Monetary Policy Report of July 2001, Section 1



MONETARY POLICY AND THE ECONOMIC
OUTLOOK  

When the Federal Reserve submitted its report on
monetary policy in mid-February, the Federal Open
Market Committee (FOMC) had already reduced its
target for the federal funds rate twice to counter
emerging weakness in the economy. As the year has
unfolded, the weakness has become more persistent
and widespread than had seemed likely last autumn.
The shakeout in the high-technology sector has been
especially severe, and with overall sales and profits
continuing to disappoint, businesses are curtailing
purchases of other types of capital equipment as
well. The slump in demand for capital goods has
also worked against businesses' efforts to correct the
inventory imbalances that emerged in the second half
of last year and has contributed to sizable declines in
manufacturing output this year. At the same time,
foreign economies have slowed, limiting the demand
for U.S. exports.  

To foster financial conditions that will support
strengthening economic growth, the FOMC has
lowered its target for the federal funds rate four
times since February, bringing the cumulative
decline this year to 2-3/4 percentage points. A
number of factors spurred this unusually steep
reduction in the federal funds rate. In particular, the
slowdown in growth was rapid and substantial and
carried considerable risks that the sluggish
performance of the economy in the first half of this
year would persist. Among other things, the
abruptness of the slowing, by jarring consumer and
business confidence, raised the possibility of
becoming increasingly self-reinforcing were
households and businesses to postpone spending
while reassessing their situations. In addition, other
financial developments, including a higher foreign
exchange value of the dollar, lower equity prices,
and tighter lending terms and standards at banks,
were tending to restrain aggregate demand and thus
were offsetting some of the influence of the lower
federal funds rate. Finally, despite some worrisome
readings early in the year, price increases remained
fairly well contained, and prospects for inflation
have become less of a concern as rates of resource
utilization have declined and energy prices have
shown signs of turning down.  

The information available at midyear for the recent
performance of both the U.S. economy and some of
our key trading partners remains somewhat
downbeat, on balance. Moreover, with inventories
still excessive in some sectors, orders for capital
goods very soft, and the effects of lower stock
prices and the weaker job market weighing on
consumers, the economy may expand only slowly, if
at all, for a while longer. Nonetheless, a number of
factors are in place that should set the stage for
stronger growth later this year and in 2002. In
particular, interest rates have declined since last fall;
the lower rates have helped businesses and
households strengthen their financial positions and
should show through to aggregate demand in
coming quarters. The recently enacted tax cuts and
the apparent cresting of energy prices should also
bolster aggregate demand fairly soon. In addition, as
firms at some point become more satisfied with their
inventory holdings, the cessation of liquidation will
boost production and, in turn, provide a lift to
employment and incomes; a subsequent shift to
inventory accumulation in association with the
projected strengthening in demand should provide
additional impetus to production. Moreover, with no
apparent sign of abatement in the rapid pace of
technological innovation, the outlook for
productivity growth over the longer run remains
favorable. The efficiency gains made possible by
these innovations should spur demand for the capital
equipment that embodies the new technologies once
the overall economic situation starts to improve and
should support consumption by leading to solid
increases in real incomes over time.  

Even though an appreciable recovery in the growth
of economic activity by early next year seems the
most likely outcome, there is as yet no hard evidence
that this improvement is in train, and the situation
remains very uncertain. In these circumstances, the
FOMC continues to believe that the risks are
weighted toward conditions that may generate
economic weakness in the foreseeable future. At the
same time, the FOMC recognizes the importance of
sustaining the environment of low inflation and
well-anchored inflation expectations that enabled the
Federal Reserve to react rapidly and forcefully to the
slowing in real GDP growth over the past several
quarters. When, as the FOMC expects, activity
begins to firm, the Committee will continue to
ensure that financial conditions remain consistent
with holding inflation in check, a key requirement
for maximum sustainable growth.  


Monetary Policy, Financial Markets, and the
Economy over the First Half of 2001   

By the time of the FOMC meeting on December 19,
2000, it had become evident that economic growth
had downshifted considerably, but the extent of that
slowing was only beginning to come into focus. At
that meeting, the FOMC concluded that the risks to
the economy in the foreseeable future had shifted to
being weighted mainly toward conditions that may
generate economic weakness and that economic and
financial developments could warrant further close
review of the stance of policy well before the next
scheduled meeting. Subsequent data indicated that
holiday retail sales had come in below expectations
and that conditions in the manufacturing sector had
deteriorated. Corporate profit forecasts had also
been marked down, and it seemed possible that the
resulting decline in equity values, along with the
expense of higher energy costs, could damp future
business investment and household spending. In
response, the FOMC held a telephone conference on
January 3, 2001, and decided to reduce the target
federal funds rate 1/2 percentage point, to 6 percent,
and indicated that the risks to the outlook remained
weighted toward economic weakness.   

The timing and size of the cut in the target rate
seemed to ease somewhat the concerns of financial
market participants about the longer-term outlook
for the economy. Equity prices generally rose in
January, risk spreads on lower-rated corporate
bonds narrowed significantly, and the yield curve
steepened. However, incoming data over the month
revealed that the slowing in consumer and business
spending late last year had been sizable.
Furthermore, a sharp erosion in survey measures of
consumer confidence, a backup of inventories, and a
steep decline in capacity utilization posed the risk
that spending could remain depressed for some time.
In light of these developments, the FOMC at its
scheduled meeting on January 30 and 31 cut its
target for the federal funds rate another 1/2
percentage point, to 5-1/2 percent, and stated that it
continued to judge the risks to be weighted mainly
toward economic weakness.  

The information reviewed by the FOMC at its
meeting on March 20 suggested that economic
activity continued to expand, but slowly. Although
consumer spending seemed to be rising moderately
and housing had remained relatively firm, stock
prices had declined substantially in February and
early March, and reduced equity wealth and lower
consumer confidence had the potential to damp
household spending going forward. Moreover,
manufacturing output had contracted further, as
businesses continued to work down their excess
inventories and cut back on capital equipment
expenditures. In addition, economic softness abroad
raised the likelihood of a weakening in U.S. exports.
Core inflation had picked up a bit in January, but
some of the increase reflected the pass-through of a
rise in energy prices that was unlikely to continue,
and the FOMC judged that the slowdown in the
growth of aggregate demand would ease inflationary
pressures on labor and other resources. Accordingly,
the FOMC on March 20 lowered its target for the
federal funds rate another 1/2 percentage point, to 5
percent. The members also continued to see the risks
to the outlook as remaining weighted mainly toward
economic weakness. Furthermore, the FOMC
recognized that in a rapidly evolving economic
situation, it would need to be alert to the possibility
that a conference call would be desirable during the
relatively long interval before the next scheduled
meeting to discuss the possible need for a further
policy adjustment.  

Capital markets continued to soften in late March
and early April, in part because corporate profits and
economic activity remained quite weak. Although
equity prices and bond yields began to rise in
mid-April as financial market investors became more
confident that a cumulative downward spiral in
activity could be avoided, reports continued to
suggest flagging economic performance and risks of
extended weakness ahead. In particular, spending by
consumers had leveled out and their confidence had
fallen further. The FOMC discussed economic
developments in conference calls on April 11 and
April 18, deciding on the latter occasion to reduce
its target for the federal funds rate another 1/2
percentage point, to 4-1/2 percent. The Committee
again indicated that it judged the balance of risks to
the outlook as weighted toward economic weakness. 


When the FOMC met on May 15, economic
conditions remained quite sluggish, especially in
manufacturing, where production and employment
had declined further. Although members were
concerned that some indicators of core inflation had
moved up in the early months of the year and that
part of the recent backup in longer-term interest
rates may have owed to increased inflation
expectations, most saw underlying price increases as
likely to remain damped as continued subpar growth
relieved pressures on resources. In light of the
prospect of continued weakness in the economy and
the significant risks to the economic expansion, the
FOMC reduced its target for the federal funds rate
an additional 1/2 percentage point, to 4 percent.
With the softening in aggregate demand still of
unknown persistence and dimension, the FOMC
continued to view the risks to the outlook as
weighted toward economic weakness. Still, the
FOMC recognized that it had eased policy
substantially this year and that, in the absence of
further sizable adverse shocks to the economy, at
future meetings it might need to consider adopting a
more cautious approach to further policy actions.  

Subsequent news on economic activity and
corporate profits failed to point to a rebound. In
June, interest rates on longer-term Treasuries and on
higher-quality private securities declined, some risk
spreads widened, and stock prices fell as financial
market participants trimmed their expectations for
economic activity and profits. When the FOMC met
on June 26 and 27, conditions in manufacturing
appeared to have worsened still more. It also
seemed likely that slower growth abroad would
restrain demand for exports and that weakening
labor markets would hold down growth in consumer
spending. In light of these developments, but also
taking into account the cumulative 250 basis points
of easing already undertaken and the other forces
likely to be stimulating spending in the future, the
FOMC lowered its target for the federal funds rate
1/4 percentage point, to 3-3/4 percent, and
continued to view the risks to the outlook as
weighted toward economic weakness.  

