Monetary Policy Report

For use at 10:00 a.m., EST Wednesday February 27, 2002 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to section 2B of the Federal Reserve Act February 27, 2002 Letter of Transmittal BOARDOFGOVERNORSOFTHE FEDERALRESERVESYSTEM Washington,D.C.,February27,2002 THEPRESIDENTOFTHESENATE THESPEAKEROFTHEHOUSEOFREPRESENTATIVES TheBoardofGovernorsispleasedtosubmititsMonetaryPolicyReporttotheCongress pursuanttosection2BoftheFederalReserveAct. Sincerely, AlanGreenspan,Chairman Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2001 and Early 2002 6 Monetary Policy Report to the Congress Report submitted to the Congress on February 27, tioningofthosemarkets.Theeconomicfalloutofthe 2002, pursuant to section 2B of the Federal Reserve events of September 11 led the Federal Open Market Act Committee (FOMC) to cut the target federal funds rate after a conference call early the following week andagainateachmeetingthroughtheendoftheyear MONETARY POLICY AND THE (see box ‘‘Monetary Policy after the Terrorist ECONOMIC OUTLOOK Attacks’’). Displaying the same swift response to economic Last year was a difficult one for the economy of the developments that appears to have characterized United States. The slowdown in the growth of much business behavior in the current cyclical epi- economic activity that had become apparent in late sode, firms moved quickly to reduce payrolls and 2000 intensified in the first half of the year. Busi- cut production after mid-September. Although these nesses slashed investment spending—making espe- adjustments occurred across a broad swath of the cially deep cuts in outlays for high-technology economy, manufacturing and industries related to equipment—in response to weakening final demand, travel, hospitality, and entertainment bore the brunt anoversupplyofsometypesofcapital,anddeclining of the downturn. Measures of consumer confidence profits. As actual and prospective sales deteriorated, fell sharply in the first few weeks after the attacks, many firms in the factory sector struggled with but the deterioration was not especially large by uncomfortably high levels of inventories, and the cyclicalstandards,andimprovementinsomeofthese accompanying declines in manufacturing output indexes was evident in October. Similarly, equity steepened. At the same time, foreign economies also prices started to rebound in late September, and risk slowed,furtherreducingthedemandforU.S.produc- spreads began to narrow somewhat by early Novem- tion. The aggressive actions by the Federal Reserve ber, when it became apparent that the economic to ease the stance of monetary policy in the first half effects of the attacks were proving less severe than of the year provided support to consumer spending manyhadfeared. and the housing sector. Nevertheless, the weakening Consumer spending remained surprisingly solid in activity became more widespread through the over the final three months of the year in the face of summer, job losses mounted further, and the unem- enormous economic uncertainty, widespread job ployment rate moved higher. With few indications losses,andfurtherdeteriorationofhouseholdbalance that economic conditions were about to improve, sheets from the sharp drop in equity prices immedi- withunderlyinginflationmoderateandedginglower, atelyfollowingSeptember11.Severalfactorswereat and with inflation expectations well contained, the work in support of household spending during this Federal Reserve continued its efforts to counter the period. Low and declining interest rates provided a ongoing weakness by cutting the federal funds rate, lift to outlays for durable goods and to activity in bringing the cumulative reduction in that rate to housing markets. Nowhere was the boost from low 3percentagepointsbyAugust. interest rates more apparent than in the sales of new ThedevastatingeventsofSeptember11furtherset motor vehicles, which soared in response to the back an already fragile economy. Heightened uncer- financing incentives offered by manufacturers. Low tainty and badly shaken confidence caused a wide- mortgageinterestratesnotonlysustainedhighlevels spread pullback from economic activity and from of new home construction but also allowed house- risk-taking in financial markets, where equity prices holds to refinance mortgages and extract equity from fell sharply for several weeks and credit risk spreads homes to pay down other debts or to increase spend- widened appreciably. The most pressing concern of ing.Fiscalpolicyprovidedadditionalsupporttocon- the Federal Reserve in the first few days following sumer spending. The cuts in taxes enacted last year, the attacks was to help shore up the infrastructure of includingtherebatespaidoutoverthesummer,cush- financial markets and to provide massive quantities ioned the loss of income from the deterioration in of liquidity to limit potential disruptions to the func- labor markets. And the purchasing power of house- 2 Monetary Policy Report to the Congress February 2002 hold income was further enhanced by the sharp drop posted a much better performance than had been in energy prices during the autumn. With businesses anticipatedintheimmediateaftermathoftheattacks. having positioned themselves to absorb a falloff of More recently, there have been encouraging signs demand, the surprising strength in household spend- thateconomicactivityisbeginningtofirm.Joblosses ing late in the year resulted in a dramatic liquidation diminished considerably in December and January, ofinventories.Intheend,realgrossdomesticproduct and initial claims for unemployment insurance and MonetaryPolicyaftertheTerroristAttacks TheterroristattacksonSeptember11destroyedaportionof line that week to channel the funds to institutions with a theinfrastructureofU.S.financialmarkets,disruptedcom- needfordollars. munication networks, and forced some market participants By Thursday and Friday, the disruption in air traffic to retreat to contingency sites in varying states of readi- causedtheFederalReservetoextendrecordlevelsofcredit ness. These developments, along with the tragic loss of to depository institutions in the form of check float. Float life among the employees of a few major financial firms, increaseddramaticallybecausetheFederalReservecontin- greatly complicated trading, clearing, and settlement of ued to credit the accounts of banks for deposited checks many different classes of financial instruments. Direct dis- even though the grounding of airplanes meant that checks locationselevateduncertaintiesaboutpaymentflows,mak- normally shipped by air could not be presented to the ingitdifficultforthereservemarkettochannelfundswhere checkwriters’banksontheusualschedule.Floatdeclinedto theywereneededmost.Depositoriesthatheldmorereserve normal levels the following week once air traffic was per- balances than they preferred had considerable difficulty mittedtorecommence.Lastly,overthecourseoftheweek unloading the excess in the market; by contrast, deposi- that included September 11, as the market for reserves tories awaiting funds had to scramble to cover overdraft began to function more normally, the Federal Reserve positions. As a result, the effective demand for reserves resumed the use of open market operations to provide the ballooned. bulkofreserves.TheopenmarketDeskaccommodatedall The Federal Reserve accommodated the increase in the propositionsdowntothetargetfederalfundsrate,operating demandforreservesthroughavarietyofmeans,therelative exclusivelythroughovernighttransactionsforseveraldays. importanceofwhichshiftedthroughtheweek.OnTuesday The injection of reserves through open market operations morning, shortly after the attacks, the Federal Reserve peakedat$81billiononFriday.Thecombinedinfusionof issued a press release reassuring financial markets that the liquidity from the various sources pushed the level of FederalReserveSystemwasfunctioningnormallyandstat- reserve balances at Federal Reserve Banks to more than ingthat‘‘thediscountwindowisavailabletomeetliquidity $100billiononWednesday,September12,abouttentimes needs.’’ Depository institutions took up the offer, and bor- the normal level. As anticipated by the FOMC, federal rowing surged to a record $451⁄2 billion by Wednesday. funds traded somewhat below their new target level for Discount loans outstanding dropped off sharply on Thurs- the rest of the week. By the end of the month, bid–asked day and returned to very low levels by Friday. Separately, spreads and trading volumes in the interbank and other overnight overdrafts on Tuesday and Wednesday rose to markets receded to more normal levels, and federal funds severalbilliondollars,asahandfulofdepositoryandother consistentlybegantotradearoundtheintendedrate. institutions with accounts at the Federal Reserve were TheFederalReservetookseveralstepstofacilitatemar- forced into overdraft on their reserve accounts. Overnight ketfunctioninginSeptemberinadditiontoaccommodating overdrafts returned to negligible levels by the end of the theheighteneddemandforreserves.Thehoursoffundsand week. securitiestransfersystemsoperatedbytheFederalReserve LiketheirU.S.counterparts,foreignfinancialinstitutions wereextendedsignificantlyforaweekaftertheattacks.The operatingintheUnitedStatesfacedelevateddollarliquidity Federal Reserve Bank of New York liberalized the terms needs. In some cases, however, these institutions encoun- under which it would lend the securities in the System tered difficulties positioning the collateral at their U.S. portfolio, and the amount of securities lent rose to record branchestosecureFederalReservediscountwindowcredit. levels in the second half of September. For the ten days Tobeinapositiontohelpmeetthoseneeds,threeforeign followingtheattacks,theFederalReservereducedorelimi- central banks established new or expanded arrangements nated the penalty charged on overnight overdrafts, largely withtheFederalReservetoreceivedollarsinexchangefor because those overdrafts were almost entirely the result their respective currencies. These swap lines, which lasted of extraordinary developments beyond the control of the for thirty days, consisted of $50 billion for the European account holders. In addition, the Federal Reserve helped CentralBank,$30billionfortheBankofEngland,andan restore communication between market participants and in increaseof$8billion(from$2billionto$10billion)forthe some cases processed bilateral loans of reserves between Bank of Canada. The European Central Bank drew on its accountholdersinlieuofmarketintermediation. Board of Governors of the Federal Reserve System 3 the level of insured unemployment have reversed two years is likely to continue to restrain the growth their earlier sharp increases. Although motor vehicle of spending in coming quarters. To be sure, the con- purchases have declined appreciably from their blis- traction in business capital spending appears to be teringfourth-quarterpace,earlyreadingssuggestthat waning. But spending on some types of equipment, consumer spending overall has remained very strong most notably communications equipment, continues early this year. In the business sector, new orders for to decline, and there are few signs yet of a broad- capitalequipmenthaveprovidedsometentativeindi- based upturn in capital outlays. Activity abroad cations that the deep retrenchment in investment remains subdued, and a rebound of foreign output is spending could be abating. Meanwhile, purchasing likely to follow, not lead, a rebound in the United managers in the manufacturing sector report that States. Furthermore, lenders and equity investors ordershavestrengthenedandthattheyviewthelevel remain quite cautious. Banks have continued to of their customers’ inventories as being in better tightentermsandstandardsonloans,andriskspreads balance.Indeed,theincreasinglyrapidpaceofinven- have increased a little this year. Stock prices have toryrunoffoverthecourseofthelastyearhasleftthe retreated from recent highs as earnings continue to level of production well below that of sales, suggest- fall amid concerns about the transparency of corpo- ing scope for a recovery in output given the current rate financial reports and uncertainty about the pace sales pace. Against this backdrop, the FOMC left its atwhichprofitabilitywillimprove. target for the federal funds rate unchanged in Janu- ary. However, reflecting a concern that growth could be weaker than the economy’s potential for a time, Monetary Policy, Financial Markets, and theFOMCretaineditsassessmentthattheriskswere the Economy over 2001 and Early 2002 tiltedunacceptablytowardeconomicweakness. The extent and persistence of any recovery in As economic weakness spread and intensified over production will, of course, depend critically on the the first half of 2001, the FOMC aggressively low- trajectory of final demand in the period ahead. Sev- ered its target for the federal funds rate. Because eral factors are providing impetus to such a recovery firms reacted unusually swiftly to indicators that in the coming year. With the real federal funds rate inventorieswereuncomfortablyhighandcapitalwas hovering around zero, monetary policy should be becoming underutilized, the drop in production and positionedtosupportgrowthinspending.Moneyand businesscapitalspendingwasespeciallysteep.More- credit expanded fairly rapidly through the end of the over, sharp downward revisions in corporate profit year, and many households and businesses have expectations caused equity prices to plunge, which, strengthened their finances by locking in relatively alongwithadeclineinconsumerconfidence,pointed low-cost long-term credit. The second installment of tovulnerabilityinhouseholdspending.Meanwhile,a personal income tax cuts and scheduled increases in significantdecelerationinenergyprices,afterasurge government spending on homeland security and early in the year, began to hold down overall infla- national defense also will provide some stimulus to tion;therestrainingeffectofenergyprices,combined activity this year. Perhaps the most significant poten- with the moderation of resource utilization, also tial support to the economy could come from further promised to reduce core inflation. Responding to the gains in private-sector productivity. Despite the pro- rapid deterioration in economic conditions, the nounced slowdown in real GDP growth last year, FOMCcutitstargetforthefederalfundsrate21⁄ 2 per- output per hour in the nonfarm business sector centagepoints—in5half-pointsteps—bythemiddle increased impressively. Continued robust gains in of May. Moreover, the FOMC indicated throughout productivity, stemming from likely advances in tech- this period that it judged the balance of risks to the nology,shouldprovideaconsiderableboosttohouse- outlookasweightedtowardeconomicweakness.The holdandbusinessincomesandspendingandcontrib- Board of Governors of the Federal Reserve System utetoasustained,noninflationaryrecovery. approvedreductionsinthediscountratethatmatched Still, the economy faces considerable risk of sub- the Committee’s cuts in the target federal funds rate. par economic performance in the period ahead. Asaresult,thediscountratedeclinedfrom6percent Becauseoutlaysfordurablegoodsandfornewhomes to31⁄ 2 percentovertheperiod. havebeenrelativelywellmaintainedinthiscycle,the AtitsJuneandAugustmeetings,theFOMCnoted scope for strong upward impetus from household information suggesting continued softening in the spendingseemsmorelimitedthanhasoftenbeenthe economy and a lack of convincing evidence that the case in past recoveries. Moreover, the net decline in end of the slide in activity was in sight. Although household net worth relative to income over the past consumer spending on both housing and nonhousing 4 Monetary Policy Report to the Congress February 2002 Selected interest rates Percent Intended federal funds rate 7 Ten-year Treasury 6 5 4 Two-year Treasury Discount rate 3 2 1 2/2 3/21 5/16 6/28 