Monetary Policy Report

For use at 10:00 a.m., EST Tuesday February 11, 2003 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress February 11, 2003 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Submitted pursuant to section 2B of the Federal Reserve Act February 11, 2003 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C. February 11, 2003 The President of the Senate The Speaker of the House of Representatives The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to section 2B of the Federal Reserve Act. Sincerely, Alan Greenspan, Chairman Contents Page Monetary Policy and the Economic Outlook 1 Economic and Financial Developments in 2002 and Early 2003 5 Monetary Policy Report to the Congress Report submitted to the Congress on February 11, 2003, Around midyear, the economy began to struggle again. pursuant to section 2B of the Federal Reserve Act Concerns about corporate governance came to weigh heavily on investors’ confidence, and geopolitical ten­ MONETARY POLICY sions, especially the situation in Iraq, elevated uncertain- ties about the future economic climate. Equity prices fell AND THE ECONOMIC OUTLOOK during the summer, liquidity eroded in corporate debt The economy of the United States has suffered a series markets, and risk spreads widened. Businesses once again of blows in the past few years, including the fall in equity became hesitant to spend and to hire, and both manufac­ market values that began in 2000, cutbacks in capital turing output and private payrolls began to decline. State spending in 2001, the horrific terrorist attacks of Sep­ and local governments struggled to cope with deteriorat­ tember 11, the emergence of disturbing evidence of cor­ ing fiscal positions, and the economies of some of our porate malfeasance, and an escalation of geopolitical major trading partners remained weak. Although the risks. Despite these adversities, the nation’s economy already accommodative stance of monetary policy and emerged from its downturn in 2001 to post moderate eco­ strong upward trend of productivity were providing nomic growth last year. The recovery was supported by important support to spending, the Committee perceived accommodative monetary and fiscal policies and a risk that the near-term weakening could become undergirded by unusually rapid productivity growth that entrenched. In August, the FOMC adjusted its weighting boosted household incomes and held down business costs. of risks toward economic weakness, and in November, it The productivity performance was also associated with a reduced the targeted federal funds rate 50 basis points, to rapid expansion of the economy’s potential, and economic 11/ 4 percent. The policy easing allowed the Committee to slack increased over the year despite the growth in return to an assessment that the risks to its goals were aggregate demand. balanced. With inflation expectations well contained, this After turning up in late 2001, activity began to additional monetary stimulus seemed to offer worthwhile strengthen more noticeably early last year. Sharp inven­ insurance against the threat of persistent economic weak­ tory cutbacks in 2001 had brought stocks into better align­ ness and substantial declines in inflation from already ment with gradually rising final sales, and firms began to low levels. increase production in the first quarter of 2002 to curtail On net, the economy remained sluggish at the end of further inventory runoffs. Moreover, businesses slowed 2002 and early this year. The household sector continued their contraction of investment spending and began to to be a solid source of demand. Motor vehicle sales surged increase outlays for some types of capital equipment. at year-end on the tide of another round of aggressive Household spending on both personal consumption items discounting by the manufacturers, other consumer out- and housing remained solid and was supported by lays trended higher, and activity in housing markets another installment of tax reductions, widespread price remained exceptionally strong. Concerns about corpo­ discounting, and low mortgage interest rates. By midyear, rate governance appeared to recede somewhat late last the cutbacks in employment came to an end, and private year, in part because no new revelations of major wrong- payrolls started to edge higher. doing had emerged. However, the ongoing situation in Although economic performance appeared to be gradu­ Iraq, civil strife in Venezuela that has curtailed oil pro­ ally improving, the tentative nature of this improvement duction, and tensions on the Korean peninsula have sus­ warranted the continuation of a highly accommodative tained investors’ uncertainty about economic prospects stance of monetary policy.Accordingly, the Federal Open and have pushed prices higher on world oil markets. Faced Market Committee (FOMC) held the federal funds rate with this uncertainty, businesses have been cautious in at 13/ 4 percent through the first part of the year. In March, spending and changed payrolls little, on net, over however, the FOMC shifted from an assessment that the December and January. risks over the foreseeable future to its goals of maximum Mindful of the especially high degree of uncertainty sustainable growth and price stability were tilted toward attending the economic outlook in the current geopoliti­ economic weakness to an assessment that the risks were cal environment, the members of the FOMC believe the balanced. most likely outcome to be that fundamentals will support 2 Monetary Policy Report to the Congress February 2003 a strengthening of economic growth. Business caution is conditions sparked a rally in equity markets late in the anticipated to give way over the course of the year to first quarter and pushed up yields on longer-term Trea­ clearer signs of improving sales. Inventories are lean rela­ sury instruments and investment-grade corporate bonds; tive to sales at present, and restocking is likely to pro- yields on speculative-grade bonds declined in reaction to vide an additional impetus to production in the period brighter economic prospects and the perceived reduction ahead. The rapid expansion of productivity, the waning in credit risk. Meanwhile, surging energy prices exerted effects of earlier declines in household wealth, and the upward pressure on overall inflation, but still-appreciable highly accommodative stance of monetary policy should slack in resource utilization and a strong upward trend in also continue to boost activity. Although state and local private-sector productivity were holding down core price governments face budgetary problems, their restraint is inflation. likely to offset only a part of the stimulus from past and At both its March and May meetings, the FOMC noted prospective fiscal policy actions at the federal level. In that the apparent vigor of the economy was importantly addition, the strengthening economies of our major trad­ attributable to a slowdown in the pace of inventory liqui­ ing partners along with the improving competitiveness dation and that considerable uncertainty surrounded the of U.S. products ought to support demand for our outlook for final sales over the next several quarters. The exports. Taken together, these factors are expected to lead Committee was especially concerned about prospects for to a faster pace of economic expansion, while inflation a rebound in business fixed investment, which it viewed pressures are anticipated to remain well contained. as key to ensuring sustainable economic expansion. Although the decline in investment spending during the first quarter of 2002 was the smallest in a year, gloomy business sentiment and large margins of excess capacity Monetary Policy, Financial Markets, in numerous industries were likely to hamper capital and the Economy over 2002 and Early 2003 expenditures. According to anecdotal reports, many firms As economic growth picked up during the early months were unwilling to expand capacity until they saw more of 2002, the FOMC maintained its target for the federal conclusive evidence of growing sales and profits. At the funds rate at 13/ 4 percent. A sharply reduced pace of same time, however, the FOMC noted that, with the fed­ inventory liquidation accounted for a significant portion eral funds rate unusually low on an inflation-adjusted basis of the step-up in real GDP growth, but other indicators and considerable fiscal stimulus in train, macroeconomic also suggested that the economy was gaining momentum. policies would provide strong support to further economic Reductions in business outlays on equipment and soft- expansion. Against this backdrop, the Committee at the ware had moderated significantly after dropping precipi­ March 19 meeting judged the accommodative stance of tously in 2001, and consumer spending was well main­ monetary policy to be appropriate and announced that it tained by sizable gains in real disposable personal income. considered the risks to achieving its long-run objectives Residential construction activity was spurred by low home as being balanced over the foreseeable future, judgments mortgage interest rates. The improvement in economic it retained at its meeting in early May. Selected interest rates Percent Ten-year Treasury 6 5 Two-year Treasury 4 Discount rate (primary credit) 3 Intended federal funds rate 2 Discount rate 1 (adjustment credit) 1/3 1/31 3/20 4/18 5/15 6/27 8/21 9/17 10/2 11/6 12/11 1/30 3/19 5/7 6/26 8/13 9/24 11/6 12/10 1/29 2001 2002 2003 NOTE. The data are daily and extend through February 5, 2003. The dates the main credit program offered at the discount window by terminating the on the horizontal axis are those of scheduled FOMC meetings and of any adjustment credit program and beginning the primary credit program. intermeeting policy actions. On January 9, 2003, the Federal Reserve changed Board of Governors of the Federal Reserve System 3 The information reviewed at the June 25–26 FOMC that outlook and the potential adverse consequences for meeting confirmed that the economy was expanding but economic prospects from possible additional deteriora­ at a slower pace than earlier in the year. As expected, the tion of financial conditions. The members noted, how- degree of impetus to economic activity from decelerat­ ever, that a further easing of monetary policy, if it came ing inventory liquidation had moderated. Residential to be viewed as appropriate, could be accomplished in a investment and consumer spending also had slowed timely manner. In light of these considerations, the FOMC appreciably after surging earlier in the year. The most opted to retain a target rate of 13/ 4 percent for the federal recent data on orders and shipments suggested a small funds rate, but it viewed the risks to the economy as hav­ upturn in business spending on equipment and software, ing shifted from balanced to being tilted toward economic but the improvement in capital spending appeared to be weakness. limited, unevenly distributed across industries, and not When the FOMC met on September 24, data indicated yet firmly indicative of sustained advance. Industrial pro­ that economic growth had picked up in the third quarter, duction continued to increase, and the unemployment rate on average, buoyed in part by a surge in motor vehicle declined somewhat. production. The uneventful passing of the mid-August In financial markets, investors and lenders had appar­ deadline for recertification of corporate financial state­ ently become more risk averse in reaction to the mixed ments briefly alleviated investors’ skittishness in debt and tone of economic data releases, growing geopolitical ten­ equity markets. However, the most timely information sions, further warnings about terrorist attacks, and addi­ suggested that some softening in economic activity had tional revelations of dubious corporate accounting prac­ occurred late in the summer. Those economic reports, tices. In concert, these developments pushed down yields along with a darker outlook for corporate profits and on longer-term Treasury securities, while interest rates escalating fears of a possible war against Iraq, led mar­ on lower-quality corporate bonds rose notably, and ket participants to revise down their expectations for the equity prices dropped sharply. Although the economy con­ economy. Equity prices and yields on both longer-term tinued to expand and the prospects for accelerating Treasury and private securities moved sharply lower in aggregate demand remained favorable, downbeat busi­ early autumn. In the Committee’s view, heightened geo­ ness sentiment and skittish financial markets rendered the political tensions constituted a significant additional timing and extent of the expected strengthening of the source of uncertainty clouding the economic outlook. Still, expansion subject to considerable uncertainty. In these fundamentals suggested reasonable prospects for contin­ circumstances, the FOMC left the federal funds rate ued expansion. Accordingly, the FOMC left the federal unchanged to keep monetary policy very accommoda­ funds rate unchanged at the close of the September meet­ tive and once again assessed the risks to the outlook as ing but also reiterated its view that the risks to the out- being balanced. look were weighted toward economic weakness. By the time of the August 13 FOMC meeting, it had The information reviewed at the November 6 meeting become apparent that economic activity had lost some of indicated a more persistent spell of below-par economic its earlier momentum. Turbulence in financial markets performance than the FOMC had anticipated earlier. With appeared to be holding back the pace of the economic home mortgage rates at very low levels, residential con­ expansion. Market participants focused their attention on struction activity remained high. But consumer spending the lack of convincing evidence that the recovery was had decelerated noticeably since midsummer under the gaining traction and the possibility that more news of combined weight of stagnant employment and declining corporate misdeeds would surface in the run-up to the household wealth resulting from further decreases in Securities and Exchange Commission’s August 14 dead- equity prices. Worries about the potential for war against line for the certification of financial statements by cor­ Iraq, as well as persistent concerns about the course of porate executives. Although the cumulative losses in economic activity and corporate earnings, were appar­ financial wealth since 2000 were restraining expenditures ently engendering a high degree of risk aversion among by households, very low mortgage interest rates were business executives that was constraining capital spend­ helping to sustain robust demand for housing. Moreover, ing and hiring. Despite a weakening in the exchange value the financial resources made available by a rapid pace of of the dollar, sluggish economic growth among major trad­ mortgage refinancing activity, in combination with attrac­ ing partners spelled difficulties for U.S. exports, and a tive incentives offered by auto manufacturers, supported rebound in foreign output seemed more likely to follow other consumer spending. The Committee continued to than to lead a rebound at home. Moreover, economic slack judge the prevailing degree of monetary accommodation that was larger and more persistent than previously as appropriate to foster a solid expansion that would bring anticipated ran the risk of reducing core inflation appre­ the economy to fuller resource utilization. At the same ciably further from already low levels. Given these con­ time, the Committee recognized the considerable risks to siderations, the Committee lowered its target for the fed- 4 Monetary Policy Report to the Congress February 2003 eral funds rate 1/ 2 percentage point, to 11/ 4 percent. The eral Reserve policymakers believe the most probable relatively aggressive adjustment in the stance of mon­ outcome for this year to be a pickup in the pace of eco­ etary policy was deemed to offset the potential for greater nomic expansion. The