 2000, it had become evident that economic growth ary 30 and 31 cut its target for the federal funds rate had downshifted considerably, but the extent of that another1⁄ 2 percentagepoint,to51⁄ 2 percent,andstated slowing was only beginning to come into focus. At that it continued to judge the risks to be weighted that meeting, the FOMC concluded that the risks to mainlytowardeconomicweakness. the economy in the foreseeable future had shifted to The information reviewed by the FOMC at its being weighted mainly toward conditions that may meetingonMarch20suggestedthateconomicactiv- generate economic weakness and that economic and ity continued to expand, but slowly. Although con- financial developments could warrant further close sumer spending seemed to be rising moderately and review of the stance of policy well before the next housing had remained relatively firm, stock prices scheduled meeting. Subsequent data indicated that had declined substantially in February and early holiday retail sales had come in below expectations March, and reduced equity wealth and lower con- and that conditions in the manufacturing sector had sumer confidence had the potential to damp house- deteriorated. Corporate profit forecasts had also been holdspendinggoingforward.Moreover,manufactur- marked down, and it seemed possible that the result- ing output had contracted further, as businesses ing decline in equity values, along with the expense continued to work down their excess inventories and of higher energy costs, could damp future business cut back on capital equipment expenditures. In addi- investment and household spending. In response, the tion, economic softness abroad raised the likelihood FOMC held a telephone conference on January 3, of a weakening in U.S. exports. Core inflation had 2001, and decided to reduce the target federal funds picked up a bit in January, but some of the increase rate 1⁄ 2 percentage point, to 6 percent, and indicated reflected the pass-through of a rise in energy prices that the risks to the outlook remained weighted that was unlikely to continue, and the FOMC judged towardeconomicweakness. thattheslowdowninthegrowthofaggregatedemand Board of Governors of the Federal Reserve System 3 would ease inflationary pressures on labor and other interest rates on longer-term Treasuries and on resources.Accordingly,theFOMConMarch20low- higher-quality private securities declined, some risk ered its target for the federal funds rate another spreads widened, and stock prices fell as financial 1⁄ 2 percentage point, to 5 percent. The members also market participants trimmed their expectations for continuedtoseetheriskstotheoutlookasremaining economic activity and profits. When the FOMC met weighted mainly toward economic weakness. Fur- on June 26 and 27, conditions in manufacturing thermore, the FOMC recognized that in a rapidly appeared to have worsened still more. It also seemed evolvingeconomicsituation,itwouldneedtobealert likely that slower growth abroad would restrain to the possibility that a conference call would be demandforexportsandthatweakeninglabormarkets desirable during the relatively long interval before would hold down growth in consumer spending. In the next scheduled meeting to discuss the possible light of these developments, but also taking into needforafurtherpolicyadjustment. account the cumulative 250 basis points of easing Capital markets continued to soften in late March already undertaken and the other forces likely to be and early April, in part because corporate profits and stimulating spending in the future, the FOMC low- economic activity remained quite weak. Although ered its target for the federal funds rate 1⁄ 4 percent- equity prices and bond yields began to rise in mid- age point, to 33⁄ 4 percent, and continued to view the Aprilasfinancialmarketinvestorsbecamemorecon- risks to the outlook as weighted toward economic fident that a cumulative downward spiral in activity weakness. could be avoided, reports continued to suggest flag- The Board of Governors of the Federal Reserve ging economic performance and risks of extended System approved cuts in the discount rate in the first weakness ahead. In particular, spending by consum- half of the year that matched the FOMC’s cuts in ers had leveled out and their confidence had fallen thetargetfederalfundsrate.Asaresult,thediscount further. The FOMC discussed economic develop- rate declined from 6 percent to 31⁄ 4 percent over the ments in conference calls on April 11 and April 18, period. decidingonthelatteroccasiontoreduceitstargetfor the federal funds rate another 1⁄ 2 percentage point, to 41⁄ 2 percent. The Committee again indicated that it Economic Projections for 2001 and 2002 judgedthebalanceofriskstotheoutlookasweighted towardeconomicweakness. The members of the Board of Governors and the WhentheFOMCmetonMay15,economiccondi- FederalReserveBankpresidents,allofwhompartici- tionsremainedquitesluggish,especiallyinmanufac- pate in the deliberations of the FOMC, expect eco- turing, where production and employment had nomicgrowthtoremainslowinthenearterm,though declined further. Although members were concerned most anticipate that it will pick up later this year at that some indicators of core inflation had moved up leastalittle.Thecentraltendencyoftheforecastsfor in the early months of the year and that part of the the increase in real GDP over the four quarters of recent backup in longer-term interest rates may have 2001 spans a range of 11⁄ 4 percent to 2 percent, and owed to increased inflation expectations, most saw the central tendency of the forecasts for real GDP underlyingpriceincreasesaslikelytoremaindamped growth in 2002 is 3 percent to 31⁄ 4 percent. The as continued subpar growth relieved pressures on civilianunemploymentrate,whichaveraged41⁄ 2 per- resources.Inlightoftheprospectofcontinuedweak- cent in the second quarter of 2001, is expected to ness in the economy and the significant risks to the moveuptotheareaof43⁄ 4 percentto5percentbythe economic expansion, the FOMC reduced its target endofthisyear.In2002,withtheeconomyprojected for the federal funds rate an additional 1⁄ 2 percentage to expand at closer to its trend rate, the unemploy- point, to 4 percent. With the softening in aggregate ment rate is expected to hold steady or perhaps to demand still of unknown persistence and dimension, edge higher. With pressures in labor and product theFOMCcontinuedtoviewtheriskstotheoutlook markets abating and with energy prices no longer as weighted toward economic weakness. Still, the soaring, inflation is expected to be well contained FOMC recognized that it had eased policy substan- overthenextyearandahalf. tially this year and that, in the absence of further DespitetheprojectedincreaseinrealGDPgrowth, sizable adverse shocks to the economy, at future the uncertainty about the near-term outlook remains meetings it might need to consider adopting a more considerable. This uncertainty arises not only from cautiousapproachtofurtherpolicyactions. the difficulty of assessing when businesses will feel Subsequent news on economic activity and cor- that conditions are sufficiently favorable to warrant a porate profits failed to point to a rebound. In June, pickupincapitalspendingbutalsofromthedifficulty 4 Monetary Policy Report to the Congress July 2001 Economicprojectionsfor2001and2002 benefit from a strengthening of the U.S. economy, a Percent stabilization of the global high-tech sector, an easing ofoilprices,andstimulativemacroeconomicpolicies BoardofGovernors andReserveBankpresidents insomecountries. Indicator Central The chain-type price index for personal consump- Range tendency tionexpendituresrose21⁄ 4 percentoverthefourquar- 2001 ters of 2000, and most FOMC participants expect inflationtoremainaroundthatratethroughnextyear; Change,fourthquarter tofourthquarter1 indeed, the central tendency of their forecasts for the NominalGDP .................... 31⁄4–5 31⁄2–41⁄4 RealGDP2 ....................... 1–2 11⁄4–2 increaseinthispricemeasureis2percentto21⁄ 2 per- PCEprices ....................... 2–23⁄4 2–21⁄2 cent in 2001 and 13⁄ 4 percent to 21⁄ 2 percent in 2002. Averagelevel, One favorable factor in the inflation outlook is the fourthquarter Civilianunemployment behaviorofenergyprices.Thosepriceshavedeclined rate.......................... 43⁄4–5 43⁄4–5 recently after having increased rapidly in the past 2002 couple of years, and prospects are good that they could stabilize or even fall further in coming quar- Change,fourthquarter tofourthquarter1 ters. In addition to their direct effects, lower energy NominalGDP .................... 43⁄4–6 5–51⁄2 RealGDP2 ....................... 3–31⁄2 3–31⁄4 pricesshouldtendtolimitincreasesinotherpricesby PCEprices ....................... 11⁄2–3 13⁄4–21⁄2 reducing input costs for a wide range of energy- Averagelevel, intensive goods and services and by helping damp fourthquarter Civilianunemployment inflation expectations. More broadly, the competitive rate.......................... 43⁄4–51⁄2 43⁄4–51⁄4 conditions that have restricted businesses’ ability to 1. Changefromaverageforfourthquarterofpreviousyeartoaveragefor raise prices in recent years are likely to persist. And fourthquarterofyearindicated. 2. Chain-weighted. although labor costs could come under upward pres- sure as wages tend to catch up to previous increases of gauging where businesses stand in the inventory in productivity, the slackening in resource utilization cycle. Nonetheless, all the FOMC participants fore- thisyearisexpectedtocontributetoreducedinflation see a return to solid growth by 2002. By then, the pressuresgoingforward. inventory correction should have run its course, and themonetarypolicyactionstakenthisyear,aswellas therecentlyenactedtaxreductions,shouldbeprovid- ECONOMIC AND FINANCIAL DEVELOPMENTS ingappreciablesupporttofinaldemand. IN 2001 In part because of lower interest rates, many firms have been able to shore up their balance sheets. And Economicgrowthremainedveryslowinthefirsthalf although some lower-rated firms, especially in of 2001 after having downshifted in the second half telecommunications and other sectors with gloomy of 2000. Real gross domestic product rose at an near-term prospects, may continue to find it difficult annual rate of just 11⁄ 4 percent in the first quarter, to obtain financing, businesses generally are fairly about the same as in the fourth quarter, and appears wellpositionedtostepuptheircapitalspendingonce to have posted at best a meager gain in the second the outlook for sales and profits improves. By all quarter. Businesses have been working to correct the accounts,technologicalinnovationisstillproceeding inventoryimbalancesthatemergedinthesecondhalf rapidly, and these advances should eventually revive of last year, which has led to sizable declines in high-tech investment, especially with the price of manufacturingoutput,andcapitalspendinghasweak- computingpowercontinuingtodropsharply. ened appreciably. In contrast, household spending— Inaddition,consumerspendingisexpectedtogeta especially for motor vehicles and houses—has held boost from the tax cuts and from falling energy up well. Employment increased only modestly over prices, which should help offset the effects of the the first three months of the year and turned down in weaker job market and the decline over the past year the spring; the unemployment rate in June stood at in stock market wealth. Housing activity, which has 41⁄ 2 percent, 1⁄ 2 percentage point higher than in the been buoyed in recent quarters by low mortgage fourthquarteroflastyear. interest rates, is likely to remain firm into 2002. The inflation news early this year was not very Significant concerns remain about the foreign eco- favorable, as energy prices continued to soar and as nomic outlook and the prospects for U.S. exports. measures of core inflation—which exclude food and Nevertheless,economicactivityabroadisexpectedto energy—registered some pickup. More recently, Board of Governors of the Federal Reserve System 5 ChangeinrealGDP Consumer Spending Percent, annual rate Real consumer spending grew at an annual rate of 31⁄ 2 percent in the first quarter. Some of the increase reflected a rebound in