8/22 10/3 11/15 12/191/3 1/31 3/20 4/18 5/15 6/27 8/219/1710/2 11/6 12/11 1/30 2000 2001 2002 Note. The data are daily and extend through February 21, 2002. The dates on the horizontal axis are those of scheduled FOMC meetings and of any intermeeting policy actions. items—buoyedbythetaxcutsandrebates,lowmort- in the very near future. Accordingly, the FOMC, at a gage interest rates, declining energy prices, and real- telephone conference on September 17, voted to ized capital gains from home sales—remained fairly reduceitstargetforthefederalfundsrate1⁄ 2 percent- resilient,economicconditionsinmanufacturingdete- agepoint,to3percent,andstatedthatitcontinuedto riorated further. Firms continued to reduce payrolls, judge the risks to the outlook to be weighted toward work off excess inventories, and cut back capital economicweakness. equipment expenditures amid sluggish growth in Over subsequent weeks, heightened aversion to business sales, significantly lower corporate profits, risk, which caused investors to flock from private to and greater uncertainty about future sales and earn- Treasury and federal agency debt, boosted risk ings. With energy prices in retreat, price inflation spreads sharply, especially on lower-rated corporate remainedsubdued.Inreachingitspolicydecisionsat debt. Increased demand for safe and liquid assets its June and August meetings, the FOMC took into contributedtosellingpressureinthestockmarket.At account the substantial monetary policy stimulus its October 2 meeting, the FOMC had little hard already implemented since the start of the year—but information available on economic developments not yet fully absorbed by the economy—and the since the attacks. However, evidence gleaned from oncoming effects of stimulative fiscal policy mea- surveys, anecdotes, and market contacts indicated sures recently enacted by the Congress. Conse- that the events of September 11 had considerable quently,theCommitteeoptedforsmallerinterestrate adverse repercussions on an already weak economy: cuts of 1⁄ 4 percentage point at both the June and Surveyindicatorsofconsumerconfidencehadfallen, August meetings, which brought the target federal and consumer spending had apparently declined. At fundsratedownto31⁄ 2 percent;asearlierintheyear, thesametime,anecdotalinformationpointedtoaddi- the FOMC continued to indicate that it judged the tional deep cutbacks in capital spending by many balance of risks to the outlook as weighted toward firms after an already-significant contraction in busi- economic weakness. After both meetings, the Board nessfixedinvestmentoverthesummermonths. of Governors of the Federal Reserve System also When the FOMC met on November 6, scattered approved similar reductions in the discount rate, early data tended to confirm the information that the whichmoveddownto3percent. declineinproduction,employment,andfinaldemand After the terrorist attacks on September 11, the had steepened after the terrorist attacks. Although an available Committee members held a telephone con- economic turnaround beginning in the first half of ference on September 13, during which they agreed 2002 was a reasonable expectation according to the thatthefinancialmarketsweretoodisruptedtoallow Committee, concrete evidence that the economy was foranimmediatealterationinthestanceofmonetary stabilizinghadyettoemerge.Meanwhile,themarked policy. However, the members were in agreement decrease in energy prices since the spring had that the attacks’ potential effects on asset prices and inducedadeclineinoverallpriceinflation,andinfla- ontheperformanceoftheeconomy,andtheresulting tionexpectationshadfallen.Accordingly,theFOMC uncertainty, would likely warrant some policy easing voted to lower its target for the federal funds rate Board of Governors of the Federal Reserve System 5 1⁄ 2 percentage point at both its October and Novem- stantially, the FOMC left the federal funds rate ber meetings and reiterated its view that the risks to unchanged at the close of its meeting, but it contin- the outlook were weighted toward economic weak- uedtoseetheriskstotheoutlookasweightedmainly ness. The sizable adjustments in the stance of mone- towardeconomicweakness. tary policy in part reflected concerns that insufficient policy stimulus posed an unacceptably high risk of a moreextendedcyclicalretrenchmentthatcouldprove Economic Projections for 2002 progressivelymoredifficulttocounter,giventhatthe federalfundsrate—at2percent—wasalreadyatsuch Federal Reserve policymakers are expecting the alowlevel. economy to begin to recover this year from the mild By the time of the December FOMC meeting, the downturnexperiencedin2001,butthepaceofexpan- most recent data were suggesting that the rate of sion is not projected to be sufficient to cut into the economic decline might be moderating. After plung- margin of underutilized resources. The central ten- ing earlier in the year, orders and shipments of dency of the real GDP growth forecasts made by the nondefense capital goods had turned up early in the members of the Board of Governors and the Federal fourth quarter, and the most recent survey evidence Reserve Bank presidents is 21⁄ 2 percent to 3 percent, for manufacturing also suggested that some expan- measured as the change between the final quarter of sion in that sector’s activity might be in the offing. 2001 and the final quarter of this year. The pace of In the household sector, personal consumption expansion is likely to increase only gradually over expenditures appeared to have been quite well main- the course of the year, and the unemployment rate is tained, an outcome that reflected the continuation of expected to move higher for a time. The FOMC zero-ratefinancingpackagesofferedbytheautomak- members project the civilian unemployment rate to ers, widespread price discounting, and low interest stand at about 6 percent to 61⁄ 4 percent at the end of rates. In an environment of very low mortgage inter- 2002. est rates, household demand for housing remained at A diminution of the rate of inventory liquidation a relatively high level, and financial resources freed is likely to be an important factor helping to buoy up by a rapid pace of mortgage refinancing activity production this year. In 2001, businesses cut inven- alsosupportedconsumerspending. toriessharplysoastoavoidcarryingexcessivestocks Nonetheless, the evidence of emerging stabiliza- relativetotheweakerpaceofsales,andalthoughthis tion in the economy was quite tentative and limited, process of liquidation probably is not yet complete and the Committee saw subpar economic perfor- in many industries, the overall pace of reduction is mance as likely to persist over the near term. More- likely to slow. Then, as final demand strengthens, over, in the probable absence of significant inflation- liquidation should give way to some restocking later ary pressures for some time, a modest easing action intheyear. could be reversed in a timely manner if it turned out As noted above, the forces affecting demand this nottobeneeded.Inviewoftheseconsiderations,the year are mixed. On the positive side are the stimula- FOMC lowered its target for the federal funds rate tiveeffectsofbothfiscalpolicyandtheearliermone- 1⁄ 4 percentagepoint,to13⁄ 4 percent,onDecember11, tary policy actions. A gradual turnaround in employ- 2001,andstatedthatitcontinuedtojudgetherisksto the outlook to be weighted mainly toward economic weakness. As had been the case throughout the year, Economicprojectionsfor2002 the Board of Governors approved reductions in the Percent discount rate that matched the FOMC’s cuts in the targetfederalfundsrate,bringingthediscountrateto FederalReserveGovernors and 11⁄ 4 percent,itslowestlevelsince1948. Indicator Memo: ReserveBankpresidents Subsequent news on economic activity bolstered 2001actual Central Range theviewthattheeconomywasbeginningtostabilize. tendency The information reviewed at the January 29–30, Change,fourthquarter 2002,FOMCmeetingindicatedthatconsumerspend- tofourthquarter1 NominalGDP................. 1.9 31⁄2–51⁄2 4–41⁄2 ing had held up remarkably well, investment orders RealGDP..................... .1 2–31⁄2 21⁄2–3 hadfirmedfurther,andtherateofdeclineinmanufac- PCEchain-typepriceindex .... 1.3 1–2 About11⁄2 turing production had lessened toward the end of Averagelevel,fourthquarter Civilianunemploymentrate.... 5.6 53⁄4–61⁄2 6–61⁄4 2001. With weakness in business activity abating, 1. Changefromaverageforfourthquarterofpreviousyeartoaveragefor and monetary policy already having been eased sub- fourthquarterofyearindicated. 6 Monetary Policy Report to the Congress February 2002 ment and a strengthening of the economies of our Change in real GDP major trading partners should provide some lift to final demand, and spending by both households and Percent, annual rate businessesoughttobesupportedbyrobustproductiv- ity growth. On the other hand, the problems facing 6 thehigh-techsectorhavenotyetcompletelyreceded, and indications are that spending on other types of capital equipment remains lackluster. The surprising 4 strengthofhouseholdspendingthroughthisperiodof economic weakness suggests a lack of pent-up con- 2 sumerdemandgoingforward.Inaddition,consumers likelywillnotbenefitfromdecliningenergypricesto 0 the extent they did last year, and the net decline in equity values since mid-2000 will probably continue to weigh on consumption spending in the period 1995 1997 1999 2001 ahead. Note. Here and in subsequent charts, except as noted, annual changes are Federal Reserve policymakers believe that con- measured from Q4 to Q4, and change for a half-year is measured between its final quarter and the final quarter of the preceding period. sumer prices will increase slightly more rapidly in 2002 than in 2001, as last year’s sharp decline in energy prices is unlikely to be repeated. The central tendency of the FOMC members’ projections for the terrorist attacks of September 11, which had increases in the chain-type price index for personal extremely adverse effects on certain sectors of the consumption expenditures (PCE) is about 11⁄ 2 per- economy—most notably, airline transportation and cent; last year’s actual increase was about 11⁄ 4 per- hospitalityindustries.Nevertheless,byearlythisyear cent. Nevertheless, diminished levels of resource somesignsappearedthattheeconomywasbeginning utilization,theindirecteffectsofpreviousdeclinesin tomend. energy prices on firms’ costs, and continued com- Inflationdeclinedlastyear,pulleddownbyasharp petitive pressures all ought to restrain the pace of drop in energy prices. Excluding food and energy priceincreasesoutsideoftheenergysectorthisyear. items, consumer price inflation leveled off and, by some measures, moved lower last year. Weakening economic activity, the indirect effects of declining ECONOMIC AND FINANCIAL DEVELOPMENTS energy prices on firms’ costs, and continued strong IN 2001 AND EARLY 2002 competitive pressures helped keep a lid on core con- sumerpriceinflation. In 2001, the economy turned in its weakest perfor- mance in a decade. Real GDP increased at an annual rate of 3⁄ 4 percent in the first half of the year and, according to the advance estimate from the Com- Change in PCE chain-type price index merce Department, declined at a 1⁄ 2 percent annual Percent rate in the second half. Although the effects of the weakening economy were broadly felt, the factory Total sector was especially hard hit. Faced with slumping Excluding food and energy demand both here and abroad, manufacturers cut 3 production aggressively to limit excessive buildups of inventories. Moreover, businesses sharply reduced their investment spending, with particularly dramatic 2 cuts in outlays for high-technology equipment. By contrast, household spending was reasonably well 1 maintained, buoyed by lower interest rates and cuts infederaltaxes.Firmstrimmedpayrollsthroughmost of the year, and the unemployment rate moved up nearly 2 percentage points to around 53⁄ 4 percent by 1995 1997 1999 2001 year-end. Job losses were especially large following Note. The data are for personal consumption expenditures (PCE). Board of Governors of the Federal Reserve System 7 The Household Sector exerted a notable restraining influence on household spendinglastyear. Consumer Spending Both monetary and fiscal policy supported con- sumerspendingoverthepastyear.Lowinterestrates Growth in consumer spending slowed last year but helped enable motor vehicle finance companies to remained sufficiently solid to provide an important offer favorable financing on new vehicles. In addi- source of support to overall final demand. Personal tion, low mortgage rates led to a spate of mortgage consumption expenditures (PCE) increased 3 percent refinancing that lasted most of the year, lowering in real terms in 2001 after having advanced 41⁄ 4 per- payments and freeing cash to be used by households cent in 2000 and around 5 percent in both 1998 and for other spending needs. Indeed, many households 1999. The deceleration in consumer spending was apparently used these refinancings as an opportunity widespreadamongdurablegoods,nondurablegoods, to extract equity from their homes, a move that and services. However, motor vehicle expenditures further accommodated consumer spending. Further- remainedstrongthroughmostoftheyearandsurged more, the first wave of tax reductions from the Eco- in the fall as consumers responded enthusiastically nomic Growth and Tax Relief Reconciliation Act of to automakers’ aggressive expansion of financing 2001—including the $300 and $600 rebate checks incentives. After September 11, spending declined in mailedlastsummer—likelyhelpedtoboostspending certaintravel-andtourism-relatedcategories,includ- in the latter part of the year. The continued phase-in ing air transportation, hotels and motels, and recre- ofthetaxreductionsenactedlastyearshouldprovide ation services such as amusement parks; spending in furtherstimulustoincomeandconsumptionthisyear. these categories has recovered only partially since The personal saving rate, which had declined then. through1999,leveledoffin2000andinthefirsthalf Last year’s downshift in consumption growth reflected the weakening labor market and associated deceleration of income as well as the erosion in Wealth and saving household wealth since the middle of 2000. With Ratio employment declining over much of last year, real personal income rose only about 13⁄ 4 percent after a Wealth-to-income ratio gain of 41⁄ 2 percent in 2000. The slowing of income growth was even sharper in nominal terms, but price 6 declines for gasoline and other energy items in the latter half of the year substantially cushioned the blow to real incomes. A continued rise in house 5 prices supported the wealth position of many house- holds; in the aggregate, however, household wealth 4 deteriorated further as equity prices moved lower, on net. The decline in wealth since mid-2000 likely Percent Change in real income and consumption Personal saving rate Percent, annual rate 12 Disposable personal income Personal consumption expenditures 8 8 6 4 4 0 2 1981 1985 1989 1993 1997 2001 Note. The data are quarterly. The wealth-to-income ratio is the ratio of household net worth to disposable personal income and extends through 1995 1997 1999 2001 2001:Q3; the personal saving rate extends through 2001:Q4. 