The Board of Governors of the Federal Reserve
System approved cuts in the discount rate in the first
half of the year that matched the FOMC's cuts in the
target federal funds rate. As a result, the discount
rate declined from 6 percent to 3-1/4 percent over
the period.  


Economic Projections for 2001 and 2002 

The members of the Board of Governors and the
Federal Reserve Bank presidents, all of whom
participate in the deliberations of the FOMC, expect
economic growth to remain slow in the near term,
though most anticipate that it will pick up later this
year at least a little. The central tendency of the
forecasts for the increase in real GDP over the four
quarters of 2001 spans a range of 1-1/4 percent to 2
percent, and the central tendency of the forecasts for
real GDP growth in 2002 is 3 percent to 3-1/4
percent. The civilian unemployment rate, which
averaged 4-1/2 percent in the second quarter of
2001, is expected to move up to the area of 4-3/4
percent to 5 percent by the end of this year. In 2002,
with the economy projected to expand at closer to
its trend rate, the unemployment rate is expected to
hold steady or perhaps to edge higher. With
pressures in labor and product markets abating and
with energy prices no longer soaring, inflation is
expected to be well contained over the next year and
a half.   

Despite the projected increase in real GDP growth,
the uncertainty about the near-term outlook remains
considerable. This uncertainty arises not only from
the difficulty of assessing when businesses will feel
that conditions are sufficiently favorable to warrant a
pickup in capital spending but also from the
difficulty of gauging where businesses stand in the
inventory cycle. Nonetheless, all the FOMC
participants foresee a return to solid growth by
2002. By then, the inventory correction should have
run its course, and the monetary policy actions taken
this year, as well as the recently enacted tax
reductions, should be providing appreciable support
to final demand.  

In part because of lower interest rates, many firms
have been able to shore up their balance sheets. And
although some lower-rated firms, especially in
telecommunications and other sectors with gloomy
near-term prospects, may continue to find it difficult
to obtain financing, businesses generally are fairly
well positioned to step up their capital spending
once the outlook for sales and profits improves. By
all accounts, technological innovation is still
proceeding rapidly, and these advances should
eventually revive high-tech investment, especially
with the price of computing power continuing to
drop sharply.  

In addition, consumer spending is expected to get a
boost from the tax cuts and from falling energy
prices, which should help offset the effects of the
weaker job market and the decline over the past year
in stock market wealth. Housing activity, which has
been buoyed in recent quarters by low mortgage
interest rates, is likely to remain firm into 2002.
Significant concerns remain about the foreign
economic outlook and the prospects for U.S.
exports. Nevertheless, economic activity abroad is
expected to benefit from a strengthening of the U.S.
economy, a stabilization of the global high-tech
sector, an easing of oil prices, and stimulative
macroeconomic policies in some countries.  

The chain-type price index for personal consumption
expenditures rose 2-1/4 percent over the four
quarters of 2000, and most FOMC participants
expect inflation to remain around that rate through
next year; indeed, the central tendency of their
forecasts for the increase in this price measure is 2
percent to 2-1/2 percent in 2001 and 1-3/4 percent
to 2-1/2 percent in 2002. One favorable factor in the
inflation outlook is the behavior of energy prices.
Those prices have declined recently after having
increased rapidly in the past couple of years, and
prospects are good that they could stabilize or even
fall further in coming quarters. In addition to their
direct effects, lower energy prices should tend to
limit increases in other prices by reducing input costs
for a wide range of energy-intensive goods and
services and by helping damp inflation expectations.
More broadly, the competitive conditions that have
restricted businesses' ability to raise prices in recent
years are likely to persist. And although labor costs
could come under upward pressure as wages tend to
catch up to previous increases in productivity, the
slackening in resource utilization this year is
expected to contribute to reduced inflation pressures
going forward.  

Section 2      
 
 
ECONOMIC AND FINANCIAL DEVELOPMENTS IN 2001   
 
Economic growth remained very slow in the first half of 2001 after
having downshifted in the second half of 2000. Real gross domestic
product rose at an annual rate of just 1-1/4 percent in the first
quarter, about the same as in the fourth quarter, and appears to
have posted at best a meager gain in the second quarter. Businesses
have been working to correct the inventory imbalances that
emerged in the second half of last year, which has led to sizable
declines in manufacturing output, and capital spending has
weakened appreciably. In contrast, household spending--especially
for motor vehicles and houses--has held up well. Employment
increased only modestly over the first three months of the year and
turned down in the spring; the unemployment rate in June stood at
4-1/2 percent, 1/2 percentage point higher than in the fourth quarter
of last year.   
 
The inflation news early this year was not very favorable, as energy
prices continued to soar and as measures of core inflation--which
exclude food and energy--registered some pickup. More recently,
however, energy prices have moved lower, and the monthly
readings on core inflation have returned to more moderate rates.
Moreover, apart from energy, prices at earlier stages of processing
have been quiescent this year.   
 
 
The Household Sector  
 
Growth in household spending has slowed noticeably from the 
rapid pace of the past few years. Still, it was fairly well maintained
in the first half of 2001 despite the weaker tenor of income, wealth,
and consumer confidence, and the personal saving rate declined a
bit further. A greater number of households encountered problems
servicing debt, but widespread difficulties or restrictions on the
availability of credit did not emerge.    
 
 
Consumer Spending  
 
Real consumer spending grew at an annual rate of 3-1/2 percent in
the first quarter. Some of the increase reflected a rebound in
purchases of light motor vehicles, which were boosted by a
substantial expansion of incentives and rose to just a tad below the
record pace of 2000 as a whole. In addition, outlays for non-auto
goods posted a solid gain, and spending on services rose modestly
despite a weather-related drop in outlays for energy services. In the
second quarter, however, the rise in consumer spending seems to
have lessened as sales of light motor vehicles dropped a bit, on
average, and purchases of other goods apparently did not grow as
fast in real terms as they had in the first quarter.   
 
The rise in real consumption so far this year has been considerably
smaller than the outsized gains in the second half of the 1990s and
into 2000. But the increase in spending still outstripped the growth
in real disposable personal income (DPI), which has been restrained
this year by further big increases in consumer energy prices and by
the deterioration in the job market; between the fourth quarter of
2000 and May, real DPI increased just about 2 percent at an annual
rate, well below the average pace of the preceding few years. In
addition, the net worth of households fell again in the first quarter,
to a level 8 percent below the high reached in the first quarter of
2000. On net, the ratio of household net worth to DPI has returned
to about the level reached in 1997, significantly below the recent
peak but still high by historical standards. In addition, consumer
sentiment indexes, which had risen to extraordinary levels in the late
1990s and remained there through last fall, fell sharply around the
turn of the year. However, these indexes have not deteriorated
further, on net, since the winter and are still at reasonably favorable
levels when compared with the readings for the pre-1997 period.   
 
Rising household wealth almost certainly was a key factor behind
the surge in consumer spending between the mid-1990s and last
year, and thus helps to explain the sharp fall in the personal saving
rate over that period. The saving rate has continued to fall this
year--from -0.7 percent in the fourth quarter of 2000 to -1.1
percent in May--even though the boost to spending growth from
the earlier run-up in stock prices has likely run its course and the
effects of lower wealth should be starting to feed through to
spending. The apparent decline in the saving rate may simply reflect
noisiness in the data or a slower response of spending to wealth
than average historical experience might suggest. In addition,
consumers probably base their spending decisions on income
prospects over a longer time span than just a few quarters. Thus, to
the extent that consumers do not expect the current sluggishness in
real income growth to persist, the tendency to maintain spending
for a time by dipping into savings or by borrowing may have offset
the effect of the decline in wealth on the saving rate.    
 
 
Residential Investment  
 
Housing activity remained buoyant in the first half of this year as
lower mortgage interest rates appear to have offset the restraint
from smaller gains in employment and income and from lower
levels of wealth. In the single-family sector, starts averaged an
annual rate of 1.28 million units over the first five months of the
year--4 percent greater than the hefty pace for 2000 as a whole.
Sales of new and existing homes strengthened noticeably around
the turn of the year and were near record levels in March; they fell
back in April but reversed some of that drop in May. Inventories of
new homes for sale are exceptionally low; builders' backlogs are
sizable; and, according to the Michigan survey, consumers'
assessments of homebuying conditions remain favorable, mainly
because of perceptions that mortgage rates are low.   
 
Likely because of the sustained strength of housing demand, home
prices have continued to rise faster than overall inflation, although
the various measures that attempt to control for shifts in the
regional composition of sales and in the characteristics of houses
sold provide differing signals on the magnitude of the price
increases. Notably, over the year ending in the first quarter, the
constant-quality price index for new homes rose 4 percent, while
the repeat-sales price index for existing homes was up nearly 9
percent. Despite the higher prices, the share of income required to
finance a home purchase--one measure of affordability--has fallen in
recent quarters as mortgage rates have dropped back after last
year's bulge, and that share currently is about as low as it has been
at any time in the past decade. Rates on thirty-year conventional
fixed-rate loans now stand around 7-1/4 percent, and ARM rates
are at their lowest levels in a couple of years.   
 