purchases of light motor vehi- 6 cles, which were boosted by a substantial expansion of incentives and rose to just a tad below the record pace of 2000 as a whole. In addition, outlays for 4 non-auto goods posted a solid gain, and spending on servicesrosemodestlydespiteaweather-relateddrop in outlays for energy services. In the second quarter, 2 however, the rise in consumer spending seems to Q1 havelessenedassalesoflightmotorvehiclesdropped a bit, on average, and purchases of other goods 1995 1996 1997 1998 1999 2000 2001 apparently did not grow as fast in real terms as they Note. Hereandinthesubsequentcharts,exceptasnoted,changeismea- hadinthefirstquarter. suredtothefinalquarteroftheindicatedperiodfromthefinalquarterofthe The rise in real consumption so far this year has precedingperiod. been considerably smaller than the outsized gains in the second half of the 1990s and into 2000. But the however, energy prices have moved lower, and the increase in spending still outstripped the growth in monthly readings on core inflation have returned to real disposable personal income (DPI), which has more moderate rates. Moreover, apart from energy, been restrained this year by further big increases in pricesatearlierstagesofprocessinghavebeenquies- consumer energy prices and by the deterioration in centthisyear. the job market; between the fourth quarter of 2000 and May, real DPI increased just about 2 percent at an annual rate, well below the average pace of the The Household Sector preceding few years. In addition, the net worth of households fell again in the first quarter, to a level Growthinhouseholdspendinghasslowednoticeably 8 percent below the high reached in the first quarter fromtherapidpaceofthepastfewyears.Still,itwas of 2000. On net, the ratio of household net worth to fairlywellmaintainedinthefirsthalfof2001despite DPI has returned to about the level reached in 1997, the weaker tenor of income, wealth, and consumer significantly below the recent peak but still high by confidence, and the personal saving rate declined a historical standards. In addition, consumer sentiment bit further. A greater number of households encoun- indexes, which had risen to extraordinary levels in tered problems servicing debt, but widespread diffi- the late 1990s and remained there through last fall, culties or restrictions on the availability of credit did fell sharply around the turn of the year. However, notemerge. these indexes have not deteriorated further, on net, ChangeinPCEchain-typepriceindex Changeinrealincomeandconsumption Percent, annual rate Percent, annual rate Total Excludingfoodandenergy Disposablepersonalincome 4 Personalconsumptionexpenditures 8 Q1 3 6 Q1 4 2 2 1 + 0 – 1995 1996 1997 1998 1999 2000 2001 1995 1996 1997 1998 1999 2000 2001 Note. Dataareforpersonalconsumptionexpenditures(PCE). 6 Monetary Policy Report to the Congress July 2001 since the winter and are still at reasonably favorable have offset the effect of the decline in wealth on the levels when compared with the readings for the pre- savingrate. 1997period. Rising household wealth almost certainly was a key factor behind the surge in consumer spending Residential Investment between the mid-1990s and last year, and thus helps to explain the sharp fall in the personal saving rate Housing activity remained buoyant in the first half overthatperiod.Thesavingratehascontinuedtofall of this year as lower mortgage interest rates appear this year—from −0.7 percent in the fourth quarter of to have offset the restraint from smaller gains in 2000 to −1.1 percent in May—even though the boost employment and income and from lower levels of to spending growth from the earlier run-up in stock wealth.Inthesingle-familysector,startsaveragedan prices has likely run its course and the effects of annual rate of 1.28 million units over the first five lower wealth should be starting to feed through to months of the year—4 percent greater than the hefty spending. The apparent decline in the saving rate pace for 2000 as a whole. Sales of new and existing may simply reflect noisiness in the data or a slower homes strengthened noticeably around the turn of response of spending to wealth than average histori- the year and were near record levels in March; they calexperiencemightsuggest.Inaddition,consumers fell back in April but reversed some of that drop in probably base their spending decisions on income May. Inventories of new homes for sale are excep- prospects over a longer time span than just a few tionally low; builders’ backlogs are sizable; and, quarters. Thus, to the extent that consumers do not accordingtotheMichigansurvey,consumers’assess- expectthecurrentsluggishnessinrealincomegrowth ments of homebuying conditions remain favorable, to persist, the tendency to maintain spending for a mainlybecauseofperceptionsthatmortgageratesare time by dipping into savings or by borrowing may low. Likelybecauseofthesustainedstrengthofhousing demand, home prices have continued to rise faster Wealthandsaving than overall inflation, although the various measures that attempt to control for shifts in the regional com- Ratio position of sales and in the characteristics of houses Wealth-to-incomeratio soldprovidedifferingsignalsonthemagnitudeofthe price increases. Notably, over the year ending in the 6 first quarter, the constant-quality price index for new homes rose 4 percent, while the repeat-sales price index for existing homes was up nearly 9 percent. 5 Despite the higher prices, the share of income required to finance a home purchase—one measure ofaffordability—hasfalleninrecentquartersasmort- 4 Privatehousingstarts Millions of units, annual rate Percent Personalsavingrate 14 Single-family 12 1.2 10 8 .8 6 4 Multifamily .4 2 + 0 – 1978 1982 1986 1990 1994 1998 2001 1989 1991 1993 1995 1997 1999 2001 Note. Thedataextendthrough2001:Q1.Thewealth-to-incomeratioisthe Note. Thedataextendthrough2001:Q2;thedataforthatquarterarethe ratioofhouseholdnetworthtodisposablepersonalincome. averagesforAprilandMay. Board of Governors of the Federal Reserve System 7 Mortgagerates Householddebtserviceburden Percent Percent 8.5 Fixedrate 14 8.0 7.5 13 7.0 Adjustablerate 6.5 12 6.0 1999 2000 2001 1985 1987 1989 1991 1993 1995 1997 1999 2001 Note. The data, which are monthly and extend through June 2001, are Note. Thedataarequarterlyandextendthrough2001:Q1.Debtburdenisan contractratesonthirty-yearmortgagesfromtheFederalHomeLoanMortgage estimate of the ratio of debt payments to disposable income; debt payments Corporation. consistoftheestimatedrequiredpaymentsonoutstandingmortgageandcon- sumerdebt. gage rates have dropped back after last year’s bulge, andthatsharecurrentlyisaboutaslowasithasbeen The household debt service burden—the ratio of at any time in the past decade. Rates on thirty-year minimumscheduledpaymentsonmortgageandcon- conventional fixed-rate loans now stand around sumer debt to disposable personal income—rose to 71⁄ 4 percent,andARMratesareattheirlowestlevels more than 14 percent at the end of the first quarter, a inacoupleofyears. twenty-yearhigh,andavailabledatasuggestasimilar In the multifamily sector, housing starts averaged reading for the second quarter. In part because of the 343,000 units at an annual rate over the first five elevated debt burden, some measures of household monthsoftheyear,matchingtherobustpacethathas loan performance have deteriorated a bit in recent beenevidentsince1997.Moreover,conditionsinthe quarters. The delinquency rate on home mortgage marketformultifamilyhousingcontinuetobecondu- loans has edged up but remains low, while the delin- civetonewconstruction.Thevacancyrateformulti- quency rate on credit card loans has risen noticeably family rental units in the first quarter held near its and is in the middle part of its range over the past low year-earlier level, and rents and property values decade. Personal bankruptcies jumped to record lev- continuedtoriserapidly. els in the spring, but some of the spurt was probably the result of a rush to file before Congress passed bankruptcyreformlegislation. Household Finance Delinquencyratesonhouseholdloans The growth of household debt is estimated to have slowedsomewhatinthefirsthalfofthisyeartoastill Percent fairlyhefty71⁄ 2 percentannualrate—aboutapercent- age point below its average pace over the previous Credit card accounts at banks 5 two years. Households have increased both their home mortgage debt and their consumer credit (debt 4 not secured by real estate) substantially this year, althoughinbothcasesthegrowthhasmoderatedabit 3 recently. The relatively low mortgage interest rates have boosted mortgage borrowing both by stimulat- Auto loans at domestic auto finance companies 2 ing home purchases and by making it attractive to refinance existing mortgages and extract some of the Mortgages 1 buildup in home equity. The rapid growth in con- sumer credit has been concentrated in credit card 1988 1990 1992 1994 1996 1998 2000 debt,perhapsreflectinghouseholds’effortstosustain Note. Thedataarequarterlyandextendthrough2001:Q1.Dataoncredit their consumption in the face of weaker income carddelinquenciesarefrombankCallReports;dataonautoloandelinquencies arefromtheBigThreeautomakers;dataonmortgagedelinquenciesarefrom growth. theMortgageBankersAssociation. 8 Monetary Policy Report to the Congress July 2001 Netpercentageoflargecommercialbankstightening Fixed Investment standardsforconsumerloans Real spending on equipment and software (E&S) Percent began to soften in the second half of last year, and it posted small declines in both the fourth quarter 50 of 2000 and the first quarter of 2001. Much of the Credit cards 40 weakness in the first quarter was in spending on high-tech equipment and software; such spending, 30 which now accounts for about half of E&S outlays when measured in nominal terms, declined at an 20 annual rate of about 12 percent in real terms—the 10 first real quarterly drop since the 1990 recession. An Other consumer loans + especially sharp decrease in outlays for communica- 0 – tionsequipmentreflectedtheexcesscapacitythathad emerged as a result of the earlier surge in spending, 1996 1997 1998 1999 2000 2001 the subsequent re-evaluation of profitability, and the Note. The data extend through May 2001 and are based on the Federal accompanying financing difficulties faced by some Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices, firms. In addition, real spending on computers and whichisgenerallyconductedfourtimesperyear.Netpercentageispercentage reportingatighteninglesspercentagereportinganeasing. peripheral equipment, which rose more than 40 per- centperyearinthesecondhalfofthe1990s,showed Lenders have tightened up somewhat in response little growth, on net, between the third quarter of tothedeteriorationofhouseholdfinancialconditions. 2000 and the first quarter of 2001. The leveling in In the May Senior Loan Officer Opinion Survey on real computer spending reportedly reflects some Bank Lending Practices, about a fifth of the banks stretching out of businesses’ replacement cycles for indicated that they had tightened the standards for personal computers as well as a reduced demand for approving applications for consumer loans over the servers. Outside the high-tech area, spending rose in preceding three months, and about a fourth said that the first quarter as purchases of motor vehicles theyhadtightenedthetermsonloanstheyarewilling reversed some of the decline recorded over the sec- to make, substantial increases from the November ond half of 2000 and as outlays for industrial equip- survey.Ofthosethathadtightened,mostcitedactual ment picked up after having been flat in the fourth or anticipated increases in delinquency rates as a quarter. reason. Real E&S spending likely dropped further in the secondquarter.Inadditiontotheongoingcontraction The Business Sector inoutlaysonhigh-techequipment,theincomingdata for orders and shipments point to a decline in invest- Theboomincapitalspendingthathashelpedfuelthe ment in non-high-tech equipment, largely reflecting economic expansion came to a halt late last year. theweaknessinthemanufacturingsectorthisyear. After having risen at double-digit rates over the pre- ceding five years, real business fixed investment flat- tened out in the fourth quarter of 2000 and rose only Changeinrealbusinessfixedinvestment alittleinthefirstquarterof2001.Demandforcapital Percent, annual rate equipment has slackened appreciably, reflecting the sluggish economy, sharply lower corporate profits Structures Equipmentandsoftware and cash flow, earlier overinvestment in some sec- tors,andtightfinancingconditionsfacingsomefirms. 