8 Monetary Policy Report to the Congress February 2002 of 2001. The saving rate moved erratically in the adjustable-rate mortgages moved down sharply to secondhalfoftheyearbutroseonaverage.Itshotup very low levels in the fourth quarter and into early in the summer as households received their tax 2002.AccordingtotheMichiganSRCsurvey,declin- rebates; it then declined later in the year as house- ing mortgage rates have helped elevate consumers’ holds spent some of the rebates and as purchases of assessments of homebuying conditions substantially new motor vehicles soared in response to the sincemid-2000. incentives. Inthesingle-familysector,1.27millionnewhomes Consumersentiment,asmeasuredbyboththeUni- werestartedlastyear,31⁄ 2 percentmorethanin2000, versity of Michigan Survey Research Center (SRC) when activity had been held down by higher mort- and the Conference Board, had been running at gage rates. The pace of starts moved up further in extremely high levels through most of 2000 but fell January 2002, in part because of unusually favorable considerably near the beginning of last year as con- weather. Furthermore, sizable backlogs of building cerns about the economy intensified. By the spring, permitsearlythisyearsuggestthatconstructionactiv- measuresofsentimentleveledoffneartheirhistorical ity will remain solid. Sales of new homes were averages and well above levels normally associated elevated throughout 2001—indeed, for the year, they with recessions. Sentiment dropped in September. were the highest on record—and sales of existing The SRC measure recovered gradually thereafter, homes remained strong as well. Meanwhile, the while the Conference Board index fell further before increase in home prices moderated last year. The turning up later in the year; by early 2002, both constant-quality price index of new homes, which sentiment measures again stood near their historical attempts to control for the mix of homes sold, rose averages. only 11⁄ 2 percent last year, down from a 6 percent gainin2000. In the multifamily sector, starts averaged 328,000 Residential Investment units last year, a rate close to the solid pace of the past several years. Conditions are still relatively As with consumer spending, real expenditures on favorablefortheconstructionofmultifamilyunits.In housing were well maintained last year, buoyed by particular,vacancyrateshaveremainedlow,although favorable mortgage interest rates. Interest rates on rents and property values increased at a slower rate thirty-year fixed-rate mortgages, which had been as lastyearthanin2000. high as 81⁄ 2 percent in the spring of 2000, hovered around the low level of 7 percent in the first half of 2001. They moved down further to 61⁄ 2 percent by Household Finance lateOctober,beforebackingupto7percentagainby December as prospects for the economy improved. Households continued to borrow at a brisk pace last As monetary policy eased, contract rates on year, increasing their debt outstanding an estimated 83⁄ 4 percent, a rate about 1 percentage point faster Mortgage rates Private housing starts Percent Millions of units, annual rate Fixed rate 8.5 8.0 Single-family 7.5 1.2 7.0 Adjustable rate 6.5 .8 6.0 Multifamily 5.5 .4 1999 2000 2001 2002 Note. The data, which are monthly and extend through January 2002, 1989 1991 1993 1995 1997 1999 2001 are contract rates on thirty-year mortgages from the Federal Home Loan Mortgage Corporation. Note. The data are quarterly. Board of Governors of the Federal Reserve System 9 Household debt service burden Delinquency rates on selected types of household loans Percent Percent 6 14 5 Subprime auto loan pools 13 4 3 12 2 Auto loans at domestic auto finance companies 1985 1987 1989 1991 1993 1995 1997 1999 2001 Percent Note. The data are quarterly; 2001:Q4 is a preliminary estimate. Debt burden is an estimate of the ratio of debt payments to disposable income; 8 debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. 7 6 thantheaveragegrowthovertheprevioustwoyears. 5 Subprime mortgages The cumulative declines in mortgage interest rates 4 encouraged households to take on large amounts of 3 mortgagedebt,bothbyfosteringhomebuyingandby All mortgages 2 making it attractive to refinance existing mortgages and extract some of the accumulated equity; indeed, 1 the Mortgage Bankers Association (MBA) refinanc- ing index in October reached the highest level since 1989 1991 1993 1995 1997 1999 2001 its inception in January 1980. The frenzied pace of Note. The data are quarterly and extend through 2001:Q3. Source. For auto loans, the Big Three automakers and Moody’s Investors refinancingactivitytailedoffsomelaterinthefourth Service; for mortgages, the Mortgage Bankers Association and the Mortgage quarter, when fixed mortgage interest rates backed Information Corporation. up. All told, mortgage debt grew an estimated 9 per- cent last year. Strength in durable goods outlays cies at finance companies edged up, although they supported growth in consumer credit (debt not too remained at a relatively subdued level. The eco- securedbyrealestate)inthefirstquarterof2001,but nomic slowdown and the rise in unemployment sig- as consumption spending decelerated over the next nificantly eroded the quality of loans to subprime two quarters, the expansion of consumer credit borrowers, and delinquency rates for both mortgages slowed sharply. However, consumer credit growth and consumer credit in that segment of the market surged in the fourth quarter, in large part because of movedsharplyhigher. the jump in motor vehicle sales. For the year as a whole, the rate of expansion of consumer credit, at 61⁄ 4 percent, was well below the 101⁄ 4 percent rate The Business Sector postedin2000. Heftyhouseholdborrowingoutstrippedthegrowth Much of the weakness in activity last year was con- of disposable personal income in 2001. As a result, centrated in the business sector. In late 2000, manu- despite lower interest rates, the household debt- facturers had begun to cut back production in an service burden—an estimate of minimum scheduled effort to reduce an undesired build-up of inventories, payments on mortgage and consumer debt as a share andsharpinventoryliquidationcontinuedthroughout of disposable income—finished the year near the last year. Moreover, the boom in capital outlays that peakrecordedattheendof1986.Measuresofhouse- hadhelpeddrivetheexpansionthroughthelate1990s hold credit quality deteriorated noticeably last year. gavewaytoasofteningofspendinginlate2000and According to the MBA, delinquency rates on home to sharp declines last year. Spending dropped for mortgages continued to trend higher from their his- most types of capital equipment and structures; cut- toriclowsofthelate1990s,andautoloandelinquen- backs were especially severe for high-tech equip- 10 Monetary Policy Report to the Congress February 2002 ment, some types of which may have been over- 9 percent in 2001. Spending on communications bought. A sharp reduction in corporate profits and equipment swung even more severely, moving from cashflowcontributedtolastyear’sdownturnincapi- increases of more than 20 percent on average from tal spending, as did general uncertainty about the 1998to2000toadeclineofmorethan30percentlast economic outlook. Despite the reduction in interest year. Business spending on software held up com- rates, which helped restrain businesses’ interest parativelywell,fallingonly21⁄ 2 percentin2001after expenses, financing conditions worsened somewhat, havingrisenaround12percentin1999and2000. on balance, given weaker equity values, higher bor- Anumberoffactorsmayhaveweighedonoutlays rowing costs for risky firms, and some tightening of for high-tech equipment, including businesses’ deci- banks’lendingstandards. sions to lengthen the replacement cycle for comput- ers in light of weak economic conditions and the absenceofnewapplicationsrequiringthemostup-to- Fixed Investment date machines. But in addition, the magnitude by which these categories of expenditure had increased Real spending on equipment and software (E&S) in preceding years, together with the abruptness of declined 81⁄ 2 percent in 2001 after an increase of the their downturn, suggests that firms may have been same amount in 2000 and double-digit rates of too optimistic about the immediate profitability of increase for several preceding years. Spending on sometypesofhigh-techcapital;astheseexpectations high-tech equipment, which has accounted for about were revised, businesses viewed their previous 40percentofE&Sspendinginrecentyears,dropped investmentasmorethansufficienttomeetanticipated especially sharply last year. Outlays for computers demand. This possibility is especially likely in the andperipheralequipment,whichhadrisenmorethan caseofcommunicationsequipment,forwhichexpec- 30 percent in each of the preceding seven years, fell tations about prospects for growth in demand appear tohavebeendisappointed.Someofthecutbacksmay have reflected a general pulling back in an environ- Change in real business fixed investment mentofgreateruncertainty.Thesharpriseandsubse- quentdeclineofequityvaluesinthehigh-techsector Percent, annual rate mirrors the pattern of rising and slowing investment Structures and provides some support for the notion that earn- Equipment and software 20 ingsexpectationsmayhavebeenoverlyupbeatinthe past. 10 Under the influence of ongoing weakness in the market for heavy trucks, business spending on motor 0 vehicles declined through most of the year. But spendingstabilizedinthefourthquarter,asthegener- -10 ous incentives on motor vehicles may have helped boost spending by small businesses as well as con- -20 sumers. Domestic orders for new aircraft declined lastyear,especiallyaftertheterroristattackslastfall, Percent, annual rate but these lower orders had not yet affected spending byyear-endbecauseoftheverylonglagsinvolvedin High-tech equipment and software Other equipment 40 producingplanes.Apartfromspendingontransporta- tion and high-tech equipment, real outlays declined 30 71⁄ 2 percentlastyearafterhavingincreased6percent in2000,withtheturnarounddrivenbyasharpswing 20 in spending on many types of industrial machinery 10 andonofficefurniture. Late last year, conditions in some segments of the 0 high-tech sector showed signs of bottoming. Devel- opments in the semiconductor industry have -10 improved,withproductionincreasingduringthefall. Someoftheimprovementisapparentlycomingfrom 1995 1996 1997 1998 1999 2000 2001 increaseddemandforcomputers.Intheadvanceesti- Note. High-tech equipment includes computers and peripheral equipment and communications equipment. mate from the Commerce Department for the fourth Board of Governors of the Federal Reserve System 11 quarter, real spending on computers and peripheral Change in real nonfarm business inventories equipment was reported to have surged at an annual rate of 40 percent. However, spending on communi- Percent, annual rate cations equipment, for which evidence of a capital Total overhang has been most pronounced, continued to Non-motor-vehicle 8 decline sharply in the fourth quarter, and orders for communications equipment have yet to display any convincing signs of turning around. As for other 4 types of capital equipment, spending continued to decline in the fourth quarter, but a moderate rebound 0 in new orders for many types of capital goods from their autumn lows hinted that a broader firming of -4 demandmaybeunderway. Real business spending for nonresidential struc- tures also declined sharply in 2001. Construction of 1995 1997 1999 2001 office buildings dropped last year after having increased notably for several years; industrial build- ing remained fairly steady through the first half of The motor vehicle sector accounted for about one- last year but plummeted in the second half. Vacancy quarter of last year’s overall inventory drawdown. rates for these two types of properties rose consider- Late in 2000 and early last year, automakers cut ably, and by year-end the industrial vacancy rate had production in an attempt to clear out excess stocks reacheditshighestlevelsincemid-1993.Meanwhile, held by dealers. By the spring, vehicle assemblies spendingonnon-officecommercialbuildings(acate- had stabilized, and the automakers instead dealt with gory that includes retail, wholesale, and some ware- heavy stocks by further sweetening incentives to house space) decreased moderately last year. Invest- boostsales.Bytheendoftheyear,inventoriesofcars mentinpublicutilitiesmoveddownaswell,adecline and light trucks stood at a relatively lean 21⁄ 4 million reflecting, in part, a cutback in spending for commu- units, nearly 1 million units fewer than were held a nications projects such as the installation of fiber- yearearlier. opticnetworks.Investmentintheenergysectorwasa pocket of strength last year. Construction of drilling structures surged in 2000 and much of 2001, as the Corporate Profits and Business Finance industryrespondedtoelevatedpricesofoilandnatu- ral gas. However, with oil and natural gas prices The profitability of the U.S. nonfinancial corporate reversing their earlier increases, drilling activity sector suffered a severe blow in 2001. The profit turneddowninthelatterpartoftheyear. slumphadbeguninthefourthquarteroftheprevious year, when the economic profits of nonfinancial corporations—that is, book profits from current Inventory Investment production with inventory and capital consump- tion adjustments compiled by the Commerce By late 2000, manufacturers were already cutting Department—plummeted almost 45 percent at an production to slow the pace of inventory accumula- annual rate. The first three quarters of 2001 brought tion as inventories moved up relative to sales. Pro- littlerespite,andeconomicprofitsspiraleddownward duction cuts intensified in early 2001, and producers at an average annual rate of 25 percent. The ratio of and distributers liquidated inventories at increasing theprofitsofnonfinancialcorporationstothesector’s rates throughout the year. The runoff of inventories gross nominal output fell to 71⁄ 2 percent last year, a was a major factor holding down GDP growth last levelnotseensincetheearly1980s.Earningsreports year. Indeed, the arithmetic subtraction from real forthefourthquarterindicatethatnonfinancialcorpo- GDP growth attributable to the decline in nonfarm rateprofitscontinuedtofalllateintheyear. inventory investment was 11⁄ 2 percentage points over Business borrowing slowed markedly last year the four quarters of 2001. However, because sales becausefirmsslashedinvestmentinfixedcapitaland alsowereweakening,inventory-salesratiosremained inventories even more than the drop in profits and high in much of the manufacturing sector, and in other internally generated funds. Business debt some portions of the wholesale sector as well, expanded at a 61⁄ 4 percent annual rate in 2001, well throughouttheyear. below the double-digit rates of the two previous 12 Monetary Policy Report to the Congress February 2002 Before-tax profits of nonfinancial corporations Financing gap and net equity retirement as a percent of sector GDP at nonfarm nonfinancial corporations Percent Billions of dollars 250 Net equity retirement 12 200 150 10 100 Financing gap 50 8 0 1977 1980 1983 1986 1989 1992 1995 1998 2001 1991 1993 1995 1997 1999 2001 Note. The data are quarterly and extend through 2001:Q3. Profits are from Note. The data are annual; 2001 is based on partially estimated data. The domestic operations of nonfinancial corporations, with inventory valuation financing gap is the difference between capital expenditures and internally and capital consumption adjustments. generated funds. Net equity retirement is the difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign takeovers of U.S. firms and equity issued in public or private markets, years, and its composition shifted decidedly toward including funds invested by venture capital partnerships. longer-termsourcesoffunds.Earlyintheyear,favor- able conditions in the corporate bond market, com- theircommercialpaperoutstanding.Themoveoutof bined with firms’ desire to lock in low interest rates, commercial paper also reflected elevated credit promptedinvestment-gradefirmstoissueahighvol- spreads between high- and low-tier issuers resulting ume of bonds. They used the proceeds to strengthen from the defaults of California utilities and several theirbalancesheetsbyrepayingshort-termdebtobli- debtdowngradesamongprominentfirmsearlyinthe gations, refinancing other