In the multifamily sector, housing starts averaged 343,000 units at
an annual rate over the first five months of the year, matching the
robust pace that has been evident since 1997. Moreover, conditions
in the market for multifamily housing continue to be conducive to
new construction. The vacancy rate for multifamily rental units in
the first quarter held near its low year-earlier level, and rents and
property values continued to rise rapidly.    
 
 
Household Finance  
 
The growth of household debt is estimated to have slowed
somewhat in the first half of this year to a still fairly hefty 7-1/2
percent annual rate--about a percentage point below its average
pace over the previous two years. Households have increased both
their home mortgage debt and their consumer credit (debt not
secured by real estate) substantially this year, although in both cases
the growth has moderated a bit recently. The relatively low
mortgage interest rates have boosted mortgage borrowing both by
stimulating home purchases and by making it attractive to refinance
existing mortgages and extract some of the buildup in home equity.
The rapid growth in consumer credit has been concentrated in
credit card debt, perhaps reflecting households' efforts to sustain
their consumption in the face of weaker income growth.  
 
The household debt service burden--the ratio of minimum
scheduled payments on mortgage and consumer debt to disposable
personal income--rose to more than 14 percent at the end of the
first quarter, a twenty-year high, and available data suggest a similar
reading for the second quarter. In part because of the elevated debt
burden, some measures of household loan performance have
deteriorated a bit in recent quarters. The delinquency rate on home
mortgage loans has edged up but remains low, while the
delinquency rate on credit card loans has risen noticeably and is in
the middle part of its range over the past decade. Personal
bankruptcies jumped to record levels in the spring, but some of the
spurt was probably the result of a rush to file before Congress
passed bankruptcy reform legislation.  
 
Lenders have tightened up somewhat in response to the
deterioration of household financial conditions. In the May Senior
Loan Officer Opinion Survey on Bank Lending Practices, about a
fifth of the banks indicated that they had tightened the standards for
approving applications for consumer loans over the preceding three
months, and about a fourth said that they had tightened the terms
on loans they are willing to make, substantial increases from the
November survey. Of those that had tightened, most cited actual or
anticipated increases in delinquency rates as a reason.   
 
 
The Business Sector  
 
The boom in capital spending that has helped fuel the economic
expansion came to a halt late last year. After having risen at
double-digit rates over the preceding five years, real business fixed
investment flattened out in the fourth quarter of 2000 and rose only
a little in the first quarter of 2001. Demand for capital equipment
has slackened appreciably, reflecting the sluggish economy, sharply
lower corporate profits and cash flow, earlier overinvestment in
some sectors, and tight financing conditions facing some firms. In
addition, inventory investment fell substantially in the first quarter
as businesses moved to address the overhangs that began to
develop late last year. With investment spending weakening,
businesses have cut back on new borrowing. Following the drop in
longer-term interest rates in the last few months of 2000, credit
demands have been concentrated in longer-term markets, though
cautious investors have required high spreads from marginal
borrowers.   
 
 
Fixed Investment  
 
Real spending on equipment and software (E&S) began to soften in
the second half of last year, and it posted small declines in both the
fourth quarter of 2000 and the first quarter of 2001. Much of the
weakness in the first quarter was in spending on high-tech
equipment and software; such spending, which now accounts for
about half of E&S outlays when measured in nominal terms,
declined at an annual rate of about 12 percent in real terms--the first
real quarterly drop since the 1990 recession. An especially sharp
decrease in outlays for communications equipment reflected the
excess capacity that had emerged as a result of the earlier surge in
spending, the subsequent re-evaluation of profitability, and the
accompanying financing difficulties faced by some firms. In
addition, real spending on computers and peripheral equipment,
which rose more than 40 percent per year in the second half of the
1990s, showed little growth, on net, between the third quarter of
2000 and the first quarter of 2001. The leveling in real computer
spending reportedly reflects some stretching out of businesses'
replacement cycles for personal computers as well as a reduced
demand for servers. Outside the high-tech area, spending rose in the
first quarter as purchases of motor vehicles reversed some of the
decline recorded over the second half of 2000 and as outlays for
industrial equipment picked up after having been flat in the fourth
quarter.   
 
Real E&S spending likely dropped further in the second quarter. In
addition to the ongoing contraction in outlays on high-tech
equipment, the incoming data for orders and shipments point to a
decline in investment in non-high-tech equipment, largely reflecting
the weakness in the manufacturing sector this year.  
 
Outlays on nonresidential construction posted another sizable
advance in early 2001 after having expanded nearly 13 percent in
real terms in 2000, but the incoming monthly construction data
imply a sharp retrenchment in the second quarter. The downturn in
spending comes on the heels of an increase in vacancy rates for
office and industrial space in many cities. Moreover, while financing
generally remains available for projects with viable tenants, lenders
are now showing greater caution. Not surprisingly, one bright spot
is the energy sector, where expenditures for drilling and mining
have been on a steep uptrend since early 1999 (mainly because of
increased exploration for natural gas) and the construction of
facilities for electric power generation remains very strong.   
 
 
Inventory Investment  
 
A sharp reduction in the pace of inventory investment was a major
damping influence on real GDP growth in the first quarter of 2001.
The swing in real nonfarm inventory investment from an
accumulation of $51 billion at an annual rate in the fourth quarter of
2000 to a liquidation of $25 billion in the first quarter of 2001
subtracted 3 percentage points from the growth in real GDP in the
first quarter. Nearly half of the negative contribution to GDP
growth came from the motor vehicle sector, where a sizable cut in
assemblies (added to the reduction already in place in the fourth
quarter) brought the overall days' supply down to comfortable
levels by the end of the first quarter. A rise in truck assemblies early
in the second quarter led to some backup of inventories in that
segment of the market, but truck stocks were back in an acceptable
range by June; automobile assemblies were up only a little in the
second quarter, and stocks remained lean.  
 
Firms outside the motor vehicles industry also moved aggressively
to address inventory imbalances in the first half of the year, and this
showed through to manufacturing output, which, excluding motor
vehicles, fell at an annual rate of 7-1/2 percent over this period.
These production adjustments--along with a sharp reduction in the
flow of imports--contributed to a small decline in real non-auto
stocks in the first quarter, and book-value data for the
manufacturing and trade sector point to a further decrease, on net,
in April and May. As of May, stocks generally seemed in line with
sales at retail trade establishments, but there were still some notable
overhangs in wholesale trade and especially in manufacturing,
where inventory-shipments ratios for producers of computers and
electronic products, primary and fabricated metals, and chemicals
remained very high.   
 
 
Business Finance  
 
The economic profits of U.S. corporations fell at a 19 percent
annual rate in the first quarter after a similar decline in the fourth
quarter of 2000. As a result, the ratio of profits to GDP declined 1
percentage point over the two quarters, to 8.5 percent; the ratio of
the profits of nonfinancial corporations to sector output fell 2
percentage points over the interval, to 10 percent. Investment
spending has declined by more than profits, however, reducing
somewhat the still-elevated need of nonfinancial corporations for
external funds to finance capital expenditures. Corporations have
husbanded their increasingly scarce internal funds by cutting back
on cash-financed mergers and equity repurchases. While equity
retirements have therefore fallen, so has gross equity issuance,
though by less. Inflows of venture equity capital, in particular, have
been reduced substantially. Businesses have met their financing
needs by borrowing heavily in the bond market while paying down
both commercial and industrial (C&I) loans at banks and
commercial paper. In total, after having increased 9-1/2 percent last
year, the debt of nonfinancial businesses rose at a 5 percent annual
rate in the first quarter of this year and is estimated to have risen at
about the same pace in the second quarter.   
 
The decline in C&I loans and commercial paper owes, in part, to
less hospitable conditions in shorter-term funding markets. The
commercial paper market was rattled in mid-January by the defaults
of two large California utilities. Commercial paper is issued only by
highly rated corporations, and default is extremely rare. The
defaults, along with some downgrades, led investors in commercial
paper to pull back and reevaluate the riskiness of issuers. For a
while, issuance by all but top-rated names became very difficult and
quality spreads widened significantly, pushing some issuers into the
shortest maturities and inducing others to exit the market entirely.
As a consequence, the amount of commercial paper outstanding
plummeted. In the second quarter, risk spreads returned to more
typical levels and the runoff moderated. By the end of June, the
amount of nonfinancial commercial paper outstanding was nearly
30 percent below its level at the end of 2000, with many firms still
not having returned to the market.   
 
Even though banks' C&I loans were boosted in January and
February by borrowers substituting away from the commercial
paper market, loans declined, on net, over the first half of the year,
in part because borrowers paid down their bank loans with
proceeds from bond issues. Many banks reported on the Federal
Reserve's Bank Lending Practices surveys this year that they had
tightened standards and terms--including the premiums charged on
riskier loans, the cost of credit lines, and loan covenants--on C&I
loans. Loan officers cited a worsened economic outlook,
industry-specific problems, and a reduced tolerance for risk as the
reasons for having tightened. Despite these adjustments to banks'
lending stance, credit appears to remain amply available for sound
borrowers, and recent surveys of small businesses indicate that they
have not found credit significantly more difficult to obtain.   
 