central tendency of the real GDP economic weakness, and the Committee accordingly forecasts made by the members of the Board of Gover­ announced that it judged risks to the outlook as balanced nors and the Federal Reserve Bank presidents is 31/ 4 per- with respect to its long-run goals of price stability and cent to 31/ 2 percent, measured as the change between the sustainable economic growth. final quarter of 2002 and the final quarter of this year. When the FOMC met on December 10, overall condi­ The full range of these forecasts is 3 percent to 33/ 4 per- tions in financial markets had calmed considerably. Indi­ cent. Of course, neither the central tendency nor the range cators of production and spending, however, remained is intended to convey the uncertainties surrounding the mixed. The manufacturing sector registered large job individual forecasts of the members. The civilian unem­ losses in the autumn, and industrial production contin­ ployment rate is expected to end the year in the 53/ 4 per- ued its slide, which had begun around midyear. A more cent to 6 percent range. vigorous rebound in business fixed investment was not Apart from the geopolitical and other uncertainties, evident, and indeed the recent data on orders and ship­ the forces affecting demand this year appear, on balance, ments and anecdotal reports from business contacts gen­ conducive to a strengthening of the economic expansion. erally signaled continued softness in capital spending. Monetary policy remains highly accommodative, and fed­ Very low home mortgage interest rates were supporting eral fiscal policy is and likely will be stimulative. How- residential construction activity, but consumption expen­ ever, spending by many state and local governments will ditures were sluggish. On balance, the Committee’s view continue to be restrained by considerable budget diffi­ was that in the absence of major shocks to consumer and culties. Activity abroad is expected to improve this year, business confidence, a gradual strengthening of the eco­ even if at a less robust pace than in the United States; nomic expansion was likely over the coming quarters, such growth together with the improving competitiveness especially given the very accommodative stance of mon­ of U.S. products should generate stronger demand for etary policy and probable further fiscal stimulus. The our exports. Furthermore, robust gains in productivity, FOMC left the federal funds rate unchanged and indi­ though unlikely to be as large as in 2002, ought to con­ cated that it continued to view the risks to the outlook as tinue to promote both household and business spending. balanced over the foreseeable future. Household purchasing power should be supported as well By the time of the FOMC meeting on January 28–29, by a retreat in the price of imported energy products that 2003, it had become apparent that the economy had grown is suggested by the oil futures market. And the adverse only slowly in the fourth quarter of last year, but little effects on household spending from past declines in eq­ evidence of cumulating weakness appeared in the most uity wealth probably will begin to wane. recent data, and final demand had held up reasonably well. A reduction of businesses’ hesitancy to expand invest­ The escalation of global tensions weighed heavily on ment and hiring is critical to the durability of the expan­ business and investor sentiment. Firms apparently were sion, and such a reduction should occur gradually if geo­ remaining very cautious in their hiring and capital spend­ political risks ease and profitability improves. Inventories ing, and equity prices had declined on balance since the are relatively lean, and some restocking ought to help December meeting. But yield spreads on corporate debt— boost production this year, albeit to a much smaller especially for riskier credits—narrowed further, and extent than did last year’s cessation of sharp inventory longer-term Treasury yields declined slightly. Although the fundamentals still pointed to favorable prospects for Economic projections for 2003 economic growth beyond the near term, geopolitical Percent developments were making it especially difficult to gauge the underlying strength of the economy, and uncertain- Federal Reserve Governors and ties about the economic outlook remained substantial. MEMO Reserve Bank presidents Against this background, the Committee decided to leave Indicator 2002 actual Central the federal funds rate unchanged and stated that it con­ Range tendency tinued to judge the risks to the outlook as balanced. Change, fourth quarter to fourth quarter1 Nominal GDP ............................ 4.1 4½–5½ 4¾–5 Real GDP .................................. 2.8 3–3¾ 3¼–3½ Economic Projections for 2003 PCE chain-type price index ...... 1.9 1¼–1¾ 1¼–1½ Average level, fourth quarter An unusual degree of uncertainty attends the economic Civilian unemployment rate ...... 5.9 5¾–6 5¾–6 outlook at present, in large measure, but not exclusively, 1. Change from average for fourth quarter of previous year to average for because of potential geopolitical developments. But Fed­ fourth quarter of year indicated. Board of Governors of the Federal Reserve System 5 liquidations. In addition, the continued growth of final Change in PCE chain-type price index sales, the tax law provision for partial expensing of equip­ ment purchases, replacement demand, and a more hospi­ Percent, annual rate table financial environment should induce many firms to Total increase their capital spending. The growth of investment Excluding food and energy likely will be tempered, however, by the persistence of 3 excess capital in some areas, notably the telecommuni­ cations sector, and reductions in business spending on many types of new structures may continue this year. 2 Federal Reserve policymakers believe that consumer prices will increase less this year than in 2002, especially if energy prices partly reverse last year’s sharp rise. In 1 addition, resource utilization likely will remain suffi­ ciently slack to exert further downward pressure on underlying inflation. The central tendency of FOMC mem­ 1996 1998 2000 2002 bers’ projections for increases in the chain-type price NOTE. The data are for personal consumption expenditures (PCE). index for personal consumption expenditures (PCE) is 11/ 4 percent to 11/ 2 percent this year, lower than the actual increase of about 2 percent in 2002. sumption items and housing remained solid, businesses curtailed their inventory liquidation and began to increase their outlays for some types of capital equipment, and ECONOMIC AND FINANCIAL DEVELOPMENTS private employment started to edge higher. But the for- IN 2002 AND EARLY 2003 ward momentum diminished noticeably later in the year when concerns about corporate governance put a damper In 2002, the United States economy extended the upturn on financial markets and geopolitical developments in activity that began in late 2001. Real GDP increased boosted oil prices and added to the uncertainty already 23/ 4 percent over the four quarters of last year, according faced by businesses about the economic outlook. In the to the advance estimate from the Commerce Department. summer, equity prices fell, risk spreads widened, and However, the pace of activity was uneven over the course liquidity eroded in corporate debt markets. Businesses’ of the year, as concerns about emerging economic and caution was reflected in their reluctance to substantially political developments at times weighed heavily on an boost investment, restock inventories, or add to payrolls. economy already adjusting to a succession of shocks from Responding to these developments, as well as some weak­ previous years. ening in demand from abroad, manufacturers trimmed Economic conditions improved through the first part production during the fall. Employment at private busi­ of the year. Household spending on both personal con- nesses declined again, and the unemployment rate rose to 6 percent in December. However, despite the modest pace of last year’s overall recovery, output per hour in Change in real GDP the nonfarm business sector grew 33/ 4 percent over the year—an extraordinary increase even by the standards of Percent, annual rate the past half decade or so. Signals on the trajectory of the economy as we enter 6 2003 remain mixed. Some of the factors that had notice- ably restrained the growth of real GDP in the fourth quar­ ter of last year—most especially a sharp decline in motor 4 vehicle production—are not on track to be repeated. Moreover, employment leveled off on average in Decem­ 2 ber and Janaury, and readings on industrial production have had a somewhat firmer tone of late. Nevertheless, + 0_ the few data in hand suggest that the economy has not yet broken out of the pattern of subpar performance experi­ enced over the past year. 1996 1998 2000 2002 Consumer price inflation moved up a bit last year, NOTE. Here and in subsequent charts, except as noted, annual changes are reflecting sharply higher energy prices. Excluding the 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. prices of food and energy items, the price index for per- 6 Monetary Policy Report to the Congress February 2003 sonal consumption expenditures increased 13/ 4 percent, income, and the phase-in of additional tax reductions from about 1/ 4 percentage point less than in 2001; this decel­ the Economic Growth and Tax Relief Reconciliation Act eration most likely resulted from continued slack in of 2001 boosted household purchasing power apprecia­ labor and product markets, robust gains in productivity, bly. In addition, high levels of mortgage refinancing and somewhat lower expectations of future inflation. allowed homeowners to reduce their monthly payments, pay down more costly consumer credit, and, in many cases, extract equity that could be used to support other The Household Sector spending. On the negative side, household wealth again moved lower last year, as continued reductions in equity Consumer Spending values outweighed further appreciation of house prices. Consumer spending grew at a moderate pace last year By the end of the third quarter, according to the Federal and, on the whole, continued to be an important source Reserve’s flow-of-funds accounts, the ratio of household of support for overall demand. Personal consumption net worth to disposable income had reversed nearly all of expenditures rose 21/ 2 percent in real terms, near the its run-up since the mid-1990s. 23/ 4 percent increase in 2001 and down from the more Consumer confidence, which had declined during most than 4 percent average growth over the preceding sev­ of 2001 and especially after the September 11 attacks, eral years. Sales of new motor vehicles fell only a little picked up in the first half of last year, according to both from the extremely high levels of late 2001; outlays were the Michigan Survey Research Center (SRC) and Con­ especially strong during the summer and late in the year, ference Board surveys. However, confidence retreated when manufacturers were offering aggressive price and over the summer along with the drop in equity prices, financing incentives. Growth of spending on other and by early this year, consumer confidence again stood durable goods was well maintained last year as well, close to the levels of late 2001. These levels of consumer although the gains were smaller than is often seen early confidence, though at the bottom of readings of the past in an economic recovery; in contrast to the situation in several years, are nevertheless above levels normally many previous cycles, spending on durable goods did not associated with recession. decline sharply during the recession and so had less cause The personal saving rate, which has trended notably to rebound as the recovery got under way. Apart from lower since the early 1980s, moved above 4 percent by outlays on durable goods, spending for most categories late last year after having averaged 21/ 4 percent in 2001. of consumer goods and services increased at a moderate The saving rate has been buffeted during the past two rate last year. years by surges in income induced by tax cuts and by That moderate rate of aggregate consumption growth spikes in spending associated with variations in motor was the product of various crosscurrents. On the positive vehicle incentives. But, on balance, the extent of the side, real disposable personal income rose nearly 6 per- increase in the saving rate has been roughly consistent cent last year, the fastest increase in many years. Strong with a gradual response of consumption to the reduction productivity growth partially offset the effects of stag­ in the ratio of household wealth to disposable income. nant employment in restricting the growth of household Consumer sentiment Change in real income and consumption 1966 = 100 Percent, annual rate Disposable personal income Personal consumption expenditures 10 100 8 6 80 4 60 2 + 0_ 1982 1986 1990 1994 1998 2002 1996 1998 2000 2002 SOURCE. University of Michigan Survey Research Center. Board of Governors of the Federal Reserve System 7 Wealth and saving Mortgage rates Ratio Percent Wealth-to-income ratio Fixed rate 8.5 6 7.5 5 Adjustable rate 6.5 5.5 4 4.5 2000 2001 2002 2003 Percent Personal saving rate NOTE. The data, which are monthly and extend through January 2003, are contract rates on thirty-year mortgages. SOURCE. Federal Home Loan Mortgage Corporation. 12 Private housing starts 8 Millions of units, annual rate 4 Single-family + 1.2 0_ .8 1982 1986 1990 1994 1998 2002 NOTE. The data are quarterly. The wealth-to-income ratio is the ratio of Multifamily household net worth to disposable personal income and extends through .4 2002:Q3; the personal saving rate extends through 2002:Q4. Residential Investment 1990 1992 1994 1996 1998 2000 2002 Real expenditures on residential investment increased NOTE. The data are quarterly. 