longer-term debt, and year.Announcementsofnewequitysharerepurchase building up liquid assets. Junk bond issuance was programs thinned considerably in the first half of the also strong early in 2001, as speculative-grade yields year,asfirmssoughttoconservetheircashbuffersin fell in response to monetary policy easings, although response to plummeting profits. A significant slow- investors shunned the riskiest issues amid increasing down in cash-financed merger activity further economic uncertainty and rising defaults among damped equity retirements, although these retire- below-investment-gradeborrowers. mentsstilloutpacedgrossequityissuance,whichwas The heavy pace of bond issuance, along with a restrained by falling share prices. Over the summer, reduced need to finance capital investments, enabled issuance of investment-grade bonds dropped off firms to decrease their business loans at banks and appreciably. Moreover, market sentiment toward speculative-grade issues cooled, as further erosion in Major components of net business financing that sector’s credit quality took its toll. Business Billions of dollars loansandoutstandingcommercialpapercontinuedto Sum of components contract, and with share prices in the doldrums, non- Commercial paper 500 Bonds financialfirmsraisedonlyasmallamountoffundsin Bank loans 400 publicequitymarketsinthethirdquarter. The terrorist attacks on September 11 constricted 300 corporate financing flows for a time. The stock mar- 200 ket closed for that week, and trading in corporate 100 bonds came to a virtual halt. After the shutdown of 0 the stock market, the Securities and Exchange Com- mission, in an effort to ensure adequate liquidity, -100 temporarily lifted some restrictions on firms’ repur- -200 chasesoftheirownshares.Accordingtoreportsfrom dealers, this change triggered a spate of repurchases 2000 2001 inthefirstfewdaysafterthestockmarketsreopened Note. Seasonally adjusted annual rate for nonfarm nonfinancial corporate business. The data for 2001:Q4 are estimated. on September 17. When full-scale trading in corpo- Board of Governors of the Federal Reserve System 13 Spreads of corporate bond yields over the ten-year swap rate credit quality and ratings downgrades among some high-profileissuersinthefall. Percentage points By early October, the investment-grade corporate bond market had largely recovered from the disrup- 9 tions associated with the terrorist attacks, and bond 8 issuance in that segment of the market picked up 7 considerably. Firms capitalized on relatively low 6 High yield longer-term interest rates to pay down short-term 5 obligations,torefinanceexistinghigher-coupondebt, 4 and to boost their holdings of liquid assets. With 3 high-yield bond risk spreads receding moderately, BBB 2 issuanceinthespeculative-gradesegmentofthecor- AA 1 porate bond market stirred somewhat from its 0 moribund state, although investors remained highly selective. Public equity issuance, after stalling in 2000 2001 2002 September, also regained some ground in the fourth Note. The data are daily and extend through February 21, 2002. The spreads compare the yields on the Merrill Lynch AA, BBB, and 175 indexes quarter,spurredbyareboundinstockprices.Aswas with the ten-year swap rate. the case for most of the year, initial public offerings and venture capital financing remained at depressed rate bonds resumed on September 17, credit spreads levels. oncorporatebondswidenedsharply:Riskspreadson Commercial paper issuance recovered somewhat speculative-grade private debt soared to levels not early in the fourth quarter as firms repaid bank loans seen since late 1991, and spreads on investment- made in the immediate aftermath of the terrorist grade corporate bonds also moved higher, although attacks and as credit spreads for lower-rated issuers byaconsiderablysmalleramount.Againstthisback- startedtonarrow.However,thecollapseoftheEnron drop, junk bond issuance nearly dried up for the rest Corporation combined with typical year-end pres- of the month. Commercial paper rates—even for surestowidenqualityspreadsinearlyDecember.All top-tier issuers—jumped immediately after the told, the volume of domestic nonfinancial commer- attacks, as risk of payment delays increased. In cial paper outstanding shrank by one-third over the response to elevated rates, some issuers tapped their year as a whole. Business loans at banks fell further backuplinesatcommercialbanks,andbusinessloans in the fourth quarter; for the year, business loans spikedintheweeksaftertheattacks.Riskspreadsfor contracted41⁄ 4 percent,theirfirstannualdeclinesince low-tier borrowers in the commercial paper market 1993. remained elevated, even after market operations had Theslowingofsalesandthedropinprofitscaused largelyrecovered,becauseofongoingconcernsabout corporate credit quality to deteriorate noticeably last Spread of low-tier CP rates over high-tier CP rates Net interest payments of nonfinancial corporations relative to cash flow Basis points Percent 125 100 20 75 15 50 25 10 1997 1998 1999 2000 2001 2002 Note. The data are daily and extend through February 21, 2002. The series 1977 1980 1983 1986 1989 1992 1995 1998 2001 shown is the difference between the rate on A2/P2 nonfinancial commercial paper and the AA rate. Note. The data are quarterly and extend through 2001:Q3. 14 Monetary Policy Report to the Congress February 2002 Default rate on outstanding bonds heavy issuance of CMBS, yield spreads on investment-grade CMBS over swap rates were about Percent unchanged over the year, suggesting that investors view credit problems in this sector as being con- 3.0 tained. Commercial banks, however, stiffened their lending posture in response to eroding prospects for 2.5 thecommercialrealestatesector;significantnetfrac- 2.0 tions of loan officers surveyed over the course of the year reported that their institutions had firmed stan- 1.5 dardsoncommercialrealestateloans. 1.0 .5 The Government Sector Federal Government 1991 1993 1995 1997 1999 2001 Note. The data are monthly; the series shown is a twelve-month moving average. Deteriorating economic conditions and new fiscal initiatives have led to smaller federal budget sur- year.Inpartbecauseofthedeclineinmarketinterest pluses than had been anticipated earlier. The fiscal rates, the ratio of net interest payments to cash flow 2001 surplus on a unified basis was $127 billion, or inthenonfinancialcorporatesectormovedonlymod- about 11⁄ 4 percent of GDP—well below both the estly above the relatively low levels of recent years, record $236 billion surplus recorded in fiscal 2000 andmostfirmsdidnotexperiencesignificantdifficul- and the $281 billion surplus that the Congressional ties servicing their debt. However, many firms were Budget Office had anticipated for fiscal 2001 at this downgraded, and evidence of financial distress time last year. Receipts, which had increased at least mounted over the course of the year. The twelve- 6 percent in each of the preceding seven fiscal years, month trailing average of the default rate on corpo- declined around 2 percent in fiscal 2001; the rise in rate bonds nearly tripled last year and by December individual tax receipts slowed dramatically and cor- ranalmost1⁄ 2 percentagepointhigherthanitspeakin porate receipts plunged 27 percent. The lower 1991. Delinquency rates on business loans at banks receipts reflected both the weakening economy— also rose, although not nearly as dramatically. The specifically, slow growth of personal income, the amountofnonfinancialdebtdowngradedbyMoody’s drop in corporate profits, and a pattern of declines in Investors Service last year was more than five times equity values that led to lower net capital gains the amount upgraded; downgrades were especially realizations—and changes associated with the Eco- pronounced in the fourth quarter, when ratings agen- nomic Growth and Tax Relief Reconciliation Act of cieslowereddebtratingsoffirmsinthetelecommuni- 2001. Some provisions of the act went into effect cation,energy,andautosectors. Commercial mortgage debt, supported by still- strong construction spending, expanded at a brisk Federal receipts and expenditures 10 percent pace over the first half of 2001. The Percent of nominal GDP growth of commercial mortgage debt edged down only 1⁄ 2 percentage point in the second half, despite a sharp slowdown in business spending on nonresi- 24 dential structures. As a result, the issuance of Expenditures commercial-mortgage-backed securities (CMBS) 22 Receipts maintained a robust pace throughout the year. Avail- abledataindicatesomedeteriorationinthequalityof exc E lu x d p in en g d n i e tu t r i e n s terest 20 commercial real estate credit. Delinquency rates on 18 commercialrealestateloansatbanksrosesteadilyin 2001 and have started to edge out of their recent 16 record-low range. In addition, CMBS delinquency ratesincreased,especiallytowardtheendoftheyear, amid the rise in office vacancy rates. Despite the 1983 1986 1989 1992 1995 1998 2001 erosionincreditqualityincommercialrealestateand Note. The data are from the unified budget and are for fiscal years. Board of Governors of the Federal Reserve System 15 Change in real government expenditures Federal government debt held by the public on consumption and investment Percent of nominal GDP Percent Federal State and local 9 45 6 35 3 0 25 -3 1961 1971 1981 1991 2001 1995 1997 1999 2001 Note. The data are as of the end of the fiscal year. Excludes debt held in federal government accounts and by the Federal Reserve System. immediately, including the rebate checks that were The existence of surpluses through fiscal 2001 mailed last summer. In addition, the act shifted some meant that the federal government continued to con- corporatetaxpaymentsintofiscal2002. tribute to the pool of national saving. Nevertheless, Meanwhile, outlays were up 4 percent in fiscal gross saving by households, businesses, and govern- 2001; abstracting from a decline in net interest pay- ments has been trending down over the past few ments, outlays increased nearly 6 percent, a second years from the recent high of around 19 percent of year of increases larger than had prevailed for some GDPin1998. time.Outlayshaveincreasedacrossallmajorcatego- The Treasury used federal budget surpluses over ries of expenditure, including defense, Medicare and the first half of the year to pay down its outstanding Medicaid, and social security. As for the part of marketabledebt.Inthethirdquarter,however,thecut federal spending that is counted in GDP, real federal inpersonalincometaxesandaweakeninginreceipts outlays for consumption and gross investment astheeconomycontractedledtheTreasurytoreenter increasedsomewhatmorerapidlythaninrecentyears the credit markets as a significant borrower of new through the first three quarters of 2001 as defense funds. The Treasury’s budget position swung back expenditures picked up. Spending rose faster still in into surplus late in the year owing to somewhat the fourth quarter because of increases for homeland stronger-than-expected tax receipts, which helped security and the additional costs associated with the push fourth-quarter net borrowing below its third- warinAfghanistan. quarter level. Despite the increase in the Treasury’s net borrowing over the second half of the year, pub- National saving licly held debt remained at only about one-third of nominal GDP last year, its lowest level since the Percent of nominal GDP mid-1980s and well below the 1993 peak of almost 50percent. TheterroristattacksonSeptember11andtheasso- 22 Excluding federal saving ciateddisruptionstofinancialmarketshadsomespill- 20 overeffectsonTreasuryfinancing.Onthedayofthe attacks,theTreasurycancelleditsscheduledbillauc- 18 tion; over the next several days, it drew down nearly all of its compensating balances with commercial 16 banks—about$121⁄ 2 billionintotal—tomeetitsobli- gations. On Thursday of that week, the settlement of Total saving 14 securities sold the day before the attacks eased the Treasury’s immediate cash squeeze, and the incom- ingstreamofestimatedquarterlypersonalincometax 1983 1986 1989 1992 1995 1998 2001 payments provided additional funds. Infrastructure Note. The data are quarterly and extend through 2001:Q3. National saving comprises the gross saving of households, businesses, and governments. problems involving the trading and clearing of Trea- 16 Monetary Policy Report to the Congress February 2002 surysecuritieswerelargelyresolvedoverthefollow- shifting to debt financing. Finally, a few states are ingweek,andwhentheTreasuryresumeditsregular considering actions such as postponing tax cuts that bill issuance on September 17, exceptionally strong wereenactedearlier. demand for bills pushed stop-out rates—that is, the Debt of the state and local government sector highest yield accepted during the auction—to their expandedrapidlylastyearafterslowgrowthin2000. lowest level since 1961. Although the Treasury can- Grossissuanceoflong-termmunicipalbondsacceler- celleddebtbuybacksscheduledforlateSeptemberto ated over the first half of 2001 as state and local conservecash,itlaterannouncedthatbuybackopera- governmentstookadvantageofloweryieldstorefund tionswouldbeginagaininOctober. outstandingdebt.Spurredbyfallinginterestratesand With its credit needs still limited, the Treasury declining tax revenues, these governments continued announced on October 31 that it was suspending to issue long-term bonds to finance new capital issuance of nominal and inflation-indexed thirty-year projects at a rapid clip over the second half of the securities. Subsequently, the thirty-year Treasury year. Despite a deterioration in tax receipts, credit bond yield fell sharply, bid-asked spreads on out- quality in the municipal market remained high in standing bonds widened, and liquidity in the bond 2001. Late in the year, however, signs of weakness sector deteriorated. Although bid-asked spreads nar- had emerged, as the pace of net credit-ratings rowed over the balance of the year, market partici- upgrades slowed noticeably. Especially significant pants reported that liquidity in the bond sector problems continue to plague California and New remained below its level before the Treasury’s York,bothofwhichsawtheirdebtratingsloweredin announcement. The announcement on October 31 November. In California, the problems were attrib- also indicated that after the January 2002 buyback uted to declining tax revenues and difficulties related operations,theTreasurywoulddeterminetheamount to the state’s electricity crisis earlier in the year, andtimingofbuybacksonaquarter-by-quarterbasis, while New York’s slip in credit quality resulted not thereby fueling speculation that future buybacks only from deteriorating tax receipts but also from might be scaled back in light of the changed budget fears of higher-than-expected costs related to clean outlook. upandrebuildingaftertheterroristattacks. State and Local Governments The External Sector Real expenditures for consumption and gross invest- Trade and the Current Account ment by states and localities rose 5 percent last year afteranincreaseof21⁄ 2 percentin2000.Muchofthe The U.S. current account deficit narrowed signifi- accelerationreflectedaburstofspendingonconstruc- cantly during 2001, with both imports and exports of tion of schools and other infrastructure needs. In goods and services falling sharply in response to a addition, outlays at the end of last year were boosted globalweakeningofeconomicactivity.Thedeficitin bythecleanupfromtheSeptember11attacksinNew York. As for employment, state and local govern- ments added jobs in 2001 at a more rapid pace than U.S. current account theydidoverthepreviousyearandtherebyhelpedto Percent of nominal GDP offsetjoblossesintheprivatesector. Thefiscalconditionofstateandlocalgovernments has been strained by the deterioration in economic 0 performance. State governments are considering a variety of