Meanwhile, the issuance of corporate bonds this year has proceeded
at about double the pace of the preceding two years. With the
yields on high-grade bonds back down to their levels in the first half
of 1999 and with futures quotes suggesting interest rates will be
rising next year, corporations apparently judged it to be a relatively
opportune time to issue. Although investors remain somewhat
selective, they have been willing to absorb the large volume of
issuance as they have become more confident that the economy
would recover and a prolonged disruption to earnings would be
avoided. The heavy pace of issuance has been supported, in part, by
inflows into bond mutual funds, which may have come at the
expense of equity funds.   
 
The flows are forthcoming at relatively high risk spreads, however.
Spreads of most grades of corporate debt relative to rates on swaps
have fallen a little this year, but spreads remain unusually high for
lower investment-grade and speculative-grade credits. The elevated
spreads reflect the deterioration in business credit quality that has
occurred as the economy has slowed. While declines in interest
rates have held aggregate interest expense at a relatively low
percentage of cash flow, many individual firms are feeling the pinch
of decreases in earnings. Over the twelve months ending in May, 11
percent of speculative-grade bonds, by dollar volume, have
defaulted--the highest percentage since 1991 and a substantial jump
from 1998, when less than 2 percent defaulted. This deterioration
reflects not only the unusually large defaults by the California
utilities, but also stress in the telecommunications sector and
elsewhere. However, some other measures of credit performance
have shown a more moderate worsening. The ratio of the liabilities
of failed businesses to those of all nonfinancial businesses and the
delinquency rate on C&I loans at banks have risen noticeably from
their lows in 1998, but both remain well below levels posted in the
early 1990s.   
 
Commercial mortgage debt increased at about an 8-3/4 percent
annual rate in the first half of this year, and the issuance of
commercial-mortgage-backed securities (CMBS) maintained its
robust pace of the past several years. While spreads of the yields on
investment- and speculative-grade CMBS over swap rates have
changed little this year, significant fractions of banks reported on
the Bank Lending Practices survey that they have tightened terms
and standards on commercial real estate loans. Although the
delinquency rates on CMBS and commercial real estate loans at
banks edged up in the first quarter, they remained near record lows.
Nevertheless, those commercial banks that reported taking a more
cautious approach toward commercial real estate lending stated that
they are doing so, in part, because of a less favorable economic
outlook in general and a worsening of the outlook for commercial
real estate.   
 
 
The  Government Sector  
 
The fiscal 2001 surplus in the federal unified budget is likely to be
smaller than the surplus in fiscal 2000 because of the slower growth
in the economy and the recently enacted tax legislation.
Nonetheless, the unified surplus will remain large, and the paydown
of the federal debt is continuing at a rapid clip. As a consequence,
the Treasury has taken a number of steps to preserve liquidity in a
shrinking market. The weaker economy is also reducing revenues at
the state and local level, but these governments remain in
reasonably good fiscal shape overall and are taking advantage of
historically low interest rates to refund existing debt and to issue
new debt.   
 
 
Federal Government   
 
The fiscal 2001 surplus in the federal government's unified budget is
likely to come in below the fiscal 2000 surplus of $236 billion. Over
the first eight months of the fiscal year--October to May--the
unified budget recorded a surplus of $137 billion, $16 billion higher
than during the comparable period last year. But over the balance of
the fiscal year, receipts will continue to be restrained by this year's
slow pace of economic growth and the associated decline in
corporate profits. Receipts will also be reduced significantly over
the next few months by the payout of tax rebates and the shift of
some corporate payments into fiscal 2002, provisions included in
the Economic Growth and Tax Relief Reconciliation Act of 2001.   
 
Federal saving, which is basically the unified budget surplus
adjusted to conform to the accounting practices followed in the
national income and product accounts (NIPA), has risen
dramatically since hitting a low of -3-1/2 percent of GDP in 1992
and stood at 3-3/4 percent of GDP in the first quarter--a swing of
more than 7 percentage points. Reflecting the high level of federal
saving, national saving, which comprises saving by households,
businesses, and governments, has been running at a higher rate
since the late 1990s than it did over most of the preceding decade,
even as the personal saving rate has plummeted. The deeper pool of
national saving, along with large inflows of foreign capital, has
provided resources for the technology-driven boom in domestic
investment in recent years.   
 
Federal receipts in the first eight months of the current fiscal year
were just 4-1/2 percent higher than during the first eight months of
fiscal 2000--a much smaller gain than those posted, on average,
over the preceding several years. Much of the slowing was in
corporate receipts, which dropped below year-earlier levels,
reflecting the recent deterioration in profits. In addition, individual
income tax payments rose less rapidly than over the preceding few
years, mainly because of slower growth in withheld tax payments.
This spring's nonwithheld payments of individual taxes, which are
largely payments on the previous year's liability, were relatively
strong. Indeed, although there was no appreciable "April surprise"
this year--that is, these payments were about in line with
expectations--liabilities again appear to have risen faster than the
NIPA tax base in 2000. One factor that has lifted liabilities relative
to income in recent years is that rising levels of income and a
changing distribution have shifted more taxpayers into higher tax
brackets. Higher capital gains realizations also have helped raise
liabilities relative to the NIPA tax base over this period. (Capital
gains are not included in the NIPA income measure, which, by
design, includes only income from current production.)   
 
The faster growth in outlays that emerged in fiscal 2000 has
extended into fiscal 2001. Smoothing through some timing
anomalies at the start of the fiscal year, nominal spending during the
first eight months of fiscal 2001 was more than 4 percent higher
than during the same period last year; excluding the sizable drop in
net interest outlays that has accompanied the paydown of the
federal debt, the increase in spending so far this year was nearly 6
percent. Spending in the past couple of years has been boosted by
sizable increases in discretionary appropriations as well as by faster
growth in outlays for the major health programs. The especially
rapid increase in Medicaid outlays reflects the higher cost and
utilization of medical care (including prescription drugs), growing
enrollments, and a rise in the share of expenses picked up by the
federal government. Outlays for Medicare have been lifted, in part,
by the higher reimbursements to providers that were enacted last
year.   
 
Real federal expenditures for consumption and gross investment,
the part of government spending that is included in GDP, rose at a
5 percent annual rate in the first quarter. Over the past couple of
years, real nondefense purchases have remained on the moderate
uptrend that has been evident since the mid-1990s, while real
defense purchases have started to rise slowly after having bottomed
out in the late 1990s.   
 
The Treasury has used the substantial federal budget surpluses to
pay down its debt further. At the end of June, the outstanding
Treasury debt held by the public had fallen nearly $600 billion, or
15 percent, from its peak in 1997. Relative to nominal GDP,
publicly held debt has dropped from nearly 50 percent in the
mid-1990s to below 33 percent in the first quarter, the lowest it has
been since 1984.   
 
Declines in outstanding federal debt and the associated reductions
in the sizes and frequency of auctions of new issues have diminished
the liquidity of the Treasury market over the past few years.
Bid-asked spreads are somewhat wider, quote sizes are smaller, and
the difference between yields on seasoned versus most-recently
issued securities has increased. In part, however, these
developments may also reflect a more cautious attitude among
securities dealers following the market turmoil in the fall of 1998.   
 
The Treasury has taken a number of steps to limit the deterioration
in the liquidity of its securities. In recent years, it has concentrated
its issuance into fewer securities, so that the auction sizes of the
remaining securities are larger. Last year, in order to enable
issuance of a larger volume of new securities, the Treasury began
buying back less-liquid older securities, and it also made every
second auction of its 5- and 10-year notes and 30-year bond a
reopening of the previously issued security. In February, the
Treasury put limits on the noncompetitive bids that foreign central
banks and governmental monetary entities may make, so as to leave
a larger and more predictable pool of securities available for
competitive bidding, helping to maintain the liquidity and efficiency
of the market. In May, the Treasury announced that it would begin
issuing Treasury bills with a four-week maturity to provide it with
greater flexibility and cost efficiency in managing its cash balances,
which, in part because new securities are now issued less
frequently, have become more volatile. Finally, also in May, the
Treasury announced it would in the next few months seek public
comment on a plan to ease the "35 percent rule," which limits the
bidding at auctions by those holding claims on large amounts of an
issue. With reopenings increasingly being used to maintain liquidity
in individual issues, this rule was constraining many potential
bidders. As discussed below, the reduced issuance of Treasury
securities has also led the Federal Reserve to modify its procedures
for acquiring such securities and to study possible future steps for
its portfolio.   
 
In early 2000, as investors focused on the possibility that Treasury
securities were going to become increasingly scarce, they became
willing to pay a premium for longer-dated securities, pushing down
their yields. However, these premiums appear to have largely
unwound later in the year as market participants made adjustments
to the new environment. These adjustments include the substitution
of alternative instruments for hedging and pricing, such as interest
rate swaps, prominent high-grade corporate bonds, and securities
issued by government-sponsored enterprises (GSEs). To benefit
from adjustments by market participants, in 1998, Fannie Mae and
Freddie Mac initiated programs to issue securities that share some
characteristics with Treasury securities, such as regular issuance
calendars and large issue sizes; in the first half of this year they
issued $88 billion of coupon securities and $502 billion of bills
under these programs. The GSEs have also this year begun buying
back older securities to boost the size of their new issues.
Nevertheless, the market for Treasury securities remains
considerably more liquid than markets for GSE and other
fixed-income securities.   
 