6 percent in 2002—the largest gain in several years. Demand for housing was influenced by the same factors increase was close to the average pace over the past few affecting household spending more generally, but it was years. At the same time, measures of house prices that do especially supported by low interest rates on mortgages. not control for the mix of homes sold rose considerably Rates on thirty-year fixed-rate mortgages, which stood more last year than in 2001, a difference indicating that a at around 7 percent in the first months of the year, fell to larger share of transactions were in relatively expensive around 6 percent by the autumn and dipped below that homes. level early this year—the lowest in thirty-five years. Not In the multifamily sector, starts averaged a solid surprisingly, attitudes toward homebuying, as measured 345,000 units last year, an amount in line with that of the by the Michigan SRC, remained quite favorable. preceding several years. However, the pace of building Starts of new single-family homes were at 1.36 mil- slowed a little in the fall. Apartment vacancy rates moved lion units last year, 7 percent above the already solid pace notably higher last year and rent and property values for 2001. Sales of both new and existing homes were declined; these changes suggest that the strong demand brisk as well. Home prices continued to rise but at a slower for single-family homes may be eroding demand for apart­ rate than in 2001, at least according to some measures. ment space. The repeat-sales price index for existing homes rose 51/ 2 percent over the four quarters ended in 2002:Q3, a Household Finance slowing from the 83/ 4 percent increase over the compa­ rable year-earlier period. The constant-quality price Households continued to borrow at a rapid pace last year; index for new homes rose 41/ 2 percent last year, but this the 91/ 4 percent increase in their debt outstanding was the 8 Monetary Policy Report to the Congress February 2003 largest since 1989. Low mortgage interest rates helped this backdrop, broad measures of household credit qual­ spur both very strong home purchases and refinancing of ity deteriorated very little last year, and signs of financial existing loans, which together increased home mortgage stress were confined mainly to the subprime segment of debt 111/ 2 percent. Refinancing activity was especially the market. Delinquency rates on home mortgages inched elevated in the fourth quarter, when fixed mortgage up, while those on auto loans at finance companies were interest rates dipped to around 6 percent. Torrid refinanc­ flat. Delinquency rates on credit cards bundled into ing activity helps explain last year’s slowdown of con­ securitized asset pools remained close to those of recent sumer credit, which is household borrowing not secured experience. by real estate: A significant number of households report­ edly extracted some of the equity from their homes at the The Business Sector time of refinancing and used the proceeds to repay other debt as well as to finance home improvements and other Overall business fixed investment moved lower last year, expenditures. According to banks that participated in the although the decline was not nearly so precipitous as in Federal Reserve’s Senior Loan Officer Opinion Survey 2001. Outlays for equipment and software edged up, but on Bank Lending Practices in October, the frequency and spending on structures fell sharply. Financing conditions size of cash-out refinancings were substantially greater worsened over the summer, with equity prices declining, than had been reported in the January 2002 survey. initial public offerings (IPOs) drying up, credit market Although automakers’ financing incentives and attractive spreads widening, and banks tightening up somewhat on cash rebates stimulated a substantial amount of consumer credit standards in the wake of increased reports of cor­ borrowing, the growth rate of consumer credit in 2002, porate malfeasance. In addition, geopolitical concerns at 41/ 4 percent, was more than 21/ 2 percentage points increased firms’ already heightened uncertainty about the below the pace in 2001. economic outlook. These factors contributed to an Even though households took on a large amount of apparent deterioration in business confidence, and busi­ mortgage debt last year, extraordinarily low mortgage nesses still have not felt any great urgency to boost in- rates kept the servicing requirement for that debt (mea­ vestment appreciably. For similar reasons, although firms sured as a share of homeowners’ disposable income) well slowed their rate of inventory liquidation last year, they below its previous peak levels. Moreover, reflecting large have yet to undertake a sustained restocking. gains in residential real estate values, equity in homes has continued to increase despite sizable debt-financed Fixed Investment extractions. The combined influence of low interest rates and the sizable gain in disposable personal income also After dropping sharply in 2001, real spending on equip­ kept the total servicing costs faced by households—which ment and software rose 3 percent last year. Spending on in addition to home mortgage payments include costs of high-technology equipment, one of the hardest-hit sec­ other financial obligations such as rental payments of ten- tors in 2001, showed signs of uneven improvement. The ants, consumer installment credit, and auto leases— clearest rebound was in computing equipment, for which relative to their incomes below previous peaks. Against spending rose 25 percent in real terms; this gain fell short of the increases posted in the late 1990s but far more than reversed the previous year’s decline. Software Delinquency rates on selected types of household loans investment also turned positive, rising 6 percent after declining about 3 percent in 2001. By contrast, real out- Percent lays for communications equipment were reported to be up only slightly in 2002 after plummeting 30 percent in Credit card pools 6 2001. 5 Business spending on aircraft fell sharply last year. Airlines were hit especially hard by the economic down- Auto loans at domestic auto finance companies 4 turn and by the reduction in air travel after the Septem­ ber 11 attacks; although expenditures for new aircraft held 3 up through the end of 2001 because of the very long lags 2 involved in producing planes, shipments of planes slowed Mortgages greatly thereafter. Meanwhile, business outlays on motor 1 vehicles edged up last year. Demand for autos and light trucks by rental companies weakened sharply along with 1992 1994 1996 1998 2000 2002 the drop in air traffic that occurred after September 11 NOTE. The data are quarterly and extend through 2002:Q3. but recovered gradually over the course of last year. Pur­ SOURCE. For mortgages, the Mortgage Bankers Association; for auto loans, the Big Three automakers; for credit cards, Moody’s Investors Service. chases of medium and heavy trucks fell off overall, Board of Governors of the Federal Reserve System 9 Change in real business fixed investment firms. In addition, uncertainty about the geopolitical situ­ ation, including the possible consequences for oil prices Percent, annual rate of an outbreak of war with Iraq, likely made many firms Structures reluctant to commit themselves to new expenditures. In Equipment and software 20 all, businesses have been, and appear to remain, quite cautious about undertaking new capital spending projects. 10 Real business spending for nonresidential structures declined sharply for a second year in 2002. Outlays for + 0_ the construction of office buildings and industrial build­ ings were especially weak. Vacancy rates for such build­ 10 ings increased throughout the year, and property values and rents moved lower. Construction of new 20 hotels and motels also fell considerably, reflecting the weakness in the travel industry. By contrast, spending on other commercial buildings, such as those for retail, High-tech equipment and software wholesale, and warehouse space, moved only a little lower Other equipment 40 last year. A number of factors likely account for investment in 30 structures having been much weaker than investment in 20 equipment. Structures depreciate very slowly, so busi­ nesses can defer new outlays without incurring much 10 additional deterioration of their capital stock. And + unlike investment in equipment, spending on structures 0_ is not eligible for partial expensing. According to some 10 analysts, concerns about additional acts of terrorism (and, until late in the year, the lack of insurance to cover such 1996 1997 1998 1999 2000 2001 2002 events) may also have had a damping effect on some types NOTE. High-tech equipment consists of computers and peripheral equip­ of construction, particularly large “trophy” projects. ment and communications equipment. despite the fact that demand for heavy (class 8) trucks Inventory Investment was boosted by spending in advance of the implementa­ The sharp inventory runoffs that characterized the eco­ tion of more-stringent environmental regulations. nomic downturn, together with gradually rising final sales, Investment in equipment other than high-tech and implied that, by early last year, stocks were in much bet­ transportation goods moved modestly higher through most ter alignment with sales than had been the case during of last year, as real outlays for industrial machinery and a 2001. Accordingly, businesses lessened the pace of wide range of other equipment gradually strengthened inventory liquidation early in the year and by summer through the summer. Although spending edged lower again in the fourth quarter, investment in non-high-tech, nontransportation equipment increased 31/ 2 percent for the year as a whole. Change in real business inventories Spending on equipment and software was supported Billions of chained 1996 dollars, annual rate last year by low interest rates, which helped hold down the cost of capital, as did the tax provision enacted in 75 March 2002 that allows partial expensing of new equip­ ment and software purchased before September 11, 2004. 50 Moreover, modest increases in final sales together with 25 replacement demand no doubt spurred many firms to make + new capital outlays. Nevertheless, some sectors, most 0_ notably telecommunications, probably still had excess 25 holdings of some forms of capital. Concerns about cor­ 50 porate malfeasance, which had become more intense over the spring and summer, weighed heavily on financial 75 markets and raised the cost of capital through reduced share prices and higher yields on the bonds of lower-rated 1996 1998 2000 2002 10 Monetary Policy Report to the Congress February 2003 had turned to some modest restocking. However, firms costs arising from underfunded defined-benefit pension appeared to have exerted tight control over production plans. Reflecting the pause in economic growth, earn­ and inventories; with prospects for the strength of the ings reports for the fourth quarter indicate that profits recovery having diminished in the second half of the year, may have dropped some late in the year. businesses quickly cut production, and inventories only A dearth of expenditures on fixed capital and mori­ edged up in the fourth quarter, according to incomplete bund merger and acquisition activity were the chief cul­ and preliminary data. In all, total inventories were about prits behind the sluggish pace of nonfinancial corporate unchanged last year compared with a liquidation of more borrowing last year. Also important was the propensity than $60 billion in 2001, and this turnaround contributed of some firms to draw on liquid assets—which began the 1 percentage point to the growth of real GDP over the year at high levels—rather than to seek external financ­ year. At year-end, inventory-to-sales ratios in most sec­ ing. Consequently, debt of the nonfinancial corporate tors stood near the low end of their recent ranges. sector expanded only 11/ 2 percent, a rate slower than the In the motor vehicle industry, last year’s very strong already subdued pace in 2001. The composition of busi­ sales were matched by high levels of production, and the ness borrowing was dominated last year, as it was in 2001, stock of inventories, especially for light trucks, appeared by longer-term sources of funds. Robust demand for at times to be higher than the industry’s desired levels. higher-quality corporate debt on the part of investors, Nevertheless, the surge in sales late in the year helped to combined with the desire of firms to lock in low interest pare stocks, and dealers ended the year with inventories rates, prompted investment-grade corporations to issue a of light vehicles at a comfortable level. large volume of bonds during the first half of 2002. With funding needs limited, investment-grade issuers contin­ ued to use the proceeds to strengthen their balance sheets Corporate Profits and Business Finance by refinancing higher-coupon bonds and by paying down short-term obligations such as bank loans and commer­ The profitability of the U.S. nonfinancial corporate sec­ cial paper. Buoyed by declining yields, gross issuance of tor improved from its lows of 2001 but relative to sector below-investment-grade bonds for the most part also held output remained at the low end of the range experienced up well during the first half, although this segment of the over the past thirty years. Economic profits of nonfinan­ market was hit hard after revelations of corporate mal­ cial corporations—that is, book profits adjusted for feasance, as investors shunned some of the riskiest inventory valuations and capital consumption allow­ issues; issuance was especially weak in the beleaguered ances—rebounded in late 2001 and were little changed telecom and energy sectors, which continue to be saddled through the third quarter of last year. The sluggish with overcapacity and excessive leverage. Despite fall­ expansion of aggregate demand and the lack of pricing ing share prices, seasoned equity offerings were also well power associated with intense competitive pressures were maintained over the first half of the year, in part because the main factors that held down profits in 2002. Also play­ of the decision of some firms—especially in the telecom ing a role, especially in the manufacturing sector, were and energy sectors—to reduce leverage. IPOs, by con- Before-tax profits of nonfinancial corporations as a percent of sector GDP Major components of net business financing Percent Billions of dollars Commercial paper Bonds 600 Bank loans 12 Sum of major components 400 10 200 + 0_ 8 200 1977 1982 1987 1992 1997 2002 2000 2001 2002 NOTE. The data are quarterly and extend through 2002:Q3. Profits are from NOTE. Seasonally adjusted annual rate for nonfarm nonfinancial corporate domestic operations of nonfinancial corporations, with inventory valuation business. The data for the sum of major components are quarterly. The data and capital consumption adjustments. for 2002:Q4 are estimated. Board of Governors of the Federal Reserve System 11 Financing gap and net equity retirement of the corporate bond market declined less than those on at nonfarm nonfinancial corporations Treasury securities of comparable maturity. Investors’ aversion to risk was also heightened by mounting ten­ Billions of dollars sions with Iraq; by early autumn, risk spreads on junk- rated bonds reached their highest levels in more than a 300 decade. Gross bond issuance both by investment-grade 250 and below-investment-grade firms fell off markedly, and Net equity retirement the amount of redemptions was large. By the third quar­ 200 ter, net issuance of bonds by nonfinancial corporations 150 had turned negative for the first time since the early 1950s. 100 Trading conditions in the corporate bond market deterio­ Financing gap rated during this period, as bid–asked spreads report­ 50 edly widened in all sectors. With share prices dropping + 0_ and stock market volatility increasing, issuance of sea­ soned equity nearly stalled in the summer and early 1990 1992 1994 1996 1998 2000 2002 autumn. IPOs were virtually nonexistent amid widely pub­ NOTE. The data are annual; 2002 is based on partially estimated data. The licized investigations into the IPO allocation process at financing gap is the difference between capital expenditures and internally large investment banks. generated funds. Net equity retirement is the difference between equity retired through share repurchases, domestic cash-financed mergers, or foreign A smattering of more upbeat news about the economy takeovers of U.S. firms and equity issued in public or private markets, in mid-autumn and the absence of major revelations of including funds invested by venture capital partnerships. corporate wrongdoing sparked a rally in equity prices and rekindled investors’ appetite for corporate debt. Over the trast, were sparse. The evaporation of cash-financed merg­ remainder of the year and during early 2003, risk spreads ers and acquisitions and desire by firms to conserve cash narrowed considerably on investment-grade corporate kept equity retirements at their slowest pace since 1994. bonds—especially for the lowest rated of these issues— Over the summer, investors grew more reluctant to buy and even more on speculative-grade bonds, although they corporate bonds because of concerns about the reliabil­ remained high by historical standards. In the meantime, ity of financial statements, deteriorating credit quality, liquidity in the corporate bond market generally improved. and historically low recovery rates on defaulted A brightening of investor sentiment caused a rebound in speculative-grade debt. Macroeconomic data suggesting gross bond issuance, with firms continuing to use bond that the economic recovery was losing momentum and proceeds to refinance long-term debt and to pay down widespread company warnings about near-term profits short-term debt. Rising stock prices and reduced volatil­ pushed yields on speculative-grade debt sharply higher. ity also allowed seasoned equity issuance to regain some Risk spreads on investment-grade bonds also widened ground in the fourth quarter. The improved tone in cor­ appreciably in the