20 Q1 Inaddition,inventoryinvestmentfellsubstantiallyin the first quarter as businesses moved to address the 10 overhangs that began to develop late last year. With investment spending weakening, businesses have cut back on new borrowing. Following the drop in + 0 longer-term interest rates in the last few months of – 2000, credit demands have been concentrated in longer-term markets, though cautious investors have requiredhighspreadsfrommarginalborrowers. 1995 1996 1997 1998 1999 2000 2001 Board of Governors of the Federal Reserve System 9 Outlays on nonresidential construction posted Firms outside the motor vehicles industry also another sizable advance in early 2001 after having moved aggressively to address inventory imbalances expandednearly13percentinrealtermsin2000,but in the first half of the year, and this showed through theincomingmonthlyconstructiondataimplyasharp to manufacturing output, which, excluding motor retrenchment in the second quarter. The downturn in vehicles,fellatanannualrateof71⁄ 2 percentoverthis spending comes on the heels of an increase in period. These production adjustments—along with a vacancy rates for office and industrial space in many sharp reduction in the flow of imports—contributed cities. Moreover, while financing generally remains to a small decline in real non-auto stocks in the first available for projects with viable tenants, lenders are quarter, and book-value data for the manufacturing now showing greater caution. Not surprisingly, one andtradesectorpointtoafurtherdecrease,onnet,in bright spot is the energy sector, where expenditures April and May. As of May, stocks generally seemed for drilling and mining have been on a steep uptrend in line with sales at retail trade establishments, but sinceearly1999(mainlybecauseofincreasedexplo- there were still some notable overhangs in wholesale ration for natural gas) and the construction of facili- trade and especially in manufacturing, where tiesforelectricpowergenerationremainsverystrong. inventory–shipments ratios for producers of comput- ers and electronic products, primary and fabricated metals,andchemicalsremainedveryhigh. Inventory Investment Asharpreductioninthepaceofinventoryinvestment Business Finance was a major damping influence on real GDP growth inthefirstquarterof2001.Theswinginrealnonfarm The economic profits of U.S. corporations fell at a inventory investment from an accumulation of 19 percent annual rate in the first quarter after a $51 billion at an annual rate in the fourth quarter of similar decline in the fourth quarter of 2000. As a 2000toaliquidationof$25billioninthefirstquarter result,theratioofprofitstoGDPdeclined1percent- of 2001 subtracted 3 percentage points from the age point over the two quarters, to 8.5 percent; growthinrealGDPinthefirstquarter.Nearlyhalfof the ratio of the profits of nonfinancial corp- the negative contribution to GDP growth came from orationstosectoroutputfell2percentagepointsover the motor vehicle sector, where a sizable cut in the interval, to 10 percent. Investment spending has assemblies(addedtothereductionalreadyinplacein declined by more than profits, however, reducing the fourth quarter) brought the overall days’ supply somewhat the still-elevated need of nonfinancial down to comfortable levels by the end of the first corporations for external funds to finance capital quarter.Ariseintruckassembliesearlyinthesecond expenditures. Corporations have husbanded their quarter led to some backup of inventories in that increasingly scarce internal funds by cutting back on segmentofthemarket,buttruckstockswerebackin cash-financedmergersandequityrepurchases.While an acceptable range by June; automobile assemblies wereuponlyalittleinthesecondquarter,andstocks Before-taxprofitsofnonfinancialcorporations remainedlean. asapercentofsectorGDP Percent Changeinrealnonfarmbusinessinventories Billions of chained 1996 dollars, annual rate 12 75 10 50 25 8 + 0 – 25 1977 1980 1983 1986 1989 1992 1995 1998 2001 Q1 Note. Dataextendthrough2001:Q1.Profitsarefromdomesticoperations ofnonfinancialcorporations,withinventoryvaluationandcapitalconsumption 1995 1996 1997 1998 1999 2000 2001 adjustments,dividedbygrossdomesticproductofnonfinancialcorporatesector. 10 Monetary Policy Report to the Congress July 2001 Financinggapandnetequityretirement Spreadoflow-tierCPrateoverhigh-tierCPrate atnonfarmnonfinancialcorporations Basis points Billions of dollars 125 250 Netequityretirement 100 200 150 75 100 Financinggap 50 50 25 + 0 – 1997 1998 1999 2000 2001 1991 1993 1995 1997 1999 2001 Note. ThedataaredailyandextendthroughJuly12,2001.Theseriesshown Note.Thedatathrough2000areannual;thefinalobservationisfor2001:Q1 isthedifferencebetweentherateonA2/P2nonfinancialcommercialpaperand andisatanannualrate.Thefinancinggapisthedifferencebetweencapital theAArate. expendituresandinternallygeneratedfunds.Netequityretirementisthediffer- encebetweenequityretiredthroughsharerepurchases,domesticcash-financed only by highly rated corporations, and default is mergers,orforeigntakeoversofU.S.firmsandequityissuedinpublicorprivate extremelyrare.Thedefaults,alongwithsomedown- markets,includingfundsinvestedbyventurecapitalpartnerships. grades, led investors in commercial paper to pull equity retirements have therefore fallen, so has gross back and reevaluate the riskiness of issuers. For a equity issuance, though by less. Inflows of venture while, issuance by all but top-rated names became equity capital, in particular, have been reduced sub- very difficult and quality spreads widened signifi- stantially. Businesses have met their financing needs cantly,pushingsomeissuersintotheshortestmaturi- by borrowing heavily in the bond market while pay- ties and inducing others to exit the market entirely. ingdownbothcommercialandindustrial(C&I)loans As a consequence, the amount of commercial paper at banks and commercial paper. In total, after having outstanding plummeted. In the second quarter, risk increased 91⁄ 2 percent last year, the debt of nonfinan- spreadsreturnedtomoretypicallevelsandtherunoff cial businesses rose at a 5 percent annual rate in the moderated. By the end of June, the amount of non- firstquarterofthisyearandisestimatedtohaverisen financial commercial paper outstanding was nearly ataboutthesamepaceinthesecondquarter. 30 percent below its level at the end of 2000, with The decline in C&I loans and commercial paper manyfirmsstillnothavingreturnedtothemarket. owes,inpart,tolesshospitableconditionsinshorter- Even though banks’ C&I loans were boosted in term funding markets. The commercial paper market JanuaryandFebruarybyborrowerssubstitutingaway was rattled in mid-January by the defaults of two Netpercentageofdomesticbankstighteningstandards large California utilities. Commercial paper is issued forcommercialandindustrialloans,bysizeofborrower Majorcomponentsofnetbusinessfinancing Percent Billions of dollars Commercial paper Sum of components 60 Bonds 500 Bank loans 400 Largeandmedium 40 300 20 200 Small + 100 0 – + 0 – 20 100 200 Q1 1991 1993 1995 1997 1999 2001 Q2 1999 2000 2001 Note. The data are based on the Federal Reserve’s Senior Loan Officer OpinionSurveyonBankLendingPractices,whichisgenerallyconductedfour Note. Seasonally adjusted annual rate for nonfarm nonfinancial corporate timesperyear.ThedataextendthroughMay2001.Smallfirmsarethosewith businesses.Thedatafor2001:Q2areestimated. annualsalesoflessthan$50million. Board of Governors of the Federal Reserve System 11 from the commercial paper market, loans declined, Liabilitiesoffailedbusinesses on net, over the first half of the year, in part because asaproportionoftotalliabilities borrowers paid down their bank loans with proceeds Percent from bond issues. Many banks reported on the Fed- Nonfinancialfirms eral Reserve’s Bank Lending Practices surveys this year that they had tightened standards and terms— including the premiums charged on riskier loans, the .9 cost of credit lines, and loan covenants—on C&I loans. Loan officers cited a worsened economic out- look,industry-specificproblems,andareducedtoler- June .6 ance for risk as the reasons for having tightened. Despite these adjustments to banks’ lending stance, credit appears to remain amply available for sound .3 borrowers, and recent surveys of small businesses indicate that they have not found credit significantly moredifficulttoobtain. 1991 1993 1995 1997 1999 2001 Meanwhile, the issuance of corporate bonds this Note. Annual average. Value for June 2001 is a twelve-month trailing year has proceeded at about double the pace of the average. Source. Dun&Bradstreet. preceding two years. With the yields on high-grade bonds back down to their levels in the first half of elevated spreads reflect the deterioration in business 1999andwithfuturesquotessuggestinginterestrates credit quality that has occurred as the economy has will be rising next year, corporations apparently slowed. While declines in interest rates have held judged it to be a relatively opportune time to issue. aggregateinterestexpenseatarelativelylowpercent- Although investors remain somewhat selective, they age of cash flow, many individual firms are feeling have been willing to absorb the large volume of the pinch of decreases in earnings. Over the twelve issuanceastheyhavebecomemoreconfidentthatthe months ending in May, 11 percent of speculative- economy would recover and a prolonged disruption grade bonds, by dollar volume, have defaulted—the to earnings would be avoided. The heavy pace of highestpercentagesince1991andasubstantialjump issuance has been supported, in part, by inflows into from 1998, when less than 2 percent defaulted. This bond mutual funds, which may have come at the deterioration reflects not only the unusually large expenseofequityfunds. defaults by the California utilities, but also stress in The flows are forthcoming at relatively high risk the telecommunications sector and elsewhere. How- spreads, however. Spreads of most grades of corpo- ever, some other measures of credit performance ratedebtrelativetoratesonswapshavefallenalittle have shown a more moderate worsening. The ratio thisyear,butspreadsremainunusuallyhighforlower of the liabilities of failed businesses to those of all investment-grade and speculative-grade credits. The nonfinancial businesses and the delinquency rate on C&I loans at banks have risen noticeably from their Netinterestpaymentsofnonfinancialcorporations lows in 1998, but both remain well below levels relativetocashflow postedintheearly1990s. Commercial mortgage debt increased at about an Percent 83⁄ 4 percent annual rate in the first half of this year, and the issuance of commercial-mortgage-backed securities (CMBS) maintained its robust pace of the 20 past several years. While spreads of the yields on investment- and speculative-grade CMBS over swap rates have changed little this year, significant frac- 15 tions of banks reported on the Bank Lending Prac- tices survey that they have tightened terms and stan- dards on commercial real estate loans. Although the 10 delinquency rates on CMBS and commercial real estate loans at banks edged up in the first quarter, they remained near record lows. Nevertheless, those 1977 1980 1983 1986 1989 1992 1995 1998 2001 commercial banks that reported taking a more cau- Note. Thedataarequarterlyandextendthrough2001:Q1. tiousapproachtowardcommercialrealestatelending 12 Monetary Policy Report to the Congress July 2001 statedthattheyaredoingso,inpart,becauseofaless NationalsavingasapercentofnominalGDP favorableeconomicoutlookingeneralandaworsen- Percent ingoftheoutlookforcommercialrealestate. The Government Sector Excludingfederalsaving 20 The fiscal 2001 surplus in the federal unified budget is likely to be smaller than the surplus in fiscal 2000 becauseoftheslowergrowthintheeconomyandthe recently enacted tax