 
State and Local Governments  
 
State and local governments saw an enormous improvement in their
budget positions between the mid-1990s and last year as revenues
soared and spending generally was held in check; accordingly, these
governments were able both to lower taxes and to make substantial
allocations to reserve funds. More recently, however, revenue
growth has slowed in many states, and reports of fiscal strains have
increased. Nonetheless, the sector remains in relatively good fiscal
shape overall, and most governments facing revenue shortfalls have
managed to adopt balanced budgets for fiscal 2002 with only minor
adjustments to taxes and spending.   
 
Real consumption and investment spending by state and local
governments rose at nearly a 5 percent annual rate in the first
quarter and apparently posted a sizable increase in the second
quarter as well. Much of the strength this year has been in
construction spending, which has rebounded sharply after a
reported decline in 2000 that was hard to reconcile with the sector's
ongoing infrastructure needs and the good financial condition of
most governments. Hiring also remained fairly brisk during the first
half of the year; on average, employment rose 30,000 per month,
about the same as the average monthly increase over the preceding
three years.   
 
Although interest rates on municipal debt have edged up this year,
they remain low by historical standards. State and local
governments have taken advantage of the low interest rates to
refund existing debt and to raise new capital. Credit quality has
remained quite high in the municipal sector even as tax receipts
have softened, with credit upgrades outpacing downgrades in the
first half of this year. Most notable among the downgrades was that
of California's general obligation bonds. Standard and Poor's
lowered California's debt two notches from AA to A+, citing the
financial pressures from the electricity crisis and the likely adverse
effects of the crisis on the state's economy.   
 
 
The External Sector  
 
The deficits in U.S. external balances narrowed sharply in the first
quarter of this year, largely because of a smaller deficit in trade in
goods and services. Most of the financial flows into the United
States continued to come from private foreign sources.   
 
 
Trade and Current Account     
 
After widening continuously during the past four years, the deficits
in U.S. external balances narrowed in the first quarter of 2001. The
current account deficit in the first quarter was $438 billion at an
annual rate, or 4.3 percent of GDP, compared with $465 billion in
the fourth quarter of 2000. Most of the reduction of the current
account deficit can be traced to changes in U.S. trade in goods and
services; the trade deficit narrowed from an annual rate of $401
billion in the fourth quarter of 2000 to $380 billion in the first
quarter of this year. The trade deficit in April continued at about the
same pace. Net investment income payments were a bit less in the
first quarter than the average for last year primarily because of a
sizable decrease in earnings by U.S. affiliates of foreign firms.   
 
As U.S. economic growth slowed in the second half of last year and
early this year, real imports of goods and services, which had grown
very rapidly in the first three quarters of 2000, expanded more
slowly in the fourth quarter and then contracted 5 percent at an
annual rate in the first quarter. The largest declines were in
high-tech products (computers, semiconductors, and
telecommunications equipment) and automotive products. In
contrast, imports of petroleum and petroleum products increased
moderately. A temporary surge in the price of imported natural gas
pushed the increase of the average price of non-oil imports above
an annual rate of 1 percent in the first quarter, slightly higher than
the rate of increase recorded in 2000.   
 
U.S. real exports were hit by slower growth abroad, the strength of
the dollar, and plunging global demand for high-tech products. Real
exports of goods and services, which had grown strongly in the first
three quarters of 2000, fell 6-1/2 percent at an annual rate in the
fourth quarter of last year and declined another 1 percent in the first
quarter of this year. The largest declines in both quarters were in
high-tech capital goods and automotive products (primarily in
intra-firm trade with Canada). By market destination, the largest
increases in U.S. goods exports during the first three quarters of
2000 had been to Mexico and countries in Asia; the recent declines
were mainly in exports to Asia and Latin America. In contrast,
goods exports to Western Europe increased steadily throughout the
entire period. About 45 percent of U.S. goods exports in the first
quarter of 2001 were capital equipment; 20 percent were industrial
supplies; and 5 to 10 percent each were agricultural, automotive,
consumer, and other goods.   
 
After increasing through much of 2000, the spot price of West
Texas intermediate (WTI) crude oil reached a peak above $37 per
barrel in September, the highest level since the Gulf War. As world
economic growth slowed in the latter part of 2000, oil price
declines reversed much of the year's price gain. In response, OPEC
reduced its official production targets in January of this year and
again in March. As a result, oil prices have remained relatively high
in 2001 despite weaker global economic growth and a substantial
increase in U.S. oil inventories. Oil prices have also been elevated
by the volatility of Iraqi oil exports arising from tense relations
between Iraq and the United Nations. During the first six months of
this year, the spot price of WTI has fluctuated, with only brief
exceptions, between $27 and $30 per barrel.   
 
 
Financial Account     
 
In the first quarter of 2001, as was the case in 2000 as a whole,
nearly all of the net financial flows into the United States came from
private foreign sources. Foreign official inflows were less than $5
billion and were composed primarily of the reinvestment of
accumulated interest earnings. Reported foreign exchange
intervention purchases of dollars were modest.   
 
Inflows arising from private foreign purchases of U.S. securities
accelerated further in the first quarter and are on a pace to exceed
last year's record. All of the pickup is attributable to larger net
foreign purchases of U.S. bonds, as foreign purchases of both
corporate and agency bonds accelerated and private foreign sales of
Treasuries paused. Foreign purchases of U.S. equities are only
slightly below their 2000 pace despite the apparent decline in
expected returns to holding U.S. equities.   
 
The pace at which U.S. residents acquired foreign securities
changed little between the second half of last year and the first
quarter of this year. As in previous years, most of the foreign
securities acquired were equities.   
 
Net financial inflows associated with direct investment slowed a
good bit in the first quarter, as there were significantly fewer large
foreign takeovers of U.S. firms and U.S. direct investment abroad
remained robust.   
 
 
The Labor Market  
 
Labor demand weakened in the first half of 2001, especially in
manufacturing, and the unemployment rate rose. Increases in hourly
compensation have continued to trend up in recent quarters, while
measured labor productivity has been depressed by the slower
growth of output.   
 
 
Employment and Unemployment   
 
After having risen an average of 149,000 per month in 2000,
private payroll employment increased an average of only 63,000 per
month in the first quarter of 2001, and it declined an average of
117,000 per month in the second quarter. The unemployment rate
moved up over the first half of the year and in June stood at 4-1/2
percent, 1/2 percentage point higher than in the fourth quarter of
last year.   
 
Much of the weakness in employment in the first half of the year
was in the manufacturing sector, where job losses averaged 78,000
per month in the first quarter and 116,000 per month in the second
quarter. Since last July, manufacturing employment has fallen nearly
800,000. Factory job losses were widespread in the first half of the
year, with some of the biggest cutbacks at industries struggling with
sizable inventory overhangs, including metals and industrial and
electronic equipment. The weakness in manufacturing also cut into
employment at help-supply firms and at wholesale trade
establishments.   
 
Apart from manufacturing and the closely related help-supply and
wholesale trade industries, employment growth held up fairly well
in the first quarter but began to slip noticeably in the second
quarter. Some of the slowing in the second quarter reflected a drop
in construction employment after a strong first quarter that likely
absorbed a portion of the hiring that normally takes place in the
spring; on average, construction employment rose a fairly brisk
15,000 per month over the first half, about the same as in 2000.
Hiring in the services industry (other than help-supply firms) also
slowed markedly in the second quarter. Employment in retail trade
remained on a moderate uptrend over the first half of the year, and
employment in finance, insurance, and real estate increased
modestly after having been unchanged, on net, last year.   
 
 
Labor Costs and Productivity  
 
Through the first quarter, compensation growth remained quite
strong--indeed, trending higher by some measures. These gains
likely reflected the influence of earlier tight labor markets, higher
consumer price inflation--largely due to soaring energy prices--and
the greater real wage gains made possible by faster structural
productivity growth. The upward pressures on labor costs could
abate in coming quarters if pressures in labor markets ease and
energy prices fall back.   
 
Hourly compensation, as measured by the employment cost index
(ECI) for private nonfarm businesses, moved up in the first quarter
to a level about 4-1/4 percent above its level of a year earlier; this
compares with increases of about 4-1/2 percent over the preceding
year and 3 percent over the year before that. The slight deceleration
in the most recent twelve-month change in the ECI is accounted for
by a slowdown in the growth of compensation for sales workers
relative to the elevated rates that had prevailed in early 2000; these
workers' pay includes a substantial commission component and thus
is especially sensitive to cyclical developments. Compensation per
hour in the nonfarm business sector--a measure that picks up some
forms of compensation that the ECI omits but that sometimes has
been revised substantially once the data go through the annual
revision process--shows a steady uptrend over the past couple of
years; it rose 6 percent over the year ending in the first quarter after
having risen 4-1/2 percent over the preceding year.   
 