third quarter, as yields in that segment porate debt markets carried over into early 2003. Gross corporate bond issuance continued at a moderate pace, Spreads of corporate bond yields over and despite the drop in stock prices in the latter half of the ten-year Treasury yield January, seasoned equity issuance has been reasonably well maintained. IPO activity and venture capital financ­ Percentage points ing, however, remained depressed. The heavy pace of bond issuance, sagging capital 10 expenditures, and diminished merger and acquisition High yield 8 activity allowed firms to pay down large amounts of both business loans at banks and commercial paper last year. 6 The runoff in business loans that started in early 2001 intensified in the first half of 2002. At the same time, 4 commercial paper issuers that were perceived as having BBB 2 questionable accounting practices encountered significant AA + investor resistance, and most of these issuers discontin­ 0_ ued their programs. Bond rating agencies stepped up the pressure on firms to substitute longer-term debt for 2001 2002 2003 shorter-term debt and thereby reduce rollover risk. In NOTE. The data are daily and extend through February 5, 2003. The addition, banks raised the total cost of issuing commer­ spreads compare the yields on the Merrill Lynch AA, BBB, and 175 indexes with the yield on the ten-year off-the-run Treasury note. cial paper by tightening underwriting standards and boost- 12 Monetary Policy Report to the Congress February 2003 ing fees and spreads on the associated backup lines of Net interest payments of nonfinancial corporations credit—especially for lower-rated issuers. In doing so, relative to cash flow respondents to the April Senior Loan Officer Opinion Survey on Bank Lending Practices cited heightened con­ Percent cerns about the deterioration of issuers’ credit quality and a higher probability of lines being drawn. Many com­ mercial paper issuers either turned to longer-term financ­ 20 ing or dropped out of the credit markets altogether, and the volume of nonfinancial commercial paper outstand­ ing shrank about one-fourth during the first six months 15 of the year after having dropped one-third in 2001. The volatility that gripped equity and bond markets 10 around midyear, however, did not spill over to the com­ mercial paper market. Quality spreads in the commercial paper market were largely unaffected, in part because many of the riskiest issuers had already exited the mar­ 1978 1981 1984 1987 1990 1993 1996 1999 2002 ket, while others had strengthened their cash positions NOTE. The data are quarterly and extend through 2002:Q3. and significantly reduced rollover risk earlier in the year. July propelled the average rate to a record level. The Indeed, because of difficulties in the corporate bond mar­ amount of nonfinancial corporate debt downgraded by ket, some nonfinancial firms turned temporarily to the Moody’s Investors Service last year was more than four- commercial paper market to obtain financing, and the teen times the amount upgraded. At less than 25 percent, volume of outstanding paper rose in July after a lengthy the average recovery rate in 2002 on all defaulted bonds— period of declines. Over the remainder of the year, busi­ as measured by the price of bonds at default—was at the ness loans at banks and commercial paper outstanding low end of recovery rates over the past decade. Delin­ contracted rapidly, as inventory investment remained quency rates on business loans at commercial banks rose negligible, and firms continued to take advantage of rela­ noticeably before stabilizing in the second half of the year, tively low longer-term interest rates by issuing bonds. and charge-off rates remained quite high throughout 2002. A decline in market interest rates and improved prof­ After expanding rapidly in 2001, commercial mort­ itability helped reduce the ratio of net interest payments gage debt grew much more slowly during the first quar­ to cash flow in the nonfinancial corporate sector last year. ter of last year, as business spending on nonresidential Even so, many firms struggled to service their debt, and structures fell. Despite the continued contraction in out- corporate credit quality deteriorated markedly. The trail­ lays on nonresidential structures, commercial mortgage ing average default rate on corporate bonds, looking back debt accelerated over the remainder of the year, appar­ over the preceding twelve months, was already elevated ently because of refinancing to extract a significant por- and climbing when WorldCom’s $26 billion default in Default rate on outstanding bonds Spread of low-tier CP rates over high-tier CP rates Percent Basis points 3.5 150 3.0 2.5 125 2.0 100 1.5 75 1.0 50 .5 25 1992 1994 1996 1998 2000 2002 1997 1998 1999 2000 2001 2002 2003 NOTE. The default rate is monthly and extends through December 2002. The rate for a given month is the face value of bonds that defaulted in the NOTE. The data are daily and extend through February 5, 2003. The series twelve months ending in that month divided by the face value of all bonds shown is the difference between the rate on A2/P2 nonfinancial commercial outstanding at the end of the calendar quarter immediately preceding the paper and the AA rate. twelve-month period. Board of Governors of the Federal Reserve System 13 Ratings changes of nonfinancial corporations Federal receipts and expenditures Percent Percent of nominal GDP Upgrades 20 24 10 Expenditures 22 0 Receipts 10 Expenditures 20 excluding net interest 20 18 30 Downgrades 16 40 1995 1996 1997 1998 1999 2000 2001 2002 1984 1987 1990 1993 1996 1999 2002 NOTE. Data are at an annual rate. Debt upgrades (downgrades) are NOTE. The budget data are from the unified budget and are for fiscal years expressed as a percentage of par value of all bonds outstanding. (October through September); GDP is for Q3 to Q3. SOURCE. Moody’s Investors Service. interest expenses. Spending increased notably in many tion of equity from existing properties. The issuance of categories, including defense, homeland security, Med­ commercial-mortgage-backed securities (CMBS), a key icaid, and income security (which includes the tempo­ source of commercial real estate financing in recent years, rary extended unemployment compensation program). was well maintained in 2002. Even as office vacancy rates Federal government consumption and investment—the rose, the quality of commercial real estate credit remained part of spending that is counted in GDP—rose more than stable last year. Commercial banks firmed standards on 7 percent in real terms in 2002. (Government spending commercial real estate loans in 2002, on net, and delin­ on items such as interest payments and transfers are not quency rates on commercial real estate loans at banks counted in GDP because they do not constitute a direct stayed at historically low levels. Delinquency rates on purchase of final production.) CMBS leveled off after increasing appreciably in late The turn to deficit in the unified budget means that 2001, and forward-looking indicators also do not sug­ the federal government, which had been contributing to gest elevated concerns about prospective defaults: Yield national saving since 1997, began to reduce national sav­ spreads on CMBS over swap rates remained in the fairly ing last year. The reversal more than offset an increase in narrow range that has prevailed over the past several years. saving by households and businesses, and gross national saving declined to 15 percent of GDP by the third quar­ The Government Sector ter of last year—the lowest national saving rate since the 1940s. Federal Government Despite modest economic growth, the federal budget position deteriorated sharply in 2002. After running a Change in real government expenditures unified budget surplus of $127 billion in fiscal 2001, the on consumption and investment federal government posted a deficit of $158 billion in Percent fiscal 2002—and that deficit would have been $23 bil­ lion larger if not for the shifting of some corporate tax Federal State and local payments from fiscal 2001 to fiscal 2002. After adjust­ 9 ment for that tax shifting, receipts declined 9 percent in fiscal 2002: A $50 billion drop in corporate payments 6 stemmed largely from tax provisions enacted in the 2002 3 stimulus bill (especially the partial-expensing provision on investment), and a decline in individual tax payments + of $136 billion was largely attributable to a drop in capi­ 0_ tal gains realizations and to lower tax rates that were 3 enacted in the 2001 tax bill. Meanwhile, federal outlays increased nearly 8 percent in fiscal 2002 and 11 percent excluding a decline in net 1996 1998 2000 2002 14 Monetary Policy Report to the Congress February 2003 National saving default. And indeed, the Congress approved legislation raising the statutory borrowing limit to $6.4 trillion on Percent of nominal GDP June 27. With its credit needs remaining substantial, the Treasury continued to borrow heavily over the second 22 half of 2002. The increase in the Treasury’s net borrow­ Excluding federal saving ing last year caused the ratio of publicly held debt to nomi­ 20 nal GDP to rise for the first time since 1993. 18 State and Local Governments 16 State and local governments have continued to struggle Total saving 14 in response to sluggish growth of receipts. In the current fiscal year (which ends June 30 for most states), most state governments are reported to be facing significant 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 shortfalls. Although a variety of strategies may be avail- NOTE. The data are quarterly and extend through 2002:Q3. able for the purpose of technically complying with balanced-budget requirements, including tapping nearly $20 billion in combined rainy-day and general fund After it reentered the credit markets as a significant balances and turning to the capital markets, many states borrower of net new funds in the second half of 2001, the will be forced to boost revenues and hold the line on Treasury continued to tap markets in volume last year. spending. Federal net borrowing was especially brisk over the first Real expenditures for consumption and gross invest­ half of the year. With federal debt rapidly approaching ment by state and local governments rose less than its statutory borrowing limit, the Secretary of the Trea­ 2 percent in 2002—the smallest increase in ten years. The sury declared a debt ceiling emergency on May 16 and slowdown in spending growth was widespread across identified about $80 billion worth of accounting measures expenditure categories and included notably smaller that could be used to create financing room within the increases in outlays for construction. Employment in the existing $5.95 trillion limit. The Secretary’s announce­ state and local sector continued to rise in 2002, but at a ment and subsequent employment of one of these slower rate than in recent years. devices—in which Treasury securities held in government Debt of the state and local government sector expanded trust funds were temporarily replaced by Treasury IOUs last year at the fastest pace since 1987. Governments used not subject to the debt ceiling—had little effect on Trea­ the proceeds to finance capital spending and to refund sury yields, as market participants were apparently con­ existing debt in advance. Net issuance of short-term fident that the ceiling would be raised in time to avoid municipal bonds was also well maintained, as California Federal government debt held by the public State and local government current surplus or deficit Percent of nominal GDP Percent of GDP 45 .5 35 + 0_ 25 .5 1962 1972 1982 1992 2002 1982 1986 1990 1994 1998 2002 NOTE. Through 2001, the data for debt are year-end figures and the corresponding value for GDP is for Q4 at an annual rate; the final observation NOTE. The data, which are quarterly, are on a national income and product is for 2002:Q3. Excludes securities held as investments of federal gov­ account basis and extend through 2002:Q3. The current surplus or deficit ernment accounts. excludes social insurance funds. Board of Governors of the Federal Reserve System 15 and some other states facing fiscal difficulties turned to U.S. dollar real exchange rate, broad index shorter-term borrowing while fashioning more permanent solutions to their budget problems. Worsening budget situ­ January 2000 = 100 ations contributed to some deterioration in municipal credit quality last year. Credit-rating downgrades out- 115 paced upgrades by a significant margin, and the yield spread of BBB-rated over insured AAA-rated municipal 110 bonds rose significantly over the second half of 2002. 105 The External Sector 100 The U.S. current account deficit widened again in 2002 after a brief respite during the cyclical slowdown in 2001. Two-thirds of the expansion of the deficit last year was 2000 2001 2002 2003 attributable to a decline in the balance on goods and ser­ NOTE. The data are monthly. The last observation is the average of trading vices, although net investment income also fell sharply days through February 5, 2003. Exchange rates are adjusted for inflation with as receipts from abroad declined more than payments the consumer price index and are in foreign currency units per dollar. The broad index is a weighted average of the foreign exchange values of the U.S. to foreign investors in the United States. The broad dollar against the currencies of a large group of major U.S. trading partners. exchange value of the dollar peaked around February The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. 2002 after appreciating about 13 percent in real terms from January 2000; in early February 2003 it was down growth of imports relative to exports over the past two about 5 percent from the February 2002 level. years was consistent with the historical pattern in which the responsiveness of imports to income is greater in the United States than in the rest of the world. Although Trade and the Current Account the dollar depreciated on balance last year, the lagged effects of its prior appreciation over the two previous years Both exports and imports rebounded in 2002 as the contributed to the faster growth in imports relative to cyclical downturn of the previous year was reversed and exports in 2002. spending on travel recovered from the post–September Real exports of goods posted a strong gain in the 11 slump. As is often the case, the amplitude of the second quarter of 2002 after six consecutive quarters of recent cycle in trade has been greater than that of real decline. However, as output growth slowed abroad, GDP. In 2001, stagnant real GDP in the United States exports decelerated in the third quarter and then fell in and abroad was coupled with declines of 111/ 2 percent in the fourth quarter. On balance, exports of goods rose about real exports and 8 percent in real imports. Last year, 2 percent over the course of the year, reversing only a moderate growth of both foreign and domestic real GDP small portion of the previous year’s decline. Not surpris­ was exceeded by gains of 5 percent and 9 percent, ingly, the increase in goods exports in 2002 was concen- respectively, in our real exports and imports. The faster U.S. trade and current account balances Change in real imports and exports of goods and services Billions of dollars, annual rate Percent, annual rate + 0_ Imports Exports 20 100 15 Trade 200 10 Current account 5 300 + 0_ 400 5 500 10 15 1996 1997 1998 1999 2000 2001 2002 1996 1998 2000 2002 NOTE. The data are quarterly and extend through 2002:Q3. 