legislation. Nonetheless, the 16 unified surplus will remain large, and the paydown Total of the federal debt is continuing at a rapid clip. As a consequence, the Treasury has taken a number of steps to preserve liquidity in a shrinking market. The 1985 1989 1993 1997 2001 weaker economy is also reducing revenues at the Note. The data extend through 2001:Q1. National saving comprises the stateandlocallevel,butthesegovernmentsremainin grosssavingofhouseholds,businesses,andgovernments. reasonably good fiscal shape overall and are taking advantage of historically low interest rates to refund Federal receipts in the first eight months of the existingdebtandtoissuenewdebt. current fiscal year were just 41⁄ 2 percent higher than during the first eight months of fiscal 2000—a much Federal Government smaller gain than those posted, on average, over the preceding several years. Much of the slowing was in The fiscal 2001 surplus in the federal government’s corporate receipts, which dropped below year-earlier unified budget is likely to come in below the fiscal levels,reflectingtherecentdeteriorationinprofits.In 2000 surplus of $236 billion. Over the first eight addition, individual income tax payments rose less monthsofthefiscalyear—OctobertoMay—theuni- rapidly than over the preceding few years, mainly fied budget recorded a surplus of $137 billion, because of slower growth in withheld tax payments. $16billionhigherthanduringthecomparableperiod This spring’s nonwithheld payments of individual last year. But over the balance of the fiscal year, taxes, which are largely payments on the previous receipts will continue to be restrained by this year’s year’s liability, were relatively strong. Indeed, slow pace of economic growth and the associated although there was no appreciable ‘‘April surprise’’ decline in corporate profits. Receipts will also be this year—that is, these payments were about in line reducedsignificantlyoverthenextfewmonthsbythe with expectations—liabilities again appear to have payout of tax rebates and the shift of some corporate risen faster than the NIPA tax base in 2000. One payments into fiscal 2002, provisions included in the factor that has lifted liabilities relative to income in EconomicGrowthandTaxReliefReconciliationAct recent years is that rising levels of income and a of2001. changing distribution have shifted more taxpayers Federal saving, which is basically the unified bud- into higher tax brackets. Higher capital gains reali- get surplus adjusted to conform to the accounting zations also have helped raise liabilities relative to practicesfollowedinthenationalincomeandproduct the NIPA tax base over this period. (Capital gains accounts (NIPA), has risen dramatically since hitting arenotincludedintheNIPAincomemeasure,which, a low of −31⁄ 2 percent of GDP in 1992 and stood at by design, includes only income from current 33⁄ 4 percent of GDP in the first quarter—a swing of production.) more than 7 percentage points. Reflecting the high The faster growth in outlays that emerged in fiscal level of federal saving, national saving, which com- 2000 has extended into fiscal 2001. Smoothing prisessavingbyhouseholds,businesses,andgovern- through some timing anomalies at the start of the ments,hasbeenrunningatahigherratesincethelate fiscal year, nominal spending during the first eight 1990s than it did over most of the preceding decade, monthsoffiscal2001wasmorethan4percenthigher even as the personal saving rate has plummeted. The than during the same period last year; excluding the deeper pool of national saving, along with large sizabledropinnetinterestoutlaysthathasaccompa- inflows of foreign capital, has provided resources for nied the paydown of the federal debt, the increase in the technology-driven boom in domestic investment spendingsofarthisyearwasnearly6percent.Spend- inrecentyears. ing in the past couple of years has been boosted by Board of Governors of the Federal Reserve System 13 sizable increases in discretionary appropriations as with a four-week maturity to provide it with greater well as by faster growth in outlays for the major flexibility and cost efficiency in managing its cash health programs. The especially rapid increase in balances, which, in part because new securities are Medicaid outlays reflects the higher cost and utiliza- now issued less frequently, have become more vola- tion of medical care (including prescription drugs), tile. Finally, also in May, the Treasury announced it growing enrollments, and a rise in the share of would in the next few months seek public comment expenses picked up by the federal government. Out- on a plan to ease the ‘‘35 percent rule,’’ which limits lays for Medicare have been lifted, in part, by the the bidding at auctions by those holding claims on higherreimbursementstoprovidersthatwereenacted large amounts of an issue. With reopenings increas- lastyear. ingly being used to maintain liquidity in individual Real federal expenditures for consumption and issues,thisrulewasconstrainingmanypotentialbid- gross investment, the part of government spending ders. As discussed below, the reduced issuance of that is included in GDP, rose at a 5 percent annual Treasury securities has also led the Federal Reserve rateinthefirstquarter.Overthepastcoupleofyears, tomodifyitsproceduresforacquiringsuchsecurities real nondefense purchases have remained on the andtostudypossiblefuturestepsforitsportfolio. moderate uptrend that has been evident since the Inearly2000,asinvestorsfocusedonthepossibil- mid-1990s,whilerealdefensepurchaseshavestarted ity that Treasury securities were going to become to rise slowly after having bottomed out in the late increasingly scarce, they became willing to pay a 1990s. premium for longer-dated securities, pushing down The Treasury has used the substantial federal bud- their yields. However, these premiums appear to getsurplusestopaydownitsdebtfurther.Attheend have largely unwound later in the year as market of June, the outstanding Treasury debt held by the participants made adjustments to the new environ- public had fallen nearly $600 billion, or 15 percent, ment. These adjustments include the substitution of from its peak in 1997. Relative to nominal GDP, alternative instruments for hedging and pricing, such publicly held debt has dropped from nearly 50 per- as interest rate swaps, prominent high-grade cor- centinthemid-1990stobelow33percentinthefirst porate bonds, and securities issued by government- quarter,thelowestithasbeensince1984. sponsoredenterprises(GSEs).Tobenefitfromadjust- Declinesinoutstandingfederaldebtandtheassoci- ments by market participants, in 1998, Fannie Mae atedreductionsinthesizesandfrequencyofauctions and Freddie Mac initiated programs to issue securi- of new issues have diminished the liquidity of the ties that share some characteristics with Treasury Treasury market over the past few years. Bid–asked securities, such as regular issuance calendars and spreads are somewhat wider, quote sizes are smaller, large issue sizes; in the first half of this year they andthedifferencebetweenyieldsonseasonedversus issued $88 billion of coupon securities and $502 bil- most-recentlyissuedsecuritieshasincreased.Inpart, lion of bills under these programs. The GSEs have however,thesedevelopmentsmayalsoreflectamore also this year begun buying back older securities to cautious attitude among securities dealers following boost the size of their new issues. Nevertheless, the themarketturmoilinthefallof1998. market for Treasury securities remains considerably The Treasury has taken a number of steps to limit more liquid than markets for GSE and other fixed- the deterioration in the liquidity of its securities. In incomesecurities. recent years, it has concentrated its issuance into fewer securities, so that the auction sizes of the remaining securities are larger. Last year, in order to State and Local Governments enable issuance of a larger volume of new securities, the Treasury began buying back less-liquid older State and local governments saw an enormous securities, and it also made every second auction of improvement in their budget positions between the its5-and10-yearnotesand30-yearbondareopening mid-1990s and last year as revenues soared and of the previously issued security. In February, the spending generally was held in check; accordingly, Treasury put limits on the noncompetitive bids that thesegovernmentswereablebothtolowertaxesand foreign central banks and governmental monetary tomakesubstantialallocationstoreservefunds.More entities may make, so as to leave a larger and more recently, however, revenue growth has slowed in predictable pool of securities available for competi- many states, and reports of fiscal strains have tive bidding, helping to maintain the liquidity and increased. Nonetheless, the sector remains in rela- efficiency of the market. In May, the Treasury tively good fiscal shape overall, and most govern- announced that it would begin issuing Treasury bills ments facing revenue shortfalls have managed to 14 Monetary Policy Report to the Congress July 2001 adopt balanced budgets for fiscal 2002 with only U.S.currentaccount minoradjustmentstotaxesandspending. Billions of dollars, annual rate Real consumption and investment spending by stateandlocalgovernmentsroseatnearlya5percent + annualrateinthefirstquarterandapparentlyposteda 0 – sizable increase in the second quarter as well. Much of the strength this year has been in construction 100 spending, which has rebounded sharply after a reported decline in 2000 that was hard to reconcile 200 withthesector’songoinginfrastructureneedsandthe good financial condition of most governments. Hir- 300 ing also remained fairly brisk during the first half of the year; on average, employment rose 30,000 per 400 month, about the same as the average monthly Q1 increaseovertheprecedingthreeyears. 1995 1996 1997 1998 1999 2000 2001 Although interest rates on municipal debt have edged up this year, they remain low by historical standards. State and local governments have taken inAprilcontinuedataboutthesamepace.Netinvest- advantage of the low interest rates to refund existing ment income payments were a bit less in the first debt and to raise new capital. Credit quality has quarter than the average for last year primarily remained quite high in the municipal sector even as because of a sizable decrease in earnings by U.S. tax receipts have softened, with credit upgrades out- affiliatesofforeignfirms. pacingdowngradesinthefirsthalfofthisyear.Most As U.S. economic growth slowed in the second notable among the downgrades was that of Califor- half of last year and early this year, real imports of nia’s general obligation bonds. Standard and Poor’s goods and services, which had grown very rapidly in lowered California’s debt two notches from AA to thefirstthreequartersof2000,expandedmoreslowly A+, citing the financial pressures from the electricity in the fourth quarter and then contracted 5 percent at crisis and the likely adverse effects of the crisis on anannualrateinthefirstquarter.Thelargestdeclines thestate’seconomy. were in high-tech products (computers, semiconduc- tors, and telecommunications equipment) and auto- motive products. In contrast, imports of petroleum The External Sector andpetroleumproductsincreasedmoderately.Atem- porary surge in the price of imported natural gas The deficits in U.S. external balances narrowed pushed the increase of the average price of non-oil sharply in the first quarter of this year, largely imports above an annual rate of 1 percent in the first because of a smaller deficit in trade in goods and quarter, slightly higher than the rate of increase services. Most of the financial flows into the United recordedin2000. States continued to come from private foreign U.S.realexportswerehitbyslowergrowthabroad, sources. the strength of the dollar, and plunging global demandforhigh-techproducts.Realexportsofgoods and services, which had grown strongly in the first Trade and Current Account three quarters of 2000, fell 61⁄ 2 percent at an annual rate in the fourth quarter of last year and declined After widening continuously during the past four another1percentinthefirstquarterofthisyear.The years, the