actions to achieve budget balance in the -1 current fiscal year. Most states are intending to cut planned expenditures, and many are considering -2 drawing down rainy-day funds, which governments -3 had built up in earlier years. According to the NationalConferenceofStateLegislators,theserainy- -4 day funds stood at the relatively high level of $23 billion at the end of fiscal 2001 (June 30). Moreover,somestatesthathadplannedtofundcapi- 1981 1985 1989 1993 1997 2001 tal expenditures with current receipts appear to be Note. The observation for 2001 is the average of the first three quarters. Board of Governors of the Federal Reserve System 17 goods and services narrowed to $333 billion at an declined in almost all major goods categories, with annual rate in the fourth quarter of 2001 from thelargestdropsbyfarinhigh-techcapitalgoodsand $401 billion at the end of the previous year. In other machinery. Two exceptions were exports of addition, the deficit was temporarily reduced further automotive products, which rose during the second in the third quarter because service import payments and third quarters (largely parts to Canada and were lowered by a large one-time estimated insur- Mexico destined ultimately for use in U.S. markets, ance payment from foreign insurers (reported on an and vehicles to Canada), and agricultural goods. accrualbasis)relatedtotheeventsofSeptember11.1 About 45 percent of U.S. exports of goods were Excluding the estimated insurance figure, the current capital equipment; 20 percent were industrial sup- account deficit was $434 billion at an annual rate plies; and 5 percent to 10 percent each were agricul- overthefirstthreequartersoftheyear,or41⁄ 4 percent tural, automotive, consumer, and other goods. The of GDP, compared with $445 billion and 41⁄ 2 percent valueofexportedgoodsdeclinedatdouble-digitrates for the year 2000. Net investment income payments for almost all major market destinations. Even wereaboutthesameduringthefirstthreequartersof exports to Canada and Mexico declined sharply, 2001 as in the corresponding period a year earlier; despite support from two-way trade with the United higher net payments on our growing net portfolio Statesinsuchsectorsasautomotiveproducts. liability position were offset by higher net direct AsgrowthoftheU.S.economyslowednoticeably, investmentreceipts. real imports of goods and services turned down and U.S.realexportswerehitbyslowergrowthabroad, declined 8 percent for 2001 as a whole. Service continued appreciation of the dollar, and plunging paymentsdropped15percentlastyear.Theplungein global demand for high-tech products. Real exports outlaysfortravelandpassengerfaresafterSeptember of goods and services fell 11 percent over the four 11 held down total real service payments, bringing quarters of 2001, with double-digit declines begin- theirlevelinthefourthquarter15percentbelowthat ninginthesecondquarter.Servicereceiptsdecreased in the second quarter. Spending on services other 7 percent; all of the decline came after the events of than travel and passenger fares changed little during September 11. Receipts from travel and passenger the year.2 Imported goods fell 6 percent last year, fares, which plunged following the terrorist attacks, with much of the decrease in capital goods (comput- were about one-fourth lower in the fourth quarter ers, semiconductors, and other machinery). In con- than in the second quarter. Receipts from foreigners trast, real imports of automotive products, consumer forotherserviceschangedlittleovertheyear.Exports goods, oil, and other industrial supplies were little changed, and imports of foods rose. The pattern of importgrowthappearstohaveshiftedtowardtheend 1. The ‘‘insurance payment’’ component of imported services is of the year. Imports of real non-oil goods declined at calculatedasthevalueofpremiumspaidtoforeigncompanieslessthe about a 10 percent annual rate during the first three amount of losses recovered from foreign companies. In the third quarters of the year but fell less rapidly in the fourth quarter,theestimatedsizeoflossesrecoveredfarexceededtheamount paidforinsurancepremiums,resultinginanegativerecordedinsur- quarter. The price of imported non-oil goods, after ancepayment.AccordingtoNIPAaccounting,theentireamountofa risinginthefirstquarter,declinedatanannualrateof recoveryisrecordedinthequarterinwhichtheincidentoccurred. about 6 percent from the second quarter through the fourth quarter, led by decreases in the price of Change in real imports and exports of goods and services importedindustrialsupplies. The value of imported oil fell more than one-third Percent, annual rate overthefourquartersof2001,adropresultingalmost Imports entirely from a sharp decline in oil prices. The spot Exports price of West Texas intermediate (WTI) crude 10 decreased about $10 per barrel during the year, with much of the decline occurring after September 11. During the first eight months of 2001, the spot price 0 ofWTIaveraged$28perbarrelasweakeneddemand for oil and increased non-OPEC supply were largely -10 2. AccordingtoNIPAaccounting,thevalueoftheone-timeinsur- ance payments by foreign insurers is not reflected in NIPA real imports of services. The deflator for service imports was adjusted downforthethirdquartertooffsetthelowervalueofserviceimports; 1995 1997 1999 2001 thedeflatorreturnedtoitsusualvalueinthefourthquarter. 18 Monetary Policy Report to the Congress February 2002 Prices of oil and of other commodities U.S. international securities transactions January 2000 = 100 Dollars per barrel Billions of dollars Private foreign purchases of U.S. securities Net foreign purchases of U.S. bonds Oil Net foreign purchases of U.S. equities 200 100 30 150 95 20 Other 100 90 10 50 2000 2001 2002 Billions of dollars Note. The data are monthly; the last observation for oil is the average of Private U.S. purchases of foreign securities trading days through February 21, 2002; the last observation for other commodities is December 2001. The oil price is the spot price of West Net U.S. purchases of foreign bonds Texas intermediate crude oil. The price of other commodities is a weighted Net U.S. purchases of foreign equities 100 average of thirty-nine nonfuel primary-commodity prices from the International Monetary Fund. 50 offset by OPEC production restraint. In the wake of the terrorist attacks, oil prices dropped sharply in responsetoadeclineinjetfuelconsumption,weaker 0 economic activity, and reassurance from Saudi Ara- bia that supply would be forthcoming. Oil prices continued to drift lower during the fourth quarter, 1999 2000 2001 reflecting OPEC’s apparent unwillingness to con- tinue to sacrifice market share in order to defend Source. Department of Commerce and the Federal Reserve Board. higher oil prices. In late December, however, OPEC worked out an arrangement in which it agreed to typesofU.S.securitiesdemandedbyprivateforeign- reduceitsproductiontargetsanadditional1.5million ers but did not reduce the overall demand for them. barrels per day, contingent on the pledges from sev- Indeed,duringthefirsthalf,foreignprivatepurchases eralnon-OPECproducers(Angola,Mexico,Norway, ofU.S.securitiesaveraged$137billionperquarter,a Oman, and Russia) to reduce oil exports a total of rate well above the record $109 billion pace set in 462,500 barrels per day. Given the uncertainty over 2000. A slowing of foreign purchases of U.S. equi- the extent to which these reductions will actually be ties, relative to 2000, was more than offset by a implemented and the comfortable level of oil inven- pickup in foreign purchases of corporate and agency tories, the spot price of WTI remained near $20 per bonds.Inaddition,privateforeigners,whohadsolda barrelinearly2002. significant quantity of Treasury securities during 2000, roughly halted their sales in the first half of 2001. The increased capital inflows arising from Financial Account larger foreign purchases of U.S. securities in the first half was only partly offset by an increase in the pace The slowing of U.S. and foreign economic growth at which U.S. residents acquired foreign securities, over the course of last year had noticeable effects on especiallyequities. the composition of U.S. capital flows, especially The pattern of private securities transactions when the slowing became more pronounced in the changed significantly in the third quarter: Foreign secondhalf.Onbalance,netprivatecapitalflowedin purchases of U.S. equities slowed markedly, and at a pace only slightly below the record set in 2000, U.S. investors shifted from net purchases of foreign including unprecedented net inflows through private securities to net sales. However, the reduced flows securitiestransactions. inthethirdquarterseemtohavereflectedshort-lived During the first half of 2001, sagging stock prices reactionstoeventsinthequarter.Preliminarydatafor and signs of slower growth brought a shift in the the fourth quarter show a significant bounceback in Board of Governors of the Federal Reserve System 19 foreign purchases of U.S. securities and a return to Net change in payroll employment purchasesofforeignsecuritiesbyU.S.residents. Thechangingeconomicclimatealsoaffecteddirect Thousands of jobs, monthly average investmentcapitalflows.During2000,foreigndirect Private nonfarm investment in the United States averaged more than 300 $70 billion per quarter. These flows slowed to less 200 than $60 billion per quarter in the first half and then dropped to only $26 billion in the third quarter (the 100 last available data). The drop resulted in part from a Jan. decline in the outlook for corporate profits and a 0 significant reduction in general merger and acquisi- -100 tion activity. By contrast, U.S. direct investment abroad picked up over the course of 2001. The third -200 quarter outflow of $52 billion—a record—reflected both a large merger and robust retained earnings by 1990 1992 1994 1996 1998 2000 2002 the foreign affiliates of U.S. firms. Capital inflows Manufacturing and related from official sources were relatively modest in 2001, Non-manufacturing-related 300 totaling only $15 billion, compared with $36 billion in2000. 200 100 Jan. The Labor Market 0 Employment and Unemployment -100 -200 Last year’s weakening in economic activity took its toll on the labor market. Payroll employment edged 1998 1999 2000 2001 upearlylastyearandthendroppednearly11⁄ 2 million by January 2002. Declines were particularly large in Note. Manufacturing and related industries includes establishments in manufacturing, wholesale trade, and help supply services. manufacturing, which has shed one in twelve jobs Non-manufacturing-related industries includes the remainder of private since mid-2000. Job cuts accelerated in the months nonfarm establishments. following the terrorist attacks of September 11, with declines occurring in a wide variety of industries. The unemployment rate moved up from 4 percent in Measures of labor utilization late 2000 to 5.8 percent by December 2001. In Janu- ary 2002, the unemployment rate edged down to Percent 5.6percent. Early last year, employment in manufacturing, 15 which had been trending down for several years, began to decline more rapidly. Job losses were wide- Augmented unemployment rate 12 spreadwithinthemanufacturingsectorbutweremost pronouncedindurable-goodsindustries,suchasthose 9 producing electrical and industrial machinery and metals. Employment at help supply firms and in 6 wholesale trade—industries that are directly related Civilian unemployment rate to manufacturing—also began to decline. Outside of 3 manufacturing and its related industries, private pay- rollscontinuedtoincreaserobustlyinthefirstquarter 1972 1982 1992 2002 of last year, but hiring then slowed, although it remained positive, on net, in the second and third Note. The data extend through January 2002. The augmented umemployment rate is the number of unemployed plus those who are not in quarters. Construction payrolls increased into the the labor force and want a job, divided by the civilian labor force plus spring but flattened out thereafter. Employment at those who are not in the labor force and want a job. In January 1994, a redesigned survey was introduced; data for the augmented rate from that retail trade establishments also continued to increase point on are not directly comparable with those of earlier periods. For the moderatelythroughthespringbutbegantodeclinein augmented rate, the data are quarterly through December 1993 and monthly thereafter; for the civilian labor force rate, the data are monthly. thelatesummer.Inservicesindustriesotherthanhelp 20 Monetary Policy Report to the Congress February 2002 supply firms—a broad group that accounted for Change in output per hour nearly half of the private payroll increases over the preceding several years—job gains slowed but Percent, annual rate remained positive in the second and third quarters of last year. In all, private payroll employment declined 4 about 115,000 per month in the second and third quarters, and the unemployment rate moved up 3 steadily to 41⁄ 2 percent by the spring and to nearly 5percentbyAugust. 2 The labor market was especially hard hit by the terrorist attacks. Although labor demand was weak 1 prior to the attacks, the situation turned far worse 0 following the events of September 11, and private payrolls plunged more than 400,000 per month on average in October and November. Employment fell 1991 1993 1995 1997 1999 2001 substantiallynotonlyinmanufacturingandinindus- Note. Nonfarm business sector. tries directly affected by the attacks, such as air transportation, hotels, and restaurants, but also in a compensationmeasurespaintdifferentpicturesofthe wide variety of other industries such as construction magnitude of that deceleration. The slowing likely andmuchoftheretailsector. reflected the influence of the soft labor market, Employment continued to decline in December energy-driven declines in price inflation toward the and January but much less than in the preceding two latter part of the year, and subdued inflation expecta- months. Manufacturing and its related industries lost tions.Compensationprobablywasalsohelddownby jobs at a slower pace, and employment leveled off in a reduction in variable pay, such as bonuses that are other private industries. The unemployment rate tied to company performance and stock-option movedupto5.8percentinDecemberbutthenticked activity. downto5.6percentinJanuary.Therecentreversalof According to the employment cost index, hourly the October and November spikes in new claims for compensation costs increased 41⁄ 4 percent during unemployment insurance and in the level of insured 2001,downfroma41⁄ 2 percentincreasein2000;both unemployment also point to some improvement in the wages and salaries and benefits components labormarketconditionsearlythisyear. recorded slightly smaller increases. The deceleration in the index for wages and salaries was concentrated among sales workers, whose wages often include a Productivity and Labor Costs substantial commission component and so are espe- cially sensitive to cyclical developments. Although Given economic conditions, growth of labor produc- tivity was impressive in 2001. Productivity growth Measures of the change in hourly compensation typically drops when the economy softens, partly Percent because businesses tend not to shed workers in pro- portion to reduced demand. Last year, however, out- Employment cost index 7 putperhourinthenonfarmbusinesssectorincreased Nonfarm compensation per hour a relatively solid 11⁄ 2 percent, according to the 6 advance estimate, after having risen 21⁄ 2 percent in 5 2000—amilddecelerationbypastcyclicalstandards. Indeed,productivityisestimatedtohaveincreasedat 4 an annual rate of more than 2 percent in the second 3 half of the year, an impressive performance during a 2 period when real GDP was, on net, contracting. The buoyancy of productivity during 2001 provides fur- 1 ther support to the view that the underlying trend of productivity growth has stepped up notably in recent 1991 1993 1995 1997 1999 2001 years. Note. For the employment cost index (ECI), change is from December to Hourly labor compensation costs increased more December; for nonfarm compensation, Q4 to Q4. The ECI is for private industry excluding farm and household workers. Nonfarm compensation per slowly last year than in 2000, although different hour is for the nonfarm business sector. Board of Governors of the Federal Reserve System 21 Change in unit labor costs Prices Percent Inflation declined in 2001 largely because of a steep drop in energy prices. The chain-type price index for 5 personal consumption expenditures (PCE) increased 1.3 percent last year after having increased 2.6 per- 4 cent in 2000; the turnaround in consumer energy prices accounted for almost all of that deceleration. 