According to the ECI, wages and salaries rose at an annual rate of
about 4-1/2 percent in the first quarter. Excluding sales workers,
wages rose 5 percent (annual rate) in the first quarter and 4-1/4
percent over the year ending in March; this compares with an
increase of 3-3/4 percent over the year ending in March 2000.
Separate data on average hourly earnings of production or
nonsupervisory workers also show a discernable acceleration of
wages: The twelve-month change in this series was 4-1/4 percent in
June, 1/2 percentage point above the reading for the preceding
twelve months.   
 
Benefit costs as measured in the ECI have risen faster than wages
over the past year, with the increase over the twelve months ending
in March totaling 5 percent. Much of the pressure on benefits is
coming from health insurance, where employer payments have
accelerated steadily since bottoming out in the mid-1990s and are
now going up about 8 percent per year. The surge in spending on
prescription drugs accounts for some of the rise in health insurance
costs, but demand for other types of medical care is increasing
rapidly as well. Moreover, although there has been some revamping
of drug coverage to counter the pressures of soaring demand, many
employers have been reluctant to adjust other features of the health
benefits package in view of the need to retain workers in a labor
market that has been very tight in recent years.   
 
Measured labor productivity in the nonfarm business sector has
been bounced around in recent quarters by erratic swings in hours
worked by self-employed individuals, but on balance, it has barely
risen since the third quarter of last year after having increased about
3 percent per year, on average, over the preceding three years. This
deceleration coincides with a marked slowing in output growth and
seems broadly in line with the experience of past business cycles;
these readings remain consistent with a noticeable acceleration in
structural productivity having occurred in the second half of the
1990s. Reflecting the movements in hourly compensation and in
actual productivity, unit labor costs in the nonfarm business sector
jumped in the first quarter and have risen 3-1/2 percent over the
past year.   
 
Looking ahead, prospects for favorable productivity performance
will hinge on a continuation of the rapid technological advances of
recent years and on the willingness of businesses to expand and
update their capital stocks to take advantage of the new
efficiency-enhancing capital that is becoming available at declining
cost in many cases. To be sure, the current weakness in business
investment will likely damp the growth of the capital stock relative
to the pace of the past couple of years. But once the cyclical
weakness in the economy dissipates, continued advances in
technology should provide impetus to renewed capital spending and
a return to solid increases in productivity.   
 
 
Prices  
 
Inflation moved higher in early 2001 but has moderated some in
recent months. After having risen 2-1/4 percent in 2000, the chain
price index for personal consumption expenditures (PCE) increased
about 3-1/4 percent in the first quarter of 2001 as energy prices
soared and as core consumer prices--which exclude food and
energy--picked up. Energy prices continued to rise rapidly in April
and May but eased in June and early July. In addition, core PCE
price inflation has dropped back after the first-quarter spurt, and the
twelve-month change in this series, which is a useful indicator of
the underlying inflation trend, stood at 1-1/2 percent in May, about
the same as the change over the preceding twelve months. The core
consumer price index (CPI) continued to move up at a faster pace
than the core PCE measure over the past year, rising 2-1/2 percent
over the twelve months ending in May, also the same rate as over
the preceding year.   
 
PCE energy prices rose at an annual rate of about 11 percent in the
first quarter and, given the big increases in April and May,
apparently posted another sizable advance in the second quarter.
Unlike the surges in energy prices in 1999 and 2000, the increases
in the first half of 2001 were not driven by developments in crude
oil markets. Indeed, natural gas prices were the major factor
boosting overall energy prices early this year as tight inventories
and concerns about potential stock-outs pushed spot prices to
extremely high levels; natural gas prices have since receded as
additional supplies have come on line and inventories have been
rebuilt. In the spring, gasoline prices soared in response to strong
demand, refinery disruptions, and concerns about lean inventories;
with refineries back on line, imports up, and inventories restored,
gasoline prices have since fallen noticeably below their mid-May
peaks. Electricity prices also rose substantially in the first half of the
year, reflecting higher natural gas prices as well as the problems in
California. Capacity problems in California and the hydropower
shortages in the Northwest persist, though California's electricity
consumption has declined recently and wholesale prices have
dropped. In contrast, capacity in the rest of the country has
expanded appreciably over the past year and, on the whole, appears
adequate to meet the normal seasonal rise in demand.   
 
Core PCE prices rose at a 2-1/2 percent annual rate in the first
quarter--a hefty increase by the standards of recent years. But the
data are volatile, and the first-quarter increase, no doubt,
exaggerates any pickup. Based on monthly data for April and May,
core PCE inflation appears to have slowed considerably in the
second quarter; the slowing was concentrated in the goods
categories and seems consistent with reports that retailers have
been cutting prices to spur sales in an environment of soft demand.   
 
Core consumer price inflation--whether measured by the PCE index
or by the CPI--in recent quarters almost certainly has been boosted
by the effects of higher energy prices on the costs of producing
other goods and services. Additional pressure has come from the
step-up in labor costs. That said, firms appear to have absorbed
much of these cost increases in lower profit margins. Meanwhile,
non-oil import prices have remained subdued, thus continuing to
restrain input costs for many domestic industries and to limit the
ability of firms facing foreign competition to raise prices for fear of
losing market share. In addition, apart from energy, price pressures
at earlier stages of processing have been minimal. Indeed, excluding
food and energy, the producer price index (PPI) for intermediate
materials has been flat over the past year, and the PPI for crude
materials has fallen 11 percent. Moreover, inflation expectations, on
balance, seem to have remained quiescent: According to the
Michigan survey, the median expectation for inflation over the
upcoming year generally has been running about 3 percent this year,
similar to the readings in 2000.   
 
In contrast to the step-up in consumer prices, prices for private
investment goods in the NIPA were up only a little in the first
quarter after having risen about 2 percent last year. In large part,
this pattern was driven by movements in the price index for
computers, which fell at an annual rate of nearly 30 percent in the
first quarter as demand for high-tech equipment plunged. This drop
in computer prices was considerably greater than the average
decrease of roughly 20 percent per year in the second half of the
1990s and the unusually small 11 percent decrease in 2000.
Monthly PPI data suggest that computer prices were down again in
the second quarter, though much less than in the first quarter.   
 
All told, the GDP chain-type price index rose at an annual rate of
3-1/4 percent in the first quarter and has risen 2-1/4 percent over
the past four quarters, an acceleration of 1/2 percentage point from
the comparable year-earlier period. The price index for gross
domestic purchases--which is defined as the prices paid for
consumption, investment, and government purchases--also
accelerated in the first quarter--to an increase of about 2-3/4
percent; the increase in this measure over the past year was 2-1/4
percent, about the same as over the preceding year. Excluding food
and energy, the latest four-quarter changes in both GDP and gross
domestic purchases prices were roughly the same as over the
preceding year.   
 
 
U.S. Financial Markets  
 
Longer-term interest rates and equity prices have shown remarkably
small net changes this year, given the considerable shifts in
economic prospects and major changes in monetary policy. To
some extent, the expectations of the economic and policy
developments in 2001 had already become embedded in financial
asset prices as last year came to a close; from the end of August
through year-end, the broadest equity price indexes fell 15 percent
and investment-grade bond yields declined 40 to 70 basis points. In
addition, however, equity prices and long-term interest rates were
influenced importantly by growing optimism in financial markets
over the second quarter of 2001 that the economy and profits
would rebound strongly toward the end of 2001 and in 2002. On
net, equity prices fell 6 percent in the first half of this year as
near-term corporate earnings were revised down substantially.
Rates on longer-term Treasury issues rose a little, but those on
corporate bonds were about unchanged, with the narrowing spread
reflecting greater investor confidence in the outlook. But risk
spreads remained wide by historical standards for businesses whose
debt was rated as marginally investment grade or below; many of
these firms had been especially hard hit by the slowdown and the
near-term oversupply of high-tech equipment and services, and
defaults by these firms became more frequent. Nevertheless, for
most borrowers the environment for long-term financing was seen
to be quite favorable, and firms and households tended to tap
long-term sources of credit in size to bolster their financial
conditions and lock in more favorable costs.  
 
 
Interest Rates   
 
In response to the abrupt deceleration in economic growth and
prospects for continued weakness in the economy, the FOMC
lowered the target federal funds rate 2-3/4 percentage points in six
steps in the first half of this year, an unusually steep decline relative
to many past easing cycles. Through March, the policy easings
combined with declining equity prices and accumulating evidence
that the slowdown in economic growth was more pronounced than
had been initially thought led to declines in yields on intermediate-
and longer-term Treasury securities. Over the second quarter,
despite the continued decrease in short-term rates and further
indications of a weakening economy, yields on intermediate-term
Treasury securities were about unchanged, while those on
longer-term securities rose appreciably. On net, yields on
intermediate-term Treasury securities fell about 3/4 percentage
point in the first half of this year, while those on longer-term
Treasury securities rose about 1/4 percentage point.   
 