deficits in U.S. external balances narrowed largest declines in both quarters were in high-tech in the first quarter of 2001. The current account capital goods and automotive products (primarily in deficit in the first quarter was $438 billion at an intra-firmtradewithCanada).Bymarketdestination, annual rate, or 4.3 percent of GDP, compared with thelargestincreasesinU.S.goodsexportsduringthe $465billioninthefourthquarterof2000.Mostofthe first three quarters of 2000 had been to Mexico and reduction of the current account deficit can be traced countries in Asia; the recent declines were mainly in to changes in U.S. trade in goods and services; exportstoAsiaandLatinAmerica.Incontrast,goods the trade deficit narrowed from an annual rate of exports to Western Europe increased steadily $401billioninthefourthquarterof2000to$380bil- throughout the entire period. About 45 percent of lion in the first quarter of this year. The trade deficit U.S. goods exports in the first quarter of 2001 were Board of Governors of the Federal Reserve System 15 Changeinrealimportsandexportsofgoodsandservices U.S.internationalsecuritiestransactions Percent, annual rate Billions of dollars Imports Private foreign purchases of U.S. securities Exports 20 Net foreign purchases of U.S. bonds 150 Net foreign purchases of U.S. equities 15 125 10 100 5 + 75 0 – 50 5 Q1 25 1995 1996 1997 1998 1999 2000 2001 Note. Changeforthehalf-yearindicatedismeasuredfromthepreceding half-year,andthechangefor2001:Q1isfrom2000:Q4.Importsandexportsfor eachhalf-yeararetheaverageofthelevelsforcomponentquarters. Private U.S. purchases of foreign securities Net U.S. purchases of foreign bonds 125 capital equipment; 20 percent were industrial sup- Net U.S. purchases of foreign equities plies; and 5 to 10 percent each were agricultural, 100 automotive,consumer,andothergoods. After increasing through much of 2000, the spot 75 price of West Texas intermediate (WTI) crude oil 50 reached a peak above $37 per barrel in September, the highest level since the Gulf War. As world eco- 25 nomic growth slowed in the latter part of 2000, oil + pricedeclinesreversedmuchoftheyear’spricegain. 0 – In response, OPEC reduced its official production targetsinJanuaryofthisyearandagaininMarch.As 1999 2000 2001 a result, oil prices have remained relatively high in Source. DepartmentofCommerce,SurveyofCurrentBusiness. 2001 despite weaker global economic growth and a substantial increase in U.S. oil inventories. Oil prices chases of U.S. bonds, as foreign purchases of both have also been elevated by the volatility of Iraqi oil corporate and agency bonds accelerated and private exports arising from tense relations between Iraq foreignsalesofTreasuriespaused.Foreignpurchases andtheUnitedNations.Duringthefirstsixmonthsof of U.S. equities are only slightly below their 2000 this year, the spot price of WTI has fluctuated, with pace despite the apparent decline in expected returns only brief exceptions, between $27 and $30 per toholdingU.S.equities. barrel. The pace at which U.S. residents acquired foreign securities changed little between the second half of last year and the first quarter of this year. As Financial Account in previous years, most of the foreign securities acquiredwereequities. Inthefirstquarterof2001,aswasthecasein2000as Net financial inflows associated with direct invest- a whole, nearly all of the net financial flows into the ment slowed a good bit in the first quarter, as there United States came from private foreign sources. were significantly fewer large foreign takeovers of Foreign official inflows were less than $5 billion and U.S. firms and U.S. direct investment abroad were composed primarily of the reinvestment of remainedrobust. accumulated interest earnings. Reported foreign exchange intervention purchases of dollars were modest. The Labor Market Inflows arising from private foreign purchases of U.S. securities accelerated further in the first quarter Labor demand weakened in the first half of 2001, and are on a pace to exceed last year’s record. All of especially in manufacturing, and the unemployment the pickup is attributable to larger net foreign pur- rate rose. Increases in hourly compensation have 16 Monetary Policy Report to the Congress July 2001 continued to trend up in recent quarters, while mea- Measuresoflaborutilization sured labor productivity has been depressed by the Percent slowergrowthofoutput. 15 Employment and Unemployment Augmented unemployment rate 12 After having risen an average of 149,000 per month in 2000, private payroll employment increased an 9 average of only 63,000 per month in the first quarter 6 of 2001, and it declined an average of 117,000 per month in the second quarter. The unemployment rate Civilian unemployment rate 3 moved up over the first half of the year and in June stood at 41⁄ 2 percent, 1⁄ 2 percentage point higher than inthefourthquarteroflastyear. 1970 1975 1980 1985 1990 1995 2000 Much of the weakness in employment in the first Note. ThedataextendthroughJune2001.Theaugmentedunemployment rateisthenumberofunemployedplusthosewhoarenotinthelaborforceand half of the year was in the manufacturing sector, wantajob,dividedbythecivilianlaborforceplusthosewhoarenotinthelabor where job losses averaged 78,000 per month in the forceandwantajob.InJanuary1994,aredesignedsurveywasintroduced;data fromthatpointonarenotdirectlycomparablewiththoseofearlierperiods. first quarter and 116,000 per month in the second quarter. Since last July, manufacturing employment help-supply firms) also slowed markedly in the sec- has fallen nearly 800,000. Factory job losses were ond quarter. Employment in retail trade remained on widespread in the first half of the year, with some of amoderateuptrendoverthefirsthalfoftheyear,and the biggest cutbacks at industries struggling with employment in finance, insurance, and real estate sizable inventory overhangs, including metals and increased modestly after having been unchanged, on industrial and electronic equipment. The weakness net,lastyear. in manufacturing also cut into employment at help- supplyfirmsandatwholesaletradeestablishments. Apart from manufacturing and the closely related Labor Costs and Productivity help-supply and wholesale trade industries, employ- ment growth held up fairly well in the first quarter Through the first quarter, compensation growth but began to slip noticeably in the second quarter. remained quite strong—indeed, trending higher by Someoftheslowinginthesecondquarterreflecteda somemeasures.Thesegainslikelyreflectedtheinflu- drop in construction employment after a strong first ence of earlier tight labor markets, higher consumer quarter that likely absorbed a portion of the hiring price inflation—largely due to soaring energy that normally takes place in the spring; on average, prices—and the greater real wage gains made pos- construction employment rose a fairly brisk 15,000 sible by faster structural productivity growth. The per month over the first half, about the same as upward pressures on labor costs could abate in com- in 2000. Hiring in the services industry (other than ing quarters if pressures in labor markets ease and energypricesfallback. Netchangeinprivatenonfarmpayrollemployment Hourlycompensation,asmeasuredbytheemploy- ment cost index (ECI) for private nonfarm busi- Thousands of jobs, monthly average nesses, moved up in the first quarter to a level about 41⁄ 4 percent above its level of a year earlier; this compares with increases of about 41⁄ 2 percent over 400 theprecedingyearand3percentovertheyearbefore that. The slight deceleration in the most recent twelve-monthchangeintheECIisaccountedforbya 200 slowdown in the growth of compensation for sales workers relative to the elevated rates that had pre- + vailed in early 2000; these workers’ pay includes a 0 – substantial commission component and thus is espe- cially sensitive to cyclical developments. Compensa- Q2 tionperhourinthenonfarmbusinesssector—amea- 1991 1993 1995 1997 1999 2001 sure that picks up some forms of compensation that Board of Governors of the Federal Reserve System 17 Measuresofchangeinhourlycompensation Changeinoutputperhour,nonfarmbusinesses Percent Percent 6 6 4 4 Q1 2 Employmentcostindex 2 + 0 – Nonfarmcompensationperhour 1993 1995 1997 1999 2001 1993 1995 1997 1999 2001 Note. The data extend through 2001:Q1. The ECI is for private industry Note. ChangesareQ4toQ4exceptthechangefor2001:Q1,whichisfrom excludingfarmandhouseholdworkers.Nonfarmcompensationperhourisfor 2000:Q1. thenonfarmbusinesssector. Measured labor productivity in the nonfarm busi- ness sector has been bounced around in recent quar- the ECI omits but that sometimes has been revised ters by erratic swings in hours worked by self- substantially once the data go through the annual employed individuals, but on balance, it has barely revision process—shows a steady uptrend over the risen since the third quarter of last year after having past couple of years; it rose 6 percent over the year increased about 3 percent per year, on average, over ending in the first quarter after having risen 41⁄ 2 per- theprecedingthreeyears.Thisdecelerationcoincides centovertheprecedingyear. with a marked slowing in output growth and seems AccordingtotheECI,wagesandsalariesroseatan broadly in line with the experience of past busi- annual rate of about 41⁄ 2 percent in the first quarter. ness cycles; these readings remain consistent with a Excluding sales workers, wages rose 5 percent noticeableaccelerationinstructuralproductivityhav- (annual rate) in the first quarter and 41⁄ 4 percent over ingoccurredinthesecondhalfofthe1990s.Reflect- the year ending in March; this compares with an ing the movements in hourly compensation and in increaseof33⁄ 4 percentovertheyearendinginMarch actual productivity, unit labor costs in the nonfarm 2000. Separate data on average hourly earnings of business sector jumped in the first quarter and have production or nonsupervisory workers also show a discernableaccelerationofwages:Thetwelve-month risen31⁄ 2 percentoverthepastyear. Looking ahead, prospects for favorable productiv- change in this series was 41⁄ 4 percent in June, 1⁄ 2 per- ity performance will hinge on a continuation of the centage point above the reading for the preceding rapid technological advances of recent years and on twelvemonths. Benefit costs as measured in the ECI have risen Changeinunitlaborcosts,nonfarmbusinesses fasterthanwagesoverthepastyear,withtheincrease over the twelve months ending in March totaling Percent 5percent.Muchofthepressureonbenefitsiscoming Q1 from health insurance, where employer payments have accelerated steadily since bottoming out in the 3 mid-1990sandarenowgoingupabout8percentper year. The surge in spending on prescription drugs accounts for some of the rise in health insurance 2 costs, but demand for other types of medical care is increasing rapidly as well. Moreover, although there hasbeensomerevampingofdrugcoveragetocounter 1 the pressures of soaring demand, many employers have been reluctant to adjust other features of the health benefits package in view of the need to retain 1993 1995 1997 1999 2001 workers in a labor market that has been very tight in Note. ChangesareQ4toQ4exceptthechangefor2001:Q1,whichisfrom recentyears. 2000:Q1. 