3 Increases in PCE prices excluding food and energy itemsalsoslowedalittlelastyearafterhavingmoved 2 up in 2000. The chain-type price index for gross domestic purchases—the broadest price measure for 1 domestically purchased goods and services— deceleratedconsiderablylastyear.Thesmallincrease 1991 1993 1995 1997 1999 2001 in this index reflected both the drop in energy prices and a resumption of rapid declines for prices of Note. Nonfarm business sector. investment goods, especially computers, following a the increase in employers’ cost of benefits slowed period of unusual firmness in 2000. The price index overall, the cost of providing health insurance for GDP—the broadest price measure for domesti- increased more than 9 percent last year; the rise callyproducedgoodsandservices—postedasmaller continued this component’s accelerating contribution deceleration of about 1⁄ 2 percentage point between tolaborcostsoverthepastfewyearsafteraperiodof 2000 and 2001 because lower oil prices have a restrainedcostincreasesinthemid-1990s. smaller weight in U.S. production than in U.S. An alternative measure of hourly compensation is purchases. the BLS’s measure of compensation per hour in the Consumer energy prices continued to move higher nonfarmbusinesssector,whichisderivedfromcom- through the early months of 2001 before turning pensation information in the national accounts; this down sharply in the second half of the year. Despite measure increased 4 percent last year, a very large the fact that crude oil prices were declining over the dropfromthe73⁄ 4 percentincreaseregisteredin2000. first half of the year, retail gasoline prices increased One reason that these two compensation measures atanannualrateof8percentduringthatperiod.The may diverge is that only nonfarm compensation per sizableincreaseinmarginsongasolinereflectedboth hour captures the cost of stock options. Although the refinery disruptions and low inventory levels going twocompensationmeasuresdifferinnumerousother into the summer driving season. But gasoline prices respects as well, the much sharper deceleration in fellsharplythereafterasrefineriescamebackonline, nonfarm compensation per hour may indicate that imports of gasoline picked up, and crude oil prices stockoptionexercisesleveledoffordeclinedin2001 moved considerably lower over the latter half of the in response to the fall in equity values. However, year. In all, gasoline prices were down 19 percent because nonfarm compensation per hour can be over the year as a whole. Heating oil prices reflected revised substantially, one must be cautious in inter- preting the most recent quarterly figures from this Change in consumer prices series. Percent Unit labor costs, the ratio of hourly compensation to output per hour in the nonfarm business sector, Consumer price index Chain-type price index for PCE 6 increased about 2 percent last year. Although down from a huge 5 percent increase in 2000 that reflected 5 that year’s surge in nonfarm compensation per hour, the figure for 2001 is still a little higher than the 4 moderate increases seen over the preceding several 3 years. Last year’s increase in unit labor costs was held up by the smaller productivity increases that 2 accompanied weak economic activity; accordingly, 1 subsequent increases in unit labor costs would be helddownifoutputperhourbeginstoincreasemore rapidlyastheeconomystrengthens. 1991 1993 1995 1997 1999 2001 22 Monetary Policy Report to the Congress February 2002 Change in consumer prices excluding food and energy livestock prices—especially beef. But these prices softened later in the year under the influence of Percent highersupplies,lowerdomesticdemand,andforeign outbreaks of mad cow disease, which apparently Consumer price index Chain-type price index for PCE 6 dampeddemandforbeefnomatterwhereproduced. Excluding food and energy items, PCE prices rose 5 1.6 percent last year, a small deceleration from its 4 1.9percentincreaseover2000.Thatdecelerationwas concentrated in prices of goods, with prices espe- 3 cially soft for motor vehicles and apparel. By con- trast, prices of many services continued to accelerate 2 last year. In particular, shelter costs—which include 1 residential rent, the imputed rent of owner-occupied housing, and hotel and motel prices—increased 1991 1993 1995 1997 1999 2001 41⁄ 4 percentlastyearafterhavingrisen31⁄ 2 percentin 2000. Standing somewhat in contrast to the small decel- crude oil developments more directly and declined eration in core PCE prices, the core consumer price sharply through most of the year. Meanwhile, spot prices of natural gas peaked in January 2001 at the index(CPI)increased23⁄ 4 percentlastyear,aboutthe same rate as in 2000. Although components of the extraordinarily high level of nearly $10 per million CPI are key inputs of the PCE price index, the two BTUs, and prices at the consumer level continued to pricemeasuresdifferinavarietyofways.Oneimpor- surge in the first few months of the year. These tant difference is that the PCE measure is broader in increasesreflectedthepressurefromongoingstrength scope; it includes expenditures made by nonprofit indemandcoupledwithunusuallycoldweatherearly institutions and consumption of items such as check- last winter that left stocks at very low levels. But the ing services that banks provide without explicit situation improved as expanded supply allowed charge.PricesforthePCEcategoriesthatareoutside stocks to be replenished: Spot prices reversed those thescopeoftheCPIdeceleratednotablyin2001and earlier increases, and prices of consumer natural gas accounted for much of the differential movements of declinedsubstantiallythroughtherestoftheyear. inflationmeasuredbythetwopriceindexes.Another In contrast, electricity prices rose through most of difference is that the CPI places a larger weight on last year. The increases reflected the effects of the housing than does the PCE price index, and last earlier rises in the prices of natural gas and coal on year’s acceleration of housing prices therefore fuel costs of utilities as well as problems with elec- boostedtheCPIrelativetothePCEmeasure. tricitygenerationinCalifornia.Californiawasableto The leveling off or decline in core consumer price avoidseriouspowerdisruptionslastsummerbecause inflation reflects a variety of factors, including the high electricity prices, weak economic activity, and weakening of economic activity and the accompany- moderateweatherallhelpedkeepdemandincheck. ing slackening of resource utilization; the decline in Consumer food prices increased more rapidly last energy prices that reduced firms’ costs; and continu- year, rising about 3 percent after having risen only ingintensecompetitivepressuresinproductmarkets. 21⁄ 2 percentin2000.Earlyintheyear,strongdemand, These factors also likely helped to reduce inflation both domestic and foreign, led to large increases in expectations late last year, and this reduction itself may be contributing to lower inflation. According to Alternativemeasuresofpricechange the Michigan SRC, median one-year inflation expec- Percent tations, which had held near 3 percent through 2000 Pricemeasure 2000 2001 and into last summer, moved down to 23⁄ 4 percent in thethirdquarterandplummetedto1percentorlower Chain-type Grossdomesticproduct .................. 2.4 1.8 in October and November. Falling energy prices and Grossdomesticpurchases ................ 2.5 1.1 Personalconsumptionexpenditures ....... 2.6 1.3 widespreadreportsofdiscountingfollowingtheSep- Excludingfoodandenergy............. 1.9 1.6 tember 11 attacks likely played a role in causing this Fixed-weight sharp break in expectations. Part of this drop was Consumerpriceindex.................... 3.4 1.9 Excludingfoodandenergy............. 2.5 2.7 reversed in December, and since then, inflation expectationshaveremainedaround2percent—arate Note. Changes are based on quarterly averages and are measured to the fourthquarteroftheyearindicatedfromthefourthquarteroftheprecedingyear. still well below the levels that had prevailed earlier. Board of Governors of the Federal Reserve System 23 Meanwhile, the Michigan SRC’s measure of longer- Interest Rates term inflation expectations, which had also remained close to 3 percent through 2000 and the first half of Short-term market interest rates moved down with 2001, ticked down to 23⁄ 4 percent in October and the FOMC’s cumulative cut in the target federal stoodatthatlevelearlythisyear. funds rate of 43⁄ 4 percentage points, and yields on intermediate-termTreasurysecuritiesdeclinedalmost 2 percentage points. Longer-term interest rates had U.S. Financial Markets already fallen in the latter part of 2000, when inves- tors began to anticipate significant policy easing in As a consequence of the Federal Reserve’s aggres- response to weakening economic growth. As the siveeasingofthestanceofmonetarypolicyin2001, FOMC aggressively eased the stance of monetary interest rates on short- and intermediate-term Trea- policyduringthewinterandspring,investors’expec- surysecuritiesfellsubstantiallyoverthecourseofthe tations of a prompt revival in economic activity took year. Longer-term Treasury bond yields, however, hold and were manifested in a sharp upward tilt of ended the year about unchanged, on balance. These moneymarketfuturesratesandanappreciablerisein rates had already fallen appreciably in late 2000 in longer-term interest rates over the second quarter. anticipation of monetary policy easing. They may However, signs of the anticipated economic turn- also have been held up last year by an increased around failed to materialize as the summer pro- likelihood of federal budget deficits and, except in gressed. Indeed, the weakening in economic activity the immediate aftermath of the terrorist attacks, by was becoming more widespread, which prompted investors’optimismaboutfutureeconomicprospects. expectations of further monetary policy easing over Despitethisoptimism,theslowdowninfinaldemand, the near term, and longer-term interest rates turned a slump in corporate earnings, and a marked deterio- downagain. ration in credit quality of businesses in a number of The terrorist attacks of September 11 dramatically sectors made investors more wary about risk. redrew the picture of the nation’s near-term eco- Although interest rates on higher-rated investment- nomic prospects. Market participants lowered mark- grade corporate bonds generally moved in line with edly their expected trajectory for the path of the those on comparably dated government securities, federal funds rate in the immediate aftermath of the lower-rated firms found credit to be considerably attacks, and revisions to policy expectations, com- more expensive, as risk spreads on speculative-grade binedwithconsiderableflight-to-safetydemands,cut debt soared for most of the year before narrowing short-andintermediate-termTreasuryyieldssubstan- somewhat over the last few months. Interest rates on tially over subsequent days. The FOMC, confronted commercialpaperandbusinessloansfelllastyearby withevidenceofadditionalweaknessinfinaldemand about as much as the federal funds rate, but risk and prices, eased policy further over the balance of spreads generally remained in the elevated range. In the year, and short-term market interest rates contin- addition, commercial banks tightened standards and ued to decline. In early November, however, terms for business borrowers throughout the year. intermediate- and long-term interest rates turned up, Equity prices were exceptionally volatile and fell further,onbalance,in2001. Rates on selected Treasury securities Increased caution on the part of lenders did not Percent appear to materially damp aggregate credit flows. Private borrowing was robust last year, especially 7 when compared with the marked slowing in nominal spending. Relatively low long-term interest rates Ten-year 6 encouraged both businesses and households to con- 5 centrate borrowing in longer-term instruments, thereby locking in lower debt-service obligations. 4 Two-year Theproceedsoflong-termborrowingwerealsoused 3 to strengthen balance sheets by building stocks of Three-month 2 liquid assets. A shift toward safer and more liquid asset holdings showed through in rapid growth of 1 M2,whichwasspurredfurtherbyreducedshort-term market interest rates and elevated stock market 2000 2001 2002 volatility. Note. The data are daily and extend through February 21, 2002. 24 Monetary Policy Report to the Congress February 2002 Corporate bond yields Yields on higher quality investment-grade corpo- rate bonds generally followed those on comparably Percent dated Treasury securities last year, although risk spreads widened moderately before narrowing over the last few months. In contrast, interest rates on 20 speculative-gradecorporatedebtincreasedsteadilyin 2001,asriskspreadsballoonedinresponsetomount- ing signs of financial distress among weaker firms. 15 Even with a considerable narrowing over the final two months of the year, risk spreads on below- High yield investment-grade bonds remained quite wide. 10 Spreads for high-yield bonds edged down further in AA 2002 after rising sharply in early January, when sev- eral important technology and telecommunications 1990 1992 1994 1996 1998 2000 2002 companies revised down their earnings forecasts or released corrections to past earnings statements. Note. The data are monthly averages and extend through January 2002. The AA rate is calculated from bonds in the Merrill Lynch AA index with Interest rates on commercial and industrial (C&I) seven to ten years remaining maturity. The high-yield rate is the yield loans at banks fell last year by about as much as the on the Merrill Lynch 175 high-yield index. federalfundsrate.AccordingtotheFederalReserve’s as it became apparent that the economic fallout from quarterly Survey of Terms of Business Lending, the the attacks would be more limited than some had spread over the target federal funds rate of the aver- originallyfeared,andasmilitarysuccessinAfghani- age interest rate on C&I loans varied somewhat over stan bolstered investors’ confidence and moderated the year, falling for a while then rising sharply safe-havendemands.Bytheendoftheyear,yieldson between August and November; nonetheless, it has intermediate-term Treasury securities had reversed generally remained in the elevated range that has about half of their post–September 11 decline, while persisted since late 1998. The same survey also indi- yields on longer-term Treasury securities had risen cated that over the course of last year commercial enough to top their pre-attack levels. In early 2002, banks, like other lenders, have become especially however, yields on intermediate- and longer-term cautious about lending to marginal credits, as indi- Treasuries edged down again, as market participants cated by the average spread on riskier C&I loans not trimmed their expectations for the strength of the madeunderapreviouscommitment,whichsoaredin economic rebound, and the Congress failed to move 2001. forwardwithadditionalfiscalstimulus. Equity Markets Spread of average business loan rate over the intended federal funds rate The exceptional volatility of equity prices in 2001 Percentage points likelyreflectedthedramaticfluctuationsininvestors’ assessmentoftheoutlookfortheeconomyandcorpo- High-risk loans not made rateearnings.Sharepricestumbledearlylastyear,as under commitment 2.5 pessimism and uncertainty about the direction of the economy were intensified by a spate of negative All loans earnings announcements and profit warnings in Feb- 2.0 ruaryandMarch.Thepronouncedsell-offofequities came to a halt at the end of the first quarter, with the Wilshire5000—averybroadindexofstockprices— 1.5 downabout13percent,whilethetech-heavyNasdaq ended the first quarter at its lowest level since 1998 and more than 60 percent below its record high 1991 1993 1995 1997 1999 2001 reachedinMarchof2000. Companies, especially in the technology sector, Note. The data are for loans made by domestic commercial banks and are based on a survey conducted in the middle month of each quarter; the final reported weak profits for the first quarter, but their observation is for November 2001. High-risk loans are those in categories announcementsgenerallysurpassedanalysts’sharply ‘‘moderate’’ and ‘‘acceptable.’’ Source. Federal Reserve Survey of Terms of Business Lending. lowered expectations. With the 1 percentage point Board of Governors of the Federal Reserve System 25 Major stock price indexes In late September, stock prices staged a comeback that lasted through the fourth quarter, as incoming January 3, 2000 = 100 information suggested that the economy had proven remarkably resilient and economic prospects were improving. On the perception that the worst for the 100 technology sector would soon pass, share prices of firmsintechnologyindustriesjumpedsharply,lifting S&P 500 the Nasdaq more than 35 percent from its September 75 nadir.Onbalance,lastyear’sgyrationsinstockprices Wilshire 5000 left the Wilshire 5000 down about 10 percent, while theNasdaqfell20percent.Thewidespreaddeclinein 50 equity prices through the first three quarters of 2001 Nasdaq is estimated to have wiped out nearly $31⁄ 2 trillion in householdwealth,translatinginto81⁄ 4 percentoftotal 2000 2001 2002 household net worth. Of this total, however, about Note. The data are daily and extend through February 21, 2002. $11⁄ 4 trillionwasrestoredbythestockmarketrallyin the fourth quarter. Moreover, the level of household net worth at the end of last year was still almost reduction in the federal funds rate over March and 50 percent higher than it was at the end of 1995, April, investors became more confident that an when stepped-up productivity gains had begun to improvement in economic conditions was in train, induce investors to boost significantly their expecta- and equity prices rallied; the rebound was particu- tions of long-term earnings growth. In January and larly strong for technology companies—the Nasdaq earlyFebruaryof2002,investorsreactedtogenerally rose almost 40 percent between April and the end of disappointing news about expected earnings, espe- May. The forward momentum in equity markets was cially in the telecommunications sector, and to con- checked in June, however, in part because analysts cernsaboutcorporateaccountingpracticesbyerasing slashed their estimates for near-term corporate earn- some of the fourth-quarter gain in equity prices. ings growth. Although the stock market initially Despite this decline, the price-earnings ratio for the proved resilient in the face of the bleak profit news, S&P 500 index (calculated using operating earnings suggesting that weak earnings had been largely expected over the next year) remained close to its anticipatedbyinvestors,thesteadybarrageofdismal levelatthebeginningof2001.Therelativelyelevated economic news—particularly in the technology and ratio reflected lower market interest rates as well as telecommunications sectors—started to exert down- investor anticipation of a return to robust earnings ward pressure on share prices by early August. The growth. slide in stock prices intensified in early September, with technology stocks taking an exceptional drub- bing.BySeptember10,theWilshire5000wasdown Price–earnings ratios for the S&P 500 almost 10 percent from the end of July, while the Nasdaqhadlostmorethan16percent. Ratio The attacks on September 11, a Tuesday, caused stock markets to shut down and to remain closed for 25 the rest of that week. Trading resumed in an orderly fashiononMonday,September17,butthedayended 20 with the market as a whole down about 5 percent— with airline and hotel stocks pounded most—and 15 trading volume on the New York Stock Exchange hitting a record high. Major stock price indexes, 10 which sagged further in subsequent days and weeks, were weighed down by investors’ more pessimistic 5 evaluationofthenear-termeconomicoutlookandby sizabledownwardrevisionstoanalysts’earningspro- 1984 1987 1990 1993 1996 1999 2002 jectionsfortherestof2001.Bythethirdweekofthe month, broad stock price indexes had fallen a total Note. The data are monthly and extend through January 2002. The ratios are based on I/B/E/S consensus estimates of earnings over the coming twelve of12percentfromtheirlevelsonSeptember10. months. 26 Monetary Policy Report to the Congress February 2002 Debt and Depository Intermediation nominalGDPdeceleratingsharply,theratioofnonfi- nancialdebttoGDPmovedupnotablyin2001,more The growth of the debt of nonfederal sectors was thanreversingitsdecreaseinthepreviousyear. strongoverthefirsthalfoftheyear,asthedeclinein Theeconomicslowdownandthedeclineinmarket longer-term interest rates during the final months of interestrateslastyearleftanoticeableimprintonthe 2000 prompted some opportunistic tapping of bond composition of financial flows, with borrowing by marketsbybusinessesandhelpedkeeptheexpansion businesses and households migrating toward longer- of household credit brisk. However, the combination term bond and mortgage markets. As a consequence, of a stepdown in the growth of consumer durables credit at depository institutions expanded sluggishly purchases,afurtherdropincapitalexpenditures,and over the year. Growth of loans at commercial banks a substantial inventory liquidation over the second dropped off sharply, from 12 percent in 2000 halfoftheyearresultedinasignificantlyslowerpace to 21⁄ 4 percent in 2001. The slowdown in total of private borrowing. On balance, growth of nonfed- bank credit—after adjustments for mark-to-market eral debt retreated about 1 percentage point in 2001, accounting rules—was less severe, because banks to 71⁄ 2 percent. Federal debt continued to contract acquired securities, largely mortgage-backed securi- early last year; it then turned up as the budget fell ties, at a brisk pace throughout the year. A healthy into a deficit reflecting the implementation of the tax banking sector served as an important safety valve cut,theeffectoftheweakereconomyontaxreceipts, for several weeks after September 11, as businesses and emergency spending in the wake of the terrorist tapped backup lines of credit to overcome problems attacks. As a result, the federal government paid associated with the repayment of maturing commer- down only 11⁄ 4 percent of its debt, on net, over 2001, cialpaperandissuanceofnewpaper.Moreover,with comparedwith63⁄ 4 percentinthepreviousyear.With payment flows temporarily interrupted by the terror- ist attacks, a substantial volume of overdrafts was created, causing a spike in the ‘‘other’’ loan category Growth of nonfinancial debt that includes loans to depository institutions. By the Percent end of October, however, the disruptions to business financing patterns and payment systems that bloated bankbalancesheetshadlargelydissipated,andloans 8 contractedsharply. Commercialbanksreportedamarkeddeterioration 6 in loan performance last year. Delinquency and Total charge-offratesonC&Iloanstrendedupappreciably, 4 although they remained well below rates recorded during the 1990-91 recession. Delinquency rates on credit card accounts increased for the second year in 2 Delinquency rates on commercial and industrial and credit card loans at banks Percent Percent Nonfederal 10 6 5 Credit cards 5 0 4 Federal -5 3 C&I loans 2 1989 1991 1993 1995 1997 1999 2001 Note. The data are monthly. Annual growth rates are computed from 1991 1993 1995 1997 1999 2001 fourth-quarter averages. Domestic nonfinancial debt consists of the outstanding credit market debt of governments, households, nonprofit Note. The data, from bank Call Reports, are quarterly, seasonally adjusted organizations, nonfinancial businesses, and farms. and extend through 2001:Q3. Board of Governors of the Federal Reserve System 27 Net percentage of domestic banks tightening standards on Percent of all U.S. commercial bank assets credit card and selected commercial and industrial loans at well-capitalized banks Percent Percent 60 Credit cards 100 40 80 20 60 0 C&I loans to large 40 and medium-sized firms -20 1990 1992 1994 1996 1998 2000 2002 1991 1993 1995 1997 1999 2001 Note. The data extend through January 2002 and are based on a survey Note. The data are quarterly and extend through 2001:Q3. Capital status is generally conducted four times per year. Large and medium-sized firms are determined using the regulatory standards for the leverage, tier 1, and total those with annual sales of $50 million or more. Net percentage is percentage capital ratios. reporting a tightening less percentage reporting an easing. Source. Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices. exposure to Enron and, to a lesser extent, Argentina. On the positive side, wider net interest margins helpedsupportprofitsthroughout2001. arow,reaching5percentforthefirsttimesinceearly 1992. Banks responded to the deteriorating business and household balance sheets by tightening credit The Monetary Aggregates standardsandtermsforbothtypesofloan,according totheFederalReserve’sSeniorLoanOfficerOpinion The broad monetary aggregates grew very rapidly in Survey on Bank Lending Practices. Banks indicated 2001. Over the four quarters of the year, M2 that they had tightened business lending policies in increased 101⁄ 4 percent, a rate significantly above the response to greater uncertainty about the economic pace of the past several years. Because the rates of outlook and their reduced tolerance for risk. Simi- return provided by many components of M2 move larly, the net fractions of banks reporting that they sluggishly, the swift decline in short-term market hadtightenedstandardsforbothcreditcardandother interest rates last year significantly lowered the consumer loans rose markedly over the first half of opportunity cost of holding M2 assets, especially for last year. As household financial conditions contin- uedtoslip,thenetproportionofbanksthattightened M2 growth rate standardsonconsumerloansremainedatanelevated levelinthesecondhalfoftheyear. Percent In response to rising levels of delinquent and charged-off loans, commercial banks significantly 10 boosted the rate of provisioning for loan losses last year, which, along with reduced income from capital 8 marketactivities,cutintothebankingsector’sprofits. Nonetheless, through the third quarter of 2001— 6 thelatestperiodforwhichCallReportdataareavail- able—measures of industry profitability remained 4 near the elevated range recorded for the past several years,andbankscontinuedtoholdsubstantialcapital 2 to absorb losses. Indeed, virtually all assets were at well-capitalized banks at the end of the third quarter, 1991 1993 1995 1997 1999 2001 and the substitution of securities for loans on banks’ Note. M2 consists of currency, travelers checks, demand deposits, other balancesheetsalsohelpededgeuprisk-basedcapital checkable deposits, savings deposits (including money market deposit ratios. In the fourth quarter, a number of large banks accounts), small-denomination time deposits, and balances in retail money market funds. Annual growth rates are computed from fourth-quarter saw their profits decline further because of their averages. 28 Monetary Policy Report to the Congress February 2002 M2 velocity and opportunity cost plunging equity prices led to a sharp step-up in the growth of retail money market mutual funds. After a Ratio, ratio scale Percentage points, ratio scale substantial unwinding of distortions to money flows in October, M2 growth over the balance of the year 2.1 M2 velocity wasspurredbyfurtherdeclinesinitsopportunitycost resulting from additional monetary policy easings and by heightened volatility in equity markets. The 10 hefty advance in M2 last year outpaced the anemic 1.9 expansion of nominal income, and M2 velocity—the 4 ratio of nominal GDP to M2—posted a record decline. 2 M2 M3—the broadest monetary aggregate—grew 1.7 opportunity cost 1 13 percent over 2001. In addition to the surge in its M2component,hugeinflowsintoinstitutionalmoney 1977 1980 1983 1986 1989 1992 1995 1998 2001 funds boosted M3 growth. Investors’ appetite for these instruments was enormous last year because Note. The data are quarterly. The velocity of M2 is the ratio of nominal gross domestic product to the stock of M2. The opportunity cost of holding their returns were unusually attractive as they lagged M2 is a two-quarter moving average of the difference between the the steep decline in market interest rates. The slow- three-month Treasury bill rate and the weighted average return on assets included in M2. down in the growth of bank credit over the summer, whichresultedinacontractioninmanagedliabilities, its liquid deposits (the sum of checking and savings dampedtheriseinM3somewhat.ThevelocityofM3 accounts)andretailmoneyfundscomponents.More- dropped for the seventh year in the row, to a record over,negativereturnsandelevatedvolatilityinequity low. markets likely raised household demand for M2 assets through the fall. An unprecedented level of mortgage refinancing activity (which results in pre- International Developments payments that temporarily accumulate in deposit accounts before being distributed to investors in Economic activity in foreign economies weakened mortgage-backedsecurities),aswellasincreasedfor- substantially in 2001. Early in the year, activity eign demand for U.S. currency, also bolstered the abroad was depressed by high oil prices, the global growthofM2overthecourseoftheyear. slump in the high-tech sector, and spillover from the Involuntaryaccumulationofliquiddepositsresult- U.S. economic slowdown. The September terrorist ingfrompaymentsystemdisruptionsaftertheterror- attacks further heightened economic uncertainty. ist attacks, combined with elevated safe-haven On average, foreign economic activity was about flat demands, caused M2 to surge temporarily in the over the year. The weakest performer among indus- weeks following September 11. At the same time, trial economies was Japan, where output declined. M3 growth rate The euro area eked out a slight increase in its real GDP.Activityinmostemergingmarketeconomiesin Percent both Asia and Latin America declined. Asian devel- oping economies were particularly hard hit by the 12 falloffindemandfortheirhigh-techexports.InLatin America, the output decline in Mexico largely 10 reflected sharply reduced export demand from the 8 United States; Argentina’s financial crisis precipi- tated a further sharp drop in output in that country. 6 An easing of average foreign inflation reflected the 4 weaknessofactivityaswellasanetdeclineinglobal oilpricesoverthecourseoftheyear. 