The increase in longer-term Treasury yields in the second quarter
appears to have been the result of a number of factors. The main
influence seems to have been increased investor confidence that the
economy would soon pick up. That confidence likely arose in part
from the aggressive easing of monetary policy and also in part from
the improving prospects for, and passage of, a sizable tax cut. The
tax cut and the growing support for certain spending initiatives
implied stronger aggregate demand and less federal saving than
previously anticipated. The prospect that the federal debt might be
paid down less rapidly may also have reduced slightly the scarcity
premiums investors were willing to pay for Treasury securities.
Finally, a portion of the rise may have been the result of increased
inflation expectations. Inflation compensation as measured by the
difference between nominal Treasury rates and the rates on
inflation-indexed Treasury securities rose about 1/4 percentage
point in the second quarter. Despite this increase, there is little
evidence that inflation is expected to go up from its current level.
At the end of last year, inflation compensation had declined to
levels suggesting investors expected inflation to fall, and the rise in
inflation compensation in the second quarter largely reversed those
declines. Moreover, survey measures of longer-term inflation
expectations have changed little since the middle of last year.   
 
Yields on longer-maturity corporate bonds were about unchanged,
on net, over the first half of this year. Yields on investment-grade
bonds are near their lows for the past ten years, but those on
speculative-grade bonds are elevated. Spreads of corporate bond
yields relative to swap rates narrowed a bit, although they still
remain high. Amidst signs of deteriorating credit quality and a
worsening outlook for corporate earnings, risk spreads on
speculative-grade bonds had risen by about 2 percentage points late
last year, reaching levels not seen since 1991. Much of this
widening was reversed early in the year, as investors became more
confident that corporate balance sheets would not deteriorate
substantially, but speculative-grade bond spreads widened again
recently in response to negative news about second-quarter
earnings and declines in share prices, leaving these spreads at the
end of the second quarter only slightly below where they began the
year. Nonetheless, investors, while somewhat selective, appear to
remain receptive to new issues with speculative-grade ratings.  
 
Interest rates on commercial paper and C&I loans have fallen this
year by about as much as the federal funds rate, although some risk
spreads widened. The average yield spread on second-tier
commercial paper over top-tier paper widened to about 100 basis
points in late January, about four times its typical level, following
defaults by a few prominent issuers. As the year progressed,
investors became less concerned about the remaining commercial
paper borrowers, and this spread has returned to a more normal
level. According to preliminary data from the Federal Reserve's
quarterly Survey of Terms of Business Lending, the spread over the
target federal funds rate of the average interest rate on commercial
bank C&I loans edged up between November and May and remains
in the elevated range it shifted to in late 1998. Judging from the
widening since 1998 of the average spread between rates on riskier
and less-risky loans, banks have become especially cautious about
lending to marginal credits.   
 
 
Equity Markets  
 
After rising in January in response to the initial easing of monetary
policy, stock prices declined in February and March in reaction to
profit warnings and weak economic data, with the Wilshire 5000,
the broadest major stock price index, ending the first quarter down
13 percent. Stock prices retraced some of those losses in the
second quarter, rising 7 percent, as first-quarter earnings releases
came in a little above sharply reduced expectations and as investors
became more confident that economic growth and corporate profits
would soon pick up. On net, the Wilshire 5000 ended the half down
6 percent, the DJIA declined 3 percent, and the tech-heavy Nasdaq
fell 13 percent. Earnings per share of the S&P 500 in the first
quarter decreased 10 percent from a year earlier. A
disproportionate share of the decline in S&P earnings--more than
half--was attributable to a plunge in the technology sector, where
first-quarter earnings were down nearly 50 percent from their peak
in the third quarter of last year.   
 
The decline in stock prices has left the Wilshire 5000 down by
about 20 percent, and the Nasdaq down by about 60 percent, from
their peaks in March 2000. Both of these indexes are near their
levels at the end of 1998, having erased the sharp run-up in prices
in 1999 and early 2000. But both indexes remain more than two
and one-half times their levels at the end of 1994, when the bull
market shifted into a higher gear. The ratio of expected
one-year-ahead earnings to equity prices began to fall in 1995
when, as productivity growth picked up, investors began to build in
expectations that increases in earnings would remain rapid for some
time. This measure of the earnings-price ratio remains near the
levels reached in 1999, suggesting that investors still anticipate
robust long-term earnings growth, likely reflecting expectations for
continued strong gains in productivity.   
 
Despite the substantial variation in share prices over the first half of
this year, trading has been orderly, and financial institutions appear
to have encountered no difficulties that could pose broader systemic
concerns. Market volatility and a less ebullient outlook have led
investors to buy a much smaller share of stock on margin. At the
end of May, margin debt was 1.15 percent of total market
capitalization, equal to its level at the beginning of 1999 and well
below its high of 1.63 percent in March of last year.   
 
 
Federal Reserve Open Market Operations  
 
As noted earlier, the Federal Reserve has responded to the
diminished size of the auctions of Treasury securities by modifying
its procedures for acquiring such securities. To help maintain supply
in private hands adequate for liquid markets, since July of last year
the System has limited its holdings of individual securities to
specified percentages, ranging from 15 percent to 35 percent, of
outstanding amounts. To stay within these limits, the System has at
times not rolled over all of its holdings of maturing securities,
generally investing the difference by purchasing other Treasury
securities on the open market. The Federal Reserve also has
increased its holdings of longer-term repurchase agreements (RPs),
including RPs backed by agency securities and mortgage-backed
securities, as a substitute for outright purchases of Treasury
securities. In the first half of the year, longer-term RPs, typically
with maturities of twenty-eight days, averaged $13 billion.   
 
As reported in the previous Monetary Policy Report, the FOMC
also initiated a study to evaluate assets to hold on its balance sheet
as alternatives to Treasury securities. That study identified several
options for further consideration. In the near term, the Federal
Reserve is considering purchasing and holding Ginnie Mae
mortgage-backed securities, which are explicitly backed by the full
faith and credit of the U.S. government, and engaging in repurchase
operations against foreign sovereign debt. For possible
implementation later, the Federal Reserve is studying whether to
auction longer-term discount window credit, and it will over time
take a closer look at a broader array of assets for repurchase and
for holding outright, transactions that would require additional legal
authority.   
 
 
Debt and the Monetary Aggregates  
 
The growth of domestic nonfinancial debt in the first half of 2001 is
estimated to have remained moderate, slowing slightly from the
pace in 2000 as a reduction in the rate of increase in nonfederal
debt more than offset the effects of smaller net repayments of
federal debt. In contrast, the monetary aggregates have grown
rapidly so far this year, in large part because the sharp decline in
short-term market interest rates has reduced the opportunity cost of
holding the deposits and other assets included in the aggregates.   
 
 
Debt and Depository Intermediation  
 
The debt of the domestic nonfinancial sectors is estimated to have
expanded at a 4-3/4 percent annual rate over the first half of 2001,
a touch below the 5-1/4 percent growth recorded in 2000. Changes
in the growth of nonfederal and federal debt this year have mostly
offset each other. The growth of nonfederal debt moderated from
8-1/2 percent in 2000 to a still-robust 7-1/4 percent pace in the first
half of this year. Households' borrowing slowed some but was still
substantial, buoyed by continued sizable home and durable goods
purchases. Similarly, business borrowing moderated even as bond
issuance surged, as a good portion of the funds raised was used to
pay down commercial paper and bank loans. Tending to boost debt
growth was a slowing in the decline in federal debt to a 6-1/4
percent rate in the first half of this year from 6-3/4 percent last year,
largely because of a decline in tax receipts on corporate profits.   
 
The share of credit to nonfinancial sectors held at banks and other
depository institutions edged down in the first half of the year.
Bank credit, which accounts for about three-fourths of depository
credit, increased at a 3-1/2 percent annual rate in the first half of the
this year, well off the 9-1/2 percent growth registered in 2000.
Banks' loans to businesses and households decelerated even more,
in part because borrowers preferred to lock in the lower rates
available from longer-term sources of funds such as bond and
mortgage markets and perhaps also in part because banks firmed up
their lending stance in reaction to concerns about loan performance.
Loan delinquency and charge-off rates have trended up in recent
quarters, and higher loan-loss provisions have weighed on profits.
Nevertheless, through the first quarter, bank profits remained in the
high range recorded for the past several years, and virtually all
banks--98 percent by assets--were well capitalized. With banks'
financial condition still quite sound, they remain well positioned to
meet future increases in the demand for credit.   
 
 
The Monetary Aggregates  
 
The monetary aggregates have expanded rapidly so far this year,
although growth rates have moderated somewhat recently. M2 rose
10-1/4 percent at an annual rate in the first half of this year after
having grown 6-1/4 percent in 2000. The interest rates on many of
the components of M2 do not adjust quickly or fully to changes in
market interest rates. As a consequence, the steep declines in
short-term market rates this year have left investments in M2 assets
relatively more attractive, contributing importantly to the
acceleration in the aggregate. M2 has also probably been buoyed by
the volatility in the stock market this year, and perhaps by lower
expected returns on equity investments, leading investors to seek
the safety and liquidity of M2 assets.   
 
M3, the broadest monetary aggregate, rose at a 13-1/4 percent
annual rate through June, following 9-1/4 percent growth in 2000.
All of the increase in M3, apart from that accounted for by M2,
resulted from a ballooning of institutional money market funds,
which expanded by nearly a third. Yields on these funds lag market
yields somewhat, and so the returns to the funds, like those on
many M2 assets, became relatively attractive as interest rates on
short-term market instruments declined.   
 