18 Monetary Policy Report to the Congress July 2001 the willingness of businesses to expand and update sizable advance in the second quarter. Unlike the their capital stocks to take advantage of the new surges in energy prices in 1999 and 2000, the efficiency-enhancing capital that is becoming avail- increases in the first half of 2001 were not driven by able at declining cost in many cases. To be sure, the developments in crude oil markets. Indeed, natural current weakness in business investment will likely gas prices were the major factor boosting overall damp the growth of the capital stock relative to the energy prices early this year as tight inventories and paceofthepastcoupleofyears.Butoncethecyclical concerns about potential stock-outs pushed spot weakness in the economy dissipates, continued prices to extremely high levels; natural gas prices advances in technology should provide impetus to have since receded as additional supplies have come renewed capital spending and a return to solid on line and inventories have been rebuilt. In the increasesinproductivity. spring, gasoline prices soared in response to strong demand,refinerydisruptions,andconcernsaboutlean inventories; with refineries back on line, imports up, Prices and inventories restored, gasoline prices have since fallen noticeably below their mid-May peaks. Elec- Inflation moved higher in early 2001 but has mod- tricitypricesalsorosesubstantiallyinthefirsthalfof erated some in recent months. After having risen the year, reflecting higher natural gas prices as well 21⁄ 4 percent in 2000, the chain price index for per- as the problems in California. Capacity problems sonal consumption expenditures (PCE) increased in California and the hydropower shortages in the about 31⁄ 4 percent in the first quarter of 2001 as Northwestpersist,thoughCalifornia’selectricitycon- energy prices soared and as core consumer prices— sumption has declined recently and wholesale prices which exclude food and energy—picked up. Energy have dropped. In contrast, capacity in the rest of the prices continued to rise rapidly in April and May but country has expanded appreciably over the past year eased in June and early July. In addition, core PCE and, on the whole, appears adequate to meet the priceinflationhasdroppedbackafterthefirst-quarter normalseasonalriseindemand. spurt, and the twelve-month change in this series, Core PCE prices rose at a 21⁄ 2 percent annual rate whichisausefulindicatoroftheunderlyinginflation inthefirstquarter—aheftyincreasebythestandards trend,stoodat11⁄ 2 percentinMay,aboutthesameas of recent years. But the data are volatile, and the the change over the preceding twelve months. The first-quarter increase, no doubt, exaggerates any core consumer price index (CPI) continued to move pickup. Based on monthly data for April and May, up at a faster pace than the core PCE measure over core PCE inflation appears to have slowed consider- the past year, rising 21⁄ 2 percent over the twelve ably in the second quarter; the slowing was concen- monthsendinginMay,alsothesamerateasoverthe trated in the goods categories and seems consistent precedingyear. with reports that retailers have been cutting prices to PCE energy prices rose at an annual rate of about spursalesinanenvironmentofsoftdemand. 11 percent in the first quarter and, given the big Core consumer price inflation—whether measured increasesinAprilandMay,apparentlypostedanother by the PCE index or by the CPI—in recent quarters Changeinconsumerprices Changeinconsumerpricesexcludingfoodandenergy Percent, annual rate Percent, annual rate Chain-typepriceindexforPCE Chain-typepriceindexforPCE CPI CPI 6 5 Q1 5 4 4 3 Q1 3 2 2 1 1 1993 1995 1997 1999 2001 1993 1995 1997 1999 2001 Note. TheCPIisforallurbanconsumers(CPI-U). Note. TheCPIisforallurbanconsumers(CPI-U). Board of Governors of the Federal Reserve System 19 almost certainly has been boosted by the effects of rable year-earlier period. The price index for gross higher energy prices on the costs of producing other domestic purchases—which is defined as the prices goods and services. Additional pressure has come paid for consumption, investment, and government from the step-up in labor costs. That said, firms purchases—also accelerated in the first quarter—to appeartohaveabsorbedmuchofthesecostincreases an increase of about 23⁄ 4 percent; the increase in this in lower profit margins. Meanwhile, non-oil import measureoverthepastyearwas21⁄ 4 percent,aboutthe prices have remained subdued, thus continuing to same as over the preceding year. Excluding food and restrain input costs for many domestic industries and energy, the latest four-quarter changes in both GDP tolimittheabilityoffirmsfacingforeigncompetition andgrossdomesticpurchasespriceswereroughlythe to raise prices for fear of losing market share. In sameasovertheprecedingyear. addition, apart from energy, price pressures at earlier stages of processing have been minimal. Indeed, excluding food and energy, the producer price index U.S. Financial Markets (PPI)forintermediatematerialshasbeenflatoverthe past year, and the PPI for crude materials has fallen Longer-term interest rates and equity prices have 11 percent. Moreover, inflation expectations, on bal- shown remarkably small net changes this year, given ance,seemtohaveremainedquiescent:Accordingto the considerable shifts in economic prospects and the Michigan survey, the median expectation for major changes in monetary policy. To some extent, inflation over the upcoming year generally has been the expectations of the economic and policy devel- running about 3 percent this year, similar to the opments in 2001 had already become embedded in readingsin2000. financial asset prices as last year came to a close; Incontrasttothestep-upinconsumerprices,prices from the end of August through year-end, the broad- for private investment goods in the NIPA were up est equity price indexes fell 15 percent and only a little in the first quarter after having risen investment-gradebondyieldsdeclined40to70basis about 2 percent last year. In large part, this pattern points. In addition, however, equity prices and long- was driven by movements in the price index for term interest rates were influenced importantly by computers, which fell at an annual rate of nearly growing optimism in financial markets over the sec- 30percentinthefirstquarterasdemandforhigh-tech ond quarter of 2001 that the economy and profits equipment plunged. This drop in computer prices would rebound strongly toward the end of 2001 and wasconsiderablygreaterthantheaveragedecreaseof in 2002. On net, equity prices fell 6 percent in the roughly 20 percent per year in the second half of the first half of this year as near-term corporate earnings 1990sandtheunusuallysmall11percentdecreasein were revised down substantially. Rates on longer- 2000.MonthlyPPIdatasuggestthatcomputerprices termTreasuryissuesrosealittle,butthoseoncorpo- were down again in the second quarter, though much ratebondswereaboutunchanged,withthenarrowing lessthaninthefirstquarter. spread reflecting greater investor confidence in the Alltold,theGDPchain-typepriceindexroseatan outlook.Butriskspreadsremainedwidebyhistorical annual rate of 31⁄ 4 percent in the first quarter and has standards for businesses whose debt was rated as risen 21⁄ 4 percent over the past four quarters, an marginallyinvestmentgradeorbelow;manyofthese acceleration of 1⁄ 2 percentage point from the compa- firms had been especially hard hit by the slowdown andthenear-termoversupplyofhigh-techequipment Alternativemeasuresofpricechange and services, and defaults by these firms became Percent,Q1toQ1 more frequent. Nevertheless, for most borrowers the 1998 1999 2000 environment for long-term financing was seen to be Pricemeasure to to to quite favorable, and firms and households tended to 1999 2000 2001 taplong-termsourcesofcreditinsizetobolstertheir Chain-type financialconditionsandlockinmorefavorablecosts. Grossdomesticproduct .............. 1.5 1.8 2.3 Grossdomesticpurchases ............ 1.2 2.3 2.2 Personalconsumptionexpenditures ... 1.5 2.5 2.2 Excludingfoodandenergy......... 1.8 1.6 1.7 Fixed-weight Interest Rates Consumerpriceindex................ 1.7 3.3 3.4 Excludingfoodandenergy......... 2.2 2.2 2.7 In response to the abrupt deceleration in economic Note. A fixed-weight index uses quantity weights from a base year to aggregatepricesfromeachdistinctitemcategory.Achain-typeindexisthe growth and prospects for continued weakness in the geometricaverageoftwofixed-weightindexesandallowstheweightstochange economy,theFOMCloweredthetargetfederalfunds eachyear.Theconsumerpriceindexesareforallurbanconsumers.Changesare basedonquarterlyaverages. rate23⁄ 4 percentagepointsinsixstepsinthefirsthalf 20 Monetary Policy Report to the Congress July 2001 RatesonselectedTreasurysecurities Measuresoflong-terminflationexpectations Percent Percent Two-year 6.5 Ten-year FRBPhiladelphiasurvey 3.5 6.0 Michigansurvey 3.0 5.5 Three-month 5.0 2.5 4.5 2.0 4.0 TIISinflationcompensation 1.5 3.5 J FMAMJ J ASOND J FMAMJ J ASOND J FMAMJ J J FMAMJ J ASOND J FMAMJ J ASOND J FMAMJ J 1999 2000 2001 1999 2000 2001 Note. ThedataaredailyandextendthroughJuly12,2001. Note. The data for the Michigan survey, which are monthly and extend through June 2001, measurefive-year to ten-year inflation expectations. The datafortheFRBPhiladelphiasurvey,whicharequarterlyandextendthrough 2001:Q2,measureten-yearinflationexpectations.TIISinflationcompensation is the rate of inflation at which the price of the ten-year Treasury inflation- of this year, an unusually steep decline relative to indexedsecurityequalsthevalueofaportfolioofzero-couponsecuritiesthat many past easing cycles. Through March, the policy replicatesitspayments;dataforthismeasureareweeklyaveragesandextend throughJuly13,2001. easings combined with declining equity prices and accumulating evidence that the slowdown in eco- nomic growth was more pronounced than had been thesecondquarter.Despitethisincrease,thereislittle initially thought led to declines in yields on evidence that inflation is expected to go up from its intermediate- and longer-term Treasury securities. current level. At the end of last year, inflation com- Over the second quarter, despite the continued pensation had declined to levels suggesting investors decreaseinshort-termratesandfurtherindicationsof expected inflation to fall, and the rise in inflation a weakening economy, yields on intermediate-term compensation in the second quarter largely reversed Treasury securities were about unchanged, while thosedeclines.Moreover,surveymeasuresoflonger- those on longer-term securities rose appreciably. On term inflation expectations have changed little since net, yields on intermediate-term Treasury securities themiddleoflastyear. fell about 3⁄ 4 percentage point in the first half of this Yields on longer-maturity corporate bonds were year, while those on longer-term Treasury securities about unchanged, on net, over the first half of this roseabout1⁄ 4 percentagepoint. year.Yieldsoninvestment-gradebondsareneartheir The increase in longer-term Treasury yields in the lows for the past ten years, but those on speculative- second quarter appears to have been the result of a grade bonds are elevated. Spreads of corporate bond numberoffactors.Themaininfluenceseemstohave yields relative to swap rates narrowed a bit, although been increased investor confidence that the economy they still remain high. Amidst signs of deteriorating would soon pick up. That confidence likely arose in credit quality and a worsening outlook for corporate part from the aggressive easing of monetary policy earnings, risk spreads on speculative-grade bonds andalsoinpartfromtheimprovingprospectsfor,and had risen by about 2 percentage points late last year, passage of, a sizable tax cut. The tax cut and the reaching levels not seen since 1991. Much of this growing support for certain spending initiatives widening was reversed early in the year, as investors implied stronger aggregate demand and less federal became more confident that corporate balance sheets saving than previously anticipated. The prospect that would not deteriorate substantially, but speculative- thefederaldebtmightbepaiddownlessrapidlymay grade bond spreads widened again recently in also have reduced slightly the scarcity premiums responsetonegativenewsaboutsecond-quarterearn- investors were willing to pay for Treasury securities. ings and declines in share prices, leaving these Finally,aportionoftherisemayhavebeentheresult spreads at the end of the second quarter only slightly ofincreasedinflationexpectations.Inflationcompen- belowwheretheybegantheyear.Nonetheless,inves- sation as measured by the difference between nomi- tors, while somewhat selective, appear to remain nal Treasury rates and the rates on inflation-indexed receptive to new issues with speculative-grade Treasury securities rose about 1⁄ 4 percentage point in ratings. Board of Governors of the Federal Reserve System 21 Corporatebondyields remains in the elevated range it shifted to in late 1998. Judging from the widening since 1998 of the Percent averagespreadbetweenratesonriskierandless-risky loans, banks have become especially cautious about lendingtomarginalcredits. 