16 Monetary Policy Report to the Congress February 2003 trated in the destinations where GDP growth was stron­ Prices of oil and of nonfuel commodities gest—Canada, Mexico, and several developing Asian economies. A gain of 12 percent in real exports of ser­ January 2001 = 100 Dollars per barrel vices in 2002 more than reversed the previous year’s decline and reflected both a pickup in tourism and an increase in other private services. Export prices turned 110 Oil 30 up in the second quarter after a year of decline and con­ tinued to rise at a moderate pace in the second half. The very rapid growth of real imports of goods in the 100 20 first half of last year was a reaction to the revival of U.S. activity, and they gained about 9 percent over the year. Nonfuel The particularly large gains in imports of consumer goods 90 10 and automotive products reflected the buoyancy of U.S. consumption expenditures. Imports of most major cat­ egories of capital goods also increased on balance over 2001 2002 2003 the year. However, as with exports, import growth was NOTE. The data are monthly; the last observation for oil is the average of considerably stronger in the first half of the year than in trading days through February 5, 2003; the last observation for nonfuel commodities is December 2002. The oil price is the spot price of West Texas the second. This pattern likely reflected the deceleration intermediate crude oil. The price of nonfuel commodities is a weighted in U.S. GDP, along with the effects of some depreciation average of thirty-nine primary-commodity prices from the International Monetary Fund. of the dollar. In addition, there may have been some shift­ ing of import demand from later in the year to the earlier pre-strike levels in early 2003. Concern over a possible months as it began to appear more likely that labor con- war with Iraq, along with a very low level of crude oil tract negotiations at West Coast ports would not go inventories in the United States, has helped to keep spot smoothly.1 Imports of services more than reversed their prices high. Also in response to the heightened tensions, 2001 decline over the course of the year, and gains were the price of gold shot up about 30 percent over the past recorded for both travel and other private services. Prices year. of non-oil imports turned up in the second quarter after declining over the preceding four quarters, as a result of the weaker exchange rate and a turnaround in prices of The Financial Account internationally traded commodities. The spot price of West Texas intermediate crude oil The increase in the current account deficit in 2002 was climbed above $35 per barrel in early 2003, its highest about equal on balance to the stepped-up foreign official level since the beginning of 2000. Oil prices had fallen purchases of U.S. assets, as changes in the components to around $20 per barrel during 2001 amid general eco­ of private capital flows were offsetting. Private foreign nomic weakness, but they began rising in February and purchases of U.S. securities were about $360 billion at March of last year in response to both improving global an annual rate through November, a volume similar to economic activity as well as a production-limiting agree­ last year’s total. However, there was some shift in the ment between OPEC and several major non-OPEC pro­ composition of flows away from equities and toward Trea­ ducers. Even though production in a number of OPEC sury securities. This shift may have reflected the damp­ and non-OPEC countries in fact exceeded the agreed lim­ ing of equity demand caused by slower economic growth its last year, heightened tensions in the Middle East along and continued concern about corporate governance and with severe political turmoil in Venezuela continued to accounting. Over the same period, purchases by private put upward pressure on prices. The pressure intensified U.S. investors of foreign securities declined nearly $100 late in the year as a strike in Venezuela that began on billion. Accordingly, the net balance of private securities December 2 virtually shut down that country’s oil indus­ trading recorded a sharp increase in net inflows. try, and Venezuelan oil production was still well below In contrast, net foreign direct investment inflows fell about $70 billion between 2001 and 2002. Foreign investment in the United States and investment abroad by U.S. residents both declined, but the decline in flows 1. The dispute between the Pacific Maritime Association and the into the United States was considerably larger, as merger International Longshore and Warehouse Union eventually led to an eleven-day port closure in late September and early October that ended activity slowed and corporate profits showed little vigor. when President Bush invoked the Taft-Hartley Act. Although the U.S. direct investment abroad held up fairly well in 2002, monthly pattern of trade was influenced by the closure, the overall a result largely reflecting retained earnings. level of imports for the year does not appear to have been much affected. Board of Governors of the Federal Reserve System 17 U.S. international securities transactions trade—two sectors in which activity closely tracks that of manufacturing proper—rose over the summer but also Billions of dollars turned down again later in the year. And employment in Private foreign purchases of U.S. securities retail trade, though quite erratic, leveled off over the sum­ mer before declining further in the fall. However, Bonds, net 200 employment in services other than help supply grew rea­ Equities, net sonably steadily throughout the year and rose nearly 150 50,000 per month after March; health services and edu­ cation services contributed more than half of those job 100 gains. The finance and real estate sectors also added jobs last year, probably because of the surge in mortgage refinancings and high levels of activity in housing mar­ 50 kets. Last year’s job losses in the private sector were par­ tially offset by an increase in government employment that averaged about 20,000 per month; the increase Private U.S. purchases of foreign securities resulted mostly from hiring by states and municipalities, Bonds, net 125 but it also reflected hiring in the fall by the Transporta­ Equities, net 100 tion Security Administration. Overall employment moved lower, on net, and the 75 unemployment rate increased a little less than 1/ 2 percent- 50 age point over the year, to 6 percent, before dropping back to 5.7 percent in January 2003. The unemployment rate 25 + probably has been boosted slightly by the federal tempo­ 0_ rary extended unemployment compensation program. By 25 extending benefits for an additional three months, the pro- 2000 2001 2002 Net change in payroll employment SOURCE. Department of Commerce and the Federal Reserve Board. Thousands of jobs, monthly average Private nonfarm The Labor Market 300 Employment and Unemployment 200 Jan. Labor markets appeared to stabilize last spring after the 100 sharp deterioration of 2001 and early 2002. Employment + on private payrolls, which had declined an average of 0_ 160,000 per month in 2001, leveled off in the spring and 100 moved slightly higher over the summer. But labor demand weakened again as the economy softened later 200 in the summer, and private employment declined about 80,000 per month on average in the last four months of 1991 1993 1995 1997 1999 2001 2003 the year. Private payrolls rebounded nearly 150,000 in January, though the magnitude of both the especially sharp decline in December and the rebound in January likely was exaggerated by difficulties in adjusting for the nor- Jan. 200 mal seasonal movements in employment during these months. + The manufacturing sector continued to be the weakest 0_ segment of the labor market; even during the spring and early summer, when the overall labor market seemed to 200 be improving, factory payrolls contracted on average. Declines in factory employment were more pronounced— at about 50,000 per month—toward the end of the year. Employment at help-supply firms and in wholesale 2000 2001 2002 2003 18 Monetary Policy Report to the Congress February 2003 Measures of labor utilization Measures of change in hourly compensation Percent Percent 15 8 Augmented civilian unemployment rate 12 Nonfarm compensation per hour 6 9 4 6 Employment cost index Civilian unemployment rate 2 3 1973 1983 1993 2003 1994 1996 1998 2000 2002 NOTE. The data extend through January 2003. The civilian rate is the NOTE. The data extend through 2002:Q4. For nonfarm compensation, number of civilian unemployed divided by the civilian labor force. The change is over four quarters; for the employment cost index (ECI), change is augmented rate adds to the numerator and the denominator of the civilian rate over the twelve months ending in the last month of each quarter. Nonfarm the number of those who are not in the labor force but want a job. The small compensation is for the nonfarm business sector; the ECI is for private in­ break in the augmented rate in January 1994 arises from the introduction of a dustry excluding farm and household workers. redesigned survey. For the civilian rate, the data are monthly; for the augmented rate, the data are quarterly through December 1993 and monthly thereafter. fers in an economic downturn as businesses reduce hours worked by proportionally less than the decline in output; conversely, productivity typically rebounds early in an gram allows unemployed individuals whose regular ben­ expansion as labor is brought back toward fuller utiliza­ efits have expired to be more selective in accepting job tion. During the most recent downturn, however, produc­ offers and provides them with an incentive not to with- tivity held up comparatively well, a performance that draw from the labor force. In addition, as would be makes last year’s surge all the more impressive. Indeed, expected in a still-weak labor market, the labor force par­ productivity rose at an average annual rate of nearly 3 per- ticipation rate moved lower last year. cent over the past two years, faster than the average pace of increase during the late 1990s. Very likely, the rapid pace of last year’s productivity Productivity and Labor Costs growth was due in part to the special circumstances that Labor productivity rose impressively in 2002. Output per developed after the September 11 attacks. Businesses cut hour in the nonfarm business sector increased an esti­ labor substantially in late 2001 and early 2002 amid wide- mated 33/ 4 percent from the fourth quarter of 2001 to the spread fear of a sharp decline in demand; when demand fourth quarter of 2002. Labor productivity typically suf- held up better than expected, businesses proved able to operate satisfactorily with their existing workforces. Moreover, the fact that this step-up in productivity was Change in output per hour not reversed later in the year suggests that at least a por­ tion of it is sustainable. The recent rapid growth in pro­ Percent, annual rate ductivity may derive in part from ongoing improvements in the use of the vast amount of capital installed in earlier 8 years, and it may also stem from organizational innova­ tions induced by the weak profit environment. 6 Indicators of hourly compensation sent mixed signals last year. The rise in the employment cost index (ECI) 4 for hourly compensation in private nonfarm businesses, 31/ 4 percent, was 1 percentage point lower than the 2 increase in 2001. Compensation increases likely were + damped last year by the soft labor market and expecta­ 0_ tions of lower consumer price inflation. The wages and salaries component and the benefits component of the 1992 1994 1996 1998 2000 2002 ECI both posted smaller increases last year. The decel­ eration was less pronounced for the benefits component, NOTE. Nonfarm business sector. Board of Governors of the Federal Reserve System 19 however, which was boosted by further large increases in Change in consumer prices excluding food and energy employers’ health insurance costs. According to the ECI, health insurance costs, which constitute about 6 percent Percent of overall compensation, rose 10 percent last year after Consumer price index having risen about 9 percent in each of the preceding two Chain-type price index for PCE 4 years. An alternative measure of compensation costs is com­ pensation per hour in the nonfarm business sector, which 3 is derived from information in the national income and product accounts. According to this measure, hourly com­ 2 pensation rose 41/ 4 percent last year—a little more than the increase in the ECI and up from a much smaller 1 increase in 2001. One important difference between these two measures of compensation is that the ECI omits stock options, while nonfarm compensation per hour captures 1992 1994 1996 1998 2000 2002 the value of these options upon exercise. The very small increase in the latter measure in 2001 likely reflects, in part, a drop in option exercises in that year, and the larger are not included in GDP because they are not part of do­ increase in 2002 may point to a firming, or at least to a mestic production. On net, GDP prices rose only 11/ 4 per- smaller rate of decline, of these exercises. cent last year, a deceleration of 3/ 4 percentage point that reflected not just the deceleration in core consumer prices but also considerably smaller increases for prices of Prices construction. The upturn in consumer energy prices in 2002 was The chain-type price index for personal consumption ex­ driven by a jump in crude oil prices. Gasoline prices penditures (PCE) rose about 2 percent last year, compared increased some 25 percent from December 2001 to with an increase of 11/ 2 percent in 2001. This step-up in December 2002; prices of fuel oil increased consider- consumer price inflation resulted from a jump in energy ably as well. By contrast, consumer prices of natural gas prices. Outside of the energy sector, consumer price in­ posted only a modest rise after declining sharply in 2001, flation was pushed lower last year by continued slack in and electricity prices moved lower. More recently, the labor and product markets as well as by expectations of rise in crude oil prices since mid-December, together with future inflation that appeared to be lower in 2002 than in cold weather, has increased the demand for natural gas most of 2001. The increase in PCE prices excluding food and has led to higher spot gas prices; the higher spot prices and energy, which was just 13/ 4 percent, was about 1/ 4 per­ for both oil and gas are likely to be boosting consumer centage point less than in 2001. The price index for GDP energy prices early this year. was less affected by last year’s rise in energy prices than The PCE price index for food and beverages increased was the PCE measure; much of the energy price increase was attributable to higher prices of imported oil, which only 11/ 2 percent last year; the increase followed a 3 percent rise in 2001 that reflected supply-related price increases for many livestock products including beef, Change in consumer prices poultry, and dairy products. But livestock supplies had Percent Consumer price index Alternative measures of price change Chain-type price index for PCE Percent 4 Price measure 2001 2002 3 Chain-type Gross domestic product .............................. 2.0 1.3 Gross domestic purchases ........................... 1.3 1.6 Personal consumption expenditures ........... 1.5 1.9 2 Excluding food and energy ..................... 1.9 1.7 Chained CPI ................................................ 1.2 1.9 Excluding food and energy ..................... 1.8 1.6 1 Fixed-weight Consumer price index ................................. 1.9 2.3 Excluding food and energy ..................... 