 
International Developments  
 
So far this year, average foreign growth has weakened further and
is well below its pace of a year ago. Activity abroad was restrained
by the continued high level of oil prices, the global slump of the
high-technology sector, and spillover effects from the U.S.
economic slowdown, but in some countries domestic demand
softened as well in reaction to local factors. High oil prices kept
headline inflation rates somewhat elevated, but even though core
rates of inflation have edged up in countries where economic slack
has diminished, inflationary pressures appear to be well under
control.   
 
Monetary authorities in most cases reacted to signs of slowdown by
lowering official rates, but by less than in the United States. Partly
in response to these actions, yield curves have steepened noticeably
so far in 2001. Although long-term interest rates moved down
during the first quarter, they more than reversed those declines in
most cases as markets reacted to a combination of the anticipation
of stronger real growth and the risk of increased inflationary
pressure. Foreign equity markets--especially for high-tech
stocks--were buffeted early this year by many of the same factors
that affected U.S. share prices: negative earnings reports, weaker
economic activity, buildups of inventories of high-tech goods, and
uncertainties regarding the timing and extent of policy responses. In
recent months, the major foreign equity indexes moved up along
with U.S. stock prices, but they have edged off lately and in most
cases are down, on balance, for the year so far.   
 
Slower U.S. growth, monetary easing by the Federal Reserve,
fluctuations in U.S. stock prices, and the large U.S. external deficit
have not undermined dollar strength. After the December 2000
FOMC meeting, the dollar lost ground against the major currencies;
but shortly after the FOMC's surprise rate cut on January 3, the
dollar reversed all of that decline as market participants evidently
reassessed the prospects for recovery in the United States versus
that in our major trading partners. The dollar as measured by a
trade-weighted index against the currencies of major industrial
countries gained in value steadily in the first three months of 2001,
reaching a fifteen-year high in late March. Continued flows of
foreign funds into U.S. assets appeared to be contributing
importantly to the dollar's increase. Market reaction to indications
that the U.S. economy might be headed toward a more prolonged
slowdown undercut the dollar's strength somewhat in early April,
and the dollar eased further after the unexpected April 18 rate cut
by the FOMC. However, the dollar has more than made up that loss
in recent months as signs of weakness abroad have emerged more
clearly. On balance, the dollar is up about 7 percent against the
major currencies so far this year; against a broader index that
includes currencies of other important trading partners, the dollar
has appreciated 5 percent.   
 
The dollar has gained about 9 percent against the yen, on balance,
as the Japanese economy has remained troubled by structural
problems, stagnant growth, and continuing deflation. Industrial
production has been falling, and real GDP declined slightly in the
first quarter, with both private consumption and investment
contracting. Japanese exports also have sagged because of slower
demand from many key trading partners. Early in the year, under
increasing pressure to respond to signs that their economy was
weakening further, the Bank of Japan (BOJ) slightly reduced the
uncollateralized overnight call rate, its key policy interest rate. By
March, the low level of equity prices, which had been declining
since early 2000, was provoking renewed concerns about the
solvency of Japanese banks. In mid-March, the BOJ announced that
it was shifting from aiming at a particular overnight rate to
targeting balances that private financial institutions hold at the
Bank, effectively returning the overnight rate to zero; the BOJ also
announced that it would continue this easy monetary stance until
inflation moves up to zero or above. After the yen had moved near
the end of March to its weakest level relative to the dollar in more
than four years, Japanese financial markets were buoyed by the
surprise election in May of Junichiro Koizumi to party leadership
and thereby to prime minister. The yen firmed slightly for several
weeks thereafter, but continued weak economic fundamentals and
increased market focus on the daunting challenges facing the new
government helped push the yen back down and beyond its
previous low level.   
 
At the start of 2001, economic activity in the euro area had slowed
noticeably from the more rapid rates seen early last year but still
was fairly robust. Average GDP growth of near 2 percent was only
slightly below estimated rates of potential growth, although some
key countries (notably Germany) were showing signs of faltering
further. Although high prices for oil and food had raised headline
inflation, the rate of change of core prices was below the 2 percent
ceiling for overall inflation set by the European Central Bank
(ECB). The euro also was showing some signs of strength, having
moved well off the low it had reached in October. However,
negative spillovers from the global slowdown started to become
more evident in weaker export performance in the first quarter, and
leading indicators such as business confidence slumped.
Nevertheless, the ECB held policy steady through April, as further
weakening of the euro against the dollar (following a trend seen
since the FOMC's rate cut in early January), growth of M3 in
excess of the ECB's reference rate, and signs of an edging up of
euro-area core inflation were seen as militating against an easing of
policy.   
 
In early May, the ECB surprised markets with a 25 basis point
reduction of its minimum bid rate and parallel reductions of its
marginal lending and deposit rates. In explaining the step, the ECB
noted that monetary developments no longer posed a threat to price
stability and projected that moderation of GDP growth would damp
upward price pressure. The euro has continued to fall since then
and, on balance, has declined 9 percent against the dollar since the
beginning of the year. Faced with a similar slowdown in the U.K.
economy that was exacerbated by the outbreak of foot-and-mouth
disease, the Bank of England also cut its official call rate three
times (by a total of 75 basis points) during the first half of the year.
The Labor Party's victory in parliamentary elections in early June
seemed to raise market expectations of an early U.K. euro
referendum and put additional downward pressure on sterling, but
that was partly offset by signs of stronger inflationary pressure. On
balance, the pound has lost about 6 percent against the dollar this
year, while it has strengthened against the euro.   
 
The exchange value of the Canadian dollar has swung over a wide
range in 2001. In the first quarter, the Canadian dollar fell about 5
percent against the U.S. dollar as the Canadian economy showed
signs of continuing a deceleration of growth that had started in late
2000. Exports--especially autos, auto equipment, and electronic
equipment--suffered from weaker U.S. demand. Softer global prices
for non-oil commodities also appeared to put downward pressure
on the Canadian currency. With inflation well within its target
range, the Bank of Canada cut its policy rate several times by a
total of 125 basis points. So far this year, industries outside of
manufacturing and primary resources appear to have been much
less affected by external shocks, and domestic demand has
maintained a fairly healthy pace. Since the end of March, the
Canadian dollar has regained much of the ground it had lost earlier
and is down about 2 percent on balance since the beginning of the
year.   
 
Global financial markets were rattled in February by serious
problems in the Turkish banking sector. Turkish interest rates
soared and, after market pressures led authorities to allow the
Turkish lira to float, it experienced a sharp depreciation of more
than 30 percent. An IMF program announced in mid-May that will
bring $8 billion in support this year and require a number of
banking and other reforms helped steady the situation temporarily,
but market sentiment started to deteriorate again in early July.  
 
In Argentina, the weak economy and the government's large and
growing debt burden stoked market fears that the government
would default on its debt and alter its one-for-one peg of the peso
to the dollar. In April, spreads on Argentina's internationally traded
bonds moved up sharply, and interest rates spiked. In June, the
government completed a nearly $30 billion debt exchange with its
major domestic and international creditors aimed at alleviating the
government's cash flow squeeze, improving its debt amortization
profile, and giving it time to enact fiscal reforms and revive the
economy. Argentine financial conditions improved somewhat
following agreement on the debt swap. However, this improvement
proved temporary, and an apparent intensification of market
concerns about the possibility of a debt default triggered a sharp fall
in Argentine financial asset prices at mid-July. This financial
turbulence in Argentina negatively affected financial markets in
several other emerging market economies. The turmoil in Argentina
took a particular toll on Brazil, where an energy crisis added to
other problems that have kept growth very slow since late last year.
Intervention purchases of the real by the Brazilian central bank and
a 300 basis point increase in its main policy interest rate helped take
some pressure off the currency, but the real has declined about 24
percent so far this year.   
 
The weak performance of the Mexican economy at the end of last
year caused largely by a fall in exports to the United States (notably
including a sharp drop in exports of automotive products) and tight
monetary policy carried over into early 2001. With inflation
declining, the Bank of Mexico loosened monetary policy in May for
the first time in three years. Problems with Mexican growth did not
spill over to financial markets, however. The peso has remained
strong and is up about 3 percent so far this year, and stock prices
have risen.   
 
Average growth in emerging Asia slowed significantly in the first
half; GDP grew more slowly or even declined in economies that
were more exposed to the effects of the global drop in demand for
high-tech products. Average growth of industrial production in
Malaysia, Singapore, and Hong Kong, for example, fell from a 15
percent annual rate in late 2000 to close to zero in mid-2001. The
turnaround of the high-tech component of industrial production in
those countries was even more abrupt--from more than a 30
percent rate of increase to a slight decline by midyear. In the
Philippines and Indonesia, economic difficulties were compounded
by serious political tensions. Currencies in many of these countries
moved down versus the dollar, and stock prices declined. In Korea,
the sharp slump in activity that began late last year continued into
2001, as weakness in the external sector spread to domestic
consumption and investment. The Bank of Korea lowered its target
interest rate a total of 50 basis points over the first half of the year
in response to the weakening in activity. The Chinese economy,
which is less dependent on technology exports than many other
countries in the region, continued to expand at a brisk pace in the
first half of this year, as somewhat softer export demand was offset
by increased government spending.