20 Equity Markets 15 After rising in January in response to the initial Highyield easing of monetary policy, stock prices declined in 10 February and March in reaction to profit warnings AA andweakeconomicdata,withtheWilshire5000,the broadest major stock price index, ending the first 1991 1993 1995 1997 1999 2001 quarter down 13 percent. Stock prices retraced some of those losses in the second quarter, rising 7 per- Note. ThedataaremonthlyaveragesandextendthroughJune2001.The AArateiscalculatedfrombondsintheMerrillLynchAAindexwithsevento cent,asfirst-quarterearningsreleasescameinalittle tenyearsremainingtomaturity.Thehigh-yieldrateistheyieldontheMerrill above sharply reduced expectations and as investors Lynch175high-yieldindex. became more confident that economic growth and Interest rates on commercial paper and C&I loans corporate profits would soon pick up. On net, the have fallen this year by about as much as the federal Wilshire 5000 ended the half down 6 percent, the funds rate, although some risk spreads widened. The DJIA declined 3 percent, and the tech-heavy Nasdaq averageyieldspreadonsecond-tiercommercialpaper fell13percent.EarningspershareoftheS&P500in overtop-tierpaperwidenedtoabout100basispoints the first quarter decreased 10 percent from a year in late January, about four times its typical level, earlier. A disproportionate share of the decline in followingdefaultsbyafewprominentissuers.Asthe S&Pearnings—morethanhalf—wasattributabletoa year progressed, investors became less concerned plunge in the technology sector, where first-quarter about the remaining commercial paper borrowers, earnings were down nearly 50 percent from their and this spread has returned to a more normal level. peakinthethirdquarteroflastyear. According to preliminary data from the Federal The decline in stock prices has left the Wilshire Reserve’s quarterly Survey of Terms of Business 5000 down by about 20 percent, and the Nasdaq Lending,thespreadoverthetargetfederalfundsrate downbyabout60percent,fromtheirpeaksinMarch of the average interest rate on commercial bank C&I 2000. Both of these indexes are near their levels at loans edged up between November and May and the end of 1998, having erased the sharp run-up in prices in 1999 and early 2000. But both indexes Spreadofaveragebusinessloanrate remainmorethantwoandone-halftimestheirlevels overintendedfederalfundsrate Majorstockpriceindexes Percentage points January 4, 1999 = 100 2.2 Nasdaq 200 2.0 Wilshire5000 1.8 150 1.6 100 S&P500 1991 1993 1995 1997 1999 2001 Note. Thedata,whicharebasedontheFederalReserve’sSurveyofTerms J FMAMJ J ASOND J FMAMJ J ASOND J FMAMJ J ofBusinessLending,areforloansmadebydomesticcommercialbanks.The 1999 2000 2001 surveyisconductedinthemiddlemonthofeachquarter;thefinalobservationis forMay2001andispreliminary. Note. ThedataaredailyandextendthroughJuly12,2001. 22 Monetary Policy Report to the Congress July 2001 S&P500earnings–priceratioandtherealinterestrate generallyinvestingthedifferencebypurchasingother Treasury securities on the open market. The Federal Percent Reserve also has increased its holdings of longer- S&P500earnings–priceratio term repurchase agreements (RPs), including RPs backed by agency securities and mortgage-backed 8 securities, as a substitute for outright purchases of Treasury securities. In the first half of the year, 6 longer-termRPs,typicallywithmaturitiesoftwenty- eightdays,averaged$13billion. 4 As reported in the previous Monetary Policy Report, the FOMC also initiated a study to evaluate 2 assets to hold on its balance sheet as alternatives to Realinterestrate Treasury securities. That study identified several optionsforfurtherconsideration.Inthenearterm,the 1991 1993 1995 1997 1999 2001 Federal Reserve is considering purchasing and hold- Note. ThedataaremonthlyandextendthroughJune2001.Theearnings– ing Ginnie Mae mortgage-backed securities, which priceratioisbasedonI/B/E/Sconsensusestimatesofearningsoverthecoming areexplicitlybackedbythefullfaithandcreditofthe year.Therealrateisestimatedasthedifferencebetweentheten-yearTreasury rateandthefive-yeartoten-yearexpectedinflationratefromtheFRBPhiladel- U.S. government, and engaging in repurchase opera- phiasurvey. tions against foreign sovereign debt. For possible at the end of 1994, when the bull market shifted into implementationlater,theFederalReserveisstudying a higher gear. The ratio of expected one-year-ahead whether to auction longer-term discount window earnings to equity prices began to fall in 1995 when, credit, and it will over time take a closer look at a as productivity growth picked up, investors began to broaderarrayofassetsforrepurchaseandforholding buildinexpectationsthatincreasesinearningswould outright, transactions that would require additional remain rapid for some time. This measure of the legalauthority. earnings-price ratio remains near the levels reached in 1999, suggesting that investors still anticipate robust long-term earnings growth, likely reflecting Debt and the Monetary Aggregates expectations for continued strong gains in productivity. The growth of domestic nonfinancial debt in the first Despite the substantial variation in share prices halfof2001isestimatedtohaveremainedmoderate, over the first half of this year, trading has been slowingslightlyfromthepacein2000asareduction orderly, and financial institutions appear to have in the rate of increase in nonfederal debt more than encountered no difficulties that could pose broader offsettheeffectsofsmallernetrepaymentsoffederal systemic concerns. Market volatility and a less ebul- debt. In contrast, the monetary aggregates have lientoutlookhaveledinvestorstobuyamuchsmaller grown rapidly so far this year, in large part because share of stock on margin. At the end of May, margin the sharp decline in short-term market interest rates debt was 1.15 percent of total market capitalization, has reduced the opportunity cost of holding the equal to its level at the beginning of 1999 and well depositsandotherassetsincludedintheaggregates. belowitshighof1.63percentinMarchoflastyear. Debt and Depository Intermediation Federal Reserve Open Market Operations The debt of the domestic nonfinancial sectors is esti- As noted earlier, the Federal Reserve has responded mated to have expanded at a 43⁄ 4 percent annual rate to the diminished size of the auctions of Treasury overthefirsthalfof2001,atouchbelowthe51⁄ 4 per- securities by modifying its procedures for acquiring centgrowthrecordedin2000.Changesinthegrowth such securities. To help maintain supply in private of nonfederal and federal debt this year have mostly hands adequate for liquid markets, since July of last offset each other. The growth of nonfederal debt yeartheSystemhaslimiteditsholdingsofindividual moderated from 81⁄ 2 percent in 2000 to a still-robust securities to specified percentages, ranging from 71⁄ 4 percent pace in the first half of this year. House- 15 percent to 35 percent, of outstanding amounts. To holds’ borrowing slowed some but was still substan- stay within these limits, the System has at times not tial, buoyed by continued sizable home and durable rolled over all of its holdings of maturing securities, goodspurchases.Similarly,businessborrowingmod- Board of Governors of the Federal Reserve System 23 Growthofdomesticnonfinancialdebt PercentofallU.S.commercialbankassets atwell-capitalizedbanks Percent Percent 8 100 6 Total 80 4 60 2 40 1991 1993 1995 1997 1999 2001 Nonfederal Note. Thedataarequarterlyandextendthrough2001:Q1.Capitalstatusis 10 determined using the regulatory standards for the leverage, tier 1, and total capitalratios. 5 quarter, bank profits remained in the high range recorded for the past several years, and virtually all + 0 banks—98 percent by assets—were well capitalized. – Withbanks’financialconditionstillquitesound,they Federal remainwellpositionedtomeetfutureincreasesinthe 5 demandforcredit. 1989 1991 1993 1995 1997 1999 2001 The Monetary Aggregates Note. Annual growth rates are computed from fourth-quarter averages. Growthinthefirsthalfof2001istheJuneaveragerelativetothefourth-quarter averageatanannualrateandisbasedonpartiallyestimateddata.Domestic The monetary aggregates have expanded rapidly so nonfinancialdebtconsistsoftheoutstandingcreditmarketdebtofgovernments, householdsandnonprofitorganizations,nonfinancialbusinesses,andfarms. far this year, although growth rates have moderated erated even as bond issuance surged, as a good por- somewhatrecently.M2rose101⁄ 4 percentatanannual rate in the first half of this year after having grown tion of the funds raised was used to pay down com- mercial paper and bank loans. Tending to boost debt 61⁄ 4 percentin2000.Theinterestratesonmanyofthe components of M2 do not adjust quickly or fully to growthwasaslowinginthedeclineinfederaldebtto a 61⁄ 4 percent rate in the first half of this year from M2growthrate 63⁄ 4 percent last year, largely because of a decline in taxreceiptsoncorporateprofits. Percent, annual rate The share of credit to nonfinancial sectors held at H1 banks and other depository institutions edged down 10 in the first half of the year. Bank credit, which accounts for about three-fourths of depository credit, 8 increased at a 31⁄ 2 percent annual rate in the first half of the this year, well off the 91⁄ 2 percent growth 6 registered in 2000. Banks’ loans to businesses and households decelerated even more, in part because 4 borrowers preferred to lock in the lower rates avail- able from longer-term sources of funds such as bond 2 and mortgage markets and perhaps also in part becausebanksfirmeduptheirlendingstanceinreac- 1991 1993 1995 1997 1999 2001 tiontoconcernsaboutloanperformance.Loandelin- Note. M2 consists of currency, travelers checks, demand deposits, other quencyandcharge-offrateshavetrendedupinrecent checkabledeposits,savingsdeposits(includingmoneymarketdepositaccounts), quarters, and higher loan-loss provisions have small-denominationtimedeposits,andbalancesinretailmoneymarketfunds. Seefootnoteunderthedomesticnonfinancialdebtchartfordetailsonthecom- weighed on profits. Nevertheless, through the first putationofgrowthrates. 24 Monetary Policy Report to the Congress July 2001 M3growthrate Monetaryauthoritiesinmostcasesreactedtosigns of slowdown by lowering official rates, but by less Percent, annual rate than in the United States. Partly in response to these H1 actions,yieldcurveshavesteepenednoticeablysofar 12 in 2001. Although long-term interest rates moved downduringthefirstquarter,theymorethanreversed 10 those declines in most cases as markets reacted to 8 a combination of the anticipation of stronger real growthandtheriskofincreasedinflationarypressure. 6 Foreign equity markets—especially for high-tech stocks—werebuffetedearlythisyearbymanyofthe 4 same factors that affected U.S. share prices: negative 2 earnings reports, weaker economic activity, buildups of inventories of high-tech goods, and uncertainties 1991 1993 1995 1997 1999 2001 regarding the timing and extent of policy responses. In recent months, the major foreign equity indexes Note. M3consistsofM2pluslarge-denominationtimedeposits,balances ininstitutionalmoneymarketfunds,RPliabilities(overnightandterm),and movedupalongwithU.S.stockprices,buttheyhave eurodollars(overnightandterm).Seefootnoteunderthedomesticnonfinancial edged off lately and in most cases are down, on debtchartfordetailsonthecomputationofgrowthrates. balance,fortheyearsofar. changes in market interest rates. As a consequence, Slower U.S. growth, monetary easing by the Fed- thesteepdeclinesinshort-termmarketratesthisyear eralReserve,fluctuationsinU.S.stockprices,andthe have left investments in M2 assets relatively more largeU.S.externaldeficithavenotundermineddollar attractive, contributing importantly to the accelera- strength. After the December 2000 FOMC meeting, tion in the aggregate. M2 has also probably been the dollar lost ground against the major currencies; buoyedbythevolatilityinthestockmarketthisyear, but shortly after the FOMC’s surprise rate cut on and perhaps by lower expected returns on equity Foreigninterestrates investments, leading investors to seek the safety and liquidityofM2assets. Percent M3, the broadest monetary aggregate, rose at a Short-term (three-month) 131⁄ 4 percent annual rate through June, following 91⁄ 4 percent growth in 2000. All of the increase in U.K. interbank 6 M3, apart from that accounted for by M2, resulted from a ballooning of institutional money market Euro-area interbank 4 funds, which expanded by nearly a third. Yields on these funds lag market yields somewhat, and so the Canadian finance paper 2 returns to the funds, like those on many M2 assets, becamerelativelyattractiveasinterestratesonshort- Japanese CD + termmarketinstrumentsdeclined. 