2.7 2.1 1992 1994 1996 1998 2000 2002 Note. Changes are based on quarterly averages and are measured to the fourth quarter of the year indicated from the fourth quarter of the preceding year. 20 Monetary Policy Report to the Congress February 2003 recovered by early last year, and a drought-induced selloff meted after the September 11 attacks, but by early 2002, of cattle herds last summer pushed prices still lower. expectations returned to the 23/ 4 percent range that had The prices of goods other than food and energy items prevailed during the previous summer. These expecta­ decelerated sharply last year. Prices for apparel, new and tions gradually moved lower over the course of last year used motor vehicles, and a wide range of other durable and now stand around 21/ 2 percent. Meanwhile, the Michi­ goods all declined noticeably and, on average, at a faster gan SRC’s measure of five- to ten-year inflation expecta­ pace than in 2001. Price increases for services were much tions remained steady at about 23/ 4 percent during 2002, larger than for goods and slowed less from the previous a rate a little lower than the 3 percent inflation expecta­ year. Both tenants’ rent and the imputed rent of owner- tions that had prevailed through most of 2001. occupied housing—categories that account for a sizable share of services—rose significantly less last year than U.S. Financial Markets they did in 2001. But many other services prices posted increases in 2002 that were about the same as in 2001. Developments in financial markets last year were shaped Information on medical prices was mixed. According to importantly by sharp declines, on net, in equity prices the CPI, the price of medical services continued to accel­ and most long-term interest rates and by periods of height­ erate, rising 51/ 2 percent last year. But the increase in the ened market volatility. In contrast to 2001, when the Fed­ PCE measure of medical services prices was less than eral Reserve eased the stance of monetary policy eleven 3 percent, a smaller increase than in 2001. One reason times, last year saw one reduction in the intended federal for this difference is that the prices of services paid for funds rate—in early November—and interest rates on by Medicare and Medicaid are included in the PCE short-term Treasury securities had moved little until then. index but not in the CPI (because services provided by Longer-term interest rates, by contrast, were more vola­ Medicare and Medicaid do not represent out-of-pocket tile. Investors’ optimism about future economic prospects costs to consumers and so are outside of the CPI’s scope), pressured longer-term Treasury bond yields higher early and Medicare reimbursement rates for physicians were in 2002. But as the year progressed, that optimism faded reduced last year. when the economy failed to gather much momentum, and Despite the acceleration in medical prices in the CPI longer-term Treasury yields ended the year appreciably but not in the PCE price index, the CPI excluding food lower. Softer-than-expected readings of the economic and energy decelerated notably more than did the core expansion, a marked deterioration in corporate credit PCE price index between 2001 and 2002. The two price quality, concerns about corporate governance, and height­ measures differ in a number of respects, but much of last ened geopolitical tensions made investors especially wary year’s greater deceleration in the CPI can be traced to the about risk. Lower-rated firms found credit substantially fact that the CPI suffers from a form of “substitution bias” more expensive, as risk spreads on speculative-grade debt that is not present in the PCE index. The CPI, being a soared for most of the year before narrowing somewhat fixed-weight price index, overstates increases in the cost over the last few months. Even for higher-quality firms, of living because it does not adequately take into account risk spreads widened temporarily during the tumultuous the fact that consumers tend to substitute away from goods conditions that prevailed in financial markets over the that are rising in relative price; by contrast, the PCE price summer. In addition, commercial banks tightened stan­ index does a better job of taking this substitution into dards and terms for business borrowers, on net, in 2002, account. Last year, the Bureau of Labor Statistics began and risk spreads on business loans remained in an elevated to publish a new index called the chained CPI; like the range throughout the year. Increased caution on the part PCE price index, the chained CPI does a more complete of investors was particularly acute in the commercial job of taking consumer substitution into account, but it paper market, where the riskiest issuers discontinued their is otherwise identical to the official CPI. In 2001, an programs. unusually large gap between increases in the official CPI Federal borrowing surged last year, while private bor­ and the chained CPI arose, pointing to very large substi­ rowing was held down by the significantly reduced credit tution bias in the official CPI in that year. This gap nar­ needs of business borrowers. Declines in longer-term rowed in 2002, indicating that substitution bias declined interest rates during the first half of the year created between the two years. (Final estimates of the chained incentives for both businesses and households to lock in CPI are not yet available; the currently available data for lower debt-service obligations by heavily tapping corpo­ both 2001 and 2002 are preliminary and subject to rate bond and home mortgage markets, respectively. revision.) While mortgage borrowing remained strong, businesses Survey measures of expected inflation generally ran a sharply curtailed their issuance of longer-term debt dur­ little lower in 2002 than in 2001. According to the Michi­ ing the second half of 2002 amid the nervousness then gan SRC, median one-year inflation expectations plum- prevailing in the financial markets. Board of Governors of the Federal Reserve System 21 Interest Rates Implied volatility of short-term interest rates Reflecting an unchanged stance of monetary policy over Percent most of last year, short-term market interest rates moved little until early November, when the FOMC lowered the 60 target federal funds rate 1/ 2 percentage point, and other short-term interest rates followed suit. Yields on 50 intermediate- and long-term Treasury securities, by con­ 40 trast, declined as much as 11/ 2 percentage points, on net, in 2002. Longer-term interest rates began last year under 30 upward pressure, as signs that the economy had bottomed out started to nudge rates higher in the final weeks of 20 2001. Positive economic news pushed interest rates up 10 appreciably further during the first quarter of 2002. The increase in longer-term interest rates was consistent with 1997 1998 1999 2000 2001 2002 2003 the sharp upward tilt of money market futures rates, which suggested that market participants expected that the NOTE. The data are daily and extend through February 5, 2003. The series shown is the implied volatility of the three-month eurodollar rate over the FOMC would almost double the intended level of the coming four months, as calculated from option prices. funds rate by year’s end. However, as readings on the strength of the economic expansion came in on the soft The uneventful passing of the Securities and Exchange side, investors substantially trimmed their expectations Commission’s August 14 deadline for officers of large for policy tightening, and yields on longer-term Treasury companies to certify corporate financial statements securities turned down in the spring. somewhat assuaged investors’ anxieties about corporate The slide in longer-term Treasury yields intensified governance problems. But subsequent news suggesting over the summer amid weaker-than-expected economic that the economy was losing momentum and a flare-up in data, heightened geopolitical tensions, fresh revelations tensions with Iraq further boosted demand for Treasury of corporate malfeasance, and disappointing news about securities. The FOMC’s decision at the August meeting— near-term corporate profits. In concert, these develop­ to leave the intended federal funds rate unchanged but to ments prompted investors to mark down their expecta­ judge the balance of risks to the outlook as weighted tions for economic growth and, consequently, their toward economic weakness—pulled the expected path of anticipated path for monetary policy. A widespread the funds rate lower, and longer-term Treasury yields sank retrenchment in risk-taking sent yields on speculative- to forty-year lows in early autumn. A high degree of grade corporate bonds sharply higher and kept those on investor uncertainty about the future path of monetary the lower rungs of investment grade from declining, even policy was evidenced by implied volatilities of short-term as longer-term nominal Treasury yields fell to very low interest rates derived from option prices, which soared to levels by the end of July. record levels in early autumn. The size of the FOMC’s November cut in the target federal funds rate and the shift to balance in its assessment of risks surprised market Interest rates on selected Treasury securities participants, but the policy easing appeared to lead investors to raise the odds that the economy would pick Percent up from its sluggish pace. Generally positive economic news and rising equity prices over the remainder of the 7 year also bolstered confidence and prompted market par­ 6 ticipants to mark up the expected path for monetary policy Ten-year and push up longer-term Treasury yields. 5 Yields on higher-quality investment-grade corporate 4 bonds generally tracked those on Treasuries of compa­ Two-year rable maturity last year, although risk spreads on these 3 instruments widened moderately over the summer and 2 early autumn before narrowing over the remainder of the Three-month 1 year. Interest rates on below-investment-grade corporate debt, by contrast, increased for much of last year, as 2001 2002 2003 spreads over Treasuries ballooned in response to mount­ NOTE. The data are daily and extend through February 5, 2003. ing concerns about corporate credit quality, historically 22 Monetary Policy Report to the Congress February 2003 Corporate bond yields economy and corporate earnings and by doubts about the quality and transparency of corporate balance sheets. Net Percent declines in stock prices in 2002 exceeded those posted during either of the preceding two years. Worries about the pervasiveness of questionable corporate governance 20 and a deterioration in the earnings outlook—especially in the technology sector—depressed equity prices in early 15 2002. The positive tenor of economic data, however, High yield managed to outweigh those concerns, and stock prices 10 staged a rally halfway through the first quarter, with the AA gains tilted toward “old economy” firms. But the rebound was short lived. Share prices started to tumble in early 5 spring across all sectors as weaker-than-expected eco­ nomic data eroded investors’ confidence in the strength 1991 1993 1995 1997 1999 2001 2003 of the economic expansion. These developments were reinforced by first-quarter corporate earnings reports that, NOTE. The data are monthly averages and extend through January 2003. The AA rate is calculated from bonds in the Merrill Lynch AA index with though mostly matching or exceeding investors’ expec­ seven to ten years remaining maturity. The high-yield rate is the yield on the tations, painted a bleak picture of prospective sales and Merrill Lynch 175 high-yield index. profits. low recovery rates on defaulted bonds, and revelations Over the spring and summer, accounting scandals, of improper corporate governance; credit risk spreads widespread warnings about near-term corporate profit- widened in all speculative sectors but especially in ability, and heightened geopolitical tensions intensified telecom and energy. By the summer, investors’ retreat the slide in stock prices. Particularly large declines in from risk-taking had widened bid–asked spreads in the share prices were posted for technology firms, whose corporate bond market enough to impair trading. Risk prospects for sales and earnings were especially gloomy. spreads on speculative-grade bonds narrowed consider- Equity prices were boosted briefly by the uneventful pass­ ably over the year’s final quarter and in early 2003, though ing of the August 14 deadline to certify financial state­ they remain elevated by historical standards; risk spreads ments, but they quickly reversed course on continued for the weaker speculative-grade credits remain excep­ concerns about the pace of economic growth and corpo­ tionally wide, as investors evidently anticipate a contin­ rate earnings and the escalating possibility of military ued high level of defaults and low recovery rates. action against Iraq. By early October, equity indexes sank to their lowest levels since the spring of 1997, and implied stock price volatility on the S&P 100 surged to Equity Markets its highest reading since the stock market crash of 1987. Equity prices were buffeted last year by considerable fluc­ tuations in investors’ assessments of the outlook for the Implied S&P 100 volatility Major stock price indexes Percent January 2, 2001 = 100 50 40 125 Nasdaq 30 Wilshire 5000 100 20 75 10 S&P 500 50 1997 1998 1999 2000 2001 2002 2003 NOTE. The data are daily and extend through February 5, 2003. The series 2001 2002 2003 shown is the implied volatility of the S&P 100 stock price index as calculated from the prices of options that expire over the next several months. NOTE. The data are daily and extend through February 5, 2003. SOURCE. Chicago Board Options Exchange. Board of Governors of the Federal Reserve System 23 S&P 500 forward earnings-price ratio panies helped brighten investors’ sentiment regarding that and the real interest rate sector, and the Nasdaq is down about 3 percent this year. Percent Debt and Financial Intermediation S&P 500 earnings-price ratio A deceleration of business borrowing slowed growth of 8 the debt of nonfederal sectors about 1 percentage point in 2002, to 61/ 2 percent. By contrast, the decline in 6 interest rates last year kept borrowing by households and state and local governments brisk. At the federal level, 4 weak tax receipts and an acceleration in spending pushed debt growth to 71/ 2 percent last year after a slight con- 2 traction in 2001. Real interest rate For the year as a whole, corporate borrowing was quite weak, mainly because of sagging capital expenditures, a 1990 1992 1994 1996 1998 2000 2002 drying up of merger and acquisition activity, and a reli­ NOTE. The data are monthly and extend through December 2002. The ance on liquid assets. Although businesses tapped bond earnings-price ratio is based on I/B/E/S consensus estimates of earnings over markets in volume over the first half of the year, subse­ the coming year. The real rate is estimated as the difference between the ten-year Treasury rate and the five-year to ten-year expected inflation rate quent concerns about the reliability of financial statements from the FRB Philadelphia survey. The drop in stock prices widened the gap between the Change in domestic nonfinancial debt expected year-ahead earnings–price ratio for the S&P 500 Percent and the real ten-year Treasury yield—one simple mea­ sure of the equity premium—to levels not seen since the mid-1990s. Share prices turned around in late October, as the third- 8 quarter corporate earnings reports were not as weak as investors had originally feared. Equity prices were also 6 given a boost in early November by the larger-than- expected monetary policy easing, and the rally was sus­ Total tained over the remainder of the year by the generally 4 encouraging tone of economic data. Greater confidence among investors in the economic outlook also helped bring down the implied volatility on the S&P 100 signifi­ cantly by year-end, although it remains at an elevated level Percent by historical standards. Despite the fourth-quarter rebound, broad equity indexes were down, on net, about Nonfederal 20 percent in 2002, while the tech-heavy Nasdaq lost more 10 than 30 percent. The decline in equity prices during the first three quar­ 5 ters of 2002 is estimated to have erased more than $31/ 2 trillion in household wealth, a loss of nearly 9 per- + 0_ cent of total household net worth, although the fourth- quarter rise in stock prices restored about $600 billion. Federal, Still, the level of household net worth at the end of last held by public 5 year was more than 40 percent higher than it was at the start of the bull market in 1995. Equity prices maintained 1988 1990 1992 1994 1996 1998 2000 2002 their upward momentum during the first half of January NOTE. For 2002, change is from 2001:Q4 to 2002:Q3 at an annual rate. For 2003 but then fell sharply amid the looming prospects of earlier years, the data are annual and are computed by dividing the annual military action against Iraq and a still-gloomy outlook flow for a given year by the level at the end of the preceding year. The total consists of nonfederal debt and federal debt held by the public. Nonfederal for corporate earnings. Broad stock price indexes have debt consists of the outstanding credit market debt of state and local lost almost 5 percent this year; however, solid fourth- governments, households, nonprofit organizations, nonfinancial businesses, and farms. Federal debt held by the public excludes securities held as quarter earnings from many prominent technology com­ investments of federal government accounts. 