2 In response to the pronounced weakness in eco- nomic activity, monetary authorities in the major 1991 1993 1995 1997 1999 2001 industrial countries eased policy throughout the year. Note. M3 consists of M2 plus large-denomination time deposits, balances Nevertheless, interest rates on long-term government in institutional money market funds, repurchase-agreement liabilities securities showed little net change from the begin- (overnight and term), and eurodollars (overnight and term). Annual growth rates are computed from fourth-quarter averages. ning to the end of the year in most major industrial Board of Governors of the Federal Reserve System 29 countries. Weak economic conditions tended to put Nominal U.S. dollar exchange rate indexes downward pressure on long-term rates, but moves toward more stimulative macroeconomic policies January 1999 = 100 appeared to encourage market participants to expect economic recovery, thereby supporting long-term Major currencies 115 interest rates. Following the terrorist attacks in Sep- tember, interest rates declined around the globe as expected economic activity weakened and demand 110 shifted away from equities and toward the relative safety of bonds. However, toward year-end, as the 105 period of crisis passed, long-term interest rates reboundedstrongly. Broad 100 Overall stock indexes in foreign industrial econo- mies declined for the second consecutive year as activity faltered and actual and projected corporate 1999 2000 2001 2002 earnings fell sharply. Technology-oriented stock Note. The data are monthly. Indexes are trade-weighted averages of the indexes again fell more than the overall indexes. exchange value of the dollar against major currencies and against the currencies of a broader group of important U.S. trading partners. Last Amongemergingmarketeconomies,theperformance observations are the average of trading days through February 21, 2002. of stocks was mixed; stock indexes in several Asian emerging market economies rebounded strongly late The dollar’s average foreign exchange value intheyear,amovepossiblyreflectingmarketpartici- remained strong through most of 2001. The dollar pants’ hopes for a revival in global demand for the continuedtorisedespitemountingevidenceofweak- high technology products that feature prominently in ening U.S. economic activity and the significant eas- these countries’ exports. Argentine financial markets ingofmonetarypolicybytheFOMC.Marketpartici- came under increasing pressure throughout the year pants may have felt that the falloff in economic because of growing fears of a debt default and the growth in foreign economies and expectations that end of the peso’s peg to the dollar. Near year-end, the United States offered stronger prospects for eco- Argentine authorities in fact suspended debt pay- nomicgrowthinthefutureoutweigheddisappointing ments to the private sector and, early in 2002, ended U.S. economic performance in the near term. The the one-to-one peg to the dollar. There was limited dollar’s average foreign exchange value against the negative spillover to other emerging financial mar- currencies of other major industrial countries kets from the sharp deterioration in Argentina’s eco- recorded a net increase of 8 percent over 2001 as a nomic and financial condition, in contrast to the whole. The dollar also strengthened, but by a lesser situationthatprevailedduringotheremergingmarket amount, against the currencies of our most important financialcrisesofrecentyears. developing country trading partners. So far this year, the dollar’s average value has risen further on balance. Foreign equity indexes January 1999 = 100 Industrial Economies 200 The dollar showed particular strength against the Latin America Japanese yen last year, appreciating nearly 15 per- 175 cent.Theweaknessoftheyenreflectedseriousongo- 150 ing structural problems and the relapse of the Japa- Europe nese economy back into recession. Early in the year, 125 in response to signs of renewed weakening of the economy, the Bank of Japan announced that it was 100 easingpolicybyshiftingitsoperatingtargetfromthe Developing Asia Japan 75 overnight rate—already not far above zero—to bal- ances held by financial institutions at the Bank of Japan. Policy was eased further and more liquidity 1999 2000 2001 2002 was injected into the banking system when the bal- Note. The data are monthly. The last observations are the average of trading days through February 21, 2002. ances target was raised three times later in the year. 30 Monetary Policy Report to the Congress February 2002 U.S. dollar exchange rate against the euro activity in Europe, the euro again declined. On bal- and the Japanese yen ance, the dollar appreciated more than 5 percent relative to the euro over the course of the year. Real January 1999 = 100 GDP in the euro area is estimated to have increased at less than a 1 percent rate in 2001, a sharp slowing 130 fromthenearly3percentgrowthrateoftheprevious year.Fixedinvestmentandinventoryinvestmentboth Euro 120 are estimated to have made negative contributions to thegrowthofrealGDP,whereasconsumptiongrowth 110 remained near the rate of the previous year. The slowing of growth in the euro area was not uniform 100 across countries, with weakness being more pro- Japanese yen nouncedinGermanyandlesssoinFrance. 90 The European Central Bank (ECB) held off easing monetary policy in the early months of the year, 1999 2000 2001 2002 restrainedbytheeuro’sweakness,growthofM3that Note. The data are monthly. Exchange rates are in foreign currency remainedinexcessoftheECB’sreferencevalue,and units per dollar. Last observations are the average of trading days through a euro-area inflation rate above its 2 percent target February 21, 2002. ceiling. In May, evidence of slowing activity prompted the ECB to reduce its key policy rate The yen received a temporary boost when Junichiro 25basispoints.Threeadditionalreductionsfollowed Koizumi, widely seen as more likely to introduce laterintheyear,asactivityweakenedfurtherandthe economic reforms, became prime minister in April. inflation rate receded toward its target ceiling. The Theyenagainstrengthenedintheimmediatewakeof total reduction in the ECB’s key policy rate over the the September terrorist attacks, prompting the Bank course of the year was 150 basis points. The begin- of Japan to make substantial intervention sales of ning of 2002 saw the introduction of euro notes and yen. However, later in the year, amid signs of a coins,aprocessthatproceededsmoothly. renewed deterioration of economic conditions, the The dollar appreciated 6 percent against the Cana- yenagainstartedtoweakensignificantly. diandollarin2001astheCanadianeconomyslowed For the year as a whole, Japanese real GDP is abruptly. Real GDP in Canada is estimated to have estimated to have declined more than 1 percent, a been about flat last year after growing more than reversal of the rebound recorded the previous year. 3 percent in 2000. A key factor in this slowing was Private investment declined and private consumption the sharp drop-off in Canadian exports to the United movedlower,ashouseholdscurtailedspendinginthe States. An inventory correction also depressed out- faceofrisingunemploymentandfallingrealincome. put. Earlier in the year, consumption was buoyed by The winding-down of the large-scale public works continued employment growth, tax cuts, and a hous- programs of recent years more than offset the effect ing boom. However, later in the year, growth of on growth from the additional spending contained in consumptionfalteredasemploymentprospectswors- several supplemental budgets. Last year marked the enedandassetpricesweakened.TheBankofCanada third consecutive year of deflation, with the prices of has moved aggressively to counter the slowing of both consumer goods and real estate continuing to economic activity by lowering its key policy interest movelower. rate nine times in 2001 and once in January 2002 for The dollar’s movements against the euro in 2001 a cumulative total of 375 basis points.3 When the appear to have been mainly influenced by market BankofCanadainitiatedeasingmovesearlyin2001, perceptions of the strength of economic activity in inflation was slightly above the Bank’s target range the United States relative to that in the euro area. In of 1 percent to 3 percent; but by the end of the year, the early part of the year, the euro weakened as slack activity and falling energy prices had pushed evidence mounted that the economic slowdown that the inflation rate down to near the bottom of the was already apparent in the United States as the year range. began was also taking hold in Europe. During the summer, the euro rose against the dollar as market participants appeared to revise downward their 3. Among these reductions was one on September 17, when the BankofCanada(alongwiththeECB)announcedareductionofits expectation of an early U.S. recovery. Then, later in policyrateby50basispoints,followingthe50basispointreduction the year, with more signs of a further weakening of inthefederalfundsrateannouncedbytheFOMCearlierintheday. Board of Governors of the Federal Reserve System 31 Emerging Market Economies restrictions led to widespread protests, which trig- gered the resignation of President de la Rua and an Argentina was a main focus of attention among interval of political turmoil. After the resignation of emerging market economies in 2001. In the first part President de la Rua, the government announced it of the year, worse-than-expected data on the fiscal would suspend debt payments to the private sector. situationandconcernsthatthegovernmentwouldbe The government of the new president, Eduardo unable to implement announced fiscal measures Duhalde, suspended Argentina’s currency board heighteneddoubtsaboutwhetherArgentinawouldbe arrangement and established a temporary dual abletoavoidadefaultonitsdebt.Argentinefinancial exchange rate system. In early February, the dual markets received only temporary support from a exchange rate system was abandoned, and the peso’s large-scale debt exchange completed in June and an floating rate moved to about 2 pesos per dollar amid enhancementofIMFsupportapprovedinSeptember. continuing economic uncertainty. For 2001 as a Withfinancialmarketconfidenceeroding,conditions whole, Argentine real GDP is estimated to have took a dramatic turn for the worse late in the year; fallen at well over a 5 percent rate, and prices financial asset prices fell sharply, and funds moved declinedfurther. out of the banking system as the government moved To date, the negative spillover from events in to restructure its debt and the one-to-one peg to the Argentina to other emerging financial markets has dollar looked increasingly precarious. In early been limited, possibly because market participants December, the government imposed capital controls, had been well aware of Argentina’s problems for including limits on bank account withdrawals. These some time and viewed them as largely confined to that country. Brazil was probably most heavily affected by events in Argentina, and the bond spread Selected emerging markets on Brazilian debt showed a net increase of about 110basispointsoverthecourseoflastyearwhilethe January 1999 = 100 spread on Argentina debt exploded upward. Other Dollar exchange rates important factors weighing on Brazilian economic 200 activity last year likely were weak growth in the United States—Brazil’s most important export 175 market—andtheemergenceofanenergyshortageas drought limited hydroelectric output. For the year as 150 a whole, Brazilian real GDP is estimated to have Brazilianreal risen at less than a 1 percent rate after growing at a Korean won 125 4 percent rate the previous two years. The Brazilian currency registered a net depreciation against the 100 Argentine peso dollarofabout16percentoverthecourseoflastyear, while stock prices declined more than 10 percent. The Brazilian central bank tightened policy last year Percentage points in an effort to hold down the inflationary impact of Bond spreads currencydepreciation. 40 Real GDP in Mexico declined about 1 percent in 2001, a sharp reversal from the 5 percent growth rates recorded in the previous two years. The falloff 30 in activity was mainly a reflection of the negative effects on direct trade and confidence in Mexico Argentina 20 arising from the slowdown of the U.S. economy. In Brazil light of the marked weakening of activity, declining 10 inflation, and a strong peso, the Bank of Mexico Korea started to loosen the stance of monetary policy in May, and short-term interest rates continued to 1999 2000 2001 2002 decline over the rest of the year. In February 2002, Note. The data are monthly. Exchange rates are in foreign currency the Bank of Mexico moved to tighten monetary con- units per dollar. As of January 2002, the Argentine peso rate is the floating rate. Bond spreads are the J.P. Morgan Emerging Market Bond ditions, citing concerns that an increase in adminis- Index (stripped Brady-bond) spreads over U.S. Treasuries; the dotted line tered prices would raise inflation. Mexican financial is a break in the series for Argentina in December 2001. Last observations are the average of trading days through February 21, 2002. markets fared quite well last year, with the peso 32 Monetary Policy Report to the Congress February 2002 appreciating 5 percent against the dollar and stock Korea is an important exporter of high-tech products prices rising nearly 15 percent. The effect on Mexi- such as semiconductors, it has a relatively more can financial markets from Argentina’s difficulties diversified economy than most of its Asian neigh- appeared to have been quite limited, as indicated by bors, and thus the magnitude of its slowdown last the net decline of the Mexican debt spread by year was somewhat muted. Government moves 80basispointsoverthecourseoftheyear. toward monetary and fiscal policy stimulus over the Economic growth in the Asian emerging market course of the year helped support domestic demand economiesturnednegativelastyear.Onaverage,real inKorea. GDPindevelopingAsiaisestimatedtohavedeclined In China, recorded growth of real GDP remained about 1 percent in 2001, compared with average robustlastyear.China’slesserdependencyonexports growthof6percentinthepreviousyear.Akeyfactor in general, and high-tech exports in particular, cush- inthisslowingwasthesharpfalloffinglobaldemand ioned it from last year’s global slowdown, and the forthehigh-techproductsthathadfueledrapidexport government stepped up the pace of fiscal stimulus to growthintheregioninrecentyears. offset weakening private demand. Hong Kong, with The economies of Taiwan, Singapore, and Malay- exports not heavily concentrated in high-tech goods sia are highly dependent on exports of semiconduc- and an economy closely integrated with a rapidly tors and other high-tech products, and as global growing Chinese economy, is nevertheless estimated demand for these goods was cut back sharply, real to have experienced a decline in real GDP last year. GDP in these countries declined by an estimated ThepegofHongKong’scurrencytoastrengthening 5 percent on average last year. Indonesia and Thai- U.S. dollar put pressure on its competitive position, land, both relatively less dependent on high-tech anddomesticpricedeflationcontinued. exports and experiencing some reduction in political Conditions in financial markets in emerging Asia tension over the course of the year, managed to were, for the most part, not particularly volatile last recordsmallpositiverealGDPgrowthrateslastyear, year.Debtspreadswerelittlechangedonaveragefor albeitwellbelowratesofthepreviousyear. the region as a whole, exchange rates against the Korean real GDP is estimated to have increased dollar generally moved lower, and stock indexes about 2 percent in 2001. While in an absolute sense declinedsomewhatonaverage.

Federal Reserve (2002, February 26). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20020227

@misc{wtfs_monetary_policy_report_20020227,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2002},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20020227},
  note = {Retrieved via When the Fed Speaks corpus}
}