0 – International Developments Long-term (ten-year government bonds) Canada United Kingdom So far this year, average foreign growth has weak- 6 enedfurtherandiswellbelowitspaceofayearago. Activityabroadwasrestrainedbythecontinuedhigh Germany level of oil prices, the global slump of the high- 4 technologysector,andspillovereffectsfromtheU.S. economic slowdown, but in some countries domestic Japan demand softened as well in reaction to local factors. 2 High oil prices kept headline inflation rates some- whatelevated,buteventhoughcoreratesofinflation haveedgedupincountrieswhereeconomicslackhas Q1 Q2 Q3 Q4 Q1 Q2 Q3 diminished, inflationary pressures appear to be well 2000 2001 undercontrol. Note. ThedataareweeklyandextendthroughJuly11,2001. Board of Governors of the Federal Reserve System 25 January 3, the dollar reversed all of that decline as The dollar has gained about 9 percent against market participants evidently reassessed the pros- the yen, on balance, as the Japanese economy has pects for recovery in the United States versus that remained troubled by structural problems, stagnant inourmajortradingpartners.Thedollarasmeasured growth, and continuing deflation. Industrial produc- by a trade-weighted index against the currencies of tion has been falling, and real GDP declined slightly major industrial countries gained in value steadily in inthefirstquarter,withbothprivateconsumptionand thefirstthreemonthsof2001,reachingafifteen-year investment contracting. Japanese exports also have high in late March. Continued flows of foreign funds sagged because of slower demand from many key into U.S. assets appeared to be contributing impor- trading partners. Early in the year, under increasing tantly to the dollar’s increase. Market reaction to pressure to respond to signs that their economy was indications that the U.S. economy might be headed weakening further, the Bank of Japan (BOJ) slightly toward a more prolonged slowdown undercut the reduced the uncollateralized overnight call rate, its dollar’s strength somewhat in early April, and the key policy interest rate. By March, the low level of dollareasedfurtheraftertheunexpectedApril18rate equity prices, which had been declining since early cutbytheFOMC.However,thedollarhasmorethan 2000, was provoking renewed concerns about the made up that loss in recent months as signs of weak- solvency of Japanese banks. In mid-March, the BOJ ness abroad have emerged more clearly. On balance, announced that it was shifting from aiming at a the dollar is up about 7 percent against the major particular overnight rate to targeting balances that currencies so far this year; against a broader index private financial institutions hold at the Bank, effec- that includes currencies of other important trading tively returning the overnight rate to zero; the BOJ partners,thedollarhasappreciated5percent. also announced that it would continue this easy monetary stance until inflation moves up to zero or above. After the yen had moved near the end of NominalU.S.dollarexchangerates March to its weakest level relative to the dollar in more than four years, Japanese financial markets Week ending January 5, 2000 = 100 were buoyed by the surprise election in May of Exchange rate indexes Junichiro Koizumi to party leadership and thereby to prime minister. The yen firmed slightly for several 115 Major currencies weeks thereafter, but continued weak economic fun- damentals and increased market focus on the daunt- 110 ing challenges facing the new government helped pushtheyenbackdownandbeyonditspreviouslow Broad 105 level. At the start of 2001, economic activity in the euro 100 areahadslowednoticeablyfromthemorerapidrates seen early last year but still was fairly robust. Aver- age GDP growth of near 2 percent was only slightly below estimated rates of potential growth, although Selected bilateral rates Japanese yen somekeycountries(notablyGermany)wereshowing Euro 120 signsoffalteringfurther.Althoughhighpricesforoil U.K. pound and food had raised headline inflation, the rate of 115 changeofcorepriceswasbelowthe2percentceiling foroverallinflationsetbytheEuropeanCentralBank 110 (ECB). The euro also was showing some signs of strength, having moved well off the low it had 105 reached in October. However, negative spillovers Canadian dollar from the global slowdown started to become more 100 evident in weaker export performance in the first quarter,andleadingindicatorssuchasbusinessconfi- Q1 Q2 Q3 Q4 Q1 Q2 Q3 dence slumped. Nevertheless, the ECB held policy 2000 2001 steady through April, as further weakening of the Note. ThedataareweeklyandextendthroughJuly11,2001.Indexes(top euro against the dollar (following a trend seen since panel)aretrade-weightedaveragesoftheexchangevalueofthedollaragainst majorcurrenciesandagainstthecurrenciesofabroadgroupofimportantU.S. theFOMC’sratecutinearlyJanuary),growthofM3 tradingpartners.Bilateralrates(bottompanel)areinforeigncurrencyunitsper inexcessoftheECB’sreferencerate,andsignsofan dollar. 26 Monetary Policy Report to the Congress July 2001 edging up of euro-area core inflation were seen as In Argentina, the weak economy and the govern- militatingagainstaneasingofpolicy. ment’s large and growing debt burden stoked market In early May, the ECB surprised markets with a fears that the government would default on its debt 25 basis point reduction of its minimum bid rate andalteritsone-for-onepegofthepesotothedollar. and parallel reductions of its marginal lending and In April, spreads on Argentina’s internationally deposit rates. In explaining the step, the ECB noted traded bonds moved up sharply, and interest rates thatmonetarydevelopmentsnolongerposedathreat spiked. In June, the government completed a nearly to price stability and projected that moderation of $30 billion debt exchange with its major domestic GDPgrowthwoulddampupwardpricepressure.The and international creditors aimed at alleviating the eurohascontinuedtofallsincethenand,onbalance, government’s cash flow squeeze, improving its debt has declined 9 percent against the dollar since the amortizationprofile,andgivingittimetoenactfiscal beginningoftheyear.Facedwithasimilarslowdown reforms and revive the economy. Argentine financial in the U.K. economy that was exacerbated by the conditions improved somewhat following agreement outbreak of foot-and-mouth disease, the Bank of onthedebtswap.However,thisimprovementproved Englandalsocutitsofficialcallratethreetimes(bya temporary, and an apparent intensification of market total of 75 basis points) during the first half of the concerns about the possibility of a debt default trig- year.TheLaborParty’svictoryinparliamentaryelec- gered a sharp fall in Argentine financial asset prices tions in early June seemed to raise market expecta- at mid-July. This financial turbulence in Argentina tions of an early U.K. euro referendum and put addi- negatively affected financial markets in several other tional downward pressure on sterling, but that was emerging market economies. The turmoil in Argen- partly offset by signs of stronger inflationary pres- tina took a particular toll on Brazil, where an energy sure. On balance, the pound has lost about 6 percent crisis added to other problems that have kept growth against the dollar this year, while it has strengthened againsttheeuro. Emergingmarkets The exchange value of the Canadian dollar has swungoverawiderangein2001.Inthefirstquarter, Week ending January 5, 2000 = 100 the Canadian dollar fell about 5 percent against Daily exchange rates the U.S. dollar as the Canadian economy showed Brazil 130 signs of continuing a deceleration of growth that had started in late 2000. Exports—especially autos, auto equipment, and electronic equipment—suffered from 120 weaker U.S. demand. Softer global prices for non- Korea oilcommoditiesalsoappearedtoputdownwardpres- 110 sure on the Canadian currency. With inflation well within its target range, the Bank of Canada cut its Argentina 100 policy rate several times by a total of 125 basis Mexico points.Sofarthisyear,industriesoutsideofmanufac- turing and primary resources appear to have been Percentage points much less affected by external shocks, and domestic Bond spreads demand has maintained a fairly healthy pace. Since 12 the end of March, the Canadian dollar has regained Argentina much of the ground it had lost earlier and is down 10 Brazil about2percentonbalancesincethebeginningofthe 8 year. Global financial markets were rattled in February 6 by serious problems in the Turkish banking sector. Mexico 4 Turkish interest rates soared and, after market pres- suresledauthoritiestoallowtheTurkishliratofloat, 2 it experienced a sharp depreciation of more than Korea 30 percent. An IMF program announced in mid-May Q1 Q2 Q3 Q4 Q1 Q2 Q3 that will bring $8 billion in support this year and 2000 2001 requireanumberofbankingandotherreformshelped Note. ThedataareweeklyandextendthroughJuly11,2001.Exchangerates steadythesituationtemporarily,butmarketsentiment (toppanel)areinforeigncurrencyunitsperdollar.Bondspreads(bottompanel) are the J.P. Morgan Emerging Market Bond Index ‘‘plus’’ (sovereign yield) startedtodeteriorateagaininearlyJuly. spreadsoverU.S.Treasuries. Board of Governors of the Federal Reserve System 27 very slow since late last year. Intervention purchases example, fell from a 15 percent annual rate in late of the real by the Brazilian central bank and a 2000toclosetozeroinmid-2001.Theturnaroundof 300 basis point increase in its main policy interest the high-tech component of industrial production in rate helped take some pressure off the currency, but those countries was even more abrupt—from more therealhasdeclinedabout24percentsofarthisyear. than a 30 percent rate of increase to a slight decline TheweakperformanceoftheMexicaneconomyat by midyear. In the Philippines and Indonesia, eco- theendoflastyearcausedlargelybyafallinexports nomicdifficultieswerecompoundedbyseriouspoliti- to the United States (notably including a sharp drop cal tensions. Currencies in many of these countries in exports of automotive products) and tight mone- moved down versus the dollar, and stock prices tary policy carried over into early 2001. With infla- declined. In Korea, the sharp slump in activity that tion declining, the Bank of Mexico loosened mone- beganlatelastyearcontinuedinto2001,asweakness tary policy in May for the first time in three years. intheexternalsectorspreadtodomesticconsumption Problems with Mexican growth did not spill over to andinvestment.TheBankofKorealowereditstarget financial markets, however. The peso has remained interest rate a total of 50 basis points over the first strong and is up about 3 percent so far this year, and half of the year in response to the weakening in stockpriceshaverisen. activity. The Chinese economy, which is less depen- Average growth in emerging Asia slowed signifi- dent on technology exports than many other coun- cantly in the first half; GDP grew more slowly or tries in the region, continued to expand at a brisk even declined in economies that were more exposed pace in the first half of this year, as somewhat softer to the effects of the global drop in demand for high- export demand was offset by increased government tech products. Average growth of industrial produc- spending. tion in Malaysia, Singapore, and Hong Kong, for

Federal Reserve (2001, July 17). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20010718

@misc{wtfs_monetary_policy_report_20010718,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2001},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20010718},
  note = {Retrieved via When the Fed Speaks corpus}
}