24 Monetary Policy Report to the Congress February 2003 and the quality of corporate governance and deteriorat­ Delinquency rates on selected types of loans at banks ing creditworthiness ruined investors’ appetite for cor­ porate debt in the summer and early autumn. Households, Percent by contrast, flocked to the mortgage markets to take advantage of low mortgage rates throughout the year, and Commercial and industrial 6 strong motor vehicle sales supported the expansion of consumer credit. For depository institutions, the net 5 effect of these developments was an acceleration of credit to 61/ 2 percent last year, 2 percentage points above the Consumer 4 pace of 2001. The growth of credit at thrift institutions moderated, though the slowdown can be attributed for 3 Residential real estate the most part to a large thrift institution’s conversion to a 2 bank charter. The growth of credit at commercial banks accelerated to 63/ 4 percent—a significant increase from the anemic pace in 2001; the pickup was driven by large 1992 1994 1996 1998 2000 2002 acquisitions of securities, especially mortgage-backed NOTE. The data, from bank Call Reports, are quarterly, seasonally ad­ securities, as well as a surge in home equity and residen­ justed, and extend through 2002:Q3. tial real estate lending. By contrast, business lending at commercial banks to greater uncertainty about the economic outlook and dropped 7 percent last year after falling almost 4 percent rising corporate bond defaults, although the proportions in 2001; last year’s decline kept overall loan growth for of banks that reported doing so declined noticeably. 2002 to about 5 percent. In the October Senior Loan Direct measures of loan pricing conditions from the Fed­ Officer Opinion Survey on Bank Lending Practices, eral Reserve’s quarterly Survey of Terms of Business respondents noted that the decline in commercial and Lending also indicated that banks were cautious lenders industrial (C&I) lending since the beginning of the year last year, as the average spread of C&I loan rates over reflected not only the limited funding needs of credit- market interest rates on instruments of comparable matu­ worthy borrowers that found bond financing or a runoff rity remained wide, and spreads on new higher-risk loans of liquid assets more attractive, but also a reduction in declined only slightly from the lofty levels that prevailed the pool of creditworthy borrowers. Over the course of over the first half of the year. Although bank lenders were last year, banks reported some additional net tightening wary about business borrowers, especially toward lower- of standards and terms on C&I loans, mainly in response rated credits, they did not significantly constrict the sup- ply of loans: Most small firms surveyed by the National Federation of Independent Businesses in 2002 reported Net percentage of domestic banks tightening standards on commercial and industrial loans that they experienced little or no difficulty satisfying their to large and medium-sized firms borrowing needs. Loan quality at commercial banks improved overall Percent last year. Loan delinquency rates edged down through the third quarter of 2002—the latest period for which Call 60 Report data are available—in response to better per­ formance of residential real estate and consumer loans 40 and a stable delinquency rate on C&I loans. Despite the improvement in consumer loan quality, domestic banks 20 imposed somewhat more stringent credit conditions when + lending to households, according to the survey on bank 0_ lending practices. Moderate net proportions of surveyed institutions tightened credit standards and terms for credit 20 card and other consumer loans throughout last year. The net fraction of banks that tightened standards on residen­ 1991 1993 1995 1997 1999 2001 2003 tial mortgage loans rose late in the year to the highest NOTE. The data are based on a survey generally conducted four times per share in the past decade, but nonetheless remained quite year; the last reading is from the January 2003 survey. Large and low. Commercial banks generally registered strong profit medium-sized firms are those with annual sales of $50 million or more. Net percentage is the percentage reporting a tightening less the percentage gains last year, although steep losses on loans to energy reporting an easing. and telecommunications firms significantly depressed SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank Lending Practices. profits at several large bank holding companies. Despite Board of Governors of the Federal Reserve System 25 Net percentage of domestic banks tightening standards on prices and the deterioration in corporate credit quality. consumer loans and residential mortgage loans However, these negative pressures were offset somewhat by the continued strong growth of insurance premiums, Percent and both sectors of the insurance industry stayed fairly well capitalized in 2002. 30 Consumer loans Monetary Aggregates 20 The broad monetary aggregates decelerated noticeably 10 last year after surging in 2001. Short-term market inter­ + est rates, which had declined swiftly during 2001, were 0_ stable over the first half of the year; deposit rates, in a typical pattern of lagged adjustment, continued to fall. Residential mortgage 10 loans Consequently, the opportunity cost of holding M2 assets increased, especially for its liquid deposit (checking and 1991 1993 1995 1997 1999 2001 2003 savings accounts) and retail money fund components, NOTE. The data are based on a survey generally conducted four times per thereby restraining the demand for such assets. After year; the last reading is from the January 2003 survey. Net percentage is the decelerating in the first half of the year, M2 rebounded percentage reporting a tightening less the percentage reporting an easing. SOURCE. Federal Reserve, Senior Loan Officer Opinion Survey on Bank significantly in the second half, because of a surge in liq­ Lending Practices. uid deposits and retail money market mutual funds. The the increased rate of provisioning for loan losses, the bank­ strength in both components partly reflected elevated ing sector’s profitability stayed in the elevated range re- volatility in equity markets against the backdrop of a still- corded for the past several years, as a result of the low opportunity cost of holding such deposits. In addi­ robust fee income from mortgage and credit card lend­ tion, another wave of mortgage refinancing boosted M2 ing, effective cost controls, and the relatively inexpen­ growth during this period. (Refinancings cause prepay­ sive funding offered by inflows of core deposits. As of ments to accumulate temporarily in deposit accounts the third quarter of last year, virtually all assets in the before being distributed to investors in mortgage-backed banking sector were at well-capitalized institutions, and securities.) All told, over the four quarters of the year, the substitution of securities for loans on banks’ balance M2 increased 7 percent, a pace that exceeded the expan­ sheets helped edge up risk-based capital ratios. sion of nominal income. As a result, M2 velocity—the The financial condition of insurance companies, by ratio of nominal GDP to M2—declined for the fifth year contrast, worsened notably last year. Both property and in a row, roughly in line with the drop in the opportunity casualty insurers and life and health insurers sustained cost of M2 over this period. significant investment losses from the decline in equity Reflecting in part the slowing of its M2 compo­ nent, M3—the broadest money aggregate—expanded Regulatory capital ratios of commercial banks M2 growth rate Percent Percent, annual rate Total (tier 1 + tier 2) ratio 14 10 12 8 Tier 1 ratio 6 10 4 8 2 1990 1992 1994 1996 1998 2000 2002 1990 1992 1994 1996 1998 2000 2002 NOTE. The data, which are quarterly and extend through 2002:Q3, are ratios of capital to risk-weighted assets. Tier 1 capital consists primarily of NOTE. M2 consists of currency, travelers checks, demand deposits, other common equity and certain perpetual preferred stock. Tier 2 capital consists checkable deposits, savings deposits (including money market deposit primarily of subordinated debt, preferred stock not included in tier 1 capital, accounts), small-denomination time deposits, and balances in retail money and a limited amount of loan-loss reserves. market funds. 26 Monetary Policy Report to the Congress February 2003 M2 velocity and opportunity cost changes to its Regulation A that established two new types of loans to depository institutions—primary and second­ Ratio, ratio scale Percentage points, ratio scale ary credit—and discontinued the adjustment and extended 2.3 credit programs. The new programs were implemented 8 on January 9, 2003. The seasonal credit program was not M2 velocity altered. 4 The primary reason for adopting the new programs 2.1 was to eliminate the subsidy to borrowing institutions that M2 2 was implicit in the basic discount rate, which since the opportunity late 1960s had usually been set below market interest cost 1 rates. The subsidy required Federal Reserve Banks to administer credit extensions heavily in order to ensure 1.9 that borrowing institutions used credit only in appropri­ ate circumstances—specifically, when they had exhausted 1993 1996 1999 2002 other reasonably available funding sources. That admin­ istration was necessarily somewhat subjective and con­ NOTE. The data are quarterly and extend through 2002:Q4. The velocity of M2 is the ratio of nominal gross domestic product to the stock of M2. The sequently difficult to apply consistently across Reserve opportunity cost of holding M2 is a two-quarter moving average of the difference between the three-month Treasury bill rate and the weighted Banks. In addition, the heavy administration was one fac­ average return on assets included in M2. tor that caused depository institutions to become reluc­ tant to use the window even in appropriate conditions. Also, depository institutions were concerned at times M3 growth rate about being marked with a “stigma” if market analysts and counterparties inferred that the institution was bor­ Percent, annual rate rowing from the window and suspected that the borrow­ ing signaled that the institution was having financial dif­ 12 ficulties. The resulting reluctance to use the window reduced its usefulness in buffering shocks to the reserve 10 market and in serving as a backup source of liquidity to 8 depository institutions, and thus undermined its perfor­ mance as a monetary policy tool. 6 To address these issues, the Board of Governors speci­ fied that primary credit may be made available at an 4 above-market interest rate to depository institutions in 2 generally sound financial condition. The above-market interest rate eliminates the implicit subsidy. Also, restrict­ 1990 1992 1994 1996 1998 2000 2002 ing eligibility for the program to generally sound institu­ NOTE. M3 consists of M2 plus large-denomination time deposits, balances tions should reduce institutions’ concerns that their bor­ in institutional money market funds, repurchase-agreement liabilities rowing could signal financial weakness. (overnight and term), and eurodollars (overnight and term). The Federal Reserve set the initial primary credit rate at 2.25 percent, 100 basis points above the FOMC’s tar- 61/ 2 percent in 2002, a pace well below the 123/ 4 percent get federal funds rate as of January 9, 2003. The target advance posted in 2001. Growth in M3 was also held federal funds rate remained unchanged, and thus the adop­ down by a sharp deceleration of institutional money funds, tion of the new programs did not represent a change in as their yields dropped to close alignment with short-term the stance of monetary policy. In the future, the primary market interest rates. This effect was only partly offset credit rate will be adjusted from time to time as appropri­ by the pickup in needs to fund bank credit, which ate, using the same discretionary procedure that was resulted in an acceleration in the issuance of managed used in the past to set the adjustment credit rate. The Fed­ liabilities, including large time deposits. M3 velocity con­ eral Reserve also established procedures to reduce the tinued to decline in 2002. primary credit rate to the target federal funds rate in a national emergency, even if key policymakers are unavailable. New Discount Window Programs Institutions that do not qualify for primary credit may On October 31, 2002, following a three-month public obtain secondary credit when the borrowing is consistent comment period, the Board of Governors approved with a prompt return to market sources of funds or is Board of Governors of the Federal Reserve System 27 necessary to resolve severe financial difficulties. The Equity indexes in selected foreign industrial countries interest rate on secondary credit is set by formula 50 ba­ sis points above the primary credit rate. The rate was set Week ending January 5, 2001 = 100 initially at 2.75 percent. Because secondary credit bor­ rowers are not in sound financial condition, extensions of secondary credit usually involve some administration. Japan 100 Canada 80 International Developments The international economy rebounded in 2002 after a stag­ Euro area nant performance in 2001, but recovery was uneven in 60 both timing and geographical distribution. Growth abroad picked up sharply in the first half of last year, as a strong United Kingdom rally in the high-tech exporting economies in developing 2001 2002 2003 Asia was joined by robust growth in Canada and, to a NOTE. The data are weekly. The last observations are the average of lesser extent, Mexico. Japan also posted respectable trading days through February 5, 2003. growth in the first half, largely as a result of a surge of exports. However, performance in the euro area remained response to generally favorable economic news, but later sluggish, and several South American economies experi­ they flattened out and moved back down as the outlook enced difficulties, with full-fledged crises in Argentina deteriorated. Similarly, equity prices in the major foreign and Venezuela and mounting concerns about prospects industrial economies held up well early in the year but for Brazil. As the U.S. economy decelerated in the sec­ then declined along with the U.S. stock market and ended ond half, the rapid pace of recovery slowed in develop­ the year down sharply from the previous year. The per­ ing Asia and in Canada, while performance remained lack- formance of the stock markets in the emerging-market luster in much of the rest of the world. economies was mixed. Share prices in Brazil and Mexico Monetary policy actions abroad also diverged across fell sharply in the second and third quarters but then countries in 2002 as authorities reacted to differing eco­ showed some improvement toward the end of the year. In nomic conditions. In Canada, official interest rates were the Asian emerging-market economies, equity prices rose raised in three steps by July amid concerns that buoyant in the first half of 2002 on a general wave of optimism, domestic demand and sharply rising employment would especially in the high-technology producing economies; ignite inflationary pressures. Monetary authorities in equity prices began to decline around midyear as global Australia and Sweden also increased policy rates in the demand softened but posted modest rebounds late in the first half of the year. However, as economic conditions year. weakened around the world in the second half, official interest rates were held constant in Canada and Australia and were lowered in Sweden. Monetary policy was held steady throughout 2002 in the United Kingdom, where Equity indexes in selected emerging markets growth was moderate and inflation subdued, but official interest rates were lowered 25 basis points, to 3.75 per- Week ending January 5, 2001 = 100 cent, in early February 2003 in response to concerns about Developing Asia the prospects for global and domestic demand. The European Central Bank (ECB) held rates constant through Argentina 120 Mexico most of the year, as inflation remained above the ECB’s 2 percent target ceiling, but rates were lowered 50 basis 100 points in December as the euro area’s already weak re­ covery appeared to be stalling. Japanese short-term in­ 80 terest rates remained near zero, while authorities took some limited further steps to stimulate demand through 60 nontraditional channels. Monetary policy was tightened Brazil in both Mexico and Brazil in response to concerns about the inflationary effects of past currency depreciation. 2001 2002 2003 Yield curves in the major foreign industrial countries NOTE. The data are weekly. The last observations are the average of steepened and shifted up in the first quarter of 2002 in trading days through February 5, 2003. 28 Monetary Policy Report to the Congress February 2003 The foreign exchange value of the dollar continued half of the year, but it dropped back somewhat in the sec­ its mild upward trend into the early part of 2002, as it ond half as the economy slowed; by the end of the year it appeared that the United States was poised to lead a glo­ was up only slightly on balance. The Canadian dollar has bal economic recovery. However, the dollar weakened moved up somewhat more so far this year. sharply in the late spring and early summer amid deepen­ The Japanese economy recorded positive growth dur­ ing concerns about U.S. corporate governance and prof­ ing 2002, although it was not enough to fully reverse itability. Around that time market analysts also appeared the decline in output that occurred in 2001. Despite about to become more worried about the growing U.S. current 10 percent appreciation of the yen against the dollar in account deficit and its potential negative influence on the 2002, Japanese growth was driven largely by exports, with future value of the dollar. The dollar rebounded some- smaller contributions from both increased consumption what around midyear as growth prospects for other and a slower pace of inventory reduction. In contrast, major economies, particularly in the euro area, appeared private investment continued to decline, although not as to dim; the dollar dropped back again late in the year as sharply as in 2001. Labor market conditions remained geopolitical tensions intensified, and continued to depre­ quite depressed, and consumer prices continued to fall. ciate in early 2003. In nominal terms the dollar has Little progress was made on the serious structural prob­ declined about 5 percent on balance over the past year, lems that have plagued the Japanese economy, including with depreciations against the currencies of the major the massive and growing amount of bad loans on the books industrial countries and several of the developing Asian of Japanese banks. A new set of official measures that economies partly offset by appreciation against the cur­ aims at halving the value of bad loans within two and a rencies of several Latin American countries. half years was announced in the fall, but the details of this plan are still not fully specified. In September, the Bank of Japan announced a plan to buy shares from Industrial Economies banks with excessive holdings of equity, which would The Canadian economy recorded the strongest perfor­ help to reduce bank exposure to stock market fluctua­ mance among the major foreign industrial countries last tions. Because the transactions are to occur at market year despite some slowing in the second half. The strength, prices, there would be no net financial transfer to which was largely homegrown, reflected robust growth the banks. Near the end of last year the Bank of Japan of consumption and residential construction as well as an (BOJ) raised its target range for bank reserves at the BOJ end to inventory runoffs early in the year. The expansion from ¥10–15 trillion to ¥15–20 trillion, increased the was accompanied by very rapid increases in employment monthly amount of its outright purchases of long-term and utilization of capacity, and the core inflation rate government bonds, and broadened the range of collat­ breached the upper end of the government’s 1 percent to eral that can be used for market operations. In December 3 percent target range near the end of the year. The Cana­ the monetary base was up about 20 percent from a year dian dollar appreciated against the U.S. dollar in the first earlier, a rise partially reflecting the increased level of bank reserves at the BOJ. However, the twelve-month rate of base money growth was considerably below the 36 percent pace registered in April. Broad money growth U.S. dollar exchange rate against selected major currencies remains subdued. Economic performance in the euro area was quite slug­ Week ending January 5, 2001 = 100 gish last year. Although exports were up sharply, growth in consumption was modest, and private investment Japanese yen declined. The area’s lackluster economic performance 110 pushed the unemployment rate up by several tenths of a percentage point by the end of the year. Economic weak­ U.K. ness was particularly pronounced in some of the larger Canadian dollar pound 100 countries—Germany, Italy, the Netherlands, and, to a lesser extent, France. In contrast, growth in Spain and some of the smaller euro-area countries—Ireland, Portu­ 90 gal, Finland, and Greece—was much more robust. Head- Euro line inflation jumped to a bit above 21/ 2 percent early in the year, owing to higher food and energy prices and in 2001 2002 2003 small part to the introduction of euro notes and coins. NOTE. The data are weekly. Exchange rates are in foreign currency units Increased slack in the economy, however, together with per dollar. Last observations are the average of trading days through February 5, 2003. the 15 percent appreciation of the euro by the end of the Board of Governors of the Federal Reserve System 29 year, helped to mitigate inflation concerns, and the ECB ment that had pegged the peso at a one-to-one rate with lowered its policy interest rate in December. The euro the dollar collapsed early last year; the peso lost nearly continued to appreciate in early 2003. three-fourths of its value by late June, and sovereign bond Economic growth in the United Kingdom held up bet­ spreads spiked to more than 7,000 basis points. By early ter than in the other major European countries last year, 2002, the banking system had become effectively insol­ and sterling strengthened about 10 percent versus the vent as a result of the plunging peso, the weak economy, dollar. However, the expansion remained uneven, with and the government’s default on debt that the banks held the services sector continuing to grow more rapidly than mostly involuntarily. Confronted with this situation, the the smaller manufacturing sector. Despite tight labor government forced the conversion of the banks’ dollar- markets, inflation remained a bit below the Bank of denominated assets and liabilities to pesos and also man- England’s target of 21/ 2 percent for most of the past year. dated the rescheduling of a large share of deposits. As a A sharp rise in housing prices has, however, raised some result of these and other measures, confidence in the bank­ concern about the possibility of a real estate price bubble. ing system, already shaken, was further impaired. Finan­ The British government announced its intention to com­ cial and economic conditions eventually stabilized in the plete a rigorous assessment of its criteria for joining the second half of the year, but there are no signs yet of a European Monetary Union (EMU) by the middle of this sustained recovery. The government also defaulted on year and, if they are met, to hold a referendum on entry. obligations to multilateral creditors in late 2002 and early 2003. In January, Argentina and the International Mon­ etary Fund reached agreement on a $6.6 billion short- term program that will go to meeting Argentina’s pay­ Emerging-Market Economies ments to the IMF at least through the elections expected The Brazilian economy posted a surprisingly strong rebound in 2002 despite a major political transition and Exchange rates and bond spreads accompanying turbulence in financial markets. The Bra­ for selected emerging markets zilian real depreciated sharply between May and Octo­ ber, and sovereign bond spreads climbed to 2,400 basis Week ending January 5, 2001 = 100 Week ending January 5, 2001 = 100 points as it became increasingly likely that Luiz Inácio Dollar exchange rates Lula da Silva (Lula), the Workers’Party candidate, would win the presidential election. Given some of the past 360 220 stances of the party, this possibility fueled concerns among foreign investors about a potential erosion of fiscal and Argentine peso 280 180 monetary discipline. In response to the sharp deteriora­ tion in financial conditions facing Brazil, a $30 billion 200 Brazilian real 140 IMF program was approved in September 2002, $6 bil­ Mexican peso lion of which was disbursed by the end of the year. How- ever, financial conditions improved markedly after Lula 120 100 Korean won won the election in late October and appointed a cabinet perceived to be supportive of orthodox fiscal and mon­ etary policies, including greater central bank indepen­ Percentage points Percentage points dence. By January 2003 the real had reversed about one- Bond spreads fourth of its previous decline against the dollar, and bond 80 Brazil 20 spreads had fallen sharply. However, the new adminis­ tration still faces some major challenges. In particular, serious concerns remain over the very large quantity and 60 Argentina 15 relatively short maturity of the outstanding government debt. In addition, last year’s currency depreciation 40 10 fueled a rise in inflation that has prompted several increases in the monetary policy interest rate. In January Mexico 20 5 the government raised the upper bound of its inflation target range for this year to 8.5 percent from 6.5 percent, although the target for next year was lowered at the same 2001 2002 2003 time to 5.5 percent from 6.25 percent. NOTE. The data are weekly. Exchange rates (top panel) are in foreign Argentine GDP contracted further in 2002 after currency units per dollar. Bond spreads (bottom panel) are the J.P. Morgan Emerging Market Bond Index (EMBI+) spreads over U.S. Treasuries. Last declining 10 percent in 2001. The currency board arrange­ observations are the average of trading days through February 5, 2003. 30 Monetary Policy Report to the Congress February 2003 in the spring and also to clearing its overdue obligations The Asian emerging-market economies generally per- to the multilateral development banks. formed well in 2002, although there were significant dif­ Venezuela experienced extreme economic and politi­ ferences within the region. Outside of China, the stron­ cal turmoil over the past year. In February 2002 the cen­ gest growth was recorded in South Korea, which benefited tral bank abandoned the bolivar’s crawling peg to the in the first half of the year from both an upturn in global dollar, and the bolivar depreciated sharply. Opponents of demand for high-tech products and a surge in domestic President Hugo Chavez mounted a short-lived coup in demand, particularly consumption. However, consumer April and declared a national strike in early December. confidence deteriorated at the end of the year as tensions The strike brought the already-weak economy to a stand- over North Korea intensified; the uneasy situation, as well still, and output in the key oil industry plummeted. The as the substantial existing consumer debt burden, pose strike abated in early February in all sectors but oil. In significant risks to growth in consumption this year. The response to the strike, Chavez increased his control of Korean won appreciated sharply against the dollar the state-owned oil company and oil production began between April and midyear in response to improving eco­ rising in early 2003, but it was still well below pre-strike nomic conditions; it then dropped back in late summer levels. With the exchange rate plunging in late January, and early fall as perceptions about the strength of the glo­ the government suspended currency trading for two weeks bal recovery were adjusted downward. However, the won before establishing a fixed exchange rate regime and some turned back up against the dollar late last year. restrictions on foreign currency transactions. The performance of the ASEAN-5 economies—Indo­ One of the few bright spots in Latin America last year nesia, Malaysia, the Philippines, Singapore, and Thai­ was the Mexican economy. Boosted by the U.S. recov­ land—also was generally robust in 2002, although the ery, growth was moderate for the year as a whole despite overall softening in global demand in the second half of some late slowing. However, financial conditions dete­ the year was evident there as well. The second-half slow­ riorated somewhat after midyear as market participants ing in production was particularly pronounced in reevaluated the strength of the North American recovery. Singapore, which is heavily dependent on exports of high- Mexican stock prices slid about 25 percent between April technology products. Taiwan, another high-technology and September, and sovereign bond spreads widened producer, also showed a significant deceleration in out- nearly 200 basis points to around 430 basis points over put between the first and second halves of the year. Both the same period. Nevertheless, the Mexican economy did of these economies experienced some mild deflation in not appear to be much affected by spillovers from the 2002, although prices turned up toward the end of the problems elsewhere in Latin America; bond spreads year. dropped sharply between October and the end of the year Although the Hong Kong economy did not show as to around 300 basis points, a level considerably lower much improvement as most other emerging Asian econo­ than elsewhere in the region. The peso depreciated about mies in the first half of last year, it recorded very strong 12 percent against the dollar over the course of last year. growth in the third quarter. Nevertheless, prices contin­ The decline fueled an increase in twelve-month inflation ued to fall for the fourth consecutive year. The mainland to more than 51/ 2 percent by year-end. The acceleration Chinese economy, which again outperformed the rest of put inflation above the government target rate of 41/ 2 per- the region in 2002, enjoyed surging investment by the cent and well above the ambitious 3 percent target set for government and by foreign investors as well as robust 2003. In response to increasing inflation, the Bank of export growth. The Chinese economy continued to expe­ Mexico has tightened monetary policy four times since rience mild deflation last year. September 2002. The peso has continued to depreciate in early 2003, and bond spreads have moved back up a bit.

Federal Reserve (2003, February 10). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20030211

@misc{wtfs_monetary_policy_report_20030211,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2003},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20030211},
  note = {Retrieved via When the Fed Speaks corpus}
}